ACCA P4 Advanced Financial Management Key Point Notes December 2010

ACCA P4 Advanced Financial Management Key Point Notes December 2010
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! Sunil Bhandari

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Key Point Notes
December 2010

ACCA
P4
Advanced Financial Management

Prepared By:
Sunil Bhandari

Tutor Contact Details
Mobile: 00(+)44 7833 438771
E-mail:
Sunil@IntelligentAccountancyTutorsLtd.co.uk

These notes are not intended to cover the whole syllabus, but target key examinable areas.

Copyright to Sunil Bhandari

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Use of these Key Point Notes

These notes have been prepared exclusively for use as a
revision aide. They cover the major topics in the current
syllabus as well as showing the way in which these have
been tested in all of the past papers. In addition, the notes
now accrue for the expected change in style of the P4 exam
as outlined in Shish Maldes article. I have also encapsulated
my knowledge gained from marking the P4 June 2010 exam.

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Contents

Chapter
Number
Chapter Name
Preliminaries
Chapter One Financial Objectives-Review of F9 Knowledge
Chapter Two

Cost of Capital
Chapter Three Risk Adjusted WACC
Chapter Four

Capital Structure and Raising Finance
Chapter Five

Dividend Policy
Chapter Six

Advanced Investment Appraisal I
Chapter Seven

Advanced Investment Appraisal II
Chapter Eight

Valuations of Options & Value at Risk
Chapter Nine

Risk Management

Chapter Ten Foreign Currency Risk Management
Chapter Eleven

Interest Rate Risk Management

Chapter Twelve

Business Valuation & Mergers & Acquisitions
Chapter Thirteen Company Performance Analysis
Chapter Fourteen Corporate Reconstruction & Reorganisation

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Exam Formulae and Tables

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Please note that FOREX Modified BSOP will NOT be examined
in December 2010 as it has been removed from the June
2011 formulae sheet.

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My Summary

Strong Link To F9
Core Topics will make up most of the paper
Questions will be Scenario Based and Longer
More Analytical Skills needed less Technical Difficulty

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Chapter One

Financial Objectives-
Review of F9 Knowledge

1 Primary Financial Objective

1.1 For profit making business Maximise Shareholder(S/H)
Wealth

1.2 To Measure S/H wealth

Value of Equity (V
e
) =Number of issued Equity/Ordinary
Shares X Current Market Price (P
o
)

1.3 To find P
o
:

! Given in the Question if it is a listed company(see
below)

! Compute Using:-

Dividend Valuation Model(DVM)
Earnings Based Models(PE)

1.4 Check the question very carefully for the size of the
company is it:-

! Listed
! Private Company

Make your comments relevant to the size and
nature of the company stated within the
question.
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2 Indicators

2.1 Financial indicators pointing towards maximising S/H
wealth include:-

! Earning per share(EPS)
! Dividend per share(DPS)
! Return on Capital Employed(ROCE)
! Return on Shareholder Capital(ROSC)
! Profit after tax
! Revenue

2.2 Non-Financial Indicators include:

! Market Share
! Customer Satisfaction
! Quality Measures

The above are all Key Performance Indicators (KPIs)
that need to be measured and reviewed on a regular
basis by the board of directors. (Board)

3. External Factor Affecting V
e
& P
o

3.1 The Board cannot control all aspects that effect
V
e
and/or P
o
. One of the major factors is macroeconomic
variables.

3.2 Economic Variables -what are they and how may
directional changes effect the share price?

3.2.1 Interest Rates- If they fall:-

! Stimulate demand and revenue
! Lower the cost of debt and improve profits
! Investors switch to share market for better returns

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3.2.2 Inflation Rates- If it rises:-

! Costs rise causing a drop in profits
! Cause interest rates to rise.
! Devalues the home currency

3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-

! Reduce cash receipts for exporters
! Lowers the cost for importers
! Discourage exporting

3.2.4 Gross Domestic Product- If it falls:-

! Reduce demand and revenue
! Cause interest rates to fall to stimulate demand

3.2.5 General Taxation If it rises:-

! Damage company profits
! Not encourage investment by companies
! More savings from tax effect of tax allowable
depreciation.

Important to relate your comments to the effect upon P
o

& V
e
.

3.3 Agency Problem

3.3.1 S/H are the owners of the company and expect
their directors (agents) to take decisions to maximise
S/H wealth. The agency problem occurs when directors
take decisions that DO NOT lead to maximising S/H
wealth.

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3.3.2 Examples of decisions that may damage S/H wealth:

! Directors pay
! Taking high risk business decisions
! Non-payment of dividends
! Using debt finance (against the wishes of the
S/H)

3.3.3 Solutions to this problem include:

! Company Law
! Corporate Governance (eg UK Combined Code)
! Share Options (ESOPS)

3.3.4 ESOPS

This provides a way of rewarding Directors by
granting them options to buy shares in their company
at a fixed price. They can buy the shares in future
(normally 1 year) at the fixed price which usually is
todays price. Hence, directors are encouraged to take
decisions to maximise future share prices. This
benefits both the directors and the shareholders.

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4 The Three Key Decisions

4.1 To maximize S/H wealth the board must take

! Investment
! Finance
! Dividend

4.2 Investment

4.2.1 Allocate cash for:-

! Organic Growth (Projects)
! Acquisitions

4.2.2 Must always consider how investments
impact upon:-

! Company Liquidity
! Future Profits and Asset values
! Business Risk Profile i.e. effect upon
variability of the cash flows and profits.

4.3 Finance

4.3.1 To finance investments the board have to
decide the best balance of equity and debt.

4.3.2 They will consider:-

! Cash available within the company
! Access to new sources of finance
! Impact on KPIs like gearing
ratio(Debt:Equity)
! Cost of Finance (WACC)

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4.4 Dividends

4.4.1 The Board needs to establish a dividend policy
see Chapter 5

4.5 The three decisions are interlinked.

Example: New projects need new finance but must
generate cash to service the finance providers
including paying dividends to the shareholders.

5 Objectives of Not-For-Profit- Organisations (NFP)

5.1 These include:

! government funded functions(Public Sector)
! charities
! trade unions

5.2 With no shareholders it is important to ascertain.

a) who are the main stakeholders?
b) what are there objectives?

5.3 It is widely recognised that NFP entities should
demonstrate the principles of Value for money(VFM)

The indicators are:-

1) Economy - lowest cost of input resources
2) Efficiency - ratio of input to output measures
3) Effectiveness - how outputs are measured.

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5.4 For example, in a government funded school measures
could be:-

Economy - cost of teachers
- cost of admin

Efficiency - cost/pupil
- Number of pupils/teacher

Effectiveness - pass rates
- number of pupils moving to higher
education

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Chapter Two

Cost of Capital

1 Weighted Average Cost of Capital (WACC)

1.1 This is the formula given on your formula sheet.

1.2 The Symbols:-

! K
e
= Cost Of Equity

! K
d
(1-t) = Post Tax Cost of Debt

! K
d
= Yield to maturity on debt or Pre Tax Cost of Debt

! V
e
=Market value of the Equity Capital.

! V
d
= Market Value of the Debt Capital

! t= Corporation tax rate

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1.3 Some past P4 answers used the following symbols:-

WACC= W
e
r
e
+ W
d
r
d
(1-t)

! W
e
= V
e
or (1-W
d
)
V
e
+V
d

! W
d
= V
d
or (1-W
e
)
V
e
+V
d

! r
e
=K
e
=Cost Of Equity

! r
d
(1-t)=K
d
(1-t)=Cost of Debt

Therefore, its the same Formula!!

2 Cost of Equity (K
e
, r
e
)

2.1 Formulae are given in the exam as:-
a)

This can be simply presented as:-

K
e
or r
e
=R
f
+!
e
(R
m
-R
f
)

b)

This you have to rearrange to:-

r
e
=D
o
(1+g) +g
P
o

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c)

This latter formula applies under M&M assumptions with tax.
(see later)

2.2 Lets clear up the additional symbols to those listed under
2.1 above:-

R
f
=Risk Free Return
R
m
= Return on the Market Portfolio
!
e
=Systematic Risk being faced by the
shareholders.
D
o
=The dividend per share (DPS) today or last paid.
g = Constant annual growth rate in dividends.
P
o
=Share price currently
Ke
i
= Cost of equity assuming all equity position.
(R
m
-R
f
)= Equity Risk Premium.

2.3 Remember from F9 if you are going to we

K
e
= D
O
(1+g) +g
P
O

You need to find g

There are two ways:-

i) Historic Estimate - example

Year End Dividend per share
$
2007 0.24
2008 0.27
2009 0.29
2010 0.32

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g=
3
"(0.32/0.24) -1

g=10%

ii) Gordon Growth Model

g=br
e

b= the proportion of profits retained by the
business.
r
e
= the accounting rate of return (ARR)

Example

A company has an ARR of 12% and pays out 30% of
its profits as a dividend.

g=0.70 x 0.12=0.084

2.4 At P4 level, the Gordon Growth Model can be extended
such that if r
e
is the cost of equity, a LONGTERM
growth rate is computed.

Example

If K
e
=11%

g= 0.70 x 0.11= 0.077

2.5 If using CAPM, the !
e
must reflect the companys
systematic business and financial risk. Skills taught at
F9 are needed at P4.

! Degear !
e
s to find !
a

! Regear !
a
s to find !
e

We can remove the financial risk element via
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!
a
= Asset Beta, measure of systematic business risk
!
d
= Debt Beta (Often nil)

Example

!
e
is 1.95 V
d
:V
e
1:4

t= 30% !
d
=NIL

Find !
a

!
a
= 4 x 1.95
4+1(1-0.30)
= 4 x 1.95
4.7
= 1.66

If the company operates on a divisional basis and each
division is in a different business area. Then:-

1) Find !
a
s of each industry field that the company
operates in.

2) Combine using the weighted average method.

3) Gear up to the companys gearing level.

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Example

ABC is made up of two divisions

Division Asset !eta Proportion of the
Business
Food 0.75 40%
Clothes 1.80 60%

The company gearing level is 32%.

Tax =25%

!
a
=(0.75 x 40%)+(1.80 x 60%)

= 1.38

1.38 = 68 x !
e

68+32(1-0.25)

1.38= 68 x

!
e

92

!
e
=1.87

3 Post Tax Cost of Debt (K
d
(1-t) or r
d
(1-t))

3.1 K
d
or r
d
is the yield or minimum return for the debt
holder pre tax cost of debt.

K
d
(1-t) or r
d
(1-t) is the post tax cost of debt for the
company.

3.2 To find the cost of debt we need to look at the type of
debt finance skills taught at F9.

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3.3 Bank Loans

K
d
(1-t)=Interest % x (1-t)

Example

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

K
d
(1-t)=11 x (1-0.30)=7.7%

3.4 Traded Bonds-Irredeemable

K
d
(1-t)=Ints x (1-t)
P
o

Remember P
o
is the market value per block of $100.

Example

9% Bonds trading at $89 t=30%

K
d
(1-t)= 9 x (1-0.30) = 7.1%
89

3.5 Traded Bonds-Redeemable

K
d
(1-t) is an IRR computation based upon

Time $
T
o
P
o
(X) Take two guesses
T
1
-T
n
Ints X(1-t) X like 10% and 1%
T
n
Capital
Repayment
X and do an IRR

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3.6 The main method used in the P4 exam is:-

K
d
(1-t)=(Yield on similar Government debt

+ Credit Risk
Premium) x (1-t)

Example

Table of credit spreads for industrial company bonds in Basis
Points (BP=0.01%).
Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
AAA 5 10 15 22 27 30 55
AA 15 25 30 37 44 50 65
A 40 50 57 65 71 75 90
BBB 65 80 88 95 126 149 175
BB 210 235 240 250 265 275 290
B+ 375 402 415 425 425 440 450
The current return on 5-year treasury bonds is 2.8%. F plc
has equivalent bonds in issue but has an A rating.

(i)
calculate the expected yield on Fs bonds

(ii)
find Fs cost of debt associated with these bonds if
the rate of corporation tax is 30%

(i) Yield =2.8+0.65 =3.45%
(ii) Kd(1-t)= 3.45% x (1-0.30)
= 2.42%
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3.7 MARKET VALUE OF TRADED BONDS

As can be seen above the market value of debt (P
o
) is
given per block of $100 we need this to find Vd .This
may have to be computed using the Dividend Valuation
Model (DVM).

i.e P
o
=Present Value of all future cash flows discounted
at the yield to maturity for the relevant debt.

Example

$20 m 7% Bond will be redeemed in 3 years at par
($100). Yield to maturity is 5.25%.

NB: Dont 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 P
o
=

$7 + $7 + $7+$100
1.0525 1.0525
2
1.0525
3

6.65 + 6.32 + 91.77

= $104.97

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4 Use of WACC

4.1 The WACC is the nominal cost of capital to be used in
advanced project appraisal involving DCF methods.

i.e. NPV
IRR
MIRR

4.2 The nominal cost of capital has the symbol i at P4 and
can be found via:-

4.3 The WACC is only useable providing:-

! The project under consideration is a core activity of the
company.

! The project finance will not significantly change the
current gearing ratio of the entity.

4.4 If the new project is a NON CORE Activity but the project
will have no significant effect upon the companys
gearing ratio then the nominal cost of capital to use is
the RISK ADJUSTED WACC.
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Chapter Three

Risk Adjusted WACC

1 When do we use this?

As stated in Chapter Two above if the:-

a) Project is a non-core one
b) Will have no effect upon the companys gearing ratio

2 Approach

a) Find an equity !eta for the industry relating to the
project.

b) Degear !
e
to find the asset !eta.

c) Re-gear !
a
to find the project equity !eta . Use either:-

i. The companys existing gearing level or

ii. The specified gearing level post project

d) Use the answer to (c) above known as the project !
e
in
CAPM to find the project K
e

e) Find the relevant Kd(1-t)

f) Use WACC Formula, project K
e
, Kd(1-t) and gearing
level stated in (c) i) or ii) above to find the Risk
Adjusted WACC-a nominal cost of capital.
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3 What to do if WACC or Risk Adjusted WACC cant be used.

This can happen if:-

i. Project is core or non-core.

ii. Project Finance will significantly change the
companys gearing ratio.

iii. Finance may include subsidised loans-lower interest
rate than market rate.

Solution lies in Adjusted Present Value (APV)-covered
later in the notes.

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Chapter Four

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

Debt/Equity+Debt OR Debt/Equity

! Will the debt providers exercise influence over the
company?
! The chance of bankruptcy.

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3 Theories of Optimal Capital Structure

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

a) Yield<K
e

b) Gearing causes K
e
to rise

3.2 Traditional View

% K
e

Cost
Of
capital
WACC

K
d

0 X Gearing

Key Points:-

1) K
e
rises due to financial risk caused by gearing.
2) K
d
is initially uneffected by gearing but rises at high
gearing levels due to the perception of the possibility of
bankruptcy.
3) WACC-trade off of K
e
and K
d
. Point X is the optimum
gearing level where WACC is lowest.
4) Once point X is reached via trial and error it must be
maintained.
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3.3 MM and Tax

% K
e

Cost of
Capital

WACC
K
d

0 Gearing

Key points:-

1) Assumption 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 companies should gear up to the
maximum levels.

3.4 Specific Equations can be used under MM+ Tax theory.

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V
d
=V
u
+V
D
T

WACC=K
eu
{1-T x V
d
}
(V
e
+V
d
)

Only the latter is given on the formulae sheet.

4 Pecking Order Theory

In this approach, there is no search for an optimal capital
structure through a theorised process. Instead it is argued
that firms will raise new funds as follows:-

! Internally-generated funds
! Debt
! New issue of equity

Firms simply use all their internally generated funds first
then move down the pecking order to debt and the finally to
issuing new equity. Firms follow a line of least resistance that
establishes the capital structure.

Internally generated funds-i.e. retained earnings.

! Already have funds.
! Do not have to spend any time persuading outside
investors of the merits of the project.
! No issue costs.

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Debt

! The degree of questioning and publicity associated with
debt is usually significantly less than that associated
with a share issue.
! Moderate issue costs.

New issue of equity

! Perception by stock markets that it is possible sign of
problems. Extensive questioning and publicity
associated with a share issue.
! Expensive issue costs.

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Chapter Five

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 P
o
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 V
e
will rise and the S/H can sell shares
to create the cash the need(Manufacture Dividends).

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3 Practical Considerations

There are many to consider:

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

4 Alternatives to Cash Dividends

4.1 Scrip Dividends

4.1.1 The S/H will receive extra shares instead of cash on a
pro rata basis.

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

4.1.3 The effect will:-

a) Increase the issued equity capital
b) Dilute EPS and P
o
values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue

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4.2 Share Buy Back

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

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

4.2.2 Considerations:-

a) Allowable under company law.
b) Increase gearing as V
e
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 Six

Advanced Investment
Appraisal I

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

(X)
Incremental non-current
asset investment(IAI)
(X)
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Incremental working capital
investment(IWCI)
(X)
Free cash flow for the
company
X used in NPV comps
Debt Interest (X)
Debt Repayments (X)
Debt Issues X
FCF to equity X used to value equity in
certain business valuation
models.

1.2 Skills Learned at F9

Remember, Shish has clearly stated in his article that you
must remember the skills taught to you at F9.They are:

Relevant Cash Flows

Inflation
Taxation
Working Capital
Financial Maths

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

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1.4 Inflation (Symbol h)

Two acceptable approaches based upon matching the
cash flow to the cost of capital.

Include

Cash Flows must be given in nominal terms or must
be converted into nominal terms using

Nominal CF
n
=Real CF
n
X (1+h)
n

Cost of capital must be nominal (symbol i) which
will:-

a) Given in question
b) WACC or Risk Adjusted WACC Formula /Method
c) Fisher Formula

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

Exclude

Cash flows are given in real terms or can be
converted into real terms.

Real CF
n
= Money x CF
n

(1+h)
n

Cost of Capital has to be in real terms (r) which will
be given or to rearrange the Fisher Formula

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

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The exclude method is used when it makes practical sense
to do so. For example, the cash flow is a long annuity or
perpetuity.

1.5 Taxation

This is a relevant cash flow to be included in the FCF
schedule. Two acceptable approaches:-

One Line tax flows
Two Line tax flows

One Line tax Flow

This was in Shishs sample question. The FCF schedule
shows only one line for tax.

A tax working is required:-

$000

Incremental Revenue XXX Netted are
operating
Cash flows
Incremental Costs (XXX)

Tax Allowable Depn (XXX)

Taxable Profit XXX

Above x Tax Rate = Tax Cash Flow

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Two Line tax Flows

After chatting with Shish, he said that this method is
perfectly acceptable as it was used in many past F9
questions.

Here:-

Tax is computed on Operating Cash Flows.

Tax saved on tax allowable depreciation is shown on a
separate line.

Both One Line and Two Line will give the same yearly
FCFS.

Finally,

READ THE QUESTION CAREFULLY RE TIMIMG OF TAX
DUE.

1.6 Working Capital

! Think as it is a project bank account.

! Invest, Adjust, Close!!

eg

$000 T
0
T
1
T
2
T
3

WC needed - 100 170 300
Relevant
Cash Flows
(100) (70) (130) 300

These go into the NPV
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1.7 Financial Maths

A quick reminder

a) 5 year discount Factor at 12%

From tables, 0.567

b) 8 year annuity factor at 7%

From tables, 5.971

c) Perpetuity Factor at 11.2%

1
= 8.928
0.112

d) Annuity Factor starting at time 4 stopping at time 9 at
8%

AF
4-9
= AF
1-9
AF
1-3

= 6.247-2.577=3.67

e) The present value of a cash flow starting at T5 at $200
then growing in perpetuity at 2% at 12% cost of capital.

1 x DF
3

r-g

1 X .712
0.12-0.02

= 7.12

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2 Layouts

Two options depending upon the nature and style of the
FCFS

Format A (Assuming One Line Tax)

Time
$000 T
0
T
1
T
2
T
3
T
4
T
5

Revenue - X X X X
Materials - (X) (X) (X) (X)
Labour - (X) (X) (X) (X)
VOH - (X) (X) (X) (X)
Incremental
FOH
- (X) (X) (X) (X)
Operating
CF
- X X X X
Tax(w1) - - (X) (X) (X) (X)

Capex &
Scrap
(X) - - - X
W Capital (X) (X) (X) (X) X
FCF (X) X X X X (X)
i% 1.0 X X X X X
PV (X) X X X X X
NPV $ XXX

Format B

Time $000 % PV$000
T
0
(X) 1.0 (X)
T
1
-T
30
X X X
T
2
-T
31
(X) X X
T
32
X X X
NPV $XXX
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Chapter Seven

Advanced Investment
Appraisal II

1 IRR

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

1.2 Example

NPV @ 10% = $30K
NPV @ 20% = ($160K)

IRR=10 + ( 30 ) x (20-10) =11.6%
30-(-160)

1.3 IRR has weaknesses:-

a) Cannot be used to compare mutually exclusive projects.

b) Multiple IRRs 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 Class Illustration

Cost of Capital=10%

2.2 Using The Formula

NPV had been computed at 10%.

Time $ 10% PV
T
0
(1000) 1.0 (1000)
T
1
400 0.909 363.6
T
2
600 0.826 495.6
T
3
300 0.751 225.3
84.5

* PV of Return Phase=$1084.50

Formula given

PV
R
=PV of Return Phase Cash Flows
PV
I
=PV of Investment Cash flows
r
e
=Cost of Capital
n= Year of the final cash flow

Time $000
T
0
(1000)
T
1
400
T
2
600
T
3
300
Return phase
of the project
*
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MIRR= (1084.50)
1/3
(1.10)-1
1000
=13%

Alternative Method:

a) Terminal value of Return Phase cash flows.

Time $000
T
1
400 X 1.10
2
= 484
T
2
600 X 1.10 = 660
T
3
300 X 1.0 = 300
1444

Therefore, we now have a revised set of cash flows

T
0
(1000)
T
3
1444

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

MIRR = r

1444 - 1000=NIL
(1+r)
3

Therefore,
3
"1444 -1 =13%
1000

Both NPV rule and MIRR rule indicate project is worthwhile.

2.4 Problems with MIRR

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

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! MIRR may itself have to be modified to accrue of
variable reinvestment rates.

! Defining the Investment Phase. Per Q1 Dec 08 two
definitions were possible giving slightly different
answers.

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3 Foreign Investment Appraisal

3.1Predicting future spot rates via formulae provided:-

S
1
=F
0
=Future Spot Rate
S
0
=Spot Rate Today
h
c
=Inflation Rate abroad
h
b
=Inflation Rate home
i
c
=Interest Rate abroad
i
b
=Interest Rate Home

3.2 Double Taxation-the golden rule is you must pay the
higher of the two rates

3.3 Format-one line tax layout is best here to accrue for
double tax.

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3.4 Suggested Layout FCF

Foreign Currency T
0
T
1
T
2
T
3
T
4

Revenue
Costs
T.A.D(not a C.F)
-
-
-
X
(X)
(X)
X
(X)
(X)
X
(X)
(X)
X
(X)
(X)
Foreign Profit
Foreign Tax
Add:
TAD(above)
CAPEX & Scrap
W.C.

-
-

-
(X)
(X)
X
(X)

X
-
(X)
X
(X)

X
-
(X)
X
(X)

X
-
(X)
X
(X)

X
X
X
Foreign FCF
Spot Rates
(X)
X
X
X
X
X
X
X
X
X
Home Currency
Cash Flows
Additional Home
Tax
(X)

X

(X)
X

(X)
X

(X)
X

(X)
FCF (X) X X X X

4 Adjusted Present Value (APV)

4.1.1 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.

4.1.2 APV is still the change in shareholder wealth arising
from the project.

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4.2 Method

! Establish the !asset for the project.
! Using the !asset in CAPM find K
eu
(all equity K
e
i
)
! Discount the relevant project cash flows using K
eu
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

4.3 Subsidised Loans

4.3.1 If any part of the loan Finance is at a subsidised rate,
then the APV must include an extra benefit.

4.3.2 PV of the post tax subsidy discounted at the pretax cost
of debt.

APV

$m
Base case NPV X
PV of issue costs (X)
PV of tax savings on interest X
PV of net of tax subsidised interest X
APV
X

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5 Capital Rationing

5.1 When there is a lack of sufficient cash to invest in all
projects with a positive NPV

5.2 Cash can be restricted due

a. Hard Reasons external constraint eg Credit Crunch.
b. Soft Reasons internal restrictions eg Capex Budget

Single Period-Divisible Projects

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

PI= NPV
Cash outlay in critical period

5.4 Rank the projects based upon the PI

Example

ABC inc has $30m to spend today and has the following
projects available:-

Project Spend-Today NPV
$m $m
A 22 67
B 17 25
C 40 65
D 18 36

What are the PIs?

a. 67/22=3.05

b. 25/17=1.47

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c. 65/40=1.63

d. 26/18=2.00

Multi-period-Divisible Projects

5.5 This is when cash is restricted in more than one period.
You must understand that the aim will be to maximise the
wealth of the shareholders but stay within the cash limits
each year. Also, some projects can cross fertilise meaning
that they generate positive cash flows which can fund those
with deficits. Deposit accounts can be used to carry cash
forward into future periods.

5.6 A optimum solution can be found using linear
programming (divisible projects) and integer programming
(non divisible projects).

6 Dealing with Risk within Investment Appraisal

6.1 Sensitivity Analysis

6.1.1 Remember from ACCA F9 that this is defined as change
one variable within the project and cause the NPV to go from
positive to nil.

6.1.2 A quick way to compute the sensitivity margin%:-

For any Cash Flow

NPV x 100

PV Of Cash Flow

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For Cost Of Capital

IRR Cost of Capital x 100
Cost of Capital

Example

Time $000 10% PV $000
T
0
Capex (1000) 1.0 (1000)
T
1
-T
5

Revenue
400 3.791 1516
T
1
-T
5
Cost (20) 3.791 (76)
T
5
Scrap 200 0.621 124
NPV 564

What are the sensitivity margin % for

! Revenue
! Capex

Revenue = 564 = 37%
1516

CAPEX = 564 =56%
1000

6.2 Simulation

The assessment of the volatility (or standard deviation)
of the net present value of a project entails the
simulation of the financial model using estimates of the
distributions of the key input parameters and an
assessment of the correlations between variables. Some
of these variables are normally distributed but some
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(such as decommissioning cost) are assumed to have
limit values and a most likely value. Given the shape of
the input distributions, simulation employs random
numbers to select specimen value for each variable in
order to estimate a trial value for the project NPV. This
is repeated a large number of times until a distribution of
net present values emerge. By the central limit theorem
the resulting distribution will approximate normality and
from which project volatility can be estimated.

In its simplest form, Monte Carlo simulation assumes
that the input variables are uncorrelated. However, more
sophisticated modelling can incorporate estimates of the
correlation between variables. Other refinements such as
the Latin Hypercube technique can be reduce the
likelihood of spurious results occurring through chance in
the random number generation process. The output from
a simulation will give the expected net present value for
the project and a range of other statistics including the
standard deviation of the output distribution. In addition,
the model can rank order the significance of each
variable in determining the project net present value.

(These are the words of Shish)

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Chapter Eight

Valuation of Options
+Value at Risk
1 Valuation of Options

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

Details and terminology: -

(a) Put right to sell.

(b) Call right to buy.

(c) Exercise price / strike price price at which shares
can be bought or sold.

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

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

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1.2 Components of Option Value

Intrinsic value and time value

There are 5 main components to the value of an option

(a) Intrinsic value, the difference between

(i) The current price of the asset(P
a
)

(ii) The exercise price of the option(P
e
)

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

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

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

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

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The Black Scholes Option Pricing Model

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

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

Symbols:

P
a
=share price

P
e
=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
In =natural logarithm
On Your calculator!!
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d
1
& d
2
= Compute to two decimal places.

N(d
1
)& N(d
2
)=the cumulative value from the normal
distribution tables for the value d
1
or d
2
.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) e
-rt

rt =0.1 x 0.25 = 0.025

e
-0.025
=0.975

2) N (d
1
) & N (d
2
)

d
1
= In(100/95)+(0.10+0.5 x 0.5
2
)0.25
0.5 x "0.25

d
1
= 0.0513 + 0.05625 =0.43
0.25

d
2
=0.43-0.25=0.18

N (d
1
) = 0.50+0.1664=0.6664

N (d
2
) = 0.50+0.0714=0.5714

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3) C

C = (100 x .6664) - (95 x 57.14 x .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

Example

p = 13.71-100 + (95 x .975)

= $6.34

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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.

3 Black and Scholes applied to Investment Appraisal.

3.1 Real options on projects

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

3.2 Use the normal BSOP equations but:-

P
a
= PV of future Cash Flows

P
e
= Given or CAPEX

R= Risk Free Rate

t= time to expiry (in years)

s= standard deviation

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4. Value at Risk (VaR)

4.1 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.

4.2 Used by Investment banks to measure the market risk of
their portfolios.

4.3 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

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There is a 5% chance that the portfolio will fall below
$42m.

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Chapter Nine

Risk Management

1 Introduction

1.1 I expect Shish may well write an article on this topic as
guidance. I would guess that it will cover how he
expects students to deal with this topic at P4 level. This
chapter has been written in anticipation of that article.

1.2 Risk Management is a substantial part of ACCA P1. A lot
of that knowledge will be required here but with some
emphasis on particular areas.

2 Summary of P1

2.1 Sources and impacts of common business risks

! market
! credit
! liquidity
! technological
! legal
! health and safety
! reputation
! business probity
! derivatives

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2.2 Approach to risk management

! Identify
! Assess
! Measure
! Avoid
! Accept
! Hedge/Reduce Effect

3 P4-Main Risk Categories

3.1 At this level there are four major areas of risk:-

! Business Risk
! Financial Risk (Chapter 4)
! Foreign Currency Risk (Chapter 10)
! Interest Rate Risk (Chapter 11)

4 Business Risk

4.1 Defined as being the cause of variations in:

! Company profits
! Returns to a shareholder

It is related to:

i. Nature of business activity
ii. Level of operational gearing amount of fixed costs that
make up the operational cost base.

4.2 Total business risk is measured using the standard
deviation #
i.
Hand in hand goes expected return Ri.

4.3 Business risk can be managed or reduced initially using
Portfolio Theory.
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5 Portfolio Theory(PT)

5.1 PT can be used by

! Directors-combine business activities logically
! Shareholders- create a logical share portfolio

5.2 PT relies upon the basic concept that if shares or
business activities that are combined are LESS THAN
PERFECTLY CORRELATED, risk can be reduced

5.3 The correlation coefficient is a key value and its range is:

-1 0 +1

Perfect No Correlation Perfect
Negative Positive
Correlation Correlation

5.3 When two investments are combined PT Formulae
exist to:-

S
p
= Risk of the portfolio

Return from = (R
a
x W
a
) + (R
b
x W
b
)
the portfolio(R
p
)

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6 Extend PT-more investments

6.1 The above only assumes that two investments are
combined. Naturally the more the investments are added
the lower S
p
should go.

6.2 S
p
does not reach nil

Market Portfolio
S
p

Unsystematic
Risk

Systematic Risk

20
No of investments

6.3 PT removes one part of Sp unsystematic risk. This is the
specific risk caused by factors relating to the company or
industry.

6.4 The risk remaining is systematic risk-that caused by
general economic and political factors. This can be
measured via Beta factor.

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7 CAPM

7.1 Once the market portfolio fully diversified position has
been reached ,the company and shareholders should use
CAPM.

Risk =!
e

Return= R
F
+ (R
m
-R
F
)!
e

OR
R
F
+ (ERP)!
e

7.2 Remember from Chapter Two Cost Of Capital how a !
e

can be analysed.

8 WHY DO DIRECTORS LIKE TO HAVE A DIVERSIFIED
BUSINESS?

Several Reasons:

! Stabilise profits
! Lead to move predictable cash flows
! Larger or safer business
! Conglomerate theory-some directors feel they can run
any type of business (Virgin, Tata)
! Foreign acquisitions will reduce economic risk.
! Risk of the investment failing a more of a problem for
the shareholder than the director
! May be the only expansion option.

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Chapter Ten

Foreign Currency Risk
Management
1. Translation Exposure

1.1 Risk caused by change in the value of a Forex asset or
liability over the long term.

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

2009 - at $1.50 6.67m

2010 - at $1.75 5.71m

Loss to equity (0.96m)

Funded by a $10m loan.

2009 - at $1.50 6.67m

2010 - at $1.75 5.71m

Gain to equity 0.96m

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

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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!!

3 SPOT Rates

3.1 Rate of exchange at a point in time.

(Bid) (Offer)
$1.5000 - $1.5555 /

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
Reciprocal and
cross over!!!!!
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4.2 Foreign currency bank account

! Held in the main currencies ($, Euro)

! Pool all transactions in same FX

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

! Basic is to match all FX transactions that occur on
the same.

Class Illustration

Today 30 Sep

$200K = Expected Receipt
($ 120K)=Expected Payment
$80K)

! Multigroup netting-used in group planning and
currency risk management. All future FX transactions
are converted into one common currency through one
company.
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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.

5.2 Money Market Hedge(Rate used is Todays Spot Rate)

The exchange will take place today at the known spot
rate.

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Technique

Home Abroad

Todays Spot
Answer FX

X

Answer FX

FX

5.3 Futures(Lock into a rate that will approximately equal
Todays 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 todays Spot
Rate.

Technique: -

Today
1+ints home
Future Date
1 + ints foreign
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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 tick / contract value
Deposit the returnable margin

3. Close out future date

(a)Transaction at spot XXX

(b) Futures Profit / Loss
(No of contracts x Tick value x Tick Movement) @ SPOT XXX
XXX

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

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5.4 Options

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

No receipt or payment in FX options lapse
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Compare spot with strike rate choose the best
rate for the business

6. Pros & Cons

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

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.

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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 years 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.

Solution

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

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

Interest Rate Risk
Management

Interest Rate Risk

1 ISSUE

There are two issues / type of F9 questions:-

! Term Structure of Interest rates
! Risk Management.

2 Term Structure of Interest Rates

2.1 Interest rates on the market generally follow this
relationship:

Return on LIBOR Lenders
Govt Bonds < (Interbank < Rates
(R
F
) Rate)

2.2 Hence if the R
F
was to change it has a direct impact on
all other rates.

2.3 To predict the change in the R
F
, we use the Theory of
the Yield Curve

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%

Years until maturity

The curve is upward due to:-

a) Liquidity Preference Theory- the longer there is to
maturity the greater the return wanted by the lender.

b) Expectations theory-the yield reflects the expectation of
higher future inflation rates

2.4 Some research has indicated it may not be a curve but a
kinked function.

%

5 years Years to
Maturity
The standard of the
yield curve
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2.5 If inflation expectations are in reverse ie deflation, it is
feasible to get a reverse yield curve.

3 Risk Management

3.1 Normally, this occurs when a company has produced a
short term budget and believe that in the near future
they will run up a cash deficit (possibly a surplus). They
want to hedge against interest change that could damage
their profits.

3.2 For example

1 Jan 31 Mar 31 May

Now (Deficit) Return to
Pay o/d interest surplus
for 2 months

No of years of maturity
%
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3.3 To hedge this risk a company has two basic choices:-

! Lock the Rate
! Ceiling/ cap the rate

4 Lock the Rate

4.1 Forward Rate Agreements

Companies can lock the future interest rate by
purchasing a FRA from the markets. There is no fee
payable but the market likes to deal with minimum loan
size of $1m.

On the day the company pays the interest to the loan
provider a settlement/cash transaction takes place
between the company and the seller of the FRA.

4.2 Futures

! The aim here is to lock the interest rate to a value
approximately the same as the current value of
interest.

! The Futures market is similar to spread betting-
taking a bet that the interest rate will change from
current position.

! The hedge is complicated due to:

i. Standard contract sizes

ii. 3 month contract lengths

iii. Margins/deposits

iv. Tick sizes of 0.01%
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5 CEILING/CAPPED RATE

5.1 IRG

All aspects are the same as a FRA except

1) Rate is capped /maximum is created
2) Fee is payable up front.

5.2 Options

All the aspects same as a Futures hedge except

1) Create a ceiling by buying a put option
2) Pay a Fee
3) No margins/deposits

6 SWAPS

6.1 Longterm method of hedging where companies swap
their interest commitments but no their loans.

6.2 Class Illustration

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
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assume savings are split equally.

6.3 Exam Technique

(1) Table of Interest Rates.

Company Fixed Float Want
A 10% LIBOR +1% FLOAT
B 13% LIBOR +2% FIXED

(2) Interest Difference.

%
A (Fixed)+B (Float)
10+LIBOR+2 =LIBOR +12
A(Float)+B (Fixed)
LIBOR+1+13 =LIBOR+14
Difference 2%

(3) SWAP Diagram

LIBOR + 2
A B
12(w
1
)
10 LIBOR+2

Net = LIBOR Net Rate=12
Rate

(w
1
) B-(0.5 x 2) = 12

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Chapter Twelve

Business Valuation &
Acquisitions

1 Valuation Methods

1.1 The aim is to find a range of values for a
company. The answer can be presented:-
a) V
e

b) P
o

1.2 Net Asset Valuation

1.2.1 Business is worth just the value of its Net Assets.

To establish the net assets:-

Total Assets-(Total Liabilities +Preference Shares)

1.2.2 The Net Asset value equals the V
e
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 its future
dividends discounted at the cost of equity

1.3.2 V
e
= Total D
o
(1+g)
(K
e
-g)

OR

P
o
= D
o
(1+g)
(K
e
-g)

1.3.3 Take Care:-

! Growth may not be constant forever
! Where to we get g from?
! CAPM may be needed to find K
e

! Often better for valuing a small shareholding

1.3.4 Finding g
a) Past Growth model
eg:
Year DPS
2006 $0.45
2007 $0.49
2008 $0.52
2009 $0.54
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g=
3
" (0.54)-1
(0.45)

g=0.063

b) Gordon Growth Model

g=br
e

where b=Profit retention ratio
r
e
= ARR or Cost of equity

eg A company has a retained profit ratio of 0.45.It has
an ARR of 12% and r
e
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 its profits.

1.4.2 V
e
=Sustainable PAT X Suitable P/E

P
o
=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
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i. Ltd Cos deduct 30%off proxy Co P/E
ii. Non-listed PLCs-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:-

! It relies on estimates of both cash flows and discount
rates.

! What time period should we evaluate in detail and
then how do you value the companys worth beyond
this period i.e. the realisable value at the end of the
planning period.

! The NPV method does not evaluate further options
that may occur.

! It assumes that the discount rate and tax rates are
constant through the period.

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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

V
e
= FCF
0
(1+g)
(r
e
-g)

= $400m (1.0255) = $6,894m
(0.085-0.0255)

1.5.5 Another Example

A company has projected its FCF to equity at:-

T
1
$420m
T
2
$490m
T
3
$510m

From T
4
onwards growth will be at 3 %pa.r
e
=7.92%.
Find V
e

Time

$m T
1
T
2
T
3
T
4
-F.Ever
FCF 420 490 510 510(1.03)
1/1.0792 1/1.0792
2
1/1.0792
3
16.171*
PV 389 421 406 8,495

Ve=$9,711m

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

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

V
e
under DVM or P/E Book value of Net
Or PV of CFs method - Assets

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

Approach:-
$ 000

1) Last reported profit before tax X
Less: Industry of Proxy x Cos total (X)
Return on assets assets

Value Spread X

2) Take value spread X

Tax @X% (X)

Post tax value spread X

3) Assume post tax value spread will stay constant
From time 1 to perpetuity.

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

4) Value of Equity is

Value of IC + Book value of the Assets

Option Valuation Method

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Business Valuation-Option Pricing Theory Question

Sparks PLC is a company in the electronics industry and is
looking to expand through acquisition. A target company,
EBMS Plc, has been identified and the directors of Sparks Plc
are looking to value the entire equity capital to EBMS.

From discussions with the director of EBMS, the assets of
EBMS have been valued at 1,450 m which the directors of
EBMS consider to be their fair value in use in the business.
The volatility of the asset value has been agreed at 10% per
annum.

EBMS currently has 4% debentures in issue with a book
value of 900m which are redeemable in 3 years time at a
premium of 25% over par. Interest is payable annually.

Short dated Government bonds are currently yielding on
average 4.25% and LIBOR is 0.75% above this. EBMS
currently has a BBB credit rating and the following data on
credit risk premiums (in basis points) has been obtained from
commercial rating sources:

1 year 75
2 year 95
3 year 120
5 year 135

The directors of Sparks plc always try to obtain as many
different valuations as possible when evaluating a potential
acquisition and wish to use option pricing theory in addition
to the more usual methods.

Required

Using the Black Scholes option pricing model, derive a value
for the total equity of EBMS.
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Answer

The approach to answering this question is as per Bob Ryans
article in Novembers Student Accountant. The basic process
is to recognise that the equity represents a call option to
purchase the company from the debenture holders in three
years time.

Firstly, calculate the exercise price. This is the redemption
value of the debt BUT including the interest element also.
This requires calculating the fair value of the debt and then
converting it to a zero coupon bond with the same fair value
and time to maturity to obtain a redemption value
incorporating interest as well.

Required yield=risk free rate + credit premium = 4.25+1.20
=5.45%

Fair value calculation:

Year C. Flow DCF (5.45%) PV
1 4 0.9483 3.79
2 4 0.8993 3.60
3 4 0.8528 3.41
4 125 0.8528 106.60

Fair Value per 100 117.40

For a 3 year zero coupon bond to have the same fair value,
the redemption premium would need to be:

Premium in 3 years =117.40 * (1+5.45%) 3 = 137.66

Therefore, theoretical exercise price=137.66/100*900m=
1,238.94m

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The variables can now be assigned:

Exercise Price 1,238.94
Asset Value 1,450.00
Risk Free Rate 0.0425
Time to maturity 3
Volatility 1

Calculate Black Scholes figures

D1 = 1.73
D2 = 1.56
N (D1) = 0.95818
N (D2) = 0.94062

Calculating the main formula gives an option value of
363.5m.

This can be broken down into:

Intrinsic value 211.06m (1,450-1,238.94)
Time value 152.44m

Therefore, the equity value is 363.5m which is 152.44 m
more than the current net assets value of the business.

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2 Post Acquisition Analysis

2.1 The main aim of an acquisition is to add value i.e 2+2
=5

2.2 To establish post acquisition value there are several
methods to consider.

a) Pre Acquisition of A X
Pre Acquisition of A X
A+B X
P.V of Synergies X
XX

b) Pre Acquisition PAT of A X
Pre Acquisition PAT of A X
Combined PAT X
* P/E Ratio of A X
XX

c) Combine the FCFS of each company and discount
at AS WACC

2.3 Maximum A would be willing to pay for B is:-

Combined Valve A+B XX
Less: Pre Acquisition (XX)
Value of A XX

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3 Factors to consider in Mergers and Takeovers

3.1 Assets of shares-most companies buy the victim
companys 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.

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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Cash offers

Advantages:

! When the bidder gas sufficient cash the takeover can
be achieved quickly and at low cost.

! Target company shareholders have certainty about the
bids value i.e. there is les risk compared to accepting
shares in the bidding company.

! Increased liquidity to target company shareholders,
i.e. accepting cash in takeover, is a good way of
realising an investment.

! The acceptable consideration is likely to be less than
share exchange as there is less risk to target company
shareholders. This reduces the overall cost of the bid
to the bidding company.

Disadvantages:

! With the larger acquisitions the bidder must often
borrow in the capital markets or issue new shares in
order to raise the cash.

! Target company shareholders liable to CGT.

! Target company shareholders do not participate in new
group.

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Loan Stock

Advantages:

! Low cost when interest rates low.

! Interest payments tax deductible

! Less dilution of EPS than in a share for share
exchange.

Disadvantages:

! Increases gearing hence shareholders risk.

Share Exchange

Advantages:

! Shareholders of the acquired company will be
shareholders in the post acquisition company.

! Can finance very large acquisitions.

Disadvantages:

! Price risk- there is a risk that the market price of the
bidding companys shares will fall during the bidding
process, which may result in the bid failing.

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3.4 Regulation of Takeovers

City Code on Takeovers

! Self-regulatory system of the stock exchange

! Applies only to plcs.

! No legal authority but SE can apply a range of
sanctions.

Main points of the code

! All shareholders of both the bidding and target
company must be informed as soon as firm offer is
made.

! Offers cannot be withdrawn without SE consent

! Shareholders must be given sufficient information to
make an informed judgement.

! If more than 30% of voting shares acquired, offer
must be made for all remaining shares.

! Offers must be open for at least 21 days.

! Offer is conditional on gaining 50 o the voting rights of
a target company.

Competition Commission

Under the Fair Trading Act of 1973, the Office of Fair
Trading (OFT) may refer a bid to the Commission if the
OFT thinks that a merger might be against the public
interest.

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The Commission can they investigate whether or not the
bid results in a reduction in competition in the market. If
it is felt that a takeover would reduce competition, then
they can recommend to the Secretary of State that the
bid be blocked.

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)

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

Company Performmance
Analysis

Ratios

1. Ratios-You must Learn!!!!

1.1 Investor

EPS = PAT less Preference Dividends
No of ordinary shares in issue

P/E = P
o

EPS

Dividend Cover= EPS
DPS

Payout Ratio = DPS
EPS

Dividend Yield = DPS
P
o

Total Shareholder = Dividend for + Capital Gain
Return(TSR) the year for the year
Share Price at start of the
year
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1.2 Gearing

Capital Gearing= Debt or Debt X 100
Equity Debt+Equity

NB Preference shares are generally treated as debt.

Interest Cover = Operating Profit
Interest

1.3 Profitability

ROCE = Operating Profit X 100
Equity +Debt

ROE = PAT X 100
Equity

Margin = Operating Profit X 100
Turnover

1.4 Liquidity

Current Ratio= C.Assets
C.Liabilities

Quick/Acid Test = (C.Assets-Inventory)
Ratio C.Liabilities

Inventory Days= Inventory x 365
COS or purchases

Receivables Days= Trade Receivables x 365
Sales

Payables Days = Trade Payables x 365
COS or Purchases
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2 Cash Flow Statement

In addition to the liquidity ratios above, you need to be
able to prepare a cash flow statement to assess liquidity
position

Suggested layout:

$000
Operating Profit xxx
Add: Depreciation xxx

Change in Inventory xxx
Change in Receivables xxx
Change in payables xxx

Cash from operations xxx

Sale of NCA xxx
Issue of Shares xxx
New Loans xxx

Tax paid (xxx)
Interest paid (xxx)
Dividends paid (xxx)
Purchase of NCA (xxx)
Loans repaid (xxx)

Share buyback (xxx)

Cash generated this year xxx
Balance b/f xxx
Cash Balance C/F $xxx

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3 Economic Value Added

a. 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.

b. 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.

c. 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.

d. 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.

e. 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
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f. 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
Retained earnings 22
Additional information:

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

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

(c) The 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.
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Required

Calculate the EVA in the year to September 20X2 and
the value of the equity.

g. Solution

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

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

50.25

EVA = 50.25m (10.75% X 108m)

= 38.64m

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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 firms ability to adapt to changes in its
environment.

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2 Predicting Corporate Failure

2.1 Altman Z-Score Model

The Z score model was first developed by Altman in
1968 based on research in the USA into bankrupt
manufacturing companies:

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

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

Z score=1.2 X
1
+1.4X
2
+3.3X
3
+0.6X
4
+1.0X
5

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2.2 Assessing the risk of failure

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

Z score<1.81 indicates that the Company is in danger
and possibly heading towards bankruptcy.

Z score of 3 or above indicates financially sound.

Companies with scores between 1.81 and 2.99 need
further investigation

2.3 Limitations of corporate failure prediction models

There are number of limitations of the Z score and
other similar failure prediction models:

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

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! Sunil Bhandari

136
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 chairmans report and the directors
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 companys assets and their earning
potential.
! New capital is normally desperately required to
regenerate the business, but this will not be forthcoming
without a restructuring of the existing capital and
liabilities.
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! Sunil Bhandari

137

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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! Sunil Bhandari

138

ACCA P4 Advanced Financial Management Key Point Notes December 2010

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