ACCA+P4+Key+Point+Notes+June+2010

ACCA P4 Advanced Financial Management Key Point Notes

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ACCA P4 Advanced Financial Management

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

Tutor:

Sunil Bhandari

Tutor Contact Details

Mobile: 07833 096979 E-mail: via www.IntelligentAccountancyTutorsLtd.co.uk

Copyright to Intelligent Accountancy Tutors Ltd

________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 1


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Use of these Key Point Notes These notes have been written as an aid to assist students preparing for the ACCA P4 June 2010. They accrue for the topics tested in the past exams. It is of paramount importance that they are used with an up to date Revision Kit (KAPLAN or BPP). A combination of using the notes and question practice is the best way to prepare for the forthcoming exams.



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Index Chapter Number Chapter Name

Page Numbers

Preliminaries

5-16

Chapter One

Cost of Capital

17-26

Chapter Two

Capital Structure & Raising Finance Dividend policy

27-35

How lenders set their Interest Rates Advanced Investment Appraisal Adjusted Present Value

41-46

65-70

Chapter Eight

Modified Internal Rate of Return (MIRR) Capital Rationing

Chapter Nine

Foreign Currency Risk

75-84

Chapter Ten

Interest Rate Risk

85-96

Chapter Eleven

Valuaton of Options+Value at Risk

97-112

Chapter Twelve

Business Valuations & 115-134 Mergers & Acquisitions Modern Valuation 135-139 Methods Corporate Reconstruction 141-145 & Reorganisation

Chapter Three Chapter Four Chapter Five Chapter Six Chapter Seven

Chapter Thirteen Chapter Fourteen Chapter Fifteen

Question 4 & Emerging Issues

37-39

47-57 59-64

71-74

147-148



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Exam Formulae and Tables



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Exam Technique First 15 minutes  Read the questions carefully  Recognise the topic being tested  I would recommend that Section B questions are done

first and then Section A

Next 180 minutes  Attempt the questions in your ranked order.  Stay within your time allocation both on each part of the question and on the question itself.  If the written elements are unrelated to the computations-try front load as they represent ‘easier’ marks.  Try to attempt all parts to all the questions.  If in doubt about how to compute a value-make a reasonable estimate and move on.



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General Numerical Questions  State formula  Show method  Explain as you go  Make assumptions if in doubt

Written Questions  Check format – report / essay/ listed points  Headings / subheadings / columnar  Simple short paragraphs-essays and reports  Use ‘numbered’ points for most questions-simple sentence approach.



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



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'What the Current Examiner (Bob Ryan) Has Said Recently' Key facts  The Examiner sees this as a “Masters Level” paper. He expects students to demonstrate expertise, and real world knowledge / awareness. For example, when questioned about the Futures question (Q5 D08) he said that students should be familiar with Open and Settlement quotes since this is how prices are quoted in the real world (e.g. on the NYBOT website).  There’s no point question spotting. It is more important to have worked through past exam questions.

Main problems in the last 3 papers  Weak knowledge of basic F9 topics  Weak integration with other Professional Level papers. The Examiner expects the students to have a good knowledge of (for example) P1 and P2 topics.  Lack of contextual understanding. He has suggested the students should read widely around the subject e.g. the Financial Times, his own text book “Corporate Finance and Valuation”. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 15


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 The “essay question” (Q4) and written areas in general were badly done.

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

Positives  Good standards of English  Good attention to presentation  Good understanding of options and their role



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

1.1 This is the formula given on your formula sheet. 1.2 Remember that: Ke= Cost Of Equity  Kd(1-t) = Cost of Debt  Kd= Yield to maturity on debt  Ve=Market value of the Equity Capital.  Vd= Market Value of the Debt Capital  t= Corporation tax rate



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1.3 The examiner often re-presents the above formula as:WACC= Were + Wdrd(1-t)  We=

Ve or (1-Wd) Ve+Vd  Wd= Vd or (1-We) Ve+Vd  re=Ke=Cost Of Equity  rd(1-t)=Kd(1-t)=Cost of Debt Therefore, it’s the same Formula!! 2 Cost of Equity (Ke, re) 2.1 Formulae are given in the exam as:-

This can be simply presented as:Ke or re =Rf +βe(Rm-Rf)

This you have to rearrange to:re=Do(1+g) +g Po



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This latter formula applies under M&M assumptions with tax. 2.2 Lets clear up the additional symbols to those listed under 1.2 above:Rf=Risk Free Return Rm= Return on the Market Portfolio βe=Systematic Risk being faced by the shareholders. Do=The dividend per share (DPS) today or last paid. g = Constant annual growth rate in dividends. Po =Share price currently Kei= Cost of equity assuming all equity position. (Rm-Rf)= Equity Risk Premium. 2.3 A common issue is finding the g value. There are several ways that this can be found. a) Past growth rate is assumed to be future growth rate. Example Today is 31st December 2008 31st December 2005 2006 2007 2008

DPS $0.24 $0.27 $0.29 $0.32

g= n√ (Do) -1 Dn n=Increments of growth Dn=Oldest DPS given ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 19


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g= 3√(0.32) -1 0.24 g= 0.10 b) Gordon’s Growth Model

b=the proportion of profits retained by the business re= can be the accounting rate of return(ARR) or cost of equity Example If a company has an ARR of 12% and pays out 30% of profits as a dividend.re =14% g= 0.12 x 0.70=0.084 This is a short term growth measure. g= 0.14 x 0.70=0.098 This is a long term measure



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3 Cost of Debt (Kd(1-t) or rd(1-t)) 3.1 Kd or rd is the yield or minimum return for the debt holder. Kd(1-t) or rd(1-t) is the cost of debt for the company. 3.2 To find the cost of debt we need to look at the type of debt finance. 3.3 Bank Loans Kd(1-t)=Interest % x (1-t) Example A company has a 11% Bank Loan .Tax =30% Kd(1-t)=11x(1-0.30)=7.7% 3.4 Traded Bonds-Perpetual Kd(1-t)=Ints x (1-t) Po Remember Po is the market value per block of $100. Example 9% Bonds trading at $89 t=30% Kd(1-t)=$9 x(1-030) = 7.1% $89



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3.5 Traded Bonds-Redeemable Kd(1-t) is an IRR computation based upon Time To Po T1-Tn Ints X(1-t) Tn Capital Repayment

$ (X) X X

Take two guesses like 10% and 1% and do an IRR

Example 7.5% Bond redeemable at par ($100)in 5 years time. Trading at $105. t=30% Time

$

To Po T1-Tn Ints X(1-t) T5 CR

(105) 7.50 X(10.30) 100

10% PV 1.0 (105) 3.791 19.90

1% 1.0 4.853

PV (105) 25.48

0.621 62.10 (23)

0.951

95.10 15.58

Kd(1-t)=1 +

15.58 X (10-1)=4.63% (15.58+23) 3.6 Quick assumption that the examiner might indicate is that Kd(1-t)=RF X (1-t) OR Kd(1-t)=Yield X (1-t) OR Kd(1-t)=(Yield or Rf + Credit Risk Premium) x 1-t ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 22


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3.7 As can be seen above the market value of debt (Po) is given per block of $100.This may have to be computed using the Dividend Valuation Model (DVM). i.e Po=Present Value of all future cash flows discounted at the yield to maturity. Example: $20 m 7% Bond will be redeemed in 3 years at par ($100). Yield to maturity is 5.25%. NB: Don’t forget that discount factor tables also show formulae at the top of each table. On the PV Table the formula is (1+r)-n =

1 (1+r)n

Hence the Po= $7 + $7 + $107 1 2 (1+0.0525) (1+0.0525) (1+0.0525)3 =$6.65+$6.32+£91.77 = $104.74 The Vd is $20m X $104.74= $20.948m $100 i.e Book value of Debt X Po $100 ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 23


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4 Degearing/Regearing βeta 4.1 βe must reflect the combination of the systematic business and financial risk being faced by a shareholder. 4.2 We can remove the financial risk element via

βa = Asset Beta, measure of systematic business risk βd= Debt Beta (Often nil) Example βe is 1.95 t= 30% βa = =

Vd:Ve 1:4 βd=NIL

4 4+1(1-0.30)

X 1.95

4 X 1.95 4.7

= 1.66



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Now, if the gearing went Vd: Ve 1:2 1.66 =

2 X βe 2+1(1-0.30)

1.66 =

2 X βe 2.7

1.66 X 2.7 = 2.24 2 4.3 βasset values may have to be combined before gearing up to find βe Example ABC is made up of two divisions. Division

Asset βeta

Food Clothes

0.75 1.80

Proportion of the Business 40% 60%

The company has Wd=0.32 and t=30%.Rf=5% and the equity risk premium is 9% Hence, Combined Asset βeta = (0.75 x40%) + (1.80 X 60%) = 1.38 β a=

Ve X βe Ve+Vd(1-t)

(Note: Wd =Debt Proportion of the company’s finance) ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 25


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1.38= 1.38=

0.68 X βe 0.68+0.32 (1-0.30) 0.68 X βe 0.904

1.38 X 0.904 =1.83 0.68 Take Ke for the company via CAPM Ke=Rf+(Rm-Rf) βe (Note (Rm-Rf) is equity risk premium) Ke =5+ (9)1.83 = 21.47%



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Chapter Two Capital Structure And Raising Finance 1 Introduction How should the company decide the mix of equity and debt capital? 2 Practical Issues If the company uses Debt capital funding it should consider:      

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

 Effect upon the company gearing ratio(Wd) Vd:Ve

 Will the debt providers exercise influence over the company?  The chance of bankruptcy. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 27


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3 3.1

Theories of Optimal Capital Structure Common Ground-both major views accept two facts:a) Yield
3.2

Traditional View

(NB Ko=WACC)

Key Points:1) Ke rises due to financial risk caused by gearing. 2) Kd is initially uneffected by gearing but rises at “high” gearing levels due to the perception of the possibility of bankruptcy. 3) Ko-trade off of Ke and Kd. Point X is the optimum gearing level where WACC is lowest. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 28


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4) Once point X is reached via trial and error it must be maintained. 3.3 MM and Tax

Ve+Vd

Key points:1) Assumptions behind the model: All debt is risk free  Only corporation tax exists  Debt is issued to replace Equity  All types of debt carry one yield, the risk free rate  Full distribution of profits  Perfect Capital Market 2) MM concluded that due to the benefit of the tax shield, companies should maximise the use of debt finance. 3) Specific Equations can be used under MM +Tax theory. Vg=Vu+VDT ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 29


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WACC= Keu {1-T x Vd} (Ve+Vd)

Only the latter is given on the formulae sheet. Example ABC is all equity financed. Its Ve is $500m.It has a Ke=12%. If it raises $150m of Debt Finance and tax is 30%.Yield is 5%. Vg=Vu+VDT Vg=$500m+ ($150m X 30%) = $545m Split Vd=$150m Ve=$395m WACC = 12(1-{0.30 X 150}) 545 = 11.01% Ke = 12+ (1-0.30) (12-5) 150 395 = 12+1.86 = 13.86%



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4 Practical Approached /Views 4.1 Static Trade off Theory MM +TAX view can be reviewed in the light of the practical issue that too much gearing leads a company towards bankruptcy. A revised equation is:Vg=Vu+VDt - (Probability of Financial Distress X Costs of Finance Distress)

Hence an optimum point exists for gearing where Vg is maximised. 4.2 Pecking Order Theory  Funds are raised in a practical order-ease of accessing funds.  Order :- 1) Internal Generated Fund 2) Debt 3) New Issue of Equity 5 Recent Exam Questions on Raising Debt Finance. “ ….. raise new capital through a bond issue of $2400 million….. would be in the form of 10 year, fixed interest bonds with half being in the Yen and half in the Euro market”



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Key Point Answer:Bond issue attractive way of raising $2400 million. Issue costs will be incurred May not be fully subscribed May need to be underwritten –mitigate some of the risk.  Alternative could be via a syndicated loan  Syndicated entails: Led by arranging bank.  Bring banks together who will provide the loan.    

 Syndication advantages are: Loan sizes are larger than one bank can take on its own.  Banks may be based in different countries –mixed lending package.  Low transaction costs.  Disadvantages  Forex Risk of foreign loans.  Risk of a Bank default  Rates may be greater than that on Bond market



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Solution:a) Key Point answer  Coupon Rate=5.1% +0.90%=6%  0.90% is credit risk premium is key. If too low, debt will not be taken. If too high, issued at an attractive premium but costly for the company.  Underwriting agreement would be sensible but costly. b) Current Vd  WD=0.25 W D = Vd Ve+Vd  Ve=$1.2billion ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 33


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 0.25=

Vd 1.2+Vd

 0.25(1.2+Vd)=Vd  0.30+0.25 Vd=Vd  0.30=0.75 Vd  Vd=0.30 0.75

=$0.4billion

Revised Vd  The existing debt of $0.4 billion ($400 million) carries a coupon and assumed yield of 4%.This is 50bp’s above RF%.  However, the new credit rating is 90bp’s above the RF%.Hence yield now be 3.5+0.90=4.4% Therefore, value of the existing debt (via DVM) will now be:$4 + 1.044

$4 + 1.0442

$104 1.0443

=$3.83+$3.67+$91.40=$98.90 Therefore, existing debt’s new Vd= $400million x $98.90 =$395.60 $100 The new debt will be issued at its market value. Therefore, Vd=$395.60+$400=$795.60million. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 34


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Current Cost of Debt  rd(1-t) =4% X (1-0.30) = 2.8%  New rd(1-t)would be based on a weighted average approach. {( 400 795.60

X 6) +( 395.60 X 4.4)} x (1-0.30) 795.60

=3.64% Hence increase of 84 bp’s. c) Advantages and Disadvantages of this mode of financing Pros

Cons

 Tax Shield benefit

Cost

 Lower Co’s WACC

Damage to credit rating of the company

 Secure on the tangible asset(plane)

WACC could rise therefore lowering Ve



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Chapter Three Dividend Policy 1 Introduction To maximise S/H wealth the Board should establish a dividend policy-the payment pattern to the equity investors. 2 Theories Several theories have been put forward to assist:2.1 Residual – If spare cash exists at the end of the year pay dividend. 2.2 Pattern – Be consistent with dividend payments. Either a) Pay the same dividend per share (DPS) each year. b) Maintain the payout ratio (DPS/EPS) c) Maintain the same year-on-year growth rate in dividends.The latter links into the Po via the dividend valuation model (DVM)

2.3 Irrelevancy (M&M) In a perfect capital market providing the directors can invest in projects with a positive NPV no dividends are required. The Ve will rise and the S/H can sell shares to create the cash the need(Manufacture Dividends). ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 37


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3 Practical Considerations There are many to consider:  Availability of cash  What dividends do S/H want (clientele effect)?  Signalling effect –payment of dividends indicates a healthy company  Retaining cash is a key source of finance.  Dividend growth should be greater than inflation  Tax impact upon S/H  Effect the dividend will have on dividend cover(EPS/DPS)  Number of investment opportunities will restrict dividend payments.  Risk-paying now is safer than promising to pay next year  Is the dividend within the company law regulations? 4 Alternatives to Cash Dividends 4.1 Scrip Dividends 4.1.1 The S/H will receive extra shares instead of cash on a pro rata basis. 4.1.2 This will allow the S/H to sell extra shares for cash and the gain will be subject to CGT. 4.1.3 The effect will:a) Increase the issued equity capital b) Dilute EPS and Po values c) Create pressure for the board to pay more total dividends in the future as more shares are in issue ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 38


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4.2 Share Buy Back 4.2.1 If the board has “one off” period of excess cash, they could consider a share buy back. i.e. Buy back shares at Po and cancel them. 4.2.2 Considerations:a) Allowable under company law. b) Increase gearing as Ve may fall. c) Tax implications for the S/H(CGT) d) Reduced number of shares will cut supply for trading purposes. e) Less dividend pressure on the board in future. f) Criticism-is this the best use of company cash.



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Chapter Four How lenders set their interest rates? 1 Credit Risk 1.1 This is the risk of default by the borrower. Occurs when the secured asset value falls below the value of the loan 1.2 Loss to the lender depends upon: Probability of default occurring.  Part of the debt recovered from the sale of the assets. 1.3 Lenders action re credit risk  Assess via credit assessment agencies (the chance the company is unable to pay the interest or principal)  Set credit risk premiums to the borrower. 2 Credit Risk Premium 2.1 Risk Neutral Lender –Example A company has an asset worth $2m and secured debt of $0.8m.The asset can vary in value by 10%monthly. Therefore,

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

Therefore, Asset can vary in value by ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 41


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34.64% X $2m = $692,800 annually Hence using the “Z” value concept (how many standard deviations) from normal distribution table. $1,200,000 = 1.732 $692,800 Therefore, $0.8m lies 1.732 standard deviations below the $2m asset value.

Value of the asset

$0.8m $2m Lies 1.732 σ σ =$692,800 Away from $2m Checking the normal distribution tables for 1.732 (or 1.73)=0.4582. The ‘chance ‘of the asset not falling below $0.8m is 0.4582+0.50=0.9582 If the company defaults then the bank need to recover the debt. This depends upon:________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 42


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 Type of Asset  Covenants on disposing the asset If (say) only 75% of the debt can be recovered and LIBOR is 6%.What premium above LIBOR should the bank set? Based on a 1 year period and a discount rate equal to LIBOR, the bank needs a present value to equal $800,000 – value of the loan today. i.e $800,000= (PV of the cash recd in 1year not defaulting) + (PV of the cash recd in 1year if default occurs) i= Interest rate the bank sets (inc the risk premium) $800,000= {$800,000 X (1+i) X 0.9582} + {75% X $800,000 X (1+i) X0.0418} 1+0.06 1+0.06

“Note: 0.0418=1-0.9582” 800,000=723,170(1+i) +23,660(1+i) 800,000=723,170+23,660+746,830 i (800,000-723,170-23,660) = 0.0712 746,830 i.e 7.12% which is 112 basis points above LIBOR OF 6%. 2.2 Risk Adverse Lender  If the bank were more risk adverse the discount rate above can be adjusted to value greater than LIBOR. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 43


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 In other words the “i” would increase accordingly.  (Say) in the above example the bank set a discount rate of 6.5% and not 6%.LIBOR is still 6%. $800,000= {$800,000(1+i) X 0.9582}+ {$800,000 X 75%X(1+i) X 0.0418} 1.065 1.065

800,000 = 719,775+23,549+743,324i i = 0.0762 i.e = 7.62% 162 Basis points above LIBOR 3 Problems  Finding asset values  Assessing the recoverable amounts on default  σ assessment



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Chapter Five Advanced Investment Appraisal 1 Net Present Value of Free Cash Flows (FCF) 1.1 Free Cash Flows(FCF)  The cash is available after expenditure and reinvestment into the business.  Computed two ways:1) Incremental cash flow approach Revenue – Costs – Tax -Capex + Scrap Value - Asset Replacement Spending – Working Capital Injection + Tax saved on Tax Allowable Depreciation. 2) Adjusting Accounting Profit Net operating profit (before interest and tax) Plus Depreciation Less Taxation Operating cash flow Less Investment: Replacement non-current asset investment(RAI) Incremental non-current asset investment(IAI)

X X (X) X (X) (X)



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Incremental working capital investment(IWCI) Free cash flow for the company Debt Interest Debt Repayments Debt Issues FCF to equity

(X) X used in NPV comps (X) (X) X X used to value equity in certain business valuation models.

1.2 Proforma

Time $’000 Revenue(inc Inflation) Costs(inc Inflation) Operating Cash flows Tax @ (1year delay) Capex&Scrap Value Tax savings on TAD Asset replacement spending Working Capital Free Cash Flows Cost of Capital% PV NPV

T0 -

T1 X

T2 X

T3 X

T4 -

-

(X)

(X)

(X)

-

-

X

X

X

-

-

-

(X)

(X)

(X)

(X)

-

-

X

-

-

X

X

X

-

(X)

(X)

(X)

-

(X) (X) 1.0 (X)

(X) X X X $XXX

(X) X X X

X X X X

(X) (X) (X)



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1.3 Relevant Cash Flows  Incremental –caused by the project  Future –still to occur  Exclude:1) Sunk Costs 2) Finance Charges 3) Dividends 4) Non-Cash flows 5) Non-incremental fixed overheads 1.4 Inflation  Include in the cash flows Money/Nominal CFn=Real CFn X (1+h)n eg Real CF3=$600 = 7%pa Money CF = $600 X (1+0.07)3 = $735  Include in the cost of capital 3 possibles:Chapter 1

a) Company WACC is inflation inclusive b) Risk adjusted WACC is inflation inclusive. c) Use the Formula given. (1+i) = (1+r) (1+h) h = inflation r = real cost of capital i = money cost of capital

eg r = 10% h=5% ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 49


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(1+i) = (1+0.10) (1+0.05) 1+i = 1.155 i =0.155 or 15.5% 1.5 Taxation  Using the December 08 paper as benchmark, the examiner showed taxation as a “2 line approach”.  Timings –could be no delay or 1 year delay  Tax on operating cash flows. eg Extract from the NPV:$’000 Operating Cash Flows Tax 30%(say 1year delay)

T1 200

T2 300

T3 -

-

(60)

(90)

 Tax saved on Tax allowable depreciation /Capital Allowances. eg Capex will take place over the first year and be finished by the end of the year. Cost $6.2m.TAD is 50%.First year allowance followed by straight line allowances for a further three years. Tax is 30 %( no time delay). T1 Tax saving =50% X $6.2m X 30%=$930,000 T2-T4 Tax saving=50% X $6.2m X 30%=$310,000 3 years



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Another Example T0=1/Jan/09 T0 CAPEX $1000K T5 Scrap

$200K

TAD is 25% reducing balance and tax is 30% with a one year delay. Extract from the NPV:-

Time $’000 T0 Capex & (1000) Scrap T.A.D(w1) -

T1 -

T2 -

-

75

T3 -

T4 -

T5 200

T6 -

56.25 42.19 31.64 34.92

(w1) Timing and Tax Saving T2 1000 X 25% X 30% T3 75 X (100%-25%) T4 56.25 X 75% T5 42.19 X 75% T6 Balance figure 30%(1000-200)=

$’000 75 56.25 42.19 31.64 34.92 240

NB: Other assumptions are possible –so read the question carefully.



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1.6 Working Capital  Think as it is a project bank account.  Invest, Adjust, Close!!! eg $’000 WC needed Relevant Cash Flows

T0

(100)

T1

100 (70)

T2

170 (130)

T3

300 300

These go into the NPV 1.7 Cash flows into Perpetuity. Eg Project has following cash flows and a cost of capital of 10%.

Time $’000 Cash Flows 10%

*

T0 (1000)

T1 200

T2 400

T3 300

T4-Tperp 350pa

1.0

0.909

.826

.751

1 X 0.751 0.10 *

1 =discount rate for perpetuity 0.10

If applied to a cash flow starting at T4 it discounts back to T3 ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 52


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Therefore, 1 X 0.751 =7.51 is the effective discount rate. 0.10

Take the same example as above and now bring in constant growth of 2% from T5 each year in perpetuity. $’000 Cash Flows 10% *

T0 (1000)

T1 200

T2 400

T3 300

T4-Tperp 350

1.0

0.909

0.826

0.751

9.388 *

1 X 0.751 r-g

1 X 0.751=9.388 (0.10-0.02) i.e

1 (r-g)

computes the discount factor for a cash flow with a constant growth rate pa

2 IRR 2.1 The Internal Rate of Return is the cost of the capital that gives an NPV of NIL 2.2 Example NPV @10%=$300K NPV @20%=($160K)



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IRR= 10+ {

300 } X (20-10) (300-(-160)

= 16.52% 2.3 Decision rule with IRR is if IRR>Cost of Capital –Accept However IRR has many weaknesses which are overcome by MIRR (see a later chapter) 3 Foreign Investment Appraisal 3.1 Predicting future spot rates via formulae provided:-

S1= F0= Future Spot Rate S0= Spot Rate Today hc = Inflation Rate abroad hb= Inflation Rate home ic = Interest Rate abroad ib = Interest Rate Home 3.2 Double Taxation-the golden rule is you must pay the higher of the two rates.



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3.3 Format-may need to change from earlier in this chapter to accrue for double tax. Example Jon inc (USA company) has a project in the UK. Cash flows have been computed already as:Time T0 T3 scrap T1 operating flows T2 operating flows T3 operating flows

£’000 1,000 100 500 600 400

TAD in the UK is straight line and tax rates are UK 20% USA 30% with a one year delay S0=$1.50/£ and inflation is expected to be USA=5%pa

UK=3%pa

What are the free cash flows ready for discounting? Solution Notes:USA=Home, UK=Foreign S0=$1.50/£ or £0.67/$ Spot Rates via PPP:-



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Time

£/$ 0.67 0.66

S0 S1 0.67 X 1.03 = 1.05 S2 0.66 X 1.03 = 1.05 S3 0.65 X 1.03 = 1.05 S4 0.63 X 1.03 = 1.05

£’000 Operating Flows TAD (1000-100) 3 Taxable “Profit” Tax@20% Add back TAD(not cash flow)

0.65 0.63 0.62

T1 500

T2 600

T3 400

-

-

(300)

(300)

(300)

-

-

200

300

100

-

-

300

(40) 300

(60) 300

(20) -

500 500 £0.66 758 758

560 560 £0.65 862 (30) 832

340 100 440 £0.63 698 (46) 652

(20) (20) £0.62 (32) (16) (48)

-

T0

Capex&Scrap (1000) £’000 (1000) Spot Rates £0.67 $’000 (1493) USA Tax(w1) FCF (1493)

T4



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(w1) Example working T1 Taxable Profit=£200 Additional Tax=10% X £200=£20 Converted @ T1 spot =£20/£0.66 =$30 Paid at T2!!!



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Chapter Six Adjusted Present Value 1 When to use it 1.1 APV is a NPV method to be used when: Project is core or non-core activity  Specific debt Finance is being use on a project.  Subsidised interest exists on the project debt finance. 1.2 APV is still the change in shareholder wealth arising from the project. 2 Method  Establish the βasset for the project.  Using the βasset in CAPM find Keu(all equity Kei)  Discount the relevant project cash flows using Keu to find the base case NPV  Establish the yield on the debt.  Find PV of the issue costs (possibly post tax) using yield as a discount rate.  Find PV of the tax savings on the interest paid on the loan finance raised using the yield as a discount rate.



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APV $m Base case NPV PV of issue costs PV of tax savings on interest

APV

X (X) X X

Recent Exam Question



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Following steps above:a) βa =

=

Ve X βe Ve+Vd(1-t) 7500 7500+2500(1-0.30)

X 1.40

= 1.14 b) Keu=RF+ (Rm-RF)βa Keu=5.0+ (3.5)1.14 Note:-

= 9%

 RF=Gilt Yield =5.40-0.40=5  (Rm-RF)=Equity Risk =Premium =3.5



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c) Base Case NPV $m Revenue Direct Costs Lost Cont’n Operating Cashfows Tax at 30 %

T0 -

Capex&Scrap (800) Tax Saved on Capital Allowances (w) FCF (800) 9% 1.0 PV (800)

T1 T2 T3 T4 T5 680 900 900 750 320 (408) (540) (540) (450) (192) (150) (150) 122 210 360 300 128

T6 -

-

(37)

(63)

(108)

(90)

(38)

-

120

48

29

40 17

14

122 .917 112

293 .842 247

345 .772 266

221 .708 156

95 .650 62

(24) .596 (14)

Base Case NPV = $29m Assumptions: Indirect costs are not incremental  Design costs are sunk therefore ignored. (w) Timing and Tax Saving T2 800 x 50% x 30% T3 400 x 40% x 30% T4 48 x (100-40)% T5 29 X 60% T6 Balance figure 30%(800-40)=

$m 120 48 29 17 14 228



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d) Yield on new debt= 5.40+1.80=7.2% i.e LIBOR + 180BP’s e) Issue costs payable to has to be 2% of loan +Issue costs i.e $800 m X 2%=$16.33m 0.98 f) PV of tax savings on interest paid:Loan inc Issue Costs Ints Paid in T1-T5 @ 7.2% pa Tax saved @30%T2-T6 Discounted at 7.2%

$816.33m $58.77m pa $17.63m pa

$17.63m + $17.63m + $ 17.63m + $17.63m + $17.63m 1.0722 1.0723 1.0724 1.0725 1.0726 15.34+ 14.31+ 13.34+ 12.45+ 11.62 = $67.06m

Base Case NPV Issue Costs PV of Tax Savings

$m 29 (16.33) 67.06 $79.73m



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3 Subsidised Loans 3.1 If any part of the loan Finance is at a subsidised rate, then the APV must include an extra benefit. 3.2 PV of the post tax subsidy discounted at the yield. i.e Ints pa not paid less tax not saved all discounted at the yield.



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Chapter Seven Modified Internal Rate of Return (MIRR) 1 NPV vs IRR vs MIRR 1.1 NPV represents the increase in Ve arising from the project. However, it can be hard to explain the “layman”. 1.2 IRR is the cost of capital that causes the NPV to be nil. It’s decision rule IRR > Project Cost of Capital

Accept

1.3 IRR has weaknesses:a) Cannot be used to compare mutually exclusive projects. b) Multiple IRR’s exist when the cash flow pattern is not standard ie Standard Pattern -,+,+,+,+ Non-Standard Pattern -, +, +, +,1.4 MIRR is a measure that gives an NPV of nil but will lead to a project decision rule consistent with NPV.



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2 Computing MIRR 2.1 Simple Example Time T0 T1 T2 T3

$’000 (1000) 400 600 300

Return phase of the project

Cost of Capital=10% 2.2 Using The Formula NPV had been computed at 10%. Time T0 T1 T2 T3

$ (1000) 400 600 300

10% 1.0 0.909 0.826 0.751

PV (1000) 363.6 495.6 225.3 84.5

* PV of Return Phase=$1084.50 Formula given

PVR=PV of Return Phase Cash Flows PVI=PV of Investment Cash flows re=Cost of Capital n= Year of the final cash flow ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 66

*


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(1/3)

MIRR= {1084.50} (1+0.10)-1 1000 = 0.1301. i.e 13.01% Alternative Method: a) Terminal value of Return Phase cash flows. Time T1 T2 T3

$’000 400 X 1.102= 600 X 1.10 = 300 X 1.0 =

484 660 300 1444

Therefore, we now have a revised set of cash flows T0 T3

(1000) 1444

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

1444 - 1000 =NIL 3 (1+MIRR) 1444 =1000 3 (1+MIRR)

MIRR = 3√(1444) -1 1000

0.1303 OR 13.03%



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2.3 More complex Example Time T0 T1 T2 T3 T4

$,000 (700) (300) 400 600 300

10% 1.0 0.909 0.826 0.751 0.683 NPV

PV (700) (272.7) 330.4 450.6 204.9 13.2

(972.7)

985.9

PVI=972.7 PVR =985.9 Therefore, MIRR= {985.9}¼ (1.10)-1 972.7 = 10.37% Both NPV rule and MIRR rule indicate project is worthwhile. 3 Problems with MIRR 3.1 Both NPV and MIRR assume cash flows from a project are reinvested at re.This may not be the case. 3.2 MIRR may itself have to be “modified” to accrue of variable reinvestment rates. 3.3 Defining the “Investment Phase”. Per Q1 Dec 08 two definitions were possible giving slightly different answers.



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Chapter Eight Capital Rationing 1 The Problem 1.1 When there is a lack of sufficient cash to invest in all projects with a positive NPV 1.2 Cash can be restricted due a. “Hard” Reasons –external constraint eg Credit Crunch. b. “Soft” Reasons –internal restrictions eg Capex Budget 2 Single Period-Divisible Projects 2.1 Compute the Profitability Index (PI) for each project. PI=

NPV Cash outlay in critical period

2.2 Rank the projects based upon the PI 3 Multiperiod-Divisible Projects 3.1 Can only be solved by linear programming 3.2 The examiner has indicated the formulation may be tested but not arriving at a solution.



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Example A company has identified the following independent investment projects, all of which are divisible and exhibit constant returns to scale. No project can be done more than once. Project

Cash Flows at time:

A B C

0

1

2

3

$000 -10 -10 -5

$000 -20 -10 +2

$000 +10 +30 +2

$000 +20 +6 +2

There is only $20,000 of capital available at T0 and only $5000 at T1, plus the cash inflows from the projects undertaken at T0.In each time period thereafter, capital is freely available. The appropriate discount rate is 10%. Solution  Using the Dividend Formulation Model. (Assuming A Full Distribution Policy) 1) Symbols Dn=Dividends paid at time n. a,b,c,d = Proportions invested in each project. Z= Objective. 2) Objective Maximise the PV of dividends. Z= D0+ D1 + 1.10

D2 + D3 1.102 1.103



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



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Chapter Nine Foreign Currency Risk 1. Translation Exposure 1.1 Risk caused by change in the value of a Forex asset or liability over the longterm. 1.2 Example: ABC plc has a US subsidiary worth $10m. 2007

-

at $1.50

£6.67m

2008

-

at $1.75

£5.71m

Loss to equity

(£0.96m)

Funded by a $10m loan. 2007 -

at $1.50

£6.67m

2008 -

at $1.75

£5.71m

Gain to equity

£0.96m

1.3 Not a cash risk, only due to financial reporting!!!! 2 Transaction Exposure 2.1 Change in the value of the spot rate over the short term causing a cash gain or loss. 2.2

Must hedge!!



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3 SPOT Rates 3.1 Rate of exchange at a point in time. (Bid) (Offer) $1.5000 - $1.5555 / £

Reciprocal and cross over!!!!!

£0.6429 - £0.6667 / $ (Bid) (Offer)

3.2 Picking the correct rate-Quick Method  If the SPOT Rates are FX/Home Currency  We are RECEIVING FX then  Use the right hand rate 4 Internal Hedges 4.1 Invoice in home currency  All transactions in home currency  Transfer risk to the other party  Monopoly power-over our customers or suppliers 4.2 Foreign currency bank account  Held in the main currencies ($, Euro)  Pool all transactions in same FX ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 76


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4.3 Leading and Lagging  Watcher / predictor of spot rate changes in short term(say 3 months)  Leading – accelerate exchange(early)  Lagging – delay the exchange(late as possible)  Used a lot by Importers who have to sell their home currency 4.4 Netting  Match all FX transactions in the same FX occurring on the same day 5

External Hedges

5.1 Forward Market(Lock into a Fixed Rate) “Fix the rate today that will apply on a set future date” Technique: 1.

Net the future transactions in same FX and same date. Ascertain if “buying” or “selling” the £.

2.

Forward contract, X months, at Forward Rate “may” have to computed as :SPOT + Discount (- Premium)

3.

Exchange FX at the forward rate on the future date.



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5.2 Money Market Hedge(Rate used is Today’s Spot Rate) “The exchange will take place today at the known spot rate”. Technique Home

Abroad Today’s Spot

Today

£ Answer

FX

X

 1 + ints foreign

1+ints home

Future Date

£ Answer

FX

FX

5.3 Futures(Lock into a rate that will approximately equal Today’s Spot Rate) The hedge is ‘effectively’ like a spread bet. If the company will make a transaction loss by the spot rate rising, then the hedge is to ‘effectively bet’ that this event will occur on the Futures Market. Hence the loss on the Spot Market is offset by the profit on the Futures Market. If a gain is made on the Spot Market then a loss will be made on the Futures Market. Hence it is trying to lock the rate at approx today’s Spot Rate. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 78


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Technique: 1.

Draw the timeline showing all rates. Best if rates are presented as value of the currency of the contracts.

2.

Setup – Today  Ascertain the downside(d/s) risk  ‘Bet’ on the d/s risk via the futures market.  No. of contracts = Net FX Transaction Futures Rate Standard Contract Size (in currency of the contract)  Work out ticks / contract(normally 0.0001/currency)  Deposit the returnable margin

3.

Close out – future date (a)Transaction – at spot (b)

£ XXX

Futures Profit / Loss

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

XXX

XXX

NB: Loss on transaction, gain on the future or gain on transaction ,loss on the futures.



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5.4 Options (Bet possible Hedge) “Right to buy (call) or sell (put) FX at a fixed rate over a set period (American) or on a set date (European)”. Technique: 1. Timeline-As for futures 2. Set up today  Ascertain if we need a put or a call option  Pick a strike rate from: 1. Cheapest premium or 2. Nearest to spot or 3. Best possible rate  No. of contracts Transaction



Number

Strike Rate Standard Contract Size  Summary Number of contracts x size x rate.  Compute the premium and convert at spot 3.

Close out – Future date  All situations cost = premium paid



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 No receipt or payment in FX – options lapse 

Compare spot with strike rate – choose the best rate for the business

6.

Pros & Cons Pros

             

Cons

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



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7. SWAPS 7.1 In forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate.  The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a ‘fixed rate/fixed rate’ swap. The main objectives of a forex swap are:  To hedge against forex risk, possibly for a longer period than is possible on the forward market.  Access to capital markets, in which it may be impossible to borrow directly.  Forex swaps are especially useful when dealing with countries that have exchange controls and /or volatile exchange rates. 7.2 Example- Say the bridge will require an initial investment of 100m pesos and is will be sold for 200m pesos in one year’s time. The currency spot rate is 20 pesos/£, and the government has offered a forex swap at 20 pesos/£. A plc cannot borrow pesos directly and there is no forward market available. The estimated spot rate in one year is 40 pesos/£.The current UK borrowing rate is 10%. Determine whether A plc should do nothing or hedge its exposure using the forex swap.



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Solution £m Without swap Buy 100m pesos @20 Sell 200m pesos @40 Interest on sterling loan (5 x 10%)

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

0

1

(5.0) 5.0 (0.5) (5.0)

4.5

0

1

(5.0) 5.0 2.5 (0.5) (5.0)

7.0

A plc should use a forex swap. (Key idea: The forex swap is used to hedge foreign exchange risk. We can see that in this basic exercise that the swap amount of 100m pesos is protected from any depreciation, as it is swapped at both the start and end of the year at the swap rate of 20, whilst in the spot market pesos have depreciated from a rate of 20 to 40 pesos per pound.)



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Chapter Ten Interest Rate Risk 1

What are the issues?

We have loan finance interest rates are set at a variable rate on a regular basis

Cover an interest rate rise

We have deposits and earning a variable interest rate

Cover an interest rate fall



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2 “FIXING” INSTRUMENTS (Lock in to Fixed Rate) Forward rate agreements (FRA)

Purchased from a merchant the money markets

Pros - easy -flexible - cheap

Cons - contract -size (≥ $1m)

Contract that fixes future interest rates for a set period FRA

3-9

Fix start 3months from now

@ 4% pa

Fix stops 9 months from now

Fixed Rate



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Interest rate future

Fixing the interest rate can be achieved by using futures. One of the main markets that is used is the UK LIFFE (London International Financial Futures Exchange).

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

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

Futures are complicated by a number of factors.  Contract sizes  Margins / deposits payable at the start of the hedge  Not perfect hedge .May not look in at the current rate. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 87


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3 “CAPPING” METHODS (Setting a ceiling for the loan interest rate) Interest rate guarantee (IRG)

Purchased from a merchant bank for a fee

Covers the adverse of interest rate changes but at a cost!!!

Contract that caps the future interest rate for a set period

IRG

3-9

@ 4% pa

Cap starts in 3 months time

Cap stops 9 months from now

Capped rate



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Interest Rate Option The future and options market provides a product that can cap interest rates for borrowers like an IRG. The hedge is to effectively have the ‘right to bet’ on an interest rate increase as shown on the futures market.

As an example, suppose that today is 30 June and the following data is available on September LIFFE options. Strike price (SP) % 93.75 94.25 94.75

Interest rate cap (100 – SP) % 6.25 5.75 5.25

Call options premium %

Put options premium %

1.29 0.69 0.16

0.23 0.77 1.33

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

Contract sizes and a standard length of three months complicate interest rate options. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 89


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NB Collars  Create a cap & floor simultaneously  Save premium  Lose benefit of interest rate drops below the floor 4 SWAPS 4.1 Longterm method of hedging where companies “swap” their interest commitments but no their loans. 4.2 Example Company A wishes to raise $10m and to pay interest at a floating rate, as it would like to be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 10% or at a floating rate of 1% above LIBOR. Company B also wishes to raise $10m.They would prefer to issue fixed rate debt because they want certainty about their future interest payments, but can only borrow for one year at 13% fixed or LIBOR+2%floating as it has a lower credit rating than company A. Calculate the effective swap rate for each company – assume savings are split equally. 4.3 Exam Technique (1) Table of Interest Rates. Company A B

Fixed 10% 13%

Float LIBOR +1% LIBOR +2%

Want FLOAT FIXED



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(2) Interest Difference. % A (Fixed)+B (Float) 10+LIBOR+2 A(Float)+B (Fixed) LIBOR+1+B Difference

=LIBOR +12 =LIBOR+14 2%

(3) SWAP Diagram LIBOR+2

A

B

12 (w1) 10

LIBOR+2

(w1) 13-(0.5 x2) =12 (4) Effective Rates A PAY LIBOR B PAY 12 Both save 1% and get what they want. 4.4 Problems  Fees payable to intermediaries  Default risk by one party.



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Recent Exam Question:



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Solution a) (i) Interest Rate Futures Use a simple 3 step approach 1) Timeline 1 Jan (Now) LIBOR = 6.00 Mar Futures=6.12 * Basis =0.12

1 March 5.00 or 7.00 5.04 (w2)7.04 0.04 (w1) 0.04

* Use settlement values if given (100-93.880)

31 March

NIL

Basis falls to nil at the end of the quarter

(w1) Basis of 0.12 [12 Basis points] will fall to nil by 31st March. On the 1st March one month from three is still remaining. Hence, 1/3 x 0.12=0.04 (w2) As the Mar Futures at 1 Jan was higher than LIBOR [6.12 vs 6.00] it is assumed to stay higher until expiry.



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2) 1st Jan-Set up the Hedge  The company will be exposed to movements on the LIBOR for a period of 4 months from 1st March  Buying futures (or effectively betting on a rise in interest rates)  Number of contacts:£30m £500,000

X 4 months = 80 contracts 3 months

3) 1st Mar-Close Out Hedge LIBOR Falls LIBOR Rises 5.00% 7.00% Company will pay 50 BP’s above 5.50% 7.50% LIBOR £ £ Payment of 4 months Interest (550,000) (750,000) £30m X 4/12 X Interest Rate Loss on Futures (108,000) (6.12-5.04) X £12.50 X80 0.01 Profit on Futures 92,000 (7.04 -6.12) X £12.50 X80 0.01 Effective Cost of Loan (658,000) (658,000) As a % of £30m 6.58% 6.58% i.e £658,000 X 12 X 100% £30m 4



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(ii) Options 1) Timeline-as for futures above 2) 1st Jan –Set up the Hedge  As the current LIBOR is at 6.00%, the company will buy March put options at 94000(100-6.00) to cap it’s interest rate.  No of contracts – as above 80  Premium Payable 0.168 X 80c X £500,000 X 3/12 100 = £16,800 3) 1st March –Close out Hedge

Premium Paid Interest paid-see Futures above Compare Cap vs Mar Futures Interest Rate 6.00% vs 5.04% 6.00% vs 7.04% Therefore, Use the option and receive (7.04-6.00) X 80 X £12.50 0.01 Total Cost Effective Annual%

LIBOR 5.00% £ (16,800) (550,000)

LIBOR 7.00% £ (16,800) (750,000)

104,000

(566,800) 5.67%

(662,800) 6.63%



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As both are equally as likely (5.67% X 0.50) + (6.65% X 0.50) = 6.15% Both methods keep the APR below the treasures target of 6.60% However the options are preferred at 6.15% b) What did the examiner write to answer this:-



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Chapter Eleven Valuation of Options +Value at Risk 1

Valuation of Options

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

Put – right to sell.

(b)

Call – right to buy.

(c)

Exercise price / strike price – price at which shares can be bought or sold.

(d)

Expiry Date – date on which the option can be exercised (European type option).

Our aim is to find the value of the options on the open market.



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1.2 Components of Option Value Intrinsic value and time value There are 5 main components to the value of an option (a)

(b)

Intrinsic value, the difference between (i)

The current price of the asset(Pa)

(ii)

The exercise price of the option(Pe)

The time value of the premium, reflecting the uncertainty surrounding the intrinsic value between now and the exercise date. Relevant factors: (i)

Variability in the daily value of the asset (currency, interest etc)(s)

(ii)

Time until expiry of the option (a later expiry date having greater risk)(t)

(iii) Interest rates (since cash flows occur at two different times)(r)



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

All three formulae are given in the tables but you must know what the symbols stand for. Symbols: Pa=share price Pe=exercise price option r =annual (continuously compounded) risk free rate of return t =time to expiry of option in years s =share price volatility, the standard deviation of the rate of return on shares e =the exponential constant 2.7183 On Your calculator!!

In =natural logarithm ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 99


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d1 &d2= Compute to two decimal places. N(d1)& N(d2)=the cumulative value from the normal distribution tables for the value d1 or d2.Read the bottom of the tables very carefully. Example The current share price of B plc shares=$100 The exercise price =$95 The risk free rate of interest = 10%pa =0.1 The standard deviation of =50% =0.5 return on the shares The time to expiry =3 months=0.25 1) Find d1 and d2 d1=In (100/95)+(0.10+0.5X0.52)0.25 0.5√0.25 d1=0.051+0.056 0.25 d1=0.43 d2=0.43-0.25=0.18 2) N (d1) =0.50+0.1664=0.6664 N (d2) =0.50+0.0714=0.5714 3) Find e-rt rt =0.1 X0.25 =0.025 e-0.025=0.975



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Hence, c= (100 x 0.6664)-(95 x 0.5714 x 0.975) =$13.71 1.3 Put-call parity Black Scholes’ model will only calculate the value of a call option. The value of a call option, a put option, the exercise price and the share price are related (where the put and call have the same strike and exercise date):

Find the value of the put option

p =$13.71-$100+$95 X 0.975 = $6.34



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2

‘The Greeks’ There are five indicators of how the option price changes according to the different factors in the Black Scholes equation.

2.1 Change In

Varying With

Delta

δ

Option value

Underlying asset value

Gamma

Υ

Delta

Underlying asset value

Theta

θ

Time

Vega

no symbol

Time premium Option value

Volatility

Rho

ρ

Option value

Interest rates

2.2

The Delta Hedge Delta hedging is used by options traders who have written options and wish to calculate how many shares they need to hold to hedge their position. If the delta is 0.7 they will need to hold 0.7 shares for every option written. The delta also measures how many shares one option will ‘cover’ if used to hedge a holding of shares.



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3 FOREX modified Black-Scholes option pricing model. (Grabbe variant) 3.1 Formulae

where FO=Forward Rate X=Exercise Rate R=Domestic interest rate. 3.2 Used for the valuation of Forex options.



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3.3 Example



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4 Black and Scholes applied to Investment Appraisal. 4.1 Real options on projects    

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

4.2 Recent Exam Questions



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Solution Pa=PV of the project = ($4m+$24m) =$28m Pe=Capex=$24m t=2 years r=5% (0.05) s=25 %( 0.25) 1) Find d1&d2

2

d1=ln (28/24)+(0.05+0.5x0.25)2 0.25 X √2 = 0.154+0.1625 0.35 = 0.90 d2= 0.90-0.35=0.55 2) N(d1)=0.50+0.0159=0.8159 N(d2)=0.50+0.2088=0.7088 3) e-rt rt=0.05 x 2=0.10 e-0.10=0.9048 Hence c= (28 X 0.8159) – (24 X 0.9048 X 0.7088) =$7.45m Hence “value “of the project is NPV +value to delay $4m+$7.45m =$11.45m ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 111


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5. Value at Risk (VaR) 5.1 VaR is a measure of how the market value of asset or a portfolio of assets is likely to decrease over certain time, the holding period (usually 1 to 10 days), under normal conditions. 5.2 Used by Investment banks to measure the market risk of their portfolios. 5.3 Confidence levels are normally set at 95% or 99%. Example A bank has estimated the expected value of its portfolio in 2 week time will be $50m.with standard deviation of $4.85m. At 95%,what is VaR?

45%

50%

$50m s=$4.85m $ 50m-(1.65 X $4.85m) =$42m There is a 5% chance that the portfolio will fall below $42m. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 112


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Chapter Twelve Business Valuations & Mergers &Acquisitions 1 Pre-Acquisition Values 1.1 The aim is to find a range of values for a company. The answer can be presented:a) Ve b)Po 1.2 Net Asset Valuation 1.2.1 Business is worth just the value of it’s Net Assets. To establish the net assets:Total Assets-(Total Liabilities +Preference Shares) 1.2.2 The Net Asset value equals the Ve and can be based on:a) Book Values b) Net Realisable Value(NRV) c) Replacement cost 1.2.3 Useful For:a) “Seller “ to set minimum value of the company (NRV) b) Companies with lots of tangible high value assets.Eg: Property Investment company



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1.2.3 Major Weaknesses are:a) Not include non-tangible assets b) Excludes what all assets generate future:i. Dividends ii. Profits iii. Cash Flows 1.2.4 Dividend Valuation Model 1.3.1 The company is worth the present value of it’s future dividends discounted at the cost of equity 1.3.2 Ve = Total Do(1+g) (Ke-g) OR Po = Do(1+g) (Ke-g) 1.3.3 Take Care:Growth may not be constant forever Where to we get “g” from? CAPM may be needed to find Ke Often better for valuing a small shareholding 1.3.4 Finding g a) Past Growth model eg: Year 2006 2007 2008 2009

DPS $0.45 $0.49 $0.52 $0.54



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g= 3√ (0.54)-1 (0.45) g=0.063 b) Gordon Growth Model g=bre where b=Profit retention ratio re= ARR or Cost of equity eg A company has a retained profit ratio of 0.45.It has an ARR of 12% and re of 14%. Short term g=0.45 X 0.12=0.054 Long term g=0.45 X 0.14=0.063 1.4 Price –Earnings Model 1.4.1 A business is worth a multiple of it’s profits. 1.4.2 Ve=Sustainable PAT X Suitable P/E Po=Sustainable EPS X Suitable P/E 1.4.3 Sustainable PAT-have to adjust the latest reported reports for non-reoccurring items (post tax) 1.4.4 Suitable P/E:a) Take a proxy Company P/E b) Adjust to suit the company we are valuing. c) Simple rules i. Ltd Co’s – deduct 30%off proxy Co P/E ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 117


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ii. Non-listed PLC’s-deduct 10% to proxy Co P/E 1.4.5 Concerns are: Finding a proxy Co P/E  Adjustments are arbitrary  Sustainable profits needs forecasting adjustments. 1.5 Present value of Free Cash Flows 1.5.1 A business is worth the discounted value of the future cash flows. 1.5.2 Establish:a) Future Cash flows and timescales b) Cost of capital (WACC or Risk adjusted WACC) 1.5.3 Weaknesses are:-

1.5.4 Example A company has FCF for equity currently at $400m. It has a re of 8.5% and returns 30% of its profits. If growth is expected in perpetuity what is the Ve? g =b X re =0.30 X 0.085 = 0.0255 ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 118


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Ve= FCF0(1+g) (re-g) = $400m (1.0255) = $6,894m (0.085-0.0255) 1.5.5 Another Example A company has projected its FCF to equity at:T1 T2 T3

$420m $490m $510m

From T4 onwards growth will be at 3 %pa.re=7.92%. Find Ve Time $m FCF PV

T1 420 1/1.0792 389

T2 490 1/1.07922 421

T3 510 1/1.07923 406

T4-F.Ever 510(1.03) 16.171* 8,495

Ve=$9,711m *

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



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1.6 Intellectual Capital(IC) 1.6.1 There are several methods of valuing IC and /or other non-tangible assets. 1.6.2 Simple estimate Ve under DVM or P/E Or PV of CF’s method

-

Book value of Net Assets

1.6.3 Computed Intangible value (CIV)- to compute this an industry /proxy return on total assets % must be given in the question. Approach:-

$ ‘000

1) Last reported profit before tax Less: Industry of Proxy x Co’s total Return on assets assets

X (X)

Value Spread

X

2) Take value spread

X

Tax @X%

(X)

Post tax value spread

X

3) Assume post tax value spread will stay constant From time 1 to perpetuity. Value of IC=Post tax value Spread

x

1/r

r =Cost of Capital ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 120


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4) Value of Equity is Value of IC + Book value of the Assets 1.6.4 Lev’s knowledge earning method An alternative method of valuing intangible assets involves isolating the earnings deemed to be related to intangible assets, and capitalising them. However its is more complex than the CIV model in how it determines the return to intangibles and the future growth assumptions made. In practice, this model does produce results that are close to the actual traded share price, suggesting that is a good valuation technique. However, it is often criticised as over complex given that valuations are in the end dependent on negotiation between the parties. Method 1) Calculate normalised earnings. These are taken as a weighted average of:  3-5 years of past earnings (adjusted for any one-off items)  3-5 years of forecast earnings (based on analyst predictions or sales patterns) with the forecast earnings being given heavier weight. Note: In the exam you may simply have to use current earnings as an approximation. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 121


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2) Isolate the earnings driven by intangible assets.

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

$ X (X)

(X)

X

Lev identified the expected returns on assets as the:  financial /monetary assets-risk free rate  tangible assets-average market return in industries primarily driven by their investment in tangible assets  intangible assets-6% premium on the risk free rate. Note: Financial assets are cash and other assets that convert directly into known amounts of cash. The three basic categories are cash, marketable securities, and receivalbles.They are essentially current assets. 3) Capitalise the intangible earnings Rather than simply assume these earnings will grow in perpetuity as under the CIV model, Lev’s model is more sophisticated .He assumes they will grow as follows:  Five years at the current rate of growth. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 122


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 Declining growth year on year for the next five years.  Year eleven onwards-growing at the long term predicted growth rate.  2 Post Acquisitions Values Follow a 3 step approach 2.1 PreAcquisition Data Predator

Target

No of Equity shares in Issue

X

X

PAT

X

X

EPS

X

X

Pre acquisition Po

X

X

P/E Ratio

X

X

If the P/E ratio of Predator is greater than target then a bootstrap method is possible



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2.2 Post Acquisition value of Predator a) Using Bootstrap

$000

Predator PAT

X

Target PAT

X

Total PAT

X

Total PAT X PREDATOR P/E = Ve* b) Using Add Together

$000

Predator Preacquisition Ve

X

Target Preacquisition Ve

X X

PV of Synergy Cash flows

X Ve *

*Divide this by the new number of total issued shares in Predator to find Post Acquisition Po



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2.3 Assess the Takeover Predator Check the KPI’s post acquisition against pre acquisition:a) Po risen? b) EPS risen? Target Compute the Bid Premium:Per Share $ Value received post acquisition Per target share Preacquisition price

X (X) X

3 Factors to consider in Mergers and Takeovers 3.1 Assets of shares-most companies buy the victim company’s shares rather than transferring their assets. Both are feasible. 3.2 Synergies-concept of “2+2=5”.Many sources exist: a) Economies of scale from horizontal combinations reduces costs and increase profits. b) Buying suppliers can reduce profit charged on purchases i.e. cut out the middle man. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 125


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c) Improve badly managed /inefficient businesses. d) Diversify to stabilise profits and cash flows. e) Access companies that generate cash (Cash Cow) f) Use the managerial talent of the victim in a more productive way. g) Market power may allow consumer price increases and more profits. 3.3 Finance-to fund the takeover the predator company Could use:a) Cash b) Shares c) Loan Stock



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3.4 Regulation of Takeovers

3.5 Defences-The victim company could defend a take-over in several ways:a)Appeal to the Competition Commission indicating the takeover is anticompetitive. b)Find an alternative/Friendly buyer (White Knight)



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c) Appeal to the shareholders and manage a defence showing that the takeover will not benefit them. d)Super majority-set up in the Articles requiring a high proportion of S/H to agree on takeovers. e)Poison pill strategy –creation of “tripwires” invoked on a takeover causing the acquirer to spend more money.



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Chapter Thirteen Modern Valuation Methods 1 VALUE BASED MEASURES 1.2 More recent approaches to valuations and performance measures have focused on shareholder value. It is accepted that companies exits to maximise shareholder value, yet managers continue to be rewarded based on traditional accounting measures. The three terms to be familiar with are: (a)

Economic value added (EVA)

(b)

Market value added (MVA)

(c)

Shareholder value added (SVA)

Economic Value Added 1.3 EVA = Net operating profit after tax (NOPAT) – imputed interest charge EVA shows whether a company is making sufficient profit to cover its cost of capital. It is a similar approach to residual income. 1.4 NOPAT is calculated by taking the operating profit from published accounts, adding back interest and taking off the tax paid. It is sometimes referred to as cash earnings before interest but after tax.



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1.5 The imputed interest charge is calculated as the capital employed multiplied by the WACC. This represents the return on capital required to keep the investors happy. 1.6 A positive EVA indicates that a company is adding value for its shareholders. Therefore, if managers’ remuneration is linked to EVA, the interests of managers and shareholders should be aligned. 1.7 Disadvantages of EVA include:  Calculations can be complicated and involve many adjustments to accounting information  EVA is a historic measure  EVA cannot be used to directly compare companies as it requires an adjustment for their relative sizes  The calculation relies on CAPM for the WACC, which itself is subject to many restrictive assumptions 1.8 Example The directors of Old Nick plc wish to establish whether they have increased shareholder value in the year to September 20X2. They use the EVA model. Profit and loss account for year ended 30 September 20X2 £m Turnover 150 PBT 50 Tax 18 PAT 32 Dividends 10 ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 136


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Retained earnings Additional information:

22

(a)

Included in cost of sales and expenses is £10 million of economic depreciation. This is the same as the depreciation used for tax purposes.

(b)

Non-cash expenses amounted to £15 million.

(c)

The opening capital employed on the balance sheet was £108 million.

(d)

The pre-tax cost of debt is 10%.

(e)

The cost of equity is 15%.

(f)

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

(g)

The interest expense in 20X2 was £5 million.

(h)

The gearing ratio is 50:50 debt to equity by market value.

Required Calculate the EVA in the year to September 20X2.



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1.9 Solution  WACC  NOPAT:-

= (50% X 15%) + (50% X 10% X 0.65) = 10.75% £m 32 15 47 3.25

PAT Add: Non – cash Expenses Add: Post tax ints (5m X 0.65)

£50.25 EVA = £50.25m – (10.75% X £108m) = £38.64m Market Value Added 1.10 MVA is the value added to a business since it was formed, over and above the money invested in the company by shareholders and long term debt holders. Quick Example BB Plc 2003 Ve = £25m 2004 Ve = £40m Rights issue in 2004 = £5m MVA = £40m - £25m - £5m = £10m



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Shareholder Value Added 1.11 SVA represents the discounted future free cash flows less the value of the company’s debt. The discount rate will be the company’s WACC. Quick Example CC Plc Free cash flows for T1 on in perpetuity of £1.5m p.a. WACC = 14% Vd = £2.5m SVA =

£1.5m x

1 0.14

- £2.5m = £8.21m



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Chapter Fourteen Corporate Reconstruction and Reorganisation 1 Causes of Corporate Failure Corporate failure when a company cannot achieve a satisfactory return on capital over the longer term:  If unchecked, the situation is likely to lead to an ability of the company to pay its obligations as they become due.  The company may still have an excess of assets over liabilities, but if it is unable to convert those assets into cash it will be insolvent.  The issue is more problematic in sectors, or economies, where profitability is not an issue. For example, in the former Soviet Bloc, the economy simply does not identify poorly performing companies  For not-for-profit organisations, the issue is usually one of funding, and failures indicated by the inability to raise sufficient funds to carry out activities effectively.  Although stated in financial terms, the reasons behind such failure are rarely financial, but seem to have more to do with a firm’s ability to adapt to changes in its environment.



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2 Predicting Corporate Failure 2.1 Altman Z-Score Model The Z score model was first developed by Altman in 1968 based on research in the USA into bankrupt manufacturing companies:  Z scores are an attempt to anticipate strategic and financial failures by examining company financial statements.  The Z score is generated by calculating five ratios, which are then multiplied by a predetermined weighting factor and added together to produce the Z score.  The five ratios, which ,once combined ,were considered to be the best predictors of failure, are:

X1 X2 X3 X4

X5

Ratio Working capital to total assets Retained earnings to total assets Earnings before interest and tax to total assets Market value of equity(including preference shares)to total liabilities Sales to total assets

Included to measure Liquidity Gearing Productivity of the company’s assets. The extent to which the equity can decline before the liabilities exceed the assets and the company becomes insolvent The ability of the company’s assets to generate revenue.

Z score=1.2 X1 +1.4X2 +3.3X3 +0.6X4 +1.0X5 ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 142


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2.2 Assessing the risk of failure  The accuracy of prediction of the model.  The Z score model was found to be an accurate predictor of failure for up to two years prior to bankruptcy, but that the accuracy decreases over longer periods.  What level of Z score indicates different levels of likelihood of failure? It was found that: Z score<1.81 indicates that the Company is in danger and possibly heading towards bankruptcy. Z score of 3 or above indicates financially sound. Companies with scores between 1.81 and 2.99 need further investigation 2.3 Limitations of corporate failure prediction models There are number of limitations of the Z score and other similar failure prediction models:  The score estimated is a snapshot-it gives an indication of the situation at a given point in time but does not determine whether the situation is improving or deteriorating.  Further analysis is needed to fully understand the situation.  Scores are only good predictors in the short term.  Some scoring systems tend to rate companies low-that is they are likely to classify distressed firms as actually failing.  The Z score was estimated based on manufacturing companies. Care needs to be taken when applying it to other types of companies. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 143


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3 Other signs of Corporate Failure Information in the published accounts, for example:  very large increases in intangible fixed assets  a worsening cash and cash equivalents position shown by the cash flow statement  very large contingent liabilities  important post balance sheet events  Information in the chairman’s report and the director’s report (include warnings, evasions, changes in the composition of the board since last year.  Information in the press (about the industry and the company or its competitors).  Information about environmental or external matter. You should have a good idea as to the type of environmental or competitive factors that affect firms. 4 Financial Reconstructions 4.1 Options open to failing companies  a company Voluntary Arrangement (CVA)  an administration order 4.2 General principles in devising a scheme In most cases the company is ailing:  Losses have been incurred with the result that capital and long term abilities are out of line with the current value of the company’s assets and their earning potential.  New capital is normally desperately required to regenerate the business, but this will not be forthcoming without a restructuring of the existing capital and liabilities. ________________________________________________________________________  Sunil Bhandari – www.IntelligentAccountancyTutorsLtd.co.uk 144


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



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Chapter Fifteen Question 4 and Emerging Issues 1 The Written Question The Examiner has been consistent on all papers he has set so far. Q4 has been a full written question. There is no indication that this is likely to change in the near future. Common points in past question have been:  Either a two part question of at least two themes within the requirements  Ethical Issues  Providing a solution to a Financial or Strategic problem. 2 Preparation In my view, one way to prepare for this question is to look back and review what the examiner has set so far and how he has answered the question. Go on to the ACCA Global website and read and review the past answers to ‘Q4’ set by Bob Ryan.



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ACCA+P4+Key+Point+Notes+June+2010

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