Professional Documents
Culture Documents
ACCA P4 Notes
ACCA P4 Notes
Exam
Section A contains two compulsory questions with aggregate marks of 50 to 70, each question
with 25 to 40 marks. Section B contains three questions and you are required to answer two,
each with 15 to 25 marks. You are expected to demonstrate an integrated knowledge of the
subject and an ability to relate your technical understanding of the subject to issues of strategic
importance to the company. Therefore, understand the syllabus and practice past year
questions are the key to success.
Note
You are assumed to have F9 knowledge and also other knowledge from earlier papers. It is
advised that you go through with your F9 notes again before reading this note. Also, read
through articles published for P4 in ACCA website. It is advised that you study according to this
sequence: C, D, E, F, A, B and finally G, although it is fine to study sequentially if you remember
your F9 well.
Syllabus areas
A: Role and responsibility towards stakeholders
Page numbers
2-17
18-22
23-48
49-61
62-67
68-98
99-103
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retained earnings first to finance investments, most adopted constant dividend payout policy.
Factors such as liquidity will be considered before distributing dividends.
Communicating financial policy and corporate goals to internal and external stakeholders
For financial strategy to be successful it needs to be communicated and supported by
stakeholders. Each stakeholder may have different goals and sometime conflict with each
other, this is where the influence of stakeholders will be considered, influence = power x
interest (Mendelows matrix).
Financial planning and control
Financial planning is a long-term profit planning aimed at generating greater return on assets,
growth in market share, and at solving foreseeable problem. This includes strategic cash flow
planning and strategic fund management (consider the dealings with unforeseen problems with
cash flows as well).
Financial control includes management control/tactical planning and operational control.
Management control is where managers assure that resources are well-utilised to achieve
organisations objectives. Operational control is the process of assuring that specific tasks are
carried out effectively and efficiently.
The management of risk
Investors that persuaded higher risk should be compensated with higher returns. Risk can be
managed by:
1. Hedging taking actions to make an outcome more certain.
2. Diversifying dont put all eggs in one basket; hold a portfolio of different investments. This
may reduce unsystematic risk/business risk.
3. Risk mitigation putting control procedures to avoid investments in projects whose risk is
above the shareholders required level.
2. Financial strategy formulation
Assessing corporate performance
Corporate performance can be measured using ratios, trends, economic value added (EVA)
and market value added (MVA).
Ratios
Ratio analysis is covered in many earlier papers, be sure you know the ratios. In addition to
calculating ratios, you should compare ratios in order to determine whether the business is
improving or declining. Other information such as revaluation of non-current assets, financial
obligations, events after the reporting period, contingencies and so on must also be considered
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together with ratios. Limitations of ratio analysis must also be noted. Review notes for earlier
paper regarding ratios if you have forgotten.
Trends
This involves looking at the difference of financial information from year to year. This allows
users to quickly spot significant changes.
EVA
TM represents trademark registered by Stern Steward and you need to write it whenever you
use the acronym. EVA is similar to the calculation of residual income with the exception of the
profit figure. EVA = NOPAT (cost of capital x capital employed) where NOPAT is net
operating profit after tax adjusted for non-cash expenses. Adjustments to be made to NOPAT
and also capital employed include:
1. We convert accrual accounting to cash accounting, eg. provisions are eliminated.
2. Spending on market building items such as research, staff training and advertising costs will
be capitalised.
3. Unusual items of profit or expenditure should be ignored.
4. Economic depreciation replaces accounting depreciation (sometime assume the same).
5. Interest on debt is added back to profit.
6. Impairment of goodwill is added back to profit and also goodwill.
If EVA is positive, organisation is providing a return greater than required by providers of
finance, ie. creating wealth.
Example: Division A of King Co has operating profits and assets as below:
$000
Gross profit
156
Less: non-cash expenses
(8)
Less: Impairment of goodwill
(5)
Less Interest @ 10%
(15)
Profit before tax
128
Tax @ 30%
(38)
Net profit
90
Total equity
350
Long-term debt
150
500
King Co has a target capital structure of 25% debt/75% equity. The cost of equity is 15%. The
capital employed at the start of the period amounted to $450000. The division had noncapitalised leases of $20000 throughout the period. Goodwill previously written off against
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reserves in acquisitions in previous years amounted to $40000. Calculate EVA for Division A
and comment on your results.
Solution: Remember that the adjustments you did in NOPAT can affect capital employed.
$000
Net profit
90
Add back:
Non-cash expenses
8
Impairment of goodwill
5
Interest (net of 30% tax) (15 x 0.7)
10.5
NOPAT
113.5
Capital employed at start of period
450
Non-capitalised leases
20
Impaired goodwill
40
Capital employed at end of period
510
WACC = (75 x 15% + 25 x 10% x 0.7)/100 = 13%
EVA = 113.5 510 x 13% = 47.2
EVA is positive, the business is creating value as its return is greater than groups WACC.
Advantages of using EVA include:
1. Keeps the focus on shareholder value an increase in EVA should lead to an increase in
company value and therefore increase in shareholder value.
2. Motivate managers to invest in projects where returns exceed cost of capital.
3. Easy to understand as the calculation starts with the familiar operating profit and deducts a
capital charge.
4. Results are consistent with NPV.
Disadvantages of using EVA include:
1. Adjustments to profits and capital can become cumbersome, especially if performed every
year.
2. Estimating WACC can be difficult.
3. EVA is an absolute measure, so it cannot be used to compare companies of different sizes.
4. Short-term focus EVA focuses only on current accounting period, whilst ideally
performance measures should have a longer-term focus.
MVA
MVA = market value of equity and debt book value of equity and debt. It is not a performance
measure but a wealth measure. The higher the MVA, the more wealth the company has
generated for its shareholders. It is also the discounted sum of EVA.
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Cost of preference shares calculation is similar to cost of bonds with exception that dividend is
normally not allowable for tax.
Retained earnings
Although financing through retained earnings seems to involve no cost, there is actually an
opportunity cost for shareholders because if shareholders receive dividends (rather than
company retains to finance), shareholders can use the cash to invest elsewhere to earn a
return. Cost of retained earnings can be calculated through:
1. Theoretical Valuation Models such as capital asset pricing model (CAPM) or Arbitrage Pricing
Theory (APT).
2. Bond yield-plus-premium approach (used when analysts do not have confidence in CAPM or
APT approach).
3. Market implied estimates.
CAPM
CAPM is covered in F9. CAPM is the risk-free return adds a risk premium for systematic risk. The
formula is given in exam as
=
where
is the cost of equity,
is the risk-free rate of return, is the equity beta of the individual security (eg. shares),
is the rate of return on a market portfolio. Equity or market risk premium is therefore
represented by
and the risk premium is represented by
.
APT
This theory assumes that the return on each security is based on a number of independent
factors such as interest rates and industrial production. The cost of equity formula is shown as
where
is the risk
premium on factor A,
is the risk premium on factor B and so on. The formula is
similar to CAPM formula, with the exception that it takes into account more factors. With APT,
CAPMs problem of identifying the market portfolio (to determine market rate of return) is
avoided. However, there is a problem of identifying the macroeconomic factors and their
sensitivities.
Bond-yield-plus-premium approach
The idea is that return on equity is higher than the yield on bonds. This approach simply
involves adding a judgemental risk premium to the bond yields to determine cost of retained
earnings.
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where
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Dividend capacity
This is the ability at any given time of a company to pay dividends to its shareholders. Legally,
the companys dividend capacity is determined by the amount of accumulated distributable
profits (retained earnings). More practically, dividend capacity can be calculated as the Free
Cash Flow to Equity (FCFE). FCFE is covered later.
Signaling effect
When company reduces its dividends, investors may read it as bad news. However, according
to MM (who assumed perfect capital market exists), dividend policy is irrelevant.
Residual theory
This suggests that company should invest any project with positive NPV and dividends should
be paid only when these investment opportunities are exhausted.
In practice, company tends to adopt a stable dividend policy or ratchet pattern (paying out a
table but rising dividend per share).
Rationale for risk management
Theoretical rationale
Companies should be looking to limit uncertainty and to manage speculative risks and
opportunities in order to maximise positive outcomes and hence shareholder value.
Practical rationale
Companies must be seen to be managing risk to maintain confidence of the shareholders in
their business operations.
Firms exposure to different types of risks
Most firms are exposed to business and financial risk. Assessing business and financial risk is a
skill learnt in F9, eg. calculating operational gearing and financial gearing.
Business risk
Business risk is a mixture of systematic (market risk) and unsystematic risk. It refers to the
possibility of changes in level of profit before interest as a result of changes in turnover or
operating costs. Business risk relates to the nature of business operations. Business risk can be
assessed using operational gearing.
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Financial risk
Financial risk is the systematic risk borne by the equity shareholders. It refers to the possibility
of changes in level of distributable earnings as a result of the need to make interest payments
on debt finance or prior charge capital. The ultimate financial risk is that the organisation will
be unable to continue to function as a going concern. Financial risk can be assessed using
financial gearing.
Other specific risks
1. Operational risk the risk arising from the operation of an organisations business functions.
For example, human error, fraud, systems failures.
2. Reputational risk the risk related to the way in which a business is viewed by others
(perceived value of the business).
3. Political risk the risk that political action will affect the position and value of a company.
Government stability is one key factor to be considered in assessing political risk.
4. Economic risk arises from changes in economic policy in the host country that affect the
macroeconomic environment in which the multinational company operates. For example,
changes in the monetary policy will affect aggregate demand.
5. Regulatory risk the risk that arises from the change in the legal and regulatory environment
which determines the operation of a company. For example, a new law that makes the firing of
workers more difficult may increase cost of production.
6. Fiscal risk the risk that changes in government fiscal policy will affect the present value of
investment projects and thus the value of the company. For example, an increase in the
corporate tax rate will affect the profitability of the company.
Framework for risk management
A risk management framework needs to cover:
1. Risk awareness. A formal risk assessment is needed for all estimates that are material,
looking at the potential risks that could affect the project and the probability they may occur.
2. Risk monitoring. A monitoring process is needed to alert management should the risks occur.
3. Strategies for dealing with risk. These include accepting the risk, mitigating the risk, hedging
the risk and diversification.
Risk mitigation
Risk mitigation is the process of minimising the probability of a risks occurrence or the impact
of the risk should it occur. A comprehensive set of controls help mitigate risks by working to
prevent, or identify and deal with risks before they become problematic. Management should
implement controls for the more material risks provided that the costs of doing so are less than
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the potential loss. For non-routine events, it is more common to have a strategy for dealing
with risks which actually arise.
Hedging the risk/exposure
This means taking measures to eliminate or reduce a risk. Hedging is often in the form of the
purchase or sale of a derivative security (financial hedging). Operational hedging involves using
non-financial instruments and the main way is through real options (covered later).
A perfect hedge will eliminate all risk, but also all future gains.
Diversification
This is chosen where reliance on a single customer, supplier or location has been identified as a
potential risk, and involves having a portfolio of clients, suppliers, operating in different
locations etc. The impact of one outcome is reduced by the impact of the others. This can only
reduce unsystematic risk (diversifiable risk).
Portfolio theory can be applied in diversification. The theory is concerned with the construction
of investment portfolios with the objective of reducing unsystematic risk. In order to diversify
effectively, investors should ensure that, in the event of a particular incident that affects the
market, some of the shares in the portfolio should move in the direction of the market (positive
correlation) and some should move in the opposite direction (negative correlation).
An important element of portfolio theory is that expected return of the investment portfolio is
the weighted average of the returns on the individual investments in the portfolio. However,
the risk of the portfolio (measured by standard deviation) should be less than weighted average
of the risks of the individual investments.
The formula of two-asset portfolio is given in exam as
where is the standard deviation of returns in the portfolio, is the proportion of portfolio
funds invested in share a, is the standard deviation of share a,
is the correlation coefficient
of returns in shares a and b. Correlation coefficient lies between -1 (perfect negative
correlation) and +1 (perfect positive correlation).
Example: Fire Co is planning to undertake two investment projects with the following risk and
return information.
Investment a
Investment b
Risk
8%
12%
Return
15%
25%
70% of the total portfolio funds will be invested in a and the remainder in b. The correlation
coefficient between a and b has been estimated as 0.25.
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Calculate the return and risk of the portfolio and comment on the risk-reducing effects of
diversification.
Solution: Return on portfolio = weighted average return on individual investments = 0.7 x 15 +
0.3 x 25 = 18%.
Risk of the portfolio = standard deviation of return on portfolio =
= 7.38%.
Weighted average risk on individual investments = 0.7 x 8 + 0.3 x 12 = 9.2%. Risk of the portfolio
is lower than this, implying that reduction in risk has been achieved and this is due to the
correlation coefficient of two investments being far from +1. The nearer the correlation
coefficient toward -1, the better the effect of reduction in risk as this will mean that returns of
the two shares move in opposite direction.
Capital investment monitoring and risk management system
As capital investment involves large amount of resources, the implementation of it must be
monitored to ensure that risks are being taken into account and controls are set to deal with
them. Monitoring process is closely linked to periodic risk assessment of the project. The
monitoring functions of the implementation stage seek to ensure that:
1. Project expenses are within the budgeted limits.
2. Budgeted revenues are achieved.
3. Completion time schedule is adhered to.
4. Risk factors identified during the appraisal stage remain valid.
3. Conflicting stakeholder interests
As it is common that interests of various stakeholders often conflict, company needs to ensure
that the problems are resolved before undertaking any financial decisions.
Potential sources of stakeholder conflict
In assessing the potential sources of stakeholder conflict, relevant underpinning theories should
be taken into account:
Separation of Ownership and Control
Equity shareholders are the owners of the company, but the company is managed by its board
of directors (BOD). The central source of shareholder conflict is the difference between the
interests of managers and those of owners. A good example is short-termism. This means that
managers try to achieve short-term rewards but their actions (eg. manipulate profits, cut costs)
can affect the long-term performance of the company.
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board has no executive function. Executive board will be composed of managers, responsible
for the running of business.
In Japan, shareholders dont rule. Long-term interests of the company are stressed. There are
three boards: policy board (concerned with long-term strategic issues), functional board (made
up of main senior executives with a functional role) and monocratic board (few responsibilities,
have a more symbolic role). Stock market also imposes less regulation.
In South Africa, there is a King report. The report advocates an integrated approach to
corporate governance in the interest of a wide range of stakeholders, embracing the social,
environmental and economic activities of a companys activities.
4. Ethical issues in financial management
Ethical dimension in business
Business ethics deal with the behaviour of firms and the norms they should follow so that their
behaviour is judged as ethical. However, there is no universally acceptable framework of
business ethics principles that all companies should follow. Code of corporate governance
would ensure a minimum degree of ethical commitment by firms. Although key objective of
financial management is to maximise shareholders wealth, ethical consideration is important
and forms part of non-financial objectives. Stakeholders should be taken into account in any
financial decisions.
Interconnectedness of ethics between functional areas of the firm
Business ethics should govern the conduct of corporate policy in all functional areas of a
company such as:
1. Human resources management prevent conflict between financial objectives and the rights
of the employees. This can arise due to low wages and discrimination.
2. Marketing marketing is a way of communicating with customers and this communication
should be truthful and sensitive to social and cultural impact of society. It should not, for
example, target vulnerable groups, create dissatisfaction etc.
3. Market behaviour if company dominates the market, it should not use this dominant
position to exploit suppliers or customers. It should exercise restraint in their pricing policies.
4. Product development product should be safe to use.
Ethical financial policy for financial management
Ethical policy can be implemented through measures that ensure that the company takes into
account the concerns of its stakeholders. Ethical framework should be developed first where
company should develop an ethical corporate philosophy.
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Ethical framework
Ethical framework should be developed as part of the overall corporate social responsibility
(CSR) which according to Carroll includes PEEL:
1. Philanthropic responsibility include all actions that company needs to take in order to
improve the life of its employees, to contribute to the local community and to make a
difference to society as a whole.
2. Economic responsibility company is responsible to satisfy the required return of
shareholders. As discussed before, financial objective may conflict with stakeholders
objectives, strategies have to be established to deal with them.
3. Ethical responsibility ethical responsibilities arise in situations where there is no explicit
legal or regulatory provision and the company needs to exercise judgement as to what is right
and fair. There are many elements of business ethics management, including incorporating
ethics in mission statement, developing codes of ethics which are followed, providing ethics
education and so on.
4. Legal responsibility company is responsible to comply with all the legal and regulatory
provisions, and to ensure that employees are aware of this policy.
5. Impact of environmental issues on corporate objectives and on governance
Sustainability and environmental risk
Sustainability refers to the concept of balancing growth with environmental, social and
economic concerns. This is linked to triple bottom line approach which is discussed later.
Environmental risk is an unrealised loss or liability arising from the effects of an organisation
from the natural environment or the actions of that organisation upon the natural
environment. Environmental impacts on business may be direct (eg. impact on demand,
changes affecting costs or resource availability, effect on power balances between competitors
in a market) or indirect (eg. legislative change, pressure from customers or staff as a
consequence of concern over environmental problems).
Recently, many companies are now producing environment report for external stakeholders,
covering:
1. What the business does and how it impacts on the environment.
2. An environmental objective.
3. Companys approach to achieving and monitoring these objectives.
4. An assessment of its success towards achieving the objectives.
5. An independent verification of claims made.
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Also, companies are acknowledging the advantages of having an environmental policy. These
include reduction/management of risk to the business, motivating staff, saving more costs and
enhancement of corporate reputation.
Carbon-trading economy and emissions
Carbon trading allows companies which emit less than their allowed amount of emission to sell
the right to emit
to another company. Placing a cost on carbon emissions encourages
organisations to reduce them eg. through renewable energy, improved energy efficiency or
carbon offsets.
Emissions trading is becoming a key part of strategy both within European Union (EU) and
globally to reduce the emission of greenhouse gases. EU governments are addressing the
challenge of reducing carbon emissions through a combination of increased regulation and
market mechanisms.
Countries under Kyoto Protocol are allocated quotas for maximum pollution (to reduce
greenhouse gas emissions to stable level in order to prevent climate changes.
The role of environment agency
The role of environment agency is to protect or enhance environment, so as to promote the
objective of achieving sustainable development. The responsibilities of environment agency
include:
1. Flood risk management create/maintain flood defences.
2. Waste regulation grant licenses for handling special waste (eg. ratioactive).
3. Pollution control regulate discharges to aquatic environment, air and land.
4. Air quality management regulate the release of air pollutants into atmosphere.
5. Water quality management maintain and improve the quality of surface and ground water.
6. Water resource management manage use and conservation of water through water
abstraction licenses.
7. Fisheries maintain and improve quality of fisheries.
Environmental audits
Environmental audit is an audit that seeks to assess the environmental impact of a company's
policies. Auditor will check whether the company's environmental policy:
1. Satisfies key stakeholder criteria.
2. Meets legal requirements.
3. Comply with standards or local regulations.
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2. Political risk the risk that political action will affect the position and value of a company.
This arises mainly from the different government policies employed.
3. Litigation risk the possibility that legal action will be taken because of the companies
actions, inactions, products, services or other events. Litigation risks can be reduced by keeping
abreast of changes, acting as a good corporate citizen and lobbying.
4. Cultural risk this arises from the cultural differences in different national markets. Cultural
risks affect the products and services produced and the way organisations are managed and
staffed. Businesses should take cultural issues into account when deciding where to sell abroad,
and how much to centralise activities.
Agency issues
Agency issues can arise in the central coordination of overseas operations. Agency problems
arise from different agency relationships. Agency relationships exist between:
1. Management of the parent multinational corporations (principals) and managers of the
subsidiaries (agents).
2. Managers of various subsidiaries.
3. Managers and shareholders of a subsidiary.
Managers (agents) may not always act in the best interest of the principals. This is especially
when managers of oversea subsidiaries are normally given local financial autonomy. There is a
need of balancing of local financial autonomy with effective central control.
One way of reducing agency costs is to separate the ratification and monitoring of managerial
decisions from their initiation and implementation. BODs should carry out the role of ratifying
and monitoring the managerial decisions with the help of their non-executive outside
members. Managerial compensation packages can also be used to reduce agency costs by
aligning the interests of top executives with shareholders and the interests of subsidiary
managers to those of head office.
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Solution:
Year 1
$m
3
6
Year 2
$m
2.5
Year 3
$m
3.5
1
1.5
2.5
0.3
tax, so there
Year 4
$m
3.8
Year 5
$m
4.2
1
1
0
0
1
1
0.84
0.96
will be positive earnings
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In sensitivity analysis, you will look for variables which are sensitive and attention needs to be
paid to such variables. The sensitivity of the variable is calculated as NPV/PV of the variable. To
calculate sensitivity of the cost of capital (discount rate), internal rate of return (IRR) is used to
compare against cost of capital. This is used to incorporate uncertainty into project appraisal.
Monte Carlo simulation
You will not be expected to undertake simulations in an examination context but you need to
demonstrate an understanding of certain things. Simulation is a quantitative procedure used to
describe a process. Monte Carlo simulation is a technique of spreadsheet simulation.
This method adopts a particular probability distribution for the uncertain (random) variables
that affect the NPV and then using simulations to generate values of the random variables.
To deal with uncertainty, the Monte Carlo method assumes that the uncertain parameters
(such as the growth rate or the cost of capital) or variables (such as the free cash flow) follow a
specific probability distribution. Random number generator (from EXCEL) is used to generate
random numbers for each variable. The basic idea is to generate through simulation thousands
of values for the parameters or variables of interest and use those variables to derive the NPV
for each possible simulated outcome. From the resulting values we can derive the distribution
of the NPV.
Statistical measures such as standard deviation and mean can be useful in assessing the
likelihood of project success.
Project Value at Risk (VaR)
Project VaR is the potential loss of a project with a given probability. VaR is the minimum
amount by which the value of an investment or portfolio will fall over a given period of time at
a given level of probability. Alternatively it is defined as the maximum amount that it may lose
at a given level of confidence. For example, VaR is $100000 at 5% probability (5% chance that
loss will exceed $100000), or $100000 at 95% confidence level (95% chance that loss will not
exceed $100000). Most common probability levels are 1, 5 and 10 percent.
VaR is equal to kN where k is determined by the probability level, is the standard deviation
and N is the periods over which we want to calculate the VaR. If probability level is 5% (ie.
confidence level of 95%), look at standard normal distributable table, find 0.45 (0.95 0.5), it is
near to 1.65 (1.645 to be exact). If probability level is 1% (ie. confidence level of 99%), find 0.49
(0.99 0.5), it is near to 2.33. 1.645 is k for 5% probability and 2.33 is k for 1% probability.
Example: Annual cash flows from a project are expected to follow the normal distribution with
a mean of $50000 and standard deviation of $10000. The project has a 10 year life. It is
determined that at 5% probability level, k is 1.645. What is the project VaR?
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Solution: Project VaR that takes into account the entire project life is 1.645 x $10000 x 10 =
$52019, that is the maximum amount by which the value of the project will fall at a confidence
level of 95%.
Projects margin of safety
A projects margin of safety can be indicated by internal rate of return (IRR) or modified internal
rate of return (MIRR). You learnt IRR in F9 that it is the discount rate at which NPV is equal to
zero and accept the project if IRR is greater than the cost of capital (or target rate of return).
IRR = A + [(a/a b) x (B A)] Where A is the lower discount rate and B is the higher rate, a is the
NPV at the lower rate and b is the NPV at the higher rate. However, IRR has some problems:
1. Multiple IRR this will occur when the cash flows are unconventional (eg. investment in time
0, cash inflows in time 1, investment in time 2).
2. Mutually exclusive projects these are a set of projects which only one can be accepted.
Decision on IRR and decision on NPV may conflict in this case, for example, IRR is higher for
project A but NPV is higher for project B. In this case, we should base our decision on NPV.
3. Reinvestment rate IRR assumes that cash flows can be reinvested at IRR rate over the life of
the project. NPV assumes that cash flows can be reinvested at cost of capital rate over the life
of the project. The better reinvestment rate assumption will be the cost of capital rate.
MIRR attempts to solve IRRs problems. MIRR is the IRR that would result if it was not assumed
that project proceeds were reinvested at the IRR. MIRR uses cost of capital as the reinvestment
rate. MIRR = (PV of return phase/PV of investment phase)^(1/n) x (1 + reinvestment rate) 1.
This formula is given in exam. MIRR will be lower than IRR and this reflects better measure.
MIRR also solves the problem of multiple IRR. MIRR will give the same indication as NPV.
Example: The calculations of PV for a project are done and as follows, cost of capital is 10%,
calculate IRR and MIRR.
Year Cash flow Discount factor@10% PV
Discount factor@25% PV
0
(24500)
1.000
(24500)
1.000
(24500)
1
15000
0.909
13635
0.800
12000
2
15000
0.826
12390
0.640
9600
3
3000
0.751
2253
0.512
1536
4
3000
0.683
2049
0.410
1230
5827
(134)
Solution: IRR = 10% + [(5827/5827 + 134) x (25% - 10%)] = 24.7%.
PV of return phase = 13635 + 12390 + 2253 + 2049 = $30327.
PV of investment phase = $24500.
MIRR = (30327/24500)^(1/4) x (1 + 0.1) 1 = 16%. Both show that project is acceptable.
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Alternatively, MIRR = (Terminal value of return phase/PV of investment phase)^n 1. You need
to calculate the values of the inflows if they were immediately reinvested at 10%. For example
the $15000 received at the end of year 1 could be reinvested for three years at 10% per annum
(multiply by 1.1 x 1.1 x 1.1 = 1.331). Same example will be used to illustrate.
Solution:
Year Cash flows
1
15000
2
15000
3
3000
4
3000
X
X
(X)
X
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Add net equity issued (new issues less any equity repurchases)
Free cash flow to equity
Second method is an indirect method:
Free cash flow
Less (net interest + net debt paid)
Add tax benefit from debt (net interest x tax rate)
Free cash flow to equity
X
X
X
X
X
X
Dividend capacity
Dividend capacity of a company is measured by its FCFE. In theory, the entire FCFE can be paid
as dividends as this is the amount that is available for this purpose. In practice, only a portion of
this figure will be given to the shareholders as dividends as the management team tends to
prefer a smooth dividend pattern. In the context of specific capital investment programme, if
the project is acceptable, dividend that can be paid will be FCFE investment cost.
Valuation of company using FCF and FCFE
First, you need to understand terminal value. Terminal value of a project or a stream of cash
flows is the value of all the cash flows occurring from period N + 1 onwards, ie. beyond the
normal prediction horizon of periods 1 to N. When we refer to a project, terminal value is
equivalent to the salvage value remaining at the end of the expected project horizon.
Value the company using FCF
This is similar to carrying out a NPV calculation. The value of the company is simply the sum of
the discounted FCF over the appropriate horizon. If the FCF is constant, the value of the firm is
simply FCF/cost of capital. If the FCF is growing at a constant rate every year, value of the firm
can be calculated using Gordon Model (or Constant Growth Model), which is like dividend
growth model; PV = [FCF x (1 + g)]/(k g).
Example: Ice Co currently has FCF of $5m per year and a cost of capital of 12%. Calculate the
value of Ice Co if FCF are expected to grow at a constant rate of 4% per annum.
Solution: Value of Ice Co = (5 x 1.04)/(0.12 0.04) = $65m.
When the growth of FCF is expected to start after the horizon considered, calculating terminal
value will be useful. The value of the company will be calculated as the sum of the discounted
FCF plus the discounted terminal value. The following example illustrates how to calculate
terminal value.
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Example: g = 0.05, FCF in the last year of the horizon considered is $2m, cost of capital = 0.10.
Solution: Terminal value = (2 x 1.05)/(0.1 0.05) = $42m. Therefore, this is the value in N + 1 (N
represents the normal horizon and +1 means over the horizon by 1 time).
Now we can look at an example of incorporating terminal value.
Example: Fire Co considers 8 years of FCF for valuation of the business. FCF are expected to
grow at 3% beyond the eighth year. Cost of capital is 12%. It is calculated that present value of
FCF is $9680 and the FCF of eighth year is $2070. Value Fire Co.
Solution: Terminal value = (2070 x 1.03)/(0.12 0.03) = $23690.
Discounted terminal value = 23690 x 0.404 (based on discount rate of 12% and n = 8) = $9751.
Value of Fire Co = $9680 + $9751 = $19431.
Valuation using FCFE
If you use FCFE, you are valuing the equity of the company. The approach is similar to the
above. In normal case, value of equity = present value of FCFE discounted at cost of equity.
In the case where growth starts after the horizon considered, value of equity = present value of
FCFE discounted at cost of equity + terminal value discounted at cost of equity.
If you want to value the company, value of the company = value of equity + value of debt.
2. Application of option pricing theory in investment decisions
This topic is a bit technical so we will start from some basic concepts about option. Later we will
consider something called real option which we need to value it as part of investment appraisal.
Basic concepts
An option is the right (but not an obligation), to buy (call option) or sell (put option) a particular
good at an exercise price, at or before a specified date. A premium is the cost of the option.
Exercise/Strike price is the fixed price at which the good may be bought or sold. An option
(whether call or put) is purchased by the buyer from the option seller or writer.
European-style options can be exercised on their expiry date only, and not before. Americanstyle options can be exercised at any time up to and including their expiry date. Therefore,
American options are more expensive since you are buying more rights.
The intrinsic value looks at the exercise price compared to the price of the underlying asset.
If the exercise price for an option is more favourable for the option holder than the current
market price of the underlying item, the option is said to be in-the-money.
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If the exercise price for an option is less favourable for the option holder than the current
market price of the underlying item, the option is said to be out-of-the-money. The intrinsic
value is zero and it will not be exercised.
If the exercise price for an option is exactly the same as the current market price of the
underlying item, the option is said to be at-the-money.
On the expiry date, the value of an option is equal to its intrinsic value.
Application of Black-Scholes Option Pricing (BSOP) model to financial product/asset valuation
BSOP model formula takes into account the five principal drivers of option value:
1. Value of the underlying ( ) if for example stock price goes up, call price will increase
(exercise price more favourable for call option holder) and put price will decrease.
2. Exercise price ( ) if exercise price increases, call price will decrease and put price will
increase (since put option holder can receive more if exercise price increases).
3. Time to expiry (t) both calls and puts will benefit from increased time to expiration as there
is more time for a big move in, for example, stock price.
4. Volatility (s) this is measured by standard deviation. Both the call and put will increase in
price as the underlying asset becomes more volatile as the buyer of the option receives full
benefit of favourable outcomes but avoids the unfavourable ones.
5. Risk-free rate (r) if risk-free interest rate increases, present value of exercise price
decreases, so value of the call will increase and value of the put will decrease.
Before using BSOP model to value options, there are a number of issues to consider:
1. It assumes that there are perfect markets with no taxes, no transaction costs, perfect security
divisibility, and no restrictions on short selling.
2. It assumes that interest rates are constant over the options life.
3. It assumes that no dividends are paid in the period of the option.
4. It assumes that rate of return on a share is log normally distributed.
5. It applies to European call options only. It cannot be used to accurately price American
options.
BSOP model is used first to value call option and if the option is a put option, the value of put
option depends on the value of the call option. Note that option value means the option
premium payable. The following formula is given in exam:
C = N(d) N(d)
d = [ln( / ) + r + 0.5s^2)t]/st
d = d - st
P=C +
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Where C = value of call option, P = value of put option, N( ) = the probability that a normal
distribution is less than the standard deviation above the mean, ln = natural logarithms, e =
base of the natural logarithms, ie. exponential. The ln and e can be found in scientific calculator.
Since this is an investment appraisal topic, we will apply BSOP model to relevant example later.
Embedded real options within a project
Real options theory attempts to classify and value flexibility that we have in a project. They are
actual options that a business can make in relation to investment opportunities. There are four
types of real options:
1. Option to delay this is a call option on NPV of the project.
2. Option to expand this is a call option on NPV of the project with an exercise price equals to
the additional investment cost.
3. Option to redeploy company can use its productive assets for activities other than the
original one. This is a put option to sell assets.
4. Option to withdraw/abandon this is a put option to sell the cash flows over the remainder
of the projects life for some salvage value.
Considering only NPV is not enough. NPV fails to consider the extent of managements
flexibility to respond to uncertainties surrounding the project. We may attempt to value real
option and incorporate it to NPV. Therefore, strategic NPV = conventional NPV + value of real
options and it is possible that NPV becomes positive after incorporating value of real options.
Valuation of real options using BSOP model
Real options can be valued using BSOP model, but there are certain limitations to bear in mind.
The main one is that BSOP assumes the option is European style but real option may be
exercised over any set period of time, like an American style option. In reality, the use of this
type of modelling is more appropriate for financial securities that are actively traded. Valuing
real option takes into account the uncertainty of the project but company does not actually
receive the value of the real option. The following example illustrates the use of BSOP model to
value real option:
Example: Leaf Co is considering taking a 20-year project which requires initial investment of
$250m in a real estate partnership to develop time share properties with a Spanish real estate
developer, and where the PV of expected cash flows is $254m. While the NPV of $4m is small,
assume that Leaf Co has the option to withdraw this project anytime by selling its share back to
the developer in the next 5 years for $150m. A simulation of the cash flows on this time share
investment yields a variance in the PV of the cash flows from being in the partnership of 0.09.
The 5 year risk-free rate is 7%. Calculate the total NPV of the project, including the option to
withdraw.
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Private equity
Private equity consists of equity securities in companies that are not publicly traded on a stock
exchange. In Europe, private equity funds tend to invest in more mature companies with the
aim of eliminating inefficiencies and driving growth. They might require 20-30% shareholding,
special rights to appoint a number of directors and also company to seek their prior approval
for new issues or acquisitions.
Asset securitisation
This involves aggregation of assets into pool, then issuing new securities backed by these assets
and their cash flows. The securities are then sold to investors who share the risk and reward
from these assets. New investors receive a premium (usually in the form of interest) for
investing in the success of failure of the segment. Most securitisation pools consist of
tranches. Higher tranches carry less risk of default (and therefore lower returns) whereas
junior tranches offer higher returns but greater risk. Securitisation is expensive due to
management costs, legal fees and continuing administration fees.
Assessing companys debt exposure to interest rate changes
Debt exposure to interest rate changes can be assessed using simple Macaulay duration
method. Duration is the weighted average length of time to the receipt of a bonds benefits
(coupon and redemption value), the weights being the PV of the benefits involved.
Example: Calculate the duration of 10% five year annual coupon bond trading at $97.25 (par
value of bond is normally assumed to be $100) with a gross redemption yield (GRY) of 10.743%.
Solution:
Time
1
2
3
4
5
Total
Cash flows
10
10
10
10
110
PV @ GRY
9.03
8.15
7.36
6.66
66.05
97.25
Duration = (9.03 x 1 + 8.15 x 2 + 7.36 x 3 + 6.66 x 4 + 66.05 x 5)/97.25 = 4.157 years. The longer
the duration, the higher is the sensitivity of debt price ($97.25) to the interest rate changes.
Basic features of sensitivity to interest rate risk will all be mirrored in the duration calculation.
1. Long-dated bonds will have longer durations.
2. Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zerocoupon bond where the duration will be the maturity.
3. Lower yields will give longer durations. In this case, the PV of cash flows in future will risk if
the yield falls, extending the point of balance, therefore lengthening the duration.
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Price
Duration
line
Difference captured
by convexity
measure
However used in conjunction with each other, convexity and duration can provide a more
accurate approximation of the percentage change in price resulting from a percentage change
in interest rates. It can also be used to compare bonds with the same duration but different
levels of convexity. For example, if Bond X has a higher convexity than Bond Y, its price would
fall by a lower percentage in the event of rising interest rates.
Assessing companys exposure to credit risk (default risk)
Credit risk of an individual loan or bond is determined by the following two factors:
1. Probability of default.
2. Recovery rate the fraction of the face value of an obligation that can be recovered once the
borrower has defaulted.
Loss given default (LGD) is the difference between the amount of money owed by the borrower
less the amount of money recovered. For example, a bond has a face value of $100 and the
recovery rate is 80%. LGD = 100 80 = $20.
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Expected loss (EL) from credit risk shows the amount of money the lender should expect to lose
from the investment in a bond or loan with credit risk. EL is the product of LGD and probability
of default (PD). Using the above example, if PD is 10%, EL = 10% x $20 = $2.
Principal rating agencies
The oldest and most common approach is to assess the probability of default using financial
and other information on the borrowers and assign a rating that reflects the expected loss from
investing in the particular bond. Credit rating agencies will assign credit ratings to issuers of
certain types of debt obligations. For example, AAA means lowest default risk and C means
lowest grade quality. However, lower rating will result in higher yields on bonds (higher cost of
debt) because the investment is more risky.
Another approach to credit risk assessment is called structural models. Structural models rely
on an assessment of the underlying riskiness of a firms assets or its cash generation, and the
likelihood the firm will not be able to pay interest or repay capital on the due date.
To reduce credit risk, credit enhancement may be undertaken which is the process of reducing
credit risk by requiring collateral, insurance, or other agreements to provide the lender with
reassurance that it will be compensated if the borrower defaulted. Credit enhancement is a key
part of the securitisation transaction in structured finance and is important for credit rating
agencies when raising a securitisation.
Credit spread and cost of debt capital
Credit spread is the premium required by an investor in a corporate bond to compensate for
the credit risk of the bond. Therefore, cost of debt = (risk-free rate + credit spread)(1 T).
Credit spread can be represented by basis point (1 basis point = 0.01%).
Example: Consider a corporate bond with a maturity of 4 years and a credit rating of BBB. The 4
year risk-free rate is 5% and credit spread is 200 basis points. The corporate tax rate is 30%.
Calculate the cost of debt capital.
Solution: Cost of debt = (5% + 2%)(1 0.3) = 4.9%.
However, for exam you need to have much wider knowledge than this. As a lender, we need to
know the amount above LIBOR (London Inter-Bank Offered Rate) that they should charge to
cover the loss on default and as compensation for the risk involved, ie. estimating credit spread.
The first step is to estimate the probability of default.
Example: A firm has assets with current value of $1m and outstanding debt of $0.4m. The
volatility of those assets (as given by the standard deviation of monthly asset values) is 10%.
Estimate probability of default.
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Solution: From the volatility measure, we can calculate the likelihood that within the next 12
months those assets will fall in value to less than $0.4m, thereby triggering default. A 10%
monthly volatility can be converted to an annual volatility (s) as follows:
s = 10% x 12 = 34.64%.
Standard deviation = 34.64% x $1m = $346400.
The distance to default in value terms is $1m less $0.4m = $0.6m. Dividing this by the standard
deviation tells us the number of standard deviations (z) below the average asset value the
default level lies.
z = 600000/346400 = 1.732. Using standard normal distributable table, the proportion
represented by 1.732 is near 0.4582 (to be exact, 0.4584). Adding this to the probability of an
asset value being above the mean (0.5) gives a total probability of not defaulting of 0.9584 or,
conversely, a probability of defaulting of 0.0416.
The second part of the default assessment is to estimate the potential recoverability of the
debt. A number of issues influence recoverability such as the nature of the firms assets and
their saleability, any covenants which impose restrictions on their disposal, the priority of the
lender, and any directors guarantees that may be in place. From this it is easy to see why banks
often proceed with unseemly haste when they foreclose. For a bank, at that point, the priority
is to protect the recoverability of the assets which support its loan. The following example
continues the above example:
Example: Assume bank assesses the recoverability of the debt as 80% and that it, in turn, pays
LIBOR of 5% to raise finance on the financial market. On a loan of $400,000, the bank would
expect to receive LIBOR plus the premium it wishes to charge at the end of the year, giving an
overall rate of i%. It is assumed that bank is risk neutral. Estimate credit spread.
Solution: Drawing a simple decision tree will be useful to show the main idea.
[400000 x (1 + i%)]/(1 + LIBOR)
P = 0.9584
Non-default
$400000
Default
P = 0.0416
From the tree we can see that there are two possible outcomes. Either the lender receives its
principal sum back, plus interest at i%, or it receives just 80% of that value. We have discounted
at LIBOR on the assumption that the lender is neutral towards risk.
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400000 = 0.9584 x [400000 x (1 + i%)]/(1 + 0.05) + 0.0416 x [400000 x 80% x (1 + i%)]/(1 + 0.05)
Rearranged: i = 1.05/(0.9584 + 0.0416 x 0.8) 1 = 0.0588, ie. 5.88%.
This means that it is 88 basis points above LIBOR and this is the credit spread.
Banks, however, are not neutral towards risk. The potential loss of 20% of the loan is more
significant to them than the potential gain if the lender remains solvent. To compensate, a bank
will add a percentage to the discount rate to cover its aversion to risk, and any other charges it
may wish to make. The following example continues the above example.
Example: Assume that bank requires an additional 50 basis points. Estimate credit spread.
Solution:
400000 = 0.9584 x [400000 x (1 + i%)]/(1.055) + 0.0416 x [400000 x 80% x (1 + i%)]/(1.055)
Rearranged: i = 1.055/(0.9584 + 0.0416 x 0.8) 1 = 0.0639, ie. 6.39% which is 1.39% above
LIBOR.
A problem with this type of analysis is how to estimate the asset value of the firm and the
volatility of that asset value. The solution comes from the theory of options.
Role of BSOP model in the assessment of default risk, the value of debt and its potential
recoverability
The role of option pricing models in the assessment of default risk is based on the limited
liability property of equity investments. The equity of a company can be seen as a call option on
the assets of the company with an exercise price equal to outstanding debt. The variables in the
BSOP formula in the case of valuation of the firm will be:
1. Value of underlying asset value of firm assets in use.
2. Volatility of the underlying asset standard deviation of asset value.
3. Exercise price redemption value of outstanding debt.
4. Time term to maturity of debt.
5. Risk-free rate term of debt.
The volatility of assets is probably the most difficult variable to estimate accurately. One
approach implies the asset value and the volatility from the BSOP model. Another approach is
to project and simulate the expected future cash flows of the business, generating a
distribution of present values from which the volatility can be obtained.
The value of N(d) shows how the value of equity changes when the value of the assets change.
This is the delta of the call option. The value of N(d) is the probability that a call option will be
in the money at expiration (value of asset will exceed outstanding debt). The probability of
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default is therefore given by 1 N(d). From the BSOP formula, it can be seen that probability of
default depends on three factors:
1. Debt/asset ratio.
2. Volatility of the company assets.
3. Maturity of debt.
A higher debt/asset ratio increases the probability of default. Similarly, an increase in volatility
will also increase the probability of default. The longer the maturity, the lower the probability
of default.
Example: Market value of assets is $100 and face value of the 1 year debt is $70. Risk-free rate
is 5% and volatility of asset value is 40%. Find the probability of default using BSOP model.
Solution: d = [ln( / ) + r + 0.5s^2)t]/st
d = d - st
= 100
= 70
r = ln (1 + 0.05) = 0.0488 (it is not wrong to use 5%)
s = 0.4
d = [ln(100/70) + (0.0488 + 0.5 + 0.4^2)1]/0.4 = 1.213.
d = 1.213 0.4 = 0.813.
N(d) = 0.792 so probability of default = 1 0.792 = 0.208, ie. 20.8%.
BSOP model can also be used to measure the expected loss associated with a corporate bond.
Expected losses are a put option on the assets of the firm with an exercise price equal to the
value of the outstanding debt. If you turn the equation of call option around, it becomes the
equation of put option.
Put option = Losses = N(-d)
- N(-d), also equal to N(-d)[
- x N(-d)/ N(-d)].
Note that N(-d) = 1 N(d). The term x N(-d)/ N(-d) shows the recovery value of the asset.
Example: Market value of assets is $100, and face value of the 1 year debt is $70. Risk-free rate
is 5% and volatility of asset value is 40%. What is the recovery value and the expected loss?
Solution: This example is the same as above so we already have some data.
r = 0.0488.
d = 1.213, so N(d) = 0.888, so N(-d) = 1 0.888 = 1.112.
N(-d) = 0.208.
Recovery value = 1.112/0.208 x 100 = $53.846.
Expected loss = 0.208 x [70e^(-0.0488 x 1) 53.846] = $2.667.
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Assessing the impact of financing and capital structure upon the company
Here we will look at a number of capital structure theories briefly, some you have learnt in F9.
Traditional view
WACC will initially fall with the increase in gearing because debt is cheaper. But after a certain
level, cost of debt will rise. There is an optimal capital structure where weighted average cost of
capital (WACC) is at a minimum.
Note: Maximising market value and minimising WACC are identical concepts.
Modigliani and Miller (MM) view
MM assumes there is a perfect capital market exists where investors have the same
information and will act rationally.
1. MM model without tax no optimal capital structure as cheaper cost of debt is countered by
increase in cost of equity, keeping WACC constant.
2. MM model with tax cost of debt will reduce further because of tax relief, so optimal capital
structure is where company chooses a 99.9% gearing level. In this case, cost of equity formula is
given as:
where
financial risk),
is pre-tax cost of debt, is market value of debt, is geared cost of equity
(included financial risk). The formula is given in exam.
However, market is imperfect and so such viewpoint ignored:
1. Bankruptcy costs high gearing level causes bankruptcy risk to increase.
2. Agency costs as gearing increases, more covenants could be imposed by debt holders.
3. Tax exhaustion company is tax exhausted when taxable profit is not enough to cover the
interest payments (tax shield is broken).
Pecking order theory
This theory is based on the idea that shareholders have less information (information
asymmetry) about the firm than directors do. Shareholders and other investors will use
directors actions as signals to indicate what directors believe about the firm, given their
superior information. Order of preference for sources of finance is as follow:
1. Retained earnings (internally generated funds).
2. Straight debt.
3. Convertible debt.
4. Preference shares.
5. Equity shares.
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In exam, you have to look at the information available and select the correct formula.
Cost of debt
If exam only mentions cost of debt, it means pre-tax cost of debt unless otherwise stated. There
are three ways to calculate cost of debt.
1. For irredeemable debt,
is the IRR of
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2. CAPM
debt beta.
3. Use credit spread
WACC
WACC is the average cost of companys finance weighted by the total market value or book
value of each source of finance. WACC =
. When evaluating a
project, it is important to use a cost of capital which is appropriate to the risk of the new
project. The existing WACC will therefore be appropriate as a discount if:
1. New project has the same level of business risk as the existing operations.
2. Undertaking new project will not alter the firms capital structure (financial risk).
3. Size of the project is relatively small compared to the size of the company.
If new project has different business risk, risk adjusted WACC or project-specific cost of capital
needs to be calculated using the concept of CAPM. This involves the following steps:
1. Find a proxy company with similar operations as the proposed investment.
2. Equity beta of proxy company will be ungeared to get asset beta through this formula:
and we normally assume debt to be risk-free.
3. Asset beta will be regeared to include financial risk of investing company. Here we amend
the above formula to
We can now apply this to the CAPM formula to determine specific-project cost of equity.
Cost of equity =
= 4 + 1.427 x 6 = 12.6%.
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= 1.137.
Base-case discount rate (ungeared cost of equity) = 7% + 1.137 x (15% - 7%) = 16.1%.
This discount rate can be used to discount the project cash flows to get base case NPV.
Example: A project is financed by $1m of retained earnings, $2m rights issue of new equity,
$4m 3-year loan from Regional Development Council at 4% and $2m 3-year bank loan at 10%.
The administration costs associated with the rights issue total 5% of the finance raised. Riskfree interest rate is 10%. The bank loan involves a $60000 arrangement fee. Assume that tax is
paid at 30%, one year in arrears. Calculate the PV of financing side-effects.
Solution: Tax savings on interest payments will all be considered.
CF ($000) Timing DF@10%
PV ($000)
Admin costs (5/95 x $2m)
(105)
0
1.000
(105)
Arrangement fee
(60)
0
1.000
(60)
Bank loan tax relief (2m x 10% x 30%)
60
2-4
2.261
136
RDC loan tax relief (4m x 4% x 30%)
48
2-4
2.261
109
RDC loan gross interest saved (4m x 6%) 240
1-3
2.487
597
RDC loan tax relief lost on interest
saved (4m x 6% x 30%)
(72)
2-4
2.261
(163)
PV of financing side-effects
514
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Note:
1. Admin costs are not calculated as 5% x $2m because $2m is the amount left after such costs
are paid, so $2m is 95%.
2. In this example we discount the cash flows at risk-free rate. However, it is possible to use
different rates to discount, such as cost of debt. In exam, you should make clear the reasons for
choosing the discount rate to discount the tax relief, and add comment that an alternative rate
might be used.
In APV analysis, the PV of the tax relief on interest should not be calculated on the basis of the
actual amount of debt but on the project debt capacity because tax relief on interest (tax
shield) is valuable, and to avoid a cross-subsidisation of one project with another projects debt
capacity. If a $10m project has a 60% debt capacity, this indicates that the project is capable of
acting as security for a $6m loan.
Issue costs/transaction costs are another thing to consider. Debt issue costs are tax deductible
(often with 1 years delay) but equity issue costs are not tax deductible.
We can see a number of benefits that APV can bring, such as able to evaluate the effect of
financing separately and no need to adjust WACC using assumptions of perpetual risk-free debt.
However, there are a number of practical problems:
1. The process of ungearing/degearing the industry beta to obtain a beta for an all-equity firm
does not include market imperfections such as bankruptcy costs.
2. The discount rates used to evaluate the various side effects can be difficult to determine.
3. Only appropriate where the project does not affect the firms exposure to business risk.
4. In complex investment decisions, the calculations can be extremely long.
Assessing the impact of a significant capital investment project upon the reported financial
position and performance taking into account alternative financing strategies
The source of finance chosen to finance the capital investment project will have an effect on
the reported financial position and performance. Gearing affects the volatility of EPS. The
higher the level of gearing, the higher the volatility of EPS. This is the case because the high
gearing level means that interest payments will also increase, thus affecting the net profits.
Therefore, if the project is financed mainly through debt, gearing level will rise and EPS can
easily change.
4. International investment and financing decisions
Now we are looking at overseas projects and there are certain issues to consider.
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. If
is given as 8.00
Example: Exchange rates between two currencies, the Northland florin (NF) and Southland
dollar ($S) are as follow:
Spot rates
$S1 = NF4.7250
NF1 = $S0.21164
90 days forward rates NF4.7506 per $S1
$S0.21050 per NF1
Money market interest rate for 90 day deposits in Northland florins is 7.5% annualised.
Estimate the interest rates in Southland.
Solution: Since we are given the 90 days forward rates, the interest rate of 7.5% should be
adjusted to 90 days.
Northland interest rate on 90 day deposit = 0.075 x 90/365 = 1.85%.
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There is a need to adjust the formula so that forward rate/spot rate = ratio of interest rates. If
we take $S0.21164 as spot rate, country c is Southland.
0.21050/0.21164 = (1 + )/1.0185, 1 + = 0.21050/0.21164 x 1.0185, 1 + = 1.013, so = 1.3%
OR
4.7506/4.7250 = 1.0185/1 + , 1 + = 1.0185 x 4.7250/4.7506, 1 + = 1.013 so = 1.3%.
In annual rate, 0.013 x 365/90 = 5.3%.
The fluctuations in exchange rate will affect the NPV of the overseas project.
International investment appraisal
In calculating overseas projects NPV, there are two ways and both result in same NPV:
First way
1. Estimate the projects cash flows post-tax in the overseas currency.
2. Convert the cash flows to home currency this involves forecasting exchange rates.
3. Add any home country cash flows, for example tax.
4. Discount the net home currency cash flows at the companys cost of capital to get NPV.
Second way
1. Estimate the projects cash flows post-tax in the overseas currency.
2. Convert the companys cost of capital to an overseas equivalent this can involve the use of
International Fisher effect,
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5. Restricted remittance only the proportion of cash flows that are expected to be repatriated
should be included in the calculation of the NPV.
Exchange controls and strategies for dealing with restricted remittance
Exchange controls restrict the flow of foreign exchange into and out of a country, usually to
defend the local currency or to protect reserves of foreign currencies. Government may be
restricting the supply of foreign exchange or restricting the types of transaction. These
exchange controls can impact the NPV of the project because we only include cash flows that
are expected to be repatriated.
To deal with restricted remittance, there are a number of strategies:
1. Transfer pricing parent can set high price to the foreign subsidiary, however tax authorities
will try to prevent this from happening.
2. Royalty payment parent grants subsidiary the right to make goods protected by patents
and require royalty payments from subsidiary. The size of royalty can be adjusted.
3. High interest loan to subsidiary.
4. Management charges can be charged to subsidiary.
Impact of a project upon a companys exposure to translation, transaction and economic risk
You learnt the three terms in F9 but we will talk about them again.
1. Translation risk (historical) this is the risk that when company consolidates accounts, there
will be exchange losses when the accounting results of foreign subsidiary are translated into
home currency. (IAS 21 requires holding company to translate the account of foreign subsidiary
to home currency in consolidation).
2. Transaction risk (current) this is the risk of adverse exchange rate movements between the
date the price is agreed and the date cash is received/paid, arising during normal international
trade.
3. Economic risk (future) this is the risk that exchange rate movements might reduce the
international competitiveness of a company. It is the risk that the PV of companys future cash
flows might be reduced by adverse exchange rate movements.
These three types of risks will be exposed by any companies dealing with foreign currencies.
Costs and benefits of alternative sources of finance available within the international equity
and bond markets
Companies are able to borrow short and long-term funds on the Eurocurrency (money) markets
and on the markets for Eurobonds respectively. These markets are collectively called
euromarkets. The word euro means in foreign currency, not European. Large companies can
also borrow on the syndicated loan market where a syndicate of banks provides medium to
long-term currency loans.
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Syndicated loan is a loan offered by a group of lenders (a syndicate) to a single borrower. The
lenders will share the risk together.
Shorter term international borrowing includes:
1. Euro notes debt securities with a maturity of less than a few years traded in the
Eurocurrency market.
2. Short-term syndicated credit facilities.
3. Multiple Options Funding Facility (MOFF) credit lines that are accompanied by option
contracts to provide more variety to borrowers in standard currencies.
The main cost of alternative sources of international finance is the exposure to exchange rate
risk. However there are a number of benefits:
1. Availability domestic financial markets may lack the depth and liquidity to accommodate
either large debt issues or issues with long maturities.
2. Lower cost of borrowing in Eurobond markets, interest rates are normally lower than
borrowing rates in national markets.
3. Lower issue costs cost of debt issuance is normally lower than the cost of debt issue in
domestic markets.
Conclusion
This is the end of syllabus area C. The ideas you learnt include investment appraisal techniques,
valuing real options, financing the projects and its effect on cost of capital, and investing in
overseas.
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3. Financial synergy refers to financial benefits that a corporation expects when it merges
with or acquires another company. This arises from risk diversification, surplus cash (disposal of
cash slack as discussed above), tax benefits and increased debt capacity.
2. Valuation of acquisitions and mergers
In exam you may have to derive a value by using several valuation methods and discussing the
advantages and disadvantages of each. The methods will not give a precise valuation figure, but
a starting point for negotiation.
Argument and the problem of overvaluation
When a company acquires another company, it always pays above current market value. This is
known as the overvaluation problem. Empirical studies have shown that during an acquisition,
there is normally a fall in the price of the bidder and an increase in the price of the target. This
shows that shareholders of target company will enjoy the benefits of the premium paid by
acquiring company while shareholders of the acquiring company might lose value.
Overvaluation problem may arise as a miscalculation of the potential synergies or the
overestimation of the ability of acquiring firms management to improve performance. Both
errors will result in higher price being paid.
Estimating the potential near-term and continuing growth levels of a companys earnings
The growth rate of a companys earnings is the most important determinant of a companys
value. The growth rate may be based on historical estimates (using geometric average),
analysts forecasts or company fundamentals (using Gordons growth model/earnings retention
model).
Historical estimates
This is to look at the trend of earnings over the years. This does not hold true for new
companies and companies that deal with uncertainty. The idea is that:
Earnings n year ago x (1 + g)^n = Current earnings
g = (current earnings/earnings n year ago)^(1/n) 1
Example: Earnings in 20X1 are $150000 and in year 5 are $262350, calculate the growth rate.
Solution: g = (262350/150000)^(1/4) 1 = 15%.
Company fundamentals
The determinants of rate of growth are the return on equity and the retention rate of earnings.
The formula is given in exam as g = br where r = return on equity and b = retention rate =
(earnings dividend payments)/earnings.
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Example: Leaf Co had a dividend yield (dividend per share/market price per share) of 3.8% and
P/E ratio of 15.3 times. What is the implied retention rate of Leaf Co?
Solution: Dividend yield x P/E ratio = dividend per share/EPS
3.8% x 15.3 = 0.5814.
To get retention rate, we need (EPS DPS)/EPS, we already got DPS/EPS so we can create one
EPS/EPS.
Retention rate = EPS/EPS DPS/EPS = 1 0.5814 = 0.4186 or 41.86%.
Impact of an acquisition or merger upon the risk profile of the acquirer
The risk of the acquirer in the process of acquisition can be classified as either financial risk or
business risk. We can distinguish acquisitions into three types:
1. Type 1 acquisitions these do not disturb the acquirers exposure to financial or business
risk. Capital structure of acquirer will not change and nature of business of both companies is
the same. Therefore, asset and equity beta remain the same.
2. Type 2 acquisitions these will impact upon the acquirers exposure to financial risk. Finance
cost, WACC and market value of acquirer will change.
3. Type 3 acquisitions these will impact upon the acquirers exposure to both financial and
business risk. It will be difficult to calculate WACC.
Type 1, 2 and 3 are listed in the study guide and so examiner knows the meaning of these.
Asset beta of combined entity is the weighted average of the betas of the target company, the
acquirer and the synergy generated from the acquisition. WACC of the combined entity is the
weighted average of the cost of equity and cost of debt of the combined entity.
Valuation of a type 1 acquisition of both quoted and unquoted entities
We will look at three methods to value type 1 acquisition: Book value-plus models, market
relative models, and cash flow models including EVA and MVA.
Book value-plus models
Book value or asset-based methods are based on the statement of financial position (SOFP) as
the starting point in the valuation process. This is the net assets basis of valuation which you
learnt in F9. We derive value of companys share from net asset value of equity. Net assets =
Total value of assets (ignore intangible assets) total value of liabilities or non-current assets
(ignore intangible assets) + net current assets long-term debt. Value per share = net asset
value/number of ordinary shares. This would represent the minimum value of the target
company.
Other values such as realisable values or replacement costs of asset may be used as the basis of
net asset value. Always think about the advantages and disadvantages.
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We can also value intangible assets so that total company value = net asset value + estimate of
intangible asset value. The two main ways of deriving intangible asset value are:
1. Calculated Intangible Value (CIV) involves calculating excess return on tangible assets and
this figure is used in determining the proportion of return attributable to intangible assets.
2. Levs knowledge earnings method involves separating the earnings that are deemed to
come from intangible assets and capitalise these earnings. Calculation is not examinable for
this.
In CIV we will have 5 steps to value intangible assets:
1. Find return on assets (average operating profit/average tangible assets) whether of a suitable
competitor (similar in size, structure etc) or industry average.
2. Calculate value spread companys operating profit less (return on assets x company asset
base). This is the excess return.
3. Find the post-tax value spread value spread x (1 T).
4. Using the likely short-term growth rate, find the expected post-tax value spread at T1.
5. Find CIV by discounting the post-tax value spread at T1 to PV.
Example: Directors of Rock Co intend to value the company for the purposes of negotiating with
a potential purchaser and plan to use CIV method to value the intangible element. In the past
year, Rock Co made an operating profit of $137.4m on an asset base of $307m. Earnings are
predicted to grow at 3.4% over the next few years and the companys WACC is 6.5%. A suitable
competitor is identified with operating profit of $315m on assets employed in the business of
$1583m. Corporation tax is 30%. What value should be placed on Rock Co?
Solution: Return on asset = 315/1583 x 100 = 19.9%.
Value spread = 137.4 19.9% x 307 = $76.31m.
Post-tax value spread = 76.31 x (1 0.3) = $53.42m.
At T1, post-tax value spread = 53.42 x 1.034 = $55.24m.
CIV = 55.24/0.065 = $849.85m.
Rock Cos value = $307m + $849.85m = $1156.85m.
Market relative models
Market relative models may be based on the P/E ratio which produces an earnings based
valuation of shares. Since P/E ratio = market value/EPS, then market value per share = EPS x P/E
ratio. P/E ratio applied should be that of a similar company or industry. In practice, this may be
difficult to find, and the parties involved in the acquisition will then negotiate the applied P/E
ratio up or down depending on the specific company circumstances. The P/E ratio of an
unquoted companys shares might be around 50% to 60% of the P/E ratio of a similar public
company with a full Stock Exchange listing so you need to adjust the industry average P/E ratio
suitable for unquoted company.
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For a listed company, the stock market value of the shares (or market capitalisation) is the
starting point for the valuation process. However, a premium usually has to be paid above the
current market price in order to acquire a controlling interest. Market capitalisation = current
market price of share x number of ordinary shares.
Another method is to use Tobins Q ratio (market to book ratio). Q ratio can be market
capitalisation/book value of assets. Market value of a target company = market to book ratio x
book value of assets of target company. A firm with a Q<1 is vulnerable since the assets of a
company can be acquired at a cheaper price than they were bought on their own as assets. So,
high Q firms usually buy low Q firms.
Earnings yield is also one way where earnings yield = EPS/market price per share so market
price per share = EPS/earnings yield or value of company = total earnings/earnings yield.
Cash flow models
There are a number of methods in this model:
1. Dividend valuation/growth model Share price
2. FCF or FCFE cost of equity can be used to discount FCFE to get value of equity directly, or
WACC can be used to discount FCF to give total business value from which debt value should be
deducted to give equity value. Debt value should not be part of company value.
3. EVA value of equity = PV of EVA less debt value.
4. Market Valued Added (MVA) = market value of debt + market value of equity book value of
equity book value of debt. This shows how much the management of a company has added to
the value of the capital contributed by capital providers. MVA is also the PV of EVA. A
companys equity MVA is sometimes expressed as a market to book ratio (MVA/book value).
Valuation of type 2 acquisitions using the adjusted net present value model
As type 2 acquisitions expose acquiring company to financial risk, APV model may be useful to
value the company. You have learnt APV earlier where APV = base-case NPV + PV of financing
side-effects. If the APV is positive then the acquisition should be undertaken. Note that value of
equity will be APV debt value cost of acquisition.
Valuation of type 3 acquisitions using iterative revaluation procedures
Type 3 acquisitions affect both the financial and business risk exposure of the acquiring
company. Iterative procedures can be used where the beta and the cost of capital are
recalculated to take account of the changes in the capital structure, and then the company is
re-valued. This procedure is repeated until the assumed capital structure is closely aligned to
the capital structure that has been re-calculated. This process is normally done using a
spreadsheet package such as Excel. Iterative revaluation procedures will involve a number of
steps:
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for
the
group
post-acquisition
3. Regear the asset beta to reflect the groups post-acquisition gearing average asset beta
from step 2 is regeared to become equity beta of combined company.
4. Calculate the groups new WACC cost of equity is derived using CAPM formula and use the
equity beta calculated in step 3 while cost of debt must be the cost of debt for the combined
company.
5. Discount the groups post-acquisition FCF using the new WACC.
6. Calculate the groups revised NPV and subtract debt to calculate the value of the equity.
Valuing high growth start-ups
Due to the unique characteristics of high growth start-ups such as no track record, heavy losses
initially, highly uncertain work environment, unknown competition, unknown cost structures,
inexperienced management etc, valuing them presents a number of challenges.
All valuation methods require reasonable projections to be made with regard to the key drivers
of the business. The following steps should be undertaken with respect to the valuation of a
high growth start-up company:
1. Identifying the drivers projections must be analysed in light of the market potential,
resources of the business, management team, financial characteristics of the guideline public
companies, and other factors.
2. Period of projection long-term projections, all the way out to the time when the business
has sustainable positive operating margins and cash flows, need to be prepared. These
projections will depend on the assumption made about growth. Forecast period is rare to be
less than seven years.
3. Forecasting growth growth in earnings may be g = retention rate x return on equity or
return on invested capital (ROIC). For most high growth start-ups retention rate = 1 (ie. no
dividend payment) as the company needs to invest in many areas and cant pay dividend.
Therefore, the sole determinant of growth is ROIC and this is can be determined by profit
margin and revenue growth: ROIC = PBIT/IC = EBIT/sales x sales/IC.
Now we review each valuation method:
1. Asset-based method not appropriate because value of capital in terms of tangible assets
may not be high.
2. Market-based method there is a problem in finding suitable company and take its P/E ratio.
Complicating factors include comparability problems, differences in fair market value from
value paid by strategic acquirers and lack of disclosed information.
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3. Discounted cash flows growth rates of revenues and costs may vary. FCF = revenue costs
so lets take revenue = R and costs = C:
capital,
Conclusion
You need to take some time to understand the logic of each method. None of the valuation
methods give a right answer for the value of the firm. In practice, actual price paid will depend
on the bargaining power and negotiating skills of the buyer and seller. Valuation models only
give you an idea, for example negotiation may start with net asset value and increase to an
agreed value.
Also note that additional synergy benefit after the acquisition has been paid for needs to be
ascertained which is the post-acquisition value of the combined company less the values of the
individual companies.
3. Regulatory framework and processes
Development of the regulatory framework for mergers and acquisitions globally
Regulations of takeovers vary from country to country but are mainly concerned with
controlling directors. Takeover regulation is an important corporate governance device that
seeks to protect the interests of minority shareholders and other types of stakeholders and
ensure a well-functioning market for corporate control. Two main agency problems that
emerge in the context of a takeover that regulation seeks to address are:
1. Protection of minority shareholders. In addition to existing minority shareholders, transfers
of control may turn existing majority shareholders of the target company into minority
shareholders.
2. Possibility that management of target company may implement measures to prevent the
takeover even if these are against stakeholder interests.
In the UK and the US the regulation model used is a market-based shareholder model aimed at
protecting the rights of shareholders. This involves exerting external control over management.
This model is considered more economically efficient and is becoming more dominant.
The Europeans stakeholder model (block-holder model) uses a stakeholder perspective to
protect all stakeholders in a company. This involves exerting internal control over management.
This model is considered better at dealing with the agency problem.
Main regulatory issues which are likely to arise in the context of a given offer
Regulatory issues would include level of permitted mergers, relevant legislative/regulatory
provisions, conditions imposed by regulators on merger proposals, level of approval required
from shareholders, level of information to be provided to shareholders prior to any merger,
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performance disclosure requirements, allocation of costs of merger, and the extent to which
regulators should intervene to encourage/discourage mergers.
Management needs to assess whether the offer is likely to be in the shareholders best
interests. In the same way like investment appraisal, NPV needs to be calculated.
Defence against takeovers
Directors of a target company can employ the most appropriate defence if a specific offer is to
be treated as hostile. Takeover defences can be categorised into pre-offer and post-offer
defences.
Pre-offer defences include:
1. Maximise share price this causes the cost of acquisition to increase.
2. Communicate effectively with shareholders this includes having a public relations officer
specialising in financial matters liaising constantly with the entitys stockbrokers, keeping
analysts fully informed, and speaking to journalists.
3. Super majority Articles of Association are altered to require that a higher percentage (eg.
80%) of shareholders have to vote for the takeover.
4. Poison pill take steps to make itself less attractive, eg. give rights to existing shareholders to
buy future bonds or preference shares. If a bid is made before the date of exercise of the rights,
then the rights will automatically be converted into full ordinary shares.
5. Strong dividend policy which discourages shareholders from voting for acquisition.
Post-offer defences include:
1. Counterbid/Pacman defence the acquiring company is itself the subject of a takeover bid
by the target company.
2. White knight strategy directors of the target company offer themselves to a more friendly
outside interest. This tactic should only be adopted in the last resort.
3. Press contact publish negative issue about the offer in the press.
4. Crown jewels selling or sale and leaseback the most valuable assets.
5. Golden parachute large compensation payments made to the top management of the
target company if their positions are eliminated due to hostile takeover.
6. Litigation or regulatory defence inviting an investigation by the regulatory authorities or
through the courts. The target company may be able to sue for a temporary order to stop the
predator from buying any more of its shares.
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increase in wealth will depend on combined companys future performance so the risk is
higher.
Convertible loan stock (mix mode of financing)
This gives the rights for investor to convert the loan stock into ordinary shares. This gives
investors the flexibility to convert if they want. For the acquiring company it is good as well
because it can have a lower coupon rate due to the lower risk faced by the investor.
A mix of cash and shares is also an alternative way and is practically used. However, how much
cash to pay and how much shares to issue will be an issue to consider. Two most important
factors to consider when making an offer are the effect on EPS and share prices. This is because
shareholders of both companies will be sensitive to the changes in them. There are
circumstances where a dilution in earnings is acceptable if any of the following benefits arise as
a result:
1. Earnings growth.
2. Quality of earnings acquired is superior.
3. Dilution in earnings compensated by an increase in net asset backing (target company may
be weak in earnings but strong in assets).
Impact of a given financial offer on the reported financial position and performance of the
acquirer
Different financial offer can have different impact on the reported financial position and
performance of the acquiring company, and so the impact on EPS, share prices, gearing ratio,
P/E ratio and dividend cover. If debt is issued to raise cash for acquiring the target company,
gearing level will rise. The larger the target companys earnings relative to the acquirer, the
greater the increase to EPS for the combined company. Also, the higher the P/E ratio of the
acquirer compared to the target company, the greater the increase in EPS to the acquirer.
Dilution of EPS occurs when P/E ratio paid for the target company exceeds the P/E ratio of the
acquiring company.
Example: Fire Co will acquire all the outstanding stock of Water Co through an exchange of
stock. Fire is offering $65 per share for Water Co. Financial information for the two companies
is as follow:
Fire
Water
Net income
$50000
$10000
Shares outstanding
5000
2000
EPS
$10
$5
Market price of stock
$150
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P/E ratio
15
Required:
(a) Calculate the shares to be issued by Fire Co.
(b) Calculate the combined EPS.
(c) Calculate the P/E ratio paid: price offered/EPS of target.
(d) Compare P/E ratio paid to current P/E ratio.
(e) Calculate maximum price before dilution of EPS.
Solution:
(a) Shares to be issued = $65/$150 x 2000 = 867 shares.
(b) Combined EPS = (50000 + 10000)/(5000 + 867) = $10.23
(c) P/E ratio paid = $65/$5 = $13.
(d) P/E ratio paid to current P/E ratio: since 13 is less than the current P/E ratio of 15, there
should be no dilution of EPS for the combined company.
(e) Maximum price before dilution of EPS: 15 = price/$5 so maximum price = $75.
Conclusion
This is the end of syllabus area D. The ideas you learnt include choosing suitable target
company, value the company, finance the acquisitions and defences against takeovers.
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2. Argentis A score use qualitative scoring on three areas: defects, mistakes made and
symptoms of failure.
3. Beavers ratio operating cash flow to total debt ratio. Organisations failed within 5 years
with a ratio below 0.2 and did not fail in the next 5 years with a ratio above 0.4.
4. Going concern evaluation based on ISA 570.
5. Information regarding an external or environmental issue.
6. Free cash flow analysis.
Remember that the models such as Z score only show a snapshot and are best as short-term
predictors; further analysis is required. Also, some models tend to rate companies low.
Financial reconstruction
Financial reconstruction scheme is a scheme whereby a company reorganizes its capital
structure, including leveraged buyouts, leveraged recapitalisations and debt-equity swaps. It is
part of capital restructuring in which the capital structure of a firm is changed.
1. Leveraged buyouts publicly quoted company is acquired by a specially established private
company. The private company funds the acquisition by substantial borrowing.
2. Leveraged recapitalisations firm replaces the majority of its equity with a package of debt
securities consisting of both senior and subordinated debt. This also causes the firm to be
unattractive for takeover.
3. Debt-equity swaps equity/debt swap is when all specified shareholders are given the right
to exchange their stock for a predetermined amount of debt in the same company while
debt/equity swap works the opposite way. This can be used to affect WACC.
Financial reconstruction may be undertaken by healthy companies and those in financial
distress (more likely).
Solvent company
Objectives of reconstruction may be to improve capital mix and timing of availability of funds.
The options available are: conversion of debt to equity, conversion of equity to debt,
conversion of equity from one form to another, and conversion of debt from one form to
another.
Failing company
Objectives of reconstruction are to attract fresh capital and persuading creditors to accept
some security in the company as settlement of its debts, so as to prevent the company to go
into liquidation. Options available are: Company Voluntary Arrangement (voluntary agreement
with creditors regarding repayment of corporate debts) and administration order.
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Response of the capital market and/or individual suppliers of capital to any reconstruction
scheme and the impact their response is likely to have upon the value of the company
Market response to financial reconstruction has been estimated from empirical studies of the
behaviour of share prices. Market reacts positively to firms raising their level of debt up to a
certain level, since the constraint that debt imposes (covenants) on future cash flows makes
companies choosier when selecting investment opportunities.
The design of reconstruction scheme needs to take into account the interests of, and the
impact upon ordinary shareholders, preference shareholders and creditors (including banks and
debenture holders).
1. Secured lenders respond positively if scheme is made more attractive than liquidation.
2. Unsecured creditors vote in favour of reconstruction in the hope that they recover the
maximum amount that they can.
3. Preference shareholders respond positively if they are given a share in equity or
enhancement in rate of dividend.
4. Ordinary shareholders respond positively if they retain their stake in the company and
achieve a better value for the shares upon reconstruction.
The impact of a financial reconstruction scheme on the value of the firm can be assessed in
terms of the impact of the growth rate of the company, its risk, and its required rate of return.
Through the changes of these three, WACC will be affected and therefore NPV of the firm will
change.
Effect on growth rate
Growth rate following a financial reconstruction can be calculated from the formula
where ROA is the return on net assets,
is the book
value of debt, r is the cost of debt. Original Gordons formula is g = br. Here we expand on the r.
Example: A firm currently has a debt/equity ratio of 0.12 and a ROA of 15%. The optimal debt
ratio is however much lower than the optimal level, since it can raise the debt/equity ratio up
to 0.3 without increasing the risk of bankruptcy. The firm plans to borrow and repurchase stock
to get to this optimal ratio. The interest rate is expected to increase from 7% to 8%. Tax rate is
25% and the retention rate is 50%. Find the impact of the increase in debt on the growth rate.
Solution: Before increase we have g = 0.5 x [0.15 + 0.12 (0.15 0.07 x 0.75)] = 0.08085.
After increase we have g = 0.5 x [0.15 + 0.3 (0.15 0.08 x 0.75)] = 0.0885.
The increase in debt has raised the growth rate by nearly 1%.
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3. Improvement in EPS could cause the correlation among EPS, P/E ratio and share price
changes.
Other benefits of unbundling include:
1. Loss making units are eliminated.
2. Core business activities are concentrated on.
3. The performance of the company is improved resulting in the maximisation of shareholder
value.
4. Locked up financial resources are released for new investment in profitable ventures.
Financial issues relating to a management buy-out and buy-in
In an MBO or MBI, managers are usually lack of financial resources to fund the acquisition in
full. One important source of financial backing is through venture capital. Venture capitalists
will normally require an equity stake in the company and may wish to have a representative on
the board to look after its interests. A number of clearly defined exit routes (eg. sale of shares
following flotation) in order to ensure the easy realisation of their investment when required.
Other sources of finance for MBO or MBI include clearing banks, pension funds, merchant
banks and so on.
There are a number of factors to consider before MBO or MBI:
1. Do the current owners wish to sell?
2. Potential of the business.
3. Loss of head office support.
4. Quality of the management team.
5. The price.
6. Possible resistance from employees.
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However, the development of securitisation has led to disintermediation and a reduction in the
role of financial intermediaries as borrowers can reach lenders directly. Disintermediation
describes a decline in the traditional deposit and lending relationship between banks and their
customers and an increase in direct relationships between the ultimate suppliers and users of
financing.
Characteristics and role of the principal money market instruments
There are three group of principal money market instruments that we need to consider.
Coupon bearing instruments
Coupon bearing means involving interest payment. There are two types of coupon bearing
money market instruments:
1. Certificate of Deposit (CD) a certificate of receipt for funds deposited at bank or other
financial institution for a specified term and paying interest at a specified rate.
2. Repurchase agreement (Repo) an agreement between two counterparties under which one
counterparty agrees to sell an instrument to the other on an agreed date for an agreed price,
and simultaneously agrees to buy back the instrument from the counterparty at a later date for
an agreed price. The repurchase price will be the sale price plus interest charged.
Discount instruments
Discount instruments mean those that are issued at a discount to their final redemption value.
There are a number of such instruments in money market:
1. Treasury bill (T-bill) debt instrument issued by government at a discount to the face value
with maturities ranging from one month to one year.
2. Commercial paper short-term unsecured corporate debt (short-term IOU) normally issued
by large organisations with good credit ratings. The debt is issued at a discount that reflects the
prevailing interest rates.
3. Bankers acceptances negotiable bills issued by companies and guaranteed by a bank. Bank
guaranteed the payment by the company for a fee. The interest rates are low because, as they
are guaranteed by a bank, the credit risk is low. Again, this is sold on a discounted basis.
Derivative products
Derivative is a financial instrument whose value changes in response to the change in an
underlying variable such as interest rate, that requires little or no initial investment and that is
settled at a future date (IAS 32). Derivatives are effective tools for hedging currency and
interest risk exposures. There are many derivative products and you will learn about them later
when we discuss about hedging currency risk and interest rate risk.
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Change in
Option value
Delta
Option value
Option value
Option value/time premium
With
Underlying asset value
Underlying asset value
Volatility
Interest rates
Time to expiry
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4. Decising investment strategies for short-term funds from the range of international money
markets and international marketable securities.
5. Netting and matching currency obligations (more on this later).
2. The use of financial derivatives to hedge against forex risk
You have learnt some of the hedging methods in F9 and its good to remember them. First we
will start with some basics in FOREX and the revisions of some hedging methods.
Basics and revisions
Currency rates can be quoted as direct quotes or indirect quotes. Direct quote is the amount of
domestic currency which is equal to one foreign currency unit and indirect quote is the other
way round. For example, assume that we are UK, 1 = $1.5000 or $1.5000/1 will be indirect
quote for us. Note that in currency, we always use four decimal places.
Bid price is the rate at which the bank is willing to buy the currency and offer (or ask) price is
the rate at which the bank is willing to sell the currency. The difference between the big price
and the offer price is known as the spread. Remember that bank will choose the one that is
more favourable to them. For example, assume that we are UK and we need to buy $5000 from
bank; the spot rate quoted as $/ was $1.5000 - $1.5100, bank will sell to us at $1.5000 so that
they gain more ($5000/$1.5000 = 3333.33 is more than $5000/$1.5100 = 3311.26). Just
remember that you will always get the unfavourable rate no matter spot or forward rate.
In financial management we normally assume that people are risk averse and prefer to reduce
risk if they can do so without too great a cost. Therefore, company would undertake hedging
which avoids the risk of making a foreign currency loss while also avoid the opportunity for
making a currency gain. Hedging is the purchase of contract or tangible good that will rise in
value and offset a drop in value of another contract or tangible good, thus protecting the owner
from loss.
There are two broad types of internal and external hedging methods:
Internal hedging methods
1. Invoicing in home currency we invoice the foreign customers in home currency. This will
avoid FOREX risk but foreign customers may not like it and prevent us from doing so.
2. Leading and lagging leading involves accelerating payments to avoid potential additional
costs due to currency rate movements while lagging involves delaying payments if currency rate
movements are expected to make the later payment cheaper.
3. Matching receipts and payments a company that expects to make payments and have
receipts in the same foreign currency should plan to offset its payments against its receipts in
that currency. The process of matching is made simpler by having foreign currency accounts
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with a bank. Example is where company sells to Japan and buys from USA, company can
demand for the use of Euro as the currency in the invoice so that matching is possible.
4. Netting this includes bilateral and multilateral netting and we will discuss about this later.
External hedging methods
All these will be covered later and include forward contract, money market hedge, currency
futures, currency option and currency swap. These will be more expensive than internal ones.
Impact on a company to exposure in translation, transaction and economic risks and how
these can be managed
The three FOREX risks are covered earlier. In this topic, we are concerned with managing
transaction risk only, through various hedging techniques.
Translation risk can be partially overcome by funding the foreign subsidiary using a foreign loan.
Economic risk is difficult to manage. It can be dealt with by trying to export or import from
more than one currency zone and hope that the zones dont all move together. Another way is
to make your goods in the country you sell them. Although raw materials might still be
imported and affected by exchange rates, other expenses (such as wages) are in the local
currency and not subject to exchange rate movements.
Managing transaction risk
You need to evaluate which of the hedging method is the most appropriate strategy, given the
nature of the underlying position and the risk exposure. Cost is the main factor to consider.
Use of the forward exchange market
Forward exchange market is where one can buy or sell forward exchange contract. Forward
exchange contract is a contract for currency which sets a fixed future date for a predetermined
rate (forward rate). This removes the currency risk by fixing the exchange rate in advance.
Forward contracts are negotiated with banks and can be tailored (OTC) to the exact needs of
the company, in terms of amount and maturity date. For smaller value transactions, however,
rates are not so favourable or may not be available at all. The contract is binding and must be
delivered at the fixed date so the problem here is that if a customer is paying late, we may have
no money to pay the bank for the forward contract. We will still need to close out the forward
exchange contract, by ether selling or buying the missing currency at spot rate.
Forward rate is probably an unbiased predictor of the expected value of the future exchange
rate, based on the information available today. The cost of using forward exchange contract is
easily calculated by converting the receipts or payments using forward rate.
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2. Foreign currency payment (aim to create a foreign currency asset and use this to pay the
foreign currency payment, cost involved is the borrowings to create the foreign currency asset).
Example: A UK company owes a Danish creditor Kr3500000 in three months time. Spot
exchange rate is Kr7.5509 Kr7.5548 per 1. The company can borrow in Sterling for 3 months
at 8.6% per annum and can deposit Kroner for 3 months at 10% per annum. What is the cost in
pounds with a money market hedge?
Solution: Interest rates for 3 months are 2.15% (8.6%/4) to borrow in pounds and 2.5% (10%/4)
to deposit in kroner. Amount to borrow = amount to deposit = X (1 + 2.5%) = 3500000, X =
Kr3414634. Convert this to will be 3414634/7.5509 = 452215 (spot rate given will always be
the bad one). Company has to borrow 452215 and with 3 months interest will have to repay:
452215 x 1.0215 = 461938.
In 3 months, deposit (Kr3414634 should have increased to Kr3500000) will be taken out to pay
the Danish creditor and company will pay 461938 to the bank.
The choice between forward exchange contract (forward market) and money markets is
generally made on the basis of which method is cheaper, with other factors being of limited
significance.
Example: ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan
several years ago when peso interest rates were relatively cheap compared to dollar interest
rates. Economic difficulties have now increased peso interest rates while dollar interest rates
have remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months
time. The following information is available.
Per $
Spot rate: pesos
12500 pesos 12582
Six-month forward rate: pesos
12805 pesos 12889
Interest rates that can be used by ZPS Co:
Borrow
Deposit
Peso interest rates:
100% per year
75% per year
Dollar interest rates:
45% per year
35% per year
Calculate whether a forward market hedge or a money market hedge should be used to hedge
the interest payment of 5 million pesos in six months time. Assume that ZPS Co would need to
borrow any cash it uses in hedging exchange rate risk.
Solution: The cost of both methods has to be compared.
Forward market hedge
Cost = 5000000/12.805 = $390472 (always take the rate that is bad).
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Example: Leaf Co, a company based in UK, imports and exports to USA. On 1 May it signs three
agreements, all of which are to be settled on 31 October:
(a) A sale to US customer of goods for $205500.
(b) A sale to another US customer for 550000.
(c) A purchase from a US supplier for $875000.
On 1 June the spot rate is 1 = 1.5500 1.5520$ and the October forward rate is at a premium
of 4.00-3.95 cents per pound. Sterling futures contracts are trading at the following prices:
Contract settlement date
Contract price $ per 1
Jun
1.5370
Sep
1.5180
Dec
1.4970
Contract size is 62500 and tick size is $0.0001 (so tick value is 6.25 per contract).
(a) Calculate the net amount receivable or payable in pounds if the transactions are covered on
the forward market.
(b) Demonstrate how a futures hedge could be set up and calculate the result of the futures
hedge if, by 31 October, the spot market price for dollars has moved to 1.5800-1.5820 and the
sterling futures price has moved to 1.5650.
Solution: (a) First we match receipts and payments. Sterling receipt does not need to be hedged
since it is not exposed to FOREX risk. Dollar receipt can be matched against the payment, giving
a net payment of $669500 on 31 October.
Forward rate in October for buying dollars = 1.5500 + 0.0400 (premium) = 1.5100.
Using forward contract, sterling cost of the dollar payment will be 669500/1.5100 = 443377.
The net cash received on October 31 will therefore be 550000 - 443377 = 106623.
(b) We need to pay $669500 so we like to buy dollars futures, but the problem is the contract
size will not have a US based currency of contract (dollars) as it is traded in CME. Therefore, we
sell sterling futures to buy the $ we need. As the settlement is on 31 October, we should choose
December contract.
$669500/1.4970 = 447228 so number of contract we need = 447228/62500 = 7.16 = 7 (we
round off as you cant buy part of the contract and because of this, imperfect hedge may
occur).
The closing futures price is given as 1.5650. Therefore:
$
Opening futures price sell
1.4970
Closing futures price buy
1.5650
Movement loss
0.0680
Futures market loss = 680 ticks x 6.25 x 7 contracts = $29750 or 0.0680 x 62500 x 7 = $29750.
The net outcome would be:
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$
Spot market payment
(669500)
Futures market loss
(29750)
(699250)
Translated at closing spot rate (bank sells low hence we use the rate of 1.5800) =
669250/1.5800 = 442563.
The net cash received on October 31 will therefore be 550000 - 442563 = 107437.
Currency swaps
A swap is an arrangement whereby two organisations contractually agree to exchange
payments on different terms, for example in different currencies, or one at a fixed rate and the
other at a floating rate. Currency swap is the swapping of interest rate commitments on
borrowing in different currencies and includes both the swap and re-swap of principal and an
exchange of interest rates. Currency swaps effectively involve the exchange of debt from one
currency to another. The swap of interest rates could be fixed for fixed or fixed for variable
(these swaps are also known as plain vanilla or generic currency swaps). During the life of the
swap agreement, the counterparties undertake to service each others foreign currency interest
payments. Currency swaps can provide a hedge against exchange rate movements for longer
periods than the forward market and can be a means of obtaining finance from new countries.
In practice, most currency swaps are conducted between banks and their customers.
Example: Jap Co is a Japanese firm looking to expand in USA and is looking to raise $20m at a
variable interest rate. It has been quoted the following rates:
$ LIBOR + 60 points
1.2%
Amer Co is an American company looking to refinance a 2400m loan at a fixed rate. It can
borrow at the following rates:
$ LIBOR + 50 points
1.5%
The current spot rate is $1 = 120. Show how the fixed for variable currency swap would work
in the circumstances described, assuming the swap is only for one year and that interest is paid
at the end of the year concerned.
Solution: As you can see, it is cheaper to borrow at own currency. Therefore, currency swap will
be useful. Jap Co can borrow on behalf of Amer Co 2400m at 1.2% and Amer Co can borrow on
behalf of Jap Co $20m at LIBOR + 50 points. Then, Jap Co pays LIBOR + 50 points interest rate
and Amer Co pays 1.2% interest rate. At the end of one year, Jap Co pays back $20m to Amer
Co and Amer Co pays back 2400m to Jap Co (re-swapping the principal amount).
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We can compare currency swap and forward contract. The attraction of a currency swap is that
it avoids having to enter into a sequence of forward contracts (a forward strip) with a currency
dealer with the associated charges and budget variability entailed. Inevitably, a higher rate will
be quoted on the swap to cover the required commission by currency dealer. A disadvantage of
swap agreements is the relatively complex contract procedure which must be pursued to
ensure that the counter-parties to the swap are in agreement as to the terms. Forward
contracts tend to be less cumbersome to both negotiate and contract with the currency dealer.
FOREX swaps
A FOREX swap involves the swapping and re-swapping of agreed equivalent amounts of
currency at an agreed rate for an agreed period. It is similar to currency swap with the
exception that it only involves the exchange of principal amount.
Example: Fire Co, based in Krownland, wishes to hedge 1 year foreign exchange risk, which will
arise on an investment in Chile. The investment is for 800m escudos and is expected to yield an
amount of 1000m escudos in 1 years time. Fire Co cannot borrow escudos directly and is
therefore considering two possible hedging techniques:
(a) Entering into a forward contract for the full 1000m escudos receivable.
(b) Entering into a FOREX swap for the 800m escudos initial investment, and then a forward
contract for the 200m escudos profit element.
The currency spot rate is 28 escudos to the krown, and the bank has offered a FOREX swap at
22 escudos/krown with Fire Co making a net interest payment to the bank of 1% in krowns
(assume at T1).
Interest
Borrowing
Lending
Krownland
15%
12%
Chile
N/A
25%
A forward contract is available at a rate of 30 escudos per krown. Determine whether Fire Co
should hedge its exposure using a forward contract or a FOREX swap.
Solution:
(a) In the case of forward contract, Fire Co needs to first borrow money to buy 800m escudos at
spot rate, ie. need to borrow 800/28 = 28.57m krown.
Interest on borrowing = 28.57 x 15% = 4.29m krown.
Receipts = 1000/30 = 33.33 krown.
Net receipts = 33.33 (28.57 + 4.29) = 0.47m krown.
(b) In the case of FOREX swap, again Fire Co needs to borrow money first, but this time the
amount to borrow is calculated as 800/22 = 36.36 krown (this amount is repaid at the end of 1
year). Interest = 36.36 x 15% = 5.45m krown. Swap fee = 1% x 36.36 = 0.36m krown.
Receipts hedged using forward contract = 200/30 = 6.67 krown.
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Strike price
June
July
August
June
July
August
1.4750
6.34
6.37
6.54
0.07
0.19
0.50
1.5000
3.86
4.22
4.59
0.08
0.53
1.03
1.5250
1.58
2.50
2.97
0.18
1.25
1.89
Show how traded currency options can be used to hedge the risk at a strike price of 1.525.
Calculate the sterling cost of the transaction if the spot rate in July is (a) 1.46 1.4620 or (b)
1.61-1.6120.
Solution: We need put option as we need to sell pounds in order to generate the dollars
needed. We will base on the strike price of 1.5250. As money is payable in July, we would
choose July as expiry date. Number of contracts we need = (2000000 1.525)/31250 = 41.97 =
42.
Premium payable now = 0.0125 (from July put at 1.5250 strike price) x 31250 x 42 = $16406.
Translated to sterling at spot rate = 16406/1.5350 = 10688.
Closing spot rate = (a) 1.4600 or (b) 1.6100 (since bank will always give us the adverse rate).
Options market outcome:
Strike price
1.5250
1.5250
Closing price
1.46
1.61
Exercise or not
YES
NO
Outcome of options position (31250 x 42)
1312500
$2001563
$2000000
$1563
Net outcome:
(1242236)
(10688)
(1252924)
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balance. Multilateral netting is where more than two group companies are involved and is more
complex. There are two ways to do netting and both give the same results.
1. Transactions matrix
1. Set up a table with the name of each company down the side and across the top.
2. Input all the amounts owing from one company to another into the table and convert all
currency flows to a common (base) currency using spot rates.
3. By adding across and down the table, identify the total amount payable and the total amount
receivable by each company.
4. Compute the net payable or receivable, and convert back into the original currency.
2. Route minimisation algorithm
1. Convert all currency flows to a common (base) currency using spot rates.
2. Clear the overlap of any bi-lateral indebtedness, eg:
A
10m
4m
6m
A
7m
10m
B
5m
8m
2m
4. Clear the smallest leg of any 4 way circuits (then 5, etc), eg:
A
3m
10m
m
7m
C
B
1m
m
8m
C
5m
D
2m
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Example: X, Y and Z are three companies within the same UK based international group. W is a
company outside of the group. The following liabilities have been identified for the forthcoming
year:
Owed by
Owed to
Amount (m)
X
Y
39
Y
X
10
Y
W
$20
Z
X
200
Z
Y
15
W
X
$15
W
Z
100
Midmarket spot rates (currency cross rates) are 1 = $2.00, 1 = 1.50, 1 = 250. Establish the
net indebtedness that would require external hedging.
Solution:
Owed to
Owed by
W
X
Y
Z
W
$15
100
X
39
Owed by Y
$20
10
Z
200
15
We need to convert them to a common currency. In this case, sterling is a good choice.
Owed to
Owed by
W
X
Y
Z
W
7.5
0.4
7.9
X
26
26
Owed by Y
10
10
20
Z
0.8
10
10.8
Owed to
10
18.3
36
0.4
Owed by
7.9
26
20
10.8
Net
2.1
-7.7
16
-10.4
We only need to hedge 2.1 x 2 = $4.2m as W is the only outsider.
June 2010 question 5(b) question and answer are worth looking at.
Example: Discuss the advantages and disadvantages of netting arrangements with both group
and non-group companies (8 marks).
Solution: Netting is a mechanism whereby mutual indebtedness between group members or
between group members and other parties can be reduced. The advantages of such an
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arrangement is that the number of currency transactions can be minimised, saving transaction
costs and focusing the transaction risk onto a smaller set of transactions that can be more
effectively hedged. It may also be the case, if exchange controls are in place limiting currency
flows across borders, that balances can be offset, minimising overall exposure. Where group
transactions occur with other companies, the benefit of netting is that the exposure is limited
to the net amount reducing hedging costs and counterparty risk.
The disadvantages: some jurisdictions do not allow netting arrangements, and there may be
taxation and other cross border issues to resolve. It also relies upon all liabilities being accepted
and this is particularly important where external parties are involved. There will be costs in
establishing the netting agreement and where third parties are involved this may lead to reinvoicing or, in some cases, re-contracting.
Now, we shall have a look at June 2008 question 3(b) and (c)s questions and examiners
answers for a good summary and learning.
Example: Discuss the relative advantages and disadvantages of the use of a money market
hedge compared with using exchange traded derivatives for hedging a foreign exchange
exposure (6 marks).
Solution: A money market hedge is a mechanism for the delivery of foreign currency, at a future
date, at a specified rate without recourse to the forward FOREX market. If a company is able to
achieve preferential access to the short term money markets in the base and counter currency
zones then it can be a cost effective substitute for a forward agreement. However, it is difficult
to reverse quickly and is cumbersome to establish as it requires borrowing/lending agreements
to be established denominated in the two currencies.
Exchange traded derivatives such as futures and foreign exchange options offer a rapid way of
creating a hedge and are easily closed out. For example, currency futures are normally closed
out and the profit/loss on the derivative position used to offset the gain or loss in the
underlying. The fixed contract sizes for exchange traded products mean that it is often
impossible to achieve a perfect hedge and some gain or loss on the unhedged element of the
underlying or the derivative will be carried. Also, given that exchange traded derivatives are
priced in a separate market to the underlying there may be discrepancies in the movements of
each and the observed delta may not equal one. This basis risk is minimised by choosing short
maturity derivatives but cannot be completely eliminated unless maturity coincides exactly
with the end of the exposure. Furthermore less than perfectly hedged positions require
disclosure under IAS 39. Although rapid to establish, currency hedging using the derivatives
market may also involve significant cash flows in meeting and maintaining the margin
requirements of the exchange. Unlike futures, currency options will entail the payment of a
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premium which may be an expensive way of eliminating the risk of an adverse currency
movement.
With relatively small amounts, the OTC market represents the most convenient means of
locking in exchange rates. Where cross border flows are common and business is well
diversified across different currency areas then currency hedging is of questionable benefit.
Where, as in this case, relatively infrequent flows occur then the simplest solution is to engage
in the forward market for hedging risk. The use of a money market hedge as described may
generate a more favourable forward rate than direct recourse to the FOREX market. However
the administrative and management costs in setting up the necessary loans and deposits are a
significant consideration.
Example: Discuss the extent to which currency hedging can reduce a firms cost of capital (4
marks).
Solution: The only risk which will impact on a firms cost of capital is that risk which is priced in
either the equity or the debt markets. Considering these two markets in turn:
Currency risk forms part of a firms exposure to market risk and will impact on a firms cost of
capital through its beta value and, as a result, its equity cost of capital. The extent to which this
is significant depends on the exposed volume of currency transactions conducted in a given
period, the average duration of the exposure and the correlation of the currency with the
market. If a given currency has the same correlation with the market as the company, removing
currency risk will have no impact on the firms overall exposure to market risk and as a result no
impact on the firms cost of capital. The greater the difference in the relative correlations, the
higher the potential improvement in shareholder value from hedging.
The impact on the cost of debt is more complex. The most significant impact is through the
firms exposure to default risk. If currency transactions are significant and the foreign currency
is highly correlated with the domestic currency then the impact is unlikely to be significant and
the gains from hedging modest. Where the degree of correlation is low or indeed negative then
eliminating currency risk may significantly alter the firms default risk. However, unlike market
risk, default risk is related to the overall volatility of a firms underlying value and its ability to
finance its debt. The elimination of currency risk is therefore likely to have at least some impact
on the volatility of the firms cash flows and therefore its cost of capital.
3. The use of financial derivatives to hedge against interest rate risk
Interest rate risk is the risk to the profitability or value of a company resulting from changes in
interest rates. The risk with interest rates is not that interest rates might move once the loan
has been taken out (a fixed rate will protect against this). The risk is that rates might fluctuate
between now and the date the loan is needed.
We will start with some basics and revisions.
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year. When an FRA reaches its settlement date, the buyer and seller of FRA must settle the
contract as it is binding.
Something to note of is the terminology of FRA:
1. 4.00 - 3.80 means that you can fix a borrowing rate at 4.00% (favourable to the bank).
2. A 3 - 6 FRA is one that starts in three months and lasts for three months.
3. 1 basis point is 0.01%.
Benchmark rate of interest (LIBOR) is also called the variable rate, market rate or reference
rate. When FRA rate is higher than reference rate at settlement date, buyer of FRA makes cash
payment to the seller for the amount by which the FRA rate exceeds the reference rate.
Similarly, when FRA rate is lower than market rate, seller of FRA makes cash payment to the
buyer for the amount by which the FRA rate is less than the reference rate.
1. Borrowing (concerned about interest rate rises) company will borrow the required sum on
the target date and will thus contract at the market interest rate on that date. Separately the
company will buy a matching FRA from bank or other market maker and thus receive
compensation if rates rise.
2. Depositing (concerned about fall in interest rate) company will deposit the required sum on
the target date and will thus contract at the market interest rate on that date. Separately, the
company will sell a matching FRA to a bank or other market maker and thus receive
compensation if rates fall.
In each case, the interest rate will be effectively fixed.
Example: It is 30 June. Water Co needs a $10m 6 months fixed rate loan from 1 October. Water
Co wants to hedge using an FRA and the relevant FRA rate is 6% on 30 June. What if the FRA
benchmark rate has moved to 9% later?
Solution: FRA required is 3 - 9. Water Co will buy FRA from bank as it is concerned about
interest rate rises. Since the rate increased later, Water Co will receive 3% (9 6) from bank.
$
Payment on underlying loan at market rate (9% x $10m x 6/12)
(450000)
FRA receipt ($10m x 3% x 6/12)
150000
Net payment on loan
(300000)
Effective interest rate on loan will be 6%, company will avoid the lost when interest rate rises
(but also unable to benefit from fall in interest rate).
Interest rate futures
Interest rate futures are standardised exchange-traded contracts (can be traded in exchange
such as LIFFE in London) agreed now between buyers and sellers, for settlement at a future
date. It is generally closed out before the maturity date, yielding a profit or loss that is offset
against the loss or profit on the money transaction that is being hedged.
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1. A company expecting to borrow can lock in an interest rate by selling futures as company is
receiving money at open position.
2. A company expecting to lend or invest can lock in an interest yield by buying futures as
company is giving out money at open position.
Open price is the price of the future at the beginning of the days trading. Settlement price is
the official price of the future at the end of the days trading. Open price is the benchmark for
the days trading it is compared to the settlement price at the end of the day to determine
whether the future has closed up or down.
There are two broad types of interest rate futures: short-term interest rate futures (STIRs)
which is more commonly used and bond futures. For STIRs, the minimum price movement is
usually one basis point (0.01%). Again, there are some things to learn:
1. Tick value = unit of trading x one basis point x fraction of the year.
2. Interest rate futures prices are stated as 100 minus the expected market reference rate, eg.
96.70 means that market reference rate is 3.30%.
3. Number of contracts needed = amount of loan or deposit/contract size x exposure
period/contract period. Exposure period is the period of exposure to interest rate changes. The
standard contract period is 3 months (March, June, September and December).
4. We will select the shortest available future with maturity following the commencement of
exposure.
5. Futures hedges are imperfect due to basis risk and the need sometimes to round to a whole
number of contracts, for example number of contracts needed is 10.1 and we round up to 10.
The steps involved are quite similar to currency futures.
Example: It is now March. In the UK, Fire Co has recognised from its short-term cash budgets
that it is likely to have a surplus of 10m arising in 2 months time (May) for a period of 3
months, which it plans to invest in short-term money market instruments. It is concerned that
interest rates in the next 2 months may fall and wishes to hedge this risk using futures contract.
June three-month sterling interest rate futures contracts are available with a contract size of
500000 and tick size of 12.50. They are currently priced at 96.00. Interest rates currently
stand at 4%.
Illustrate how Fire Co can hedge its interest rate exposure using the above futures contracts if,
in 2 months time, market interest rates have fallen to 3% and the futures price has moved to
97.00.
Solution: Company wants to hedge the risk of a fall in interest rates on deposits/investments. It
will buy interest rate futures in March (open position). Number of contracts = 10m/500000 x
3/3 = 20 contracts at 96.00. The exposure period is 3 months (March, April, May).
In May, company will close out the futures by selling 20 futures contract at 97.00.
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3. To obtain cheaper finance a swap should result in a company being able to borrow what
they want at a better rate under a swap arrangement, than borrowing it directly themselves
(this is known as the theory of comparative advantage).
Example: Happy Co wishes to raise 100m. It wishes to pay floating rate as it wants to take
advantage of any fall in interest rates. It can borrow at a fixed rate of 12% or at a floating rate
of LIBOR + 1%.
Funny Co wishes to raise a similar sum but can only borrow at 14% fixed or LIBOR + 2% floating.
For cash planning purposes it wishes to keep interest payments fixed.
Since Happy can borrow at the more beneficial rates, it requires 75% of any gains from a swap.
Set up the interest rate swap and show the advantages to both companies.
Solution: Happy Co has the absolute advantage in this case.
Fixed rate
Floating rate
Happy Co
12%
LIBOR + 1%
Funny Co
14%
LIBOR + 2%
Difference
2%
1%
The gains from swap = 1% (2 1) and Happy Co wants 0.75% of this. The difference in fixed rate
is higher so it is better for Funny Co to use fixed rate of Happy Co, which the company did.
Happy Co will have to pay Funny Co LIBOR + 2% while Funny Co pays Happy Co 13.75% (14% 0.25%).
Happy Co
Funny Co
Original payment
(12%)
(LIBOR + 2%)
Receipt under swap
13.75%
LIBOR + 2%
Payment under swap
(LIBOR + 2%)
(13.75%)
Net payment
(LIBOR + 0.25%) (13.75%)
Both companies can get the debt type required at advantageous rates, so the swap works. If we
examine the net payment carefully, Happy Co is paying less than 0.75% of its original floating
rate and Funny Co is paying less than 0.25% of its original fixed rate.
Banks (intermediaries) normally arrange swaps and quote the ask rate (the rate at which the
bank is willing to receive a fixed interest cash flow stream in exchange for eg. LIBOR) and a bid
rate (rate at which bank is willing to pay for receiving eg. LIBOR). The difference (the banks
profit margin) is generally at least 2 basis points. The advantage of dealing with a bank is that
there is no problem about finding a swap counterparty and the default risk is borne by bank.
However, the savings from swap will depend on the bank and counterparties will have to
accept the banks ask and bid rate. The following example extracts the December 2009 question
5.
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Example: Thunder Co raised $150 million through the issue of 12-year floating rate notes at 120
basis points over LIBOR, interest payable at six month intervals. The loan now has 10 years to
maturity. 10-year swap rates are quoted at 525540. Estimate the six-monthly interest rate
and the effective annual rate payable if a vanilla interest rate swap is agreed.
Solution: This is the case of floating for fixed swap. As interest is payable every 6 month, within
6 months the rate is LIBOR/2 + 1.2%/2 = LIBOR/2 + 0.6%. Bank always charges us the adverse
rate (ask rate), in this case 5.40 and converted to 6 months = 2.7%.
Payments
(LIBOR/2 + 0.6%)
Receipt under the swap
LIBOR/2
Payment under the swap
(2.7%)
Net payment
(3.3%)
Effective annual rate (EAR) = 1.033^(12/6) 1 = 6.71% (converting from 6 months rate to
annual rate).
Options on FRAs (interest rate guarantees, caps, floors, collars)
Interest rate guarantee (IRG) is a contract with a bank (OTC) fixing a maximum/(minimum)
borrowing/(lending) rate on a notional loan for a stated period from a stated future date in
exchange for an upfront fee (premium). It has a maximum maturity of one year. IRGs are more
expensive than the FRAs as one has to pay for the flexibility to be able to take advantage of a
favourable movement. If actual interest rate turns out to be favourable, the option can be
allowed to lapse.
1. Call option right to buy (receive interest at the specified rate).
2. Put option right to sell (pay interest at the specified rate).
Example: It is 31 October and Big Co is arranging a six-month 5m loan commencing on 1 July,
based on LIBOR. Big wants to hedge against an interest rate rise using an IRG. The current
LIBOR is 8%. The IRG fee is 0.25% per annum of the loan. If LIBOR turned out to be 9% or 5% on
1 July, evaluate the use of IRG.
Solution:
% per annum
% per annum
Actual interest payment
(9.00)
(5.00)
Premium paid on IRG
(0.25)
(0.25)
Claim on IRG
1.00
Net interest
(8.25)
(5.25)
When actual LIBOR is 5%, the IRG is allowed to lapse.
IRGs are sometimes referred to as interest rate options or interest rate caps/floors. IRG is an
interest rate cap (put option) when it sets an interest rate ceiling (maximum interest rate) or
interest rate floor (call option) when it sets a minimum interest rate. For example, company can
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buy a cap from bank to fix the maximum interest rate. However, the cost of a cap may be too
high and it may be necessary to consider interest rate collars.
Interest rate collar is a lower-cost alternative to an interest rate cap or floor. Under a collar
arrangement, the borrower limits its ability to take advantage of a favourable movement. It
buys a cap (put option) as normal but also sells a floor (call option) on the same FRA, but with a
different exercise price. In case of depositor, he can sell the cap to limit maximum receipts
while also buy a floor to limit minimum receipts. Collar is also used on interest rate futures.
Example: A collar might consist of a cap at 8% and a floor at 6.5%. The collar holder will
therefore fix a maximum LIBOR rate for borrowing at 8% but also a minimum rate of 6.5%. The
cost of a collar is the difference between the premium payable on the cap and the premium
receivable from selling the floor. This effectively reduced the premium cost of just using a cap.
Options on interest rate futures
These are exchange traded options so these have standardised amounts and standard periods.
It follows how you hedge using interest rate futures, for example if you buy futures at open
position, you will also buy call option (you are receiving interest) and if you are selling futures at
open position, then you will buy put option (you are paying interest). You need to find out the
exercise price of the option to determine which premium is applicable.
Example: It is 30 June. Ice Co requires a 5m three-month loan due to commence on 1
September. Ice can borrow at LIBOR + 1%, and wishes to protect itself against any future
interest rate increases above current LIBOR of 5.75%. Contract size of the traded options is
500000. The following data (all in %) are available on September LIFFE options:
Strike price
Interest rate cap
Call options premium
Put options premium
93.75
6.25
1.29
0.23
94.25
5.75
0.69
0.77
94.75
5.25
0.16
1.33
st
By 1 September LIBOR has risen to 8%. LIFFE price is 92.10. Illustrate how Ice Co could use
interest rate options to hedge its loan.
Solution: Ice Co is paying interest, so it will sell futures and so purchase put options. When we
are not told which strike price to use, we should use the one closest to the interest rate. In this
case, the current LIBOR is 5.75%, so our strike price is 94.25 (100 5.75) and so the premium
payable is 0.77% (September puts at strike price of 94.25).
Number of contracts = 5000000/500000 x 3/3 = 10.
At 1st September, futures price is 92.10 (7.9%) which is higher than price at open position
(94.25, ie. 5.75%). Option will be exercised so that Ice Co gains on the futures.
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%
Pay loan interest (8 + 1)
(9.00)
Pay premium
(0.77)
Exercise option: Profit on futures (94.25 92.10)
2.15
Net interest payable
(7.62)
Note: The premium can be reduced if Ice Co also sells a floor. If floor is sold at 5.25%, then Ice
Co can receive a premium of 0.16% which reduced the premium payable to 0.61% (0.77 0.16).
Options on interest rate swaps (swaptions)
Swaptions give the holder the right but not obligation to enter into a swap with the seller.
These are hybrids or embedded derivative.
A payer swaption gives the holder the right to enter into a swap as the fixed rate payer (and the
floating rate receiver). A receiver swaption gives the holder the right to enter the swap as the
fixed rate receiver (and the floating rate payer).
Swaptions generate a worst case scenario for buyers and sellers. For example an organisation
that is going to issue floating rate debt can buy a payer swaption that offers the option to
convert to being a fixed rate payer if interest rates increase.
Example: Suppose a party purchases a 1 x 5 payer swaption at a rate of 5%. A year later if the
four year swap is 6% the buyer will exercise the swaption and pay 5% fixed rate for LIBOR on a
four year swap. If instead the four year swap rate is 4% the buyer will not exercise the
swaption.
We will end this area by looking at December 2008 question 5(b) and answer.
Example: Outline the benefits and dangers of using derivative agreements in the management
of interest rate risk (6 marks).
Solution: Derivatives offer an opportunity for a firm to vary its exposure to interest rate risk at a
given rate of interest on the underlying principal (hedging) or to decrease the rate of interest
on its principal at an increased level of risk exposure. For hedging purposes derivatives permit
the management of exposure either for the long term (swaps) or for the short term (Forward
Rate Agreements (FRAs), Interest Rate Futures (IRFs), Interest Rate Options (IROs) and hybrids).
With forward and futures contracts, the mechanism of hedging is the same in that an offsetting
position is struck such that both parties forego the possibility of upside in order to eliminate the
risk of downside in the underlying rate movements. Where the option to benefit from
favourable rate movements is required or in situations where there is uncertainty whether a
hedge will be required, then an IRO may be the more appropriate but higher cost alternative.
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Such hedging can be more or less efficient depending upon the ability to set up perfectly
matched exposures with zero default risk. Matching depends upon the nature of the contract.
With OTC agreements the efficiency of the match may be perfect but the risk of default
remains. With traded derivatives, the efficiency of the match may be less than perfect either
through size effects or because of the lack of a perfect match on the underlying (for example
the use of a LIBOR derivative against an underlying reference rate which is not LIBOR). There
will also be basis risk where the maturity of the derivative does not coincide exactly with the
underlying exposure.
Where a company forms a view that future spot rates will be lower than those specified by the
forward yield curve they may decide to alter their exposure to interest rate risk in order to
capture the benefit of the reduced rate. This can be achieved through the use of IROs.
Alternatively, leveraged swap or leveraged FRA positions can be taken to avoid the upfront cost
of an IRO. For example, taking multiples of the variable leg of a swap (i.e. agreeing to swap fixed
for variable) where a higher than market fixed rate is swapped for n multiples of the variable
rate. However, as a number of cases have demonstrated it may be very difficult with these
types of arrangement to gauge the degree of risk exposure and to ensure that they are
effectively managed by the firm. In the 1990s a number of companies in the US and elsewhere
took leveraged positions, without recognising the degree of their exposure and took losses that
threatened the survival of the firm.
4. Dividend policy in multinationals and transfer pricing
Determining a companys dividend capacity and its policy
It is discussed earlier that dividend capacity can be measured by free cash flow to equity (FCFE).
Dividend capacity of a company depends on its after tax profits, investment plans and foreign
dividends. Here we are considering a number of factors that need to be considered by
multinationals when determining their dividend policy, in addition to just considering dividend
capacity.
The companys short and long-term reinvestment strategy
Company needs to finance its investment strategy which is done continuously. Short-term
investment means investing in working capital and long-term investment means investing in
project which may require significant financing. The finance required for the reinvestment must
be kept and not paid out as dividend.
The impact of any other capital reconstruction programmes on free cash flow to equity such as
share repurchase agreements and new capital issues
1. Share repurchase scheme will result in reduction in FCFE (refer to direct method) available
for payment as dividends and decrease in number of shares/increase in EPS.
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2. New capital issue new capital issue may be debt or equity issue. Both will increase FCFE
with the additional cash finance obtained but the interest payment in debt can reduce FCFE.
The impact of these on FCFE is important to consider as the changes in FCFE will result in the
need to alter the dividend policy.
The availability and timing of central remittances
Remittance blocking by the foreign countries governments can limit funds available to pay
dividends to parent company shareholders. Therefore, as discussed before, methods to prevent
or minimise the effect of blocked remittances include transfer pricing (setting high transfer
price for goods sold to the oversea subsidiary), charging royalty, make loan with high interest
rate to subsidiary, and management charges.
The timing of central remittance can also affect the FCFE. Factors like tax rate and exchange
rate should be considered and repatriation at the right time will be important.
The corporate tax regime within the host jurisdiction
Tax considerations are thought to be the primary reason for the dividend policies inside the
multinational firm. For example, parent company may reduce its overall tax liability by, for
example, receiving larger amounts of dividends from subsidiaries in countries where
undistributed earnings are taxed.
For subsidiaries of UK companies, all foreign profits, whether repatriated or not, are liable to UK
corporation tax, with a credit for the tax that has already been paid to the host country.
Similarly, the US government does not distinguish between income earned abroad and income
earned at home and gives credit to MNCs headquartered in the US for the amount of tax paid
to foreign governments.
Example: Assume that the corporate tax rate in the home country (US) is 40% and in the
overseas country where a subsidiary is located is 30%. Assume that both the parent company
and subsidiary have pre-tax profits of $1000. Show the total tax payable.
Solution: Tax paid to foreign government = 1000 x 30% = $300, therefore foreign tax credit =
$300.
US tax = 1000 x 40% = $400.
Total tax payable = (400 300) + 300 = $400.
Despite the financial sense of a residual approach to dividends, most multinationals adopt a
ratchet pattern of dividends. This means to pay out a stable but rising dividend per share and
dividends can be maintained when earnings fall.
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difficulties due to local laws in repatriating funds, transfer prices for goods sold to subsidiaries
could be increased, with this the subsidiaries profits are reduced and therefore tax paid will be
reduced.
Other issues to consider
1. Import tariffs if there are import tariffs in the country where buying division operates,
group can minimise costs by keeping the transfer price to a minimum value.
2. Anti-dumping legislation governments may take action to protect home industries by
preventing companies from transferring goods cheaply into their countries. They may do this,
for example, by insisting on the use of a fair market value for the transfer price.
3. Competitive pressures transfer pricing can be used to enable profit centres to match or
undercut local competitors.
4. Ethical issues such as social responsibility and acting as a responsible citizen need to be
considered when setting transfer prices as do the potential negative aspects of bad publicity
and loss of reputation.
5. Behavioural impact of the prices being charged must be considered.
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3. Remuneration of traders is linked to trading volumes, so traders dealt in risky assets to earn
high incentives at the cost of putting organisation at risk.
4. Poorly drafted and inadequately implemented regulation, ie. many credit rating agencies did
not have any sort of statutory regulation.
The impact of global crisis is significant, leading to losses to investors, increasing
unemployment, decline in business globally etc.
Dark pool trading systems
Dark pools are an alternative trading system that allows participants to trade without
displaying quotes publicly. They allow brokers and fund managers to place and match large
orders anonymously to avoid influencing the share price. The transactions are only made public
after the trades have been completed.
The main problem with dark pool trading is that the regulated exchanges do not know about
the transactions taking place until the trades have been completed (information asymmetry).
Such a lack of information on significant trade makes the regulated exchanges less efficient.
Transparency is definitely reduced and liquidity in the regulated exchanges is reduced as well.
This defeats the purpose of fair and regulated markets with large numbers of participants and
threatens the healthy and transparent development of these markets.
Removal of barriers to the free movement of capital
With free movement of capital, convergence of financial institutions throughout the world
becomes possible. This can lead to the creation of financial conglomerates with operations in
banking, securities and insurance. The effect of this convergence is:
1. The creation of economies of scale as operations that were previously performed by different
companies are now performed by one company.
2. The creation of economies of scope since one factor of production can be employed in the
production of more than one product.
3. The reduction of volatility of earnings since some of the earnings are fee-based and not
influenced by the economic cycle.
4. The saving of consumers significant search costs since they can buy all financial product from
one source.
As finance can be obtained more easily, the raising of capital through global equity and bond
markets has become commonplace and has made easier cross-border mergers as well as
foreign direct investment (FDI).
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