ACCA P4 Advanced Financial Management Key Point Notes June 2010

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ACCA
P4
Advanced Financial Management

Key Point
Notes
June 2010
These notes are not intended to cover the whole syllabus, but target key examinable areas.

Tutor Contact Details

Tutor: Mobile: 07833 096979
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Copyright to Intelligent Accountancy Tutors Ltd

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Use of these Key Point Notes

These notes have been written as an aid to assist students
preparing for the ACCA P4 June 2010. They accrue for the
topics tested in the past exams.

It is of paramount importance that they are used with an up

to date Revision Kit (KAPLAN or BPP). A combination of
using the notes and question practice is the best way to
prepare for the forthcoming exams.

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Index

Chapter Number Chapter Name Page Numbers

Preliminaries 5-16

Chapter One Cost of Capital 17-26

Chapter Two Capital Structure & 27-35

Raising Finance
Chapter Three Dividend policy 37-39

Chapter Four How lenders set their 41-46

Interest Rates
Chapter Five Advanced Investment 47-57
Appraisal
Chapter Six Adjusted Present Value 59-64

Chapter Seven Modified Internal Rate of 65-70

Return (MIRR)
Chapter Eight Capital Rationing 71-74

Chapter Nine Foreign Currency Risk 75-84

Chapter Ten Interest Rate Risk 85-96

Chapter Eleven Valuaton of 97-112

Options+Value at Risk

Chapter Twelve Business Valuations & 115-134

Mergers &
Acquisitions
Chapter Thirteen Modern Valuation 135-139
Methods
Chapter Fourteen Corporate Reconstruction 141-145
& Reorganisation

Chapter Fifteen Question 4 & Emerging 147-148

Issues

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Exam Formulae and Tables

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Exam Technique
First 15 minutes
 Read the questions carefully

 Recognise the topic being tested

 I would recommend that Section B questions are done

first and then Section A

Next 180 minutes

 Attempt the questions in your ranked order.

 Stay within your time allocation both on each part of

the question and on the question itself.

 If the written elements are unrelated to the

computations-try front load as they represent ‘easier’
marks.

 Try to attempt all parts to all the questions.

 If in doubt about how to compute a value-make a

reasonable estimate and move on.

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General
Numerical Questions
 State formula

 Show method

 Explain as you go

 Make assumptions if in doubt

Written Questions
 Check format – report / essay/ listed points

 Headings / subheadings / columnar

 Simple short paragraphs-essays and reports

 Use ‘numbered’ points for most questions-simple

sentence approach.

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Tips
These will be posted on my website sometime in late May
2010.

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'What the Current Examiner

(Bob Ryan) Has Said
Recently'

Key facts

 The Examiner sees this as a “Masters Level” paper. He

expects students to demonstrate expertise, and real
world knowledge / awareness. For example, when
questioned about the Futures question (Q5 D08) he
said that students should be familiar with Open and
Settlement quotes since this is how prices are quoted in
the real world (e.g. on the NYBOT website).

 There’s no point question spotting. It is more important

to have worked through past exam questions.

Main problems in the last 3 papers

 Weak knowledge of basic F9 topics

 Weak integration with other Professional Level papers.

The Examiner expects the students to have a good
knowledge of (for example) P1 and P2 topics.

 Lack of contextual understanding. He has suggested

the students should read widely around the subject e.g.
the Financial Times, his own text book “Corporate
Finance and Valuation”.

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 The “essay question” (Q4) and written areas in general

were badly done.

 Students missing easy marks. Bob Ryan explained that

there are lots of easy marks, but then his “mark ramp”
is quite steep, so only good candidates pick up the
higher level marks. He says this helps to differentiate
between candidates.

Positives

 Good standards of English

 Good attention to presentation

 Good understanding of options and their role

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Chapter One

Cost of Capital
1 Weighted Average Cost of Capital (WACC)

1.1 This is the formula given on your formula sheet.

1.2 Remember that:-

 Ke= Cost Of Equity

 Kd(1-t) = Cost of Debt

 Kd= Yield to maturity on debt

 Ve=Market value of the Equity Capital.

 Vd= Market Value of the Debt Capital

 t= Corporation tax rate

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1.3 The examiner often re-presents the above formula as:-

WACC= Were + Wdrd(1-t)

 We= Ve or (1-Wd)
Ve+Vd
 Wd= Vd or (1-We)
Ve+Vd
 re=Ke=Cost Of Equity

 rd(1-t)=Kd(1-t)=Cost of Debt

Therefore, it’s the same Formula!!

2 Cost of Equity (Ke, re)

2.1 Formulae are given in the exam as:-

This can be simply presented as:-

Ke or re =Rf +βe(Rm-Rf)

This you have to rearrange to:-

re=Do(1+g) +g
Po

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This latter formula applies under M&M assumptions with tax.

2.2 Lets clear up the additional symbols to those listed under

1.2 above:-

Rf=Risk Free Return

Rm= Return on the Market Portfolio
βe=Systematic Risk being faced by the
shareholders.
Do=The dividend per share (DPS) today or last paid.
g = Constant annual growth rate in dividends.
Po =Share price currently
Kei= Cost of equity assuming all equity position.
(Rm-Rf)= Equity Risk Premium.

2.3 A common issue is finding the g value. There are several

ways that this can be found.

a) Past growth rate is assumed to be future growth rate.

Example

Today is 31st December 2008

31st December DPS

2005 $0.24
2006 $0.27
2007 $0.29
2008 $0.32

g= n√ (Do) -1
Dn
n=Increments of growth
Dn=Oldest DPS given

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g= 3√(0.32) -1
0.24
g= 0.10

b) Gordon’s Growth Model

b=the proportion of profits retained by the business

re= can be the accounting rate of return(ARR) or cost of

equity

Example

If a company has an ARR of 12% and pays out 30% of

profits as a dividend.re =14%

g= 0.12 x 0.70=0.084

This is a short term growth measure.

g= 0.14 x 0.70=0.098

This is a long term measure

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3 Cost of Debt (Kd(1-t) or rd(1-t))

3.1 Kd or rd is the yield or minimum return for the debt

holder.

Kd(1-t) or rd(1-t) is the cost of debt for the company.

3.2 To find the cost of debt we need to look at the type of

debt finance.

3.3 Bank Loans

Kd(1-t)=Interest % x (1-t)

Example

A company has a 11% Bank Loan .Tax =30%

Kd(1-t)=11x(1-0.30)=7.7%

3.4 Traded Bonds-Perpetual

Kd(1-t)=Ints x (1-t)
Po

Remember Po is the market value per block of $100.

Example

9% Bonds trading at $89 t=30%

Kd(1-t)=$9 x(1-030) = 7.1%

$89

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3.5 Traded Bonds-Redeemable

Kd(1-t) is an IRR computation based upon

Time $
To Po (X) Take two guesses
T1-Tn Ints X(1-t) X like 10% and 1%
Tn Capital X and do an IRR
Repayment

Example

7.5% Bond redeemable at par ($100)in 5 years time.

Trading at $105. t=30%

Time $ 10% PV 1% PV
To Po (105) 1.0 (105) 1.0 (105)
T1-Tn Ints 7.50 X(1- 3.791 19.90 4.853 25.48
X(1-t) 0.30)
T5 CR 100 0.621 62.10 0.951 95.10
(23) 15.58

Kd(1-t)=1 +
15.58 X (10-1)=4.63%
(15.58+23)
3.6 Quick assumption that the examiner might indicate is
that

Kd(1-t)=RF X (1-t)

OR

Kd(1-t)=Yield X (1-t)

OR

Kd(1-t)=(Yield or Rf + Credit Risk Premium) x 1-t

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3.7 As can be seen above the market value of debt (Po) is

given per block of $100.This may have to be computed using
the Dividend Valuation Model (DVM).

i.e Po=Present Value of all future cash flows discounted at

the yield to maturity.

Example:

$20 m 7% Bond will be redeemed in 3 years at par ($100).

Yield to maturity is 5.25%.

NB: Don’t forget that discount factor tables also show

formulae at the top of each table.

On the PV Table the formula is

(1+r)-n = 1
(1+r)n

Hence the Po=

$7 + $7 + $107
(1+0.0525) (1+0.0525) (1+0.0525)3
1 2

=$6.65+$6.32+£91.77

= $104.74

The Vd is

$20m X $104.74= $20.948m

$100

i.e Book value of Debt X Po

$100

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4 Degearing/Regearing βeta

4.1 βe must reflect the combination of the systematic

business and financial risk being faced by a shareholder.

4.2 We can remove the financial risk element via

βa = Asset Beta, measure of systematic business risk

βd= Debt Beta (Often nil)

Example

βe is 1.95 Vd:Ve 1:4

t= 30% βd=NIL

βa = 4 X 1.95
4+1(1-0.30)

= 4 X 1.95
4.7

= 1.66

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Now, if the gearing went Vd: Ve 1:2

1.66 = 2 X βe
2+1(1-0.30)

1.66 = 2 X βe
2.7

1.66 X 2.7 = 2.24

2

4.3 βasset values may have to be combined before gearing

up to find βe

Example

ABC is made up of two divisions.

Division Asset βeta Proportion of the

Business
Food 0.75 40%
Clothes 1.80 60%

The company has Wd=0.32 and t=30%.Rf=5% and the

equity risk premium is 9%

Hence,

Combined Asset βeta = (0.75 x40%) + (1.80 X 60%)

= 1.38

β a= Ve X βe
Ve+Vd(1-t)

(Note: Wd =Debt Proportion of the company’s finance)

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1.38= 0.68 X βe
0.68+0.32 (1-0.30)

1.38= 0.68 X βe
0.904

1.38 X 0.904 =1.83

0.68

Take Ke for the company via CAPM

Ke=Rf+(Rm-Rf) βe

(Note (Rm-Rf) is equity risk premium)

Ke =5+ (9)1.83

= 21.47%

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Chapter Two

Capital Structure And

Raising Finance
1 Introduction

How should the company decide the mix of

equity and debt capital?

2 Practical Issues

If the company uses Debt capital funding it should

consider:-

 Credit Rating of the company

 Rate of interest it will pay
 Market conditions- access to debt capital
 Forecast Cash Flows-to service and repay the debt.
 Level of Tangible Assets on which secure the loans.
 Interest will lead to tax savings i.e Tax Shield
 Constraints on the level of debt from
a) Articles Of Association
b) Loan Agreements.

 Effect upon the company gearing ratio(Wd)

Vd:Ve

 Will the debt providers exercise influence over the

company?
 The chance of bankruptcy.
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3 Theories of Optimal Capital Structure

3.1 Common Ground-both major views accept two facts:-

a) Yield<Ke
b) Gearing causes Ke to rise –Financial Risk

3.2 Traditional View (NB Ko=WACC)

Key Points:-

1) Ke rises due to financial risk caused by gearing.

2) Kd is initially uneffected by gearing but rises at “high”
gearing levels due to the perception of the possibility of
bankruptcy.
3) Ko-trade off of Ke and Kd. Point X is the optimum
gearing level where WACC is lowest.
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4) Once point X is reached via trial and error it must be

maintained.

3.3 MM and Tax

Ve+Vd

Key points:-

1) Assumptions behind the model:-

 All debt is risk free
 Only corporation tax exists
 Debt is issued to replace Equity
 All types of debt carry one yield, the risk free
rate
 Full distribution of profits
 Perfect Capital Market

2) MM concluded that due to the benefit of the tax

shield, companies should maximise the use of debt
finance.

3) Specific Equations can be used under MM +Tax

theory.

Vg=Vu+VDT
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WACC= Keu {1-T x Vd}

(Ve+Vd)

Only the latter is given on the formulae sheet.

Example

ABC is all equity financed. Its Ve is $500m.It has a

Ke=12%.

If it raises $150m of Debt Finance and tax is 30%.Yield

is 5%.

Vg=Vu+VDT

Vg=$500m+ ($150m X 30%)

= $545m

Split Vd=$150m
Ve=$395m

WACC = 12(1-{0.30 X 150})

545
= 11.01%

Ke = 12+ (1-0.30) (12-5) 150

395
= 12+1.86

= 13.86%

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4 Practical Approached /Views

4.1 Static Trade off Theory

MM +TAX view can be reviewed in the light of the practical

issue that too much gearing leads a company towards
bankruptcy.

A revised equation is:-

Vg=Vu+VDt - (Probability of Financial Distress X Costs of Finance

Distress)

Hence an optimum point exists for gearing where Vg is

maximised.

4.2 Pecking Order Theory

 Funds are raised in a practical order-ease of accessing

funds.

 Order :- 1) Internal Generated Fund

2) Debt
3) New Issue of Equity

5 Recent Exam Questions on Raising Debt Finance.

“ ….. raise new capital through a bond issue of $2400

million….. would be in the form of 10 year, fixed interest
bonds with half being in the Yen and half in the Euro
market”

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Key Point Answer:-

 Bond issue attractive way of raising $2400 million.

 Issue costs will be incurred
 May not be fully subscribed
 May need to be underwritten –mitigate some of the
risk.
 Alternative could be via a syndicated loan
 Syndicated entails:-
 Led by arranging bank.
 Bring banks together who will provide the loan.

 Syndication advantages are:-

 Loan sizes are larger than one bank can take on its
own.
 Banks may be based in different countries –mixed
lending package.
 Low transaction costs.

 Disadvantages

 Forex Risk of foreign loans.

 Risk of a Bank default
 Rates may be greater than that on Bond market

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Solution:-

a) Key Point answer

 Coupon Rate=5.1% +0.90%=6%

 0.90% is credit risk premium is key. If too low,
debt will not be taken. If too high, issued at an
attractive premium but costly for the company.
 Underwriting agreement would be sensible but
costly.

b) Current Vd

 WD=0.25

W D = Vd
Ve+Vd

 Ve=$1.2billion

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 0.25= Vd
1.2+Vd

 0.25(1.2+Vd)=Vd

 0.30+0.25 Vd=Vd

 0.30=0.75 Vd

 Vd=0.30 =$0.4billion
0.75

Revised Vd

 The existing debt of $0.4 billion ($400 million) carries a

coupon and assumed yield of 4%.This is 50bp’s above
RF%.

 However, the new credit rating is 90bp’s above the

RF%.Hence yield now be 3.5+0.90=4.4%

Therefore, value of the existing debt (via DVM) will now

be:-

$4 + $4 + $104
1.044 1.0442 1.0443

=$3.83+$3.67+$91.40=$98.90
Therefore, existing debt’s new Vd=

$400million x $98.90 =$395.60

$100

The new debt will be issued at its market value.

Therefore, Vd=$395.60+$400=$795.60million.

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Current Cost of Debt

 rd(1-t) =4% X (1-0.30)

= 2.8%

 New rd(1-t)would be based on a weighted average

approach.

{( 400 X 6) +( 395.60 X 4.4)} x (1-0.30)

795.60 795.60

=3.64%

Hence increase of 84 bp’s.

c) Advantages and Disadvantages of this mode of financing

Pros Cons

 Tax Shield benefit Cost

 Lower Co’s WACC Damage to credit rating of

the company

 Secure on the tangible WACC could rise

asset(plane) therefore lowering Ve

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Chapter Three

Dividend Policy

1 Introduction

To maximise S/H wealth the Board should establish a

dividend policy-the payment pattern to the equity investors.

2 Theories

Several theories have been put forward to assist:-

2.1 Residual – If spare cash exists at the end of the year pay
dividend.

2.2 Pattern – Be consistent with dividend payments. Either

a) Pay the same dividend per share (DPS) each year.

b) Maintain the payout ratio (DPS/EPS)
c) Maintain the same year-on-year growth rate in
dividends.The latter links into the Po via the
dividend valuation model (DVM)

2.3 Irrelevancy (M&M)

In a perfect capital market providing the directors can

invest in projects with a positive NPV no dividends
are required. The Ve will rise and the S/H can sell shares
to create the cash the need(Manufacture Dividends).

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3 Practical Considerations

There are many to consider:

 Availability of cash
 What dividends do S/H want (clientele effect)?
 Signalling effect –payment of dividends indicates a
healthy company
 Retaining cash is a key source of finance.
 Dividend growth should be greater than inflation
 Tax impact upon S/H
 Effect the dividend will have on dividend
cover(EPS/DPS)
 Number of investment opportunities will restrict
dividend payments.
 Risk-paying now is safer than promising to pay next
year
 Is the dividend within the company law regulations?

4 Alternatives to Cash Dividends

4.1 Scrip Dividends

4.1.1 The S/H will receive extra shares instead of cash on a

pro rata basis.

4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.

4.1.3 The effect will:-

a) Increase the issued equity capital

b) Dilute EPS and Po values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue

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4.2 Share Buy Back

4.2.1 If the board has “one off” period of excess cash, they
could consider a share buy back.

i.e. Buy back shares at Po and cancel them.

4.2.2 Considerations:-

a) Allowable under company law.

b) Increase gearing as Ve may fall.
c) Tax implications for the S/H(CGT)
d) Reduced number of shares will cut supply for
trading purposes.
e) Less dividend pressure on the board in future.
f) Criticism-is this the best use of company cash.

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Chapter Four
How lenders set their
interest rates?
1 Credit Risk

1.1 This is the risk of default by the borrower. Occurs when

the secured asset value falls below the value of the loan

1.2 Loss to the lender depends upon:-

 Probability of default occurring.

 Part of the debt recovered from the sale of the assets.

1.3 Lenders action re credit risk

 Assess via credit assessment agencies (the chance the

company is unable to pay the interest or principal)
 Set credit risk premiums to the borrower.

2 Credit Risk Premium

2.1 Risk Neutral Lender –Example

A company has an asset worth $2m and secured debt of

$0.8m.The asset can vary in value by 10%monthly.

Therefore,
σa = σm x √ T
σa = 10% x √12months
= 34.64% annually

Therefore, Asset can vary in value by

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34.64% X $2m = $692,800 annually

Hence using the “Z” value concept (how many standard

deviations) from normal distribution table.

$1,200,000 = 1.732
$692,800

Therefore, $0.8m lies 1.732 standard deviations below the

$2m asset value.

Value of the
asset

$0.8m $2m
Lies 1.732 σ σ =$692,800
Away from $2m

Checking the normal distribution tables for 1.732

(or 1.73)=0.4582.

The ‘chance ‘of the asset not falling below $0.8m is

0.4582+0.50=0.9582

If the company defaults then the bank need to recover the

debt. This depends upon:-
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 Type of Asset
 Covenants on disposing the asset
If (say) only 75% of the debt can be recovered and LIBOR is
6%.What premium above LIBOR should the bank set?

Based on a 1 year period and a discount rate equal to

LIBOR, the bank needs a present value to equal $800,000 –
value of the loan today.

i.e

$800,000= (PV of the cash recd in 1year not defaulting) +

(PV of the cash recd in 1year if default occurs)

i= Interest rate the bank sets (inc the risk premium)

$800,000=

{$800,000 X (1+i) X 0.9582} + {75% X $800,000 X (1+i) X0.0418}

1+0.06 1+0.06

“Note: 0.0418=1-0.9582”

800,000=723,170(1+i) +23,660(1+i)

800,000=723,170+23,660+746,830 i

(800,000-723,170-23,660) = 0.0712
746,830

i.e 7.12% which is 112 basis points above LIBOR OF 6%.

2.2 Risk Adverse Lender

 If the bank were more risk adverse the discount rate

above can be adjusted to value greater than LIBOR.
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 In other words the “i” would increase accordingly.

 (Say) in the above example the bank set a discount
rate of 6.5% and not 6%.LIBOR is still 6%.

$800,000=

{$800,000(1+i) X 0.9582}+ {$800,000 X 75%X(1+i) X 0.0418}

1.065 1.065

800,000 = 719,775+23,549+743,324i
i = 0.0762
i.e = 7.62%

162 Basis points above LIBOR

3 Problems

 Finding asset values

 Assessing the recoverable amounts on default
 σ assessment

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Chapter Five

Advanced Investment
Appraisal
1 Net Present Value of Free Cash Flows (FCF)

1.1 Free Cash Flows(FCF)

 The cash is available after expenditure and

reinvestment into the business.

 Computed two ways:-

1) Incremental cash flow approach

Revenue – Costs – Tax -Capex + Scrap Value - Asset

Replacement Spending – Working Capital Injection + Tax
saved on Tax Allowable Depreciation.

2) Adjusting Accounting Profit

Net operating profit (before X

interest and tax)
Plus Depreciation X
Less Taxation (X)
Operating cash flow X
Less Investment:
Replacement non-current (X)
asset investment(RAI)

Incremental non-current (X)

asset investment(IAI)

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Incremental working capital (X)

investment(IWCI)
Free cash flow for the X used in NPV comps
company
Debt Interest (X)
Debt Repayments (X)
Debt Issues X
FCF to equity X used to value equity in
certain business valuation
models.

1.2 Proforma
Time
$’000 T0 T1 T2 T3 T4
Revenue(inc - X X X -
Inflation)
Costs(inc - (X) (X) (X) -
Inflation)
Operating Cash - X X X -
flows
Tax @ (1year - - (X) (X) (X)
delay)
Capex&Scrap (X) - - X
Value
Tax savings on - - X X X
TAD
Asset - (X) (X) (X) -
replacement
spending
Working Capital (X) (X) (X) X -
Free Cash Flows (X) X X X (X)
Cost of Capital% 1.0 X X X (X)
PV (X) X X X (X)
NPV $XXX

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1.3 Relevant Cash Flows

 Incremental –caused by the project

 Future –still to occur
 Exclude:-
1) Sunk Costs
2) Finance Charges
3) Dividends
4) Non-Cash flows
5) Non-incremental fixed overheads

1.4 Inflation

 Include in the cash flows

Money/Nominal CFn=Real CFn X (1+h)n

eg Real CF3=$600
= 7%pa

Money CF = $600 X (1+0.07)3

= $735

 Include in the cost of capital 3 possibles:-

Chapter 1 a) Company WACC is inflation inclusive

b) Risk adjusted WACC is inflation inclusive.
c) Use the Formula given.

(1+i) = (1+r) (1+h)

h = inflation
r = real cost of capital
i = money cost of capital

eg r = 10% h=5%
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(1+i) = (1+0.10) (1+0.05)

1+i = 1.155

i =0.155 or 15.5%

1.5 Taxation

 Using the December 08 paper as benchmark, the

examiner showed taxation as a “2 line approach”.

 Timings –could be no delay or 1 year delay

 Tax on operating cash flows.

eg Extract from the NPV:-

$’000 T1 T2 T3
Operating 200 300 -
Cash Flows
Tax 30%(say - (60) (90)
1year delay)

 Tax saved on Tax allowable depreciation /Capital

Allowances.

eg Capex will take place over the first year and be finished
by the end of the year. Cost $6.2m.TAD is 50%.First year
allowance followed by straight line allowances for a further
three years. Tax is 30 %( no time delay).

T1 Tax saving =50% X $6.2m X 30%=$930,000

T2-T4 Tax saving=50% X $6.2m X 30%=$310,000

3 years

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Another Example

T0=1/Jan/09

T0 CAPEX $1000K

T5 Scrap $200K

TAD is 25% reducing balance and tax is 30% with a one

year delay.

Extract from the NPV:-

Time

$’000 T0 T1 T2 T3 T4 T5 T6
Capex & (1000) - - - - 200 -
Scrap
T.A.D(w1) - - 75 56.25 42.19 31.64 34.92

(w1)

Timing and Tax Saving $’000

T2 1000 X 25% X 30% 75
T3 75 X (100%-25%) 56.25
T4 56.25 X 75% 42.19
T5 42.19 X 75% 31.64
T6 Balance figure 34.92
30%(1000-200)= 240

NB: Other assumptions are possible –so read the question

carefully.

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1.6 Working Capital

 Think as it is a project bank account.

 Invest, Adjust, Close!!!

eg

$’000 T0 T1 T2 T3
WC needed - 100 170 300
Relevant (100) (70) (130) 300
Cash Flows

These go into the NPV

1.7 Cash flows into Perpetuity.

Eg Project has following cash flows and a cost of capital of

10%.
Time

$’000 T0 T1 T2 T3 T4-Tperp
Cash (1000) 200 400 300 350pa
Flows
10% 1.0 0.909 .826 .751 1 X 0.751
0.10
*

* 1 =discount rate for perpetuity

0.10

If applied to a cash flow starting at T4 it discounts back to T3

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Therefore,

1 X 0.751 =7.51 is the effective discount rate.

0.10

Take the same example as above and now bring in constant

growth of 2% from T5 each year in perpetuity.

$’000 T0 T1 T2 T3 T4-Tperp
Cash (1000) 200 400 300 350
Flows
10% 1.0 0.909 0.826 0.751 9.388
*

* 1 X 0.751
r-g

1 X 0.751=9.388
(0.10-0.02)

i.e 1 computes the discount factor for a cash flow

(r-g) with a constant growth rate pa

2 IRR

2.1 The Internal Rate of Return is the cost of the capital that
gives an NPV of NIL

2.2 Example

NPV @10%=$300K
NPV @20%=($160K)

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IRR=

10+ { 300 } X (20-10)

(300-(-160)

= 16.52%

2.3 Decision rule with IRR is if

IRR>Cost of Capital –Accept

However IRR has many weaknesses which are overcome by

MIRR (see a later chapter)

3 Foreign Investment Appraisal

3.1 Predicting future spot rates via formulae provided:-

S1= F0= Future Spot Rate

S0= Spot Rate Today
hc = Inflation Rate abroad
hb= Inflation Rate home
ic = Interest Rate abroad
ib = Interest Rate Home

3.2 Double Taxation-the golden rule is you must pay the

higher of the two rates.

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3.3 Format-may need to change from earlier in this chapter

to accrue for double tax.

Example

Jon inc (USA company) has a project in the UK. Cash flows
have been computed already as:-

Time £’000
T0 1,000
T3 scrap 100
T1 operating flows 500
T2 operating flows 600
T3 operating flows 400

TAD in the UK is straight line and tax rates are

UK 20%
USA 30%
with a one year delay

S0=$1.50/£ and inflation is expected to be

USA=5%pa UK=3%pa

What are the free cash flows ready for discounting?

Solution

Notes:-

USA=Home, UK=Foreign
S0=$1.50/£ or £0.67/$
Spot Rates via PPP:-

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Time £/$
S0 0.67
S1 0.67 X 1.03 = 0.66
1.05
S2 0.66 X 1.03 = 0.65
1.05
S3 0.65 X 1.03 = 0.63
1.05
S4 0.63 X 1.03 = 0.62
1.05

£’000 T0 T1 T2 T3 T4
Operating - 500 600 400 -
Flows
TAD - (300) (300) (300) -
(1000-100)
3
Taxable - 200 300 100 -
“Profit”
Tax@20% - - (40) (60) (20)
Add back - 300 300 300 -
TAD(not
cash flow)
- 500 560 340 (20)
Capex&Scrap (1000) - - 100 -
£’000 (1000) 500 560 440 (20)
Spot Rates £0.67 £0.66 £0.65 £0.63 £0.62
$’000 (1493) 758 862 698 (32)
USA Tax(w1) - - (30) (46) (16)
FCF (1493) 758 832 652 (48)

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(w1) Example working

T1 Taxable Profit=£200
Additional Tax=10% X £200=£20
Converted @ T1 spot =£20/£0.66
=$30
Paid at T2!!!

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Chapter Six
Adjusted Present Value
1 When to use it

1.1 APV is a NPV method to be used when:-

 Project is core or non-core activity

 Specific debt Finance is being use on a project.
 Subsidised interest exists on the project debt finance.

1.2 APV is still the change in shareholder wealth arising from

the project.

2 Method

 Establish the βasset for the project.

 Using the βasset in CAPM find Keu(all equity Kei)
 Discount the relevant project cash flows using Keu to
find the base case NPV
 Establish the yield on the debt.
 Find PV of the issue costs (possibly post tax) using
yield as a discount rate.
 Find PV of the tax savings on the interest paid on the
loan finance raised using the yield as a discount rate.

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APV

$m

Base case NPV X

PV of issue costs (X)
PV of tax savings on interest X
X
APV

Recent Exam Question

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Following steps above:-

a) βa = Ve X βe
Ve+Vd(1-t)

= 7500 X 1.40
7500+2500(1-0.30)

= 1.14

b) Keu=RF+ (Rm-RF)βa

Keu=5.0+ (3.5)1.14

= 9%
Note:-

 RF=Gilt Yield =5.40-0.40=5

 (Rm-RF)=Equity Risk =Premium =3.5

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c) Base Case NPV

$m T0 T1 T2 T3 T4 T5 T6
Revenue - 680 900 900 750 320 -
Direct Costs - (408) (540) (540) (450) (192) -
Lost Cont’n - (150) (150) - - - -
Operating - 122 210 360 300 128 -
Cashfows
Tax at 30 % - - (37) (63) (108) (90) (38)

Capex&Scrap (800) - - - - 40 -
Tax Saved - - 120 48 29 17 14
on Capital
Allowances
(w)
FCF (800) 122 293 345 221 95 (24)
9% 1.0 .917 .842 .772 .708 .650 .596
PV (800) 112 247 266 156 62 (14)

Base Case NPV = $29m

Assumptions:-
 Indirect costs are not incremental
 Design costs are sunk therefore ignored.

(w)

Timing and Tax Saving $m

T2 800 x 50% x 30% 120
T3 400 x 40% x 30% 48
T4 48 x (100-40)% 29
T5 29 X 60% 17
T6 Balance figure 14
30%(800-40)= 228

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d) Yield on new debt=

5.40+1.80=7.2%

i.e LIBOR + 180BP’s

e) Issue costs payable to has to be 2% of loan +Issue costs

i.e $800 m X 2%=$16.33m

0.98

f) PV of tax savings on interest paid:-

Loan inc Issue Costs $816.33m

Ints Paid in T1-T5 @ 7.2% pa $58.77m pa
Tax saved @30%T2-T6 $17.63m pa
Discounted at 7.2%

$17.63m + $17.63m + $ 17.63m + $17.63m + $17.63m

1.0722 1.0723 1.0724 1.0725 1.0726

15.34+ 14.31+ 13.34+ 12.45+ 11.62

= $67.06m

$m
Base Case NPV 29
Issue Costs (16.33)
PV of Tax Savings 67.06
$79.73m

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3 Subsidised Loans

3.1 If any part of the loan Finance is at a subsidised

rate, then the APV must include an extra benefit.

3.2 PV of the post tax subsidy discounted at the yield.

i.e

Ints pa not paid less tax not saved all discounted at the
yield.

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Chapter Seven

Modified Internal Rate of

Return (MIRR)
1 NPV vs IRR vs MIRR

1.1 NPV represents the increase in Ve arising from the

project. However, it can be hard to explain the “layman”.

1.2 IRR is the cost of capital that causes the NPV to be nil.
It’s decision rule

IRR > Project Cost of Capital Accept

1.3 IRR has weaknesses:-

a) Cannot be used to compare mutually exclusive

projects.
b) Multiple IRR’s exist

when the cash flow pattern is not standard

ie Standard Pattern -,+,+,+,+
Non-Standard Pattern -, +, +, +,-

1.4 MIRR is a measure that gives an NPV of nil but will lead
to a project decision rule consistent with NPV.

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2 Computing MIRR

2.1 Simple Example

Time $’000
T0 (1000)
T1 400 Return phase
T2 600 of the project
T3 300
Cost of Capital=10%

2.2 Using The Formula

NPV had been computed at 10%.

Time $ 10% PV
T0 (1000) 1.0 (1000)
T1 400 0.909 363.6 *
T2 600 0.826 495.6
T3 300 0.751 225.3
84.5

* PV of Return Phase=$1084.50

Formula given

PVR=PV of Return Phase Cash Flows

PVI=PV of Investment Cash flows
re=Cost of Capital
n= Year of the final cash flow

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(1/3)
MIRR= {1084.50} (1+0.10)-1
1000
= 0.1301. i.e 13.01%

Alternative Method:

a) Terminal value of Return Phase cash flows.

Time $’000
T1 400 X 1.102= 484
T2 600 X 1.10 = 660
T3 300 X 1.0 = 300
1444

Therefore, we now have a revised set of cash flows

T0 (1000)
T3 1444

MIRR is the discount rate that causes an NPV of nil.

Therefore 1444 - 1000 =NIL

3
(1+MIRR)

1444 =1000
3
(1+MIRR)

MIRR = 3√(1444) -1
1000

0.1303 OR 13.03%

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2.3 More complex Example

Time $,000 10% PV

T0 (700) 1.0 (700) (972.7)
T1 (300) 0.909 (272.7)
T2 400 0.826 330.4
T3 600 0.751 450.6 985.9
T4 300 0.683 204.9
NPV 13.2

PVI=972.7
PVR =985.9

Therefore,

MIRR= {985.9}¼ (1.10)-1

972.7
= 10.37%

Both NPV rule and MIRR rule indicate project is worthwhile.

3 Problems with MIRR

3.1 Both NPV and MIRR assume cash flows from a project
are reinvested at re.This may not be the case.

3.2 MIRR may itself have to be “modified” to accrue of

variable reinvestment rates.

3.3 Defining the “Investment Phase”. Per Q1 Dec 08 two

definitions were possible giving slightly different
answers.

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Chapter Eight

Capital Rationing
1 The Problem

1.1 When there is a lack of sufficient cash to invest in all

projects with a positive NPV

1.2 Cash can be restricted due

a. “Hard” Reasons –external constraint eg Credit Crunch.

b. “Soft” Reasons –internal restrictions eg Capex Budget

2 Single Period-Divisible Projects

2.1 Compute the Profitability Index (PI) for each project.

PI= NPV
Cash outlay in critical period

2.2 Rank the projects based upon the PI

3 Multiperiod-Divisible Projects

3.1 Can only be solved by linear programming

3.2 The examiner has indicated the formulation may be

tested but not arriving at a solution.

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Example

A company has identified the following independent

investment projects, all of which are divisible and exhibit
constant returns to scale. No project can be done more than
once.

Project Cash 0 1 2 3
Flows at
time:
$000 $000 $000 $000
A -10 -20 +10 +20
B -10 -10 +30 +6
C -5 +2 +2 +2

There is only $20,000 of capital available at T0 and only

$5000 at T1, plus the cash inflows from the projects
undertaken at T0.In each time period thereafter, capital is
freely available. The appropriate discount rate is 10%.

Solution

 Using the Dividend Formulation Model. (Assuming A

Full Distribution Policy)

1) Symbols

Dn=Dividends paid at time n.

a,b,c,d = Proportions invested in each project.
Z= Objective.

2) Objective

Maximise the PV of dividends.

Z= D0+ D1 + D2 + D3
1.10 1.102 1.103

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3) Constraints

10a +10b+5c+D0=20,000
20a+10b+D1=5000+2c
D2=10a+30b+2c
D3=20a+6b+2c
Dn≥0
0≤ a, b, c, ≤1

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Chapter Nine

Foreign Currency Risk

1. Translation Exposure

1.1 Risk caused by change in the value of a Forex asset or

liability over the longterm.

1.2 Example: ABC plc has a US subsidiary worth $10m.

2007 - at $1.50 £6.67m

2008 - at $1.75 £5.71m

Loss to equity (£0.96m)

Funded by a $10m loan.

2007 - at $1.50 £6.67m

2008 - at $1.75 £5.71m

Gain to equity £0.96m

1.3 Not a cash risk, only due to financial reporting!!!!

2 Transaction Exposure

2.1 Change in the value of the spot rate over the short
term causing a cash gain or loss.

2.2 Must hedge!!

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3 SPOT Rates

3.1 Rate of exchange at a point in time.

(Bid) (Offer)
$1.5000 - $1.5555 / £

Reciprocal and
cross over!!!!! £0.6429 - £0.6667 / $
(Bid) (Offer)

3.2 Picking the correct rate-Quick Method

 If the SPOT Rates are FX/Home Currency

 We are RECEIVING FX then

 Use the right hand rate

4 Internal Hedges

4.1 Invoice in home currency

 All transactions in home currency

 Transfer risk to the other party

 Monopoly power-over our customers or suppliers

4.2 Foreign currency bank account

 Held in the main currencies ($, Euro)

 Pool all transactions in same FX

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4.3 Leading and Lagging

 Watcher / predictor of spot rate changes in short

term(say 3 months)

 Leading – accelerate exchange(early)

 Lagging – delay the exchange(late as possible)

 Used a lot by Importers who have to sell their home

currency

4.4 Netting

 Match all FX transactions in the same FX occurring on

the same day

5 External Hedges

5.1 Forward Market(Lock into a Fixed Rate)

“Fix the rate today that will apply on a set future date”

Technique: -

1. Net the future transactions in same FX and same

date. Ascertain if “buying” or “selling” the £.

2. Forward contract, X months, at Forward Rate

“may” have to computed as :-

SPOT + Discount (- Premium)

3. Exchange FX at the forward rate on the future

date.

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5.2 Money Market Hedge(Rate used is Today’s Spot Rate)

“The exchange will take place today at the known spot

rate”.

Technique

Home Abroad

Today’s Spot
Today £ Answer FX

X  1 + ints foreign
1+ints home

Future Date
£ Answer FX

FX

5.3 Futures(Lock into a rate that will approximately equal

Today’s Spot Rate)

The hedge is ‘effectively’ like a spread bet. If the

company will make a transaction loss by the spot rate
rising, then the hedge is to ‘effectively bet’ that this
event will occur on the Futures Market. Hence the loss
on the Spot Market is offset by the profit on the Futures
Market.

If a gain is made on the Spot Market then a loss will be

made on the Futures Market.

Hence it is trying to lock the rate at approx today’s

Spot Rate.
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Technique: -

1. Draw the timeline showing all rates. Best if rates

are presented as value of the currency of the
contracts.

2. Setup – Today

 Ascertain the downside(d/s) risk

 ‘Bet’ on the d/s risk via the futures market.
 No. of contracts =

Net FX Transaction

Futures Rate

Standard Contract Size (in currency of the

contract)

 Work out ticks / contract(normally

0.0001/currency)
 Deposit the returnable margin

3. Close out – future date

£
(a)Transaction – at spot XXX

(b) Futures Profit / Loss

(No of contracts x Tick value x Tick Movement) @ SPOT XXX
XXX

NB: Loss on transaction, gain on the future or gain

on transaction ,loss on the futures.

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5.4 Options (Bet possible Hedge)

“Right to buy (call) or sell (put) FX at a fixed rate over

a set period (American) or on a set date (European)”.

Technique: -

1. Timeline-As for futures

2. Set up today

 Ascertain if we need a put or a call option

 Pick a strike rate from: -

1. Cheapest premium or
2. Nearest to spot or
3. Best possible rate

 No. of contracts

Transaction  Number

Strike Rate

Standard Contract Size

 Summary

Number of contracts x size x rate.

 Compute the premium and convert at spot

3. Close out – Future date

 All situations cost = premium paid

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 No receipt or payment in FX – options lapse

 Compare spot with strike rate – choose the best

rate for the business

6. Pros & Cons

Pros Cons
Forward Market
 Fixed Rate, certainty  Inflexible/contract
 Easy  Lose out on the upside
 Cheap  Must ensure FX receipts
 Tailored arrive
MMH
 Convert today  Complicated
 Cheap  May not apply for FX
 Tailored receipt
 Flexible
Futures
 Effectively fix rate  Complicated
 No cost  Small loss
 Small gain  Need cash for margin
 No tailoring
Options
 Best hedge – cover  Complicated
d/s risk only  No tailoring
 Flexibility  Expensive
 Lots of choice

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7. SWAPS

7.1 In forex swap, the parties agree to swap equivalent

amounts of currency for a period and then re-swap them
at the end of the period at an agreed swap rate.

 The swap rate and amount of currency is agreed

between the parties in advance. Thus it is called a
‘fixed rate/fixed rate’ swap.

The main objectives of a forex swap are:

 To hedge against forex risk, possibly for a longer period

than is possible on the forward market.

 Access to capital markets, in which it may be impossible

to borrow directly.

 Forex swaps are especially useful when dealing with

countries that have exchange controls and /or volatile
exchange rates.

7.2 Example- Say the bridge will require an initial

investment of 100m pesos and is will be sold for 200m
pesos in one year’s time.

The currency spot rate is 20 pesos/£, and the

government has offered a forex swap at 20 pesos/£. A
plc cannot borrow pesos directly and there is no forward
market available.

The estimated spot rate in one year is 40 pesos/£.The

current UK borrowing rate is 10%.

Determine whether A plc should do nothing or hedge its

exposure using the forex swap.

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Solution

£m 0 1
Without swap
Buy 100m pesos @20 (5.0)
Sell 200m pesos @40 5.0
Interest on sterling loan (5 (0.5)
x 10%)
(5.0) 4.5

£m 0 1
With forex swap
Buy 100m pesos @20 (5.0)
Swap 100m pesos back 5.0
@20
Sell 100m pesos @40 2.5
Interest on sterling loan (5 (0.5)
x 10%)
(5.0) 7.0

A plc should use a forex swap.

(Key idea: The forex swap is used to hedge foreign

exchange risk. We can see that in this basic exercise that
the swap amount of 100m pesos is protected from any
depreciation, as it is swapped at both the start and end of
the year at the swap rate of 20, whilst in the spot market
pesos have depreciated from a rate of 20 to 40 pesos per
pound.)

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Chapter Ten

Interest Rate Risk

1
What are the issues?

We have loan finance We have deposits and

interest rates are set earning a variable
at a variable rate on a interest rate
regular basis

Cover an interest Cover an interest

rate rise rate fall

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2 “FIXING” INSTRUMENTS (Lock in to Fixed Rate)

Forward rate agreements

(FRA)

Purchased from a merchant Pros Cons

the money markets - easy - contract
-flexible -size (≥ $1m)
- cheap

Contract that fixes future

interest rates for a set period

FRA 3-9 @ 4% pa

Fix start Fix stops 9 months Fixed Rate

3months from now
from now

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Interest rate future

Fixing the interest rate can be achieved by using futures.

One of the main markets that is used is the UK LIFFE
(London International Financial Futures Exchange).

The hedge is achieved by effectively ‘betting’ on the futures

market that its interest rate will change. The bet is always
on the downside (ie those with loans are betting that rates
will increase). Also, the futures interest rate is derived from
the market interest rates (LIBOR)

If the downside occurs, the company will have to pay more

on its loans as the market rate has risen, but would have
made a profit on the futures market. If rates go down, loan
interest will fall but a loss will be made on the futures
market. In both cases, the effective interest rate is fixed.

Futures are complicated by a number of factors.

 Contract sizes

 Margins / deposits payable at the start of the

hedge

 Not perfect hedge .May not look in at the current

rate.

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3 “CAPPING” METHODS (Setting a ceiling for the loan

interest rate)

Interest rate guarantee

(IRG)

Purchased from
a merchant bank for
a fee Covers the adverse
of interest rate
changes but at a
cost!!!
Contract that caps
the future interest
rate for a set
period

IRG 3-9 @ 4% pa

Cap starts in Cap stops 9 Capped rate

3 months time months from now

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Interest Rate Option

The future and options market provides a product that can

cap interest rates for borrowers like an IRG. The hedge is to
effectively have the ‘right to bet’ on an interest rate increase
as shown on the futures market.

As an example, suppose that today is 30 June and the

following data is available on September LIFFE options.

Strike price Interest rate Call options Put options

(SP) cap premium premium
% (100 – SP) % %
%
93.75 6.25 1.29 0.23
94.25 5.75 0.69 0.77
94.75 5.25 0.16 1.33

If a company wished to protect itself against an interest rate

increase above, say, 5.75%, it would purchase a put option.
A premium of 0.77% would be payable now. If the market
interest rates started to rise, the company would have to
pay more interest on its loans. However, interest rates on
the futures market will also rise and should this exceed
5.75%, the business will exercise its put option. The cash
received from this should cover most of the extra interest
paid on the loan.

Contract sizes and a standard length of three months

complicate interest rate options.

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NB Collars

 Create a cap & floor simultaneously

 Save premium
 Lose benefit of interest rate drops below the floor

4 SWAPS

4.1 Longterm method of hedging where companies “swap”

their interest commitments but no their loans.

4.2 Example

Company A wishes to raise $10m and to pay interest at

a floating rate, as it would like to be able to take
advantage of any fall in interest rates. It can borrow for
one year at a fixed rate of 10% or at a floating rate of
1% above LIBOR.

Company B also wishes to raise $10m.They would prefer

to issue fixed rate debt because they want certainty
about their future interest payments, but can only
borrow for one year at 13% fixed or LIBOR+2%floating
as it has a lower credit rating than company A.

Calculate the effective swap rate for each company –

assume savings are split equally.

4.3 Exam Technique

(1) Table of Interest Rates.

Company Fixed Float Want

A 10% LIBOR +1% FLOAT
B 13% LIBOR +2% FIXED

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(2) Interest Difference.

%
A (Fixed)+B (Float)
10+LIBOR+2 =LIBOR +12
A(Float)+B (Fixed)
LIBOR+1+B =LIBOR+14
Difference 2%

(3) SWAP Diagram

LIBOR+2
A B

12 (w1)

10 LIBOR+2

(w1) 13-(0.5 x2) =12

(4) Effective Rates

A PAY LIBOR

B PAY 12

Both save 1% and get what they want.

4.4 Problems

 Fees payable to intermediaries

 Default risk by one party.

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Recent Exam Question:

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Solution

a) (i) Interest Rate Futures

Use a simple 3 step approach

1) Timeline

1 Jan 1 March 31 March

(Now)

LIBOR = 6.00 5.00 or 7.00

Mar Futures=6.12 * 5.04 (w2)7.04
Basis =0.12 0.04 (w1) 0.04 NIL

* Use settlement values Basis falls to

if given (100-93.880) nil at the end
of the quarter

(w1) Basis of 0.12 [12 Basis points] will fall to nil by 31st
March. On the 1st March one month from three is still
remaining. Hence,

1/3 x 0.12=0.04

(w2) As the Mar Futures at 1 Jan was higher than LIBOR

[6.12 vs 6.00] it is assumed to stay higher until expiry.

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2) 1st Jan-Set up the Hedge

 The company will be exposed to movements on the

LIBOR for a period of 4 months from 1st March
 Buying futures (or effectively betting on a rise in
interest rates)
 Number of contacts:-

£30m X 4 months = 80 contracts

£500,000 3 months

3) 1st Mar-Close Out Hedge

LIBOR Falls LIBOR Rises

5.00% 7.00%
Company will pay 50 BP’s above 5.50% 7.50%
LIBOR
£ £
Payment of 4 months Interest (550,000) (750,000)
£30m X 4/12 X Interest Rate
Loss on Futures (108,000)
(6.12-5.04) X £12.50 X80
0.01
Profit on Futures 92,000
(7.04 -6.12) X £12.50 X80
0.01
Effective Cost of Loan (658,000) (658,000)
As a % of £30m 6.58% 6.58%
i.e £658,000 X 12 X 100%
£30m 4

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(ii) Options

1) Timeline-as for futures above

2) 1st Jan –Set up the Hedge

 As the current LIBOR is at 6.00%, the company will buy

March put options at 94000(100-6.00) to cap it’s
interest rate.

 No of contracts – as above 80

 Premium Payable

0.168 X 80c X £500,000 X 3/12

100

= £16,800

3) 1st March –Close out Hedge

LIBOR LIBOR
5.00% 7.00%
£ £
Premium Paid (16,800) (16,800)
Interest paid-see Futures (550,000) (750,000)
above
Compare Cap vs Mar Futures
Interest Rate
6.00% vs 5.04% -
6.00% vs 7.04%
Therefore, Use the option and 104,000
receive
(7.04-6.00) X 80 X £12.50
0.01
Total Cost (566,800) (662,800)
Effective Annual% 5.67% 6.63%
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As both are equally as likely

(5.67% X 0.50) + (6.65% X 0.50)

= 6.15%

Both methods keep the APR below the treasures target of

6.60%

However the options are preferred at 6.15%

b) What did the examiner write to answer this:-

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Chapter Eleven
Valuation of Options
+Value at Risk
1 Valuation of Options

1.1 An option gives the holder the right, but not the
obligation to buy or sell a share at a fixed price on a
specified future date.

Details and terminology: -

(a) Put – right to sell.

(b) Call – right to buy.

(c) Exercise price / strike price – price at which shares

can be bought or sold.

(d) Expiry Date – date on which the option can be

exercised (European type option).

Our aim is to find the value of the options on the

open market.

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1.2 Components of Option Value

Intrinsic value and time value

There are 5 main components to the value of an option

(a) Intrinsic value, the difference between

(i) The current price of the asset(Pa)

(ii) The exercise price of the option(Pe)

(b) The time value of the premium, reflecting the

uncertainty surrounding the intrinsic value
between now and the exercise date. Relevant
factors:

(i) Variability in the daily value of the asset

(currency, interest etc)(s)

(ii) Time until expiry of the option (a later expiry

date having greater risk)(t)

(iii) Interest rates (since cash flows occur at two

different times)(r)

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The Black Scholes Option Pricing Model

1.1 The above five factors have been built into the Black-
Scholes formula to find the value at time 0 of a
European call option. (c).

All three formulae are given in the tables but you must
know what the symbols stand for.

Symbols:

Pa=share price

Pe=exercise price option

r =annual (continuously compounded) risk free rate of

return

t =time to expiry of option in years

s =share price volatility, the standard deviation of the

rate of return on shares

e =the exponential constant 2.7183

On Your calculator!!
In =natural logarithm
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d1 &d2= Compute to two decimal places.

N(d1)& N(d2)=the cumulative value from the normal

distribution tables for the value d1 or d2.Read the
bottom of the tables very carefully.

Example

The current share price of B plc shares=$100

The exercise price =$95
The risk free rate of interest = 10%pa =0.1
The standard deviation of =50% =0.5
return on the shares
The time to expiry =3 months=0.25

1) Find d1 and d2

d1=In (100/95)+(0.10+0.5X0.52)0.25
0.5√0.25

d1=0.051+0.056
0.25
d1=0.43

d2=0.43-0.25=0.18

2) N (d1) =0.50+0.1664=0.6664

N (d2) =0.50+0.0714=0.5714

3) Find e-rt

rt =0.1 X0.25 =0.025

e-0.025=0.975

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Hence,

c= (100 x 0.6664)-(95 x 0.5714 x 0.975)

=$13.71

1.3 Put-call parity

Black Scholes’ model will only calculate the value of a

call option. The value of a call option, a put option, the
exercise price and the share price are related (where
the put and call have the same strike and exercise
date):

Find the value of the put option

p =$13.71-$100+$95 X 0.975

= $6.34

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2 ‘The Greeks’

There are five indicators of how the option price

changes according to the different factors in the Black
Scholes equation.

2.1

Change In Varying With

Delta δ Option value Underlying asset

value

Gamma Υ Delta Underlying asset

value

Theta θ Time Time

premium
Vega no symbol Option value Volatility

Rho ρ Option value Interest rates

2.2 The Delta Hedge

Delta hedging is used by options traders who have

written options and wish to calculate how many shares
they need to hold to hedge their position. If the delta is
0.7 they will need to hold 0.7 shares for every option
written.

The delta also measures how many shares one option

will ‘cover’ if used to hedge a holding of shares.

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3 FOREX modified Black-Scholes option pricing model.

(Grabbe variant)

3.1 Formulae

where

FO=Forward Rate
X=Exercise Rate
R=Domestic interest rate.

3.2 Used for the valuation of Forex options.

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3.3 Example

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4 Black and Scholes applied to Investment Appraisal.

4.1 Real options on projects

 Delay/Defer the project

 Switch /redeploy resources
 Expand/contract the project
 Option to abandon.

4.2 Recent Exam Questions

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Solution

Pa=PV of the project = ($4m+$24m) =$28m

Pe=Capex=$24m
t=2 years
r=5% (0.05)
s=25 %( 0.25)

1) Find d1&d2
2
d1=ln (28/24)+(0.05+0.5x0.25)2
0.25 X √2

= 0.154+0.1625
0.35

= 0.90

d2= 0.90-0.35=0.55

2) N(d1)=0.50+0.0159=0.8159
N(d2)=0.50+0.2088=0.7088

3) e-rt

rt=0.05 x 2=0.10

e-0.10=0.9048

Hence c=

(28 X 0.8159) – (24 X 0.9048 X 0.7088)

=$7.45m

Hence “value “of the project is NPV +value to delay

$4m+$7.45m
=$11.45m
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5. Value at Risk (VaR)

5.1 VaR is a measure of how the market value of asset or a

portfolio of assets is likely to decrease over certain time, the
holding period (usually 1 to 10 days), under normal
conditions.

5.2 Used by Investment banks to measure the market risk

of their portfolios.

5.3 Confidence levels are normally set at 95% or 99%.

Example

A bank has estimated the expected value of its portfolio in 2

week time will be $50m.with standard deviation of $4.85m.

At 95%,what is VaR?

45% 50%

$50m
s=$4.85m
$ 50m-(1.65 X $4.85m) =$42m

There is a 5% chance that the portfolio will fall below

$42m.

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Chapter Twelve

Business Valuations &

Mergers &Acquisitions
1 Pre-Acquisition Values

1.1 The aim is to find a range of values for a

company. The answer can be presented:-
a) Ve
b)Po

1.2 Net Asset Valuation

1.2.1 Business is worth just the value of it’s Net Assets.

To establish the net assets:-

Total Assets-(Total Liabilities +Preference Shares)

1.2.2 The Net Asset value equals the Ve and can be based
on:-
a) Book Values
b) Net Realisable Value(NRV)
c) Replacement cost

1.2.3 Useful For:-

a) “Seller “ to set minimum value of the company
(NRV)
b) Companies with lots of tangible high value
assets.Eg: Property Investment company

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1.2.3 Major Weaknesses are:-

a) Not include non-tangible assets

b) Excludes what all assets generate future:-
i. Dividends
ii. Profits
iii. Cash Flows

1.2.4 Dividend Valuation Model

1.3.1 The company is worth the present value of it’s future

dividends discounted at the cost of equity

1.3.2 Ve = Total Do(1+g)

(Ke-g)

OR

Po = Do(1+g)
(Ke-g)

1.3.3 Take Care:-

Growth may not be constant forever

Where to we get “g” from?
CAPM may be needed to find Ke
Often better for valuing a small shareholding

1.3.4 Finding g
a) Past Growth model
eg:
Year DPS
2006 $0.45
2007 $0.49
2008 $0.52
2009 $0.54

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g= 3√ (0.54)-1
(0.45)

g=0.063

b) Gordon Growth Model

g=bre

where b=Profit retention ratio

re= ARR or Cost of equity

eg A company has a retained profit ratio of 0.45.It has

an ARR of 12% and re of 14%.

Short term g=0.45 X 0.12=0.054

Long term g=0.45 X 0.14=0.063

1.4 Price –Earnings Model

1.4.1 A business is worth a multiple of it’s profits.

1.4.2 Ve=Sustainable PAT X Suitable P/E

Po=Sustainable EPS X Suitable P/E

1.4.3 Sustainable PAT-have to adjust the latest reported

reports for non-reoccurring items (post tax)

1.4.4 Suitable P/E:-

a) Take a proxy Company P/E

b) Adjust to suit the company we are valuing.
c) Simple rules
i. Ltd Co’s – deduct 30%off proxy Co P/E

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ii. Non-listed PLC’s-deduct 10% to

proxy Co P/E

1.4.5 Concerns are:-

 Finding a proxy Co P/E

 Adjustments are arbitrary
 Sustainable profits needs forecasting
adjustments.

1.5 Present value of Free Cash Flows

1.5.1 A business is worth the discounted value of the

future cash flows.

1.5.2 Establish:-

a) Future Cash flows and timescales

b) Cost of capital (WACC or Risk adjusted WACC)

1.5.3 Weaknesses are:-

1.5.4 Example

A company has FCF for equity currently at $400m. It

has a re of 8.5% and returns 30% of its profits. If
growth is expected in perpetuity what is the Ve?

g =b X re =0.30 X 0.085 = 0.0255

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Ve= FCF0(1+g)
(re-g)

= $400m (1.0255) = $6,894m

(0.085-0.0255)

1.5.5 Another Example

A company has projected its FCF to equity at:-

T1 $420m
T2 $490m
T3 $510m

From T4 onwards growth will be at 3 %pa.re=7.92%.

Find Ve

Time

$m T1 T2 T3 T4-F.Ever
FCF 420 490 510 510(1.03)
1/1.0792 1/1.07922 1/1.07923 16.171*
PV 389 421 406 8,495

Ve=$9,711m

* 1 X 1 = 16.171
3
(0.0792-0.03) (1.0792)

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1.6 Intellectual Capital(IC)

1.6.1 There are several methods of valuing IC and /or other

non-tangible assets.

1.6.2 Simple estimate

Ve under DVM or P/E Book value of Net

Or PV of CF’s method - Assets

1.6.3 Computed Intangible value (CIV)- to compute this

an industry /proxy return on total assets % must be
given in the question.

Approach:-
$ ‘000

1) Last reported profit before tax X

Less: Industry of Proxy x Co’s total (X)
Return on assets assets

Value Spread X

2) Take value spread X

Tax @X% (X)

Post tax value spread X

3) Assume post tax value spread will stay constant

From time 1 to perpetuity.

Value of IC=Post tax value Spread x 1/r

r =Cost of Capital

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4) Value of Equity is

Value of IC + Book value of the Assets

1.6.4 Lev’s knowledge earning method

An alternative method of valuing intangible assets

involves isolating the earnings deemed to be related to
intangible assets, and capitalising them. However its is
more complex than the CIV model in how it
determines the return to intangibles and the future
growth assumptions made.

In practice, this model does produce results that are

close to the actual traded share price, suggesting that
is a good valuation technique.

However, it is often criticised as over complex given

that valuations are in the end dependent on
negotiation between the parties.

Method

1) Calculate normalised earnings.

These are taken as a weighted average of:

 3-5 years of past earnings (adjusted for any

one-off items)
 3-5 years of forecast earnings (based on analyst
predictions or sales patterns)

with the forecast earnings being given heavier

weight.

Note: In the exam you may simply have to use

current earnings as an approximation.

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2) Isolate the earnings driven by intangible assets.

$
Normalised earnings X
Less
Return on financial/monetary (X)
assets(Rf X monetary assets
employed)
Less
Return on physical /tangible (X)
assets(Average industry return
on tangibles X tangible assets
employed)
Earnings driven by intangible X
assets

Lev identified the expected returns on assets as the:

 financial /monetary assets-risk free rate

 tangible assets-average market return in industries
primarily driven by their investment in tangible assets
 intangible assets-6% premium on the risk free rate.

Note: Financial assets are cash and other assets that

convert directly into known amounts of cash. The three
basic categories are cash, marketable securities, and
receivalbles.They are essentially current assets.

3) Capitalise the intangible earnings

Rather than simply assume these earnings will grow in

perpetuity as under the CIV model, Lev’s model is more
sophisticated .He assumes they will grow as follows:

 Five years at the current rate of growth.

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 Declining growth year on year for the next five

years.
 Year eleven onwards-growing at the long term
predicted growth rate.

2 Post Acquisitions Values

Follow a 3 step approach

2.1 PreAcquisition Data

Predator Target

No of Equity shares X X
in Issue

PAT X X

EPS X X

Pre acquisition Po X X

P/E Ratio X X

If the P/E ratio of Predator is greater than target

then a bootstrap method is possible

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2.2 Post Acquisition value of Predator

a) Using Bootstrap
$000

Predator PAT X

Target PAT X

Total PAT X

Total PAT X PREDATOR P/E = Ve*

b) Using Add Together

$000

Predator Preacquisition Ve X

Target Preacquisition Ve X

PV of Synergy Cash flows X

Ve *

*Divide this by the new number of total issued

shares in Predator to find Post Acquisition Po

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2.3 Assess the Takeover

Predator

Check the KPI’s post acquisition against

pre acquisition:-

a) Po risen?
b) EPS risen?

Target

Compute the Bid Premium:-

Per Share $

Value received post acquisition X

Per target share

Preacquisition price (X)

3 Factors to consider in Mergers and Takeovers

3.1 Assets of shares-most companies buy the victim

company’s shares rather than transferring their
assets. Both are feasible.

3.2 Synergies-concept of “2+2=5”.Many sources exist:

a) Economies of scale from horizontal combinations

reduces costs and increase profits.

b) Buying suppliers can reduce profit charged on

purchases i.e. cut out the middle man.

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c) Improve badly managed /inefficient businesses.

d) Diversify to stabilise profits and cash flows.

e) Access companies that generate cash

(Cash Cow)

f) Use the managerial talent of the victim in a

more productive way.

g) Market power may allow consumer price

increases and more profits.

3.3 Finance-to fund the takeover the predator company

Could use:-

a) Cash
b) Shares
c) Loan Stock

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3.4 Regulation of Takeovers

3.5 Defences-The victim company could defend a

take-over in several ways:-

a)Appeal to the Competition Commission indicating

the takeover is anticompetitive.

b)Find an alternative/Friendly buyer (White Knight)

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c) Appeal to the shareholders and manage a defence

showing that the takeover will not benefit them.

d)Super majority-set up in the Articles requiring a

high proportion of S/H to agree on takeovers.

e)Poison pill strategy –creation of “tripwires”

invoked on a takeover causing the acquirer to
spend more money.

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Chapter Thirteen

Modern Valuation Methods

1 VALUE BASED MEASURES

1.2 More recent approaches to valuations and performance

measures have focused on shareholder value. It is
accepted that companies exits to maximise shareholder
value, yet managers continue to be rewarded based on
traditional accounting measures. The three terms to be
familiar with are:

(a) Economic value added (EVA)

(b) Market value added (MVA)

(c) Shareholder value added (SVA)

Economic Value Added

1.3 EVA = Net operating profit after tax (NOPAT) – imputed

interest charge

EVA shows whether a company is making sufficient

profit to cover its cost of capital. It is a similar
approach to residual income.

1.4 NOPAT is calculated by taking the operating profit from

published accounts, adding back interest and taking off
the tax paid. It is sometimes referred to as cash
earnings before interest but after tax.

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1.5 The imputed interest charge is calculated as the capital

employed multiplied by the WACC. This represents the
return on capital required to keep the investors happy.

1.6 A positive EVA indicates that a company is adding value

for its shareholders. Therefore, if managers’
remuneration is linked to EVA, the interests of
managers and shareholders should be aligned.

1.7 Disadvantages of EVA include:

 Calculations can be complicated and involve many

adjustments to accounting information

 EVA is a historic measure

 EVA cannot be used to directly compare companies

as it requires an adjustment for their relative sizes

 The calculation relies on CAPM for the WACC, which

itself is subject to many restrictive assumptions

1.8 Example

The directors of Old Nick plc wish to establish whether

they have increased shareholder value in the year to
September 20X2. They use the EVA model.

Profit and loss account for year ended 30 September

20X2
£m
Turnover 150
PBT 50
Tax 18
PAT 32
Dividends 10

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Retained earnings 22
Additional information:

(a) Included in cost of sales and expenses is £10

million of economic depreciation. This is the same
as the depreciation used for tax purposes.

(b) Non-cash expenses amounted to £15 million.

(c) The opening capital employed on the balance sheet

was £108 million.

(d) The pre-tax cost of debt is 10%.

(e) The cost of equity is 15%.

(f) Old Nick plc has an effective tax rate of 35%.

(g) The interest expense in 20X2 was £5 million.

(h) The gearing ratio is 50:50 debt to equity by market

value.

Required

Calculate the EVA in the year to September 20X2.

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1.9 Solution

 WACC = (50% X 15%) + (50% X 10% X 0.65)

= 10.75%
 NOPAT:-
£m
PAT 32
Add: Non – cash Expenses 15
47
Add: Post tax ints 3.25
(5m X 0.65)
£50.25

EVA = £50.25m – (10.75% X £108m)

= £38.64m

Market Value Added

1.10 MVA is the value added to a business since it was

formed, over and above the money invested in the
company by shareholders and long term debt holders.

Quick Example

BB Plc
2003 Ve = £25m

2004 Ve = £40m
Rights issue in 2004 = £5m

MVA = £40m - £25m - £5m = £10m

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Shareholder Value Added

1.11 SVA represents the discounted future free cash flows

less the value of the company’s debt. The discount
rate will be the company’s WACC.

Quick Example

CC Plc

Free cash flows for T1 on in perpetuity of £1.5m p.a.

WACC = 14%

Vd = £2.5m
1
SVA = £1.5m x 0.14 - £2.5m = £8.21m

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Chapter Fourteen

Corporate Reconstruction
and Reorganisation
1 Causes of Corporate Failure

Corporate failure when a company cannot achieve a

satisfactory return on capital over the longer term:

 If unchecked, the situation is likely to lead to an ability

of the company to pay its obligations as they become
due.
 The company may still have an excess of assets over
liabilities, but if it is unable to convert those assets into
cash it will be insolvent.
 The issue is more problematic in sectors, or economies,
where profitability is not an issue. For example, in the
former Soviet Bloc, the economy simply does not
identify poorly performing companies
 For not-for-profit organisations, the issue is usually one
of funding, and failures indicated by the inability to
raise sufficient funds to carry out activities effectively.
 Although stated in financial terms, the reasons behind
such failure are rarely financial, but seem to have more
to do with a firm’s ability to adapt to changes in its
environment.

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2 Predicting Corporate Failure

2.1 Altman Z-Score Model

The Z score model was first developed by Altman in

1968 based on research in the USA into bankrupt
manufacturing companies:

 Z scores are an attempt to anticipate strategic and

financial failures by examining company financial
statements.
 The Z score is generated by calculating five ratios,
which are then multiplied by a predetermined weighting
factor and added together to produce the Z score.
 The five ratios, which ,once combined ,were considered
to be the best predictors of failure, are:

Ratio Included to measure

X1 Working capital to total Liquidity
assets
X2 Retained earnings to Gearing
total assets
X3 Earnings before Productivity of the
interest and tax to company’s assets.
total assets
X4 Market value of The extent to which
equity(including the equity can decline
preference shares)to before the liabilities
total liabilities exceed the assets and
the company becomes
insolvent
X5 Sales to total assets The ability of the
company’s assets to
generate revenue.

Z score=1.2 X1 +1.4X2 +3.3X3 +0.6X4 +1.0X5

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2.2 Assessing the risk of failure

 The accuracy of prediction of the model.

 The Z score model was found to be an accurate
predictor of failure for up to two years prior to
bankruptcy, but that the accuracy decreases over
longer periods.
 What level of Z score indicates different levels of
likelihood of failure? It was found that:

Z score<1.81 indicates that the Company is in danger

and possibly heading towards bankruptcy.

Z score of 3 or above indicates financially sound.

Companies with scores between 1.81 and 2.99 need

further investigation

2.3 Limitations of corporate failure prediction models

There are number of limitations of the Z score and

other similar failure prediction models:

 The score estimated is a snapshot-it gives an indication

of the situation at a given point in time but does not
determine whether the situation is improving or
deteriorating.
 Further analysis is needed to fully understand the
situation.
 Scores are only good predictors in the short term.
 Some scoring systems tend to rate companies low-that
is they are likely to classify distressed firms as actually
failing.
 The Z score was estimated based on manufacturing
companies. Care needs to be taken when applying it to
other types of companies.

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3 Other signs of Corporate Failure

Information in the published accounts, for example:

 very large increases in intangible fixed assets

 a worsening cash and cash equivalents position shown
by the cash flow statement
 very large contingent liabilities
 important post balance sheet events
 Information in the chairman’s report and the director’s
report (include warnings, evasions, changes in the
composition of the board since last year.
 Information in the press (about the industry and the
company or its competitors).
 Information about environmental or external matter.
You should have a good idea as to the type of
environmental or competitive factors that affect firms.

4 Financial Reconstructions

4.1 Options open to failing companies

 a company Voluntary Arrangement (CVA)

 an administration order

4.2 General principles in devising a scheme

In most cases the company is ailing:

 Losses have been incurred with the result that capital

and long term abilities are out of line with the current
value of the company’s assets and their earning
potential.
 New capital is normally desperately required to
regenerate the business, but this will not be
forthcoming without a restructuring of the existing
capital and liabilities.

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The general procedure to follow would be:

 Write off fictitious assets and the debit balance on profit

and loss account. Revalue assets to determine their
current value to the business.
 Determine whether the company can continue to trade
without further finance or, if further finance is required,
determine the amount required ,in what form(shares,
loan stock) and from which persons it is obtainable
(typically existing shareholders and financial
institutions).
 Given the size of the write off required and the amount
of further finance require, determine a reasonable
manner in spreading the write off(the capital loss)
between the various parties that have financed the
company(shareholders and creditors).
 Agree the scheme with the various parties involved.

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Chapter Fifteen

Question 4 and Emerging

Issues

1 The Written Question

The Examiner has been consistent on all papers he has set

so far. Q4 has been a full written question. There is no
indication that this is likely to change in the near future.
Common points in past question have been:

 Either a two part question of at least two themes within

the requirements

 Ethical Issues

 Providing a solution to a Financial or Strategic problem.

2 Preparation

In my view, one way to prepare for this question is to look

back and review what the examiner has set so far and how
he has answered the question.

Go on to the ACCA Global website and read and review the

past answers to ‘Q4’ set by Bob Ryan.

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