Chapter summary

1 Financial objectives Financial strategy:

formulation
Profit is NOT the key financial goal
 It is historic
 It is not cash
 It ignores other factors, such as risk
The key financial objective is total shareholder
return, measured as dividend yield + capital
gain.
2 Financial strategy
formulation

2.1 Investment decision

– find attractive new projects

2.2 Financing decision 2.3 Risk management

– minimise cost of capital

Debt is a cheap source of finance, and can be used

to reduce the cost of capital; the appropriate
level of gearing depends on a number of
practical factors.

Practical issues

Life cycle – a new, growing business will find it

difficult to forecast cash flows so high levels of
gearing are unwise

Operational gearing – if fixed costs are high

then contribution (before fixed costs) will be high
relative to profits (after fixed costs). High fixed costs
mean cash flow is volatile, so high gearing is not
sensible

Stability of revenue – if operating in a highly

dynamic business environment then high gearing is
not sensible

Security – if unable to offer security then debt will

be difficult and expensive to obtain

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1: Financial strategy: formulation

2.4 Dividend decision

– pay out or reinvest?

Investment decision
 Companies with many investment opportunities (young/high
growth companies) may find it difficult to pay a dividend.
Financing decision
 Companies that have volatile cash flows (and therefore prefer to
minimise their use of debt finance) will often pay lower dividends.
Dividend capacity (free cash flow to equity)
 Cash available for paying a dividend. Calculated as:
Profits after interest, tax and preference dividends
less
debt repayment, share repurchases, investment in assets
plus
depreciation, any capital raised from new share issues or debt.
Possible policies:
 Constant payout
 Stable growth
 Residual
 Scrip dividends
 Special dividends
 Share buybacks
Dividend irrelevance theory (M&M)
 In a tax-free world, shareholders are indifferent between
dividends and capital gains, and the value of a company is
determined solely by the 'earning power' of its assets and
investments.
 Ignores impact of tax and practical difficulty and cost of raising
finance.

3 Ethics 4 Integrated reporting

Communication with stakeholders.

Reporting financial, manufactured,
human, intellectual social & natural
3.1 Ethical and 3.2 Ethics and
capitals.
environmental issues stakeholder conflict

Unfair impact on stakeholders. Companies need to understand the ethical

issues it faces, resulting from stakeholder
conflict. It should state its ethical principles
and introduce safeguards (eg to align
interests of management to shareholders:
agency theory).

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Knowledge diagnostic

1. Total shareholder return

This is a measure of the change in shareholder wealth over a year. Calculated as dividend yield
+ capital gain/loss.
2. Financial strategy
Involves key decisions over investment, financing, dividends and risk management. Each
decision affects the others.
3. Dividend capacity
Dividend capacity is the cash generated in any given year that is available to pay to ordinary
shareholders (it is also called free cash flow to equity).
4. Scrip dividend
A dividend paid in shares.
5. Integrated reporting
Designed to make visible the capitals (resources and relationships used and affected by the
organisation) on which the organisation depends, how the organisation uses those capitals and
its impact on them. The capitals are financial, manufactured, intellectual, human, natural
(remember as FISH MN).

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1: Financial strategy: formulation

Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q1 Mezza
Q2 Stakeholders and ethics

Research exercise
Use an internet search engine to identify the ethical code of conduct for a company and have a look at
the types of values and behaviours it contains. Choose any company you have an interest in, if you want
a suggestion the BP code of conduct is an interesting document to analyse. This is available here:
https://www.bp.com/content/dam/bp-country/en_au/products-services/procurement/code-of-
conduct.pdf
There is no solution to this exercise.

www.ACCAGlobalBox.com 15
 Chapter summary

4 Behavioural finance Management behaviour

affected by:
Overconfidence/entrapment/
4.1 Management behaviour
agency issues/confirmation bias
Investor behaviour affected by:
4.2 Investor behaviour Herding/cognitive dissonance/
narrow framing/availability bias/
conservatism
Financial strategy:
evaluation

1 Financing decision 2 Assessing corporate

3 Risk management
performance

2.1 Key profitability 3.1 Different types of risk

1.1 Cost of equity
1.1 Cost of equity ratios
Business risk
The most expensive finance, (most risky) ROCE
Financial risk (gearing/interest
Profit margin Asset turnover and exchange rate)
Beta measures systematic risk, average beta
=1 2.2 Shareholder 3.2 Relationship between
investor ratios business and financial risk
Limitations of the CAPM
TSR
Market This will be volatile, High business risk should mean a
Dividend yield + capital gain
return estimates don't pick up policy of minimising financial risk
(compare to Ke) and vice versa
firms that fail.
Return on equity
Beta Beta values are historic,
EPS
and become out of date if 3.3 The rationale for risk
the firm changes its P/E ratio management
gearing or strategy.
Stabilising earnings
Size Ignores impact of size on Encouraging investment
risk.
Stakeholder relationships
Alternatively: dividend growth model:
3.4 Risk management
techniques

Risk mitigation
1.2
1.2 Cost
Cost of
of debt
debt 1.3 WACC
Hedging
The cheapest finance is debt A weighted average of the cost of Diversification
(especially if secured) – the cost of debt is equity and the cost of debt (and
Kd (pre-tax). any other sources of finance)
Redeemable/convertible debt When investing in a new
Use yield curve rate + yield premium (or business a marginal cost of
IRR calculation) capital should be used
Preference shares
Use dividend growth model, but g = 0

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2: Financial strategy: evaluation

Knowledge diagnostic

1. Unsystematic risk
This is the component of risk that is associated with investing in that particular company.
2. Systematic risk
The portion of risk that will still remain even if a diversified portfolio has been created, because
it is determined by general market factors. Measured by a beta factor.
3. Credit risk premium
The expected return to bond holders can be calculated as the risk free rate (derived from the
yield curve for a bond of that specified duration) + the credit risk premium (derived from the
bond's credit rating)
4. Ratio analysis
This is an important mechanism for evaluating a financial strategy; make sure you learn the key
ratios.
5. Risk management
Failure to manage risk can result in a business being unable to raise finance and having poor
stakeholder relationships. Both business and financial risk should be considered in a financial
strategy.
6. Behavioural finance
This gives insights into potential reasons for the failure of a financial strategy in terms of meeting
shareholder expectations.

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Further study guidance

Question practice
Try the question below from the Further question practice bank (available in the digital edition of the
Workbook):
Q3 Airline Business

Further reading
There is a Technical Article available on ACCA's website, called 'Patterns of behaviour'. This article
examines behavioural finance and is written by a member of the AFM examining team.
Another useful Technical Article available on ACCA's website is called 'Risk Management'. This article
examines the potential for risk management to 'add value' and is written by a member of the AFM
examining team.
We recommend you read these articles as part of your preparation for the AFM exam.

Research exercise
Use an internet search engine to identify the beta factors for different companies. The Reuters website
(reuters.com) is a good location from which to perform this search. Search for any company and you
should find its beta factor in the section giving an overview of the company.
For example Ford's beta factor can be found here:
https://uk.reuters.com/business/stocks/overview/F.N
There is no solution to this exercise.

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SKILLS CHECKPOINT 1

Addressing the scenario

aging information
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Addresing the

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Exam success skills
Good

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Specific AFM skills

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Identifying the
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Efficient numerica
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Introduction
All of the questions in your Advanced Financial Management (AFM) exam will be
scenario-based.
In Section A of the exam (50 marks) you can expect the scenario to be approximately two
pages in length, and in the shorter (25 mark) Section B questions they will normally be
approximately one page long.
It is vital to spend time reading and assimilating the scenario as part of your answer planning.
Often the scenario will contain clues about the appropriate numerical techniques to apply (see
Skills Checkpoint 3 in this Workbook), but it is always the case that the scenario will contain
information that will be relevant to discussion parts of the question. The discussion parts of the
question will account for a significant proportion of the marks, often equalling or even
exceeding those awarded for the numerical parts of the question, and will often focus on how
an issue or issues need to be 'managed'.
It is important to score well in the discussion parts of a question; to do this you will require a
broad syllabus knowledge (see Skills Checkpoint 5 in the Workbook), avoid over-complicating
your numerical analysis (see Skills Checkpoint 4 in the Workbook), and the ability to make your
points relevant by addressing the scenario, ie by applying your points to the scenario. A
common complaint from the ACCA examining team is that 'Less satisfactory answers tended to
give more general responses rather than answers specific to the scenario'.
This skill is especially important in Section A of the AFM syllabus where we are looking at
(management) 'responsibilities of the senior financial adviser', but is relevant to all syllabus
areas and is likely to be important in every question in your AFM exam.

www.ACCAGlobalBox.com 37
Skills Checkpoint 1: Addressing the scenario

AFM Skill: Addressing the scenario

A step-by-step technique for ensuring that your discussion points are relevant to the
scenario is outlined below. Each step will be explained in more detail in the following
sections as the question 'Kilenc' is answered in stages.

STEP 1:
Allow about 20% of your allotted time for
analysing the scenario and requirements –
don't rush into starting to write your
answer. Assuming 1.95 minutes per mark
this means about 20 minutes of analysis
and planning for a 50 mark question
(1.95 minutes × 50 marks × 20%) and
about 10 minutes for a 25 mark question.

STEP 2:
Prepare an answer plan using key words from the
requirements as headings (ie a mind map or a
bullet-pointed list).

STEP 3:
Complete your answer plan by working through
each paragraph of the question identifying
specific points that are relevant to the scenario
(and requirement) to make sure you generate
enough points to score a pass mark – ACCA
marking guides typically allocate 1–2 marks per
relevant well-explained point.

STEP 4:
As you write your answer, explain what you
mean in one (or two) sentence(s) and then in the
next sentence explain why it matters here (in the
given scenario). This should result in a series of
short punchy paragraphs containing points that
address the specific content of the scenario.
Write your answer in a time efficient manner.
As 20% of your time has been used for
planning/analysis this means that the time
allocation when writing should be 1.95 × 0.8 =
1.56 minutes per mark.

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Skills Checkpoint 1

Exam success skills

The following question is an extract from a past exam question worth 15 marks.
For this question, we will also focus on the following exam success skills:
 Managing information. It is easy for the amount of information contained in
scenario-based questions to feel overwhelming. Active reading is a useful
technique to use to avoid this. This involves focusing on the requirement first, on
the basis that until you have done this the detail in the question will have little
meaning and will seem more intimidating as a result.
Focus on the requirement, underlining key verb or verbs to ensure you answer
the question properly. Then read the rest of the question, underlining and
annotating important and relevant information, and making notes of any
relevant technical information you think you will need.
 Correct interpretation of requirements. At first glance, it looks like the
following question just contains one requirement. However, on closer
examination you will discover that it contains at least two sub-requirements, this
is very common in the AFM exam. Focus on the verbs in each sub-requirement
and analyse them to determine exactly what your answer should address, and
what areas of analysis would not be relevant.
 Answer planning. Everyone will have a preferred style for an answer plan.
For example, it may be a mind map, bullet-pointed lists or simply annotating the
question paper. Choose the approach that you feel most comfortable with or if
you are not sure, try out different approaches for different questions until you
have found your preferred style.
 Effective writing and presentation. It is often helpful to use key words
from the requirement as headings in your answer. You may also wish to use
sub-headings in your answer – you could use a separate sub-heading for each
paragraph from the scenario which contains an issue for discussion. Underline
your headings and sub-headings with a ruler and write in full sentences,
ensuring your style is professional.

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Skill activity

STEP 1 Look at the mark allocation of the following question and work out
how many minutes you have to analyse and plan your answer to the
question.

Required
Discuss the key risks and issues that Kilenc Co should consider when setting up a
subsidiary company in Lanosia, and comment on how these may be mitigated.

(15 marks)

This is a 15-mark question and at 1.95 minutes a mark, it should take 29 minutes.
On the basis of spending approximately 20% of your time reading and planning, this
time should be split approximately as follows:
 Reading and planning time – 6 minutes
 Writing up your answer – 23 minutes

However, in reality this would have been part of a larger question (this was part of a
25 mark Section B question) and the planning time would take place at the start of the
question and would involve planning for all of the question's requirements (so 10 minutes
of planning for the whole question).

Also some flexibility is required and if a question contains a substantial number of

discussion issues (as here) then more reading and planning time may be needed.

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Skills Checkpoint 1

STEP 2 Read the requirement for the following question and analyse it to
identify the key words. Highlight each sub-requirement, identify the
verb(s) and ask yourself what each sub-requirement means.

Verb – see Sub-requirement 1

definition below

Required
Discuss the key risks and issues that Kilenc Co should consider when setting up a
subsidiary company in Lanosia, and comment on how these may be mitigated.

(15 marks)
Sub-requirement 2

The first key action verb is 'discuss'. This is defined by the ACCA as 'Consider and
debate/argue about the pros and cons of an issue. Examine in detail by using
arguments in favour or against'.

The requirement is to discuss 'risks and issues' in setting up a subsidiary in a foreign

country.
In this context, the verb 'discuss' is asking you to examine each of the risks and issues
in a critical way, eg debating the nature and extent of the risk.

The verb 'comment' is asking you to remark or express an opinion, in a concise

manner, on mitigating the risks/issues that you have discussed.
Points that you make for 'commenting' are likely to be worth less than the points made
for discussing (in the first part of the question) because you will be going into less
depth.

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 STEP 3 Now complete the answer plan. Focus initially on identifying the issues
because the risk mitigation points should follow logically from this.

Risks and issues

Working through each paragraph of the question, identify specific
risks/issues.
Risk mitigation
You will need to draw on your technical knowledge here ie that mitigation
involves transferring risk out of the business ie by taking action to reduce,
control or avoid the risk. However, your answer needs to be practical and
applied to the risks and issues that you have identified.
Make sure you generate enough points for the marks available – there are
15 marks available, so assuming 2 marks per relevant well-explained risk
discussed and perhaps 1 mark for commenting how to mitigate this risk,
then you should aim to generate sufficient points to score a strong pass mark
(eg 10 marks).

Note the company's main

Question – Kilenc (15 marks) business activities – possible
risk to core business if
Kilenc Co, a large listed company based in the UK, produces reputation is damaged from
poor quality overseas or
pharmaceutical products which are exported around the downsizing in the UK?

world. It is reviewing a proposal to set up a subsidiary

company to manufacture a range of body and facial Risk of local skills
and expertise and
creams in Lanosia. These products will be sold to local retailers perhaps supplier
base not being
and to retailers in nearby countries. adequate?

Lanosia has a small but growing manufacturing industry in

pharmaceutical products, although it remains largely reliant on
imports. The Lanosian Government has been keen to promote the
pharmaceutical manufacturing industry through purchasing local

Risk of these being pharmaceutical products, providing government grants and

removed?
reducing the industry's corporate tax rate. It also imposes
large duties on imported pharmaceutical products which Positive factors,
assume these will be
compete with the ones produced locally. avoided – use to
'discuss' risk
Risk of government
incentives being
Although politically stable, the recent worldwide financial crisis has
removed confirmed
had a significant negative impact on Lanosia. The country's national
debt has grown substantially following a bailout of its banks Risk of failing to
recover with knock-on
and it has had to introduce economic measures which are hampering impact on sales of
luxury products?
the country's ability to recover from a deep recession. Growth in
real wages has been negative over the past three years, the economy

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Skills Checkpoint 1
Risk of devaluation
of Lanosian currency?
has shrunk in the past year and inflation has remained higher
than normal during this time.

Risk that interest On the other hand, corporate investment in capital assets, research
rates have to rise to Points to use to
control inflation? and development, and education and training has grown recently 'discuss' risk? ie
business confidence
and interest rates remain low. This has led some economists to seems high

suggest that the economy should start to recover soon. Employment

levels remain high in spite of low nominal wage growth.
Risk of dilution of
control and impaired
Lanosian corporate governance regulations stipulate that at least 40% decision making?
Management issues?
of equity share capital must be held by the local
population. In addition, at least 50% of members on the
board of directors, including the Chairman, must be from
Risk that this finance will
Points to use to
Lanosia. Kilenc Co wants to finance the subsidiary company using a not be available?
'discuss' risk? ie
reduces exchange rate
mixture of debt and equity. It wants to raise additional equity and
risk
debt finance in Lanosia in order to minimise exchange rate
exposure. The small size of the subsidiary will have minimal impact
on Kilenc Co's capital structure. Kilenc Co intends to raise the 40%
Risk of other parts of
equity through an initial public offering (IPO) in Lanosia and provide the business being
starved of funds?
the remaining 60% of the equity funds from its own cash funds.

Required

Discuss the key risks and issues that Kilenc Co should consider when
setting up a subsidiary company in Lanosia, and comment on how
these may be mitigated. (15 marks)

Completed answer plan

Having worked through each paragraph an answer plan can now be
completed. A possible answer plan is shown here, this uses the
wording of the requirement and the initial ideas that have been noted
in the margins as shown earlier.

Risk/issue Mitigation ideas

Reputational risk (global sales/skill Redeploy staff?

shortages)

Economic risk (downturn/removal of Dialogue/negotiation

grants/increase taxes)

Impact of higher inflation (exchange rate Increase use of debt? Fixed

risk/interest rate risk) rate finance?

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 Risk/issue Mitigation ideas

Financial risk (availability/impact on other Increase proportion of

parts of the business) finance provided locally

Management difficulties (local managers Training

and shareholders, language, culture etc)

Other – natural disasters Insurance

STEP 4 Write up your answer using key words from the requirements as
headings.
Write your answer by explaining what you mean in one (or two)
sentence(s) and then in the next sentence explain why it matters
here (in the given scenario).
For the discussion part remember that this can involve debating
the nature and extent of the risk.
When commenting, remember to be practical but also concise.

Suggested solution
Use sub-headings from Risks and issues
your answer plan

There could be adverse effects on Kilenc Co's employees in

the UK because if the subsidiary is set up then Kilenc Co is likely to
export less to Lanosia and other countries in the same region. If there
are to be redundancies this may damage Kilenc Co's reputation in There are many different points that
could be made about reputation –
the UK and possibly beyond. the key is that the point is applied
to address the scenario
Use short paragraphs to
show the marker that a In addition, Kilenc Co needs to consider how the subsidiary would be
different point is being This is explaining why
made. perceived and whether the locally produced products will be seen as this matters in this
scenario – which is the
the same quality as the imported ones. This is a concern given the key skill that we are
looking at.
relatively youth of the pharmaceutical industry in Lanosia, which
may mean that there is a skills shortage in terms of availability of staff
This is explaining why
and suppliers. this matters in this
scenario – which is the
key skill that we are
The verb 'discuss' in Lanosia is currently in recession and this may have a negative looking at.
the requirement allows
you to suggest that impact on the demand for the products, especially as these
some risks are more or
less important than products do not appear to be 'necessities' and therefore could
others.
This is explaining why
be severely hit if the recession continues. However, the high levels of this matters in this
scenario – which is the
business investment indicates that there is some optimism that the key skill that we are
looking at.
recession may be coming to an end.

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Skills Checkpoint 1

Given the pressure on the national debt, there may be a

risk that government grants and tax breaks are reduced
or removed. This may significantly increase the costs of
setting up a subsidiary. Kilenc Co may also find it is subject to
restrictions if it is felt that the subsidiary is affecting local companies.
For example it may impose repatriation restrictions or increase taxes
that the subsidiary has to pay. Alternatively given the fact that 40% of
the shares will be locally owned and 50% of the board will also be
from Lanosia may mean that the subsidiary is viewed as a local

The verb 'discuss' in the company and the government support will also be available
requirement allows you to
suggest that some risks to the subsidiary.
are more or less
important than others.
Kilenc Co wants to raise debt finance in Lanosia. It needs to
consider whether this finance will actually be available. Following the
Relating different parts of
bailout of the banks there may be a shortage of funds for borrowing. the scenario adds value
to the answer.
Also the high inflation rate may mean that there will be
pressure to raise interest rates which may in turn raise
borrowing costs.
This is explaining why
The Lanosian IPO is likely to result in a number of minority this matters in this
scenario – which is the
shareholders, which combined with the composition of the board may key skill that we are
looking at.
create agency issues for the subsidiary. For example, the
board of the subsidiary may make decisions that are in local interests
rather than those of the parent company.

Cultural issues also need to be considered, which include issues

arising from dealing with people of a different nationality and also
issues of culture within the organisation. A good understanding of
cultural issues is important, as is the need to get the right balance
between autonomy and control by the parent company.

Less detail is appropriate Other risks including foreign exchange exposure (to a devaluation
if there is less material in
the scenario on these in the Lanosian currency), health and safety compliance and physical
issues.
risks all need to be considered and assessed. There are numerous
legal requirements from health and safety legislation which must be
understood and complied with. The risk of damage from events such
as fire, floods or other natural disasters should also be considered.

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 Mitigation of risks and issues
Use sub-headings from
your answer plan
Communication, both external and internal, can be used to
minimise any damage to reputation arising from the move to Lanosia.
If possible, employees should be redeployed within the organisation
to reduce any redundancies.

The Lanosian Government should be negotiated with and

communicated with regularly during the setting up of the
subsidiary and on an ongoing basis. This should help to maximise Links back to the risks
identified earlier
any government support and/or minimise any restrictions. This
Points are briefer now as
these are 'comments' may continue after the establishment of the subsidiary to reduce the
chance of new regulations or legislation which could adversely affect
the subsidiary.

Given the potential risk of rising interest rates, Kilenc Co may want to
use fixed-rate debt for its financing or use interest rate swaps to
effectively fix their interest charge. The costs of such an activity also
need to be considered.

The corporate governance structure needs to be negotiated and

agreed in order to get the right balance between autonomy and
central control. All major parties should be included in the
negotiations and the structure should be clearly
communicated.

Cultural differences should be considered from the initial setting

up of the subsidiary. Staff handbooks and training sessions can be
used to communicate the culture of the organisation to employees.

Foreign exchange exposure can be mitigated through a greater

use of local debt finance, depending on its availability and
cost. This will reduce exposure to a devaluation of the Lanosian
currency as a reduction in the value of the investment will be offset by
a reduction in the value of the loan finance.

Health and safety and physical loss risk can be mitigated through a

No conclusion required
combination of insurance, and legal advice.
given the wording of the
requirement

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Skills Checkpoint 1

Other points to note:

 This is a comprehensive, detailed answer. You could still have

scored a strong pass with a shorter answer as long as it
addressed all aspects to the question.
 Both sub-requirements (risk and mitigation) have been addressed,
each with their own heading.
 The length of answer for each part is not the same – reflecting
that commenting (on mitigation) should be more concise than
discussing (risk).
 Write your answer in a time-efficient manner. As 20% of your
time has been used for analysis this means that when you are
writing the 1.95 minutes per mark becomes 1.95 0.8 = 1.56
minutes per mark of writing time. So here this means 15 1.56
= 23 minutes should be spent writing your answer.

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Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been
completed below for the Kilenc activity to give you an idea of how to complete the
diagnostic.

Exam success skills Your reflections/observations

Managing information Did you identify the impact on Kilenc's core UK operations?
Did you link the banking bail-out to potential problems in
raising debt finance?

Correct interpretation Did you understand what was meant by the verbs 'discuss'
of requirements and 'comment'?
Did you spot the two sub-requirements?
Did you understand what each sub-requirement meant?

Answer planning Did you draw up an answer plan using your preferred
approach (eg mind map, bullet-pointed list)?
Did your plan address both the risk identification and
mitigation?
Did your plan create enough points by analysing each
paragraph of the question?

Effective writing and Did you use headings (key words from requirements)?
presentation
Did you use full sentences?

And most importantly – did you explain why your

points related to the scenario?

Most important action points to apply to your next question

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Skills Checkpoint 1

Summary
In the AFM exam, each question will be scenario based. It is therefore essential that
you try to create a practical answer that addresses the issues in the scenario instead of
simply repeating rote-learned technical knowledge.
AFM is positioned as a Masters-level exam. It is not easy to relate your points to the
scenario, but it is important to realise that this is a fundamental skill that is being tested
at this stage in your qualification.
Key skills to focus on throughout your studies will therefore include:
 Assimilating information from a scenario quickly using active reading,
accurately understanding the requirements; and
 Creating an answer plan and a final answer that concisely and accurately
addresses both the scenario and the requirements.

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3: DCF techniques

Chapter summary
1 Encourage innovation
1 Capital investment monitoring 2 Preliminary screening
3 Financial analysis
4 Authorisation
1.1 Control process 5 Monitoring and review (post-audit)

DCF techniques

2 NPV 3 IRR and MIRR 4 Risk and uncertainty

2.1 NPV layout 3.1 IRR 4.1 Techniques from

earlier exams
Calculate using two NPVs
Sales
inserted into IRR formula Risk-adjusted discount factor
– Costs
Expected values
– TAD
Payback
Operating profit 3.2 NPV versus IRR
Discounted payback
– Taxation
Sensitivity
– Capital expenditure IRR ignores size of a project,
Simulation
+ TAD and assumes inflows are
+/– change in working reinvested assumed at same
capital rate as project IRR. 4.2 Project duration
Net cash flows There may be more than one
Post-tax cost of capital IRR.
Measures the average time over
Present value
NPV is theoretically superior. which a project delivers value.

2.2 Impact of inflation

Affects cash flows and cost 3.3 MIRR 4.3 Value at risk
of capital

Assumes inflows are reinvested The maximum expected loss with

2.3 Impact of tax at the cost of capital. Normally only an x% chance of being
TAD and tax rates rules given a more reasonable assumption exceeded.
in exam questions.
Adjust the standard deviation by
Unused TAD can be carried
square root of the time period of
forward unless otherwise
the project.
stated.
Based on assumption of a normal
5 Capital rationing distribution

5.1 Single-period 5.2 Multiple-period

capital rationing capital rationing
Single-period profitability Multi-period: objective and
index – measures the extra a constraints need to be
company would pay to formulated or interpreted.
obtain short-term funds

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Knowledge diagnostic

1. Inflation
The formula for inflating the cost of capital only needs to be used if the cost of capital is given in
'real' terms; otherwise inflation can be assumed to be included in the cost of capital
automatically.
2. Tax
Tax allowable depreciation should be included as a cost for the purposes of calculating the tax
due; then it should be added back to the cash flows because it is not in itself a cash flow cost.
3. MIRR
Differs from IRR because of the assumption that cash inflows are reinvest at the cost of capital.
4. Project duration
A way of looking at the reliance of a project on later cash flows, unlike payback it looks at all
years of a project.
5. Value at risk
A statistically complex technique that makes a crucial assumption that the normal distribution is
valid to use; this may not be true.
6. Profitability index
Only valid for single-period capital rationing where projects are divisible.

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3: DCF techniques

Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q4 CD
Q5 Bournelorth

Further reading
There is a Technical Article available on ACCA's website, called 'Conditional Probability'.
We recommend you read this article as part of your preparation for the AFM exam.

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4: Application of option pricing theory to investment decisions

Chapter summary

1 Limitations of traditional DCF

analysis

Application of option pricing theory to investment

decisions

2 Types of real
options

Option to Option to delay Option to Option to

expand Eg so that valuable redeploy withdraw
Eg if successful, new business Eg assets can easily Eg easy to sell
technology or information is be switched from assets if the project
brand name used in available one project to fails, or low clear
other projects another up costs

Call option Call option Put option Put option

3 Components of 4 Applying the 5 Limitations of the

option value Black–Scholes Black–Scholes
model model

Intrinsic value Pe is not discounted Estimation of standard

 Current asset r is the risk-free rate deviation
price versus t is the time to expiry of option Assumed to be
exercise price Standard deviation is the square root exercised on a fixed
of the variance date (European style).
Time value
Steps in valuing a call option:
 Variability
 Time to expiry 1 Identify input variables
 Interest rates 2 Calculate d1 then d2
3 Use normal distribution tables to
calculate N(d1) and N(d2)
4 Complete the call option formula
A call option needs to be valued
before a put option can be valued.

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Knowledge diagnostic

1. Call option
This is an option to buy; options to expand and options to delay are call options.
2. Put option
This is an option to sell; options to redeploy and options to withdraw are put options.
3. Impact of high volatility
Higher volatility normally decreases value, but in the context of option valuation it increases the
value of both put and call options.
4. Standard deviation
You may have to calculate this as the square root of the variance.
5. Drawbacks of BSOP
Assumes that options are exercised on a fixed date, and that standard deviation can be
estimated.

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4: Application of option pricing theory to investment decisions

Further study guidance

Question practice
Now complete steps 2 to 4 in Activity 3 for further practice on using the BSOP formulae. Also try the
questions below from the Further question practice bank (available in the digital edition of the Workbook):
Q6 Four Seasons
Q7 Pandy

Further reading
There is a Technical Article available on ACCA's website, called 'Investment appraisal and real options'.
We recommend you read this article as part of your preparation for the AFM exam.

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5: International investment and financing decisions

Chapter summary

Maximisation of
shareholder wealth

International investment
International financing
decisions
decisions

1 Motives for international

investment

4 Financing decision: managing

Company – eg economies of scale
risk of international investments
Country – eg cheap labour/grants
Customer – eg shorter lead times
Competition – eg weaker rivals
4.1 Types of international debt
finance
2 Investment decision: exchange
rate risk Foreign bank loan, eurobond, syndicated loan.

The risk that the present value of a company's future cash

flows might be reduced by exchange rate movements, eg 4.2 Use of international debt
a long-term decline in the value of the foreign finance in managing risk
currency after an investment has been made Economic risk
 Matching cash flows
2.1 Economic risk Political risk
 Reduce exposure to tax rises
Foreign currency may decline in value if Translation risk
foreign inflation is higher. Impact offset  Matching assets and liabilities
by impact on cash flow.

5 Financial strategy
2.2 PPP theory
Direct investment
or Acquisition
2.3 Other danger or Joint venture
signals

Weak economic growth,

government deficit, balance of
payments deficit.

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 3 Evaluating
international
investments

3.1 Basic approach

1 Forecast foreign cash flows

2 Forecast exchange rate
3 Adjust for local cash flows and
discount at local cost of capital

3.2 Complications

Foreign tax
The home country will usually only charge the company the
differential between the tax paid overseas and the tax
due in the home country.
Intercompany transactions
Companies may charge their overseas subsidiaries for royalties
and components supplied. Domestic tax may also be payable on
the profits from these transactions.
Exchange controls
Manage via transfer pricing, other charges and loans.

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5: International investment and financing decisions

Knowledge diagnostic

1. Purchasing power parity theory

Explains exchange rate movements by looking at inflation rate differentials.
2. Economic risk
Damage to market (present value created by long-term exchange rate movements. In the context
of international investment this means a weakening of the value of the foreign currency.
3. Eurobond (or international bond)
A bond issued in a currency outside the currency of origin.
4. Translation risk
Damage to book value of equity created by exchange rate movements. In the context of
international investment this means a weakening of the value of the foreign currency.
5. Syndicated loan
A loan put together by a group of lenders (a 'syndicate') for a single borrower.

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Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q8 Novoroast
Q9 PMU

Further reading
A practical, and amusing, example of purchasing power parity is the Big Mac index (Economist, 2018).
Under purchasing power parity, movements in countries' exchange rates should in the long term mean that
the prices of an identical basket of goods or services are equalised. The McDonald's Big Mac represents this
basket. The index compares local Big Mac prices with the price of Big Macs in America. This comparison
is used to forecast what exchange rates should be, and this is then compared with the actual exchange
rates to decide which currencies are over- and undervalued.
This index can be found here:
https://www.economist.com/news/2018/07/11/the-big-mac-index

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SKILLS CHECKPOINT 2

Analysing investment decisions

aging information
Man

aging information
Man
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Analysing er
investment pl
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an
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Exam success skills
Good

Addressing the investment

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scenario decisions

uirereq rpretation
Specific AFM skills

e m e nts
Applying risk

req of rprineteation
Identifying the
Eff p ect re

management
an Eff nd p

required numerical

m eunirts
e c re i v

techniques(s) techniques
d
ti v

e
se w ri of t inteect
a

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Thinking across
r re Co

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se w ri o n
nt tin al
Efficient numeric
Co

ati g
on analysis
l
Efficient numerica
analysis

Introduction
Analysing investments to select those which are most likely to benefit shareholders is probably
the most important activity for a senior financial adviser.
Section B of the AFM syllabus is 'advanced investment appraisal' and directly focusses on the
skill of 'analysing investment decisions'. The AFM exam will always contain a question
that have a focus on this syllabus area, so this skill is extremely important.
Analysis of investment decisions requires a sound knowledge of the techniques of investment
appraisal. This means that as well as being able to apply techniques numerically you need to be
able to discuss the reasons for applying them, the meaning of the numbers, its relevance to the
scenario (as discussed in Skills Checkpoint 1), and the limitations of the techniques.
It is also important to apply the relevant investment appraisal techniques in a practical, time-
efficient way in the exam, without attempting to achieve absolute 100% perfection. Not only is
this sensible exam technique but it also reflects that in reality, as well as in the exam,
quantitative techniques are expected to form part of a broader strategic analysis of investments
rather than (as was the case in exams earlier in your studies) providing an absolute answer
concerning the acceptability or otherwise of a proposed investment.
It is important to be aware that sometimes exam questions will not directly state which investment
appraisal techniques should be applied and you may have to use clues in the scenario of the
question to select an appropriate numerical technique; this issue is addressed in Skills
Checkpoint 3 in the Workbook.
The skill of 'analysing investment decisions' is also relevant when considering the acquisition of
another company; this will be covered later in the Workbook in syllabus Section D 'Acquisitions
and Mergers'.

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Skills Checkpoint 2: Analysing investment decisions

AFM Skill: Analysing investment decisions

The key steps in applying this skill are outlined below, and will be explained in more
detail in the following sections as the question 'Your Company' is answered. The
points already covered in Skills Checkpoint 1 are also relevant here.

STEP 1:
 Analyse the scenario and requirements.
 Consider why numerical information has
been provided.
 Make notes in the margins of the
question, especially of any areas of
uncertainty.
 Work out how many minutes you have
to answer each part of the question.
 Do not perform any detailed
calculations at this stage.

STEP 2:
 Plan your answer.
 Check that you are applying the correct
type of investment analysis.

STEP 3:
 Complete your numerical analysis.
 Once a number has been analysed, make
a note on the exam paper (eg by ticking
it) that the number has been dealt with.
 This will help to make it clear if you have
forgotten to analyse a section of the question.
 Be careful not to overrun on time with your
calculations (if you come to a calculation
that you can't do, you may need to make
a simplifying assumption and move on).

STEP 4:
 Explain your points using short punchy
paragraphs, and don't forget to conclude
on the meaning of your numerical analysis.

STEP 5:
 Write up your answer in a time efficient
manner.
 It is unlikely that you will have time to
correct errors at this stage.

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Skills Checkpoint 2

Tutorial note
These five general steps apply to all AFM questions, but here will be focused on the
skill of answering advanced investment appraisal questions, which normally have a
high level of numerical content.

Exam success skills

The following question is an extract from a past exam question; this extract was worth
approximately 15 marks.
For this question, we will also focus on the following exam success skills:
 Managing information. It is easy for the amount of information contained in
scenario-based questions to feel over-whelming. Active reading is a useful
technique to use to avoid this. This involves focusing on the requirement first, on
the basis that until you have done this the detail in the question will have little
meaning.
This is especially important in investment appraisal questions where there is
likely to be a high level of numerical content and questions can be very
confusing to read through unless you first have a clear idea of the nature of the
required analysis.
 Correct interpretation of requirements. At first glance, it looks like the
following question just contains one requirement. However, on closer
examination you will discover that it contains three.
 Efficient numerical analysis. The key to success here is applying a sensible
proforma for typical investment appraisal calculations, backed up by clear,
referenced, workings wherever needed.
 Effective writing and presentation. Underline key numbers. Make sure
that your numerical analysis is supported by an appropriate level of written
narrative. It is often helpful to use key words from the requirement as headings
in your answer as you do this.
 Good time management. Complete all tasks in the time available.

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Skill activity

STEP 1 Look at the mark allocation of the following question and work out
how many minutes you have to analyse and plan your answer to the
question. Before you start your calculations it is important to realise
that the numbers that have been provided are flawed and therefore do
not need to be accepted as being correct (although some will be). Do
not perform any calculations until you have carefully read the scenario
in full.
Make notes in the margins of the question, especially of any areas of
uncertainty. Work out how many minutes you have to answer each
part of the question.

Requirement
Prepare a corrected project evaluation using the net present value technique supported
by a separate assessment of the sensitivity of the project to a $1 million change in the
initial capital expenditure. Recommend whether the project should be accepted.
(15 marks)
This is a 15-mark question and at 1.95 minutes a mark, it should take 29 minutes.
On the basis of spending approximately 20% of your time reading and planning, this
time should be split approximately as follows:
 Reading and planning time – 6 minutes
 Performing the calculations and writing up your answer – 23 minutes
You can now see from the requirement that there are errors in the scenario and you
can look for them (noting any possible errors or areas of uncertainty in the margin to
the question).

Question – Your Company (15 marks)

You have been conducting a detailed review of an investment project proposed by
one of the divisions of your business. Your review has two aims: first to correct the
proposal for any errors of principle, and second, to recommend whether or not the
project should proceed when it is presented to the company's board of directors for
approval.
The company's current weighted average cost of capital is 10% per annum.
The initial capital investment is for $150 million followed by $50 million one year
later. The other post-tax cash flows, for this project, in $ million, including the
estimated tax benefit from tax allowable depreciation for tax purposes, are as follows:
Unusually there are
Year 0 1 2 3 4 5 6
two phases of capital
Capital investment investment, which
(plant and machinery): –127.50 impacts on tax
allowable
First phase
depreciation

Second phase –36.88

Project post-tax cash flow 44.00 68.00 60.00 35.00 20.00
($ million)

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Skills Checkpoint 2

Company tax is charged at 30% and is paid/recovered in the year in which the
TAD calculations
liability is incurred. The company has sufficient profits elsewhere to recover tax assumed to be
allowable depreciation on this project, in full, in the year they are incurred. All the correct already?
capital investment is eligible for a first year allowance for tax purposes of 50%
followed by tax allowable depreciation of 25% per annum on a
reducing balance basis.
You notice the following points when conducting your review:
1 An interest charge of 8% per annum on a proposed $50 million loan has
Treatment of interest
been included in the project's post-tax cash flow before tax has been and depreciation looks
calculated. wrong

2 Depreciation for the use of company shared assets of $4 million per annum
has been charged in calculating the project post-tax cash flow.
Are these cash flows or
3 Activity based allocations of company indirect costs of $8 million have been not – not clear, state
assumption?
included in the project's post-tax cash flow. However, additional corporate
infrastructure costs of $4 million per annum have been ignored which you
discover would only be incurred if the project proceeds.
4 It is expected that the capital equipment will be written off and disposed of at
the end of Year 6. The proceeds of the sale of the capital equipment are
expected to be $7 million which have been included in the forecast of the
project's post-tax cash flow. You also notice that an estimate for site clearance
of $5 million has not been included nor any tax saving recognised on the
unclaimed tax allowable depreciation on the disposal of the capital
equipment.
Only the unclaimed
TAD to be calculated?

STEP 2 Read the requirement again. Highlight each sub-requirement, check

that you are applying the correct type of investment analysis.

Required

Verb – see ACCA

definition below Required technique 1
Verb – see ACCA
definition below

Prepare a corrected project evaluation using the net present value technique supported
by a separate assessment of the sensitivity of the project to a $1 million change in the
initial capital expenditure. Recommend whether the project should be accepted.
(15 marks)
Required technique 2
Third part to the requirement

The first key action verb is 'prepare'. This requires a synthesis of the issues to create a
corrected analysis.
Here, you need to produce a revised NPV and a sensitivity analysis.

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The second action verb is 'recommend'. This is asking you to express an opinion,
explaining and justifying the basis for this opinion.
Here, this should draw on your previous analysis of NPV and sensitivity for your
justification.

STEP 3 Now complete your workings and numerical analysis. Be careful not
to overrun on time with your calculations.
Note that this may mean accepting that it may not be possible to
complete a perfect analysis in the time, as discussed below.
As already noted, performing the calculations and writing up your
answer should take 23 minutes

Workings
(1) Calculation of unclaimed balancing allowance in time 6
Time 0 1 2 3 4 5 6

$m $m $m $m $m $m $m

New
investment 150.00 50.00

First-year
allowance
(50%) (75.00) (25.00)

Written-down
value (start
of year) 75.00 81.25 60.94 45.70 34.27 25.70

TAD (25%) (18.75) (20.31) (15.24) (11.43) (8.57) (6.43)

Written-down
value (end
year) 75.00 81.25 60.94 45.70 34.27 25.70 19.27

Scrap (7.00)

Balancing
allowance 12.27

Tax saved
30% 3.68

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Skills Checkpoint 2

(2) Impact of extra $1m capital expenditure on the tax saved on TAD.
Time 0 1 2 3 4 5 6
$m $m $m $m $m $m $m
You may run out
of time – in which Written-down
case these value (start
relatively
immaterial year) 1.00 0.50 0.37 0.28 0.21 0.16 0.12
calculations may FYA (50%) (0.50)
need to be
sacrificed (they TAD (25%) (0.13) (0.09) (0.07) (0.05) (0.04) (0.03)
will only be worth
a couple of marks)
Balance 0.05 0.37 0.28 0.21 0.16 0.12 0.09

Scrap 0.00
Simple calculations
can be referred to in Balancing
a notes column if you
allowance 0.09
prefer not to have a
separate working. Tax saved
Alternatively they can
be mentioned as
on TAD at
narrative points 30% 0.150 0.039 0.027 0.021 0.015 0.012 0.009
(see later)
Tax saved on
Also assumptions and balancing
workings can be allowance 0.027
referred to here.
Investment (1.000)
Impact on
cash flow (0.850) 0.039 0.027 0.021 0.015 0.012 0.036

Corrected project evaluation

Year 0 1 2 3 4 5 6 Notes
$m $m $m $m $m $m $m
Project (127.50) (36.88) 44.00 68.00 60.00 35.00 20.00
net interest 50m
2.80 2.80 2.80 2.80 2.80 8% (1–t)
Depreciation
net of tax 2.80 2.80 2.80 2.80 2.80 4m (1–t)
Indirect costs 8m (1–t)
5.60 5.60 5.60 5.60 5.60 assumed
not cash
flows
Add benefit
from
balancing
allowance
(W1) 3.68 Working 1
Site
clearance
costs (3.50)
Infrastructure
costs (2.80) (2.80) (2.80) (2.80) (2.80) 4m (1–t)
Revised
cash flows (127.50) (36.88) 52.40 76.40 68.40 43.40 28.58
Discount
factor 10% 1.000 0.909 0.826 0.751 0.683 0.621 0.564
DCF (127.500) (33.520) 43.280 57.380 46.710 26.950 16.120

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 NPV = $29.42m
Sensitivity analysis of project to a $1m increase in initial capital
expenditure
Extra capital expenditure will affect not only the cash outflow of the project but
also the tax allowable depreciation.
Year 0 1 2 3 4 5 6 Notes
$m $m $m $m $m $m $m
Impact on
cash flow (0.85) 0.039 0.027 0.021 0.015 0.012 0.036 Working 2
DCF at 10% (0.85) 0.0355 0.0223 0.0158 0.0102 0.0075 0.0203

Net impact on NPV = $(0.738)m

STEP 4 Write up your answer using key words from the requirements as
headings.
Explain the meaning of your numbers and ensure that your
recommendations are justified.

Narrative element to the solution

Use sub-headings
Corrected project evaluation Explain your approach
from the requirement where relevant.
Errors of principle:
(a) Interest should not be included as this is already accounted for in
the discount rate. The annual interest charge of $4 million (less
tax of 30%) should be added back to the cash flow in each year.

(b) Depreciation is not a cash flow and should be ignored in NPV

calculations. The annual charge of $4 million (less tax at 30%)
should be added back to the cash flow in each year.
(c) Indirect allocated costs are assumed not to be incremental cash
flows and are therefore not relevant. These should be added back
to the annual cash flows (net of tax). However, corporate
infrastructure costs are relevant to the project and should have
been included. These costs should be deducted from annual cash
flow figures (net of tax), as should the estimates for site clearance.
(iv) Balancing allowances in Year 6 should be included.
Sensitivity analysis
The net impact shown of $(0.738)m shows the impact of spending an This is explaining why
extra $1m on this project. This means that for the project NPV of this matters in this
scenario – which is the
$29.42m to fall to zero the investment would have to increase by key skill that we are
29.42/0.738 = approximately $40m. This is a large increase on the looking at.
initial forecast spending of $150m and indicates that the project is not
sensitive to this assumption.
Recommendation on capital investment project
On the basis that the project NPV is positive the project achieves a
Use short paragraphs,
return in excess of the required return of 10%. The positive NPV,
explain the meaning of combined with the lack of sensitivity to the forecast initial expenditure, Recommendations need a
your numbers means that the project can be recommended for acceptance on justification
financial grounds.

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Skills Checkpoint 2

Other points to note:

 This is a comprehensive, detailed answer. You could still have
scored a strong pass with a shorter answer as long as it
addressed all aspects to the question.
 All sub-requirements have been addressed, each with their own
heading.

STEP 5 Write your answer in a time-efficient manner. As 20% of your time has
been used for analysis this means that when you are writing the 1.95
minutes per mark becomes 1.95 0.8 = 1.56 minutes per mark of
writing time.
As you write your answer you are likely to identify errors. When this
happens, it is generally advisable to move on and accept that your
answer is not perfect. This is because the AFM exam is extremely time
pressured and the time you spend on correcting your errors can put
you under exam time pressure later in the exam.
It is best to briefly identify any drawbacks in your answer as part of
your narrative in your answer, but you should keep this brief.

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been
completed below for the 'Your Company' activity to give you an idea of how to complete the
diagnostic.

Exam success skills Your reflections/observations

Managing information Did you read the requirements first so that you understood
that the numbers provide in the question were incorrect,
before reading the scenario?

Correct interpretation Did you understand what was meant by the verb
of requirements 'recommend'?
Did you spot the three aspects to the requirements?

Efficient numerical Did you spend too much time on relatively unimportant parts
analysis of the question?
Did your answer present a neat NPV in a proforma that
would have been easy for a marker to follow?

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Exam success skills Your reflections/observations

Effective writing and Did you use headings (key words from requirements)?
presentation
Did you use full sentences?
Did you explain the meaning of the numbers?

Good time Did you allow yourself time to address all sub-requirements?
management

Most important action points to apply to your next question

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Skills Checkpoint 2

Summary
Each AFM exam will contain a question that focuses on investment appraisal.
This is an important area to revise and to ensure that you understand the variety of
techniques available (including their limitations). It is important that you can apply
techniques such as duration, modified internal rate of return and value at risk.
It is also important to be aware that in the exam, as in the real world,100% precision
is not expected in what is, after all, a forecasting exercise. In the exam you are
dealing with complicated calculations under timed exam conditions and time
management is absolutely crucial. You therefore need to ensure that you:
 Show clear workings and score well on the easier parts of the question
 Make a reasonable attempt at the harder calculations while accepting that
your answer is unlikely to be perfect
Remember that there are no optional questions in the AFM exam and that this syllabus
section (investment appraisal) will definitely be tested!

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Chapter summary

Cost of capital and changing

risk

1 Impact of debt finance 2 Investments that 3 Investments that

on the cost of capital change financial risk change business risk

3.1 Adjusting information

2.1 When NOT to use
1.1 M&M theory from a comparative
the WACC
quoted company
 Modigliani & Miller
Step 1 – ungear the cost of
– In a zero tax world, debt is
2.2 Adjusted present equity or equity beta relating
cheaper (lower risk) but its use
to the comparable company.
makes equity more expensive value (APV)
(higher financial risk) so the Step 2 – regear the cost of
WACC is unchanged. Step 1 – calculate the base case equity or asset beta with the
– With tax, debt brings the NPV as if ungeared using an capital structure to be used
benefit of tax savings and a asset beta or using the M&M in the new investment.
company should maximise formula for Ke.
Step 3 – use the cost of equity to
its use of debt finance to calculate a revised WACC to
Step 2 – add the PV of the tax
drive down its WACC. use in the appraisal of the project.
saved as a result of the debt &
 A lower WACC increases the benefit of subsidy (use Kd)
value of the company to its
investors Step 3 – subtract the cost of
issuing new finance 3.2 Drawbacks of
approach

1.2 Revised formula for 2.3 APV in an

Difficult to identify a
Ke international context
comparative company with
identical operating
characteristics to use as a
benchmark.

1.3 Drawbacks of M&M 2.4 Drawbacks of APV Technical flaws in the models
used (adjusting beta factors or
using M&M theory to adjust
 A key assumption of M&M theory is that capital markets
the cost of equity).
are perfect eg a company will always be able to raise finance to
fund good projects.

Capital market imperfections

Direct financial distress costs – managing the insolvency

process.
Indirect financial distress costs – costs of higher debt
payments, loss of sales/higher costs from suppliers.

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6: Cost of capital and changing risk

1.4 Static trade-off theory

The level of gearing that is appropriate for a

business depends on its specific business
context.

Mature, asset intensive, industries

tend to have high gearing because they
are at low risk of default and so financial
distress costs are likely to be outweighed by
the value of tax saved from interest payments

1.5 Other theories

Pecking order theory suggests the preferred order for

financing is: 1, retained earnings; 2, debt; 3, equity.
Agency theory. Equity finance facilitates the agency problem.

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Knowledge diagnostic

1. Modigliani and Miller theory with tax

In the absence of financial distress costs, the use of debt finance will drive down WACC and
increase value for investors.
2. Static trade-off theory
The level of gearing depends on the business context.
3. Current WACC is sometimes not appropriate as a cost of capital
If financial or business risk change.
4. APV
M&M technique: discount the project as if ungeared and adjust for financing effects separately.
5. Asset and equity betas
An asset beta is an ungeared beta, an equity beta is geared.
6. Change in business risk
Use a comparable company (if available) to act as a benchmark for risk of new business and
adjust for the impact of differences in gearing.

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6: Cost of capital and changing risk

Further study guidance

Question practice
Now try the question below from the Further question practice bank (available in the digital edition of the
Workbook):
Q10 Tampem

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 Chapter summary

Financing and credit risk

1 Credit risk and the 3 The credit risk 4 Impact of a change in

cost of debt premium credit rating

4.1 Impact of a new

2 Estimating the yield 3.1 Credit risk and the
debt issue on the
curve cost of debt
WACC

Using information about Yield curve + credit spread =  Impact of cost of new debt
government bonds with required yield (pre-tax).  Impact on cost and value of
different prices and maturities existing debt
to calculate the required yield
 Possible impact on cost of
in each year.
equity
3.2 Criteria for
establishing credit
ratings

4.2 Other impacts of a

Country, industry, management &
financial issues new debt issue

 Impact on ability to raise further

finance
 Impact on ability to pay dividends
 Impact on ability to make
investments

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7: Financing and credit risk

6 Sources of finance (1) 7 Sources of finance (2)

5 Duration of a bond – Islamic finance
– Initial coin offering
Restrictions over type of business
activity.

5.1 Calculation 6.1 What is an ICO? Prohibition on the payment of

interest

Weighted average number of Issue of tokens in exchange for

years over a which a bond cryptocurrency
7.1 Products based on
delivers its value
equity participation

6.2 Mechanism for an  Mudaraba

ICO  Musharaba (joint venture)
5.2 Modified duration  Sukuk bonds (tradeable)
If unregulated – a 'white paper'
Duration ÷ (1 + required yield) outlines detail of the venture and
provides a mechanism for
Measures price sensitivity of a payment. 7.2 Products based on
bond to a change in the required investment financing
return.
 Murabaha (trade credit)
Problem of convexity means that 6.3 Advantages of an
the impact of interest rate rises are  Ijara (leasing)
ICO
understated and impact of falls in  Salam (commodity sold for
the interest rate is overstated. Speed and ease of use future delivery)

 Istisna (instalment payments)

6.4 Disadvantages of an
ICO

Risk to issuer of regular

interference (if tokens are deemed
to be a security) Risk of money
laundering

Risk of value of cryptocurrency

falling

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7: Financing and credit risk

Knowledge diagnostic

1. Credit ratings
Determined by country, industry, management and financing factors.
2. Impact of worsening credit ratings
Worsening credit ratings will increase the cost of debt on new and existing debt (will also affect
the value of existing debt).
3. Duration of a bond
This shows the period of time over which a bond delivers its value. The higher duration is, the
greater the risk to the investor.
4. Modified duration
This shows the impact of a 1% change in interest rates on bond value.
5. Types of token or coin
Tokens can be investment, asset or utility tokens.
6. Islamic finance
Share risk and return between the entrepreneur and the finance provider.

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Further study guidance

Question practice
Now try the question below from the Further question practice bank (available in the digital edition of the
Workbook):
Q11 Levante

Further reading
There is a Technical Article available on ACCA's website, called 'Aspects of Islamic finance' which has
been written by a member of the AFM examining team.
Another useful Technical Article available on ACCA's website is called 'Bond valuation and bond yields',
again this has been written by a member of the AFM examining team.
We recommend that you read these articles as part of your preparation for the AFM exam.

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 Chapter summary

1 Overvaluation
1.1 Behavioural finance 1.2 Agency issues
problem

Overconfidence and confirmation Management self-interest

bias
Loss aversion
Entrapment Valuation for
Anchoring acquisitions and
mergers

2 Approaches to
business valuation

3 Asset-based models 4 Market-based models 5 Cash-based models

3.1 Net asset value 4.1 P/E method 5.1 Dividend basis

Ignores futures profits Earnings of target P/E

Ignores value of intangibles Constant growth model
ratio
Adapt to two phases of
P/E ratio may need
growth
adjusting
Most suitable for minority
Assumes efficient market
3.2 Book value 'plus' shareholders

Multiple of profit, or 4.2 Post-acquisition P/E

Valuation of intangibles 5.2 Free cash flows and
valuation
CIV values excess profits free cash flows to
using WACC, assumes no equity
Earnings of group P/E
growth
ratio
FCFE discounted at cost of
Subtract value of bidder = equity = value of equity
max price to pay
Or FCF discounted at WACC =
value of company
Subtract value of bidder +
Then subtract value of debt to
target = value created
obtain value of equity

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8: Valuation for acquisitions and mergers

5.3 Post-acquisition
cash flow valuation

Cash-based equity valuation

Subtract value of bidder =
max price to pay
6 Valuing start-ups: Or
Black–Scholes model Subtract value of bidder +
target = value created
Traditional valuation methods hard
to apply If business risk changes:
Calculate average asset beta
of target and bidder and
6.1 BSOP and company regear for post-acquisition
valuation gearing.

Values equity as a call option,

because there is an upside if the firm
is successful, but shareholders lose 5.4 Adjusted present
nothing other than their initial value
investment if it fails.
1 Value cash flows at
ungeared cost of equity.
2 Value tax saved on debt
6.2 BSOP and default risk at required return on
debt.
3 Adjust for issue costs.
If N(d2) is the probability that the call
option is in-the-money (ie the
company has not failed), then 1 –
N(d2) depicts the probability of
default.

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Knowledge diagnostic

1. Overvaluation problem
A significant problem in acquisitions, can be explained by behavioural or agency factors.
2. Calculated intangible values
This assesses the excess profits post-tax being made, and values these as a constant cash flow
using the company's WACC.
3. P/E ratio
This indicates the growth potential of a company.
4. Post-acquisition valuations
This approach is useful where the acquisition has an underlying impact on the growth or risk of
the bidding company (the acquirer).
5. Free cash flow
The cash flows available for all investors (whether equity or debt holders) ie before interest but
after tax.
6. Free cash flow to equity
The cash flows available for equity investors only, ie after interest and tax.

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8: Valuation for acquisitions and mergers

Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q12 Mercury Training
Q13 Kodiak Company

Further reading
There is a Technical Article on behavioural finance available on ACCA's website, called 'Patterns of
behaviour' which has been written by a member of the AFM examining team. This article was
recommended reading in Chapter 2, but if you have not had a chance to read it then please look
at it now.

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Chapter summary

Acquisitions: strategic issues and

regulation

1.1 Advantages and disadvantages of acquisition vs

internal development

Advantages: speed, synergies, acquisition of intangible assets

1 Growth strategy Disadvantages: acquisition premium, lack of control, integration
problems

1.2 Advantages and disadvantages of acquisition vs

joint venture

Advantages: reliability, autonomy

Disadvantages: cost and risk, access to overseas markets

2 Acquisition target 2.1 Types of synergy

 Sales synergy (eg share sales outlets)

 Cost synergy (eg share R&D)
 Financial synergy (eg lower risk, lower tax bill)

2.2 Working relationship

 Culture, strategy
 Due diligence (legal/financial, commercial)

Clash of cultures
3 Reasons for failure of
Uncertainty among staff
acquisitions
Customer uncertainty – fear of problems leads to a fall in sales
Assets or staff prove to be lower quality than expected
Paying too high a price for the target – empire building
Risk can be managed by a clear integration strategy and by due diligence

4 Reverse takeovers 4.1 Advantages and disadvantages of reverse takeover

vs IPO

A smaller quoted company (S Co) takes over a larger

unquoted company (L Co) by a share for share exchange.

A reverse takeover is a route to a stock market listing. An IPO

has a number of advantages compared to an IPO:

Speed – a reverse takeover can be completed in a few months

Cost – a reverse takeover will have significantly lower issue costs

Availability – it may be difficult attract investors to an IPO

In addition a reverse takeover results in two companies combining

together, with the possibility of synergies.

As a route to obtaining a stock market listing, drawbacks include:

risk (the listed company being used may have some hidden
liabilities), lack of expertise – running a listed company requires
an understanding of compliance procedures.

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9: Acquisitions: strategic issues and regulation

5 Regulation of
takeovers

A bid announcement is required if the offeree company is the subject

5.1 UK regulation – of speculation due to the bidding company's actions. The bidding company
the City Code will be forced to state whether an offer is being considered, within 28 days,
if a firm bid is not made then the bidding company will have to wait six
months before it can make another bid.
(a) Where a bid involves an element of cash, the bidding company
must obtain confirmation by a third party that it can obtain
these resources.
(b) An offer must be made for all other shares if the % shareholding rises
above 30%, at not less than the highest price paid by the
bidding company in last year.
(c) After a formal offer there is a 14 day deadline for the defence document
to be published, a 46 day deadline for the offer to be improved and
finalised, and a 81 day deadline for shareholder votes to be assessed
and the result announced. Offers are normally conditional on
more than 50% of the shares being secured.
(d) If a bid fails, the bidder cannot make another bid for
another 12 months.

 The mandatory-bid rule – aims to protect minority shareholders

5.2 EU Takeovers by providing them with the opportunity to exit the company at a fair
Directive price once the bidder has accumulated a certain percentage of the
shares. In the UK, this threshold is specified by the City Code for
Takeovers and Mergers and is at 30%.
Once the bidder obtains control they may exploit their position at the
expense of minority shareholders. This is why the mandatory-bid rule
normally also specifies the price that is to be paid for the shares.
 The principle of equal treatment – requires the bidder to offer
to minority shareholders the same terms as those offered to earlier
shareholders from whom the controlling block was acquired.
 Squeeze-out rights – give the bidder who has acquired a specific
percentage of the equity (usually 90%) the right to force minority
shareholders to sell their shares. Enables the bidder to acquire 100%
of the equity once the threshold percentage has been reached and
eliminates potential problems that could be caused by minority
shareholders.

5.3 Regulation of Regulated by national (eg CMA) or supranational authorities

large takeovers (eg EU)

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 6 Defence against a 6.1 Post-bid strategies
takeover
Where the board feels that a takeover is not in its shareholders' best
interest it may decide to launch a defence against the bid. This can
include:
(a) White knights
(b) Crown jewels
(c) Litigation/regulation

6.2 Pre-bid strategies

Poison pills and golden parachutes

May not be permitted by local takeover panel rules

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9: Acquisitions: strategic issues and regulation

Knowledge diagnostic

1. Alternative growth strategies other than acquisition

Joint venture and internal development (organic growth).
2. Types of synergy
Three types: revenue, cost, financial.
3. Reverse takeover
The takeover of a small listed company by a larger unlisted company using a share for share
exchange.
4. EU Takeovers Directive
Key points include the mandatory bid rule, the principle of equal treatment and squeeze-out
rights.
5. Pre-bid defences
These deter a bid in the first place.
6. Post-bid defences
These are used after a bid has been received.

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Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q14 Saturn Systems
Q15 Gasco

Further reading
There is a Technical Article available on ACCA's website, called 'Reverse Takeovers'.
We recommend you read this article as part of your preparation for the AFM exam.

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10: Financing acquisitions and mergers

Chapter summary

Financing acquisitions and

mergers

1 Method 1: Cash offer 2 Method 2: Paper offer 4 Impact on acquirer

1.1 Financing a cash 2.1 Impact of a paper 4.1 Impact on earnings

offer offer

This is a gearing decision and Uncertain value You may also be asked to
has been covered in earlier chapters Control issues evaluate the impact of a
– note that a cash offer/bid does given offer on earnings and
Gearing reduced
not necessarily mean that any key ratios such as EPS.
Risk shared
extra borrowing takes place.

4.2 Impact on
1.2 Impact of cash bid 2.2 Mixed offer
statement of
financial position

Definite value It is not uncommon for an This may need to be

Few control issues acquisition to be financed by analysed using ratio
a mixture of cash and analysis.
Gearing may increase
shares.
Tax issue for target
Risk borne by bidder

3 Evaluating an offer

3.1 Cash offer A cash bid can simply be compared against the current
market value of the target company or against an estimated
value of an acquisition using the techniques covered in
Chapter 8.

3.2 Paper/mixed This may require a post-acquisition valuation (using

offer earnings or cash flow) following which you may need to:
1 Deduct the cash element of the bid (if any) and
then divide by the new number of shares in issue
to calculate a post-acquisition share price.

2 Deduct the value of whole bid to see if value is

created for the bidding company's
shareholders.

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Knowledge diagnostic

1. Cash offer
Often cheaper because more attractive to target shareholders.
2. Paper offer
Impacts on control of bidding company.
3. Mixed offer
May combine the advantages of cash (certainty) and paper (cash flow).
4. Post-acquisition valuation
Especially important if evaluating a paper offer.
5. Impact of higher P/E of bidder
If this is higher than the implied P/E of the offer, EPS will rise and shareholder wealth may also
rise.
6. Goodwill
This will result from an acquisition at above the value of the net assets of the target.

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10: Financing acquisitions and mergers

Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q16 Pursuit
Q17 Olivine

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SKILLS CHECKPOINT 3
Identifying the required numerical
technique(s)
aging information
Man

aging information
Man
An
sw
er
pl
t
en
manag ime

an
em

Analysing
t

nin
Exam success skills
Good

Addressing the investment

g
scenario decisions

uirereq rpretation
Identifying the
required numerical
Specific AFM skills

e m e nts
techniques(s) Applying risk

req of rprineteation
Identifying the
Eff p ect re

management
an Eff nd p

required numerical

m eunirts
e c re i v

techniques(s) techniques
d
ti v

e
se w ri of t inteect
a

nt tin
c rr
Thinking across
r re Co

e ati g the syllabus

se w ri o n
nt tin al
Efficient numeric
Co

ati g
on analysis
l
Efficient numerica
analysis

Introduction
It is important to be aware that sometimes exam questions will not directly state which numerical
techniques should be used and you may have to use clues in the scenario of the question to
select an appropriate technique.
The reason that the need to use a specific technique is not always made clear is not due to
poorly worded exam questions – it is a deliberate test of your skill as appropriate for an exam
that is positioned as a Masters-level qualification.

This issue commonly arises in syllabus Section C, Acquisitions and Mergers. Often you will need
to assess from the scenario what type of valuation is required and what techniques can be used
given the details that are provided in the scenario. This issue is also common in syllabus
Section D, Corporate Reconstruction and Reorganisation, because this often requires valuation
techniques to be used as well.
In syllabus Section B, investment appraisal questions will also sometimes be formulated so that
you will have to infer that specific techniques (such as real options or adjusted present value) are
required ie the question may not always specifically tell you to use these techniques.
Having identified the required technique, it is also important to apply it in a practical, time-
efficient way, without attempting to achieve absolute 100% perfection; this skill has been
addressed in Skills Checkpoint 2.

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Skills Checkpoint 3: Identifying the required numerical
technique(s)

AFM Skill: Identifying the required numerical technique(s)

The key steps in applying this skill are outlined below, and will be explained in more
detail in the following sections as the question 'Mercury Training' is answered.

STEP 1:
Where a question does not make it
clear that a specific technique is to be
used, carefully analyse the
requirement and consider which
techniques could potentially be
employed to deliver a relevant
answer.

STEP 2:
Next, carefully analyse the scenario and
consider why numerical information has been
provided and which of the techniques that
you have identified in step 1 can be used
given this information. Make notes in the
margins of the question. Do not rush into
performing detailed calculations.

STEP 3:
Complete your numerical analysis.

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Skills Checkpoint 3

Exam success skills

The following question is an extract from a past exam question; this extract was worth
approximately 18 marks.
For this question, we will also focus on the following exam success skills:
 Managing information. It is easy for the amount of information contained in
scenario-based questions to feel overwhelming. In the AFM exam, each question
will be scenario based. It is therefore essential to focus on developing a clear
understanding of the scenario before moving into any calculations.
 Correct interpretation of requirements. In part (b) the word 'advice'
requires suggestions, so narrative as well as calculations.
 Efficient numerical analysis. The key to success here is to provide clear,
explained workings.
 Effective writing and presentation. Underline key numbers. Make sure
that your numerical analysis is supported by an appropriate level of written
narrative. It is often helpful to use key words from the requirement as headings
in your answer as you do this.

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Skill activity

STEP 1 Where a question does not make it clear that a specific technique is to
be used, carefully analyse the requirement and consider which
techniques could be employed to deliver a relevant answer.

Required

(a) Estimate the cost of equity capital and the weighted average cost of capital
for Mercury Training.
(8 marks)

(b) Advise the owners of Mercury Training on a range of likely issue prices for
the company. (10 marks)

(Total = 18 marks)

To some extent part (a) of this question makes it clear which techniques should be
used, although there is more than one way to calculate the cost of equity. So in part
(a) we may need to calculate the cost of equity using:
 The capital asset pricing model
 The dividend growth model, or
 Modigliani & Miller's formula for the cost of equity (as shown on the formula
sheet)
In part (b) no specific techniques are suggested. However, you will be aware from
your studies that there are a range of techniques that could be used to value a
company, including:
 Asset-based models (eg NAV, CIV)
 Market-based models (eg using P/E ratios)
 Cash-based models (eg dividend valuation, free cash flow approach, free
cash flow to equity approach, adjusted present value)
Now we need to consider whether we have what information is available in the
scenario to see which models can be applied here.

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Skills Checkpoint 3

STEP 2 Next, carefully analyse the scenario and consider why numerical
information has been provided and which of the techniques
identified in Step 1 can be used given this information. Make notes
in the margins of the question. Do not rush into performing detailed
calculations.
Mercury is unlisted and
therefore does not have
a beta factor
Question – Mercury Training (18 marks)
Mercury Training was established in 20W9 and since that time it has
developed rapidly. The directors are considering a flotation of the
company.

The company provides training for companies in the computer and

telecommunications sectors. It offers a variety of courses ranging
from short intensive courses in office software to high

1/3 of Mercury's level risk management courses using advanced modelling

business is financial
services so the techniques. Mercury employs a number of in-house experts who
remaining 2/3 is
training. Weightings provide technical materials and other support for the teams that
for an average beta?
service individual client requirements.

In recent years, Mercury has diversified into the financial

services sector and now also provides computer simulation
systems to companies for valuing acquisitions. This business
Needed for an asset
now accounts for one-third of the company's total revenue.
beta for the training
part of the business?
Mercury currently has 10 million, 50c shares in issue.

Jupiter is one of the few competitors in Mercury's line of

business. However, Jupiter is only involved in the training business.

Jupiter is listed on a small company investment market and has an

estimated beta of 1.5. Jupiter has 50 million shares in issue with a
Needed for an asset
market price of 580c. beta for the financial
services part of the
business?
The average beta for the financial services sector is 0.9. Average
market gearing (debt to total market value) in the financial services
sector is estimated at 25%.

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 Needed for
ungearing and
Other summary statistics for both companies for the year ended regearing betas?
Data supports the
calculation of an asset
31 December 20X7 are as follows:
based valuation and
Mercury Jupiter
also a dividend based
valuation of Mercury in Net assets at book value ($ million) 65 45
part (b). Earnings per share (c) 100 50
Dividend per share (c) 25 25
No information on P/E
ratios or cash flow is Gearing (debt to total market value) 30% 12%
given so an earnings Five-year historic earnings growth (annual) 12% 8%
valuation and a cash
flow valuation are not Analysts forecast revenue growth in the training side of Mercury's
possible.
business to be 6% per annum, but the financial services sector is
expected to grow at just 4%. Data permits the use of
the CAPM as it
Background information: identifies the risk
premium and the risk
 The equity risk premium is 3.5% and the rate of return on short-dated free rate
Also helps to identify
government stock is 4.5%.
the cost of debt to allow
 Both companies can raise debt at 2.5% above the risk-free rate. a WACC to be
 Tax on corporate profits is 40%. calculated in part (a)

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Skills Checkpoint 3

Use headings to briefly

STEP 3 Now complete your workings and numerical analysis.
explain your approach
to the marker

(a) Cost of equity using an average beta factor Assuming that the debt
beta is zero for
Step 1 – Ungear beta of Jupiter and financial services sector simplicity and speed of
calculation
Ve
a
= g Using beta factors and
Ve + Vd (1– T)
gearing from the
question
88
Jupiter = 1.5 = 1.3866
88 + (12 0.6)

75
Financial Services sector = 0.9 = 0.75
75 + (25 0.6)

Step 2 – Calculate average asset beta for Mercury Using the weightings given
in the question.

a = (2/3 1.3866) + (1/3 0.75) = 1.1744

Step 3 – Regear Mercury's beta Regearing using Mercury's

gearing as given
Ve
a
= a
Ve + Vd (1– T)
70
1.1744 = e
70 + 30(1– 0.4)

1.1744 = e
0.795

e
= 1.48

Step 4 – Calculate cost of equity capital and WACC

Using CAPM:

Cost of equity capital = Rf + (E(rm) – Rf) = 4.5 + (1.48

i
3.5)
= 9.68%

Ve Vd
WACC = k + kd (1 – T)
Ve + Vd e Ve + Vd

= (0.7 0.0968) + (0.3 [0.045 + 0.025] 0.6)

= 8.04%

Where kd = risk-free rate (4.5%) + premium on risk-free rate (2.5%)

(b) Range of likely issue prices

Lower range of issue price for Mercury will be the net assets at
fair value divided by the number of shares
= $65 million/10 million shares Using information
provided and
= $6.50 per share explaining meaning

This value ignores the value of Mercury's intangible assets (such

as its reputation and its employee skills and customer reputation.
As such it is likely to be the lower end of the range in terms of
Mercury's value.

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 Upper range – use dividend valuation model
Two possible earnings rates:
Historical earnings growth
rate of 12% is greater than
(a) The weighted anticipated growth rate of the two
the cost of equity capital,
therefore cannot be used in business sectors in which Mercury operates (2/3 6%) +
The mark allocation
the dividend valuation (1/3 4% = 5.33%)
model and cannot be implies that more
work is required
sustained in the long run. (b) The rate implied from the firm's reinvestment
here & so the br
(9.68% – see part (a) Step 4 above) model can be used
A weighted average
approach must therefore be to estimate growth
b = balance of earnings reinvested = (100-25)/100 = 75% or 0.75
used.
g = bre = 0.75 0.0968 = 7.26%

Using the higher of the two feasible rates – that is, 7.26%:
d0 (1 + g)
P0 =
(k e – g)

25(1 + 0.0726)
P0 = = $11.08 per share
(0.0968 – 0.0726)

Using the lower of the two feasible rates – that is, 5.34%:
d0 (1 + g)
P0 =
(k e – g)

25(1 + 0.0533)
P0 = = $6.05 per share
(0.0968 – 0.0533)

Assuming that the growth calculated by using Mercury's own data

is more reliable and relevant than the sector average growth data,
the higher of the two feasible rates – that is, 7.26% – will be more
relevant in terms of valuing Mercury. In addition, the value of
$6.05 does not look sensible as this is below the asset value
calculated earlier.
If floated, a price even above $11.08 (which is based on a
minority shareholding earning a dividend from the shares) could be
achieved. Investors are likely to be willing to pay a premium for
the benefits of control (control premium) – often as much as
30%–50% of the share price.

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Skills Checkpoint 3

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been
completed below for this activity to give you an idea of how to complete the diagnostic.

Exam success skills Your reflections/observations

Managing information Did you spend sufficient time reading the scenario and
planning your approach before starting your calculations?

Correct interpretation Did you understand what was meant by the verb 'advise'?
of requirements
ie suggestions on the meaning and reliability of the numbers

Efficient numerical Did you show your workings and add brief narrative to
analysis explain your approach to the marker (see steps in part (a)
solution)?

Effective writing and Did you use headings (key words from requirements)?
presentation
Did you use full sentences?
Did you explain the meaning of the numbers?

Most important action points to apply to your next question

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Summary
AFM is positioned as a Masters level exam. One of the skills that is required at this
level of your studies is the ability to identify the techniques required to analyse a
problem.
To test this skill, exam questions will sometimes not directly state which numerical
techniques should be used and you may have to use clues in the scenario of the
question to select an appropriate numerical technique.
This issue commonly arises in syllabus Section C, Acquisitions and Mergers where you
will often need to:
 Assess from the scenario what type of valuation is required, and
 What techniques can be used given the details that are provided in the
scenario
This issue is also common in syllabus Section D, Corporate Reconstruction and
Reorganisation, because this often requires valuation techniques to be used as well.
In syllabus Section B, advanced investment appraisal, questions will also sometimes be
formulated so that you will have to infer that specific techniques are required by
presenting you with information that allows these techniques to be used. For example,
 Real options can only be valued if a standard deviation value is provided, so
if a question contains standard deviation this is a clue that real options need
to be valued.
 Stage 1 of adjusted present value discounts a project at an all-equity financed
rate, so if a question states that a project should be discounted at an all-equity
financed rate this is a clue that adjusted present value should be calculated.

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 Chapter summary

The role of the treasury function

1 Treasury management 2 Treasury organisation 3 Managing risk –

using options

1.1 Liquidity management 2.1 Degree of 3.1 Managing the risk

centralisation of a fall in share
This is the short-term management of values
cash to ensure that a company has
access to the cash that it needs in a Centralise for economies of Buy put options to hedge this
cost-efficient manner (eg netting scale, matching, expertise, risk. Value using BSOP model.
inter-company transactions into a single netting, control.
currency). Decentralise for controllability 3.2 Delta
and local knowledge.
Delta is N(–d1) for a put option.
1.2 Risk management Regional hubs are a halfway
house. Delta measures how much an
This involves understanding and option's value changes as
quantifying the risks faced by a the underlying asset value
company, and deciding whether or changes.
not to manage the risk. This is an
Value between –1 and +1
important area and has been
covered in Section 3 of Chapter 2. Defines the hedge ratio.

1.3 Corporate finance 3.3 Gamma

This is the examination of a

Gamma measures how much
company's investment strategies.
delta changes with the
underlying asset value.
1.4 Funding
The highest gamma values are
This involves deciding on suitable when a call or put option is at-
forms of finance (and by implication the-money.
the level of dividend paid).
3.4 Other 'greeks'

Theta (time)
Vega (volatility)
Rho (rate of interest)

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11: The role of the treasury function

Knowledge diagnostic

1. Treasury management
Involves the management of liquidity, risk, funding and corporate finance.
2. Netting
Netting involves identifying amounts owed between subsidiaries of a company in different
foreign currencies. All foreign currency transactions are converted to a single common currency
and netted-off; reduces transaction fees and the time and cost of hedging inter-company
transactions.
3. Centralisation
This allows development of expertise, and for techniques such as matching and netting to be
applied.
4. Delta hedge
A delta hedge defines the number of options required.
For example the number of share options required = number of shares ÷ delta.
5. Gamma
Measure the impact of a change in delta of the underlying asset value.
6. Other 'greeks'
Other influences on option value include time (theta), interest rates (rho) and volatility (vega).

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Further study guidance

Question practice
Now complete try the questions below from the Further question practice bank (available in the digital
edition of the Workbook):
Q18 Treasury management
Q19 For4fore

Further reading
In Chapter 3 we recommended a useful Technical Article available on ACCA's website is called 'Risk
Management'. This article examines the potential for risk management to 'add value' and is written by a
member of the AFM examining team.
If you have not yet read this, we recommend you read it as part of your preparation for the AFM exam.

Research exercise
Use an internet search engine to identify treasury practices by searching for a company's annual report
and searching for treasury management within this. For example, Britvic's annual report is interesting, but
choose any company you are familiar with or are interested in.
There is no solution to this exercise.

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 Chapter summary
Managing currency risk

1.1 Transaction risk 1 Currency quotations 1.2 Terminology

Risk of exchange rate movements Company will be offered the worst

damaging the value of foreign part of the spread.
currency transactions. Indirect and direct quotes.

2 Brought-forward 3 Currency futures 4 Currency options

knowledge

3.1 Overview 4.1 OTC options

2.1 Internal methods
Aims to fix the exchange rate Optional but fixed date

For example, matching and netting Notional agreement

Pays compensation if losses are
4.2 Exchange traded
made on actual transactions
options
2.2 Forward contracts
Standard amounts, flexible dates
3.2 Features of futures
Over-the-counter agreement, fixed date
contracts
and rate
Flexible dates 4.3 Exchange traded
option quotations
Limited range of currencies
2.3 Money market hedging
Standard amounts
Prices quoted as cents per unit
Exchange traded, lower of contract currency
Borrowing in foreign currency to default risk
manage foreign currency
receivables
4.4 Steps in exchange
Investing in a foreign currency
3.3 Steps in a futures traded options hedge
manage foreign payables
hedge
1 Set up type, number and date of 1 Set up type, number and
futures contracts date of options contracts
2 Actual transaction at spot rate 2 Actual transaction at spot
rate or option
3 Close out future and net off
3 Net off including premium,
shortfall/surplus

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12: Managing currency risk

3.4 Ticks

Smallest movement in a
futures rate

3.5 Forecasting the

futures exchange rate

Using basis (futures rate – spot rate)

Basis risk.

3.6 Short-cut approach

to futures calculations
Opening futures rate – closing basis

3.7 Margins and

marking to market

Initial deposit
Variation margin
Maintenance margin

3.8 Advantages and

disadvantages of
futures

Flexible dates
Limited range of currencies, margins

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Knowledge diagnostic

1. Direct quote
This means that an exchange rate is quoted to one unit of the foreign currency.
2. Indirect quote
This means that an exchange rate is quoted to one unit of the domestic currency.
3. Basis
The difference between the future and the spot rate. This is used to forecast the closing futures
rate on the assumption that basis decreases in a linear way over time.
4. Basis risk
This is the risk that basis does not decrease in a linear way over time.
5. OTC options
Fixed-date options offered by banks.
6. Exchange-traded options
Flexible dates, offered by exchanges.

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12: Managing currency risk

Further study guidance

Question practice
Now complete try the questions below from the Further question practice bank (available in the digital
edition of the Workbook):
Q20 Fidden plc
Q21 Curropt plc

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13: Managing interest rate risk

Chapter summary

Managing interest rate risk

1 Interest rate risk

Both for borrowers and investors

Smoothing is a simple method
Risk on planned transactions is harder
to manage

2 Forward rate 3 Interest rate futures – 4 Interest rate options –

agreements – fixing the interest rate cap the interest rate
fixing the rate

Notional OTC agreement Standardised three-month agreements

Fixes the interest rate
4.1 Exchange-traded
interest rate options
3.1 Types of futures
Standard amounts, flexible dates
contracts

Borrower: contract to sell

Investor: contract to buy 4.2 Steps in exchange-
traded interest options
hedge
3.2 Quotation of futures
1 Set up type, number and
Interest rate = 100 – quoted price date of options contracts and
premium
2 Actual transaction at spot
3.3 Steps in a futures rate or option
'hedge' 3 Net off including premium,
assess whether to exercise
1 Set up type, number (adjust for
three-month contracts) and date
of futures contracts
4.3 Advantages and
2 Actual transaction at spot rate
disadvantages of
3 Close out future and net off exchange-traded
interest rate
options

3.4 Advantages and Flexible dates, can be sold on

disadvantages of Cost, standard contracts
futures

Flexible dates, exchange traded

(lower default risk)
Standard amounts, margins

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 5 Swaps 4.4 Interest rate collars

Borrower: buy puts and sell calls

at a lower rate

5.1 Interest rate swaps Investor: buy calls and sell puts
at higher rate
Exploit comparative advantage/save
issue and early redemption fees
Split gain, variable rate at LIBOR
4.5 OTC options

Bid–offer spread (for fixed leg of swap)

Optional but fixed date

5.2 Valuing interest rate

swaps

Designed initially to generate an

NPV of zero at current FRA rates

5.3 Currency swaps

Exploit comparative advantage/save

issue and early redemption fees
Valuation using NPV

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13: Managing interest rate risk

Knowledge diagnostic

1. Forward rate agreements

Unlike currency forwards, interest rate FRAs are 'notional' derivative-style agreements.
2. Interest rate futures
Unlike currency futures these are based on a standardised time period of three months; this
influence the number of interest rate futures contracts that are needed.
3. Interest rate options (exchange traded)
Unlike exchange traded currency options, these are closed out on the futures market.
4. Interest rate swaps
Variable rate leg of the swap is at LIBOR.
5. Bid–offer quotes for swaps
If given, this is the rate at which the fixed rate is being offered. As ever the company gets the
worst part of the spread.
6. Swap valuation
Uses FRA which can be derived from the yield curve.

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Further study guidance

Question practice
Now complete try the questions below from the Further question practice bank (available in the digital
edition of the Workbook):
Q22 Shawter
Q23 Carrick plc
Q24 Theta Inc

Further reading
There is are two Technical Articles available on ACCA's website, one called 'Currency swaps', and the
other 'Determining interest rate forwards and their application to swap valuation'.
We recommend you read these articles as part of your preparation for the AFM exam. Both are written by
a member of the ACCA AFM examining team.

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SKILLS CHECKPOINT 4

Applying risk management techniques

aging information
Man

aging information
Man
nt

An
meamneag e

sw
nteme
Manag Giomoed tim

er
pl
Analysing

an
investment
T

nin
Exam success skills
Good

Addressing the decisions

g
scenario
Applying risk
management Specific AFM skills
techniques

r p re t at i o n
Identifying the Applying risk
Eff p ect re

management
an Eff nd p

required numerical

m e nts
e c re i v

techniques(s) techniques
d
ti v

e
se w ri
o f c t i n te
a

u ire
nt tin Thinking across
e ati g
re q
the syllabus
se w ri o n
r re

al
nt tin Efficient numeric
Co

ati g
on a n a l ys i s
l
Efficient numerica
analysis

Introduction
Section E of the AFM syllabus is 'treasury and advanced risk management techniques' and
directly focusses on the skill of 'applying risk management techniques'.
The AFM exam will always contain a question that will have a clear focus on this syllabus area,
so this skill is extremely important.
Successful application of this skill will require a strong technical knowledge of this syllabus area,
especially of setting up arrangements to manage risk using futures and options.
Additionally, you will need to be able to forecast the outcome of a technique quickly and
efficiently under exam conditions.
Finally, as well as being able to apply the techniques numerically you need to be able to discuss
the advantages and disadvantages of using them, the meaning of the numbers and their
suitability given the scenario (as discussed in Skills Checkpoint 1).

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Skills Checkpoint 4: Applying risk management techniques

AFM Skill: Applying risk management techniques

The steps in applying this skill are outlined below, and will be explained in more detail
in the following sections as the question 'Phobos' is answered.

STEP 1:
Analyse the scenario and requirements.
Make sure that you understand the nature
of the risk being faced. Work out how
many minutes you have to answer each
part of the question. Don't rush in to
starting any detailed calculations.

STEP 2:
Plan your answer. Double-check that you are
applying the correct type of risk management
analysis given the nature of the risk that is faced
and the techniques mentioned in the scenario.
Consider using a time-line in your answer plan.
Identify a time-efficient approach.

STEP 3:
Complete your numerical analysis. Don't
over-complicate your analysis, aim for a set of
clear relevant numbers. Be careful not to overrun
on time with your calculations.

STEP 4:
Explain the meaning of your numbers – relating
your points to the scenario wherever possible.

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Skills Checkpoint 4

Exam success skills

The following question is based on a past exam question, worth approximately
15 marks.
For this question, we will also focus on the following exam success skills:
 Managing information. In risk management questions it is crucial to have
an accurate understanding of the nature of the risk. It is vital to allocate time to
carefully reading the requirements and the scenario.
 Efficient numerical analysis. The key to success here is applying a sensible
proforma for typical risk management calculations, this becomes easier with
practice.
 Effective writing and presentation. Underline key numbers. Make sure
that your numerical analysis is supported by an appropriate level of written
narrative. It is often helpful to use key words from the requirement as headings
in your answer as you do this.
 Good time management. Complete all tasks in the time available, this is a
challenge in risk management questions and is a strong argument for not being
over-ambitious in the scope of your numerical analysis.

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Skill activity

STEP 1 Analyse the scenario and requirements. Make sure that you
understand the nature of the risk being faced. Work out how many
minutes you have to answer each part of the question. Don't rush in to
starting any detailed calculations.

Requirement
Evaluate the outcome if the anticipated interest rate exposure is hedged:
(a) Using sterling interest rate futures
(b) Using options on short sterling futures
(c) Using an interest rate collar

Advise on which hedging method should be selected. (15 marks)

This is a 15-mark question and at 1.95 minutes a mark, it should take 29 minutes.
Assuming you spending approximately 20% of your time reading and planning, this
time should be split approximately as follows:
Nature of the risk
 Reading and planning time – 6 minutes
Phobos is a borrower
 Performing the calculations and writing up your answer – 23 minutes
so faces the risk of
You can immediately see from the requirement that there three derivative techniques interest rates rising in
two months' time when
that need to be employed. As we have not yet looked at the scenario, you do not yet it needs to borrow
know whether the risk is that interest rates rise (risk for a borrower) or fall (risk for an £30 million.
investor), or the amounts or time periods involved. This is the next step, and requires a
The loan will be for
careful read through of the scenario. four months (starting in
two months' time and
finishing in six months'
Question – Phobos (15 marks) time).

Following a collapse in credit confidence in the banking sector globally, there have This can be illustrated
been high levels of volatility in the financial markets around the world. Phobos Co is a as a time line on your
UK listed company and has a borrowing requirement of £30 million arising in two answer plan (see later)

months' time on 1 March and expects to be able to make repayment of the full amount
six months from now.
The governor of the central bank has suggested that interest rates are now at their
peak and could fall over the next quarter. However, the Chairman of the Federal
Reserve in the US has suggested that monetary conditions may need to be tightened,
which could lead to interest rate rises throughout the major economies. In your
judgement there is now an equal likelihood that rates will rise or fall by as much as Nature of the risk
100 basis points depending upon economic conditions over the next quarter.
Further clarification of
LIBOR is currently 6.00% and Phobos can borrow at a fixed rate of LIBOR plus 50 the risk is provided
here.
basis points on the short-term money market but the company treasurer would like to
keep the maximum borrowing rate at or below 6.6%.
Short-term sterling index futures (three-month contracts, contract size
£500,000)
The current prices of three-month futures contracts are shown below.
March 93.880
June 93.940
You may assume that basis diminishes to zero at contract maturity at a constant rate.

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Skills Checkpoint 4

Options on short sterling futures (three-month contracts, contract size

£500,000)
The premiums (shown as an annual percentage) are as follows:
Calls Puts
Exercise March June Sept March June Sept
93750 0.155 0.260 0.320 0.045 0.070 0.100
94000 0.038 0.110 0.175 0.168 0.170 0.205

STEP 2 Double-check that you are applying the correct type of risk
management analysis given the nature of the risk that is faced and the
techniques mentioned in the scenario.
Consider using a timeline in your answer plan.
Identify a time-efficient approach.

Example timeline 1 March

– take out £30 million loan

1 Jan 1 July
– this is now – loan repaid

Nature of risk
Phobos is a borrower – risk of interest rates rising when it takes out a £30m loan for a
period of four months, starting in two months' time on 1 March.

Time-efficient approach
A collar, for a borrower, consists of buying put options at a higher rate (93750 or
6.25%) and selling call options at a lower rate (94000 or 6.00%) it will save time if
we design the options hedge so that it is consistent with the collar ie choose to
hedge using put options at 6.25%.

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STEP 3 Complete your numerical analysis.
Don't over-complicate your analysis, aim for a set of clear relevant numbers.
Be careful not to overrun on time with your calculations.

As already noted, performing the calculations and writing up your answer should take 23 minutes.
There are many ways of laying out an answer to this question, one approach is shown below.

This is where your

Solution understanding of
the nature of the
(i) Futures risk is crucial.

Set-up 1 January Failure to set up

any hedge
Type of future = March future with an opening price of 93.880 correctly will
mean that few if
Amount of exposure Length of exposure any marks can
Number of contracts = be earned on this
Contract size Contract period part of your
answer
£30 million 4 months
= = 80 contracts
£500, 000 3 months

Type of contract = contract to sell (as we are a borrower)

Basis
1 January 1 March

March future 100 – 93.88 = 6.12%

LIBOR 6.00%

Basis (future – LIBOR) 0.12% 1/3 0.12% = 0.04%

Time remaining Three months One month

Outcome 1 March
Using the closing basis of 0.04%, the estimated closing futures prices at 1 March =
LIBOR rate at close-out 7% 5%
Closing futures 7.04% 5.04%

Setting up a column
for each outcome Outcome if interest rate (a) increases, or (b) decreases by 100 basis points
saves time.
(a) (b)
Leave calculations as
% also saves time. LIBOR rate at close-out (7%) (5%)
Actual loan rate (7.50%) (5.50%)

Futures opening rate (to sell) 6.12% 6.12%

Futures closing rate (to buy) 7.04% 5.04%
Profit or (loss on future) 0.92% (1.08%)

Actual loan + future position in % (6.58%) (6.58%)

In £s ( £30m 4/12) (658,000) (658,000)

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Skills Checkpoint 4

Only analyse one of the options

(ii) Traded options to use time efficiently.

Set-up 1 January Justify your choice briefly.

Type of option = March put option As already noted, the choice of

6.25% will save time when the
Chosen rate 93750 = 6.25% collar is analysed.
This is justified as the cheapest, minimising transaction costs
Number of contracts = 80 (see earlier)
Premium = 0.045% (from table)
Outcome 1 March
(a) (b)
LIBOR rate at close-out (7%) (5%)
Actual loan rate (7.50%) (5.50%)

Put option outcome (as before) 6.25% 6.25%

Futures closing rate (to buy) 7.04% 5.04%
Profit or (loss on future) 0.92% (1.08%)
Don't exercise

Option premium (0.045%) (0.045%)

Outcome in % (6.625%) (5.545%)
In £s ( £30m 4/12) (662,500) (554,500)

(iii) Collar
Set-up 1 January
Type of options
= Buy March put option at 6.25%, sell March call option at 6.00%
Number of contracts = 80 (see above)

Premium = 0.045% (from table) – 0.038% = 0.007%

Outcome 1 March
(a) (b)
Time has been saved LIBOR rate at close-out (7%) (5%)
because the put option of
6.25% was used in the Actual loan rate (7.50%) (5.50%)
options hedge.

Note that the loss to Put option (as before) 0.92% Don't exercise
Phobos on the call option
is the hardest part of the
Call option rate (holder has
analysis and it is not right to receive interest) 6.00% 6.00%
necessary to get this right
Futures closing rate 7.04% 5.04%
to score a good pass
answer. Profit or (loss on future) Don't exercise (0.96%)
Exercised against
Phobos by the
holder of the option
Option premium (0.007%) (0.007%)
Outcome in % (6.587%) (6.467%)
In £s ( £30m 4/12) (658,700) (646,700)

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 STEP 4 Write up your answer using key words from the requirements as
headings.
Write your answer, explaining the meaning of your numbers -
relating your points to the scenario wherever possible.

Narrative element to the solution

Summary table saves
time and adds

Use wording from the

Evaluation – summary clarity.

requirement
Outcome in % (a) (b) Average Then explain the
meaning of your
Future 6.58% 6.58% 6.58% numbers.
Option (6.25%) 6.625% 5.545% 6.085%
Collar 6.587% 6.467% 6.527%

If interest rates rise, a future will provide the lowest borrowing cost; however,
the option and the collar are only marginally more expensive.
If interest rates fall, an option will provide the lowest borrowing cost by a
significant margin.
Relate your
Considering the equal likelihood of an interest rate rise or fall, looking at an answer using the
details given in
average expected cost is relevant and on this basis the option is
the scenario.
recommended as it provides a significantly lower average cost.
End with
There is a danger that the objective, to achieve a maximum borrowing rate 'advice' as per
of 6.6%, is breached if interest rates rise and options are used. However, the requirement.
this breach is marginal and if interest rates fall this approach will be
significantly cheaper than any other. So, the advice here is to hedge the risk
using interest rate options.

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Skills Checkpoint 4

Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been
completed below for the Phobos activity to give you an idea of how to complete the
diagnostic.

Exam success skills Your reflections/observations

Managing information Did you understand the nature of the risk facing the
company before starting your calculations?

Efficient numerical Did you spend too much time on the calculations, could you
analysis have taken any short-cuts?
Did your answer present neat workings in a form that would
have been easy for a marker to follow?

Effective writing and Did you explain the meaning of the numbers?
presentation

Good time Did you allow yourself time to address all requirements?
management

Most important action points to apply to your next question

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Summary
Each AFM exam will contain a question that focusses on risk management.
This is an important area to revise and to ensure that you understand the variety of
techniques available (including their limitations).
It is also important to be aware that in the exam, it is more important that you limit
your numerical analysis and produce a concise meaningful analysis.
In the exam you are dealing with complicated calculations under timed exam
conditions and time-management is absolutely crucial. So you need to ensure that you:
 Show clear workings and score well on the easier parts of the question
 Make a reasonable attempt at the harder calculations while accepting that
your answer is unlikely to be perfect
Remember that there are no optional questions in the AFM exam and that this syllabus
section (risk management) will definitely be tested!

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Chapter summary

Financial reconstruction

1 Financial 2 Financial 3 Debt covenants and

reconstruction reconstruction forecasting
schemes to schemes for value
prevent business creation
failure 3.1 Debt covenants
(a) Returning cash to
shareholders using a share
Positive covenants
1.1 Legal framework repurchase scheme
 Involve taking positive
(b) A significant injection of
1 Creditors with a fixed action to achieve an
capital (debt or equity)
charge on a specific asset objective eg gearing,
(c) A leveraged buy-out. A interest cover
2 Creditors with a floating
mechanism for taking a
charge on the company's Negative covenants
company private (avoiding
assets  These place restrictions on
the costs of a listing and
3 Unsecured creditors allowing a company to the borrower's behaviour
concentrate on the
4 Preference shareholders
long-term needs of the
5 Ordinary shareholders business)
3.2 Forecasting and
The deal must be agreed by all
ratio analysis
parties – classes of creditors
should meet separately, every
1 Forecast profit
class must vote in favour for
the scheme to succeed. 2 Forecast SOFP
Use ratio analysis to evaluate
(see earlier chapters)

1.2 Approach

1 Estimate the position if

insolvency occurs
2 Apply reconstruction
scheme and check position
of each party
3 Assess if the company is
viable

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14: Financial reconstruction

Knowledge diagnostic

1. Order of repayment
In insolvency proceedings, ordinary shareholders rank behind all other claims.
2. Schemes to increase value
These include share repurchase schemes, and issues of new capital.
3. Taking a firm private
Can be viewed as a means of reducing listing expenses and increasing the ability of a firm to
take a long-term view.
4. Positive debt covenants
These require positive action, eg to attain an objective.
5. Negative debt covenants
These place restrictions on management behaviour.

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Further study guidance

Question practice
Now try the question below from the Further question practice bank (available in the digital edition of the
Workbook):
Q25 Brive Inc

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15: Business reorganisation

Chapter summary

Business reorganisations

1.1 Reasons for 1 Unbundling 1.2 Types of unbundling

unbundling

Financial motives
Strategic motives

2 Divestment (sell-off) 3 Management buy-out 4 Demerger (spin-off)

(MBO)
The sale of a division to a
Spin-off of a corporate body
third party will add value if
Allows sale of a with the into two or more separate and
the estimated sale price
co-operation of divisional independent bodies, it does
exceeds the present value of
management, and a lower risk not raise finance
lost cash flows (including
of redundancies
economies of scale lost as a The motives for a demerger
result of the sell-off). Less likely to attract the attention are likely to be strategic
of the competition authorities Does not raise finance
than a sale to another company
Aims to create a clearer
management structure and to
allow faster decision making
Risks losing synergies between
3.1 Financing different parts of the group. It
is also an expensive and time-
Equity and mezzanine consuming process. Assets
finance element will be and liabilities will have to be
mainly provided by a venture clearly segregated between
capital/private equity firm. the demerged units.
Ambitious targets will be set
for the MBO.

3.2 Other types of MBO

MBI
BIMBO
LBO

5 Valuation

An asset beta for the unbundled

division will be needed to
calculate an appropriate cost of
capital for valuing an
unbundled division.

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Knowledge diagnostic

1. Types of unbundling
These include divestment, management buy-out and demerger.
2. Types of management buy-out
These also include leveraged buy-outs, management buy-ins, and buy-in management buy-outs.
3. Mezzanine finance
This is finance with the characteristics of debt and equity, and is commonly used by venture
capitalists to finance MBOs.
4. Drawbacks of demergers
Cost, time and risk of losing synergies/economies of scale.
5. Valuing an unbundled entity
This is likely to require a cash-based valuation using a cost of capital based on the asset beta
for the unbundled entity which has been regeared to reflect the gearing of the unbundled entity.

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15: Business reorganisation

Further study guidance

Question practice
Now try the questions below from the Further question practice bank (available in the digital edition of the
Workbook):
Q26 BBS Stores
Q27 Reorganisation

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16: Planning and trading issues for multinationals

Chapter summary

Planning and trading issues for

multinationals

1.1 Types of free trade 1.2 International

1 International trade
agreements institutions

Free trade areas / customs unions WTO, IMF

Common/single market World Bank (IBRD/IDA)
Economic Union Central banks

2 Planning issues (1) – 3 Planning issues (2) – 4 Planning issues (3) –

dividend policy transfer pricing structure

2.1 Dividend capacity 3.1 General 4.1 Branch or

considerations subsidiary
Affected by dividends from foreign
subsidiaries. Extra tax may be
Goal congruence Branch: utilise initial losses
payable on the profits made by
Performance evaluation against other profits
foreign subsidiary, and withholding
Financing Subsidiary: separate legal entity,
tax may be due on dividends paid
Taxation gives impression of a long-term
by the foreign subsidiary.
commitment, parent company
benefits from limited liability
3.2 Regulation
2.2 Factors affecting
dividend policy
Arm's length standard 4.2 Debt or equity
Market based transfer pricing
Financing Debt: may be subsidised, thin
Agency issues capitalisation rules
Timing
Equity: local exchange
Tax
regulations need to be followed
Exchange controls

4.3 Agency issues

Different interests of local

management, managed by:
 Parent company ratifying key
decisions
 Managerial compensation
packages tied to the
performance of the group
 High dividend payouts
 High gearing

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 5 Developments in international markets

5.1 The credit crunch

Triggered in 2007 by massive losses on CDOs

5.2 Securitisation and tranching

Each tranche of CDOs is securitised and 'priced' on

issue to give the appropriate yield to the investors.
Typical investors of senior tranches are insurance
companies, pension funds and other risk-averse
investors. At the other end, the 'equity' tranche
carries the bulk of the risk – these junior tranches
tend to be bought by hedge funds and other
investors looking for higher risk–return profiles.

5.3 Tensions in the Eurozone

Continued downturn on some parts of the

Eurozone after the credit crunch

5.4 Dark pool trading systems

Allow large shareholdings to be disposed of

without prices and order quantities being
revealed until after trades are completed

5.5 Money laundering

Regulation requires customer due

diligence ie taking steps to check that your
customers are who they say they are

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16: Planning and trading issues for multinationals

Knowledge diagnostic

1. Free trade zones

Depending on the form these take can potentially benefit a multinational by offering frictionless
trade and common regulatory standards.
2. International institutions
The IMF, the World Bank and the WTO all bring order and stability to the international financial
system and provide benefit to multinationals as a result.
3. Dividend capacity
Dividends remitted by overseas subsidiaries will increase the dividend capacity of the parent
company – but extra tax may be payable.
4. Transfer pricing
Methods need to be in line with requirements for an 'arm's length standard'.
5. Agency issues
Local subsidiary management may not act in the best interests of the 'group'.
6. Tranching
This is the pricing of CDOs in different 'investment layers'; each tranche of CDOs is securitised
and 'priced' on issue to give the appropriate yield to the investors.

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Further study guidance

Question practice
Now try the question below from the Further question practice bank (available in the digital edition of the
Workbook):
Q28 Transfer prices

Further reading
There is a Technical Article available on ACCA's website, called 'Securitisation and tranching'. This
article examines behavioural finance and is written by a member of the AFM examining team.
We recommend you read this article as part of your preparation for the AFM exam.

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SKILLS CHECKPOINT 5

Thinking across the syllabus

aging information
Man

aging information
Man
An
sw
er
pl
t
en
manag ime

an
em

Analysing
t

nin
Exam success skills
Good

Addressing the investment

g
scenario decisions

uirereq rpretation
Specific AFM skills

e m e nts
Applying risk

req of rprineteation
Identifying the
Eff p ect re

management
an Eff nd p

required numerical

m eunirts
e c re i v

techniques(s) Thinking across

techniques
d
ti v

e the syllabus
se w ri of t inteect
a

nt tin
c rr
Thinking across
r re Co

e ati g the syllabus

se w ri o n
nt tin
Co

ati g
on
l
Efficient numerica
analysis

Introduction
A common cause for failure in the AFM exam is that students focus on mastering the key
numerical parts of the syllabus (typically investment appraisal, valuation techniques and risk
management) but leave gaps in their knowledge, in two senses:
 Failing to carefully revise discussion areas within a given syllabus section; for example,
being able to compute the value of a real option but not being able to discuss the
factors used by the model to compute this value
 Neglecting some syllabus sections entirely; for example, syllabus Sections A (role of the
senior financial adviser) and D (corporate reconstruction and reorganisation) are often
neglected because they do not contain complex numerical techniques
The structure of the AFM exam exposes students that have knowledge gaps because:
 Exams are designed so that question-spotting does not work (a topic examined in one
sitting is often examined in the next sitting too to penalise question-spotting).
 The 50 mark question is structured to test multiple syllabus areas (and will span at least
two syllabus sections)
 The 25 mark questions, although often focusing on a specific syllabus section, normally
contain three requirements which often means that a wide variety of topics within this
syllabus area is being tested.
 There are no optional questions.
It is therefore crucial that you prepare yourself for the exam by revising across the whole
syllabus, even if your knowledge is deeper in some areas than others there must not be any
'gaps', and that you practice questions that force you to address a problem from a variety of
perspectives. This skill will often involve thinking outside the confines of one specific chapter of
the Workbook and thinking across the syllabus.

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Skills Checkpoint 5: Thinking across the syllabus

AFM Skill: Thinking across the syllabus

The steps in applying this skill are outlined below, and will be explained in more detail
in the following sections as the question 'AIR' is answered.

STEP 1:
Analyse the scenario and
requirements.
Consider the wording of the
requirements carefully to understand
the nature of the problem being
faced.

STEP 2:
Plan your answer. Double-check that you are
applying the correct knowledge and that you
are not neglecting other syllabus areas that
would help to support your analysis.

STEP 3:
Produce your answer, explaining the meaning
of your points – and relating them to the
scenario wherever possible.

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Skills Checkpoint 5

Exam success skills

The following question is worth 19 marks.
For this question, we will also focus on the following exam success skills:
 Managing information. The requirements of a question will give a good
indication of the range of syllabus areas being tested and can help focus your
mind on the nature of the question before reading through the scenario.
Focus on the requirement, underlining key verbs to ensure you answer the
question properly. Then read the rest of the question, underlining and
annotating important and relevant information, and making notes of any
relevant technical information you think you will need, making sure that you do
not constrain your thinking to a single syllabus area.
 Correct interpretation of requirements. At first glance, it looks like the
following question is about management buyouts (syllabus Section D), however
careful reading of the requirement should reveal that this is not actually the
case.
 Effective writing and presentation. Make sure that your numerical
analysis is supported by an appropriate level of written narrative drawn from a
wide variety of syllabus areas where appropriate.

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Skill Activity

STEP 1 Analyse the scenario and requirements. Consider the wording of

the requirements carefully to understand the nature of the problem
being faced.
Required
Prepare an evaluation for the managers of the proposed new company AIR which:

(a) Analyses the advantages and disadvantages of the proposed financing of the
MBO (9 marks)
(b) Evaluates whether or not EPP Bank's gearing restriction in four years' time is
likely to be a problem (10 marks)
(Total = 19 marks)
This is a 19-mark question and at 1.95 minutes a mark, it should take 37 minutes.
Assuming you spending approximately 20% of your time reading and planning, this
time should be split approximately as follows:
 Reading and planning time – 7 minutes
 Performing the calculations and writing up your answer – 32 minutes
Although part (a) mentions management buy outs (MBOs), careful reading of the
requirement shows that the question actually requires an evaluation of the finance mix
that is proposed for the MBO; not of the MBO itself.
Part (b) looks like it will involve forecasting, which is a part of syllabus section D
(corporate reconstruction and reorganisation) but an area of the syllabus section that is
often neglected. Again this reinforces the need for broad syllabus knowledge.
Now carefully read through the scenario.

Question – AIR (19 marks)

The directors of ER have decided to concentrate the company's activities on three core
areas, bus services, road freight and taxis. As a result, the company has offered for
sale a regional airport that it owns. This part of the question
is looking at the
The existing managers of the airport, along with some employees, are attempting to financing – which is the
purchase the airport through a leveraged management buyout (MBO), and would form focus of part (a). You
a new unquoted company, AIR. The total value of the airport (free of any debt) has need to assess the pros
and cons of this
been independently assessed at $35 million. financing mix.
The managers and employees can raise a maximum of $4 million towards this cost.
This would be invested in new ordinary shares issued at the nominal value of 50c per
share. ER, as a condition of the sale, proposes to subscribe to an initial 20% equity
holding in the company, and would repay all debt of the airport prior to the sale.
EPP Bank is prepared to offer a floating rate loan of $20 million to the management
team, at an initial interest rate of LIBOR plus 3%. LIBOR is currently at 10%. This loan
would be for a period of seven years, repayable upon maturity, and would be secured
This is the main focus of
against the airport's land and buildings. Another condition of the loan is the no part b and indicates
dividends would be payable for the next four years. that a forecasting
exercise is required.
A condition of the loan is that gearing, measured by the book value of total loans to The forecast will be
the book value of equity, is no more than 100% at the end of 4 years. If this condition affected by the impact
of the financing mix.
is not met the bank has the right to call in its loan at one month's notice. AIR would be

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Skills Checkpoint 5

able to purchase a 4-year interest rate cap at 15% for its loan from EPP Bank for an
This part of the question
upfront premium of $800,000. is again looking at
financing ie part (a). You
A venture capital company, AV, is willing to provide up to $15 million in the form of need to assess the pros
unsecured mezzanine debt with attached warrants. This loan would be for a 5-year and cons of this financing
mix. So don't panic here,
period, with principal repayable in equal annual instalments, and have a fixed interest
it is a discussion point in
rate of 18% per year. part a and a possible
complication in part (b).
The warrants would allow AV to purchase 10 AIR shares at a price of 100 cents each
for every $100 of initial debt provided, at any time after 4 years from the date the
loan is agreed. The warrants would expire after five years.
Most recent
STATEMENT OF PROFIT OR LOSS FOR THE AIRPORT
This proforma may be
useful for your forecast $'000
in part (b).
Landing fees 14,000
Other revenues 8,600
22,600
Labour 5,200
Consumables 3,800
Central overhead payable to ER 4,000
Other expenses 3,500
Interest paid 2,500
19,000
Taxable profit 3,600
Taxation (33%) 1,188
Retained earnings 2,412

ER will continue to provide central accounting, personnel and marketing services to

AIR for a fee of $3 million per year, with the first fee payable in year one.
All revenues and cost (excluding interest) are expected to increase by approximately
5% per year.
Tax is paid one year in arrears.

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STEP 2 Plan your answer. Double-check that you are applying the correct
knowledge and that you are not neglecting areas from other syllabus
areas that would help to support your analysis.

This plan uses wording

from the requirement
Example answer plan and notes a range of
points that could be
Part a made.

There are more than

Define the financing mix
sufficient points there
for a 9 mark
Pros Cons
requirement.
Elements of the mix
$4m Relatively small investment Conflict: managers v staff
$1m ER Skills & motivation
$20m loan Term of loan Floating rate, covenant
Dividend restriction
$10m (balance) AV Unsecured, fixed rate Warrants, interest rate high
Repaid in instalments

The overall mix

– highly geared Risk of default

Part b
Forecast This part of the plan
identifies the approach
1 Forecast the profit or loss statement and then that will be followed in
2 Forecast the value of equity and debt each year constructing an answer.
3 Then evaluate gearing in four years' time

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Skills Checkpoint 5

STEP 3 Produce your answer, explaining the meaning of your points - and relating
them to the scenario wherever possible.

Solution
(a) Financing mix
If the airport can be purchased for $35 million, the financing mix is proposed as:
$m
8 million 50 cent shares purchased by managers and employees 4
2 million 50 cent shares purchased by ER 1
EPP Bank: secured floating rate loan at LIBOR + 3% 20
AV: mezzanine debt with warrants (balancing figure) 10
Total finance 35

AV finance facility
Example of
application to
Up to $15 million of the mezzanine debt is available, however this is an
scenario expensive source of finance costing 18% compared with 13% for the loan
from EPP.
If the warrants attached to the mezzanine debt are exercised, AV will be
able to purchase 1 million new shares in AIR for $1 each. This is a cheap
price considering that the book value per share at the date of buyout is
$3.50 ($35m/10 million shares). The ownership by managers and staff
will be diluted from 80% to approximately 73%, with ER holding 18% and
AV holding 9%. This should not affect management control provided that
managers and staff remain as a unified group.
The debt must be repaid in five equal annual instalments; that is, $2 million
each year. If profits dip in any particular year, AIR might experience cash
flow problems, necessitating some debt refinancing.
Short punchy
paragraphs Management and employee contribution
explaining why
your points matter A leveraged buyout of the type proposed allows managers and
employees to own 80% of the equity while only contributing $4 million out
of $35 million capital (11%). However, it is important that the managers
and employees agree on the company's strategy at the outset. If the
shareholders break into rival factions, control over the company might be
difficult to exercise. It would be useful to know the disposition of
shareholdings among managers and employees in more detail.
ER contribution
The continued involvement of ER will allow ER's skills to continue to be
drawn on. This should enhance the possibility of the MBO succeeding. On a
practical level, the continued provision of central services by ER reduces the
risk that the MBO fails due to weaknesses in its accounting systems.
EPP loan
Applied to the
scenario
The advantage of the loan is that it avoids the need for managers to invest
more money, or for the relatively expensive finance facility from AV to be
used in full. However, it is a variable rate loan and therefore exposes AIR to
the risk of interest rate increases. The covenant exposes AIR to the risk of

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 default (this is analysed in part (b)). In addition the restriction on dividend
payments for four years will reduce the short term gains to shareholders from
the MBO.
Gearing
The initial gearing of the company will be extremely high: the debt to
equity ratio is 600% ($30 million debt to $5 million equity). This makes
the overall mix a risky one for the investors and is explains the existence of
the loan covenant and restriction on dividend payments.
(b)
AIR: FINANCIAL FORECAST
Year 0 Year 1 Year 2 Year 3 Year 4
$'000 $'000 $'000 $'000 $'000
Landing fees 14,000
Other revenues 8,600
22,600

Labour 5,200
Consumables 3,800
Other expenses 3,500
12,500
Direct operating profit
growing at 5% p.a. 10,100 10,605 11,135 11,692 12,277
Central services from ER (3,000) (3,150) (3,308) (3,473)
EPP loan interest at 13% (2,600) (2,600) (2,600) (2,600)
on $20m
Neatly produced
Mezzanine debt interest at 18%
forecast with a
on $10m (1,800) column for each
on $8m (1,440) year to save
time
on $6m (1,080)
on $4m (720)
Profit before tax 3,205 3,945 4,704 5,484
Tax at 33% 1,058 1,302 1,552 1,810
Profit after tax 2,147 2,643 3,152 3,674
Reserves b/f 0 2,147 4,790 7,942
Reserves c/f 2,147 4,790 7,942 11,616

Share capital + reserves 7,147 9,790 12,942 16,616

Total debt at end of year 28,000 26,000 24,000 22,000
Gearing: debt/equity 392% 266% 185% 132%
Concise explanation of
meaning and limitations If warrants are exercised, $1m of new share capital is issued,
of the analysis as part of reducing the gearing at Year 4 to 22,000/17,616 = 125%.
the evaluation
Gearing at period end
Using these assumptions and ignoring the possible issue of new
shares when warrants are exercised, the gearing at the end of
four years is predicted to be 132%, which is significantly
above the target of 100% needed to meet the condition on
EPP's loan.

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Skills Checkpoint 5

If warrants are exercised, $1 million of new share capital will be

raised, reducing the Year 4 gearing to 125%, still significantly
above the target.
Cash flow
A key assumption is that cash generated from operations is
sufficient to repay $2 million of mezzanine debt each year,
which is by no means obvious from the figures provided.
Increase in LIBOR
Results will be worse if LIBOR rises above 10% over the
period. However, the purchase of the cap will stop interest
payments on EPP's loan rising above 15%. Conversely if LIBOR
falls, the increase in profit could be considerable, but it is
still very unlikely that the loan condition will be met by Year 4.
Problems in meeting loan condition
There will therefore definitely be a problem in meeting EPP
Bank's loan conditions. This may mean that AIR will need to Keep suggested
actions brief as this
repay the loan in full after four years. is potentially going
beyond the scope
However, if the company is still showing steady growth by of the requirement.
Year 4, and there have been no problems in meeting interest
payments, EPP Bank may not exercise its right to recall the
loan. However, in light of this risk, the directors of AIR could
consider control action to reduce the risk of the covenant being
broken, eg improvements in cost effectiveness,
renegotiating the allowed gearing ratio to a more
realistic figure, or an injection of equity funds.

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Exam success skills diagnostic

Every time you complete a question, use the diagnostic below to assess how effectively you
demonstrated the exam success skills in answering the question. The table has been
completed below for the AIR activity to give you an idea of how to complete the diagnostic.

Exam success skills Your reflections/observations

Managing information Did you understand the syllabus knowledge required to

address the requirements – some from syllabus Section B
(financing – in part (a)) and some from syllabus Section D
(forecasting – in part (b))?

Correct interpretation Did you realise the need for narrative to support your
of the requirements numerical analysis in part (b)?

Effective writing and Did your evaluation include a critical evaluation of the
presentation assumptions made in your numerical analysis?

Most important action points to apply to your next question

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Skills Checkpoint 5

Summary
Make sure that you are able to 'think across the syllabus' by making sure that you do
not have knowledge gaps by the time of the real exam. This will involve:
 Carefully revising discussion areas as well as numerical areas
 Revising all syllabus sections. Do not neglect syllabus Section A (role of the
senior financial adviser) and D (corporate reconstruction and reorganisation)
because they do not contain complex numerical techniques.
Remember that the structure of the AFM exam exposes students that have knowledge
gaps because:
 The 50-mark question is structured to test multiple syllabus areas (and will span
at least two syllabus sections)
 The 25-mark questions, although often focusing on a specific syllabus section,
normally contain three requirements which often means that a wide variety of
topics within this syllabus area is being tested
 There are no optional questions
It is therefore crucial that you prepare yourself for the exam by revising across the
whole syllabus. Even if your knowledge is deeper in some areas than others there must
not be any gaps'. Make sure when you answer questions that you try, where
appropriate, to address a problem from a variety of perspectives.
This skill will often involve thinking outside the confines of one specific chapter of the
Workbook and thinking across the syllabus.

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