Advanced Financial Management Class Note

ACCA Paper P4
Advanced Financial
Management
Class Notes
June 2013
Original version prepared by Ken Preece.
© Interactive World Wide Ltd. January 2013.
All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or
transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise,
without the prior written permission of Interactive World Wide Ltd.
Contents
PAGE
INTRODUCTION TO THE PAPER 5
FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7
CHAPTER 1: ISSUES IN CORPORATE GOVERNANCE 13
CHAPTER 2: ADVANCED INVESTMENT APPRAISAL – SECTION 1 25
CHAPTER 3: ADVANCED INVESTMENT APPRAISAL – SECTION 2 51
CHAPTER 4: COST OF CAPITAL 69
2 www.studyinteractive.org
CHAPTER 5: THEORIES OF GEARING 85
CHAPTER 6: CAPITAL ASSET PRICING MODEL 103
CHAPTER 7: ADJUSTED PRESENT VALUE 117
CHAPTER 8: INTERNATIONAL INVESTMENT APPRAISAL 129
CHAPTER 9: VALUATIONS, ACQUISITIONS AND MERGERS – SECTION 1 145
CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 197
CHAPTER 13: CORPORATE DIVIDEND POLICY 211
CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE 221
CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK 237
CHAPTER 16: HEDGING INTEREST RATE RISK 255
CHAPTER 17: FUTURES 269
CHAPTER 18: OPTIONS 283
CHAPTER 19: SWAPS 317
CHAPTER 20: PRINCIPLES OF ISLAMIC FINANCE 329
ACCA STUDY GUIDE 341
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Introduction to the paper
INTRODUCTION TO THE PAPER
Aim of the paper

The aim of the paper is to apply relevant knowledge, skills and exercise professional judgement as
expected of a senior financial executive or advisor, in taking or recommending decisions relating to the
financial management of an organisation.
Outline of the syllabus

A. Role and responsibility towards stakeholders
B. Economic environment for multinationals
C. Advanced investment appraisal
D. Acquisitions and mergers
E. Corporate reconstruction and re-organisation
F. Treasury and advanced risk management techniques
G. Emerging issues in finance and financial management
Format of the exam paper

The examination will be a three-hour paper (with the additional 15 minutes reading and planning time) of
100 marks in total, divided into two sections:
Section A:
Section A will contain a compulsory question, comprising of 50 marks.
Section A will normally cover significant issues relevant to the senior financial manager or advisor and will
be set in the form of a case study or scenario. The requirements of the section A question are such that
candidates will be expected to show a comprehensive understanding of issues from across the syllabus.
The question will contain a mix of computational and discursive elements. Within this question
candidates will be expected to provide answers in a specified form such as a short report or board
memorandum commensurate with the professional level of the paper in part or whole of the question.
Section B:
In section B candidates will be asked to answer two from three questions, comprising of 25 marks each.
Section B questions are designed to provide a more focused test of the syllabus. Questions will normally
contain a mix of computational and discursive elements, but may also be wholly discursive or evaluative
where computations are already provided.
Candidates will be provided (within the examination paper) with a formulae sheet as well as present
value, annuity and standard normal distribution tables.
FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER
Formulae & tables

provided in the
examination paper
Formulae
Modigliani and Miller Proposition 2 (with tax)
Vd
ke = kie + (1 – T)(kie – kd)
Ve
The Capital Asset Pricing Model
E(rj) = Rf + βj (E(rm) – Rf)
The asset beta formula
 Ve βe  +  Vd(1- T) βd 

βa = 
(Ve + Vd(1- T))  (Ve + Vd(1- T)) 
The Growth Model
P0 = D 0 (1 + g)
(re - g)
Gordon’s growth approximation
g = bre
The weighted average cost of capital
WACC =   Ve   ke + VeV+dVd  kd(1–T)
Ve + Vd  
The Fisher formula
(1 + i) = (1 + r) (1 + h)
Purchasing power parity and interest rate parity
(1+ ic)
S1 = S0 × (1+ hc) Fo = So ×
(1 + hb) (1 + ib)
Modified Internal Rate of Return

1
PV
 
MIRR =   PVRI  n (1 + re) – 1
The Black Scholes Option Pricing Model
-rt
c = Pa N(d1) − Pe N(d2) e
Where:
d1 = ln(P a/Pe) + (r + 0.5s2)t

s t
and
d2 = 1
d–st
The Put Call Parity relationship p = c − Pa +

-rt
Pe e
Present value table
Present value of 1 ie (1 + r)-n
Where r = discount rate n = number of periods until

payment
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2
0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2 3 0.971
0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3 4 0.961 0.924
0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4 5 0.951 0.906 0.863
0.822 0.784 0.747 0.713 0.681 0.650 0.621 5
6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6 7
0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7 8 0.923
0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10
11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2
0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2 3 0.731
0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3 4 0.659 0.636
0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4 5 0.593 0.567 0.543
0.519 0.497 0.476 0.456 0.437 0.419 0.402 5
6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6 7
0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7 8 0.434
0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10
11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
Annuity table
1 - (1 + r)- n
Present value of an annuity of 1 ie
Where r = discount rate
n = number of periods
Discount rate (r)
Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%
________________________________________________________________________________
1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1 2
1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2 3 2.941
2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3 4 3.902 3.808
3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4 5 4.853 4.713 4.580
4.452 4.329 4.212 4.100 3.993 3.890 3.791 5
6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6 7
6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7 8 7.652
7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10
11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15
________________________________________________________________________________
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%
________________________________________________________________________________
1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1 2
1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2 3 2.444
2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3 4 3.102 3.037
2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4 5 3.696 3.605 3.517
3.433 3.352 3.274 3.199 3.127 3.058 2.991 5
6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6 7
4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7 8 5.146
4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10
11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
Standard normal distribution table

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879
0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2703 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389
1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319
1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767
2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936
2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986
3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990
This table can be used to calculate N(d i), the cumulative normal distribution functions needed for the Black-
Scholes model of option pricing.
If di > 0, add 0.5 to the relevant number above.
If di < 0, subtract the relevant number above from 0.5
Chapter 1
Issues in corporate
governance
CHAPTER 1 – ISSUES IN CORPORATE GOVERNANCE
CHAPTER CONTENTS
FINANCIAL OBJECTIVES ------------------------------------------------ 15
THE UK CORPORATE GOVERNANCE CODE ----------------------------- 16

CODE OF BEST PRACTICE 16
INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 22

UNITED STATES OF AMERICA 22
GERMANY 22
JAPAN 23
FINANCIAL OBJECTIVES
Advanced Financial Management is concerned with the following key decisions:
- What to invest in (INVESTMENT DECISIONS)
- How to finance the investment (FINANCING DECISIONS)
- The level of dividend distributions (DIVIDEND DECISIONS).
Objectives
Primary objective: to maximise the wealth of shareholders. A positive NPV equates (in theory) to an
increase in shareholder wealth.
Secondary objectives may be e.g. meeting financial targets (say satisfactory ROCE), meeting productivity
targets, establishing brands and quality standards and effective communication with customers,
suppliers, employees.
As an alternative to maximising the wealth of shareholders a company must in reality consider satisficing
objectives for each of the major stakeholders.
Stakeholders (user groups) and their goals

These include:
● Shareholders
● Directors
● Management and employees
● Loan creditors
● Customers
● Suppliers
● The government
● Environmental pressure groups
● The general public
Many of these groups may have conflicting objectives, which need to be reconciled.
Corporate governance
Clearly the executive directors of a listed company are both decision-makers and major stakeholders.
They are therefore open to the accusation of making key decisions for their own benefit. Following a
number of notable financial scandals in the UK during the late 20 th century (e.g the Maxwell affair and
the collapse of the BCCI) the Cadbury Committee was set up to investigate procedures for appropriate
corporate governance.
The Cadbury Code (1992) defined corporate governance as “the system by which companies are
directed and controlled”. This initial document has been subject to subsequent amendments by the
Greenbury, Hampel and Higgs Reports. The Financial Services Authority requires listed companies to
confirm that they have complied with the Code provisions or – in the event of non-compliance – to
provide an explanation of their reasons for departure.
THE UK CORPORATE GOVERNANCE CODE
Code of best practice
Section A: Leadership
A.1 The Role of the Board

Main Principle: Every company should be headed by an effective board which is collectively responsible
for the long-term success of the company.
The annual report should identify the chairman, the deputy chairman (where there is one), the chief
executive, the senior independent director and the chairmen and members of the board committees. It
should also set out the number of meetings of the board and its committees and individual attendance
by directors.
A.2 Division of Responsibilities

Main Principle: There should be a clear division of responsibilities at the head of the company between
the running of the board and the executive responsibility for the running of the company’s business. No
one individual should have unfettered powers of decision.
The roles of chairman and chief executive should not be exercised by the same individual. The division
of responsibilities between the chairman and chief executive should be clearly established, set out in
writing and agreed by the board.
A.3 The Chairman

Main Principle: The chairman is responsible for leadership of the board and ensuring its effectiveness on
all aspects of its role.
The chairman should on appointment meet the independence criteria set out in B.1 below. A chief
executive should not go on to be chairman of the same company. If, exceptionally, a board decides that
a chief executive should become chairman, the board should consult major shareholders in advance and
should set out its reasons to shareholders at the time of the appointment and in the next annual report.
(Compliance or otherwise with this provision need only be reported for the year in which the
appointment is made).
A.4 Non-executive Directors

Main Principle: As part of their role as members of a unitary board, nonexecutive directors should
constructively challenge and help develop proposals on strategy.
The board should appoint one of the independent non-executive directors to be the senior independent
director to provide a sounding board for the chairman and to serve as an intermediary for the other
directors when necessary. The senior independent director should be available to shareholders if they
have concerns which contact through the normal channels of chairman, chief executive or other
executive directors has failed to resolve or for which such contact is inappropriate.
The chairman should hold meetings with the non-executive directors without the executives present.
Led by the senior independent director, the non-executive
directors should meet without the chairman present at least annually to appraise the chairman’s
performance and on such other occasions as are deemed appropriate.
Section B: Effectiveness
B.1 The Composition of the Board

Main Principle: The board and its committees should have the appropriate balance of skills, experience,
independence and knowledge of the company to enable them to discharge their respective duties and
responsibilities effectively.
The board should identify in the annual report each non-executive director it considers to be
independent. The board should determine whether the director is independent in character and
judgement and whether there are relationships or circumstances which are likely to affect, or could
appear to affect, the director’s judgement. The board should state its reasons if it determines that a
director is independent notwithstanding the existence of relationships or circumstances which may
appear relevant to its determination, including if the director:
● has been an employee of the company or group within the last five years;
● has, or has had within the last three years, a material business relationship with the
company either directly, or as a partner, shareholder, director or senior employee of a
body that has such a relationship with the company;
● has received or receives additional remuneration from the company apart from a
director’s fee, participates in the company’s share option or a performance-related pay
scheme, or is a member of the company’s pension scheme;
● has close family ties with any of the company’s advisers, directors or senior employees;
● holds cross-directorships or has significant links with other directors through involvement
in other companies or bodies;
● represents a significant shareholder; or
● has served on the board for more than nine years from the date of their first election.
Except for smaller companies (i.e. those below the FTSE 350 throughout the year immediately prior to
the reporting year), at least half the board, excluding the chairman, should comprise non-executive
directors determined by the board to be independent. A smaller company should have at least two
independent nonexecutive directors.
B.2 Appointments to the Board

Main Principle: There should be a formal, rigorous and transparent procedure for the appointment of
new directors to the board.
There should be a nomination committee which should lead the process for board appointments and
make recommendations to the board. A majority of members of the nomination committee should be
independent non-executive directors. The chairman or an independent non-executive director should
chair the committee, but the chairman should not chair the nomination committee when it is dealing
with the appointment of a successor to the chairmanship. The nomination committee should make
available its terms of reference, explaining its role and the authority delegated to it by the board. (This
requirement would be met by including the information on the company website).
B.3 Commitment
Main Principle: All directors should be able to allocate sufficient time to the company to discharge their
responsibilities effectively.
For the appointment of a chairman, the nomination committee should prepare a job specification,
including an assessment of the time commitment expected, recognising the need for availability in the
event of crises. A chairman’s other significant commitments should be disclosed to the board before
appointment and included in the annual report. Changes to such commitments should be reported to
the board as they arise, and their impact explained in the next annual report.
The board should not agree to a full time executive director taking on more than one non-executive
directorship in a FTSE 100 company nor the chairmanship of such a company.
B.4 Development
Main Principle: All directors should receive induction on joining the board and should regularly update
and refresh their skills and knowledge.
The chairman should ensure that the directors continually update their skills and the knowledge and
familiarity with the company required to fulfil their role both on the board and on board committees.
The company should provide the necessary resources for developing and updating its directors’
knowledge and capabilities.
To function effectively, all directors need appropriate knowledge of the company and access to its
operations and staff.
The chairman should ensure that new directors receive a full, formal and tailored induction on joining
the board. As part of this, directors should avail themselves of opportunities to meet major
shareholders.
The chairman should regularly review and agree with each director their training and development
needs.
B.5 Information and Support

Main Principle: The board should be supplied in a timely manner with information in a form and of a
quality appropriate to enable it to discharge its duties.
B.6 Evaluation
Main Principle: The board should undertake a formal and rigorous annual evaluation of its own
performance and that of its committees and individual directors.
The board should state in the annual report how performance evaluation of the board, its committees
and its individual directors has been conducted.
Evaluation of the board of FTSE 350 companies should be externally facilitated at least every three years.
A statement should be made available of whether an external facilitator has any other connection with
the company. (This requirement would be met by including the information on the company website).
The non-executive directors, led by the senior independent director, should be responsible for
performance evaluation of the chairman, taking into account the views of executive directors.
B.7 Re-election
Main Principle: All directors should be submitted for re-election at regular intervals, subject to continued
satisfactory performance.
All directors of FTSE 350 companies should be subject to annual election by shareholders. All other
directors should be subject to election by shareholders at the first annual general meeting (AGM) after
their appointment, and to re-election thereafter at intervals of no more than three years. Non-
executive directors who have served longer than nine years should be subject to annual re-election. The
names of directors submitted for election or re-election should be accompanied by sufficient
biographical details and any other relevant information to enable shareholders to take an informed
decision on their election.
Section C: Accountability
C.1 Financial and Business Reporting

Main Principle: The board should present a balanced and understandable assessment of the company’s
position and prospects.
C.2 Risk Management and Internal Control

(The Turnbull Guidance, last updated in October 2005, suggests means of applying this part of the
Code)
Main Principle: The board is responsible for determining the nature and extent of the significant risks it
is willing to take in achieving its strategic objectives. The board should maintain sound risk management
and internal control systems.
The board should, at least annually, conduct a review of the effectiveness of the company’s risk
management and internal control systems and should report to shareholders that they have done so.
The review should cover all material controls, including financial, operational and compliance controls.
C.3 Audit Committee and Auditors

(The FRC ‘Guidance on Audit Committees’ - formerly referred to as the Smith Guidance - suggests
means of applying this part of the Code)
Main Principle: The board should establish formal and transparent arrangements for considering how
they should apply the corporate reporting and risk management and internal control principles and for
maintaining an appropriate relationship with the company’s auditor.
The board should establish an audit committee of at least three, or in the case of smaller companies (i.e.
those below the FTSE 350 throughout the year immediately prior to the reporting year) two,
independent non-executive directors. In smaller companies the company chairman may be a member
of, but not chair, the committee in addition to the independent non-executive directors, provided he or
she was considered independent on appointment as chairman. The board should satisfy itself that at
least one member of the audit committee has recent and relevant financial experience.
Section D: Remuneration
D.1 The Level and Components of Remuneration

Main Principle: Levels of remuneration should be sufficient to attract, retain and motivate directors of
the quality required to run the company successfully, but a company should avoid paying more than is
necessary for this purpose. A significant proportion of executive directors’ remuneration should be
structured so as to link rewards to corporate and individual performance.
The performance-related elements of executive directors’ remuneration should be stretching and

designed to promote the long-term success of the company.
The remuneration committee should judge where to position their company relative to other
companies. But they should use such comparisons with caution, in view of the risk of an upward ratchet
of remuneration levels with no corresponding improvement in performance.
They should also be sensitive to pay and employment conditions elsewhere in the group, especially
when determining annual salary increases.
In designing schemes of performance-related remuneration for executive directors, the remuneration

committee should follow the provisions of this Code.
Where a company releases an executive director to serve as a non-executive director elsewhere, the
remuneration report (required by UK legislation) should include a statement as to whether or not the
director will retain such earnings and, if so, what the remuneration is.
D.2 Procedure
Main Principle: There should be a formal and transparent procedure for developing policy on executive
remuneration and for fixing the remuneration packages of individual directors. No director should be
involved in deciding his or her own remuneration.
The board should establish a remuneration committee of at least three, or in the case of smaller
companies two, independent non-executive directors. In addition the company chairman may also be a
member of, but not chair, the committee if he or she was considered independent on appointment as
chairman. The remuneration committee should make available its terms of reference, explaining its role
and the authority delegated to it by the board. Where remuneration consultants are appointed, a
statement should be made available of whether they have any other connection with the company (This
requirement would be met by including the information on the company website).
Section E: Relations with shareholders
E.1 Dialogue with Shareholders

Main Principle: There should be a dialogue with shareholders based on the mutual understanding of
objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with
shareholders takes place.
The chairman should ensure that the views of shareholders are communicated to the board as a whole.
The chairman should discuss governance and strategy with major shareholders. Non-executive directors
should be offered the opportunity to attend scheduled meetings with major shareholders and should
expect to attend meetings if requested by major shareholders. The senior independent director should
attend sufficient meetings with a range of major shareholders to listen to their views in order to help
develop a balanced understanding of the issues and concerns of major shareholders.
E.2 Constructive Use of the AGM

Main Principle: The board should use the AGM to communicate with investors and to encourage their
participation.
At any general meeting, the company should propose a separate resolution on each substantially
separate issue, and should, in particular, propose a resolution at the AGM relating to the report and
accounts. For each resolution, proxy appointment forms should provide shareholders with the option to
direct their proxy to vote either for or against the resolution or to withhold their vote. The proxy form
and any announcement of the results of a vote should make it clear that a ‘vote withheld’ is not a vote
in law and will not be counted in the calculation of the proportion of the votes for and against the
resolution.
The company should ensure that all valid proxy appointments received for general meetings are
properly recorded and counted. For each resolution, where a vote has been taken on a show of hands,
the company should ensure that the following information is given at the meeting and made available as
soon as reasonably practicable on a website which is maintained by or on behalf of the company:
● the number of shares in respect of which proxy appointments have been validly made;
● the number of votes for the resolution;
● the number of votes against the resolution; and
● the number of shares in respect of which the vote was directed to be withheld.
The chairman should arrange for the chairmen of the audit, remuneration and nomination committees
to be available to answer questions at the AGM and for all directors to attend.
The company should arrange for the Notice of the AGM and related papers to be sent to shareholders at
least 20 working days before the meeting.
INTERNATIONAL COMPARISONS OF CORPORATE

GOVERNANCE
The broad principles of corporate governance are similar in the UK, the USA and Germany, but there are
significant differences in how they are applied. Whereas the UK and Germany have voluntary corporate
governance codes, the US system is based upon legislation within the Sarbanes-Oxley Act.
United States of America

Whereas the UK has historically relied upon a system of self-regulation and voluntary codes of best
practice, the USA corporate governance structure is more formalised, with legally enforceable controls.
In the US, statutory requirements for publicly-traded companies are set out in the Sarbanes-Oxley Act.
These requirements include the certification of published financial statements by the CEO and the chief
financial officer (CFO), faster public disclosures by companies, legal protection for whistleblowers, a
requirement for an annual report on internal controls, and requirements relating to the audit
committee, auditor conduct and avoiding ‘improper’ influence of auditors.
The Act also requires the Securities and Exchange Commission (SEC) and the main stock exchanges to
introduce further rules, relating to matters such as the disclosure of critical accounting policies, the
composition of the Board and the number of independent directors. The Act has also established an
independent body to oversee the accounting profession, which is known as the Public Company
Accounting Oversight Board. Managers must be careful to comply with regulations to avoid possible
legal action against the company or themselves individually.
Germany
As both the UK and Germany are members of the EU, they must both follow EU directives on company
law. A major difference that exists in the board structure for companies is that the UK has a unitary
board (consisting of both executive and non-executive directors), whereas German companies have a
two-tier board of directors. The Supervisory Board of non-executives (Aufsichtsrat) has responsibility for
corporate policy and strategy and the Management Board of executive directors (Vorstand) has
responsibility primarily for the day-to-day operations of the company.
The Supervisory Board typically includes representatives from major banks that have historically been
large providers of long-term finance to German companies (and are often major shareholders). The
Supervisory Board does not have full access to financial information, is meant to take an unbiased
overview of the company, and is the main body responsible for safeguarding the external stakeholders’
interests. The presence on the Supervisory Board of representatives from banks and employees (trade
unions) may introduce perspectives that are not present in some UK boards. In particular, many
members of the Supervisory Board would not meet the criteria under UK Corporate Governance Code
for their independence.
Japan
Although there are signs of change in Japanese corporate governance, much of the system is based upon
negotiation or consensual management rather than upon a legal or even a self-regulatory framework.
Banks as well as representatives of other companies (in their capacity as shareholders) also sit on the
Boards of Directors of Japanese companies.
It is not uncommon for Japanese companies to have cross holdings of shares with their suppliers,
customers and banks etc., all being represented on each others Board of Directors. There are often
three boards of directors: Policy Boards, responsible for strategy and comprised of directors with no
functional responsibility; Functional Boards, responsible for day to day operations; and largely symbolic
Monocratic Boards. The interests of the company as a whole should dictate the actions of these boards.
This is in contrast to the UK or USA systems where, at least in theory, the board should act primarily in
the best interests of the shareholders, being the owners of the company.
Chapter 2
Advanced investment
appraisal – section
1
CHAPTER CONTENTS
INVESTMENT APPRAISAL TECHNIQUES ------------------------------- 27
1. ACCOUNTING RATE OF RETURN 27
2. PAYBACK PERIOD 28
3. DISCOUNTED CASH FLOW 28
INFLATION AND DISCOUNTED CASH FLOW -------------------------- 34

‘MONEY’ CASH FLOWS 34
‘REAL’ CASH FLOWS 34
RELATIONSHIP BETWEEN MONEY INTEREST RATES AND REAL INTEREST RATES 34
TAXATION AND INVESTMENT APPRAISAL ---------------------------- 36
CAPITAL RATIONING ---------------------------------------------------- 38

WHAT ARE THE 2 TYPES OF CAPITAL RATIONING? 38
CAPITAL RATIONING AND TIME 38
CHAPTER 2 – ADVANCED INVESTMENT APPRAISAL: SECTION 1
SINGLE PERIOD CAPITAL RATIONING 40

MULTI-PERIOD CAPITAL RATIONING 43
INVESTMENT APPRAISAL TECHNIQUES
Assumed objective is –
Selection of those projects which will maximise the wealth of the owners (or shareholders) of the
enterprise. Involves a consideration of FUTURE events, not PAST performance.
Accepted techniques are –
1. Accounting Rate of Return (alternatively called Return on Investment)
2. Payback Period
3. Discounted Cash Flow, of which there are two major variants:
(a) Net Present Value
(b) Internal Rate of Return (alternatively called Yield).
1. Accounting rate of return

The ARR (or ROI) is a measure of relative project profitability, which expresses:
1. the expected average annual profit (after allowing for depreciation, but before taxation)
emerging from a project
as a percentage of
2. the investment involved. Normally the average investment over the life of the project is
used, but initial investment is sometimes employed.
Advantages
● It is relatively easy to understand
● The required figures are readily available from accounting data.
● The ROI technique is frequently used as an assessment of management’s actual (hindsight)

performance.
● It gives an indication as to whether available projects are meeting target returns on capital
employed.
Disadvantages
● Based on accounting profits not cash flows - the success of an enterprise depends on its ability to
generate cash. The ability to invest depends on availability of cash.
● Ignores the time value of money
● It is relative rate of return, thus ignores the size of the project
● No set rules (theoretical or practical) for determining the cut-off rate of return.
2. Payback period
The Payback Period demonstrates how long an enterprise must expect to wait before the after-tax cash
flows generated by the project allow it to recoup the initial amount invested. Thus it gives an investor an
idea of “how long their money will be at risk”; a short payback period is taken to reveal low risk, and a
long payback - high risk.
Advantages
● The most tried and tested of all methods
● Easy to calculate and understand
● An enterprise with limited cash resources is obviously concerned with speed of return.
● Some companies combine DCF techniques with the payback method.
Disadvantages
● Does not measure profitability nor increases in shareholders wealth, since it ignores cash flows
expected to arise beyond the payback period.
● Ignores the time value of money (but discounted payback sometimes used).
● No set rules (theoretical or practical) for determining the minimum acceptable payback period.
● May be difficult to measure the initial amount invested when eg net outlays arise in both the initial
and final years of a project.
3. Discounted cash flow

DCF is a method of capital investment appraisal which takes account of:
1. The overall cash flows arising from projects, and
2. The timing of those cash flows.
Only relevant cash flows are considered (ie those future cash flows which arise as a result of those
projects) and the timing effect is incorporated by means of the discounting technique.
Both the Accounting Rate of Return and the Payback approaches are surpassed by the DCF methods. The
basic arguments are:
● it is better to consider cash rather than profits because cash is how investors will eventually see
their rewards (ie dividends, interest, or the proceeds from the sale of the shares or debentures).
● the timing of the cash flows is important because early cash receipts can be reinvested to earn
interest.
● it is important to consider the cash flows arising over the entire life of a project.
The technique of discounting reduces all future cash flows to current equivalent values (present values)
by allowing for the interest which could have been earned if the cash had been received immediately.
There are two common techniques, net present value and internal rate of return, but net terminal value
can be used.
DCF – Net present value
The NPV of a project is the net value of a project’s cash flows after discounting (ie allowing for
reinvestment) at the company’s cost of capital. Projects with a negative NPV should be rejected.
N.B. Cost of capital is the average required return which is set by the market for the company in view of
the risk associated with its operations.
Provided that:
1. The project under consideration is of average risk for the company, and 2. There is
no restriction on access to capital,
a positive NPV provides the best theoretical estimate of the total absolute increase in wealth which
accrues to an enterprise as a result of accepting that project.
However in the short run the use of the NPV rule may not lead to good profits being reported in the
published accounts of the enterprise – although in the long term cash flows and reported profits should
move in tandem.
The NPV rule has a sound theoretical basis and is likely to produce investment decision advice of
consistently good quality.
DCF – Internal rate of return (economic return/yield)

The IRR (or Economic return) of a project is that discount rate which when applied to a projects cash
flows provides an NPV of zero. The IRR is therefore the expected “earning rate” of an investment. If the
IRR of a project exceeds the cost of capital of that enterprise, that project is acceptable.
When considering a single project in isolation IRR will give the same decision as NPV (ie if the NPV of a
project is positive, its IRR will exceed the cost of capital). However, when choosing between mutually
exclusive projects, the two techniques may conflict and (subject to the provisos set out above) NPV always
provides the correct solution.
Disadvantages of IRR
1. IRR provides a relative (as opposed to an absolute) result, and may give incorrect decision advice if
mutually exclusive projects:
o Are of different size, or o
Have unequal lives.
2. May be multiple IRRs or no IRR
3. Cannot adapt to expected changes in cost of capital during the life of a project.
4. Makes an inconsistent assumption about the rate at which cash surpluses can be reinvested; it
assumes they are reinvested at whatever the IRR happens to be. The company’s cost of capital is a
more appropriate reinvestment rate ie the assumption underlying NPV.
5. More difficult to calculate than the theoretically more sound NPV approach.
Example Congo Ltd
Congo Ltd is considering the selection of one of a pair of mutually exclusive investment projects. Both
would involve purchase of machinery with a life of five years
Project 1 would generate annual cash flows (receipts less payments) of £200,000; the machinery would
cost £556,000 and have a scrap value of £56,000.
Project 2 would generate annual cash flows of £500,000; the machinery would cost £1,616,000 and have a
scrap value of £301,000.
Congo uses the straight-line method for providing depreciation.
Its cost of capital is 15 per cent per annum. Assume that annual cash flows arise on the anniversaries of
the initial outlay, that there will be no price changes over the project lives and that acceptance of one of
the projects will not alter the required amount of working capital.
Requirements:
(i) Calculate for each project
(a) the accounting rate of return (ie the percentage of the average accounting profit to the average
book value of investment) to the nearest 1%.
(b) the net present value
(c) the internal rate of return (Yield or Economic return) to the nearest 1%, and
(d) the payback period to one decimal place.
Ignore taxation.
(ii) WITHOUT ANY REFERENCE TO THE INCREMENTAL YIELD METHOD, briefly explain which one of the
discounted cash flow techniques used in part (i) of this question should be used by the management
of Congo Ltd, in deciding whether Project 1 or Project 2 should be undertaken.
Suggested solution to Congo Ltd
(i) Summary of results
Project 1 2
a) Accounting rate of return 33% 25%
b) Net present value (£000) 142 210
c) Internal rate of return (Economic return) 25% 20%
d) Payback period (years) 2.8 or 3 3.2 or 4 Summary of rankings
Better project
a) Accounting rate of return 1
b) Net present value 2
c) Internal rate of return 1
d) Payback period 1
WORKINGS
Project 1 Project 2
(a) Accounting rate of return £000 £000
Initial investment 556 1,616 Scrap value (56) (301)

Total depreciation 500 1,315
Annual depreciation 100 263
Cash flows 200 500

Depreciation (see above) (100) (263)
Average accounting profit 100 237
Project 1 Project 2
£000 £000
Average book value of investment (£000)
½ (556 + 56) 306
½ (1,616 + 301) 958
Accounting rate of return 33% 25%
(b) Net present value
£000 £000
Year
0 Initial outlay (556) (1,616)
1–5 Cash flows
200 x 3.352 670
500 x 3.352 1,676
5 Residual value
56 x 0.497 28
301 x 0.497 ___ 150
Net present value (£000) 142 210
(c) Internal rate of return (Economic return)

£000 £000
By trial and error
Try 20%
Initial outlays (556) (1,616)
Cash flows 598 1,495
Residual values _22 _121
NPV (£000) 64 NIL
Try 25%
Initial outlays (556) (1,616)
Cash flows 538 1,345 Residual values __18 __99 NPV (£000) NIL £(172)
IRR 25% 20%
(d) Payback period

£000 £000
Annual cash flows 200 500 Initial investment 556 1,616
Payback period in years
If cash flows arose during each year 2.8 3.2 If cash flows arose at year end (as in this
3 4
question)
(ii) Investment Decision
This example illustrates the conflict which will often be found between the two discounted cash
flow appraisal techniques in a ranking decision.
Under the net present value criterion, project 2 is preferred because it has a higher net present
value when the project cash flows are discounted at the cost of capital. On the other hand project
1 has the higher internal rate of return.
To decide which method of ranking is correct it is necessary to consider the assumed objective of
the firm, which is to maximise the wealth of the providers of finance. Both projects earn more
than the required rate of return but project 2 generates larger cash surpluses in excess of the
required amounts than project 1, as can be seen from the net present value calculations. It is
these cash surpluses which improve the wealth of the owners of the firm.
IRR provides a relative (as opposed to an absolute) result, and may give incorrect decision advice if
mutually exclusive projects are of different size (as in this instance) or have unequal lives.
IRR makes an inconsistent assumption about the rate at which cash surpluses can be reinvested; it
assumes they are reinvested at whatever the IRR happens to be. The company’s cost of capital is
a more appropriate reinvestment rate i.e. the assumption underlying NPV.
Accordingly PROJECT 2 IS PREFERRED TO PROJECT 1 and this can be justified by the following
argument:
Project 1 is relatively more profitable than project 2, but it is smaller. The two projects are
mutually exclusive, which means that only one of them can be accepted. It is better for the
owners of the company to receive the large cash surpluses from a large adequately profitable
project than to receive the smaller cash surpluses from a small very profitable project. Taken to
extremes, a return of ten per cent on £1,000 is better than a return of one thousand per cent on a
penny.
Tutorial Note
This question examines the conflicting rankings sometimes given by the NPV and IRR technique.
You may wish to “add a graph” to amplify your solution to part (c).
INFLATION AND DISCOUNTED CASH FLOW

The mechanics of allowing for inflation are basically easy to handle in DCF calculations. The real difficulty
is one of predicting what the rate will be. At this point we will discuss the mechanics.
There are two possible techniques:
1. discount ‘money’ (nominal) cash flows at the ‘money’ (nominal) discount rate.
2. discount ‘real’ cash flows at the ‘real’ discount rate.
‘Money’ cash flows

These are the predictions of the actual sums of money which will be received and paid taking into
account predicted inflation levels. The ‘money’ rate of interest is the interest rate which is normally
quoted and contains an allowance for inflation (for example, a 20% discount rate may contain an
allowance for expected inflation of 5%).
‘Real’ cash flows

These are cash flows expressed in today’s prices. A ‘real’ discount rate is the real required rate of return
after adjusting the money discount rate for the inflation allowance.
Relationship between money interest rates and real interest rates

Suppose we can invest money in a bank to earn 7% per annum interest. However, we expect inflation to
be 4% per annum next year. If I invest £1 this must grow to £1.04 to keep pace with inflation. So, if I
have £1.07 cash in the bank after one year, the real interest I have received is £1.07 - £1.04 = 3p. When
compared with the capital required to keep pace with inflation (£1.04), this shows a return of
0.03/1.04 = 2.9%.
The formula which relates real and money interest rates is as follows:
1+m
1+r =
1+i
or, according to the ACCA Formula Sheet, (1 + i) = (1 + r)(1 + h)
Where r is the real interest rate, m is the money interest rate and i is the rate of inflation.
Thus 1 + r = 1.07/1.04 in the above example, giving r = 0.029 or 2.9%.
Example AP
A project requires an outlay of £1.5m in year 0 and will repay cash flows in real terms (today’s prices) as
follows:
Year £’000
1 670
2 500
3 1,200
The company’s money cost of capital is 15½%. Appraise the project if inflation is estimated to remain at
5% per annum.
Suggested solution to AP
Method 1: Compute the real discount rate and discount the real cash flows
1 + r = 1+ m = 1.155 = 1.1
1+i 1.05
Thus r = 0.1 or 10%
‘Real’ cash flow 10% factor Present value
Year
1 (1,500) 1 (1,500)
2 670 1/1.1 609.1 2 500 1/1.12 413.2
3
3 1,200 1/1.1 901.6
NPV 423.9
Method 2: Compute the money cash flows, using the rate of inflation and discount at the money discount
rate.
‘Money’ cash flow 15.5% factor Present value
Year
1 (1,500) 1 (1,500)
2 670 x 1.05 = 703.5 1/1.155 609.1 2 500 x 1.05 2 = 551.25 1/1.1552 413.2
3 1,200 x 1.053 =1,389.15 1/1.1553 901.6
NPV 423.9
Please note that discount rates have been computed as opposed to looked up in tables, to ensure that
accuracy is obtained for the reconciliation.
TAXATION AND INVESTMENT APPRAISAL
Example AA plc
AA plc buys a fixed asset for £10,000 at the beginning of an accounting period (1 January 2001) to
undertake a two year project.
Net trading revenues at t1 and t2 are £5,000 per annum.
The company sells the fixed asset on the last day of the second year for £6,000.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required:
Calculate the net cashflows for the project.
Suggested solution to AA plc
t0 t1 t2 t3
£ £ £ £
Net trading revenue 5,000 5,000
Tax at 33% (1,650) (1,650)
Fixed asset (10,000)
Scrap proceeds 6,000
Tax savings on WDAs _____ ____ 825 495
Net cashflow (10,000) 5,000 10,175 (1,155)
WORKING
Tax savings on writing down allowances
Tax relief at Timing

33%
£ £
t0 Investment in fixed asset 10,000
t1 WDA @ 25% (2,500) 825 t2
7,500
t2 Proceeds (6,000)
Balancing allowance (1,500) 495 t3
Example BB plc
BB plc buys a fixed asset for £10,000 at the end of the previous accounting period (31 December
2000) to undertake a two year project.
Net trading revenues at t1 and t2 are £5,000 per annum.
The fixed asset has zero scrap value when it is disposed of at the end of year 2.
Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required:
Calculate the net cashflows for the project.

Suggested solution to BB plc
t0 t1 t2 t3
£ £ £ £
Net trading revenue 5,000 5,000
Tax at 33% (1,650) (1,650)
Fixed asset (10,000)
Tax savings on _____ 825 619 1,856
WDAs
Net cashflow (10,000) 5,825 3,969 206
WORKING
Tax savings on writing down allowances
Tax relief at 3% Timing
£ £
t0 Investment in fixed asset 10,000
t0 WDA @ 25% (2,500) 825 t1

7,500
t1 WDA @25% (1,875) 619 t2
5,625
t2 Proceeds ____
Balancing allowance (5,625) 1,856 t3
CAPITAL RATIONING
Where the finance available for capital expenditure is limited to an amount which prevents acceptance of
all new projects with a positive NPV, the company is said to experience “capital rationing”.
What are the 2 types of capital rationing?

They are:
1. Hard capital rationing

This applies when a company is restricted from undertaking all worthwhile investment opportunities due
to external factors over which it has no control. These factors may include government monetary
restrictions and the general economic and financial climate (eg, a depressed stock market, which
precludes a rights issue of ordinary shares).
2. Soft capital rationing

This applies when a company decides to limit the amount of capital expenditure which it is prepared to
authorise. Segments of divisionalised companies often have their capital budgets imposed by the main
board of directors. A company may purposely curtail its capital expenditure for a number of reasons eg,
it may consider that it has insufficient depth of management expertise to exploit all available
opportunities without jeopardising the success of both new and ongoing operations.
Capital rationing and time

Capital rationing may exist in a:
1. Single period
This is where available finance is only in short supply during the current period, but will become freely
available in subsequent periods.
Projects may be:
(i) Divisible – An entire project or any fraction of that project may be undertaken. In this event
projects may be ranked by means of a profitability index, which can be calculated by dividing the
present value (or NPV) of each project by the capital outlay required during the period of
restriction.
Projects displaying the highest profitability indices will be preferred. Use of the profitability index
assumes that project returns increase in direct proportion to the amount invested in each project.
(ii) Indivisible – An entire project must be undertaken, since it is impossible to accept part of a project
only. In this event the NPV of all available projects must be calculated. These projects must then
be combined on a trial and error basis in order to select that combination which provides the
highest total NPV within the constraints of the capital available. This approach will sometimes
result in some funds being unused.
2. Multi-period
This is where available finance is limited not only during the current period, but also during subsequent
periods.
Projects may be:
(i) Divisible - In this event, linear programming is used to determine the optimal combination of
projects. Two techniques, which both result in identical project selections can be used ie the
objective is to either:
● Maximise the total NPV from the investment in available projects, or
● Maximise the present value (PV) of cash flows available for dividends.
(ii) Indivisible - In this event, integer programming would be required to determine the optimal
combination of investments.
Single period capital rationing

Example of single period capital rationing – Banden Ltd
Banden Ltd is a highly geared company that wishes to expand its operations. Six possible capital
investments have been identified, but the company only has access to a total of £620,000. The projects
are not divisible and may not be postponed until a future period. After the projects end, it is unlikely
that similar investment opportunities will occur.
Expected net cash inflows (including salvage value)
Initial
Project Year 1 2 3 4 5 outlay
£ £ £ £ £ £
A 70,000 70,000 70,000 70,000 70,000 246,000
B 75,000 87,000 64,000 180,000
C 48,000 48,000 63,000 73,000 175,000
D 62,000 62,000 62,000 62,000 180,000
E 40,000 50,000 60,000 70,000 40,000 180,000
F 35,000 82,000 82,000 150,000
Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the company’s
existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9% per year. The money
market may be assumed to be an efficient market. Banden’s cost of capital is 12% per year.
Required:
(a) Calculate:
(i) The expected net present value;
(ii) The expected profitability index associated with each of the six projects.
Rank the projects according to both of these investment appraisal methods and explain briefly
why these rankings differ.
(b) Give reasoned advice to Banden Ltd recommending which projects should be selected.
Solution to single period capital rationing example – Banden Ltd
(a) (i) Calculation of expected Net Present value
Project NPV
A. £70,000 x 3.605 - £246,000 = £6,350
B. £75,000 x 0.893 + £87,000 x 0.797 + £64,000

x 0.712 - £180,000 = £1,882
C. £48,000 x 0.893 + £48,000 x 0.797 + £63,000 x 0.712 + £73,000 x 0.636 -

£175,000 = (£2,596)
D. £62,000 x 3.037 - £180,000 = £8,294
E. £40,000 x 0.893 + £50,000 x 0.797 + £60,000

x 0.712 + £70,000 x 0.636 + £40,000 x 0.567
- £180,000 = £5,490
F. £35,000 x 0.893 + £82,000 x 0.797 + £82,000

x 0.712 - £150,000 = £4,993
(ii) Calculation of Profitability Index
Present value of cash inflows ÷ initial outlay:
Project PI
A. £252,350/£246,000 = 1.026
B. £181,882/£180,000 = 1.010
C. £172,404/£175,000 = 0.985
D. £188,294/£180,000 = 1.046
E. £185,490/£180,000 = 1.031
F. £154,993/£150,000 = 1.033
Ranking NPV P.I
1 D D
2 A F
3 E E
4 F A
5 B B
6 C C
The rankings differ because NPV is an absolute measure of the benefit from a project, whilst
profitability index is a relative measure, and shows the benefit per £ of outlay. Where the initial
outlays vary in size the two methods may give different rankings.
(b) In a capital rationing situation, the projects should be selected which give the greatest total NPV
from the limited outlay available.
A. and E are mutually exclusive.
C is not considered as it has a negative NPV.
Total outlay is limited to £620,000.
Possible selections are:
Projects Expected NPV Total NPV Outlay in £’000
£ £
A, B, D (6,350 + 1,882 + 8,294) 16,526 (246 + 180 + 180) 606
A, B, F (6,350 + 1,882 + 4,993) 13,225 (246 + 180 + 150) 576
A, D, F (6,350 + 8,294 + 4,993) 19,637 (246 + 180 + 150) 576
B, D, E (1,882 + 8,294 + 5,490) 15,666 (180 + 180 + 180) 540
B, D, F (1,882 + 8,294 + 4,993) 15,169 (180 + 180 + 150) 510
B, E, F (1,882 + 5,490 + 4,993) 12,365 (180 + 180 + 150) 510
D, E, F (8,294 + 5,490 + 4,993) 18,777 (180 + 180 + 150) 510
The recommended selection is projects A, D and F
Tutorial note: Neither the NPV nor PI rankings will necessarily be appropriate because of the
sheer size of these indivisible investments. In this particular instance, because of the similarity in
size of the projects, only three can be undertaken, and the NPV ranking clearly leads to A, D and E.
Profitability index will not work if projects are indivisible or where multiple limiting factors exist.
The PI might lead to the incorrect solution of D, E and F.
Multi-period capital rationing
Please remember that you are only likely to be asked to set up the equations for both the linear
programming and integer programming formulations and then to interpret the output. The actual
solving of these equations are computer-based calculations.
Example of multi-period capital rationing using linear programming – Barney Ltd

The management team of Barney Ltd has identified the following independent investment projects, all of
which are divisible.
No project can be delayed or performed on more than one occasion. The projected cash flows during the
life of each project are as follows:
Year 0 Year 1 Year 2 Year 3 Year 4
£’000 £’000 £’000 £’000 £’000
Project A (25) (50) 25 50 50 Project B (25) (25) 75 - - Project C (12.5) 5 5 5 5 Project D -

(37.5) (37.5) 50 50 Project E (50) 25 (50) 50 50
Project F (20) (10) 37.5 25 -
The capital available at Year 0 is only £50,000 and only £12,500 is available at Year 1, together with any
cash inflows from the projects undertaken at Year 0. From Year 2 onwards there is no restriction on the
access to capital. The appropriate cost of capital is 10%.
Required:
Formulate both:
1. The NPV linear programme, and
2. The PV of dividends linear programme.

Suggested solution to Barney Ltd
NPV formulation
Since the objective is to maximise the total NPV from these projects, it is initially necessary to calculate the
NPV of each project at a discount rate of 10%:
Year 0 Year 1 Year 2 Year 3 Year 4 Total NPV
Discount factor (10%)

1.000 0.909 0.826 0.751 0.683
£’000 £’000 £’000 £’000 £’000 £’000
Project A (25) (45.45) 20.65 37.55 34.15 +21.90
Project B (25) (22.73) 61.95 - - +14.22
Project C (12.5) 4.55 4.13 3.75 3.42 +3.35
Project D - (34.09) (30.97) 37.55 34.15 +6.64
Project E (50) 22.73 (41.30) 37.55 34.15 +3.13
Project F (20) (9.09) 30.98 18.77 - +20.66
The combination of projects, which will maximise the total NPV can now be specified, where:
a = the proportion of Project A to be undertaken b =

the proportion of Project B to be undertaken c = the
proportion of Project C to be undertaken d = the proportion
of Project D to be undertaken e = the proportion of
Project E to be undertaken
f = the proportion of Project F to be undertaken
The objective function, which represents the maximum NPV that can be earned, is:
z = 21.90a + 14.22b + 3.35c + 6.64d + 3.13e + 20.66f
This is subject to the following constraints:
≤
Year 0 : 25a + 25b + 12.5c + 50e + 20f 50
Year 1 : 50a + 25b + 37.5d + 10f ≤ 12.5 + 5c + 25e
Furthermore : 0 ≤ a, b, c, d, e, f ≤ 1
When solved, the linear programme will provide the proportions of each project which should be
undertaken in order to establish the value of z, which represents the maximum NPV achievable in view of
the limitation of available capital.
Notice that the first constraint relates to the limited capital available at Year 0. The second constraint
concerns the capital limitation at Year 1, which is of course eased by the Project C and E cash inflows,
which can also be used to fund investment needs at that time.
The third constraint shows that each project can only be undertaken once and that it is impossible to
undertake a negative quantity of any project. This non-negative rule is essential, since if it were excluded
a computer model may well establish that negative quantities of a project could make cash inflows
available that would be included within the solution!!
PV of dividends formulation
The combination of projects, which will maximise the PV of cash flows available for dividends must be
specified, where:
a= the proportion of Project A to be undertaken b =

the proportion of Project B to be undertaken c = the
proportion of Project C to be undertaken d = the proportion of
Project D to be undertaken e = the proportion of Project E to
be undertaken f = the proportion of Project F to be undertaken The
objective function will be based upon the premise that:
z= the PV of dividends.
The dividend flows need to be defined for each year up to the point where the investment with the longest
life ceases – in this case up to the end of Year 4 ie
d0 = the dividend flow generated at Year 0 by the projects selected

Therefore the objective function, which represents the present value of the maximum dividends,
d d
discounted at the cost of capital of 10% is:
d4
z = d0 + d1 + 2
+ 3
+
1.1 1.12 1.13 1.14
alternatively z = d0 + 0.909 d1 + 0.826 d2 + 0.751 d3 + 0.683 d4 This is subject to the

following constraints:
Year 0 : 25a + 25b + 12.5c + 50e + 20f + d0 ≤ 50

Year 1 : 50a + 25b + 37.5d + 10f + d1 ≤ 12.5 + 5c + 25e
Year 2 : 37.5d + 50e + d2 ≤ 25a + 75b + 5c + 37.5f
Year 3 : d3 ≤ 50a + 5c + 50d + 50e + 25f
Year 4 : d4 ≤ 50a + 5c + 50d + 50e
Furthermore : 0 ≤ a, b, c, d, e, f ≤ 1
Additionally : d0, d1, d2, d3, d4 ≥ 0
When solved, the linear programme will provide the proportions of each project which should be
undertaken in order to establish the value of z, which represents the maximum PV of dividends earned in
view of the capital constraints.
With an NPV formulation, we only have constraints for the periods during which capital rationing exists
(in this instance, Years 0 and 1), whereas under the dividend formulation we have a constraint for every
year of potential project cash flows (in this case, Years 0 to 4).
The available funds are the same as in the NPV formulation (ie available capital together with cash
inflows from the projects); however the dividend flow for each period must also be included.
Furthermore an additional non-negative constraint is used, since the dividends must be greater than or
equal to zero. If this constraint were excluded, a computer model may specify negative dividend
payments, which make cash inflows available that could be used to finance more projects!!
One advantage of the PV of dividends formulation is that it removes the need to even calculate the NPV of
each investment opportunity, since the discounting process is carried out by the linear programme as part
of the calculation of the solution.
Notice the only difference in the value of z in these formulations is as follows:
● Under the NPV formulation, z provides the NPV of the project returns, whereas
● Under the PV of dividends formulation, z provides the PV of the project returns.
Dual values
Dual values (also referred to as “shadow prices”) reflect the change in the objective function as a result of
having one more or one less unit of scarce resource. In the context of capital rationing the scarce
resource is available cash, so that the dual price states the change in the objective function if one more
unit of currency (eg £1) becomes available or if one less GB pound is invested.
Shadow prices can therefore be used to calculate the impact of raising additional finance for further
investment or the effect of diverting capital away from current projects into newly discovered
investments.
The dual price depends upon which method is used to formulate the linear programme ie
● Under the NPV formulation, it reflects the change in the NPV if £1 more or £1 less is available
● Under the PV of dividends formulation, it reflects the change in the PV of cash available for dividend
payments if £1 more or £1 less capital is available.
Dual prices relate only to marginal changes in the availability of capital. Thus, suppose that a dual value
of £1.25 arises under the PV of dividends method, this means that if an additional £1 of funds became
available, the total value of the objective function would rise by £1.25. It does not necessarily mean that
if an additional £10,000 became available, that the value of the objective function would increase by
(£10,000 x 1.25) £12,500.
Shadow prices can therefore be used to test the validity of new investments which emerge. The cash
flows generated by the new project can be compared with the cash flows lost by diverting funds from
existing investments, thereby calculating the effect of diversion of that finance.
Example of the use of dual values in linear programming Bruno Ltd
Bruno Ltd is experiencing capital rationing during both Year 0 and Year 1 in relation to a number of
CHAPTER 2 – ADVANCED
divisible projects. INVESTMENT
It has used APPRAISAL: SECTION 1 to develop an investment strategy over its three year
linear programming
planning horizon for dividend payments, using a cost of capital of 10%.
Shadow prices have been calculated under the NPV formulation for the two years of capital constraints
and under the PV of dividends formulation for the three year planning horizon. The dual prices per £1 of
capital available are as follows:
NPV method PV of dividends method
£ £
Year 0 0.1 (1 + 0.1) = 1.1
Year 1 0.08 (0.909 + 0.08) = 0.989
Year 2 0 (0.826 + 0) = 0.826
A new investment opportunity has emerged with the following cash flows:
Cash flow
£’000
Year 0 (75)
Year 1 50
Year 2 50
Required:
Appraise the new project using both the NPV dual prices and the PV of dividend shadow prices.
Solution to Bruno Ltd
Appraisal using NPV dual values
The NPV of the new investment project is:
Discount
Year Cash flow Present value
factor
£000 @ 10% £000
1 (75) 1 (75)
2 50 0.909 45.45
3 50 0.826 41.3
NPV 11.75
The net dual value of the new investment project (ie the impact of diverting funds from the current
investment strategy) is:
Year Cash flow Shadow price Opportunity cost

£000 £000
0 (75) 0.1 (7.5)
1 50 0.08 4
2 50 0 -_
Net dual value (3.5)
Accordingly, the NPV of the current investment strategy would fall by £3,500 if the new project were
accepted. However, Bruno Ltd would benefit from the positive NPV of that new investment opportunity.
Therefore:
£’000
NPV of new project 11.75

Net dual value (3.5)
Net benefit of undertaking new project 8.25
This indicates that this project is worth further consideration, since if it were accepted in full (and in
doing so does not violate the marginality assumption of dual values) it would result in the value of the
objective function increasing by £8,250.
Appraisal using PV of dividends dual values
The net dual value of the new investment project (ie the impact of diverting funds from the current
investment strategy) is:
Year Cash flow Shadow price Opportunity cost
£000 £000
1 (75) 1.1 (82.5)
2 50 0.989 49.45
3 50 0.826 41.3
Net dual value (ie net benefit of undertaking new
8.25 project)
The two techniques will always provide the same result, but as can be seen the PV of dividends dual prices
technique is far quicker and simpler to solve.
Again, the project is worth considering; the linear programme should therefore be reformulated (by
including the new project) and then re-solved.
Example of multi-period capital rationing using integer programming Toby Ltd

The management team of Toby Ltd has identified four indivisible projects, which require funds to be
invested over the next few years, as set out below:
Project A Project B Project C Project D
£ £ £ £
Year 0 17,500 22,500 - 12,500
Year 1 25,000 - 15,000 15,000
Year 2 10,000 30,000 20,000 17,500
The board of directors of that company has approved the following capital expenditure programme for
those same accounting periods:
£
Year 0 40,000
Year 1 35,000
Year 2 42,500
The four projects are expected to produce the following positive net present values:
Project A Project B Project C Project D
Project NPV +£20,000 +£27,500 +£15,000 +£10,000
Required:
Discuss the approach for calculating the optimum mix of projects.
Solution to Toby Ltd
The problem is to identify that combination of investment projects which will produce the highest possible
total NPV (within the annual funding limitations).
For instance, if Projects C and D were undertaken, they would satisfy the annual capital constraints,
because the combined investment for Year 0 is £12,500, for Year 1 is £30,000 and for Year 2 is £37,500,
whilst achieving a total positive NPV of £25,000.
On the other hand, if Projects A and B were selected, they would also remain within the annual capital
limitations. The combined investment for Year 0 is £40,000, for Year 1 is £25,000 and for Year 2 is
£40,000, whilst achieving a total positive NPV of £47,500. This amount exceeds the NPV earned by the
combination of Projects C and D.
This problem can be solved by an integer programming formulation. The procedures would be to
establish the value of variables Y A, YB, YC and YD for each of the four projects, which maximise the total net
present value ie Maximise: 20,000 YA + 27,500 YB + 15,000 YC + 10,000 YD
Subject to three annual capital investment constraints:
Year 0 : 17,500 Y A + 22,500 YB + 0 Y C + 12,500 YD ≤ 40,000 Year 1 : 25,000 Y A + 0

YB + 15,000 YC + 15,000 YD ≤ 35,000
≤
Year 2 : 10,000 YA + 30,000 YB + 20,000 YC + 17,500 YD 42,500
The solution to the above problem would result in Y A = 1, YB = 1, YC = 0, YD = 0. In other words, both Project
A and Project B would be selected, whilst the other two projects would be rejected and the positive NPV
of the entire investment strategy would be £47,500.
Notice that the above solution is superior to the combination of Y A = 0, YB = 0, YC = 1, YD = 1, since the
combined positive NPV of Project C and Project D is only £25,000, as already stated.
Chapter 3
Advanced investment
appraisal – section
2
CHAPTER CONTENTS
MODIFIED INTERNAL RATE OF RETURN ------------------------------ 53

CALCULATING THE MIRR 53
FREE CASH FLOW -------------------------------------------------------- 56

DEFINITION OF FREE CASH FLOW 56
FREE CASH FLOW TO EQUITY 57
RISK AND UNCERTAINTY ----------------------------------------------- 61

SENSITIVITY ANALYSIS 61
PROBABILITY AND EXPECTED VALUES 62
MONTE CARLO SIMULATION 62
PROJECT VALUE AT RISK 63
DURATION ---------------------------------------------------------------- 64
THE MACAULAY DURATION METHOD ---------------------------------- 66
MODIFIED INTERNAL RATE OF RETURN

To assist in remedying some of the deficiencies of IRR, a technique called Modified Internal Rate of
Return (MIRR) has been developed. MIRR has certain advantages in that it:
● Eliminates the possibility of multiple internal rates of return.
● Addresses the reinvestment rate issue ie it does not make the assumption that the company’s
reinvestment rate is equal to whatever the project IRR happens to be.
● Provides rankings which are consistent with the NPV rule (which is not always the case with IRR).
● Provides a % rate of return for project evaluation. It is claimed that nonfinancial managers prefer
a % result to a monetary NPV amount, since a % helps measure the “headroom” when
negotiating with suppliers of funds.
Calculating the MIRR

The MIRR assumes a single outflow at time 0 and a single inflow at the end of the final year of the
project. The procedures are as follows:
● Convert all investment phase outlays as a single equivalent payment at time 0. Where necessary,
any investment phase outlays arising after time 0 must be discounted back to time 0 using the
company’s cost of capital.
● All net cash flows generated by the project after the initial investment (ie the return phase cash
flows) are converted to a single net equivalent terminal receipt at the end of the project’s life,
assuming a reinvestment rate equal to the company’s cost of capital.
● The MIRR can then be calculated employing one of a number of methods, as illustrated in the
following example.
Example Carter plc

Carter plc is considering an investment in a project, which requires an immediate payment of £15,000,
followed by a further investment of £5,400 at the end of the first year. The subsequent return phase net
cash inflows are expected to arise at the end of the following years:
Net cash inflows
Year £
1 6,500
2 7,750
3 5,750
4 4,750
5 3,750
Required:
Calculate the modified internal rate of return of this project assuming a reinvestment rate equal to the
company’s cost of capital of 8%.
Solution to Carter plc
Single equivalent payment discounted to year 0 at an 8% discount rate:
Year £
1 15,000
2 (£5,400 x 0.926) _5,000
Present Value (PV) of investment phase cash flows 20,000
Single net equivalent receipt at the end of year 5, using an 8% compound rate:
Year £ 8% compound factors £

1 6,500 1.3605 8,843
2 7,750 1.2597 9,763
3 5,750 1.1664 6,707 4 4,750 1.08 5,130 5 3,750 1 3,750
Terminal Value (TV) of return phase cash flows £34,193
The above compound factors are produced with a calculator.
A five year PV factor can now be established ie (£20,000 ÷ £34,193) = 0.585
Using present value tables, this 5 year factor falls between the factors for 11% and 12% ie 0.593 and
0.567. Using linear interpolation:
MIRR = 11% + x (12% - 11%) = 11.3%
Alternatively, the MIRR may be calculated as follows;
£34,193
MIRR = − 1 = 11.3%
5 20,000
Furthermore, in examples where the PV of return phase net cash flows has already been calculated,
there is yet another formula for computing MIRR (which is given on the ACCA formulae sheet). This
formula avoids having to establish the Terminal Value of those return phase net cash flows ie
PV of return phase net cash flows

(6,500 x 0.926) + (7,750 x 0.857) + (5,750 x 0.794) + (4,750 x 0.735) + (3,750 x
0.681) = £23,271
 £ 23 ,271 
MIRR =   5 20 ,000 × 1.08  - 1 = 11.3%

The reservations which are often cited concerning the MIRR technique include:
● In what are claimed to be the very exceptional circumstances where the reinvestment rate
exceeds the company’s cost of capital, the MIRR will underestimate the project’s true rate of
return.
● The determination of the life of a project can have a significant effect on the actual MIRR, if the
difference between the project’s IRR and the company’s cost of capital is large.
● Like IRR, the MIRR is biased towards projects with short payback periods and large initial cash
inflows.
● The extent to which this method is being used in industry is unclear and only time will tell
whether it eventually becomes popular.
FREE CASH FLOW
Definition of free cash flow

Free cash flow is cash that is not retained and reinvested in the business. Unfortunately, there is dispute
as to what is included within free cash flow, as can be seen from the following typical definitions:
1. The free cash flow to the company is the cash flow derived from operations, after adjustment for
working capital changes, for investment and for taxes and it represents the funds available for
distribution to the providers of capital, ie shareholders and lenders.
2. Free cash flow is the cash flow available to a company from operations after tax, any changes in
working capital and capital spending on assets needed to continue existing operations (ie
replacement capital expenditure equivalent to economic depreciation).
As can be seen, the main difference between the two definitions is whether or not to deduct capital
expenditure required to expand operations. Throughout these notes the treatment will be varied as a
reminder of the inconsistency. In addition, some authorities suggest that no adjustment is made for
working capital changes in respect of short-term measures of free cash flow.
Example Hawthorns plc

Hawthorns plc has earnings before interest and tax of £225,000 for the current year. Depreciation
charges for the year have been £15,000 and working capital has increased by £2,500. The company
needs to invest £22,500 to acquire noncurrent assets. Profits are subject to taxation @ 30% p.a.
Required:
Calculate free cash flow.
Suggested solution to Hawthorns plc
£
EBIT 225,000
Less: Corporation tax @ 30% (67,500)
Add back: Depreciation (non-cash amount) 15,000

Deduct: Capital expenditure (22,500)
Working capital increases (2,500)
Free cash flow £147,500
Free cash flow to equity
The dividend capacity of a company is measured by its free cash flow to equity. Free cash flow to equity
can be calculated by establishing the free cash flow described above, and then:
● Deducting any interest payments and any loan repayments; and
● Adding any cash inflows arising from the issue of debt.
Free cash flow to equity is thought by some authorities to provide a superior measure of dividend cover
ie
Dividend cover (in terms of free cash flow) =
Dividends paid
Example Molineux Ltd

The following data relates to Molineux Ltd:
Forecast Income statement for 2010
£m
Revenue 1,950.00
Cost of sales (1,314.00)
Gross profit 636.00
Operating expenses (322.50)
Earnings before interest and tax 313.50
Interest charges (24.00)
Profit before tax 289.50
Corporation tax(@ 35%) (101.32) Profit after tax 188.18
During the year loan repayments are expected to amount to £69 million, depreciation charges to £30
million and capital expenditure to £60 million.
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity.

Suggested solution to Molineux Ltd
(a) Free cash flow
£m
EBIT 313.5
0
Less: Corporation tax (@ 35% thereon) (109.72)
Add back: Depreciation (non-cash amount) 30.00

Deduct: Capital expenditure (60.00)
Free cash flow 173.78
(b) Free cash flow to equity
Method One
£m
Free cash flow (as above) 173.78
Deduct: Loan repayments (69.00)
Interest charges, net of tax [£24m x (1 – 0.35)] (15.60)
Free cash flow to equity 89.18
Method Two
£m
Profit after tax 188.18
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Loan repayments (69.00)
Free cash flow to equity 89.18
Example Bescot plc

The following information relates to the forecasts of Bescot plc for the forthcoming year:
£000
Capital expenditure for expansion 100
Capital expenditure to replace existing non-current assets 240
Depreciation charges 300
Amounts raised from fresh bond issue 120
Increase in working capital 220
Interest paid 40
Repayment of loans 60
Profit from operations 1,880 Corporation tax paid (@ 30%) 552
Ordinary share capital (@ 25p par value) 1,840
Dividend paid for the year is expected to be 5p per share
Required:
Calculate:
(a) Free cash flow;
(b) Free cash flow to equity;
(c) Dividend cover based upon free cash flow to equity.

Suggested solution to Bescot plc
(a) Free cash flow
£000
Profit from operations (EBIT) 1,880
Deduct: Corporation tax (@ 30% thereon) (564)
1,316
Add back: Depreciation (non-cash amount) 300
Deduct: Capital expenditure to replace existing non-current assets (240) Capital expenditure for
expansion (ARGUABLY, THIS SHOULD NOT (100)
BE DEDUCTED IN ARRIVING AT FREE CASH FLOW)
Increase in working capital (220)
Free cash flow 1,056
(b) Free cash flow to equity
Method One
£000
Free cash flow (as above) 1,056
Deduct: Loan repayments (60)
Interest charges, net of tax [£40,000 x (1 – 0.3)] (28)
Add: Proceeds of bond issue 120
Free cash flow to equity 1,088
Method Two
£000
EBIT 1,880
Interest charges (40) Corporation tax (552)
Profit after tax (ie Earnings after interest and tax) 1,288
Add back: Depreciation (non-cash amount) 300
Deduct: Increase in working capital (220) Capital expenditure [£240,000 + £100,000] (340)
Loan repayments (60)
Add: Amounts raised from bond issue 120
Free cash flow to equity 1,088
(c) Dividend cover
Earnings after interest and tax The normal

dividend cover calculation is:
Dividends for the year
£1,288,000
ie, = = 3.5 times
£368,000
WORKING:
Dividends for the year:
£1,840,000
Number of shares in issue = = 7,360,000
£0.25
Dividends for the year = 7,360,000 x £0.05 = £368,000
The above result is thought by some authorities to be misleading, since it is cash (and not
earnings) that is used to pay dividends. Therefore, dividend cover based upon free cash flow
to equity may be used, as follows:

Dividend cover (in terms of free cash flow) =
Dividends paid
£1,088,000
ie = = 2.96 times
£368,000
This would be considered a satisfactory level of assurance for ordinary shareholders.
RISK AND UNCERTAINTY

Risk occurs where there are several possible outcomes for each component of a decision and
probabilities can be assigned for each possible outcome. This allows for the calculation of an
expected value based upon the probability of each outcome.
Uncertainty occurs where there are several possible outcomes, but the probability attaching to each
cannot be established.
Sensitivity analysis
A technique which assesses the effect on an overall decision if a single constituent variable were to
change ie how sensitive is the investment decision to a change in a single aspect (eg sales revenue,
material price, project life, etc). This allows for the consideration of a range of possible outcomes.
Sadly the technique does not take into account the interdependence of the variables ie the technique
ignores the interaction of the constituent variables.
Procedure
Firstly, calculate the expected NPV, using the best estimates available.
Then, calculate for each input factor (eg initial investment, sales price, wage rate, discount rate,
residual value, etc) the necessary percentage change which would cause the NPV to become zero.
To find the percentage change required to achieve an NPV of zero, the calculation is as follows:
NPV of project
% change = ×100
PV of cash flows affected by the variable
Illustration
An expected NPV has already been calculated for the following project of CC plc:
Year Cash flow 10% discount factor Present value

£000 £000
0 Initial investment (100) 1 (100.00)
1-3 Revenues 40 2.487 99.48
3 Scrap value 10 0.751 7.51
NPV +6.99
From these results, the sensitivity to each variable, which would create an NPV of 0 is:
Initial investment: x 100 = an increase of 7%
Annual revenues: x 100 = a decrease of 7%
Scrap value: x 100 = a decrease of 93%
Discount factor: (this requires the calculation of the IRR, since this would cause the NPV to be 0. The IRR
is, of course, established by trial and error), ie:
Year Cash flow Try 13% Try 14%

£000 DF £000 DF £000
0 (100) 1 (100) 1 (100)
1-3 40 2.361 94.44 2.322 92.88 3 10 0.693 6.93 0.675 6.75
NPV +1.37 -0.37
IRR = 13% + × (14% −13%) =

13.79% 1.
Cost of capital will have to increase by 37.9% (ie from 10% to 13.79%) for an NPV of 0 to arise.
Project life: Clearly if the project life were for a shorter period than 3 years an NPV of 0 would at
some point arise. Accurate calculations are in this case not possible, since at a life of less than 3
years, the scrap value would be greater, but the precise amount is unknown.
Probability and expected values

A probability distribution of expected cash flows could be estimated and used to calculate the
expected value of the NPV and measure risk (normally the standard deviation of that NPV). This
aspect will be demonstrated during the lectures dealing with Project Value at Risk (VAR) and the
Capital Asset Pricing Model (CAPM).
This expected value is unlikely to be the same amount as one of the specific outcomes, since it is
based upon a weighted average calculation. Whilst the expected value is simple to calculate and easy
to understand, it does suffer from the following limitations:
● Probabilities usually have to be estimated and therefore may be inaccurate or unreliable;
● Expected values are long-term averages, which assume repetition of the task and may clearly be
inappropriate for one-off projects;
● Does not take into account the decision makers attitude to risk – think of a banker!;
● May not take into account the time value of money.
Monte Carlo simulation

Sensitivity analysis assesses the effect on an overall decision if a single constituent variable were to
change. Monte Carlo simulation is a mathematical model which will include all combinations of the
potential variables associated with the project. It results in the creation of a distribution curve of all
possible cash flows which could arise from the investment and allows for the probability of the
different outcomes to be calculated. The steps involved are as follows:
1. Specify all major variables
2. Specify the relationship between those variables
3. Using a probability distribution, simulate each environment.

The advantage of this technique is it includes all foreseeable outcomes. The disadvantages are the
difficulty in formulating the probability distribution and the model becoming very complex.
Project value at risk

Value at risk (VaR) is the value which can be attached to the downside of a value or price distribution
of known standard deviation and within a given confidence level. VaR and related measures give an
indication of the potential loss in monetary value which is likely to occur with a given level of
confidence. The setting of the confidence level is necessary because in principle, if a price distribution
is normally distributed for example, the downside loss is potentially infinite.
Confidence levels are often set at either 95% (in which case the VaR will provide the amount that has
only a 5% chance of decline) or at 99% (when the VaR considers a 1% chance of loss of value).
Example Andrews plc

Andrews plc estimates the expected NPV of a project to be £100 million, with a standard deviation of
£9.7 million.
Required:
Establish the value at risk using both a 95% and also a 99% confidence level.
Solution to Andrews plc
X - µ Using Z = and establishing Z from the normal distribution tables ie at a σ
95% confidence level, 1.65 is the value for a one tailed 5% probability of decline (ie
0.4505) and at a 99% confidence level, 2.33 is the value for a one tailed 1%
probability of loss of NPV (ie 0.4901).
X - 100
At 95% confidence level, Z = = –1.65;
9.7
therefore X = (9.7 x – 1.65) + 100 = 84
X - 100
At 99% confidence level, Z = = –2.33;
9.7
therefore X = (9.7 x – 2.33) + 100 = 77.4
There is a 5% chance of the expected NPV falling to £84 million or less and a 1% probability of it falling to
£77.4 million or below.
DURATION
Duration is the average time taken to recover the cash flows on an investment. The average is taken
as the value weighted average of the number of the year (1 to n) in which the cash flows arise. In
capital investment, the duration can be calculated using either the firm’s original outlay, or the
present value of its future cash flows as the basis for the annual weighting.
If duration is based upon the average time to recover the initial capital investment:
1. Calculate the value of each future net cash flow, discounted at the IRR of the project;
2. Calculate each year’s discounted cash flow as a proportion of the original capital outlay;
3. Take the time from investment to each discounted cash flow and multiply by the respective
proportion. Finally, sum the weighted year values.
If duration is based upon the average time taken to recover the present value of the project:
1. Calculate the value of each future net cash flow, discounted at the chosen hurdle rate;
2. Calculate each year’s discounted cash flow as a proportion of the PV of total cash inflows;
Example FCF plc

The forecast cash flows relating to a proposed project are:
Year 0 1 2 3 4
Incremental cash (£34,000) £7,600 £16,500 £13,000 £6,600
flows
Required:
Establish both the duration to recover the original investment (using the IRR of this project of 11.13%)
and the duration to recover the present value of the project (at an 8% hurdle rate).
Solution to FCF plc
Duration taken to recover the original investment
Year 1 2 3 4
1. Discount cash inflows @ 11.13% £6,839 £13,361 £9,473 £4,327
2. Proportion of initial outlay (£34,000) 0.201 0.393 0.279 0.127
3. Proportion multiplied by year number 0.201 0.786 0.837 0.508
Finally, sum these to provide the duration ie on average the company will take 2.332 years to recover
the initial investment ie an indication of project uncertainty (see below).
Duration taken to recover the present value of the project
Year 1 2 3 4
1. Discount cash inflows @ 8% £7,037 £14,146 £10,320 £4,851
2. Proportion of project PV (£36,354) 0.194 0.389 0.284 0.133
3. Proportion multiplied by year number 0.194 0.778 0.852 0.532
Finally, sum these to provide the duration ie on average the company will take 2.356 years to recover
half the present value of the project ie a different indication of project uncertainty. The longer the
duration, the greater the uncertainty attaching to future returns!!
THE MACAULAY DURATION METHOD

In 1938, Frederick R. Macaulay defined “Duration” as the total weighted average time for recovery of
the payments and principal in relation to the current market price of a bond.
The maturity of a bond is not a particularly good indication of the timing of the cash flows associated
with that bond, since a significant proportion of those cash flows will occur prior to maturity –
normally in the form of interest payments.
One could calculate an average of the timings of each cash flow, weighted by the size of those cash
flows. Duration is very similar to such an average, but instead of taking each cash flow as a weighting,
duration uses the present value of each cash flow.
Steps required to calculate bond duration

1. Establish the cash flows arising at each future time period;
2. Calculate the present value of these future cash flows, discounted at the IRR (ie the gross yield to
maturity) of the security. Incidentally, the sum of these figures must be the current price of the
bond;
3. Calculate each year’s discounted cash flow as a proportion of the current value of the bond;
Example Seven Years

Seven years prior to the maturity of a bond with a 10% coupon, it is trading at a price of £95.01 per
cent and has a gross yield to maturity of 11.063%. Using the Macaulay duration method, you are
required to calculate the bond duration.
Solution to Seven Years
Yr 1 2 3 4 5 6 7
1 Annual cash
10.00 10.00 10.00 10.00 10.00 10.00 110.00
flows (£)
2 Discounted
@11.063% 9.00 8.11 7.30 6.57 5.92 5.33 52.78
(£)
3 Proportion of
0.095 0.085 0.077 0.069 0.062 0.056 0.556
price (£95.01)
4 Proportion multiplied by 0.095 0.170 0.231 0.276 0.310 0.336 3.892 year number.
Finally, find the totals of row 4, since these provide the bond duration of 5.31 years, ie the weighted
average time to full recovery of an investment in this bond.
Remember that if the monetary amounts in row 2 (above) are cross-cast, the result must obviously be
the current price of the bond, since the gross yield to maturity is the internal rate of return of all cash
flows associated with the bond.
Furthermore, the above calculation is almost identical to the approach used for calculating the
duration taken to recover an original investment in project appraisal (as described earlier on page
64).
Significance of the calculation of duration
Duration is an important measure for fixed-income investors and their advisers, since bonds with
higher durations may have greater price volatility than similar bonds with lower durations. In
general:
● Changes in the value of a bond are inversely related to changes in the rate of return ie the
lower the yield to maturity, the higher the value of the bond;
● Long-term bonds have higher interest rate risk than shorter term bonds, due to the greater
probability (over the longer time period) of market interest rate increases; and
● High coupon bonds have less interest rate sensitivity than low coupon bonds, since the greater
the amounts of the cash flows received in the short-term, the earlier the purchase price of the
bond will be recouped.
The Macaulay duration method measures the number of years required to recover the cost of the
bond (taking account of the present value of all interest and capital cash flows within the future time
period). The result is expressed in years.
A measure referred to as Modified Duration (or Volatility) expands on the basic method, but the
ACCA P4 Syllabus only requires a knowledge of the “simple” Macaulay duration method, as a means
of assessing exposure to interest rate changes.
The basic lessons of “duration” are:
● As maturity increases, the measure of duration will also increase and the market value of the
bond will become more sensitive to changes in the level of interest rates;
● As the coupon rate of a bond increases, duration will decrease and the value of the bond will be
less sensitive to changes in the level of interest rates; and
● As interest rates rise, duration will decrease and the value of the bond will be less sensitive to
subsequent rate changes.
Example Macaulay Duration Method

In each of the following cases, you are required to use the Macaulay duration method to calculate the
duration for each of the following securities:
(a) A bond with a five year maturity has a current value of £92.41 per cent, a coupon rate of 8% and a
market yield of 10%.
(b) On the 1 February 2011, a 5.5% Treasury Bond (which is redeemable on 1 February 2015), has a
market value of £110.28 per cent and a yield to maturity of 2.75%.
(c) A 6% bond has three years to redemption. It has a current market price of £89.85 per cent.
Interest is paid half-yearly and its market yield is 10% per annum (ie 5% every six months).
Solution to Macaulay Duration Method
(a)
Year 1 2 3 4 5
1 Annual cash flows (£) 8.00 8.00 8.00 8.00 108.00
2 Discounted @ 10% (£) 7.27 6.61 6.01 5.46 67.06
3 Proportion of bond value
0.079 0.072 0.065 0.059 0.726
(£92.41)
4 Proportion multiplied by year
0.079 0.144 0.195 0.236 3.630
number
Finally, establish the totals of row 4, since these provide the bond duration of 4.284 years, ie the
weighted average time to full recovery of an investment in this bond.
(b)
Year 1 2 3 4
1 Annual cash flows (£) 5.50 5.50 5.50 105.50
2 Discounted @ 2.75% (£) 5.35 5.21 5.07 94.65
Proportion of bond value (£110.28)
3 0.049 0.047 0.046 0.858
4 Proportion multiplied by year 0.049 0.094 0.138 3.432

number
(c)
Period ½ 1 1½ 2 2½ 3
1 Half-yearly cash flows (£) 3 3 3 3 3 103
2 Discounted @ 5% per
2.86 2.72 2.59 2.47 2.35 76.86
half year (£)
3 Proportion of bond value
0.032 0.030 0.029 0.028 0.026 0.855
(£89.85)
4 Proportion multiplied by
0.016 0.030 0.044 0.056 0.065 2.565
period number
General observations
Note that Macaulay duration will always be lower than the term to maturity (assuming that the
coupon rate exceeds zero - you may think that this is a stupid comment, but the world of finance is
going through some amazing times!!).
Nowadays, the value of Macaulay duration is less evident, due to wide availability of computer
programs with Monte Carlo simulation. Obviously, bonds are subject to risk, but duration is not
intended to reflect risk; it measures interest rate sensitivity.
Chapter 4
Cost of capital
CHAPTER 4 – COST OF CAPITAL
CHAPTER CONTENTS
PURPOSE OF COST OF CAPITAL ---------------------------------------- 71
CALCULATING THE COMPONENT COSTS OF CAPITAL ---------------- 72
1. COST OF EQUITY SHARE CAPITAL 72
2. COST OF PREFERENCE SHARE CAPITAL 74
3. COST OF DEBT 74
CALCULATING THE WEIGHTED AVERAGE COST OF CAPITAL -------- 77
MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE DISCOUNT

RATE ---------------------------------------------------------------------- 80
SOURCES OF FINANCE -------------------------------------------------- 81

SOURCES OF SHORT-TERM FINANCE 81
SOURCES OF LONG-TERM FINANCE 82
SMALL AND MEDIUM-SIZED ENTITIES (SMES) ----------------------- 83

PROBLEMS FACED BY SMALL BUSINESSES IN RAISING EXTERNAL FINANCE 83
WAYS OF RESOLVING PROBLEMS FACED BY SMALL BUSINESSES IN RAISING FINANCE 84
PURPOSE OF COST OF CAPITAL

As a “discount rate” for NPV or “cut-off rate” for IRR.
(N.B. Cost of Capital is sometimes denoted by the letter “r”, whilst in other texts it is denoted by the
letter “k”. The note which follows uses the latter notation).
CALCULATING THE COMPONENT COSTS OF CAPITAL
1. Cost of equity share capital

(a) Retained earnings (an opportunity cost)
D
Ke =
P0 (ex - div)
Example Naylor plc

Naylor plc is expected to pay a constant annual net dividend of 30p per ordinary share. The current
market price per share is £2.30 (cum-div). The dividend is about to be paid.
What is Ke?
Solution to Naylor plc
30p
Ke = = 15%
230p − 30p
(b) Fresh issue of equity

Two views:
D
(i) Ke =
P0 − f
Example Goodman plc

Goodman plc wishes to finance a new project by the issue 40,000 ordinary shares of £2.50 each, out of
which share issue (flotation) costs of 8% of issue price have to be paid. New shareholders expect
constant annual dividends of 32.2p per share.
What is Ke?
Solution to Goodman plc
32.2p
Ke = = 14%
92% x £2.50
(ii) Carsberg recommends that share issue costs are treated as a year 0 cash outflow of the project
for which the share capital is raised. Thus share issue costs do not affect Ke. In Example 2, Ke
would be calculated as follows:
32.2p
Ke = = 12.9%
£2.50
(c) Growth
The Dividend Growth model is:
Ke = D 0 (1+ g) + g
P0
D 1+ g
=
P0
Example CCDP plc

The following relates to CCDP plc.
Current cum-div price £2.20

Impending dividend 20p
Expected growth p.a. 10%
Calculate Ke
Solution to CCDP plc
22p
Ke = +10% = 21%
£2
Two methods of estimating future growth
(i) Historical growth in dividends
Example Talbot plc

The dividends of Talbot plc over the last five years have been:
Year Annual Net Dividends

2004 £150,000
2005 £172,000
2006 £195,380
2007 £230,100
2008 £262,350
Estimate the historical growth rate as a prediction of future growth.

Solution to Talbot plc
Dividend in 2004 (1 + g)4 = Dividend in 2008
Dividend in 2008
4
(14+–g)COST
CHAPTER OF CAPITAL =
Dividend in 2004
= = 1.749
£262,350
£150,000
(1 + g) = 41.749 = 1.15
g = 15%
(ii) Use of Gordon growth approximation
g = br
where: b = proportion of earnings retained p.a.
r = average return on reinvested funds.
Strictly only applicable to all-equity companies, but is often used for geared companies as an
approximation of growth rates.
Example V plc
Establish an estimate of future growth and of Ke if:
Proportion of earnings distributed p.a. 60%

Average return on reinvested funds 10%
Current cum-div price £1.08
Impending dividend 12p
Solution to V plc
g= 40% x 10% = 4%
12.48p
Ke = + 4% = 17%
96p
2. Cost of preference share capital

D (net)
Kps =
P0 (ex - div)
3. Cost of debt
(a) Irredeemable
Interest (l − t)
Kb = Market Value of debt (ex -int)
(b) Redeemable
IRR exercise
Example VI plc
A 5% debenture is currently quoted at £95.84 (ex-int). It is redeemable at the end of 3 years at £100.
Taking corporation tax at 50%, and ignoring the timing lag for tax savings, calculate Kd.
Solution to VI plc
Year £ Try DF @ 4% £
0 Cost (95.84) 1.00 (95.84)
1 Interest £5(0.5) 0.962 2.41
2 Interest £2.50 0.925 2.31
3 Interest & Redemption £102.50 0.889 91.12
NPV NIL
Therefore, Kb = IRR = 4%
NB Try 3% (NPV + £2.74) and 5% (NPV - £2.63), then by linear interpolation
£2.74
Kb = 3% + x 2% = 4.02%
£5.37
ie linear interpolation tends to overstate the IRR of “normal” cash flows
(c) Convertible
The cost of convertible debt is calculated in a similar manner to the calculation of the cost of
redeemable debt, EXCEPT that in the final year, one must include the:
- redemption value of the debt, or
- conversion value of the debt whichever is

the GREATER.
Example
Some 8% convertible debentures have a current market value of £106 per cent. The debenture will be
converted into equity shares in 3 years time at the rate of 40 shares per £100 of debentures. The
market price is expected to be £3.5 on the date of conversion.
What is the cost of capital to the company for the convertible debentures? Assume a corporation tax of
33%.
Solution
Net interest = 8% x 100 (1 - 0.33) = £5.36

Conversion value = 40 x 3.5 = £140 higher
Redemption value = £100
Year Item cashflow DF(12%) PV DF(15%) PV

0 current MV (106) 1 (106) 1 (106)
1-3 interest 5.36 2.402 12.87 2.283 12.24

3 conversion value 140 0.712 99.68 0.658 92.12
6.55 (1.64)

 6.55 ( )
Cost of capial = 12% +  × 15% −12% = 14.4%
6.55 +1.64
(d) Floating rate debt

The cost of floating rate debt (eg most bank loans and overdrafts) is the current interest rate being
charged on such funds.
Accordingly, if a company is paying interest at LIBOR + 8%, when LIBOR is set at 5% p.a. and corporation
tax rates are at 30%, Kd will be calculated as follows:
Kd = (5% + 8%) x (1 – 0.3) = 9.1%
CALCULATING THE CAPITAL WEIGHTED AVERAGE COST OF

(WACC)
Difficult to associate a project with a specific source of finance, as a pool of resources are available in
order to invest in projects. Thus a WACC is an appropriate discount rate/cut off rate.
Example Whyte plc

Whyte plc has on issue:
(a) 500,000 ordinary shares of £1 each, whose ex-div share price is £2. A constant dividend of 36p
per share will be paid on these for several years hence.
(b) 500,000 6% preference shares of £1 each, whose ex-div share price is 50p.
(c) £1,000,000 10% irredeemable debentures, quoted at 75 (ex-interest).
Calculate K0 (ie the WACC) assuming Corporation Tax at 40%.
Solution to Whyte plc
Market Value Component Cost

£ £
Equity (½m @ £2) 1,000,000 18% 180,000
Prefs (½m @ 50p) 250,000 12% 30,000
Debt (£1m @ 75) 750,000 8%* 60,000
£2,000,000 £270,000
£270,000
K0 = = 13.5%
£2,000,000
£10 (1 − 0.4)
= 8%
*Kb = £75
Comprehensive example Hunt plc

The management of Hunt plc is trying to decide upon a cost of capital discount rate to apply to the
evaluation of investment projects.
The company has an issued share capital of 500,000 ordinary £1 shares, with a current market value cum
div of £1.17 per share. It has also issued £200,000 of 10% debentures, which are redeemable at par in 2
years and have a current market value of £105.30 per cent and £100,000 of 6% preference shares,
currently priced at 40p per share. The preference dividend has just been paid, and the ordinary dividend
and debenture interest are due to be paid in the near future. (The preference dividend is shown net).
The ordinary share dividend will be £60,000 this year, and the directors have publicised their view that
earnings and dividends will increase by 5% per annum into the indefinite future.
The fixed assets and working capital of the company are financed by:
£
Ordinary shares of £1 500,000 6% £1 Preference shares
100,000
Debentures 200,000 Reserves 380,000
1,180,000
Required:
Calculate the WACC. Assume corporation tax at 50% per annum, payable one year in arrears.
Solution to Hunt plc
12p (1.05)
Ke = + 5% = 17%
£1.17 −12p
6p
Kps = = 15%
40p
Kb
Year Capital Interest Tax Net Try DF @ 8% Net

£ £ £ £ £
1 (95.30) (95.30) 1.00 (95.30)
2 10 10 0.926 9.26
3 100 10 (5) 105 0.857 89.99 3 (5) (5) 0.794 (3.97)
-0.02
Therefore, Kb = IRR = 8%
WACC
Market Value Component Cost

£ £
Equity (½m @ £1.05) 525,000 17% 89,250
Prefs (100K @ 40p) 40,000 15% 6,000
Debt (£200K @ 95.30) 190,600 8% 15,248
£755,600 £110,498
£110,498
Ko = =
£755,600 14.6%
MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE DISCOUNT RATE

1. Only under conditions of perfect capital markets will the costs of capital calculated
represent the true opportunity cost of funds used.
2. The project must be small relative to the size of the company (ie it represents a
marginal investment). This is because the costs of capital calculated refer to the
minimum required return of marginal investors and therefore are only appropriate for
the evaluation of marginal changes in the company’s total investment.
3. Using the existing market value mix of funds as weights in the calculation assumes
that in the long run funds will be raised in this proportion (ie in the long run the capital
structure of the company will remain unchanged). This implies that the current
gearing ratio is thought to be optimal.
4. No attempt is made to match a project with a particular source of funds. All funds are
regarded as forming a pool out of which all projects are financed (the ‘pool’ concept).
5. The project is of average risk for the firm and will cause no change in the risk of the
company as perceived by investors. This is because the cost of capital estimates are
only valid for the existing level of risk in the enterprise.
SOURCES OF FINANCE
Sources of short-term finance
Bank overdrafts
If cash outflows from a bank current account exceed inflows for a temporary period, a clearing bank may
provide an overdraft. Overdrafts may be arranged speedily, but are subject to review by the bank, may
be renewable and offer a level of flexibility, whilst interest is only paid on the overdrawn amount.
Overdrafts are technically repayable on demand and may require some form of security or guarantee.
Interest is often payable at a variable rate (ie benchmark rate plus a premium) and an arrangement fee
is normally payable upon the initial grant of the facility.
Short-term loans
Bank loans are an agreement for the provision of a specific fixed sum for a predetermined period at an
agreed interest rate. A term loan is provided in full at the start of the loan period and is repaid at a
specified time or in instalments over a period of agreed dates.
Bank loans are only repayable on the agreed dates, but are more expensive and less flexible than
overdrafts. The terms of the loan must be adhered to and the bank may impose loan covenants with
which the borrower must comply.
Trade credit
Raw materials are normally purchased on credit and this effectively represents an interest free short-
term loan. It is important to remember that payment delays would worsen the credit rating of the
company and that additional credit may then be difficult to obtain. The loss of settlement discounts that
suppliers may offer for early payment must be considered.
Lease finance
Instead of the outright purchase of a non-current asset, a company may choose to obtain the temporary
use of that asset by means of an operating lease, whereby the risks and rewards of ownership are
retained by the lessor (ie the legal owner).
An operating lease contract between a lessor and lessee is for the hire of a specific asset, whereby the
lessee has possession and use of equipment for a period which is shorter than the economic useful life
of the asset, but the lessee is committed to pay specified rentals during the period of the lease. The
lessor is normally responsible for repairs and maintenance and the lease can sometimes be cancelled at
short notice.
Sources of long-term finance
The main sources are:
● Fixed interest capital (ie debt finance) and preference share capital;
● Equity finance, which is commonly raised by rights issues, placings, offers for sale or public issues
following a stock exchange introduction. Details may be found in your Study Manual.
Two other long-term sources of finance available to businesses are:
1. Lease finance
A long-term leasing arrangement is likely to be finance lease, ie a lease that transfers substantially all the
risks and rewards incidental to the ownership of an asset to the lessee. Legal title may or may not
eventually be transferred.
The lessor is likely to be a bank or other financial institution, which does not normally trade in the type
of asset concerned. The lessee normally becomes responsible for the cost of repairs and maintenance.
The substance of a finance lease arrangement is that the lessee is effectively borrowing in order to have
use of a non-current asset for substantially the whole of its useful economic life and thereby becomes
liable for all lease payments. In contrast, an operating lease is equivalent to the short-term rental of an
asset from an organisation which normally trades in that type of asset.
2. Venture capital
Venture capital is the provision of risk bearing capital, normally provided in return for an equity stake in
companies with high growth potential.
The 3i Group is one of the world’s oldest venture capital organisations and is involved in schemes in
Europe, the USA and the Far East. The 3i Group is prepared to invest in companies with a highly
motivated management team, having a well defined strategy and target market, which are committed
to innovation and a proven ability to outperform competitors.
Venture capitalists may provide finance for business start-ups, the development of existing businesses,
management buyouts and the realisation of the investments of existing owners who wish to exit their
companies.
Where company directors seek assistance from a venture capitalist they must expect that the institution
will require an equity stake in the company, need convincing that the business will be successful, seek
representation on the company’s board of directors, demand exceptional returns on their investment
and expect an obvious ultimate exit route.
SMALL AND MEDIUM-SIZED ENTITIES (SMES)
Problems faced by small businesses in raising external finance

Small businesses face a number of well-documented problems when seeking to raise additional finance.
These problems have been extensively discussed and governments regularly make initiatives seeking to
address these problems.
Risk
Investors are less willing to offer finance to small companies as they are seen as inherently more risky
than large companies.
Security
Since small companies are likely to possess little by way of assets to offer as security, banks usually
require a personal guarantee instead, and this limits the amount of finance available.
Marketability of ordinary shares

Small companies are likely to be very limited in their ability to offer new equity to anyone other than
family and friends.
The equity issued by small companies is difficult to buy and sell, and sales are usually on a matched
bargain basis, which means that a shareholder wishing to sell has to wait until an investor wishes to buy.
There is no financial intermediary willing to buy the shares and hold them until a buyer comes along, so
selling shares in a small company can potentially take a long time. This lack of marketability reduces the
price that a buyer is willing to pay for the shares.
Tax considerations
Individuals with cash to invest may be encouraged by the tax system to invest in large institutional
investors rather than small companies, for example by tax incentives offered on contributions to
pension funds. These institutional investors themselves usually invest in larger companies, such as
stock-exchange listed companies, in order to maintain what they see as an acceptable risk profile, and in
order to ensure a steady stream of income to meet ongoing liabilities. This tax effect reduces the
potential flow of funds to small companies.
Cost
Since small companies are seen as riskier than large companies, the cost of the finance they are offered
is proportionately higher. Overdrafts and bank loans will be offered to them on less favourable terms
and at more demanding interest rates than debt offered to larger companies. Equity investors will
expect higher returns, if not in the form of dividends then in the form of capital appreciation over the
life of their investment.
Lack of information
Potential lenders may refuse to provide finance to a small business because of lack of financial
information about the small business to asses it creditworthiness.
Funding gap
Funding gap is the difference between the amount available for lending and the amount required to
finance investment. Small businesses often need more funds than are available for them to finance
growth.
The maturity gap

This presents a further problem for SMEs, who may ideally wish to obtain mediumterm loans. This
arises due to the mismatching of the maturity of assets and liabilities. Since the SME can secure long-
term loans with mortgages against their property assets, they find that longer term borrowing is much
easier to obtain than the medium term loans that they require.
Ways of resolving problems faced by small businesses in raising finance
Business angel
Business Angels refer to wealthy individuals who are prepared to help smaller companies by purchasing
shares in that company. A Business Angel may have expertise and experience to offer that could be
useful in a small company situation.
Enterprise investment scheme in the UK

This is where the government offers tax advantages in terms of income tax and capital gains tax in order
to encourage investment by individuals in the ordinary shares of small companies.
Small firms loan guarantee schemes

This is where the government guarantees loans from financial institutions on behalf of small business
that have good business prospects and have failed to secure a loan because of lack of security.
Venture capital trusts

Government schemes offer tax advantages to Venture Capital Trusts, which are required to invest a
large part of their funds in the ordinary shares of small companies.
Chapter 5
Theories of gearing
CHAPTER 5 – THEORIES OF GEARING
CHAPTER CONTENTS
THE TRADITIONAL VIEW ----------------------------------------------- 87
MODIGLIANI & MILLER – TAX IGNORED (1958) -------------------- 89

GRAPH 89
FORMULAE 89
ASSUMPTIONS 90
MODIGLIANI & MILLER – INCLUDING CORPORATION TAX (1963) 91

GRAPH 91
FORMULAE 91
WHY DO COMPANIES NOT ATTEMPT A 99.9% DEBT STRUCTURE? 93
PECKING ORDER THEORY ----------------------------------------------- 94
STATIC TRADE-OFF THEORY -------------------------------------------- 95
SOLVENCY RATIOS ------------------------------------------------------ 96

1. GEARING RATIO 96
2. INTEREST COVER 97
THE TRADITIONAL VIEW

The traditional view claims that there is an optimal capital structure where WACC is at a minimum and at
this point the combined market value of the firm’s debt and equity will be at maximum. Managers
therefore should identify this optimum level of gearing and ensure that their company maintain its
capital structure.
The bases of the traditional theory are:
● The cost of equity increases as the level of gearing increases. The introduction of debt brings
financial risk. This financial risk will make the earning available to equity shareholders to become
more volatile. The equity shareholders will therefore require additional return to compensate for
the increase in financial risk, and will push the cost of equity up.
● Debts finance is cheaper than equity as it is ranked before equity in terms of distribution of
earnings and on liquidation, and also interest on debt is a tax allowable expense. The issue cost on
debt is also cheaper than issuing cost of equity.
● Cost of debt remain constant, as the level of gearing increase, up to some point of gearing level
and beyond which it will increase. The reason being that risk to providers of debt finance
increases because interest cover will be falling and there may be few assets available to offer as
security against nonpayment. This will push the cost of debt up.
● WACC will then form a type of U-shape. At first falling as level of debt increases as reflecting the
low cost of debt, and then tending to increase as rising equity cost and rising cost of debt become
more significant. The optimum capital structure is where the WACC is at its minimum.
MODIGLIANI AND MILLER – TAX IGNORED (1958)

All companies with the same earnings in the same risk class have the same future income stream and
should therefore have the same value, independent of capital structure.
Graph
Modigliani & Miller (no tax)
Formulae
Preposition 1: value of company
Vg = Vu
Preposition 2: cost of equity
D
Keg = Keu + (Keu −Kb)
E
Preposition 3: WACC
WACCg = WACCu (Keu)
N.B. These formulae may be derived from the expressions which include the effect of corporation tax
treating t = 0
Assumptions
● Investors are rational
● Investors have the same view of the future
● Personal and corporate gearing are perfect substitutes
● Information is freely available
● No transaction costs
● No tax
● Firms can be grouped into similar risk classes.
The arbitrage “proof”, which incorporates these assumptions, can be used to support this M & M proposition.
MODIGLIANI AND MILLER – INCLUDING CORPORATION TAX (1963)

The values of companies with the same earnings in the same risk class are no longer independent.
Companies with a higher gearing ratio have a greater net future income stream (purely due to
corporation tax relief on interest payments) and therefore a higher value.
Graph
Formulae
Proposition 1: value of company
Vg = Vu + Dt
Proposition 2: cost of equity
Vd
D(1− t) i i
Keg = Keu+ (Keu− Kb*) or k e +(1- T)(k e -kd)

E Ve
*Kb or kd is the PRE-TAX COST OF DEBT for this formula.
NB The formula on the right-hand side is provided on the ACCA P4 Formulae sheet.
Proposition 3: WACC
 Dt 
WACCg = Keu 1 − 
 E + D
Capital structure example Grant plc

Grant plc (an all equity company) has on issue 6,000,000 £1 ordinary shares at market value of £2.50
each.
Bell plc (a geared company) has on issue:
17,000,000 25p ordinary shares; and £8,000,000 15%

debentures (quoted at 125)
Taking corporation tax at 35%, and assuming that:
1. The companies are in all other respects identical; and
2. The market value of Grant’s equity and the market value of Bell’s debt are “in
equilibrium”.
Calculate the equilibrium price per share of Bell’s equity.

Solution to Grant plc
Vg = Vu + Dt
N.B. D = £8,000,000 x = £10m
£m
Vu = 6,000,000 @ £2.50 = 15
Dt = £10,000,000 x 35% = 3.5
Vg = £18.5m
£m
E = (balancing figure) 8.5
D (as above) 10_
Vg (as above) £18.5m
Price per share = m = 50p

£8.5m 17
Why do companies not attempt a 99.9% debt structure?
1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the associated “COSTS OF FINANCIAL
DISTRESS”.
Vg = Vu + Dt − Present value of costs of financial distress
2. Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high levels of gearing.
3. Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax relief associated with debt
interest.
4. Debt capacity
Generally loans must be secured against a company’s assets and clearly some assets (eg property)
provide better security for loans than other assets (eg hightech equipment which may become
obsolescent overnight). The depth of the asset’s second hand market and its rate of depreciation are
important characteristics.
5. Personal taxes (MILLER’S CRITIQUE 1977)

Investors will be concerned with returns net of all taxes.
● If a firm’s income is paid out as debt interest, corporation tax savings are made (see M & M 1963)
but investors will have to pay income tax on debt interest.
● If a firm’s income is paid out as an equity return, corporation tax has to be paid but personal tax
can be saved (eg by avoidance of capital gains tax using exemptions).
● In deciding its gearing level, a firm should consider its corporation tax position and the personal
tax position of its investors if it wishes to maximise their wealth.
● In his 1977 article, Miller argues that firms will gear up until marginal investors face a personal tax
cost of holding debt equal to the corporation tax saving. At this point there is no further
advantage of gearing.
PECKING ORDER THEORY

The Pecking Order Theory is that a company’s capital structure decision is not determined by the costs
and benefits of using a combination of debt and equity finance to minimise the cost of capital.
The theory suggests that a company has a well defined order of preference in relation to available sources
of finance ie
(a) The first preference is the use of retained earnings, since internal finance is readily accessible, has
no issue costs and does not involve negotiating with third parties, such as banks.
(b) If external finance has to be used (because the company has identified more positive NPV projects
than can be financed by retentions alone), bank borrowings, loan stock and debentures are the
initial preferred source of external finance. The cost of issuing new debt is normally much smaller
than the cost of equity issues. Furthermore it is possible to raise smaller amounts of debt than of
equity.
When raising debt, initially it is advisable to issue low risk secured debt, and when there are no
more assets available as security, then to issue unsecured debt with a consequent higher risk and
higher cost.
(c) If, after the company’s level of debt capacity is reached, there remain further positive NPV projects
that remain to be financed, the final and least preferred source of finance is the issue of new equity
capital.
Accordingly there appears to exist a financing pecking order ie first use retained profits, then secured
debt, then unsecured debt and finally equity.
A more sophisticated explanation of the Pecking Order Theory was developed in 1984, when it was
suggested that the order of preference stemmed from the existence of “asymmetry of information”
between the company and the capital markets. This term refers to the fact that company management
are likely to have a much better idea of the true worth of the company’s shares than do outside investors.
Accordingly if a company wishes to raise new project finance and the capital market has underestimated
the benefits of the project, company management (with their inside information) will be aware that the
market has undervalued the company.
They would therefore choose to finance the project through retentions, so that when the market
discovers the true value of the project, existing shareholders will benefit. If retained earnings are
inadequate, the company would choose to raise debt finance in preference to a new equity issue (since
they would not wish to issue new equity shares which are undervalued by the market).
However if the company’s management believe that investors are overvaluing the benefits of the new
project and therefore placing too high value on the company’s shares, they would prefer to issue new
equity at that overvalued price.
STATIC TRADE-OFF THEORY

This variation on the 1963 with corporate tax theory of Modigliani and Miller arrives at a conclusion,
which is similar to that of the traditional theory of gearing ie there exists an optimum level of leverage
that companies should attempt to attain.
Provided a company is in a static position ie not in a period of extreme growth, it is likely to have a gearing
policy that is stable over time. This is achieved by striking a balance between the benefits and the costs of
raising debt.
The benefits of debt relate to the tax relief that is enjoyed when interest payments are made – the
cheaper debt finance will reduce the weighted average cost of capital and increase corporate value.
The costs of debt relate to the increases in the costs of financial distress (eg bankruptcy costs) and
increases in agency costs that arise when the company exceeds its optimum gearing levels. The resultant
increase in required returns demanded by investors cause the weighted average cost of capital of the
company to increase and hence corporate value to fall.
There is accordingly, in theory, a trade-off between these two effects and hence the cost of capital and
the value of the company will be optimised. However, subsequent research suggests that there is little
evidence of the static trade-off theory operating in the real world.
SOLVENCY RATIOS
1. Gearing ratio
This indicates the relationship between:
Equity : Fixed return securities (or Debt) on issue
It may be based upon balance sheet values (in which case “Equity” will comprise ordinary share capital
and reserves) or upon stock exchange values (in which event the shares and debentures on issue are
valued at mid market price).
Example CGR plc

Called-up share capital:
£250,000 of ordinary shares of 25p, quoted price 53p – 55p

£500,000 of 7% preference shares of £1, quoted price 71p – 73p
Reserves £100,000
Loans: £200,000 of 12% irredeemable debentures – market yield currently 10%.
Required:
Calculate the Capital Gearing Ratio, based upon
(a) Book values
(b) Market values.

Solution to CGR plc
(a) Book values = (250,000 + 100,000) : (500,000 + 200,000) = 0.5 : 1
(b) Market values = 540,000 : (360,000 + 240,000) = 0.9 : 1
N.B. Gearing ratios are expressed in a number of ways eg
Debt Debt
Equity Equity + Debt
Debt may include long-term borrowings only or both short and long-term debt.
A further problem is the classification of hybrid securities e.g preference shares. In the above illustration
they have been classified as debt, but this is open to debate when the ratio is calculated for the benefit of
lenders.
2. Interest cover
Earnings before Interest and Tax ie
Gross Interest
Berlan and Canalot
Berlan plc
Berlan plc has annual earnings before interest and tax of £15m. These earnings are expected to remain
constant. The market price of the company’s ordinary shares is 86 pence per share cum div and of
debentures £105.50 per debenture ex-interest. An interim dividend of six pence per share has been
declared. Corporate tax is at the rate of 35% and all available earnings are distributed as dividends.
Berlan’s long-term capital structure is shown below:
£’000
Ordinary shares (25 pence par value) 12,500
Reserves 24,300
36,800
16% debentures 31.12.2007 (£100 par value) 23,697
60,497
Required:
Calculate the cost of capital of Berlan plc according to the traditional theory of capital structure. Assume
that it is now 31 December 2004.
Canalot plc
Canalot plc is an all-equity company with an equilibrium market value of £32.5 million and a cost of
capital of 18% per year.
The company proposes to repurchase £5 million of equity and to replace it with 13% irredeemable loan
stock.
Canalot’s earnings before interest and tax are expected to be constant for the foreseeable future.
Corporate tax is at the rate of 35%. All profits are paid out as dividends.
Required:
(a) Using the assumptions of Modigliani and Miller, explain and demonstrate how this change in
capital structure will affect:
(i) the market value
(ii) the cost of equity
(iii) the cost of capital
of Canalot plc.
(b) Explain any weakness of both the traditional and Modigliani and Miller theories and discuss how
useful they might be in the determination of the capital structure for a company.
Solution to Berlan and Canalot
Berlan’s weighted average cost of capital
Cost of equity
£’000
Earnings before interest and tax 15,000
Interest (16% x 23,697) 3,792
11,208
Tax (35% x 11,208) 3,923
Earnings 7,285
Dividend (full distribution) 7,285
NIL
Number of shares = £12.5 million x 4 = 50 million
Pence
Market price per share: cum div 86
Less interim dividend declared _6
Ex div 80p
Value of shares = 50 million x 80p = £40 million
Cost of equity capital, using the dividend valuation model and assuming constant dividends
= = 18.21%
Cost of debt
A market value higher than redemption value implies that the cost (pre-tax) is less than the nominal rate
of 16%.
Using 8% and 9% as discount rates.
8% 9%
Year £ PV factors PV
factors
0 Market value (105.50) 1 (105.50) 1 (105.50)
1-3 Interest (net of tax) 10.40 2.577 26.80 2.531 26.32
3 Redemption 100.00 0.794 79.40 0.772 77.20
+0.70 −1.98
 0.7 
8% +   X 1% =
Cost of debt = 0.7 +1.98 8.26%
Market value of debt = £23.697million x = £25 million
Value of debt plus equity = £(25 + 40) million = £65 million

Weighted average cost of capital
WACC = 18.21% x + 8.26% x = 14.38%

Changes to capital structure: Canalot plc
(a) (i) Market value
Using a Modigliani-Miller formula for the value of a geared company (with irredeemable
debt):
Vg = Vu + Dt
When Canalot replaces equity with loan stock, the company will increase in value by the
tax shield, Dt.
= £5 million debt issued x 35% tax rate
= £1.75 million
The market value of the company increases to
£32.5 million + £1.75 million = £34.25 million
The market value of equity becomes
£34.25 million − £5 million = £29.25 million
(ii) The cost of equity
This can be computed
- from first principles, or
- by using the MM formula for Ke
From first principles
Consider the distribution of profits before and after the change in capital structure.
Before the change, equity earnings = 18% x market value of

£32.5 million = £5.85 million.
Pre-tax profits = £5.85 million x = £9 million.
After the debt issue:
£’000
Earnings before interest and tax 9,000
Less interest: £5m x 13% _650
8,350
Tax (35% x 8,350) 2,922
Equity earnings (= dividend) 5,428
Cost of equity = = 18.56%
The cost of equity has increased by 0.56% because of the increased financial risk
experienced by shareholders.
Using the MM formula for Ke:
D(1− t)
Keg = Keu+ (Keu− Kb)
= 18% + (18% −13%) = 18.56%
(iii) Weighted average cost of capital
Again, this can be computed either from first principles or by using the MM formula for
WACC.
From first principles
WACC = x 18.56% + x 13% x 0.65 = 17.08%
Using the MM formula for WACC
 Dt 
WACCg = Keu 1 − 
 E + D
 5 x 0.35
= 18% 1 −  = 17.08%  34.25 
The WACC has declined from 18%, reflecting the benefits of tax relief on interest.
(b) Weaknesses of the traditional and Modigliani-Miller theories
The traditional theory of capital structure is an intuitive theory, which is not supported by a
rigorous model building approach, as is the case with Modigliani and Miller’s work. It describes
how the weighted average cost of capital declines as gearing increases until a point is reached
where WACC is at its lowest and starts to increase with further increases in gearing. It therefore
suggests that there is an optimal capital structure at which the firm has its lowest cost of capital
and highest value. Unfortunately, because the theory is purely descriptive, it does not suggest a
method of finding that optimal capital structure, except by trial and error.
The traditional view predicts an optimal WACC position, because it effectively suggests that the
relationship between the cost of equity and gearing is nonlinear. In this respect it is in conflict
with the capital asset pricing model and much of modern financial management theory.
Modigliani and Miller’s theory, used in our discussion of Canalot plc, suggests that the only
advantage of borrowing is the tax relief on debt interest. The theory results directly from the
assumptions that they make. Some of these are unrealistic, for example:
(i) that individuals and companies can borrow at the same interest rate
(ii) that interest rates do not increase with gearing
(iii) that personal borrowing (which is not covered by limited liability) is no different from
corporate borrowing
(iv) that the capital market is perfect
(v) that (although corporate taxes are considered) personal taxes are ignored.
Although these assumptions are unrealistic, there is still some logic in MM’s suggestion that
companies should borrow as much as they can in order to take advantage of tax relief. However,
their theory also ignores possible costs arising at high levels of gearing, such as:
(i) Bankruptcy costs: both direct (sale of assets below going concern value) and indirect
(increased time spent controlling a company which is near bankruptcy).
(ii) Agency costs: for example, restrictive covenants in loan agreements which hinder the
company’s freedom of operation.
(iii) Tax exhaustion: inability to take advantage of the all tax relief on the high debt interest
because of a lack of taxable profits.
(iv) Debt capacity: inability to offer sufficient security to be able to borrow to a high level of
gearing.
At some level of gearing these costs will start to outweigh the benefits of tax relief, implying that
optimal gearing is achieved at a level just below this point.
Unfortunately, while the MM theory allows predictions of the effect of borrowing on the cost of
capital, it does not enable this optimal borrowing level to be established, because it ignores the
costs at high gearing.
Miller, in a later paper, argues that when personal taxes are introduced, the capital structure
does not affect the firm’s cost of capital. However, this too ignores bankruptcy costs and other
costs of high gearing.
In summary neither the traditional nor the MM view of capital structure presents a practical
method for identifying a company’s optimal capital structure. This can only be achieved by
intelligent trial and error. However, Modigliani and Miller do at least identify the various factors
which affect the cost of capital and, at reasonable levels of borrowing, enable the company to
predict the effect of increasing or decreasing gearing on the value of the firm.
Chapter 6
Capital asset
pricing model
CHAPTER 6 – CAPITAL ASSET PRICING MODEL
CHAPTER CONTENTS
THE CAPITAL ASSET PRICING MODEL (CAPM) ---------------------- 105

THE UNDERLYING THEORY OF CAPM 105
SYSTEMATIC AND UNSYSTEMATIC RISK 106
CAPM FORMULAE 106
SYSTEMATIC BUSINESS RISK AND SYSTEMATIC FINANCIAL RISK 108
ASSUMPTIONS, ADVANTAGES AND LIMITATIONS OF CAPM 114
THE CAPITAL ASSET PRICING MODEL (CAPM)
The underlying theory of CAPM

The CAPM assesses investments from the viewpoint of well-diversified shareholders and considers that
when companies invest in projects they must accept that the majority of their shareholders are well-
diversified institutions (ie pension funds, insurance companies, unit trusts and investment trust
companies). In fact only about 13% of the shares in UK quoted companies are held by individuals and
many of these are so wealthy that they can invest their savings in a number of different companies in
various market sectors.
Obviously an investor can reduce risk by holding a portfolio of shares in companies in different industries,
which will to some degree offer different risk/return profiles over time. For instance an investor holding
shares in both BP and the International Consolidated Airways Group (formerly British Airways) should
find that if oil prices increase the share price of BP should rise, whereas the share price of ICAG would
probably fall. Obviously an oil price decrease would cause an opposite effect on the share prices of the
two companies.
Provided that the returns on shares do not demonstrate perfect positive correlation, any additional
investment brought into a shareholders portfolio should (subject to the point made in the next
paragraph) cause the overall risk of the portfolio to reduce.
Suppose an investor who has built up a small portfolio in the shares of (say) three companies now
decides to add to that portfolio the shares of a few more companies in different market sectors. He
should find a substantial risk reduction as the additional investments are added to the portfolio.
However as the shares of more and more companies (in different sectors) are added to the portfolio, the
risk reduction will eventually slow down and once the portfolio increases up to about 16 to 20 companies
(again in different market sectors) the risk reduction will eventually cease.
Thus a standard deviation (σ or s) is a measure of total risk, and this can be analysed between:
● UNSYSTEMATIC (aka SPECIFIC or UNIQUE) RISK ie the risk which will

initially disappear as a result of diversification, and
● SYSTEMATIC (aka MARKET) RISK ie the risk which can never be avoided when investing in
company shares.
Specific risk reflects factors which are unique to the company or to the industry in which it operates,
whereas systematic risk reflects market wide factors such as the state of the economy.
Diversification therefore eliminates the unsystematic risk relating to shares held in a well-diversified
portfolio, but sadly the systematic risk of that portfolio will remain.
Accordingly, CAPM recognises that investors cannot expect to receive a return on their exposure to
unsystematic risk – therefore returns will only be received as a result of systematic risk, which investors
can never avoid.
CAPM uses a β factor, which compares the systematic risk of the shares of a company with the systematic
risk of the market. The higher the β, the greater the return the investor demands as compensation for the
systematic risk borne. Obviously unsystematic risk (which is diversified away by holding the shares of a
sufficient number of companies) can be ignored.
Systematic and unsystematic risk
Total UNSYSTEMATIC RISK

portfolio
risk(s)
SYSTEMATIC RISK
11 5 9 13 17 21 25
Number of different companies in which shares are hNumber of different
companies in which shares are held eld
CAPM formulae
CAPM provides the return that would be required by a well-diversified, risk-averse investor. The formula
can be expressed in a variety of ways, eg:
E(ri) = Rf + βi (E(rm) – Rf)
Ke = Rf + [Rm – Rf] β Required return = rf +

(Erm – rf) βj where:
Rf = the risk free rate of interest (eg the return on 90 day Treasury bills)
Rm = the average return on a market portfolio (eg the return on FTSE 100
constituents)
[Rm – Rf] = the market risk premium or excess market return
β (beta) = an index which compares the systematic risk of the investment with
the systematic risk of the market portfolio
The above CAPM formula appears in one form or another on formulae sheets provided by the
accountancy bodies. However the following formulae for calculating β are not provided in the
examination and must therefore be committed to memory:
CAPM can be used to determine the best composition of an investor’s portfolio by comparing the
expected return and the CAPM minimum required return of each security in the portfolio to ascertain
their alpha values.
A share’s alpha value is a measure of it abnormal return, which is the amount by which the share’s
returns are above or below what would be expected, given the systematic risk.
A positive alpha value indicate that, the share is expected to yield a higher return relative to its
systematic risk, so that an investor should buy more of that share, and that the share is underpriced.
A negative alpha value, indicate that the share is not expected to give satisfactory return relatively to its
systematic risk and so should be sold, and that the shares are overpriced.
Example
Details of a portfolio, which consistent of shares in 3 UK companies, are as follows:
Company Beta(equity) Average Return
A 1.16 19.5%
B 1.28 24.0%
C 0.90 17.5%
The current market return is 19% and the treasury bill yield is 11%
Required:
Asses the best composition of the portfolio.
Solution
The alpha values of each share is:
Company expected return CAPM return Alpha

A 19.5% 11% + 1.16(19 - 11) = 20.8% -0.78%
B 24% 11% + 1.28(19 - 11) = 21.24% 2.76%
C 17.5% 11% + 0.90(19 – 11) = 18.20% -0.70%
These figures suggest that shares in A and B are to be sold because they are overpriced and buy more
shares in B because they are underpriced.
Note the following
Alpha values -
● are only temporary abnormal return;
● can be positive or negative;
● over time will tend towards zero for any individual share, and for a well diversified portfolio taken
as a whole will be zero;
● If positive might attract investors into buying the shares to benefit from the abnormal return, so
that the share price will temporarily go up.
Systematic business risk and systematic financial risk

At a gearing level of zero, the equity shareholders of a company would have to bear systematic business
risk only. However as a company increases its debt levels and becomes more and more highly leveraged,
its equity shareholders will not only have to face the same level of systematic business risk as before, but
will also have to accept increasing amounts of systematic financial risk.
Accordingly:
● Equity shareholders in an ungeared company bear systematic

business risk only, whereas
● Equity shareholders in an otherwise identical geared company bear the same level of systematic
business risk as before, but will also have to face an ever increasing level of systematic financial risk
as borrowing levels become greater and greater,
with a consequence increase in the Ke of the company concerned. This is illustrated below.
Following the M & M with corporation tax theory of 1963, as gearing levels increase, Ke behaves as
follows:
Ke Ke
%
SYSTEMATIC
FINANCIAL RISK
SYSTEMATIC BUSINESS RISK
Gearing % D
E
Now that the issue of leverage has been introduced, there becomes a need to distinguish:
● β asset (βa), which reflects systematic business risk only, and
● β equity (βe), which reflects both systematic business risk TOGETHER WITH ANY systematic financial
risk which MAY exist.
Therefore:
● In the case of an all equity company, βe = βa, since no systematic financial risk can possibly exist.
● In the case of a geared company, βe > βa, since βe contains both systematic business risk and
systematic financial risk, whereas βa reflects systematic business risk only.
The theoretical relationship between βa and βe is commonly expressed by the following formulae:
βa = ( Ve( ) β  + (VeV+dV(1d−(1T−)T))βd   

 Ve + Vd 1− T ) e  
E D(1 − t) βa =
βe ( ) + βd ( )
E + D1− t E + D1− t
The latter version will now be used throughout this course.

Example Giles plc
Giles plc is an all-equity company whose β coefficient is 0.95. Stiles plc is a levered company and in all
other respects has the same risk and operating characteristics as Giles.
The capital structure of Stiles plc is as follows:
Nominal value Market value

£m £m
Equity 6 15
Debt 4 6 10 21
The debentures of Stiles plc are virtually risk-free and the corporation tax rate is 40%.
What would be the predicted β of the equity of Stiles plc?

Solution to Giles plc
Since the debt of Stiles plc may be assumed to be risk free:
E
βa = βe E + D(1 − t )
Therefore since Giles plc is an all equity company within the same industry as Stiles plc, the β e of Stiles plc
can be calculated as follows:
E + D(1− t)
βe = βa
E
= 0.95 x
= 1.178
Example Hotalot plc
Hotalot plc produces domestic electric heaters. The company is considering diversifying into the
production of freezers. Data on four listed companies in the freezerCHAPTER
industry6and
– CAPITAL ASSET are
for Hotalot PRICING MODEL
shown
below:
Freezeup Glowcold Shiverall Topice Hotalot

£’000 £’000 £’000 £’000 £’000
Fixed assets 14,800 24,600 28,100 12,500 20,600 Working capital _9,600 _7,200 11,100
_9,600 12,700
24,400 31,800 39,200 22,100 33,300
Financed by:
Bank loans 5,300 12,600 18,200 4,000 17,400 Ordinary shares* 4,000 9,000 3,500 5,300 4,000
Reserves 15,100 10,200 17,500 12,800 11,900
24,400 31,800 39,200 22,100 33,300
Turnover 35,200 42,700 46,300 28,400 45,000 Earnings per share 25 53.3 38.1 32.3 106
(in pence)
Dividend per share 11 20 15 14 40
(in pence)
Price/earnings ratio 12 10 9 14 8
Beta equity 1.1 1.25 1.30 1.05 0.95
*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice and £1 for Glowcold
and Hotalot.
Corporate debt may be assumed to be almost risk-free, and is available to Hotalot at 0.5% above the
Treasury Bill rate, which is currently 9% per year. Corporate taxes are payable at a rate of 35%. The
market return is estimated to be 16% per year. Hotalot does not expect its financial gearing to change
significantly if the company diversifies into the production of freezers.
Required:
(a) Estimate what discount rate Hotalot should use in the appraisal of its proposed diversification
into freezer production.
(b) Corporate debt is often assumed to be risk-free. Explain whether this is a realistic assumption
and calculate how important this assumption is likely to be to Hotalot’s estimate of a discount
rate in (b) above. For this purpose assume that Hotalot and the four freezer companies all have a
debt beta of 0.3.
(c) Discuss whether systematic risk is the only risk that Hotalot’s shareholders should be concerned
with.
Solution to Hotalot plc
(a) Discount rate for the appraisal of the proposed diversification into freezers
First, estimate the average equity beta in the freezer industry, then degear this figure. Regear it up to
Hotalot’s debt/equity ratio and apply the CAPM to find Hotalot’s cost of equity. A WACC can then be
calculated for Hotalot.
Average equity beta in the freezer industry
Company Value of shares* Equity Beta factor

F 16 million x 0.25 x 12 = £48 million 1.1
G 9 million x 0.533 x 10 = £48 million 1.25
S 14 million x 0.381 x 9 = £48 million 1.30
T 10.6 million x 0.323 x 14 = £48 million 1.05
£192 million
*Value of shares = Number of shares x eps x PE ratio
Since all the companies have the same market value of shares, the average equity beta is simply:
1 .
= 1.175
Total value of debt in the companies is:
£’million F:
5.3
G: 12.6
S: 18.2
T: 4.0
£40.1 million
The average debt/equity ratio in the freezer industry is therefore
Degearing the equity beta:
E
βa = βe ( )
E + D1 − t
= 1.175 × = 1.035
The market value of Hotalot’s shares is (4 million x £1.06 x 8) = £33.92 million, the market value of its
debt is £17.4 million. Then regearing the beta to Hotalot’s debt/equity ratio:
E + D(1− t)
βe = βa
E
= 1.035x = 1.38
The required return on Hotalot’s equity, from the CAPM
= Rf + (Rm − Rf) β
= 9% + (16% − 9%) 1.38 = 18.66%
The weighted average cost of capital for Hotalot’s new diversification is
= 18.66% x + 9.5%(1 − 0.35) x = 14.42%
(b) The assumption that corporate debt is risk-free
Corporate debt is not risk-free. There is a risk of default which implies that the debt has a positive beta.
Studies show that corporate debt is likely to have a beta of between 0.2 and 0.3.
From the information given in this question Hotalot must have a debt beta of 0.0714 since its K d = 9% +
(16% − 9%) 0.0714 = 9.5%. However the instruction in the question is to assume a debt beta of 0.3,
and this must, of course, be observed.
Assuming that all corporate debt has a beta of 0.3, both the degearing and regearing calculations in part
(b) above will need to be adjusted.
The ‘asset beta’ of an organisation is the weighted average of the beta of equity and the beta of debt. The
asset beta is the same as the degeared beta, so:
βa = 1.175 x + 0.3 x =1.07
This is the revised degeared β for the freezer industry.
Regearing to Hotalot’s level of gearing -
1.07 = βe x + 0.3 x
1.07 = βe x 0.750 + 0.075

βe = 1.327
Applying the CAPM gives Hotalot’s cost of equity as
9% + (16% − 9%) 1.327 = 18.29%
Hotalot’s WACC then becomes
18.29% x + 9.5% x 0.65 x = 14.18%
compared with the original estimate of 14.42%. The margin of error on these estimates is, however,
quite high – which means that the assumption that corporate debt is risk-free is unlikely to have a
significant effect on the accuracy of Hotalot’s estimates.
(c) Does systematic risk give the complete picture?
The capital asset pricing model assumes that Hotalot’s shareholders are well diversified and are only
concerned with systematic risk. Undiversified or partly diversified shareholders should also be concerned
with unsystematic risk and should seek a total return appropriate to the total risk that they face.
Even well diversified shareholders might be concerned with unsystematic risk. The total risk of a
company comprises systematic and unsystematic risk. It is total risk (the total variability of cash flows)
which determines the probability of a company failing, and the investor experiencing additional
bankruptcy costs. The greater the expected bankruptcy costs and the greater the probability of
corporate failure, the more concerned investors are likely to be with the total risk and not just systematic
risk.
Assumptions, advantages and limitations of CAPM
Assumptions
● All shareholders hold the market portfolio. Although this is questionable in practice, even a limited
spread of shareholdings produces some
diversification, therefore this assumption is appropriate;
● A perfect capital market (eg no transaction costs, information about risk and return is freely
available);
● The ability of investors to both borrow and lend at the risk free rate of
interest;
● All forecasts are made for a single time period only;
● All investors share the same uniform expectations concerning future earnings streams and are only
concerned with risk and return.
Advantages
● It demonstrates that unsystematic risk can be diversified away, therefore the only risk premium
required is for systematic risk only;
● Probably the best practical method for establishing the Ke of a publicly traded company;
● It highlights the relationship between risk and return, based upon stock market performance and
provides a measure of the risk of shares held within a well-diversified portfolio and measures the
required rate of return in view of that level of risk;
● Helps to provide a risk adjusted discount rate for use in investment appraisal.
Limitations
● It concentrates purely upon systematic risk and is therefore of limited use for investors who do not
hold a well-diversified portfolio;
● Since CAPM only considers the level of return to investors, it ignores the manner in which that
return is received. Therefore, it treats dividends and capital gains as equally desirable to investors,
thus totally ignoring the tax position of individual investors;
● It is purely a single period model, therefore not ideal for use in projects which extend for multiple
periods;
● The model requires the use of data which can be difficult to obtain ie
(i) The risk free rate of interest: It is necessary to take the best proxy measure of a short-term
default free rate eg UK 90 day Treasury bills;
(ii) The return on the market portfolio: Should the FT all-share index be used, or the FTSE 100,
or the FTSE 350, or a world composite share price index?;
(iii) Beta: Clearly this should strictly be based on subjective probabilities of future events, but
since this is impracticable in practice, regression analysis is often used to compare the
historical behaviour of individual securities with the behaviour of a suitable market index
within the same time period.
● CAPM tends to overstate the required return of high beta securities and to understate the required
return of low beta securities. The returns of small companies, returns on certain days of the week
or months of the year have in practice been observed to differ from those expected from CAPM.
Chapter 7
Adjusted present value
CHAPTER 7 – ADJUSTED PRESENT VALUE
CHAPTER CONTENTS
ADJUSTED PRESENT VALUE ------------------------------------------- 119
SITUATIONS WHERE APV IS BETTER THAN NPV -------------------- 120
CALCULATION OF APV ------------------------------------------------- 121

ISSUE COST 122
TAX SAVINGS ON INTEREST 123
SUBSIDY 124
PRACTICAL PROBLEMS OF THE APV APPROACH -------------------- 125
ADJUSTED PRESENT VALUE (APV)

Traditionally financial management has appraised new investments by discounting their after-tax
operating cash flows to present value at the firm’s weighted average cost of capital and subtracting the
initial investment cost to arrive at an NPV. We have already noted problems with the use of the WACC
and seen that adjustments are commonly needed to tailor the discount rate to the systematic business
risk and the financial risk of the project under consideration.
M & M based adjustments to the cost of capital form one approach to this problem. Here we examine
another, adjusted present value (APV), which offers significant advantages.
APV is often described as a “divide and conquer approach”. To do this the project will first be evaluated
as if it were being undertaken by an all-equity company. “Side effects” like the tax shield on debt and
the issue costs being ignored. This first stage will give us the so-called base NPV or base case NPV. The
second stage is to calculate the present value of the side effects and to add these to the base NPV. The
result is the APV which shows the net effect on shareholder wealth of adopting the project.
SITUATIONS WHERE APV IS BETTER THAN NPV

The APV method may be better than NPV because:
1. There is a significant change in capital structure of the company as a result of the investment.
2. There are subsidised loans or other benefits (grant) associated explicitly with an individual project
and which requires discounting at different rate than that applied to the mainstream cash flows.
3. The investment involves complex tax payments and tax allowances, and or has periods when
taxation is not paid.
4. The operating risk of the company changes as a result of the investment.
CALCULATION OF APV
The APV method therefore sees the value of the project to shareholders as being:
Project value if all equity financed + present value of tax + Present value of
(the base case NPV) shield on the loan other side effects
The APV method involves two stages:
1. Evaluate the project first of all as if it were all equity financed, and so as if the company were an
all equity company to find the ‘based case NPV’.
2. Make adjustment to the based case NPV to allow for the side effects of the method of financing
that has been used. The financing effects may consist of:
(i) Present value of tax savings on interest paid on debt raised to finance the investment.
(ii) Present value of issue costs incurred in raising both debts and equity capital.
(iii) Present value of subsidies/cheap loans. This is technically an opportunity benefit.
Example
A project with an initial cost of £80,000 is expected to yield an annual return of £10,000 in perpetuity.
The £80,000 will be financed by £30,000 debts and £50,000 equity.
Required:
Calculate APV, assuming 10% ungeared cost of equity and corporation tax of 30%.
Solution
Based case NPV (NPV if all equity financed) = (£10,000/ 0.10) – 80,000 =£20,000
PV of tax shield 30,000 x 30% = 9,000 APV = 29,000
Issue cost
The issue cost is the cost associated with raising funds needed to finance the project. The issue cost is a
cash outflow and that its present value should be deducted from the base case NPV in the calculation of
APV. Risk free rate is usually used as the discount factor in calculating the present value of issue cost.
Example
A project requires immediate capital expenditure of £20m. The amount is expected to be raised from a 1
for 3 rights issue at a price of £2 per share.
Right issue costs are 5% of the amount raised. Assume a risk free rate of 10%.
Required:
Calculate the issue cost that should be included in the APV calculations assuming:
(a) the issue cost is not a tax allowable expense;
(b) the issue cost is a tax allowable expense and tax is paid one year in arrears. Corporation tax rate
is 30%.
Solution
(a) Issue cost is not tax allowable expense.
The issue cost is 5% of the amount raised. Therefore the £20m represents the amount raised less
the issue cost, hence the need to gross up as follows:
If issue cost is 5%, then the £20m represents 95%.
Issue cost = £20m x (5 / 95) = £1.05m
PV of issue cost = £1.05 as it occurs in year zero (immediately). This must be deducted from base
case NPV in APV calculation as it represents cash outflow.
(b) Issue cost is a tax allowable expense and tax is paid one year in arrears.
Issue cost = £20m x (5 / 95) = £1.05m Tax saving

on issue cost = £1.05m x 30% = £0.315m
PV of issue cost:
Year Item cash flow (£) Discount factor Present value

(10%)
1 issue cost (1.05) 1.000 (1.05)
2 tax saved 0.315 0.909 0.286 Present value
0.764 of issue cost
Tax savings on interest
Interest payments on debt are tax allowable expense and the APV will increase by the present value of
the tax savings on the interest otherwise called the tax shields.
The calculation of the tax shield depends on whether the interest is payable on a fixed amount every
year or there is equal repayment.
Example
A project requires immediate capital expenditure of £20m. The amount will be raised through a 10%
bank loan over a period of 5 years.
Tax is paid one year in arrears at a rate of 30%.
Required:
Calculate the present value of tax shields assuming:
(a) 10% interest on the £20m per annum;
(b) the amount will be paid in equal instalments over 5 years.
Solution
(a) 10% interest on the £20m per annum
Annual interest = 10% x £20m = £2m

Tax savings = £2m x 30% = £0.6m
PV of tax savings = Year 2 to Year 6 as tax is one year in arrears:

£0.6 x (4.355 – 0.909) = £2.067m
(b) The amount will be paid in equal instalments over 5 years
Annual instalment = debt value divided by the annuity factor
= £20m/3.791
= £5.3 per annum
Interest payment will therefore be as follows:
Year opening balance interest@10% instalments closing balance

£m £m £m £m
1 20 2 5.3 16.7
2 16.7 1.7 5.3 13.1
3 13.1 1.3 5.3 9.1
4 9.1 0.9 5.3 4.7
5 4.7 0.5 5.3 0

PV of tax savings on interest:
Year interest tax saved (30%) DF PV

10%
£m
1 2.0 0.00 0.909 0.00
2 1.7 0.60 0.826 0.496
3 1.3 0.51 0.751 0.383
4 0.9 0.39 0.683 0.266
5 0.5 0.27 0.621 0.167
6 0.0 0.15 0.564 0.085
Tax shield 1.397
Subsidy
It may be possible for a company to raise a subsidised loan to finance a project. In this case the
company will save interest cost which is the difference between the normal interest and the subsidised
interest. However, by paying less interest the company forfeits the tax benefit on the amount of
interest not paid.
The present value of the net interest saved represents an addition to the base case NPV in APV
calculation.
Example
A project requires immediate capital expenditure of £20m. The company normally borrow at 8% but a
government loan will be available to finance the project at 6%.
Assume a risk free rate of 5% and that the project is expected to last for 5 years. Tax rate is 30%.
Required:
Calculate the present value of tax shields and present value of subsidy.
Solution
Present value of tax shield
Annual interest = 6% x £20m = £1.2m

Tax savings = £1.2m x 0.3 = £0.36m
Present value (at risk free rate) of tax shield £0.36 x 4.329 = £1.56
Present value of subsidy

Subsidy = 8% - 6% = 2%
Total subsidy per annum = 2% x £20m = £0.4
PV of net subsidy = £0.4 x (1-0.3) x 4.329 = £1.21

PRACTICAL PROBLEMS OF THE APV APPROACH
1. Determining a suitable cost of equity for the initial DCF computation as if the project was all
equity financed, and also establishing the all equity beta are still based on M&M assumptions.
2. Difficulties in identifying all the cost associated with the method of financing.
3. Difficulties in choosing the correct discount rate used to discount the side effects such as issue
cost and the corporation tax savings on debt capital interest. Although the risk-free rate of return
is assumed.
4. In complex investment decisions the calculations can be extremely long and hence more difficult.
Example Strayer
The managers of Strayer Inc are investigating a potential $25 million investment. The investment would
be a diversification away from existing mainstream activities and into the printing industry. $6 million of
the investment would be financed by internal funds, $10 million by a rights issue and $9 million by long
term loans. The investment is expected to generate pre-tax net cash flows of approximately $5 million
per year, for a period of ten years. The residual value at the end of year ten is forecast to be $5 million
after tax. As the investment is in an area that the government wishes to develop, a subsidised loan of $4
million out of the total $9 million is available. This will cost 2% below the company's normal cost of
longterm debt finance, which is 8%.
Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by market value. The
average equity beta in the printing industry is 1.2, and average gearing 50% equity, 50% debt by market
value.
The risk free rate is 5.5% per annum and the market return 12% per annum. Issue costs are estimated to
be 1% for debt financing (excluding the subsidised loan), and 4% for equity financing. These costs are
not tax allowable. The corporate tax rate is 30%.
Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed investment. (15 marks)
(b) Comment upon the circumstances under which APV might be a better method of evaluating a
capital investment than Net Present Value
(NPV). (5
marks)
(20 marks)
Solution to Strayer
(a)
APV = Base case NPV ± Present value of financing effects
Base case NPV
This may be estimated by discounting net cash flows by the discount rate applicable to the risk
associated with an ungeared investment.
● As Strayer is moving to the printing industry the geared beta of the printing industry can be used
as a proxy beta.
● Ungear the proxy beta to an ungeared beta using the formula on the assumption that companies
in the industry have the same business risk and debt is risk free.
E
Βa = βe×
E + D(1− t)
Βa = 1.2× =0.71
● Using CAPM, calculate the ungeared cost of equity as
Keu = 5.5% + 0.71(12% – 5.5%) = 10.115%
Say 10%
● Calculate the base case NPV by discounting the relevant cash flows by 10% as follows:
Cash flow Df10% PV

$ $
Year 0 (25) 1 (25)
Y 1 –10 (5 x 0.7) 3.5 6.145 21.508
Y10 5 0.386 1.93
Base case NPV (1.562)
Present value of financing effects
Issue cost
$
Rights issue = 10m x 4% = 0.40
Debts = 5m x 1% = 0.05
PV of issue cost 0.45m
Tax savings on debt interest

8% loan of $5m
Annual interest = $5m x 8% = 0.4m

Tax saved per annum = $0.4 x 30% = 0.12m
$4m subsidized loan

Annual interest = $4m x 6% = 024m
Tax saved per annum = $0.24 x 30% = 0.072m
PV of tax savings on interest using risk-free rate of 5.5% as discount factor
Annuity factor of 5.5% over 10 years is simply calculated as the sum of annuity factor of 5% and 6% over
10 years divided by 2:
= (7.722 + 7.360)/2 = 7.541
Total tax saving on interest = 0.12m + 0.072m = $0.192m
PV of tax savings = $0.192 x 7.541 = $1.448
Present value of Subsidy
After tax interest saved as a result of subsidy = 2% x $4m = $0.08 x (1 – 0.3)

= $0.056
Present value of subsidy at risk-free rate = $0.056 x 7.541 = $0.422
APV calculation $
Base case NPV (1.562)
Present value of tax savings on interest 1.448
Present value of subsidies 0.422 Present value of issue cost
(0.45)
Adjusted present value (0.142)
Since the APV is negative, the project is financially not viable.
(b)
The APV method may be better than NPV in situations where:
● The operating risk of the company changes as a result of the new investment.
● There is a significant change in the capital structure and hence financial risk of the
company as a result of the investment.
● The investment has complex tax payments and tax allowances, and/or periods when tax is
not paid.
● There are subsidised loans or other benefits associated explicitly with an individual project.
Chapter 8
International
investment appraisal
CHAPTER 8 – INTERNATIONAL INVESTMENT APPRAISAL
CHAPTER CONTENTS
INTERNATIONAL INVESTMENT AND FINANCING DECISIONS ----- 131

INTRODUCTION 131
PARENT OR PROJECT VIEWPOINT? 131
TAXATION AND INTERNATIONAL INVESTMENT APPRAISAL 132
FORECASTING EXCHANGE RATES 132
PROJECT DISCOUNT RATES 133
REMISSION OF FUNDS 133
OVERCOMING EXCHANGE CONTROLS – BLOCK REMITTANCES 134
EXCHANGE RATE RISK 134
POLITICAL RISK 134
ECONOMIC RISK 135
FISCAL RISK 135
REGULATORY RISK 135
FINANCING OVERSEAS PROJECTS 136
INTERNATIONAL DECISIONS INVESTMENT AND FINANCING
Introduction
In essence capital budgeting for overseas investments is similar to domestic investment appraisal. It
includes the following steps:
● Identification of relevant cash flows.
● Dealing with inflation to assess real or nominal cash flows.
● Dealing with tax, including the tax savings on capital allowances.
● Dealing with inter-company transactions, such as management charges and royalties and cash
flow remittance restrictions.
● Estimating future exchange rates (spot rates).
● Dealing with double taxation arrangements.
● Estimating the appropriate cost of capital (discount factor).
Parent or project viewpoint?

Any overseas capital project can be assessed from the point of view of the parent company or the local
subsidiary. Relevant cash flows may vary between the two viewpoints due to the following factors:
● Timing of the receipt of funds;
● Impact of exchange rate changes on the value of the funds;
● Impact of local and home country tax on the value of funds received;
● Effect on other parts of the organisation (eg sales by the subsidiary reducing the parent’s export
market sales).
As the objective of financial management is to maximise shareholder wealth, and the vast majority of
the shareholders are likely to be located in the parent country, it is essential that projects are evaluated
from a parent currency viewpoint. After all, in the UK only sterling receipts can be used to pay sterling
dividends. Accordingly, the following three-step procedure is recommended for calculating project cash
flows:
1. Compute local currency cash flows from a subsidiary viewpoint as if it were an independent
entity;
2. Calculate the amount and timing of transfers to the parent company in sterling terms;
3. Allow for the indirect costs and benefits of the project in sterling terms (eg the contribution lost
due to the turnover of other members of the group being affected by this overseas project).
Taxation and international investment appraisal
The following procedure can be applied:
1. Allow for host country investment incentives (capital allowance) before applying the local tax rate
to local taxable cash flows.
2. Apply the relevant parent company rate of tax to the taxable/remitted cash flows.
3. Adjust point 2 above for any double taxation agreement.
Consider the following:
Italy tax UK tax

(1) 20% 20%
(2) 20% 30%
(3) 20% 18%
In (1) no further tax will be paid in the UK as profit is taxed in Italy at 20%.
In (2) profit would be taxed at 30%, 20% in Italy and a further 10% in the UK.
In (3) no further tax will be paid in the UK. The 20% is charged in Italy.
Forecasting exchange rates

Exchange rates can be estimated using purchased power parity (PPP) or international Fisher effect (IFF).
The PPP is used when inflation rates are given and the IFE is used when interest rates are given.
The formula is simply stated as:
Purchasing power parity and interest rate parity
(1 ic)
S1 = S0 × (1+ hc) Fo = So × +
(1+ hb) (1+ ib)
Example Startall plc

Startall plc wishes to estimate future exchange rates based upon the following projections of
inflation.
UK USA Bargonia
Year 1 5% 5% 20%
2 5% 5% 30%
3 5% 7% 30%
4 5% 7% 30%
5 5% 7% 30%
Required:
If current spot rates are US$1.60 = £1 and Bargonian Dowl 250 = £1, using the PPPT, what are
the predicted spot rates for the currencies concerned at the end of each of the next five years?
Solution to Startall plc
Exchange rates
Year 0 1 2 3 4 5
Dowl/£ 250.0 285.7 353.7 438.0 542.2

671.3
× × × × ×
US$/£ 1.60 1.60 1.60 1.630 1.662 1.693
× × × × ×
Project discount rates

In the same way as for domestic capital budgeting, project cash flows should be discounted at a rate
that reflects their systematic risk. Many firms assume that overseas investment must carry more risk
than comparable domestic investment and therefore increase discount rates accordingly.
This assumption, however, is not necessarily valid. Although the total risk of an overseas investment
may be high, in the context of a well-diversified parent company portfolio much of the risk may be
diversified away. Because of the lack of correlation between the performance of some national
economies, the systematic risk of overseas investment projects may in fact be lower than that of
comparable domestic projects.
It must therefore be realised that the automatic addition of a risk premium simply because a project is
located overseas does not always make sense, and any increase in the discount rates used for foreign
projects should be viewed with caution.
Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company. For example,
royalties, supervisory fees and purchases of components from the parent company are costs to the
project, but result in revenues to the parent. Care should be exercised in identifying exactly how and
when funds are repatriated. The normal methods of returning funds to the parent company are:
● Dividends
● Royalties
● Transfer prices; and
● Loan interest and principal
It is important to note that some of these items may be locally tax-deductible for the subsidiary but
taxable in the hands of the parent.
Overcoming exchange controls – block remittances

Block funds are funds in overseas bank accounts subject to exchange controls, such that restrictions are
placed on remitting the funds out of the country.
A number of ways have been devised to try and avoid such restrictions. They mainly aim to circumvent
restrictions on dividends payments out of the account by reclassifying the payment as something else:
1. Management Charges
The parent company can impose a charge on subsidiary for the general management services provided
each year. The fees would normally be based on the number of management hours committed by the
parent on the subsidiary’s activities.
2. Royalties
The parent company can charge the subsidiary royalties for patent, trade names or know-how. Royalties
may be paid as a fixed amount per year or varying with the volume of output.
3. Transfer Pricing
The parent can charge artificially higher prices for goods or services supplied to the subsidiary as a
means of drawing cash out. This method is often prohibited by the foreign tax authorities.
Exchange rate risk

Changes in exchange rates can cause considerable variation in the amount of funds received by the
parent company. In theory this risk could be taken into account in calculating the project’s NPV, either
by altering the discount rate or by altering the cash flows in line with forecast exchange rates. Virtually
all authorities recommend the latter course, as no reliable method is available for adjusting discount
rates to allow for exchange risk.
Political risk
This relates to the possibility that the NPV of the project may be affected by host country government
actions. These actions can include:
● Expropriation of assets (with or without compensation!);
● Blockage of the repatriation of profits;
● Suspension of local currency convertibility;
● Requirements to employ minimum levels of local workers or gradually to pass ownership

to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their possible occurrence
must be considered when evaluating new investments. High levels of political risk will usually
discourage investment altogether, but in the past certain multinational enterprises have used various
techniques to limit their risk exposure and proceed to invest. These techniques include the following:
(a) Structuring the investment in such a way that it becomes an unattractive target for government
action. For example, overseas investors might ensure that manufacturing plants in risk-prone
countries are reliant on imports of components from other parts of the group, or that the
majority of the technical “know-how” is retained by the parent company. These actions would
make expropriation of the plant far less attractive.
(b) Borrowing locally so that in the event of expropriation without compensation, the enterprise can
offset its losses by defaulting on local loans.
(c) Prior negotiations with host governments over details of profit repatriation, taxation, etc, to
ensure no problems will arise. Changes in government, however, can invalidate these
agreements.
(d) Attempting to be “good citizens” of the host country so as to reduce the benefits of expropriation
for the host government. These actions might include employing large numbers of local workers,
using local suppliers, and reinvesting profits earned in the host country.
Economic risk
Economic risk is the risk that arises from changes in economic policies or conditions in the host country
that affect the macroeconomic environment in which a multinational company operates. Examples of
economic risk include:
● Government spending policy.
● Economic growth or recession.
● International trading conditions.
● Unemployment levels.
● Currency inconvertibility for a limited time.
Fiscal risk
Fiscal risk is the risk that the host country may increase taxes or changes the tax policies after the
investment in the host country is undertaken. Examples of fiscal risk include:
● An increase in corporate tax rate.
● Cancellation of capital allowances for new investment.
● Changes in tax law relating to allowable and disallowable tax expenses.
● Imposition of excise duties on imported goods or services.
● Imposition of indirect taxes.
Regulatory risk
Regulatory risk is a risk that arises from changes in the legal and regulatory environment which
determines the operation of a company. Examples are:
● Anti-monopoly laws.
● Health and safety laws.
● Copyright laws.
● Employment legislation.
Financing overseas projects
The chief sources of long-term finance are the following:
1. Equity
The subsidiary is likely to be 100% owned by the parent company. However, in some countries it
is necessary for nationals to hold a stake, sometimes even a majority of the ordinary shares on
issue.
2. Eurocurrency Loan
Eurocurrency loan is a loan by a bank to a company denominated in a currency of a country other

than that in which they are based. For example, a UK company may require a loan in dollars
which it can acquire from a UK bank operating in the Eurocurrency market. This is called
Eurodollar loan.
The usual approach taken is to match the assets of the subsidiary as far as possible with a loan in
the local currency. This has the advantage of reducing exposure to currency risk. However, this
reduced risk must be weighed against the interest rate paid on the loan. A loan in the local
currency may carry a higher interest rate, and it may be preferable, for example, to arrange a
Eurocurrency loan in a major currency which is highly correlated with the currency of the
overseas operations.
3. Government grants
Finance may be available from the UK, the overseas government, or an international body, such
as the World Bank.
4. Intercompany accounts
Financing by intercompany account is useful in a situation where it is difficult to get funds out of
the foreign country by way of dividends. This is further discussed below.
5. Syndicated Loan Market
Syndicated loan market developed from the short-term eurocurrency market. A syndicate of
banks is brought together by a lead bank to provide medium-to long-term currency loans to large
multinational companies. These loans may run to the equivalent of hundreds of millions of
pounds. By arranging a syndicate of banks to provide the loan, the lead bank reduces its risk
exposure.
6. Eurobond
Eurobond are bonds sold outside the jurisdiction of the country in whose currency the bond is
denominated.
Eurobond is a bond issued in more than one country simultaneously, usually through a syndicate
of international banks, denominated in a currency other than the national currency of the issuer.
They are long-term loans, usually between 3 to 20 years and may be fixed or floating interest rate
bonds
An investor subscribing to such a bond issue will be concerned about the following factors:
● security;
● marketability;
● return on the investment.
7. Euroequity
These are equity sold simultaneously in a number of stock markets. They are designed to appeal
to institutional investors in a number of countries. The shares will be listed and so can be traded
in each of these countries.
The reasons why a company might make such an issue rather than an issue in just its own
domestic markets include:
● larger issues will be possible than if the issue is limited to just one market;
● wider distribution of shareholders;
● to become better known internationally;
● queuing procedures which exist in some national markets may be avoided.
Example Brookday plc

Brookday plc is considering whether to establish a subsidiary in the USA. The subsidiary would cost a
total of $20 million, including $4 million for working capital.
A suitable existing factory and machinery have been located and production could commence quickly. A
payment of $19 million would be required immediately, with the remainder required at the end of year
one.
Production and sales are forecast at 50,000 units in the first year and 100,000 units per year thereafter.
The unit price, unit variable cost and total fixed costs in year one are expected to be $100, $40 and $1
million respectively. After year one prices and costs are expected to rise at the same rate as the previous
year’s level of inflation in the USA; this is forecast to be 5% per year for the next 5 years. In addition a
fixed royalty of £5 per unit will be payable to the parent company, payment to be made at the end of
each year.
Brookday has a 4 year planning horizon and estimates that the realisable value of the fixed assets in 4
years time will be $20 million.
It is the company’s policy to remit the maximum funds possible to the parent company at the end of each
year. Assume that there are no legal complications to prevent this.
Brookday currently exports to the USA yielding an after tax net cash flow of £100,000. No production will
be exported to the USA if the subsidiary is established. It is expected that new export markets of a
similar worth in Southern Europe could replace exports to the USA. United Kingdom production is at full
capacity and there are no plans for further expansion in capacity.
Tax on the company’s profits is at a rate of 50% in both countries, payable one year in arrears. A double
taxation treaty exists between the UK and the USA and no double tax is expected to arise. No
withholding tax is levied on royalties payable from the USA to the UK.
Tax allowable ‘depreciation’ is at a rate of 25% on a straight line basis on all fixed assets.
Brookday believes that the appropriate beta for this investment is 1.2 The aftertax market rate of
return is 12%, and the risk free rate of interest 7% after tax.
The current spot exchange rate is US $1.300/£1, and the pound is expected to fall in value by
approximately 5% per year relative to the US dollar.
Required:
(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State clearly any
assumptions that you make.
(b) What further information and analysis might be useful in the evaluation of this project?
Solution to Brookday plc
(a) Brookday’s stated policy is to remit the maximum funds possible to the parent company. The net
present value of relevant cash flows to the parent company will be the appropriate decision
criterion, and should lead to maximisation of parent shareholder wealth.
The dollar profit and relevant cash flow from the subsidiary must be determined first:
Projected earnings data of the US subsidiary

$’000 $’000 $’000 $’000 $’000
Sales (note 1) 5,000 10,500 11,025 11,580
Variable cost 2,000 4,200 4,410 4,630

Fixed costs 1,000 1,050 1,102 1,158
Royalty 309 586 557 529
(note2)
Depreciation 4,000 4,000 4,000 4,000
7,309 9,836 10,069 10,317
Taxable profit (2,309) 664 956 1,263

US tax payable (note
3) 0 0 0 0 (287)
Profit after tax (2,309) 664 956 1,263 (287)
Projected cash flow data of the US subsidiary

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
$’000 $’000 $’000 $’000 $’000 $’000
Profit after tax (2,309) 664 956 1,263 (287)
Depreciation 4,000 4,000 4,000 4,000
Initial
investment (19,000)
Additional
capital Realisable (1,000)
value of fixed
assets (note 4) Tax on 20,000
realisable value Working capital (10,000)
available ______ _____ _____ _____ 4,000 ______

Cash flow available to
parent (19,000) 691 4,664 4,956 29,263 (10,287)
Projected cash flow data for the parent company

Year 0 Year 1 Year 2 Year 3 Year 4 Year 5
£’000 £’000 £’000 £’000 £’000 £’000
Available from
US subsidiary (14,615) 559 3,976 4,445 27,633 (10,226)
Royalty 250 500 500 500
payment UK
tax on
royalty (note5) _____ ___ (125) (250) (250) (250)
Net cash flow (14,615) 809 4,351 4,695 27,883 (10,476)
Discount factors @
13%
(note 6) 1 0.885 0.783 0.693 0.613 0.543
Present values (14,615) 716 3,407 3,254 17,092 (5,688)
Net present value = +£4,166,000
The loss of exports to the USA if the project is undertaken is not a relevant cash flow.
Notes:
1. Sales price increases by 5% per year
Year 1 Year 2 Year 3 Year 4

Price ($) 100.00 105.00 110.25 115.80
Units (000) 50 100 100 100
Sales revenue ($’000) 5,000 10,500 11,025 11,580
Similar calculations are necessary for variable costs and price adjustments for fixed costs.
2. The royalty is payable in £’s and will depend upon the $/£ exchange rate. The £ is expected
to fall in value by 5% per year relative to the $.

Expected exchange rates $/£ 1.235 1.173 1.115 1.059 1.006
Royalty (£’000) 250 500 500 500
Royalty ($’000) 309 586 557 529
3. Losses are assumed to be carried forward and allowed against future profits for taxation
purposes.
4. Although the subsidiary will exist for more than four years, the company’s planning horizon is
only four years. A value must be placed upon the subsidiary at this time. The only
information available is an estimate of realisable value of fixed assets. Tax on this realisable
value will be payable as the assets are fully depreciated. Potential working capital available
must also be considered.
5. There will be no double taxation on cash flows from the USA. However, the royalty has not
been subject to US tax, and will be liable to UK taxation.
6. Using the capital asset pricing model to determine the discount rate:
ke = rf + (Erm – rf) β project
ke = 7% + (12% − 7%) 1.2 = 13%
(b) Further information and analysis might include:
(i) How accurate are the cash flow forecasts? How have they been established?
(ii) Why has a four year planning horizon been chosen? The valuation of the fixed assets at
year 4 is highly significant to the NPV solution. How has this valuation been established? Is
this valuation based upon future earnings as a going concern? It would be more desirable
to evaluate the project over the whole of its projected life.
(iii) Risk is taken into account by using a CAPM derived discount rate. How has this rate been
derived for a situation involving two countries? Does this fully reflect the risk of the
project? Is the use of CAPM appropriate as it is a single period model? Other, theoretically
weaker, measures of risk might be useful as an aid to decision-making eg, sensitivity
analysis of the key variables or simulation.
(iv) Cash flow is usually assumed to occur at the end of each year. Greater accuracy would
result if consideration were given to when during the year cash flow arises and these cash
flows discounted at the appropriate rate.
Example Polycalc plc
Polycalc plc is an internationally diversified company. It is presently considering undertaking a capital
investment
CHAPTER in Australia toINVESTMENT
8 – INTERNATIONAL manufacture agricultural fertilizers. The project would require immediate
APPRAISAL
capital expenditure of A$15m, plus A$5m of working capital which would be recovered at the end of the
project’s four year life. It is estimated that an annual revenue of A$18m would be generated by the
project, with annual operating costs of A$5m. Straight-line depreciation over the life of the project is an
allowable expense against company tax in Australia, which is charged at a rate of 50%, payable at each
year-end without delay. The project can be assumed to have a zero scrap value.
Polycalc plans to finance the project with a £5m 4-year loan at 10% from the Eurosterling market, plus
£5m of retained earnings. The proposed financing scheme reflects the belief that the project would
have a debt capacity of two-thirds of capital cost. Issue costs on the Euro debt will be 2½ % and are tax
deductible.
In the UK the fertilizer industry has an equity beta of 1.40 and an average debt:equity gearing ratio of
1:4. Debt capital can be assumed to be virtually riskfree. The current return on UK government stock is
9% and the excess market return is 9.17%.
Corporate tax in the UK is at 35% and can be assumed to be payable at each yearend without delay.
Because of a double-taxation agreement, Polycalc will not have to pay any UK tax on the project. The
company is expected to have a substantial UK tax liability from other operations for the foreseeable
future.
The current A$/£ spot rate is 2.0000 and the A$ is expected to depreciate against the £ at an annual rate
of 10%.
Required:
Using the Adjusted Present Value technique, advise the management of Polycalc on the project’s
desirability.
(v) Political and economic factors should be considered. How stable is the US government
policy? Will a change in government lead to changes in taxation policy, exchange controls,
restrictions on the remittance of funds or attitudes towards foreign investment?
(vi) Are there any intangible benefits of establishing a manufacturing plant in the USA eg
making the American public more aware of Brookday’s product?
Solution to Polycalc
Base-case discount rate
β asset = 1.40 x = 1.20
Base-case discount rate = 9% + (9.17% x 1.20) = 20%
Project tax charge and cash flows in A$m (Years 1 to 4)
Tax Cash flow Revenue 18 18

Operating costs (5) (5)
Depreciation (15 ÷ 4) (3.75)
Taxable profit 9.25
Tax charge @ 50% 4.625 (4.625)
8.375
Base-case net present value calculation in £m
Exch.
Rate 20%
increasing Discount £m PV of
Year A$m at 10% pa £m rate cash flows
1 (15 + 5) = (20) ÷ 2 = (10) x 1 = (10)
2 8.375 ÷ 2.2 = 3.807 x 0.833 = 3.171
3 8.375 ÷ 2.42 = 3.461 x 0.694 = 2.402
4 8.375 ÷ 2.662 = 3.146 x 0.579 = 1.821
5 (8.375 + 5) = 13.375 ÷ 2.9282 = 4.568 x 0.482 = 2.202
Base-case NPV = (£0.404m)
PV of tax shield
Based upon debt capacity created ie
A$15m 2
x = £5m (which happens to be equal to the loan raised)
23
Annual tax relief on interest = £5m x 0.10 x 0.35 = £175,000
PV of tax relief for 4 years: £175,000 x 3.170 = £554,750
PV of issue costs
£5m x 0.025 x (1 − 0.35) = £81,250
Adjusted present value
£m
Base case NPV (0.404) PV of tax shield
0.555 PV of issue costs (0.081)
Adjusted present value £0.07m or +£70,000 approx
Therefore accept project and finance it in the manner indicated.
Chapter 9
Valuations, acquisitions
and mergers – section 1
CHAPTER 9 – VALUATIONS, ACQUISITIONS AND MERGERS: SECTION 1
CHAPTER CONTENTS
REASONS FOR VALUATIONS ------------------------------------------- 147
METHODS OF SHARE VALUATION ------------------------------------- 148
THE DIVIDEND VALUATION MODEL ---------------------------------- 149
DISCOUNTED CASH FLOW BASIS ------------------------------------- 151
PRICE EARNINGS RATIO BASIS --------------------------------------- 153
NET ASSETS BASIS ----------------------------------------------------- 155
DIVIDEND YIELD BASIS ----------------------------------------------- 157
VALUATION OF DEBT AND PREFERENCE SHARES ------------------- 158

IRREDEEMABLE DEBT 158
REDEEMABLE LOAN STOCK 158
PREFERENCE SHARES 159
CONVERTIBLE DEBT 159
THE THREE ACQUISITION TYPES ------------------------------------- 161
TYPE I ACQUISITIONS 161
TYPE II ACQUISITIONS 161
TYPE III ACQUISITIONS 163

HIGH GROWTH START-UPS -------------------------------------------- 166
REASONS FOR VALUATIONS

Valuations of businesses and financial assets may be needed for several reasons, eg
● To establish the terms of takeover bids or mergers;
● To fix a share price for an initial public offering;
● For investors to make buy, hold or sell decisions; ● For capital gains tax or inheritance tax
purposes;
● Where a major shareholder or director wishes to dispose of a large block of shares;
● When the company needs to raise additional finance.
METHODS OF SHARE VALUATION

The main approaches are:
● The dividend valuation model or dividend growth model;
● The discounted cash flow basis;
● The PE ratio (or earnings yield) basis;
● The net assets basis; ● The dividend yield method.
THE DIVIDEND VALUATION MODEL

This method is based upon the fundamental theory of share valuation, whereby a current share price is
taken to reflect the PV of expected future cash flows, discounted at the required rate of return of the
shareholder. In the case of minority shareholders, this would represent the PV to infinity of the future
dividend stream. In the case of majority shareholders, these amounts will be increased by the PV of
synergies achieved as a result of the acquisition.
Example Winterburn plc

The market expects a rate of return of 20% per annum on ordinary shares in Winterburn plc, a company
which is expected to pay constant annual dividends of 20p per share.
At what price will the market value the shares?
Solution to Winterburn plc
D £0.20
P0 = = = £1.00
Ke 0.2
Example Seaman plc

Seaman plc is expected to pay a dividend of 30p per share next year. The market expects dividends to
grow at the rate of 5% per annum and has a required return of 20%.
Estimate the share price.
Solution to Seaman plc
£0.30
D1
P0 = = = £2.00
Ke − g 0.2 − 0.05
Example Merson plc

Merson plc is just about to pay a dividend of 40p per share. Future dividends are expected to grow at
the rate of 6% per annum. The market’s required return on shares of this risk level is 25%.
What is the cum-div share valuation?

Solution to Merson plc
This year’s dividend, D0 = 40p. Next year’s dividend will be a factor of g higher:
D1 = D0 (1 + g) = 40p (1 + 0.06)
= 42.4p
42.4p
D + 40p
P0 = D 1+ 0 Ke − g =
0.25 − 0.06
= £2.63
Example Wright plc

Wright plc has just paid a dividend of 15p per share. The market is in general agreement with directors’
forecasts of 30% growth in earnings and dividends for the next 2 years. Thereafter, a reasonable
estimate is 15% growth in year 3 followed by 6% growth to perpetuity.
The market’s required return on investments of this risk level is 25% per annum.
Estimate the share value.
Solution to Wright plc
For years1 to 3, compute the expected dividends and discount them.
Dividend computation, Years 1 – 3
Year Dividend 25% factor Present value, p

1 15p x 1.3 = 19.5 0.800 15.60
2 19.5p x 1.3 = 25.35 0.640 16.22
3 25.35p x 1.15 = 29.15 0.512 14.93
46.75p
Then compute the dividend for year 4 and ‘plug’ this into the growth formula with g
= 0.06
Year 4 dividend = 29.15p x 1.06 = 30.90p
30.90p
Using the growth formula P3 = = 162.63p 0.25 − 0.06
The growth formula for P is based on dividends from year 1 to perpetuity. Since the dividends in the
above calculation go from year 4 to perpetuity, the value for P above must be at year 3. But we want its
present value at year 0. Therefore we must discount back three further years, using the 3 year factor at
25%, which is
0.512.
Present value at year 0 of dividends from year 4 to perpetuity = 162.63p x 0.512 = 83.27p
Adding the present value of dividends from years 1 to 3 gives:
Share value = 46.75p + 83.27p = £1.30
DISCOUNTED CASH FLOW BASIS

This method is based upon the present value of the free cash flow to equity of an enterprise, either for a
limited time horizon (fifteen years may be regarded as typical) or to infinity.
There are a number of variations in the definition of free cash flow to equity, but it is often described as
follows:
Free cash flow to equity is the cash flow available to a company from operations after interest
expenses, tax, repayment of debt and lease obligations, any changes in working capital and capital
spending on assets needed to continue existing operations (ie replacement capital expenditure
equivalent to economic depreciation)
In theory, this is probably the best method by which to value a company. However it relies on estimates
of cash flows, discount rates, tax rates, inflation rates and the choice of a suitable time horizon. The
notion of using a valuation to infinity is probably unrealistic.
Example Miller Ltd

The predicted free cash flows of Miller Ltd, an all equity company, for its planning horizon, (which for
simplicity is taken to be the next five years) are:
Year Free cash flows

£000
1 150
2 200
3 250
4 375
5 500
A cost of capital of 12% is assumed to represent the systematic risk of the cash flows of Miller Ltd.
What is the estimated market capitalisation of this company?
Solution to Miller Ltd
Year Free cash flows Discount factor Present values

£000 12% £
1 150 0.893 133,950
2 200 0.797 159,400
3 250 0.712 178,000
4 375 0.636 238,500
5 500 0.567 283,500
Estimated market capitalisation for 5 year planning horizon £993,350

Example Morrison Ltd
The following data relating to Morrison Ltd is expected to continue annually for the foreseeable future:
£m
Turnover 525
Cost of goods sold, excluding depreciation 315
Distribution costs and administrative expenses, excluding depreciation 36
Capital allowances claimed 46.5

Non-current assets purchased in the year 72
Irredeemable bonds (market value £130) 21
Working capital changes are assumed to be insignificant because of the absence of growth.
Corporation tax rate 30%
Weighted average cost of capital in nominal (ie money) terms 13.3%
Predicted inflation rate 3%
Calculate the estimated equity market capitalisation of this company.
Solution to Morrison Ltd
Net cash flows
£000
Turnover 525,000
Cost of goods sold (315,000)
Distribution costs and administrative expenses (36,000)
174,000
Tax on operating profits (30% x 174,000) (52,200) Tax saved on writing down allowances
(30% x 46,500) 13,950
Non-current assets purchased (72,000) Annual net cash flows 63,750
Real discount rate (using Fisher effect)
r = −1 = −1 = 10%
Since the annual net cash flows are perpetuities expressed in terms of real cash flows, it has been
necessary to establish a real discount rate.
£000
63,750
Corporate value 637,500
%
Less market value of irredeemable bonds (21,000 x 1.3) (27,300)
Equity market capitalisation 610,200
PRICE EARNINGS RATIO BASIS
This income based method is popular for the valuation of majority holdings in a going concern. It
requires the prediction of a maintainable EPS for the company being valued and the use of the PE ratio of
a listed company, whose activities are very similar to those of the business being valued ie
Share value = EPS of company being valued x PE of similar listed company
If a similar listed company (pure−play company) is not readily available, it may be appropriate to use the
average PE for the market sector in which the company operates.
It may be necessary to adjust the PE used or the final calculated price, if the company being valued is an
unlisted company, or where the company in question has different risk or different growth potential from
the similar company or constituents of the industry average.
Since an earnings yield is simply a reciprocal of the PE ratio, a valuation on an earnings yield basis would be
as follows:
Share value = EPS of company being valued ÷ earnings yield of similar listed company.
Example Flycatcher Ltd

Flycatcher Ltd wishes to make a takeover bid for the shares of an unlisted company, Mayfly Ltd. The
earnings of Mayfly Ltd over the past five years have been as follows.
2002 £50,000 2005 £71,000

2003 £72,000 2006 £75,000
2004 £68,000
The average P/E ratio of listed companies in the industry in which Mayfly Ltd operates is 10. Listed
companies which are similar in many respects to Mayfly Ltd are:
Bumblebee plc, which has a P/E ratio of 15, but is a company with very good growth prospects;
Wasp plc, which has had a poor profit record for several years, and has a P/E ratio of 7.
What would be a suitable range of valuations for the shares of Mayfly Ltd?
Solution to Flycatcher Ltd
Earnings. Average earnings over the last five years have been £67,200, and over the last four years
£71,500. There might appear to be some growth prospects, but estimates of future earnings are
uncertain.
A low estimate of earnings in 2007 would be, perhaps, £71,500.
A high estimate of earnings might be £75,000 or more. This solution will use the most recent earnings
figure of £75,000 as the high estimate.
P/E ratio. A P/E ratio of 15 (Bumblebee’s) would be much too high for Mayfly Ltd, because the growth of
Mayfly Ltd earnings is not as certain, and Mayfly Ltd is an unlisted company.
On the other hand, Mayfly Ltd’s expectations of earnings are probably better than those of Wasp plc.
A suitable P/E ratio might be based on the industry’s average, 10; but since Mayfly is an unlisted company
and therefore more risky, a lower P/E ratio might be more appropriate: perhaps (60% to 70% of 10) = 6 or
7, or conceivably even as low as (50% of 10) = 5.
Valuation. The valuation of Mayfly’s shares might therefore range between:
High P/E ratio and high earnings: 7 x £75,000 = £525,000; and
Low P/E ratio and low earnings: 5 x £71,500 = £357,500
NET ASSETS BASIS

Asset-based valuation models include:
● net book value (balance sheet basis) – largely a meaningless figure, since it is affected by
accounting conventions;
● net realisable value basis – again, not particularly relevant. However, where the break-up value
exceeds income-based valuations, it would be advisable for the proprietor to cease trading and
sell the assets as quickly as possible;
● net replacement cost basis – this represents the current cost of setting up the existing business.
Sadly it totally ignores goodwill, which can only be established by using income-based valuations.
Example Cactus Ltd

The current balance sheet of Cactus Ltd is as follows:
£ £
Fixed assets
Land and buildings 160,000 Plant and machinery 80,000
Motor vehicles 20,000
Goodwill 20,000
280,000
Current assets Stocks 80,000
Debtors 60,000
Short-term investments 15,000
Cash 5,000 160,000
440,000
£ £
Capital and reserves
Ordinary shares of 50p 80,000
Reserves 140,000
220,000
4.9% preference shares of £1 50,000
270,000
12% debentures 60,000 Deferred taxation 10,000
70,000
Creditors: amounts falling due within one year
Creditors 60,000
Taxation 20,000
Proposed ordinary dividend 20,000
100,000
440,000
What is the value of an ordinary share using the net assets basis?
Solution to Cactus Ltd
THERE IS INSUFFICIENT INFORMATION TO ANSWER THIS QUESTION, BUT AN ATTEMPT MUST BE MADE,
OTHERWISE NO MARKS WILL BE GAINED, ie:
£
Total value of net assets 270,000
Less: Goodwill (20,000)
Preference shares (50,000)
Net asset value of equity £200,000
Number of ordinary shares (of 50p each) 160,000

Share price £1.25
NOW STATE THAT FAIR VALUE (UNDER IFRS 3 OR FRS 7) DETAILS ARE NEEDED FOR A DECENT ANSWER!
FURTHERMORE, HOW DOES ONE ESTABLISH GOODWILL?
DIVIDEND YIELD BASIS

This income based method is popular for the valuation of minority holdings in a going concern. It
requires the prediction of a maintainable dividend for the company being valued and the use of the
dividend yield of a listed company, whose activities are very similar to those of the business being valued,
ie:
Dividend of the company being valued

Share value =
Dividend yield of similar listed company
If a similar listed company (pure−play company) is not readily available, it may be appropriate to use the
average dividend yield for the market sector in which the company operates.
It may be necessary to adjust the calculated price if the company being valued is an unlisted company, or
where the company in question has different risk or different growth potential from the similar company
or constituents of the industry average.
Care must be taken to ensure consistency in the treatment of tax credits ie look at the information given
in a question very carefully to establish whether the yields given are net or gross dividend yields and
whether the dividends provided include or exclude related tax credits.
Example Taylor Ltd

Taylor Ltd, which has on issue £500,000 ordinary shares of 25p each, intends to pay a constant dividend of
£360,000 (net) for the foreseeable future. Listed companies within the same industry sector as Taylor Ltd
currently provide a gross dividend yield of 5% p.a. The current rate of tax credit on gross dividends is 10%
(ie 1/9th of net dividend).
Estimate a current share price for Taylor Ltd.
Solution to Taylor Ltd
Number of ordinary shares on issue = 2,000,000

£360,000
Expected net dividend per share = = 18p
2,000,000
Expected gross dividend per share = 18p + (1/9 x 18p) = 20p
Net dividend yield for market sector = 5% x 0.9 = 4.5%
Gross dividend 20p
Share price = = = £4.00
Gross yield 5%
Net dividend 18p
or = = £4.00
Net yield 4.5%
Since Taylor Ltd is a private company the calculated share price of £4.00 could be reduced by between
30% to 50%, ie around £2.80 to £2.00, due to lack of marketability.
VALUATION OF DEBT AND PREFERENCE SHARES
Irredeemable debt
Example Koren plc

Koren plc has on issue 7% irredeemable loan stock. The gross return required by investors is 5% p.a. The
corporation tax rate is 30%.
Establish the current market value for this stock.
Solution to Koren plc
Gross interest payment 7% × 100

Market value = = = £140
Gross yield 5%
Redeemable loan stock
Example Beattie plc

Beattie plc has issued £1,000,000 of 6% redeemable bonds. Interest payments will be made at the end of
March, June, September and December of each year until redemption occurs on 30 June 2010 at £120 per
cent. Bondholders require a gross redemption yield of 1% per quarter.
Calculate the current market value of these bonds at 1 January 2007.
Solution to Beattie plc
6% × £1,000,000
Interest payment for 14 quarters = = £15,000
Redemption value = 120% x £1,000,000 = £1,200,000
Market value
Period Cash flow Discount factor 1% per Present value

quarter
£ £
1-14 15,000 13.00 195,000
14 1,200,000 0.870 1,044,000
Market value of redeemable bonds £1,239,000
Since there are 10,000 bonds on issue each with a £100 par value, an individual bond has a market value
of:
£1,239,000
= £123.90
,000
Preference shares
Example Steele Ltd

Steele Ltd has on issue some 9% preference shares of £1 nominal value. Investors require a return of
12.5% p.a. on these shares.
Estimate the current market price per share.
Solution to Steele Ltd
D 9% × £1
P0 = = Kps = 72p
0.125
Convertible debt
The value of a convertible cannot fall below its value as debt, but upside potential exists due to the
possibility of an increase in the share price prior to expiry of the conversion period.
Therefore the theoretical value of a convertible (known as its “formula value”) is the greater of its value
as debt and its value as shares ie its conversion value. In practice the actual price of convertibles will
tend to trade at a value in excess of formula value, reflecting so called “time value” ie the possibility that
the share price could rise prior to expiry of the conversion period.
Example Kiely plc

Kiely plc has 11% convertible loan notes on issue. Each £100 unit may be converted at any time up to the
date of expiry (in seven years time) into 15 fullypaid ordinary shares in Kiely plc. Any loan notes which
remain outstanding at the end of the seven year period are to be redeemed at £120 per cent.
Loan note holders normally require a yield of 9% p.a. on seven year debt.
Recommend whether investors should convert, if the current share price is:
(a) £7.0
0, or
(b) £8.0
0, or (c) £9.00.
Solution to Kiely plc
Value as debt (ie if conversion does not take place):
Discount Present
End of year
factor value
£ 9% £
1 - 7 Gross annual interest 11 5.033 55.36 7 Redemption value 120 0.547 65.64
Value as debt 121.00
Value as equity Value as debt Formula value Convert ?
(a) (15 shares @ £7) = £105 £121 £121 NO
(b) (15 shares @ £8) = £120 £121 £121 NO
(c) (15 shares @ £9) = £135 £121 £135 YES
Notice that there is no need to calculate the present value of the share price, since under the
fundamental theory of share valuation a current share price reflects the PV of the future cash flow
streams associated with holding the share.
The conversion price where the investor would be indifferent between redemption and conversion is
(£121 ÷ 15 shares) ie £8.07. The value of the convertible will never fall below its value as debt (£121).
However if the share price rises above £8.07, the convertible loan notes will then reflect the value of the
equity receivable on conversion.
THE THREE ACQUISITION TYPES
Type I acquisitions
These are acquisitions that do not disturb the acquirer’s exposure to either business risk or financial risk.
In theory, the value of the acquired company, and hence the maximum amount that should be paid for it,
is the Present Value of the future cash flows of the target business discounted at the WACC of the
acquirer. The valuation techniques already considered would deal adequately with this type of business
combination.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do impact upon the
acquirer’s exposure to financial risk, eg through changing the gearing levels of the acquirer. Such
acquisitions may be valued using the Adjusted Present Value (APV) technique by discounting the Free
Cash Flows of the acquiree using an ungeared cost of equity and then adjusting for the tax shield.
Example Heincarl plc

The directors of Heincarl plc are considering the acquisition of Newscot Ltd, an unlisted company. The
shareholders of Newscot Ltd are willing to sell the business on 1 st January 2009 for £500 million. From
the perspective of the directors of Heincarl plc, the projections of the performance of Newscot Ltd are as
follows:
Current
Projections during planning horizon (years)
year
2008 2009 2010 2011 2012 2013 2014
£m £m £m £m £m £m £m
EBITDA 117.00 138.70 162.57 188.83 217.71 249.48 251.48
(40.00) (42.00) (44.00) (46.00) (48.00) (50.00) (52.00)
Depreciation
&
amortisation
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Interest
charges _ -_ (32.00) (26.88) (20.19) (11.73) (1.28) _ -__
Profit before
tax 77.00 64.70 91.69 122.64 157.98 198.20 199.48
The assumed rate of corporation tax is 35% p.a. The terminal value of the investment is treated as a
constant perpetuity equal to the free cash flows for the year 2014. The risk free rate of interest is
assumed to be 6% p.a., the return on a market portfolio is taken to be 13.5%, whilst an asset beta of 1.1
is used for purposes of the appraisal.
Annual capital expenditure from 2008 onwards is estimated at £20 million each year indefinitely.
Newscot Ltd currently has on issue £400 million of 8% debt and it is intended that all available cash flows
should be applied to repaying this debt at the earliest opportunity.
Advise the directors of Heincarl plc whether to proceed with the acquisition.
Solution to Heincarl plc
Calculation of Keu
Keu = Rf + (Rm – Rf) βa = 6% + (13.5% – 6%) 1.1 = 14.25%
Calculation of Free Cash Flow of Newscot Ltd
2008 2009 2010 2011 2012 2013 2014

£m £m £m £m £m £m £m
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Less CT @
35% (26.95) (33.84) (41.50) (49.99) (59.40) (69.82) (69.82)
50.05 62.86 77.07 92.84 110.31 129.66 129.66
Add back
Depreciation Less 40.00 42.00 44.00 46.00 48.00 50.00 52.00
Capital
expenditure (20.00) (20.00) (20.00) (20.00) (20.00) (20.00) (20.00)
Company
Free Cash
Flow 70.05 84.86 101.07 118.84 138.31 159.66 161.66
Total
£m
Discount factor
(14.25%) - 0.875 0.766 0.671 0.587 0.514

PV (£m) - 74.25 77.42 79.74 81.19 82.07 394.67
161.66
From 2014 to infinity: × 0.514 = 583.11
0.1425
PV to infinity of Company Free Cash Flow 977.78
Tax Shield (discounted at Kd of 8%)
(32.00 x 35% x 0.926) + (26.88 x 35% x 0.857) + (20.19 x 35% x 0.794)

+ (11.73 x 35% x 0.735) + (1.28 x 35% x 0.681) = 10.37 + 8.06 + 5.61 + 3.02 +
0.31 = 27.37
APV £m
Corporate value (977.78 + 27.37) 1005.15
Less Value of debt (400.00)
Value of equity 605.15
Less Purchase consideration (500.00)
APV 105.15
Therefore, the directors of Heincarl plc should proceed with the acquisition of Newscot Ltd.
Type III acquisitions
These are acquisitions that impact upon the acquirer’s exposure to both business risk and financial risk.
In order to estimate WACC there is a need to establish the cost of capital of the combined businesses.
However, the Ke of the combination is dependent upon the price paid for the equity capital of the target,
but it is impossible to establish the price to be paid until the value of the target is determined.
Example Edwards plc

Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order to achieve backward
vertical integration. Considerable savings are anticipated due to the combination of both the marketing
operations and distribution networks of the two companies. Therefore synergies will arise to create cash
flows which are in excess of the current estimated cash flows of the two separate companies. Upon the
acquisition of Colman Ltd, Edwards plc will immediately sell one of the warehouses of the target
company, providing instant cash inflows of £5 million. The forecast cash inflows of the merged
businesses are as follows:
Year £ millions Year £ millions

2008 (proceeds from warehouse 5.00 2014 92.32 sale)
2009 60.00 2015 100.63
2010 65.40 2016 109.68
2011 71.29 2017 119.55
2012 77.70 2018 130.29
2013 84.69 Terminal value 2,396.84
The forecast rate of corporation tax is expected to remain at 30%. The risk free rate of interest is to be
taken at 5% and the expected return on a market portfolio is 9%.
Information currently relating to the two companies is as follows:
Edwards plc Colman Ltd

£m £m
Market values: Debt 100 20 Equity 900 280
Total 1,000 300
β asset 0.9 2.4
Cost of debt 7% 7%
Edwards plc plans to make a cash offer of £380 million for the purchase of the entire share capital of
Colman Ltd. This cash offer will be funded by additional borrowings undertaken by Edwards plc.
Advise the directors of Edwards plc whether to proceed with the acquisition.
Solution to Edwards plc
β asset of combined company
1,000 300
βa= × 0.9 + × 2.4 = 1.25
1,000 + 300 1,000 + 300
β equity of combined company

Revised gearing levels are: £m
E = 900 + 280 = 1,180
D = 100 + 20 + 380 = 500
1,680
E + D (1 − t) 1,180 + 500 (1− 0.3)

= 1.62
βe = βa × = 1.25 ×
E 1,180
Cost of equity
Ke = 5% + (9% − 5%) 1.62 = 11.48%
Weighted average cost of capital
WACC = × 11.48% + × 7% × (1− 0.3) = 9.52%
Present value of combined cash flows

Discount factor
Cash flows of Present value @
combined entity (9.52%) 9.52%
£m £m
2008 5.00 1 5.00
2009 60.00 1÷1.0952 54.78
2010 65.40 1÷1.09522 54.52
2011 71.29 1÷1.09523 54.27
2012 77.70 1÷1.09524 54.01
2013 84.69 1÷1.09525 53.75
2014 92.32 1÷1.09526 53.50
2015 100.63 1÷1.09527 53.24
2016 109.68 1÷1.09528 52.99
2017 119.55 1÷1.09529 52.74
2018 130.29 1÷1.095210 52.48
Terminal value 2,396.84 1÷1.095211 881.48
1,422.76
Value of equity
£m
PV of combined entity 1,422.76
Less combined value of debt (500.00)
Value of equity 922.76 Therefore the combination is beneficial to the shareholders of Edwards plc, since the
value of their equity shareholding will increase from £900 million to £922.76 million.
However, one further major problem remains! There is an inconsistency! In the weightings used for the
WACC calculation, (1,180 ÷ 1,680) about 70% has been applied to equity, whilst (500 ÷ 1,680) about 30%
has been used for debt. On the other hand, ultimately the value of equity has been shown to represent
(922.76 ÷ 1,422.76) about 65% of corporate value and the value of debt (500 ÷ 1,422.76) about 35% of
corporate value.
Where these two sets of weights differ significantly an inconsistent valuation will occur. There is then a
need to adopt an iterative revaluation procedure to achieve consistency between the WACC and the
corporate value. This would involve a recalculation of βe, using weightings that are closer to those
derived from the valuation. This procedure would be continuously repeated until the assumed weights
and the weightings ultimately derived from the corporate valuation are reasonably consistent.
Thankfully this iterative process is not performed manually, since it can be calculated in Excel (shown in
Tools > Options > Calculation). The consistent results of the iterative revaluation procedure apparently
work out as follows:
£m
PV of combined entity 1,395.45
Less combined value of debt (500.00)
Value of equity 895.45
βe will now become: 1.25× = 1.74
Ke is now revised to become: 5% + (9% − 5%) 1.74 = 11.96%
The weighted average cost of capital is revised to:
WACC = × 11.96% + × 7% × (1− 0.3) = 9.43%
The increased proportion of debt (500 ÷ 1,395.45) ie about 36% of corporate value has caused both βe
and Ke to increase, whilst there has been a slight reduction in WACC due to the larger weighting applied
to debt.
Since the value of equity has now fallen to £895.45 million, which is below the current value of the equity
shares in Edwards plc (ie £900 million), the acquisition would cause a reduction in shareholder wealth of
£4.55 million. The business combination should thus be abandoned.
HIGH GROWTH START-UPS
The valuation of Start-ups create additional problems to that of well established businesses. This may be
due to:
● their lack of a proven track record,
● initial on-going losses,
● untested products with little market acceptance,
● little market presence,
● unknown competition,
● high development costs, and
● inexperienced managers with over-ambitious expectations of the future.
The valuation procedures depend upon the reasonableness of financial projections, the length of the
period chosen for long-term projections and the selection of future growth rates. The growth in earnings
may be forecast using Gordon’s growth approximation ie g = br, where normally b = 1, since all profits
made are likely to be reinvested into the business. Therefore the sole determinant of growth is the
measure of “r”.
The decision as to growth expectations is rather critical as shown in the following illustration:
Example Bednar plc

Bednar plc anticipates costs of £1,200 million in the coming year, thereafter growing at a rate of 4% per
annum. The anticipated revenues for that year are expected to be £320 million. The company expects to
achieve a return on reinvested funds of between 16% and 18% per annum. Furthermore the directors of
Bednar plc do not anticipate the payment of any dividends for the foreseeable future.
Using a cost of equity of 20% p.a., produce a valuation for Bednar plc based upon both the maximum and
the minimum growth rate predictions, using the Growth Model combined with Gordon’s growth
approximation.
Solution to Bednar plc
Since no dividends are expected to be paid, b = 1
Maximum valuation
Growth prediction: (g = br) g = 1 x 0.18 Valuation using the = 18%

Growth Model:
320 1,200 = £8,500 million
− = 16,000 – 7,500 20% −18% 20% − 4%
Minimum valuation
Growth prediction: (g = br) g = 1 x 0.16 Valuation using the = 16%
Growth Model:
320 1,200
− = 8,000 – 7,500 = £500 million
% −16% 20% − 4%
Growth rates are affected by changes in technology, management competence, demand and inflation
levels, and are therefore extremely difficult to predict. Notice the dramatic change in the business
valuation that has been caused by a slight change in the predicted rate of growth.
Chapter 10
CHAPTER CONTENTS
MERGERS AND ACQUISITIONS ---------------------------------------- 171
1. SYNERGY 171
2. HIGH FAILURE RATE OF ACQUISITIONS IN ENHANCING SHAREHOLDER VALUE 172
3. MODE OF OFFER 173
4. STRATEGIC DEFENCES 176
5. REGULATION OF TAKEOVERS 177
6. COMPETITION COMMISSION IN UNITED KINGDOM 177
DARK POOL TRADING -------------------------------------------------- 178
MERGERS AND ACQUISITIONS
1. Synergy
● An expansion policy based on merger or takeover can be justified on the basis of synergy.
(Sometimes stated as 2 + 2 = 5) ie
Value of A plc Value of A plc Value of B plc and B plc combined > operating + operating
independently independently
Acquisitions and mergers are ultimately justified as leading to an increase in shareholder wealth.
● The potential for synergy is often classified as follows:
Revenue synergy: Sources of which include:
o Economies of vertical integration;
o Market power and the elimination of competition ie the desire to earn monopoly profits
(which is good for shareholders but not in the public interest);
o Complementary resources eg a company with marketing strengths could usefully combine

with the company owning excellent research and development facilities.
Cost synergy: Sources of which include:
o Economies of scale (arising from eg larger production volumes and bulk buying);
o Economies of scope (which may arise from reduced advertising and distribution costs
where combining companies have duplicated activities); o Elimination of inefficiency; o
More effective use of existing managerial talent. Financial synergy: Sources of which
include:
o Elimination of inefficient management practices;
o Use of the accumulated tax losses of one company that may be made available to the
other party in the business combination; o Use of surplus cash to achieve rapid expansion;
o Diversification reduces the variance of operating cash flows giving less bankruptcy risk and
therefore cheaper borrowing;
o Diversification reduces risk (however this is a suspect argument, since it only reduces total
risk not systematic risk for well diversified shareholders);
o High PE ratio companies can impose their multiples on low PE ratio companies (however
this argument, known as “bootstrapping”, is rather suspect).
● Conclusions on Synergy o Synergy is not automatic
o When bid premiums are considered, the consistent winners in mergers and takeovers are
victim company shareholders.
2. High failure rate shareholder of acquisitions in enhancing

value
In practice, the shareholders of predator companies seldom enjoy synergistic gains, whereas the
shareholders of victim companies benefit from a takeover. The acquiring company often pays a
significant premium over and above the market value of the target company prior to acquisition; this
problem is particularly acute for the successful predator following a contested takeover bid.
The reasons advanced for the high failure rate of business combinations from the perspective of the
predator shareholders are as follows:
● Agency theory suggests that takeover bids are primarily motivated by the self- interest of the
managers of bidding companies. Often free cash flow may be used to increase the size of their
company in order to enhance the status of directors who wish to be seen as heading a large listed
plc. Diversification of the activities of the predator may provide job security for the directors of
such companies;
● Over-optimistic assessment of the economies of scale or economies of scope that may be

achieved as a result of the business combination;
● Inadequate investigation of the victim company prior to the bid being made, or insufficient
appreciation of the problems that may arise after the acquisition takes place (eg the difficulties
experienced by Wm. Morrison Supermarkets following the takeover of Safeway);
● Following a successful bid, the directors and managers of the predator become too keen to
identify their next victim, instead of devoting time to ensuring that the company that they have
already taken over provides the expected synergies;
● Directors of the predator company become so obsessed with the success of their bid that they fail
to seek alternative target companies. Furthermore, their valuations of the victim and their
justifications for the acquisition become exaggerated.
3. Mode of offer
Cash consideration
The offer is made to purchase the shares of the target company for cash. This method is very
appropriate for relatively small acquisitions, unless the acquirer has accumulation of cash from
operations or divestments.
The advantages of cash offer to the target entity’s shareholders are that:
● The price that they will receive is obvious. It is not like share exchange where the movements in
the market price may change their wealth.
● The cash purchase increases the liquidity of the target shareholders who are in position to alter
their investment portfolio to meet any changing opportunities.
A disadvantage to target shareholders’ for receiving cash is that if the price that they receive is on sale is
more than the price paid when purchasing the shares, they may be liable to capital gains tax.
The advantages to the predator company are that:
● The value of the bid is known and target company shareholders’ are encouraged to sell their
shares.
● It represents a quick and easily understood approach when resistance is expected.
● The shareholders of the target company are bought out and have no further participation in the
control and profits of the combined entity.
The main disadvantages to the predator company are that it may deplete the company’s liquidity
position and may increase gearing.
Methods of raising cash

The predator company can raise cash from many sources to finance the acquisition, some of the sources
are:
Borrowing to obtain cash
The predator company may not have enough cash immediately available to finance the acquisition and
may have to raise the necessary cash through bank loans and issuing of debt instruments.
Mezzanine finance
Mezzanine finance is a form of finance that combines features of both debt and equity. It is usually used
when the company has used all bank borrowing capacity and cannot also raise equity capital.
It is a form of borrowing which enables a company to move above what is considered as acceptable
levels of gearing. It is therefore of higher risk than normal forms of borrowing.
Mezzanine finance is often unsecured.

It offers equity participation in the company either through warrants or share options. If the venture
being financed is successful the lender can obtain an equity stake in the company.
Retained earnings
This method is used when the predator company has accumulated profits over time and is appropriate
when the acquisition involves a small company and the consideration is reasonably low. This method
may be the cheapest option of finance.
Vendor placing
In a vendor placing the predator company issues its shares by placing the shares with institutional
investors to raise the cash required to pay the target shareholders.
Share exchange
The predator company issues its own shares in exchange for the shares of the target company and the
shareholders of the target company become shareholders of the predator company.
The advantages of a share exchange to target shareholders include:
● Capital gains tax is delayed.
● The shareholders of the target company will participate in the control and profits of the
combined entity.
The main disadvantage is that there is uncertainty with a share exchange where the movements in the
market price may change their wealth.
The advantages to the predator company are that:
● It preserves the liquidity position of the company as there are no outflows of cash.
● Share exchange reduces gearing and financial risk. However, this may depend on the gearing of
the target company.
● The predator company can bootstrap earnings per share if its price earnings ratio is higher than
that of the target company.
The main disadvantages of a share exchange are that:
● It causes dilution in control.
● It may cause dilution in earnings per share.
● As equity shares are issued this comparatively more expensive than debt capital.
● The company may not have enough authorized share capital to issue the additional shares
required.
Debentures, loan stock and preference shares
Very few companies use debentures, loan stock and preference shares as a means of paying a purchase
consideration on acquisitions.
The main problems of using debentures and loan stock to the predator company are that:
● It affects gearing and financial risk.
● Difficulty in determining appropriate interest rate to attract the shareholders of the target
company.
● Availability of collateral security against repayment.
The main advantages of using debentures and loan stock are that:
● Interest payments are a tax allowable expense.
● Cost of debt is cheaper than equity.
● Does not dilute control.
The main problems of using preference shares are that:
● Dividends on preference shares are fixed and not tax allowable.
● May not be attractive to target shareholders as preference shares carry no voting power.
● Preference shares are less marketable.
Earn-out arrangements
An earn-out arrangement is where the purchase consideration is structured such that an initial payment
is made at the date of acquisition and the balance is paid depending upon the financial performance of
the target company over a specified period of time.
The main advantages of earn-out arrangements are that:
● Initial payment is reduced.
● The risk to the predator company is reduced as it is less likely to pay more than the target is
worth. The price is limited to future performance.
● It encourages the management of the target company to work hard as the overall consideration
depends on future performance.
4. Strategic defences
Post-bid
A target company can use the following to defend itself against a possible takeover:
● Try to convince the shareholders that the terms of the offer are unacceptable. This can be done
using the following:
o Attempt to show that the current share price of the company is unrealistically low relative
to the future potential. Assets revaluation, new profit forecasts, dividends and promises
of rationalisation are commonly employed here.
o If it is for share for share exchange, the target company can attempt to convince the
shareholders that the offer’s equity is currently overvalued. The suitability of the bidding
company to run the merged business can also be questioned.
● Lobbying the office of fair trading and or the department of trade and industry to have the offer
referred to the competition commission. This will at least delay the takeover and may prevent it
completely.
● Launching an advertising campaign against the takeover bid. One technique is to attack the
account of the predator company.
● A reverse takeover (Pac Mac), that is make a counter offer for the predator company. This can be
done if the companies are of reasonably similar size.
● Finding a ‘white knight’, a company which will make a welcome takeover bid. This involves
finding a more suitable acquirer and promoting it to compete with the predator company.
● Crown jewels (or scorched earth) policy, with the approval of shareholders in general meeting.
Pre-bid
● Selling crown jewels – the tactic of selling off certain highly valued assets of the company subject
to a bid is called selling the crown jewels. The intention is that, without the crown jewels, the
company will be less attractive.
● Golden parachutes – this is a policy of introducing attractive termination packages for the senior
executives of the victim company. This makes it more expensive for the predator company.
● Shark repellent – super-majority. The articles of association are changed to require a very high
percentage of shares to approve an acquisition or merger, say 80%.
● Poison pill
The most commonly used and seeming most effective takeover defence is the so called poison
pill.
An example is the Flip-in pill. This involves the granting of rights to shareholders, other than the
potential acquirer, to purchase the shares of the target company at a deep discount. This dilutes
the ownership interest of the potential acquirer.
5. Regulation of takeovers
The regulation of takeovers varies from country to country and mainly concentrates on controlling
directors in order to ensure that all shareholders are treated fairly.
Typically, the rules will require the target company to:
● notify its shareholders of the identity of the bidder and the terms and conditions of the bid;
● seek independent advice;
● not issue new shares or purchase or dispose of major assets of the company, unless agreed prior
to the bid, without the agreement of a general meeting;
● not influence or support the market price of its shares by providing finance or financial guarantees
for the purchase of its own shares;
● the company may not provide information to some shareholders which is not made available to all
shareholders;
● shareholders must be given sufficient information and time to reach a decision. No relevant
information should be withheld;
● the directors of the company should not prevent a bid succeeding without giving shareholders the
opportunity to decide on the merits of the bid themselves.
Directors and managers should disregard their own personal interest when advising shareholders.
6. Competition commission in United Kingdom

Under the terms of this commission, the office of fair trading (OFT) is entitled to scrutinise all major
mergers and takeovers. If the OFT thinks that a merger or takeover might be against the public interest,
it can refer it to competition commission. If no referral is made to the commission within normally 20
days, the merger can proceed without fear of a referral.
The function of the competition commission is to advise the government. The commission can make
recommendations to the relevant government department or to any other body including the
companies involved in the bid.
The result of the investigation by the commission might be:
● Withdrawal of the proposal for the merger or takeover, in anticipation of it rejection by the
commission.
● Acceptance or rejection of the proposal by the commission.
● Acceptance of the proposal by the commission subject to the new company agreeing to certain
conditions laid down by the commission, for example on prices, employment or arrangement for
the sale of the group’s products.
DARK POOL TRADING
The recent financial crisis has seen the alleged (see newspaper article below) growth of a practice, which
is sometimes referred to as “Dark pool trading”. It is also known as “Dark pool liquidity”, the “Upstairs
market”, “Dark liquidity” or simply “Dark pool”.
The term “Dark pool” relates to trades which are concealed from the public – as if they had been
undertaken in “pools of murky water”. Many traders believe that such activities should be publicised in
order to make trading more fair for all parties involved, so that all such transactions are performed on “a
level playing field”.
Dark pool trading refers to the volume of trade created by institutional investors in financial trading
venues or “crossing networks” that are unavailable to the general public. The bulk of Dark pool liquidity
is represented by block trades undertaken away from the central exchanges. Such transactions are
never displayed and are useful for institutions who wish to deal in large numbers of shares, whilst not
revealing such trades to the open market.
Dark liquidity pools avoid the risk of revealing the actions of such institutions, since neither the identity
of the trader nor the price at which the transactions took place are displayed. Dark pools are recorded
as over-the-counter transactions, but detailed information is only reported to clients if they so desire
and are under a contractual obligation to do so.
The Upstairs market allows Fund managers to move large blocks of equity shares without revealing
details as to what has actually occurred. The lack of human intervention within the electronic platforms
employed has reduced the time scale for such trades. The increased responsiveness of equity price
movements has made it extremely difficult to trade large blocks of shares without affecting the price.
A report in “The Independent” newspaper on 25th May 2010 stated:
“Six big investment banks published trading volumes for their “dark pools” for the first time yesterday,
showing them as a tiny fraction of the market and not the major hidden rivals to stock exchanges that
some argue.
Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS together executed
€596 million (£513 million) of equity trades from 15 countries on their automated crossing systems on
Friday, according to Markit data.
That accounted for about 0.4 per cent of all types of cash equity trades in Europe and 1.6 per cent of all
over-the-counter (OTC) trades reported on the Markit BOAT service that day, according to Thomson
Reuters data.
Dark pools are electronic platforms that allow would-be buyers and sellers of large orders of shares to
avoid revealing pre-trade information and signalling their intentions to the rest of the market.
Bankers argue that for the bulk of OTC trades they act purely as dealers, using their own money or share
inventories to take one or another side, or they act in a non-automated way to match buyers and sellers
for big blocks of stock.”
Chapter 11
CHAPTER CONTENTS
SHAREHOLDER VALUE ADDED (SVA) --------------------------------- 181

VALUE DRIVERS 181
STRENGTHS OF SVA 182
PROBLEMS 183
ECONOMIC VALUE ADDED (EVA) -------------------------------------- 184
STRENGTHS OF EVA 186
PROBLEMS OF EVA 186
INTELLECTUAL CAPITAL ----------------------------------------------- 187

VALUING INTANGIBLE ASSETS/INTELLECTUAL CAPITAL 187
SHAREHOLDER VALUE ADDED (SVA)

Shareholder value added was developed in the 1980’s from the work of Rappaport and focuses on the
value creation using the NPV approach. Thus SVA assumes that the value of a business is the present
value of its future cash flows discounted at the appropriate cost of capital.
Shareholder value added involves calculating the present value of the projected future free cash flows to
equity of the business. Any increase in the present value should result in an equivalent increase in
market value added and thus increase shareholder wealth.
Value drivers
Seven key factors, called value drivers, are identified as being fundamental to the determination of value:
● sales growth rate;
● operating profit margin;
● tax rate;
● incremental fixed capital investment;
● incremental working capital investment;
● the planning horizon;
● the required rate of return.
The model assumes a constant percentage rate of sale growth and a constant operating profit margin.
Tax is assumed to be a constant percentage of operating profit. Finally, fixed and working capital
investments are assumed to be a constant percentage of change in sale.
Free cash flows

Given sales for the current year and the input values for the various percentage relationships, the operating free
cash flows can be calculated as:
Free cash flows = operating profit – tax – incremental investment in fixed and working capital.
Corporate value
Using the free cash flows, corporate value is then computed using the company’s WACC as a discounting factor:
Corporate value = PV of free cash flows + current value of marketable securities and other non operating
investment.
Share value
The share value may then be calculated as:
SV = Corporate value – Debt

Example 1 Zoozo Ltd
The following information is available for Zoozo Ltd.
Sales growth rate 15% pa
Current sales £10m

Operating profit margin 6%
Tax rate 35% of Operating profit
Incremental fixed capital investment 15%of changes in sales
Incremental working capital investment 10% of changes in sales
WACC 20%
Perpetuity planning horizon
Debt capital 600,000 Investment in shares and other
securities 530,000
Required:
Compute Zoozo’s corporate value and share value.
Solution to Zoozo Ltd
In year one free cash flows is calculated as:
Sales £10m x 1.15 £11.5m

Operating profit £11.5 x 6% £690,000
Tax 690,000 x 35% (£241,500)
Fixed capital investment (11.5 – 10) x 15% (£225,000)
Working capital investment (11.5 - 10) x 10% (£150,000)
Free cash flows 73,500
This means that £73500 is available to be distributed to the suppliers of finance after investment in non-current
assets and working capital.
Since the planning horizon is in perpetuity, we can calculate the PV of free cash flows using the dividend
valuation approach as:
FCF
PV =
R-g
Where: FCF = free cash flows

R = WACC
g = growth rate of sales
PV of FCF = =£1.47m 0.
Corporate value = 1.47 + 0.53 = 2m
Share value = 2 - 0.6 = £1.4m
Strengths of SVA
● Simple approach.
● It is consistent with the concept of share valuation by DCF.
● It creates management awareness of the key value variables (drivers).
● Sensitivity analysis can be applied to each of the value drivers.

Problems
● The constant percentage assumptions may be unrealistic.
● The input data may not be easily available from current system.
● There are subjective judgments necessary to determine the value drivers.
ECONOMIC VALUE ADDED (EVA)

EVA developed by Stern Stewart focuses on the concept of economic income. Economic income is the
income generated by the company less investors required return on capital.
EVA is based on simple concept that a business must make economic profit in excess of the cost of capital
that has been invested to earn that profit in order to add to its economic value.
EVA is simply calculated as:
EVA = NOPAT – CAPITAL CHARGE
NOPAT = net operating profit after tax
Capital charge = investor required return on capital, calculated as:
(WACC x Adjusted capital employed)
Calculating EVA
To calculate EVA the following steps can be followed:
● Calculate the net operating profit after tax (NOPAT).
● Calculate the adjusted/economic capital employed.
● Find the weighted average cost of capital (WACC) of the company.
● Calculate capital charge as the WACC multiplied by the adjusted/economic capital employed.
● Calculate the EVA as difference between NOPAT and capital charge.
Net operating profit after tax (NOPAT)

The NOPAT can be calculated as:
Reported accounting profit before interest and tax xxxx
Add
- accounting depreciation xx
- any goodwill written off for the year xx
- any increase ( less any decrease) in provision for doubtful debts xxx - any increase in net
capitalised development cost xxx - any increase in net capitalised lease expenditure xxx
Less
- replacement cost depreciation (economic depreciation) (xx) - amortisation of development cost
and leases (xx) - cash payment for tax on operating profit (xx)
NOPAT xxxx
Adjusted/economic capital employed
Reported accounting total asset (current and non-current) xxxx
Add
- cumulative amortised goodwill xxx
- provision for doubtful debts xxx
- economic value = (net book value) of capitalised development cost xxx
- economic value = (net book value) of leased expenditure xxx
Less
- non-interest bearing liabilities such as trade payables and tax payable (xxx)
- economic capital employed xxxxx
Example
A company has reported annual operating profits for the year of £89·2m after charging £9·6m for the full
development costs of a new product that is expected to last for the current year and two further years. The cost
of capital is 13% per annum. The balance sheet for the company shows fixed assets with a historical cost of
£120m. A note to statement of financial position estimates that the replacement cost of these fixed assets at the
beginning of the year is £168m. The assets have been depreciated at 20% per year.
The company has a working capital of £27·2m.
Ignore the effects of taxation.
Required:
Calculate EVA.
Solution
£m
Profit 89·20
Add
Current depreciation (120 x 20%) 24·00
Development costs (9·60 x 2/3) 6·40
Less
Replacement depreciation (168 x 20%) 33·60
Adjusted profit 86·00
Less cost of capital charge (Working 1) 21·84
EVA 64·16
Working 1
Cost of capital charge
Fixed assets (168 – 33·6) 134·4
Working capital 27·2
Development costs 6·4
Adjusted capital employed 168.0
x 13% = 21·84
The value of a company using EVA technique can be seen as the adjusted capital employed plus the
present value of future EVA discounted at the WACC.
Strengths of EVA
● It measures the value added to the organisation after deducting a charge for the use of capital made
by that organisation.
● It is based on economic profit and economic value of capital employed, not accounting profit and
assets values which can be manipulated.
● EVA may be consistent with the objective of maximising shareholder wealth.
● It can easy be communicated to, and understood by, managers and employees.
● EVA can be used to assess performance by managers, and linked to
remuneration schemes that reward the creation of value to the organization
Problems of EVA
● EVA is complicated and requires many adjustments to accounting information. ● It does not capture
all the value drivers, especially non-purchase goodwill.
● EVA is normally historic. It does not help to decide future investments and strategy. It is based on
historical accounts which may be of limited use as a guide to the future.
● It usually relies on CAPM for the estimation of the weighted average cost of capital. CAPM is based on
restrictive assumptions and may not accurately determine cost of capital.
INTELLECTUAL CAPITAL
Valuing intangible assets/intellectual capital

Valuing intangible assets, such as intellectual capital, is not an exact science but several methods exist to estimate
their value.
Market-to-book values
Compare the market value of the company to the book value of the assets. The difference between the two
should be equivalent to the value of the intangibles.
However, this method values the assets based on accounting policies and therefore may no longer
represent their ‘true worth’. A better alternative would be to value the assets based on realisable value.
Calculated intangible value (CIV)

The CIV involves taking the excess return on intangible assets and uses this figure as a basis to determine
the proportion of return attributable to intangible assets.
The CIV can be calculated using the following steps:
1. Calculate average pre-tax earnings for a given period.
2. Calculate the average year-end tangible assets over the same given period
3. Divide average earnings by the average assets to get the return on assets (ROA).
4. For the same given period find the industry’s return on assets as average earnings divided by average
tangible asset.
5. Calculate the ‘excess return’. Multiply the industry-average ROA by the company’s average tangible assets;
this shows what the average the company would earn from that amount of tangible assets. Now subtract
that from the company’s pre-tax earnings.
This figure shows how much more the company earns from its assets than the industry average.
6. Calculate the given period average income tax rate and multiply this by the excess return. Subtract the
result from the excess return to show the aftertax premium attributable to intangible assets.
7. Calculate the net present value (NPV) of the premium. This is done by dividing the premium by an
appropriate discount factor such as the company’s cost of capital. This is the CIV of the company’s
intangible assets – the one that does not appear on the balance sheet.
Example Emboss plc

The summarised financial information about Emboss plc for the last three years is provided below:
Income statement for the years ended 31 March:
2009 2010 2011
£millions £millions £millions
Revenue 125 137.5 149.9

Less cash operating cost 37.5 41.3 45
Depreciation 20 22 48
Pre-tax earnings 67.5 74.2 56.9
Taxation 20.25 22.26 17.07
Statement of financial position as at 31March:

2009 2010 2011
£millions £millions £millions
Non-current asset 150 175 201
current assets 48 54 62
198 229 263
Share capital (£1) 30 30 30

retained earnings 148 179 203
178 209 233
Current liabilities 20 20 30
198 229 263
Additional information:
(1) The average pre-tax return on total assets for the industry over three years has been 15%.
(2) The estimated cost of equity capital for the industry is 10% after tax.
(3) The market price of Emboss plc share is £12 per share at 31 March 2011.
(4) The current replacement cost of a plant with a book value of £60 million is estimated at £80
million.
Required:
Calculate the value of the company using the asset valuation method including estimate of intellectual
capital.
Solution to Emboss plc
Valuing intellectual capital/intangible assets
Based on the information in the question the following methods can be used to value intellectual capital:
Market-to-book value method
£millions
Market value at 31 March 2011 30 x 12 360
book value 31 March 2011 233
Value of intangible asset 127
Market-to-replacement cost method

£millions
Market value at 31 March 2011 30 x 12 360
Replacement value 31 March 2011 233 -60 + 80 253
Value of intangible asset 107
Calculated intangible value (CIV) method
Average pre-tax earnings =
= £66.2 million
Average tangible assets =
= £230 million
Return on assets = ×100%
= 28.8%
Return that an average company can earn from £230 tangible asset in the industry would be = 15% x 230 = £34.5
million.
Premium attributable to intangible assets = 66.2 – 34.5 = £31.7 million
After tax premium = £31.7 x (1 -0.3) = £22.19
Net present value of premium (value of intellectual capital) = 22.19 x 1/0.1
= £221.9 million.
Example Destroying Value

The most recent published results for V plc are sho wn below.
£m
20 XX profit before tax 13.6
Summary consolidated balance sheet at 31 December 2 0XX

£m
Fixed assets 35.9
Current assets 137.2

Less: current liabilities (95.7)
Net current assets 41.5
Total assets less current liabilities 77.4

Borrowings (15.0)
Deferred tax provisions (7.6)
Net assets 54.8
Capital and reserves 54.8
An analyst working for a stockbroker has taken thes e published results, made the
adjustments shown below, and has reported his concl usion that ‘the management
of V plc is destroying value’.
Analyst’s adjustments to profit before tax

£m
Profit before tax 13.6
Adjustments
Add: Interest paid (net) 1.6
R & D (research and development) 2.1
Advertising 2.3
Amortisation of goodwill 1.3
Less: Taxation paid (4.8 )
Adjusted profit 16.1
Analyst’s adjustments to summary consolidated balan ce sheet at 31 December

20 XX
£m
Capital and reserves 54.8
Adjustments
Add: Borrowings 15.0
Deferred tax provisions 7.6
R&D 17.4 Last 7 years’ expenditure
Advertising 10.5 Last 5 years’ expenditure
Goodwill 40.7 Written off against
reserves on acquisitions in
previous years
_____
Adjusted capital employed 146.0
£m
Required return (12 % x £146.0m) 17.5 ( weighted aver age cost of capital = 12%)
Adjusted profit 16.1
Value destroyed 1.4
The chairman of V plc has obtained a copy of the analyst’s report.
Required:
(a) Explain, as management accountant of V plc, in a report to your chairman, the principles of the
approach taken by the analyst. Comment on the treatment of the specific adjustments to R & D,
advertising, interest and borrowings and goodwill.
(b) Having read your report, the chairman wishes to know which division or divisions are ‘destroying
value’, when the current internal statements show satisfactory returns on investment (ROIs). The
following summary statement is available.
Divisional performance, 20XX

Division A Division B Division C Head
Total
(Retail) (Manufacturing) (Services) Office
£m £m £m £m £m
Turnover 81.7 63.2 231.8 - 376.7
Profit before
5.7 5.6 5.8 (1.9) 15.2
interest and tax
Total assets less
27.1 23.9 23.2 3.2 77.4
current liabilities
ROI 21.0% 23.4% 25.0%
Some of the adjustments made by the analyst can be related to specific divisions:
● Advertising relates entirely to Division A (retail)
● R & D relates entirely to Division B (manufacturing)
● Goodwill write-offs relate to
Division B (Manufacturing) £10.3m

Division C (Services) £30.4m
● The deferred tax relates to
Division B (Manufacturing) £1.4m

Division C (Services) £6.2m
● Borrowings and interest, per divisional accounts, are as follows:
Division A Division B Division C Head

Total
(Retail) (Manufacturing) (Services) Office
£m £m £m £m £m
Borrowings - 6.6 6.9 1.5 15.0
Interest
(0.4) 0.7 0.9 0.4 1.6
paid/(received)
Required:
Explain, with appropriate comment, in a report to the chairman, where ‘value is being destroyed’.
Your report should include:
● A statement of divisional performance
● An explanation of any adjustments you make
● A statement and explanation of the assumptions made ● Comment on the limitations of the
answers reached.
Solution to Destroying Value
(a)
REPORT
To: Chairman
From: Management accountant Date: XX.XX.XXXX
Subject: Destroying value in V plc
This report considers the recent observations by the analyst of X Stockbrokers on our 20XX results.
It will explain the principles of the approach taken by the analyst and will provide a commentary
on the treatment of the specific adjustments made to our reported profit figure and balance
sheet.
I Principles of the approach taken: economic value added
1. A management team is required by an organisation’s shareholders to maximise the

value of their investment in the organisation and several performance indicators are
used to assess whether or not the management team is fulfilling this function.
2. The majority of these performance measures are based on the information contained
in the organisation’s published accounts. These indicators can be easily manipulated
and often provide misleading information. Earnings per share, for example, are
increased by deferring expenditure in research and development and in marketing.
3. The financial statements themselves do not provide a clear picture of whether or not
shareholder value is being created or destroyed:
(a) The profit and loss account, for example, indicates the quantity but not
quality of earnings
(b) It ignores the cost of equity financing and only takes into account the costs of
debt financing, thereby penalising organisations such as ourselves which
choose a mix of debt and equity finance.
(c) Neither does the Cash flow statement provide particularly appropriate
information. Cash-flows can be large and positive if an organisation reduces
expenditure on maintenance and undertakes little capital investment in an
attempt to increase short-term profits at the expense of longterm success.
4. The analyst has therefore adopted an approach known as economic value added to evaluate
our performance.
● This approach hinges on the calculation of economic profit, which requires

several adjustments to be made to traditionally reported accounting profits.
● These adjustments are made to avoid the immediate writeoff of value-

enhancing expenditure such as research and development or the purchase of
goodwill. They are intended to produce a figure for capital employed, which
is a more accurate reflection of the base upon which shareholders expect
their returns to accrue. They also provide a profitafter-tax figure, which is a
more realistic measure of the actual cash yield generated for shareholders
from recurring business activities.
It is not very surprising that if management are assessed using performance

measures calculated using traditional accounting policies, they are unwilling to
invest in activities which immediately reduce current year’s profit.
II The Treatment of specific items
1. Research and development
The analyst has added back expenditure of £2.1 million to the 20XX profit figure on
the grounds that the expenditure is providing a base for future activities. Similarly
the research and development expenditure over the last seven years of £17.4million
has been added back to the capital employed figure on the basis that we are
continuing to benefit from the expenditure. A depreciation charge should probably
be made against this capitalised value, however, to reflect any fall in its value.
2. Advertising
The analyst has added back advertising expenditure of £2.3 million to the 20XX profit
figure on the assumption that the expenditure has supported sales, raised customer
awareness and/or increased brand image/loyalty, all of which could produce
significant cashflows in the future and hence are for the long-term benefit of the
organisation. The advertising expenditure over the last five years of £10.5 million
has been added back to the capital employed figure (in much the same way as the
research and development expenditure) to reflect the fact that the costs will provide
for future growth. Again, an amortisation charge should be made if brand values are
being eroded, possibly by competition.
3. Interest and borrowings
Because our profits are being earned using both debt and equity finance, the
published profit figure is overstated since it takes no account of the cost of the equity
finance. The analyst has therefore added back the cost of the debt finance to the
20XX profit figure and the borrowings figure to the capital employed. This produces
a profit figure before the cost of borrowing, which can be compared with a figure
representing the total long-term finance in our organisation.
4. Goodwill
The analyst has added back goodwill amortisation of £1.3 million to the 20XX profit
figure. Goodwill is the difference between the price paid for a business acquisition
and the current cost valuation of that acquisition’s net assets. On the assumption
that a realistic price was paid, the goodwill purchased should provide benefits in the
future, not just in the year of purchase. And the goodwill of £40.7 million, which has
been written off against reserves on acquisitions in previous years has been added
back to the capital employed figure so as to provide a more realistic base upon
which we must earn a return. Again, the goodwill capitalised should be regularly
reviewed and amortised to reflect any reductions in its value.
I hope this information has been of use. If I can be of any further assistance please do not hesitate to
contact me.
Signed: Management Accountant
(b)
REPORT
To: Chairman
From: Management accountant Date: XX.XX.XX
Subject: Where is value being destroyed?
An analyst working for X Stockbrokers has recently commented that ‘the management of V plc is
destroying value’. In an attempt to establish where value is being destroyed in our organisation, a
revised statement of divisional performance has been prepared, adopting an approach similar to
that used by the analyst. The statement, plus supporting explanations, is set out in Appendix 1.
The analysis shows that value of £0.1 million was destroyed in Division B, while value of £2.3
million was destroyed in Division C. Division A, on the other hand, created value of £1 million.
This is in marked contrast to the performance indicated in the conventional divisional

performance report prepared for 20XX. This shows all three divisions earning a return on
investment in excess of 20%, with Divisions B and C, the destroyers of value, making higher
returns on investment than Division A, the creator of value.
The analyst’s approach is similar to performance evaluation using residual income in that a charge
is made for the capital employed within the division. Further adjustments are also made to both
profit and capital employed to provide more realistic measures for performance analysis (as
explained in my earlier report and in Appendix 1). The results of the analysis are dependent upon
the following factors:
1. Head office expenses are assumed to have been incurred in relation to divisional turnover.
Any one of a number of other bases might be equally valid.
2. Tax paid is assumed to be related to divisional profit after interest and head office
expenses. Deferred tax liabilities have not been incorporated into the analysis.
3. Each division’s share of head office assets has been assumed to be in proportion to the
division’s share of total turnover. Other bases could be equally valid.
4. It has been assumed that each division has the same cost of capital. This takes no account
of the individual characteristics of each division, its risk profile and its mix of financing.
Despite the limitations set out above, the analyst’s approach provides an alternative insight into
how our divisions are performing and could well prove useful in enabling us to create value for our
shareholders in the future.
Signed: Management Accountant
APPENDIX 1
Statement of profitability
Divisions
A B C Head office Total
£m £m £m £m £m
20XX PBIT 5.7 5.6 5.8 (1.9) 15.2
Add back
Advertising 2.3 - - - 2.3
R&D - 2.1 - - 2.1
Goodwill (1) - 0.3 1.0 - 1.3
Head office expenses (2) (0.4) (0.3) (1.2) 1.9 -
(4.8)
Less: tax paid (2.0) (1.2) - 16.1
Revised profit 5.6 4.4 -
Statement of capital employed

Divisions
£m £m £m £m £m
Total assets less current liabilities 27.1 23.9 23.2 3.2 77.4
Adjustments
Advertising 10.5 - - - 10.5
R&D - 17.4 - - 17.4
Goodwill - 10.3 30.4 - 40.7
Head office assets (4) 0.7 0.5 2.0 (3.2) -
Revised capital 38.3 52.1 55.6 - 146.0
Economic value added

Divisions
£m £m £m £m £m
Revised profit 5.6 6.1 4.4 - 16.1
Required return (5) 4.6 6.2 6.7 - Value added/(destroyed) 1.0 (0.1) (2.3) - 17.5
Explanation of adjustments made (1.4)
1. Goodwill
Goodwill amortised has been apportioned to Divisions B and C in proportion to the value of goodwill
written off to capital and reserves.
Goodwill
Division Goodwill amortised
write-off
£m % £m
B 10.3 25.3 x £1.3m 0.3289
C 30.4 74.7 x £1.3m 0.9711
40.7 100.0 1.3000
2. Head office expenses
No direction is provided as to the way in which head office expenses should be apportioned
to the three divisions. An activity-based approach could be the most suitable but, in the
absence of appropriate data, allocation based on turnover has been adopted.
3. Tax paid
The tax liability of £4.8 million for V plc has to be apportioned over the three trading
divisions. Given that the divisions’ taxable profits will be affected by the allocation of head
office expenses and the interest paid, the overall tax liability has been apportioned on the
basis of divisional profit after interest paid and allocated head office costs.
Interest Head office Apportionme

Division PBIT Charge
paid expenses nt figures

£m £m £m % £m
A 5.7 − (0.4) − 0.4 = 5.7 41 2.0
B 5.6 − 0.7 − 0.3 = 4.6 33 1.6
C 5.8 − 0.9 − 1.2 = 3.7 26 1.2
14.0 100 4.8
4. Head office assets
Head office assets have been apportioned to the three trading divisions on the basis of
divisional turnover so as to be consistent with the basis used to apportion head office
expenses
5. Required return
The required return is based on a weighted average cost of capital of 12%.
Chapter 12
Corporate reconstruction
and reorganisation
CHAPTER 12 – CORPORATE RECONSTRUCTION AND REORGANISATION
CHAPTER CONTENTS
BUSINESS REORGANISATION ----------------------------------------- 199

UNBUNDLING 199
DIVESTMENT 199
SELL-OFFS 199
SPIN-OFFS/DEMERGERS 200
MANAGEMENT BUY-OUT (MBO) 200
MANAGEMENT BUY-IN 202
SHARE REPURCHASE 202
GOING PRIVATE 203
CAPITAL RECONSTRUCTION SCHEMES ------------------------------- 204
BUSINESS REORGANISATION
Unbundling
Unbundling is the process of selling off incidental non-core businesses to release funds, reduce gearing,
and allow management to concentrate on their chosen core business.
The main forms of Unbundling are:
● Divestment.
● Demergers.
● Sell-offs.
● Spin-offs.
● Management buy-outs.
Divestment
Divestment is a proportional or complete reduction in ownership stake in an organisation. It is the
withdrawal of investment in a business. This can be achieved either by selling the whole business to a
third party or by selling the assets piecemeal.
Reasons for divestment

● The principal motive for divestment will be if they either do not conform to group or business
unit strategy.
● A company may decide to abandon a particular product/activity because it fails to yield an

adequate return.
● Allowing management to concentrate on core business.
● To raise more cash possibly to fund new acquisitions or to pay debts in order to reduce gearing
and financial risk.
● The management lack the necessary skills for this business sector
● Protection from takeover possibly by disposing of the reasons for the takeover or producing
sufficient cash to fight it effectively.
Sell-offs
A sell-off is a form of divestment involving the sale of part of an entity to a third party, usually in return
for cash. The most common reasons for a sell-off are:
● To divest of less profitable and/or non-core business units.
● To offset cash shortages.
The extreme form of sell-off is liquidation, where the owners of the company voluntarily dissolve the
business, sell-off the assets piecemeal, and distribute the proceeds amongst themselves.
Spin-offs/demergers
This is where a new company is created and the shares in the new company are owned by the
shareholders of the original company which is making the distribution of assets. There is no change in
ownership of assets but the assets are transferred to the new company. The result is to create two or
more companies whereas previously there was only one company. Each company now owns some of
the assets of the original company and the shareholders own the same proportion of shares in the new
company as in the original company.
An extreme form of spin-off is where the original company is split up into a number of separate
companies and the original company broken up and it ceases to exist. This is commonly called
demerger.
Demerger involves splitting a company into two or more separate parts of roughly comparable size
which are large enough to carry on independently after the split.
The main disadvantages of de-merger are:
● Economies of scale may be lost, where the de-merged parts of the business had operations in
common to which economies of scale applied.
● The ability to raise extra finance, especially debt finance, to support new investments and
expansion may be reduced.
● Vulnerability to takeovers may be increased.
● There will be lower revenue, profits and status than the group before the demerger.
Management buy-out (MBO)

A management buy-out is the purchase of a business from its owners by its managers. For example, the
directors of a company in a subsidiary company in a group might buy the company from the holding
company, with the intention of running it as proprietors of a separate business entity.
Reasons for MBOs

MBOs may exist for several reasons including:
● A parent company wishes to divest itself of a business that no longer fits in with its corporate
objectives and strategy.
● A company/group may need to improve its liquidity. In such circumstances a buy-out might be
particularly attractive as it would normally be for cash.
● A company may decide to abandon a particular product/activity because it fails to yield an

adequate return.
● In administration a buy-out may be the management’s only best alternative to redundancy.
Advantages of MBOs to disposing company
● To raise cash to improve liquidity.
● If the subsidiary is loss-making, sale to the management will often be better financially than
liquidation and closure costs.
● There is a known buyer.
● Better publicity can be earned by preserving employer’s jobs rather than closing the business down.
● It is better for the existing management to acquire the company rather than it possibly falling into
enemy hands.
Advantages of buy-out to acquiring management

● It preserves their jobs.
● It offers them the prospects of significant equity participation in their company.
● It is quicker than starting a similar business from scratch.
● They can carry out their own strategies, no longer having to seek approval from the head office.
Problems of MBOs
● Management may have little or no experience financial management and financial accounting.
● Difficulty in determining a fair price to be paid.
● Maintaining continuity of relationships with suppliers and customers.
● Accepting the board representation requirement that many sources of funding may insist on.
● Inadequate cash flow to finance the maintenance and replacement of assets.
Sources of finance for MBOs

Several institutions specialise in providing funds for MBOs. These include:
● The clearing banks.
● Pension funds and insurance companies.
● Venture capital.
● Government agencies and local authorities, for example Scottish Development Agency.
Factors a supplier of finance will consider before lending

● The purchase consideration. Is the purchase price right or high?
● The level of financial commitment of the buy-out team.
● The management experience and expertise of the buy-out team.
● The stability of the business’s cash flows and the prospects for future growth.
● The rate of technological change in the industry and the costs associated with the changing
technologies.
● The level of actual and potential competition.
● The likely time required for the business to achieve a stock market flotation, (so as to provide an
exit route for the venture capitalist).
● Availability of security.
Conditions attached to provision of finance
● Board representation for the venture capitalist.
● Equity options.
● A right to take a controlling equity stake and so replace the existing management if the company
fails to achieve specified performance targets.
Management buy-in
A management buy-ins occurs when a group of outside managers buys a controlling stake in a business.
Share repurchase
Any limited company may, if authorised by it articles, purchase its own shares. The Companies Act
permits any company to purchase its own shares. Therefore if a company has surplus cash and cannot
think of any profitable use of that cash, it can use that cash to purchase its own shares.
Share repurchase is an alternative to dividend policy where the company returns cash to its shareholders
by buying shares from the shareholders in order to reduce the number of shares in issue.
Shares may be purchased either by:
● Open market purchase – the company buys the shares from the open market at the current market
price.
● Individual arrangement with institutional investors.
● Tender offer to all shareholders.
Reasons for share repurchase

● Shares may be purchased in order to buy out dissident shareholders.
● To adjust the gearing ratio towards an optimal capital structure.
● Reduction in the size of the company. Where circumstances indicate a permanent reduction in
company size is desirable this can be achieved easily with share repurchase and subsequent
cancellation of the shares.
● Purchase of own shares may be used to take a company out of the public market and back into
private ownership.
● Purchase of own shares provide an efficient means of returning surplus cash to the shareholders.
● It enables companies to reduce total dividend payments whiles maintaining or increasing the level
of dividend to individual shareholders. This may mean more earnings available for capital
investment which leads to growth.
● Purchase of own shares increases earning per share and return on capital employed.
● To increase the share price by creating artificial demand.
Problems of share repurchase

● Lack of new ideas. Shares repurchase may be interpreted as a sign that the company has no new
ideas for future investment strategy. This may cause the share price to fall.
● Costs. Compared with a one-off dividend payment, share repurchase will require more time and
transaction costs to arrange.
● Resolution. Shareholders have to pass a resolution and it may be difficult to obtain their consent.
● Gearing. If the equity base is reduced because of share repurchase, gearing may increase and
financial risk may increase.
Going private
A public company may occasionally give up its stock market quotation and return itself to the status of a
private company.
The reasons for such move are varied, but are generally linked to the disadvantages of being in the stock
market and the inability of the company to obtain the supposed benefits of a stock market quotation.
Other reasons are:
● To avoid the possibility of takeover by another company.
● Savings of annual listing costs.
● To avoid detailed regulations associated with being a listed company.
● Where the stock market undervalues the company’s shares.
● Protection from volatility in share price with its financial problems.

CAPITAL RECONSTRUCTION SCHEMES
A capital reconstruction scheme is a scheme whereby a company reorganises its capital structure by
changing the rights of its shareholders and possibly the creditors. This can occur in a number of
circumstances, the most common being when a company is in financial difficulties, but also when a
company is seeking floatation or being acquired.
Financial difficulties
If a company is in financial difficulties it may have no recourse but to accept liquidation as the final
outcome.
Typical financial difficulties
● Large accumulated losses.
● Large arrears of dividends on cumulative preference shares.
● Large arrears of debenture interest.
● No payment of ordinary dividend.
● Market share price below nominal value.
However, it may be in position to survive, and indeed flourish, by taking up some future contract or
opening in the market. The only major problem is the cash needed to finance such operations because
the present structure of the company will not be attractive to outside investors. To get cash the
company will need to reorganise or reconstruct.
Possible reconstruction
The changing or reconstruction of the company’s capital could solve these problems. The company can
take any or all of the following steps:
● write off the accumulated losses.
● write of the debenture interest and preference share dividend arrears.
● write down the nominal value of the shares.
To do this the company must ask all or some of its existing stakeholders to surrender existing rights and
amount owing in exchange for new rights under a new or reformed company.
The question is ‘why would the stakeholder be willing to do this? The answer to this is that it may be
preferable to the alternatives which are:
● to accept whatever return they could be given in a liquidation;
● to remain as they are with the prospect of no return from their investment and no growth in their
investment.
Generally, stakeholders may be willing to give up their existing rights and amounts owing (which are
unlikely to be met) for the opportunity to share in the growth in profits which may arise from the extra
cash which can be generated as a consequence of their actions.
General guidelines in reconstruction
For a reconstruction to be successful the following principles are to be followed:
1. Creditors must be better off under reconstruction than under liquidation. If this is not the case
they will not accept the reconstruction as their agreement is a requirement for the scheme to take
place.
2. The company must have a good chance of being financially viable and profitable after the
reconstruction.
3. The reconstruction scheme must be fair to all the parties involved, for example preference
shareholders should have preferential treatment over ordinary shareholders.
4. Adequate finance is provided for the company’s needs.
In solving reconstruction questions the following steps can be followed:
1. State the above principles of reconstruction.
2. Check what each party will get if the company were to go on liquidation. This can be done by
adding up the break-up values of the assets.
Note the sequence of creditor priorities as followings:
● taxes and unpaid wages
● secured debts, including unpaid interest – fixed charge
● secured debt – floating charge
● unsecured creditors
● preference shareholders including unpaid dividend
● ordinary shareholders.
3. Check the sufficiency of the amount of finance that will be raised from the scheme. This includes
proceeds from the sale of investment, existing assets when new assets are to be bought to replace
them, and reduction in working capital.
4. Check if the parties will be better off under the proposed scheme than under liquidation. Assess
the fairness of the scheme.
5. Assess the post-reconstruction financial viability and profitability of the company by calculating
post-reconstruction EPS and P/E ratio.
6. Come to a conclusion.
Example Jenkins plc
Jenkins plc has been suffering from adverse trading conditions largely due to the effect of obsolescence
on its
CHAPTER 12 products. This
– CORPORATE has resulted inAND
RECONSTRUCTION losses in each of the last five years. The company’s bankers have
REORGANISATION
refused to extend the present overdraft facility and creditors are pressing for payment.
The directors feel that a new product recently developed by the company will make the company
You ascertain
profitable in thethe following:
future, but they are worried that a winding-up order may be made before this can be
achieved.
1. Scheme costs are estimated at £4,800.
They
2. have thereforeshares
Preference askedrank
you in
topriority
suggesttoaordinary
scheme shares
of capital reduction
in the event ofthat would be acceptable to
windingup.
both
3. the court and creditors and to advise them as to what action should be
The bank has indicated that it would advance a loan of up to £50,000 providedtakenthat
to the
enable the
overdraft
companyistocleared
continue
andtrading.
a second mortgage on the freehold is given.
4. following
The To ensure
is thespeedy
presentmanufacture
balance sheetofofthe
thenew product it would be necessary to expend £20,000 on
company:
new plant and £15,000 on increasing stocks.
Present
5. The creditors’ figure of £118,000 includes £19,000 that would be preferential in a liquidation.
Book “going
Required: values concern”

values
(a) Suggest a scheme of capital reduction and write up the capital reduction account.
£ £ £ £
Non-current
(b) assets
Outline your suggestions as to the action that should be taken by the directors.
Intangible
(c) Show the balance sheet after implementing your suggestions.
Goodwill 30,000 -
Ignore taxation.
Patents, trademarks etc 11,000 2,000
41,000
Tangible
Freehold land and buildings 120,000 150,000 Plant and vehicles _50,000 36,000
170,000
Current assets
Stocks and debtors 64,000 58,000 Listed shares at cost 15,000 14,000
79,000
Creditors falling due within one year
Trade 118,000 Overdraft _31,000
(149,000)
Net current liabilities (70,000)
Total assets less current liabilities 141,000 Creditors falling due after one year
12% mortgage loan secured on freehold (60,000)

£81,000
Capital and reserves

Called up share capital
7% cumulative preference shares (£1) 50,000 fully paid (dividends are
three years in arrears)
Ordinary shares of 50p each – fully paid 200,000
250,000
Share premium account 60,000
Profit and loss account reserve (229,000)
£81,000
Solution to Jenkins plc
Explanation
The first step is to estimate the losses to be suffered by preference shareholders on a liquidation.
For example, on liquidation the following position may arise
Proceeds
£
Freehold 150,000
Plant (say 2/3 of £36,000) 24,000
Stocks and debtors (say ½ of £58,000) 29,000
Listed shares _14,000
£217,000
These proceeds will be used to repay the liabilities:
£
Secured mortgage 60,000
Overdraft 31,000
Trade creditors 118,000
£209,000
This leaves £8,000 for the shareholders. This will go to the preference shareholders in priority to the
ordinary shareholders. Therefore, the loss suffered by the preference shareholders is £(50,000 – 8,000),
ie £42,000. The loss allocated to them under the scheme must be less than this.
Memorandum to the board
(a) Scheme of capital reduction
The objective of such a scheme is to write down the capital of the company so that it realistically reflects
the present values of the assets (on a going concern basis).
The major part of the loss should be borne by the ordinary shareholders although the preference
shareholders should bear a part of the loss where it is unlikely that they would receive all their capital in
a winding-up. A corresponding increase in the rate of preference dividend is sometimes given as
compensation. The reduced capital of the company will ensure that it is possible to pay dividends when
the company achieves profitability.
Where arrears of cumulative preference dividends have accrued, it is usual to compensate preference
shareholders by issuing reduced ordinary shares in part satisfaction of such arrears.
Explanation
Draw up a pro forma balance sheet after the scheme, and capital reduction account; post through the
opening position (writing off all goodwill and accumulated losses); then adjust the assets to going
concern values posting the double entry as you work through.
Remember to post through the scheme costs and compensation in new shares to the preference
shareholders; then write down the ordinary and preference shares to a round sum amount to cover the
overall loss. The loss written off to the preference shareholders may not exceed £42,000 and ideally
should be less than that.
Capital reduction account

£ £
Write offs Surplus on freehold 30,000
Profit & loss reserve 229,000
Plant & vehicles 14,000
Goodwill, patents etc 39,000
Investments 1,000
Current assets 6,000 Losses c/d 259,000

£289,000 £289,000
Losses b/d 259,000 Share premium account 60,000

Costs of scheme 4,800 Amounts written off
Ordinary share capital Ordinary shares (49p) 196,000
Issue re arrears of preference Preference shares (30p) 15,000
dividend (50%) 5,250
Balance c/d __1,950 ______
£271,000 £271,000
Explanation
Use notes c) to e) in the question; list total costs, compare to money coming in (always sell any non-trade
investments). Issue enough new shares to leave a positive cash balance. Complete double entries as you
work. Finally complete the balance sheet.
(b) Suggested action (outline)
(i) The preferential creditors to be paid off in full immediately to prevent them “blocking” the scheme.
(ii) The investments to be sold to produce part of the funds necessary to continue trading.
(iii) Accept the bank’s offer of a maximum loan of £50,000 (subject to a second mortgage charge being
created)
(iv) The balance of the funds necessary to be provided by an issue of shares (on a 10 for 1 basis) at par
for cash to the directors and shareholders. The following cash is required:
£
Preferential creditors 19,000
Purchase of new plant 20,000
Additional stock 15,000
Pay costs of scheme 4,800 Clear existing overdraft 31,000
£89,800
£
Produced by
Sale of investments (ignoring costs) 14,000
Bank loan 50,000
Issue of shares to directors and existing shareholders
(10 x 400,000 x 1p) _40,000
£104,000
Leaving a balance at bank of £14,200
(c) Balance sheet if scheme adopted
£ £
Non-current assets
Intangible
Patents £(11,000 – 9,000) 2,000
Tangible
Freehold £(120,000 + 30,000) 150,000
Plant and vehicles £(50,000 – 14,000 + 20,000) 56,000
206,000 208,000
Current assets
Stock/debtors £(64,000 – 6,000 + 15,000) 73,000
Bank balance (per b) iv) above) 14,200
87,200
Creditors – Amounts falling due within one year
Trade £(118,000 – 19,000) (99,000)
Net current liabilities (11,800)
Total assets less current liabilities 196,200
Creditors falling due after one year Loan (secured on the freehold) (60,000)
Bank loan (50,000)
(110,000)
£86,200 Capital and reserves
Called up share capital
1p ordinary shares fully paid
£(200,000 – 196,000 + 5,250 + 40,000) 49,250
70p 10% preference shares fully paid
£(£50,000 – 15,000) 35,000
84,250
Reserve arising on scheme (capital reduction account) 1,950
£86,200
Explanation
It could be argued that Jenkins plc is still not in a sufficiently strong liquidity position.
Chapter 13
Corporate dividend policy
CHAPTER 13 – CORPORATE DIVIDEND POLICY
CHAPTER CONTENTS
DIVIDEND IRRELEVANCE HYPOTHESIS ------------------------------ 213
DIVIDENDS IN AN IMPERFECT MARKET ----------------------------- 214
POSSIBLE APPROACHES TO DIVIDEND POLICY --------------------- 215
ALTERNATIVES TO A CASH DIVIDEND ------------------------------- 216
DIVIDEND IRRELEVANCE HYPOTHESIS
Theory
The proponents of the dividend irrelevance hypothesis (Miller & Modigliani) claim that the value of a
firm is determined by its future earnings stream. The way this stream is split between dividends and
retentions has no impact upon shareholder wealth.
Given a set investment policy, a dividend cut now to finance new projects will be compensated by higher
dividends at a later stage.
The shareholder will be indifferent to the dividend policy provided the PRESENT VALUE of dividend
payments remains unchanged.
Assumptions
● A set investment policy so that shareholders know the reason for withholding dividends.
● No transactions costs.
● No distorting taxes.
● Share prices move in the manner predicted by the model.
In the case of a withheld dividend, the shareholder can maintain his level of income by selling shares to
generate ‘home made’ dividends, with no consequent decrease in wealth.
DIVIDENDS IN AN IMPERFECT MARKET
Information content (dividend signalling)

● Dividends are an important current source of information.
● Share price will increase if the dividend is greater than expected and vice versa. Tendency to
over-react.
Transactions costs
● Shareholder can no longer replace a withheld dividend by selling shares without incurring dealing
commissions.
● Company will benefit by financing investments from retained earnings to avoid the high costs
associated with raising new finance.
Preference for current income

It is sometimes argued that shareholders prefer high dividend payouts as they see these as more secure
than capital gains (the “bird in the hand” theory).
This argument is sometimes thought to be weak. Current dividends are safe, but so are current capital
gains. Future dividends are just as uncertain as future capital gains.
Distorting taxes
Individuals will generally prefer dividends to capital gains whether a basic-rate or higher-rate tax payer,
subject to certain complications:
● exemption limit for capital gains tax;
● non-tax-paying individuals; ● tax-exempt institutions.
POSSIBLE APPROACHES TO DIVIDEND POLICY
Stable policy with moderate payout

● Stable level of dividends with occasional increases (where justified). This would avoid sharp
movements in share price.
● Moderate payout policy in order to sustain the level of dividends in the face of fluctuating
earnings.
● Very common approach for listed companies.
Constant payout ratio

● Constant proportion of earnings paid out as a dividend.
● Not particularly suitable as dividends will fluctuate, causing erratic share price movements.
Residual dividend policy

● Remaining earnings, after funding all profitable projects, are paid out as dividend.
● Tends to lead to fluctuating dividends and therefore not particularly suitable.
Clientele theory
● Consistent dividend policy is maintained which will attract a group of shareholders to whom the
policy is suited in terms of tax, need for current income, etc.
Other considerations
● Legality, re distributable profits.
● Existence of inflation and consideration of real profitability.
● Growth and requirements for retained earnings.
● Liquidity position.
● Limited sources of funds (particularly for small companies).
● Stability of earnings.
ALTERNATIVES TO A CASH DIVIDEND
During the last twenty years or so, a number of companies have established ways of rewarding
shareholders other than by traditional dividend payments. These methods include:
Shareholder perks
Several UK companies (notably hotel operators) offer discounts to shareholders on room bookings and
restaurant meals. A number of transport companies offer reductions in fares. Some retailers provide
discount vouchers, which are sent to shareholders at the same time as the annual report and accounts.
Scrip dividends
When the directors of a company consider that they must pay a certain level of dividend, but would
really prefer to retain funds within the business, they can introduce a scrip dividend scheme.
This involves giving ordinary shareholders the choice of a cash dividend or newly created shares in the
company of a similar monetary value. Scrip dividend plans were very popular in the 1990s since they
enabled companies to use share premium accounts to create the new shares (instead of reducing
retained profits) and there were certain tax advantages for the company.
However a change in the accounting regulations subsequently forced companies to charge the profit and
loss account with the scrip dividend, and a later change in UK legislation removed the tax advantages,
which companies had enjoyed. Therefore UK companies abandoned scrip dividend schemes at the turn
of the century, although there is now evidence of a few companies re-introducing this method (eg
Millennium and Copthorne Hotels plc and Whitbread plc).
Dividend reinvestment plans (DRIPs)

Since many companies had spent the 1990s persuading shareholders to take more shares in the
company (rather than receive a cash dividend) shareholders were keen for an alternative to be offered
when scrip dividend schemes were abandoned.
In the early years of the 21 st century DRIPs were created. Shareholders opting for these schemes choose
to have their dividends used to purchase existing shares in the company on the open market, through a
special arrangement involving very low dealing charges and the payment of stamp duty.
Share repurchases
Companies with cash surpluses, but having no positive NPV projects, may choose to introduce a share
buy-back scheme, whereby the company’s shares are purchased at the company’s instructions on the
open market.
This will have the effect of using up the surplus cash, increasing future EPS (because of the reduction in
the number of shares in issue), changing the gearing level of the company and (hopefully) reducing the
likelihood of a takeover. However share repurchases are often seen as an admission that the company
cannot make better use of shareholders’ funds.
Example Parabat plc

Parabat plc has an issued capital of 2 million ordinary shares of 50p each and no fixed interest securities.
It has paid a dividend of 70p per share for several years, and the stock market generally expects that level
to continue. The market price is £4.20 per share, cum div.
The firm is now considering the acceptance of a major new investment which would require an outlay of
£500,000 and generate net cash receipts of £120,000 per annum for an indefinite period. The additional
receipts would be used to increase dividends.
Parabat is appraising three alternative sources of finance for the new project:
(i) Retained earnings. The usual annual dividend could be reduced. Parabat currently holds £1.4
million for payment of the dividend which is due in the near future.
(ii) A rights issue of ordinary shares. One new share would be offered for every ten shares held at
present at a price of £2.50 per share; the new shares would rank for dividend one year after issue,
when cash receipts from the new project would first be available.
(iii) An issue of ordinary shares to the general public. The new shares would rank for dividend one
year after issue.
Assume that, if the project were accepted, the firm’s expectations of future results would be discovered
and believed by the stock market, and that the market would perceive the risk of the firm to be
unaltered.
Required:
(a) Estimate the price ex div of Parabat’s ordinary shares, following acceptance of the new project, if
finance is obtained from (i) retained earnings or (ii) a rights issue.
(b) Calculate the price at which the new shares should be issued under option (iii) assuming the
objective of maximising the gain of existing shareholders.
(c) Calculate the gain made by present shareholders under each of the three finance options.
Ignore taxation and issue costs of new shares.

Solution to Parabat plc
(a) This is a company financed entirely by equity, hence the dividend valuation model can be used to
find the cost of capital ie
D
Ke =
P0 (ex − div)
70p 70p
Ke = = = 20%
(420p − 70p) 350p
(i) Financed by retained earnings
Here the valuation model incorporating a new project can be used ie
existing dividend + future increase
New Price =
cost of equity capital
£120,000
Future increase per share = = 6p
2,000,000
70p + 6p
Hence new price = = £3.80
0.20
(ii) Financed by rights issue
First the new dividend per share must be calculated, and then the new ex div price
Future expected earnings £1,400,000 + £120,000 = £1,520,000 Future number of shares

2,000,000 + 200,000 = 2,200,000
£1,520,000 = 69p
Future dividend per share =
2,200,000 approx.
69p
= £3.45
0.20
(b) Issue of ordinary shares to the public
The issue price can be calculated by reference to the change in wealth of the shareholders ie
New market value = old market value + NPV of new project
Old market value = 2m shares x £3.50 = £7m
£120,000
NPV of new project = − £500,000 = £100,000 0.20
Therefore new market value = £7,100,000
£7,100,000
Issue price per new share should be = £3.55p
,0,00,000
As £500,000 is required, this would result in the issue of (£500,000 ÷ £3.55) = 140,845 new 50p shares.
This can be checked as follows:
Total number of shares x Market Price = Market Value of company

2,140,845 shares x £3.55 per share = £7,600,000
Expected dividend now equals £1,520,000.
Hence the return of = 20% to the shareholders has been

7,600,00
maintained.
(c) Gain made by present shareholders under each option:

Retained
New
Earnings Rights Issue Issue
£ £ £
Expected future value 3.80 3.80* 3.55
Current value per share 3.50 3.50 3.50
Gain 0.30 0.30 0.05
£500,000
£1,520,000
Less: Dividend foregone 0.25

2,000,000
£2.50
Paid for rights issue 10 0.25
___ ___ ___
Net gain per share £0.05 £0.05 £0.05
* This
represents 1.1 shares @ £3.45 each (ie allowing for the 1 for 10 rights issue).
Hence the gain to the original shareholders is 5p per share in each case, whatever the method of
financing. The NPV of the project (ie £100,000) has been allocated over the 2,000,000 shares already
on issue, irrespective of whether the project has been financed by retentions, a rights issue or a
correctly priced issue of shares to the general public.
Hence the dividend decision was “irrelevant”.
Chapter 14
Management of
international trade and
finance
CHAPTER 14 – MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE
CHAPTER CONTENTS
INTERNATIONAL TRADE ----------------------------------------------- 223

FREE TRADE AND PROTECTIONISM 223
TRADE BLOCKS 223
GATT AND THE WORLD TRADE ORGANISATION (WTO) 224
MULTINATIONAL COMPANIES (MNCS) 224
THE BALANCE OF PAYMENTS 224
THE INTERNATIONAL FINANCIAL INSTITUTIONS 225
THE EUROMARKETS 225
THE GLOBAL DEBT PROBLEM 226
RISKS OF FOREIGN TRADE 226
SOURCES OF FINANCE FOR FOREIGN TRADE 227
COUNTERTRADE 228
ARTICLE FROM STUDENTS’ NEWSLETTER ---------------------------- 229
INTERNATIONAL TRADE
International trade occurs to allow companies to enjoy economies of scale, increase their turnover and
profits, use up spare capacity and to promote division of labour. In economics, theoretical justifications
of the benefits of international trade were put forward by:
● Adam Smith – the theory of absolute advantage.
● David Ricardo – the theory of comparative advantage.
Sources of advantage may include close proximity to raw materials or markets, access to capital or an
available labour force with the necessary skills.
Free trade and protectionism

Free trade is the unhindered movement of goods and services throughout world markets.
Protectionism aims to boost the economic wealth of the country concerned through government
measures which prevent free trade. However retaliatory measures may defeat such government action.
Protectionist measures may include:
● Tariffs.
● Import quotas.
● Bureaucratic regulations (red tape).
● Exchange controls.
● Government subsidies to domestic industries.
● Imposition of import licenses.
● Devaluation of the currency – making imports more expensive.
● Subsidies to exporters.
Trade blocks
Trade blocs arise where a group of countries conspire to promote trade between themselves. Trade
blocs include:
● Free trade area – free movement of goods and services (no internal tariffs) between member
countries, with external tariffs set individually, eg North American Free Trade Area (NAFTA).
● Customs union – no internal tariffs between member countries and with common external tariffs
against non-member countries, eg the former European Economic Community.
● Common market – no internal tariffs, common external tariffs, as well as the free movement of
labour and capital between member countries, eg European Union.
GATT and the World Trade Organisation (WTO)
The General Agreement on Tariffs and Trade was set up in 1947 with the aim of achieving agreements
between trading nations to reduce protectionism and to free international trade by the progressive
removal of artificial barriers. Several rounds of agreement were achieved - notably the Kennedy Round
in the mid 1960s, the Tokyo Round in the late 1970s and the Uruguay Round which ended in 1994.
The treaty at the conclusion of the Uruguay Round created the WTO as a replacement body to continue
the work of GATT into the future. GATT ceased to exist in 1994.
The WTO will press for future reductions on trade barriers in areas such as agriculture, textiles,
intellectual property rights and services. The WTO, based in Geneva, currently has a membership of
about 150 countries. Membership obliges countries to sign up to an extensive range of agreements,
rather than be selective, as was the case with GATT.
Multinational companies (MNCs)

A MNC owns or controls production or service facilities based in a number of overseas countries. MNCs
may engage in “foreign direct investment” (FDI) in order to seek markets, raw materials, knowledge,
production efficiency, or safety from political interference. Horizontal or vertical integration and
product specialisation have fuelled the growth of companies such as General Motors, Royal Dutch Shell,
BP Amoco, Nissan and Hitachi and many MNCs now have annual turnovers exceeding the GNPs of
several large countries.
The balance of payments

The balance of payments is a statistical record of a country’s international trade transactions (current
account) and capital transactions with the rest of the world over a period of time eg
UK balance of payments 2010

£bn
Current account
Exports 200
Imports (215)
Visible balance (15)
Invisibles balance 5
(10)
UK external assets and liabilities: net transactions 2

Balancing item 8
10
N.B. The statistics that are gathered are not wholly perfect and some transactions will be omitted. Thus
the balancing item is unavoidable.
Temporary deficits can be financed by short term borrowing, but persistent balance of payments deficits
usually require government intervention, such as:
● Devaluation of the currency or government intervention on the foreign exchange markets.
● Raising interest rates.
● Restricting the money supply.
● Imposing tariffs or import quotas.
The international financial institutions
International Monetary Fund (IMF)

Founded in Bretton Woods, New Hampshire in 1944 with the aim of promoting world trade and
maintaining global monetary stability. Assists countries with balance of payments problems by making
loans in the form of Special Drawing Rights.
Such loans are normally dependent upon the country concerned making strict internal financial
adjustments to solve their economic problems.
The International Bank for Reconstruction and Development (IBRD)

Popularly known as the World Bank, it was also created at Bretton Woods in 1944, with the aim of
financing the reconstruction of Europe after the Second World War. The World Bank is now an
important source of long-term low interest funds for developing countries.
The Bank for International Settlements (BIS)

Established in Basle, Switzerland in 1930, it acts as a supervisory body for central banks assisting them in
the investment of monetary assets. It acts as a trustee for the IMF in loans to developing countries and
provides bridging finance for members pending their securing longer term finance for balance of
payments deficits.
The Euromarkets
The Euromarkets refer to transactions between banks and depositors/borrowers of Eurocurrency.
● Eurocurrency refers to a currency held on deposit outside the country of its origin eg Eurodollars
are $US held in a bank account outside the USA.
● Eurocurrency loans are bank loans made to a company, denominated in a currency of a country
other than that in which they are based. The term of these loans can vary from overnight to the
medium term.
● Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than one country. They
usually involve a syndicate of international banks and are denominated in a currency other than
the national currency of the issuer. Interest is paid gross.
● Euronotes are issued by companies on the Eurobond market. Companies issue short-term
unsecured notes promising to pay the holder of the Euronote a fixed sum of money on a specified
date or range of dates in the future.
● Euroequity market refers to the international equity market where shares in US or Japanese
companies are placed on as overseas stock exchange (eg London or Paris). These have had only
limited success, probably due to the absence of a effective secondary market reducing their
liquidity.
The global debt problem

This problem arose following the oil price increases in the 1970s, when the OPEC countries invested
their large surpluses with banks in the western world. The banks then lent substantial sums to the less
developed countries (LDCs) believing the default risk to be low. The oil price rises fuelled inflation and
interest rates increased, forcing most of the world’s economies into recession.
High interest rates and reduced exports placed LDCs in a situation where they could no longer pay
interest or repay loans. These problems made economic conditions in many LDCs extremely difficult,
affecting the position of multinationals and making international banks less willing to lend.
Methods of dealing with such excessive debt burdens have been:
● A programme of debt write-offs by banks and other lenders.
● Rescheduling existing debt repayments.
● Re-selling debt at a discount to recoup capital.
● Provision of additional loans where the debt problem is regarded as temporary.
● Drastic changes in the economic policies of the LDC imposed and monitored by the IMF.
Risks of foreign trade

Importing from and exporting to foreign countries includes the following categories of risk:
● Currency risk – sometimes referred to as “exchange rate risk”. It involves the possibility of
financial gains or losses arising out of unpredictable changes in exchange rates. It can be
classified into:
o Translation risk – the gains or losses to be reported when overseas operations are
consolidated into group accounts in accordance with SSAP 20/UITF 9, or IAS 21 and 29, or
FRS 23 and 24.
o Economic risk – the possibility that the value of the overseas entity (based upon the PV of
all future cash flows) will change due to unexpected exchange rate movements arising at
sometime in the future. o Transaction risk – the gains or losses that are made when
ultimate settlement occurs at a date when the exchange rate differs from the rate
prevailing at the date of the original transaction. This is seen as the short-term
manifestation of economic risk. It is this category of foreign currency risk, which is
particularly relevant to this syllabus.
● Political risk – the possibility of the financial success of a venture being affected by the actions of
an overseas government or population. Government agencies can advise on potential risks.
● Physical risk – the likelihood of damage or theft arising from the physical distances involved and
the length of time between despatch and receipt of the goods by the customer. Normal
commercial insurance is, of course, available.
● Credit risk – this is the risk of non-payment for the goods/services involved in an export
transaction. Insurance cover for up to 180 days can be provided by
NCM UK; for longer periods the ECGD may provide this service. Private sector companies such as
Trade Indemnity plc provide similar services.
● Trade risk – the overseas customer may refuse to accept the goods and be uncooperative in
returning them, thus taking advantage of the long physical distances involved.
● Liquidity risk – this is caused by the duration of the delivery period and the lengthy periods of
credit expected by some overseas customers.
● Cultural risk – there may be misunderstandings caused by differences in trade practice, religious
and moral attitudes, legal systems and language barriers.
Sources of finance for foreign trade

● Bank overdrafts – either in sterling or in the overseas currency.
● Bills of exchange – a negotiable instrument drafted by the exporter (the drawer), accepted by the
importer (the drawee) who thereby agrees to pay for the goods/services either immediately or
more commonly after a specified period of credit. If the importer accepts the bill it is known as a
“trade bill”, whereas if the importer arranges for its bank to accept the bill, it becomes a less risky
“bank bill”.
Where payment will be made after the specified period of credit, the exporter can sell the bill at a
discount to its face value and receive the cash immediately. If the bill is dishonoured the
exporter can seek legal remedies in the country of the importer.
● Promissory notes – similar, but less common than bills of exchange, since they cannot usually be
discounted prior to maturity.
● Documentary letters of credit – the importer obtains a Letter of Credit from its bank, which
guarantees payment to the exporter via a trade bill. Though slow to arrange, this method is
virtually risk free provided the exporter presents specified error free documents (eg shipping
documents, certificates of origin and a fully detailed invoice) within a specified time period. The
high bank fees for this procedure are normally borne by the importer, and the DLC is normally
reserved for expensive goods only.
● Factoring – the factoring company (often the subsidiary of a bank) assumes the responsibility for
collecting the trade debts of another – in this case an exporter. The factor may provide a range of
services (eg providing advances, administering the sales ledger, credit insurance etc) for an
additional fee. Widely regarded as a useful means of obtaining trade finance and collecting of
debts for small or medium sized exporters. However the exporter must always bear in mind the
eventual consequences of dispensing with the services of the factor and undertaking the running
of the sales ledger and cash collection activities itself.
● Forfaiting – a medium term source of finance whereby a domestic bank will discount a series of
medium term bills of exchange, which have normally been guaranteed by the importers bank.
The forfaiting bank normally forgoes the right of recourse to the exporter if the bill is
dishonoured. The exporter obtains the benefit of immediate funds, but the bank charges are
expensive. Forfaiting is normally used for the export of capital goods, where the importer pays in
a series of instalments over a period of years.
● Leasing and hire purchase – the exporter sells capital goods to a lessor, which in turn enters into a
leasing agreement with the exporter’s overseas customer. Alternatively the equipment can be
sold to a hire purchase company which resells to the importer under a HP agreement.
● Acceptance credits – a large reputable exporter can arrange for its bank to accept bills of
exchange (which are related to its export activities) on a continuing basis. These bills can then be
discounted at an effective cost, which is lower than the bank overdraft interest rate.
● Produce loans – where an importer acquires commodities for the purpose of immediate resale, it
can raise a loan from its bank, which takes custody of the goods until the importer is able to sell
them. Thereafter the principal sum, interest and storage costs are repaid to the bank out of the
proceeds of the sale.
● Requesting payment in advance from the importer – if this were possible it would avoid all of the
above complications.
Countertrade
This is an agreement in which the export of goods to a country is matched by a commitment to import
goods from that country. This usually occurs because the foreign importing country either lacks foreign
currency, has exchange controls in place or where there are barriers to imports which can be
circumvented by means of countertrade.
The volume of countertrade is now reported at about 30% of total international trade. In the case of
some Eastern European and Third World countries it is the only way of organising international trade
because of their shortage of foreign currency. Many countertrade deals can be highly complex involving
many parties.
ARTICLE FROM STUDENTS’ NEWSLETTER
This is a slightly updated version of an article, which appeared in the November 1999 edition of
Students’ Newsletter. The article was not originally intended for Paper 3.7 or Paper P4 students, but it
provides a useful insight into the introduction of the Euro. You are therefore asked not to learn the
contents of this article in detail, but to gain an overall insight into the features of the single European
currency and the arguments in favour and against the entry of the UK into the European Monetary
Union. The author, John O’Toole, is a lecturer at Griffith College, Dublin.
EUROPEAN MONETARY UNION AND THE SINGLE EUROPEAN CURRENCY
In 1998, the Heads of State or Government of the European Union (EU) Member States confirmed that
12 Member States qualified to form Economic and Monetary Union (EMU) and adopt the single
currency, the euro, from 1 January 1999. The twelve original member states of the “Eurozone” were
Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal
and Spain. On 31 December 1998 the Council of Economic and Finance Ministers irrevocably fixed the
conversion rates to apply between the currencies of these Member States and the euro, and on 1
January 1999 the euro came into being.
The United Kingdom and Denmark exercised their Treaty opt-outs from EMU and Sweden deliberately
failed to fulfil all the criteria for entry and was therefore rejected by the Commission.
Slovenia also joined the Eurozone on 1 January 2007, followed by Malta and Cyprus on 1 January 2008.
In addition, three European microstates (Vatican City, Monaco, and San Marino), although not EU
members, have adopted the euro via currency unions with member states. Andorra, Montenegro,
Kosovo, and Akrotiri and Dhekelia have adopted the euro unilaterally despite not being EU members.
Ten relatively new EU member states are required by their Accession Treaties to join the Eurozone, on 1
January of the following years:
Slovakia in 2009; Lithuania in 2010; Estonia in 2011; Bulgaria, Czech Republic, Hungary, Latvia and
Poland in 2012; Croatia in 2013; and finally Romania in 2014.
The formation of EMU and the creation of the euro were the culmination of a process of preparation
which had been going on since the signing in 1992 of the Treaty on European Union (the Maastricht
Treaty). EMU is one of the most farreaching steps in the history of the European enterprise.
Internally, the single currency was intended contribute to a greater sense of common purpose and
common endeavour among the peoples of the European
Union; externally it is intended to strengthen the Union’s ability to play a role in the world
commensurate with its economic and political importance.
The European Monetary System (EMS)
To understand why this single currency was set up it is necessary to look at the previous arrangements.
The idea of a single currency in Europe is not new. It goes back at least to 1970. While its fortunes have
varied since, the then European Community never lost sight of it as a goal. The European Monetary
System (EMS) and its Exchange Rate Mechanism (ERM), which were set up in 1979, were intended to
move towards monetary union. The Single Market programme of the late 1980s gave fresh impetus to
it.
In April 1978 at a meeting of the European Heads of State the German Chancellor
Schmidt and the French President, Giscard d’Estaing, proposed the creation of a European Monetary
System (EMS) with the purpose of creating a zone of monetary stability in Europe. In March 1979 the
EMS commenced operations in the hope that closer monetary co-operation between member states
would lead to monetary stability and economic growth. The EMS utilised a system of quasi-fixed
exchange rates, known as the Exchange Rate Mechanism (ERM), and had as its unit of account the
European Currency Unit (ECU). The value of the ECU was the weighted average of a basket of national
currencies with the weight allocated to each currency being determined by that country’s GNP and
intra-EC trade.
Those countries which were members of the ERM declared a central exchange value for their currency
and the majority of currencies agreed to fluctuate within a band ± 2.25% of this central value. This
meant that the Central Bank of each participating currency was committed to intervening, when
necessary, in order to maintain their exchange rate within the specified band. This was done by buying
their own currency when it was weak and selling their currency when it was strong. The UK, although a
member of the EMS since its inception, did not join the ERM until October 1990.
The rules of the EMS allowed governments to realign the central value of their exchange rate if changing
circumstances showed it to be no longer appropriate. In the early part of the EMS from 1979 to 1983
there were a number of realignments. However, from 1987 the system became very rigid and there was
only one realignment from 1987 – the lira was realigned in January 1990 – until the currency crisis in
1992.
The currency crisis
Speculators interpreted a number of developments in the world economy during 1992 as being
attributable to fundamental weaknesses within currency markets. This perception stimulated a period
of intense speculative pressure which caused a currency crisis.
German unification was a principal cause of the currency crisis. It is difficult to imagine a bigger shock to
the fixed parities of the ERM than the absorption of the then East Germany into the European economy.
Demand for consumer goods soared, pushing up inflation. The government’s budget expanded adding
to the Bundesbank’s (German Central Bank) alarm. Very low, short-term American interest rates caused
huge surges of money from the US into Germany, further fuelling German inflation rates. The
Bundesbank reacted by pushing up German interest rates. These high German interest rates occurred
just when the rest of Europe needed the rates to be low. The German mark was the anchor currency of
the ERM, so no European country could hold its interest rates below those in Germany. When interest
rates in Germany were increased all other EMS countries followed suit.
Other causes of the currency crisis were the lack of realignments with the EMS, so that its exchange
rates had become increasingly rigid and out of touch with international developments. Furthermore,
the necessary behind the scenes macroeconomic co-ordination was not taking place as EU Member
States publicly bickered over interest rate policy. The existence of widespread unemployment as
economic recession threw millions out of work intensified these tensions.
The straw that broke the camel’s back was 2 June 1992 when the Danish people rejected the Maastricht
Treaty in a referendum. The Danish rejection by 50.7% to 49.3% cast immediate doubt over the whole
process of economic and monetary union. Under EU law, the Danish failure to ratify the Maastricht
Treaty made the treaty null and void. As there had been no realignments within the ERM since January
1987, the money markets had assumed that the European Union’s political commitment to EMU meant
that the parties were virtually fixed. Doubts over Maastricht destroyed this assumption. Almost
immediately the weaker currencies came under selling pressure.
The pressure resulted in the devaluation of the Finnish mark, the Spanish peseta, the Irish punt, the
Portuguese escudo and the Swedish krona, in addition to forcing the UK and Italy to leave the ERM in
September 1992. In August 1993, further speculative pressure against the French franc and the Danish
krone led to a decision to widen fluctuation bands within the ERM to ± 15%. This action effectively
ended the currency crisis.
These events strengthened the political resolve in Europe to introduce Economic and Monetary Union
and the single currency.
The Maastricht Treaty
The Treaty on European Union was signed at the Dutch town of Maastricht in February 1992. This
Treaty became known as the Maastricht Treaty. The centrepiece of the Maastricht Treaty was the
decision to set up a single European currency.
A single European currency meant that all the participating countries would use the same currency. The
new currency was called the “euro”. It is divided into one hundred cents.
An essential aspect of a single European currency is the close co-ordination of economic policies
between Member States of the European Union. Economic and Monetary Union means that the
currencies of the member states are locked irrevocably to one another at the same exchange rate.
(Irrevocably means that these exchange rates cannot be changed afterwards). The EMU depends on a
similar level of development of the economies of the countries which are members. In order to ensure
that the economies of the countries concerned are at similar levels of development five convergence
criteria were developed. These convergence criteria are economic indicators of the strength of each
economy.
Economic and Monetary Union involves:
● an internal market with free movement of persons, goods, services and

capital;
● the irreversible locking of exchange rates;
● a single currency among participating Member States;
● EU management of macro-economic policy with intensified co-ordination of the economic and

budgetary policies of participating countries;
● EU management of market-regulating policies, for example, competition policy, to ensure every

country plays by the same rules;
● a European Central Bank in Frankfurt deciding European monetary policy.
The Stability and Growth Pact is part of the arrangements agreed by those countries which are part of
the EMU. The pact requires Member States in the EMU to commit themselves to aim for a medium-
term budgetary position of close to balance or in surplus. As part of the process of ensuring that the
euro is as stable as possible, the Stability and Growth Pact is aimed at minimising internal fiscal
imbalances in the short term. The rationale underlying the pact is that in favourable economic times,
Member States should so manage their budgets as to ensure that they can, over the course of a normal
economic cycle, reliably keep under the 3% ceiling on budget deficits set out in the Treaty. The pact
allows for exceptional circumstances when deficits can exceed 3% of GDP. It provides for penalties and
fines of up to 0.5% of GDP if deficits persist.
The five Maastricht criteria
These criteria are measures of the economy of each country across a number of headings:
Inflation
The level of inflation must be within 1.5% of the average of the three lowest inflation countries in the
system.
Government borrowing
The amount of Government borrowing is an important measure of the strength of the economy. The
amount of this borrowing as a percentage of the Gross Domestic Product must be below 60% or making
progress towards 60%.
Interest rates
States are permitted a maximum of 2% points above the average of the three lowest inflation countries.
Budget deficit
This is the toughest and politically most sensitive criterion involving tax policy and overall debt. Member
states must keep their government budget deficit within 3% of Gross Domestic Product.
Exchange rates
The fifth and final criterion for joining the EMU covers exchange rates. Countries must carefully manage
their exchange rate and must not have unilaterally devalued their currency within two years.
The timetable to EMU
The timetable to Economic and Monetary Union was decided by European leaders. On 1 January 1999
the new European currency, the euro, came into being. From this date there was be no change in the
exchange rates of the member countries.
Euro notes and coins were introduced into circulation on 1 January 2002. Dual circulation of the euro
and the legacy currencies of each country continued for a short period of time. Thereafter participating
countries have only used euro notes and coins.
The arguments in favour of EMU
Transparency
The strongest argument in favour of a single European currency is transparency – prices of goods in the
shops will be in the same currency and this will allow people to compare prices between euro countries.
Foreign exchange costs
Another advantage is that bank commission charges will no longer be levied on transactions between
the currencies of member states. Economists call these transaction costs. The EU Commission has
estimated that there will be savings of 0.25% of GDP on transaction costs which will improve conditions
for trade within the EU and make EU industry more competitive on world markets. The elimination of
these transaction costs will help also tourism and investment among participating Member States.
Stability in global trade
The introduction of a single currency will help eliminate exchange rate uncertainty and currency
fluctuations within Europe and with other countries. This will increase trade among members of the
Union and globally. This is because currency movements can inhibit business people from expanding
their sales in other countries.
Political union
Economic and monetary union is an important step towards closer European integration.
Interest rates
Interest rates will be lower and fairly uniform in participating countries within the EMU, and this will
reduce costs for government and business.
Price stability
With prices, margins and profits coming under competitive pressure as a result of the introduction of the
single currency, inflation rates will tend to move towards lower levels under the EMU.
Economic growth and stability
Economic growth will be increased by entering the EMU and there will be increased attractiveness of
participating Member States to foreign investment.
The EMU makes it necessary that Governments act very responsibly as regards tax and spending.
Fragmentation of Europe
If a country refuses to join, it may be isolated and risk becoming excluded from important decisions that
will apply to it in any event.
Global currency
The euro is emerging as a significant international reserve currency.
The level playing field
The discipline of a single currency prevents individual countries depreciating their currency to steal
competitive advantages over each other. Without a single currency, there would always be a
temptation for some countries to devalue, which undermines a single market.
The arguments against EMU
Loss of control over economic policy
The most important argument against the EMU is the loss of economic sovereignty. Countries are no
longer able to pursue their own independent economic policies.
This is particularly important in the area of exchange rates. With independent monetary policies the
countries with weaker economies were able to devalue their currencies. With the EMU, devaluation will
not be possible for any reason. European monetary policy will now be decided by the European Central
Bank in Frankfurt, Germany.
Less flexibility
A disadvantage of joining the EMU would be that countries would have less flexibility in their economic
policies. Under the Stability and Growth Pact countries will have less economic flexibility.
Loss of national pride
Many countries, like Britain, are proud of their currencies as a symbol of economic success and national
cohesion.
Price increases
Some firms might use the transition to the euro to disguise price increases.
The weak currencies
Those in favour of the EMU make much of the benefits of being tied to Europe’s stronger currencies.
There would be powerful pressures on members to bail out economies that borrow too much. This
could be very costly.
Regional disparities
Another disadvantage of the EMU is that it may contribute to greater regional disparities, especially for
more peripheral regions. There may be a tendency for economic activity to move towards the core of
Europe, the golden triangle between Paris, Hamburg and Rome.
Loss of foreign exchange earnings
A disadvantage of the EMU is the loss of money to the banks for the purchase and sale of foreign
exchange.
One way Street
The EMU sets EU member states on an inevitable track to a federal Europe. Effectively, once a country
signs up it loses control of economic policy. As a result, national parliaments would be no more than
regional town halls within Europe, with effectively little more power than local government.
Changeover costs
The changeover to the euro involves transition costs for business, public administrations and financial
institutions.
The position of the UK
In a speech in July 1997, the UK Chancellor of the Exchequer specified five economic tests of the UK’s
suitability for EMU membership. The five economic tests are:
1 Are business cycles and economic structures compatible, so that the UK and others could live
comfortably with euro interest rates on a permanent basis?
2 If problems emerge, is there sufficient flexibility to deal with them?
3 Would joining the EMU create better conditions for firms making long-term decisions to invest in
Britain?
4 What impact would entry into the EMU have on the competitive position of the UK’s financial
services industry, particularly the City’s wholesale markets?
5 Will joining the EMU promote higher growth, stability and a lasting increase in jobs?
In his statement on the EMU to the House of Commons on 27 October 1997, the Chancellor assessed
these five economic tests. His analysis was based on a UK Treasury paper published on that date. This
concluded that a successful EMU would bring benefits for the UK economy by securing macro-economic
stability and underpinning a well-functioning single market. This in turn would be good for investment,
growth and employment in the UK economy.
However, reflecting the cyclical divergences between the UK and continental European economies at
this time, the Chancellor concluded it would not be right for the UK to join the EMU from the outset.
On 23 February 1999 the UK Prime Minister, in a statement to the House of Commons, launched an
Outline National Changeover Plan. In his statement he indicated that Britain’s intention is that it should
join a successful single currency provided that the five conditions are met. The plan indicated that
making a decision to join the single currency at that time was not realistic but that, should the economic
tests be met, this could be decided at some future time.
Conclusion
The global economic environment is changing fast. This process will continue, and would continue if the
EMU had never been thought of. It involves greater globalisation of activity, increasing intensification of
competition among all the countries of the world and increasing technological change.
The formation of the EMU marked a substantial change in the economic environment of the European
Union as a whole. This is true for all Member States, and it is true whether or not they have joined the
EMU. Continuation of the status quo is not an option for any Member State, whether it has joined the
EMU or not.
Appendix One: International Financial Institutions
The European Central Bank
A European Central Bank (ECB) to operate the single monetary policy of the euro was set up on 1 June,
1998. The European System of Central Banks (ESCB) is comprised of the ECB and the central banks of
the Member States. The primary objective of the ESCB is to maintain price stability. Without prejudice
to this objective, the ESCB supports the general economic policies of the EU with a view to contributing
to the achievement of EU objectives. Briefly, these are to promote sustainable and non-inflationary
growth, a high level of employment and social protection, economic and social cohesion and solidarity
among the Member States.
The basic tasks of the ESCB are to:
● decide and implement the monetary policy of the EU;
● conduct foreign exchange operations;
● hold and manage the official external reserves of the Member States; and
● promote the smooth operation of payment systems
The Maastricht Treaty provides for the strict independence and accountability of the ECB.
The International Monetary Fund – the IMF
The IMF is a specialised agency within the UN system. It had its origins in the desire of members of the
international community to avoid unemployment and economic recession. It is the central institution in
the international monetary system and its aims are:
● to promote international monetary co-operation and to allow the expansion of international

trade
● to provide financial support to countries with temporary balance of payments

deficits
● to provide for the orderly growth of international liquidity.
The World Bank
The World Bank (the International Bank for Reconstruction and Development ie the IBRD) assists the
economic development of countries by making loans available. These loans are used to build up the
educational system, through new schools, and the health system, through new hospitals. This helps to
reduce poverty in the developing countries. In recent years the World Bank has increasingly emphasised
environmental protection in its work.
Chapter 15
Hedging foreign
exchange risk
CHAPTER 15 – HEDGING FOREIGN EXCHANGE RISK
CHAPTER CONTENTS
EXCHANGE RATES ------------------------------------------------------ 239

VARIABLE AND BASE CURRENCY 239
BID AND OFFER PRICES 239
SPOT AND FORWARD RATES 239
OUTRIGHT QUOTATION 240
POINT QUOTATION 240
CROSS RATES 240
RISK AND FOREIGN EXCHANGE --------------------------------------- 242
TRANSACTION EXPOSURE 242
TRANSLATION EXPOSURE 242
ECONOMIC EXPOSURE 242
RELATIVE IMPORTANCE OF THE DIFFERENT TYPES OF EXPOSURES 243
PROTECTION AGAINST ECONOMIC EXPOSURE ---------------------- 244
FACTORS TO CONSIDER BEFORE DECIDING TO PROTECT TRANSACTION EXPOSURE 244
PROTECTION AGAINST TRANSACTION EXPOSURE ----------------- 245

INTERNAL HEDGING TECHNIQUES 245
EXTERNAL HEDGING TECHNIQUES 247
INTEREST RATE PARITY THEORY (IRPT) 252
EXCHANGE RATES
An exchange rate is the rate at which one country’s currency can be traded in exchange for another
country’s currency.
Variable and base currency

Exchange rate is quoted as the number of one currency for one of another currency. The base currency
is the currency expressed as one and the variable currency is the currency expressed as the number of a
currency for the base currency.
Example 1
Consider the following exchange rate quotation:
$/£
1.500
This means $1.500 dollars is equal to £1. The dollar is the variable currency and the pound is the base
currency.
Bid and offer prices
Bid
A bid is the rate at which the dealer is willing to buy the foreign currency (base currency) from a
customer by paying in home currency (variable currency).
Offer or ask price
It is the rate the dealer will sell the foreign currency (base currency) and buying the home currency
(variable currency).
Spread
The spread is the difference between the bid price and the offer price. The offer price is slightly higher
than the bid price and the difference (spread) exist to compensate the dealer for holding the risky
foreign currency and for providing the services of converting currencies.
Spot and forward rates

Spot rate is the price at which foreign exchange can be bought or sold today with payment made within
two business days. It is simply the rate of buying or selling for immediate settlement.
Forward rate is the rate quoted today for delivery at a fixed future date of specified amount of one
currency against another currency. It is simply the buying or selling now, but settlement at an agreed
future date. Note that the agreed future date could be one month, two, three, six months up to one
year, although two years contract can exist in some currencies like sterling and dollar.
Outright quotation
Outright quotation means that the full price to all of its decimal point is given.
Example 2
Bid Offer
Spot rate 1.6878 1.7694
One month forward rate 1.6078 1.7574
Here both the spot and forward bid/offer are given in the full decimal places.
Point quotation
A point quotation is the number of points away from the outright spot rate with the first number
referring to points away from the spot bid and second number to points away from the spot offer price.
Whether the point quotation is subtracted or added to the spot rate is explained by premium or
discount on the exchange rate movements.
Subtract premium from the spot rate and add discount to the spot rate.
Example 3
Bid Offer
Spot rate 1.4432 1.4442

One month forward rate (premium) 58 56
Solution 3
58 – 56 is the point quotation, hence the forward rate is
Spot rate 1.4432 1.4442

Point -0.0058 -0.0056
One month forward rate 1.4374 1.4386
Cross rates
A cross rate is the computation of an exchange rate for a currency from the exchange rates of two other
currencies. In other words it is the exchange rate between two currencies determined by their common
relationships to a third currency.
Example 4
If
Y1 = $0.55 £1
= $1.60
Required:
What is the price of the pound in Yen?
Solution
If $0.55 = Y1
$1.60 = x
X= (1.6 x 1) / 0.55 = Y2.91 Hence Y2.91 =
£1.
Example 5
Consider the following exchange rates:
Bid Offer
Dollar/sterling ($/£) 1.4580 1.4980 Sterling/Euro (£/€) 0.4570
0.4890
Required:
(a) What would be received in pounds sterling by a UK company expecting to receive $400,000?
(b) What would be paid in pound sterling by a UK company expecting to pay $500,000?
(c) What would be received in pounds sterling by a UK company expecting to receive €400,000?
(d) What would be paid in pound sterling by a UK company expecting to pay €500,000?
Solution 5
(a) 400,000/1.4980 = £267,023

(b) 500,000/1.4580 = £342,936
(c) 400,000 x 0.4570 = £182,800

(d) 500,000 x 0.4890 = £244,500
RISK AND FOREIGN EXCHANGE
Foreign exchange risk, basically Currency risk, is the possibility of making profit or loss as a result of
changes in exchange rate. Examples of situations a company may be exposed to currency risk are:
● Imports of raw materials.
● Exports of finished goods.
● Importation of foreign-manufactured non-current assets.
● Investments in foreign securities.
● Raising an overseas loan.
● Having a foreign subsidiary or being a foreign subsidiary.
The foreign exchange risk exposures are divided broadly into three categories as follows:
● transaction exposure;
● economic exposure;
● translation exposure.
Transaction exposure
Transaction exposure relates to the gains and losses to be made when settlement takes place at some
future date of a foreign currency denominated contract that has already been entered into. These
contracts may include import or export of goods on credit terms, borrowing or investing funds
denominated in a foreign currency, receipt of dividends from over-seas, or unfulfilled foreign exchange
contract. Transaction exposure can be protected against by adopting a hedged position: that is, entering
into a counter balancing contract to offset the exposure.
Translation exposure
This arises from the need to consolidate worldwide operations according to predetermined accounting
rules. This is the risk that the organisation will make exchange losses or gains when the accounting
results of its foreign subsidiaries are translated into the presentation currency of the parent company.
Assets, liabilities, revenue and expenses must be restated into presentation currency of the parent
company in order to be consolidated into the group accounts.
Translation exposure can result from restating the book value of a foreign subsidiary’s assets at the
exchange rate on the balance sheet date. Such exposure will not affect the firm’s cash flows unless the
asset is sold.
Economic exposure
Economic exposure also called operating or competitive exposure or strategic exposure measures the
changes in the present value of the firm resulting from any changes in the future operating cash flows of
the firm caused by an unexpected changes in exchange rates. The change in value depends on future
sale volume, price and costs.
For example, a UK company might use raw materials which are priced in US dollars, but export its
product mainly within the EU. A depreciation of the pound against the dollar or appreciation of pound
against the Euro will both erode the competitiveness of this UK company.
The magnitude of economic exposure is difficult to measure as it considers unexpected changes in

exchange rates and also because such changes can affect firms in many ways.
Relative importance of the different types of exposures to the financial

manager
Transaction and economic exposures both have cash flow consequences for the firm and they are
therefore considered to be extremely important. Economic exposure is really the long-run equivalent of
transaction exposure, and ignoring either of them could lead to reduction in the firm future cash flows,
resulting in a fall in shareholders wealth.
Both of these exposures should therefore be protected against.
The importance of translation exposure to financial managers is however often questioned. In financial
management terms we ask the question ‘does translation loss reduces shareholders wealth? The
answer is that it is unlikely to be of consequence to shareholders who should in an efficient market,
value shares on the basis of the firm’s future cash flows, not on assets value in the published accounts.
Unless management believes that translation losses will greatly affect shareholders there would seem
little point in protecting against them.
PROTECTION AGAINST ECONOMIC EXPOSURE

The usual methods of protecting economic exposure include the following;
Diversification of financing
If a firm borrows in a foreign currency it must pay back in that same currency. If that currency should
appreciate against the home currency, this can make interest and principal repayments far more
expensive. However, if borrowing is spread across many currencies it is unlikely they will all appreciate
at the same time and therefore risk can be reduced. Borrowing in foreign currency is only truly justified
if returns will then be earned in that currency to finance repayment and interest.
Diversification of product and supply

If a firm manufactures all its products in one country and that country’s exchange rate strengthens, then
the firm will find it increasingly difficult to export to the rest of the world. Its future cash flows and
therefore its present value would diminish.
However, if it had established production plants worldwide and bought its components worldwide it is
unlikely that the currencies of all its operations revalue at the same time. It would therefore find that,
although it was losing exports from some of its manufacturing locations, this would not be the case in all
of them.
Also if it had arranged to buy its raw materials worldwide it would find that a strengthening home
currency would result in a fall in its input cost and this would compensate for lost sales.
Factors to consider transaction before deciding to protect

exposure
The factors may include the following:
● Future exchange rate movement, where the currency is very volatile. The future movements in
exchange rate may depend on a number of factors including interest rate, inflation, central bank
actions and economic growth.
● The availability of a market for the currency in question.
● The cost involved in the hedging, eg commission.
● The ability of the company to absorb foreign exchange losses.
● Expertise within the company.
● the company’s attitude towards foreign currency transactions and the importance of overseas
trading.
PROTECTION AGAINST TRANSACTION EXPOSURE
Once, a company has decided to hedge a particular foreign currency risk, there are a number of methods
to consider. They can be grouped as internal and external hedging techniques.
Internal hedging techniques
Invoicing in the home currency

One way of avoiding exchange risk is for an exporter to invoice his foreign customer in his home
currency, or for an importer to arrange with his supplier to be invoiced in his home currency. However,
although either the exporter or importer can avoid any exchange risk in this way, only one of them can
deal in his home currency. The other must accept the exchange risk.
Although invoicing in the home currency has the advantage of eliminating exchange rate risk, the
company is unlikely to compete well with a competitor who invoice in the buyers home currency, hence
the customer may purchase from the competitor.
Leading and lagging

Leading and lagging is a mechanism whereby a company accelerates (leads) or delay (lags) payment or
receipt in anticipation of exchange rate movements. This technique can be used only when exchange
rate forecasts can be made with some degree of confidence. Interest rates would also have to be
considered in granting long term credit.
Netting
Netting is setting the debtors and creditors of all the companies in the group resulting from transactions
between them so that only net amount is either paid or received.
There are two types of netting:
1. Bilateral Netting
In the case of bilateral netting, only two companies are involved. The lower balance is netted against the
higher balance and the difference is the amount remaining to be paid.
2. Multilateral Netting
Multilateral netting is a more complex procedure in which the debts of more than two group companies
are netted off against each other. There are different ways of arranging for multilateral netting. The
arrangement might be co-ordinated by the company’s own central treasury or alternatively by the
company’s bankers. The common currency in which netting is to be affected needs to be decided on.
Example 7
A group of companies controlled from the USA has subsidiaries in the UK, South Africa and France. At
31/12/X3, inter-company indebtedness were as follows
Debtors Creditors Amount
UK SA 1,200,000 SA Rand ®
UK FR 480,000 Euro
FR SA 800,000 SA rand
SA UK 74,000 Sterling
SA FR 375,000 Euro
It is the company’s policy to net off inter-company balances to the greatest extent possible. The
central treasury department is to use the following exchange rates for these purposes:
US $ = R 6.126 / £0.6800 / Euro 5.880
Required:
Calculate the net payment to be made between the subsidiaries after netting of inter-company
balances.
Solution 7
Step 1: convert the balance into a common currency, the US dollar.
Debtors creditors amount

UK SA 1,200,000/6.126 = 195,886
UK FR 480,000/5.880 = 81,633
FR SA 800,000/6.126 = 130,591
SA UK 74,000/0.6800 = 108,824
SA FR 375,000/5.880 = 63,776
Paying subsidiaries
TOTAL
UK SA FR
Receipts
$ $ $ $
Receiving subsidiary
UK - 108,824 - 108,824
SA 195,886 - 130,591 326,477
FR 81,633 63,776 - 145,409
Total payments (277,519) (172,600) (130,591) (580,710)
Total receipts 108,824 326,477 145,409 580,710

Net receipts/(payments) (168,695) 153,877 14,818 0
The possible advantages of this method are that, transaction cost may be lower as a result of fewer
transactions, and regular settlements may reduce intra-company exposure risk.
It disadvantages may include:
● The central treasury may have difficulties in exercising control that the procedure demands.
● Subsidiary company’s result may be distorted if the base currency is weaken in the sustained period.
Matching
This is the use of receipts in a particular currency to match payment in that same currency. Wherever
possible, a company that expects to make payments and have receipts in the same foreign currency
should plan to of set it payments against its receipts in that currency.
Since the company is offsetting foreign payment and receipt in the same currency, it does not matter
whether that currency strengthens or weakens against the company’s domestic currency because there
will be no purchase or sale of the currency.
The process of matching is made simply by having a foreign currency account, whereby receipts and
payments in the currency are credited and debited to the account respectively. Probably, the only
exchange risk will be limited to conversion of the net account balance into the domestic currency. This
account can be opened in the domestic country or as a deposit account in oversees country.
External hedging techniques

External hedging techniques means using the financial markets to hedge foreign currency movements.
The techniques include the following:
● forward contract,
● money market hedge,
● currency futures contract,
● currency options, and ● currency swaps.
Forward contract
The foreign-exchange forward market is an inter-bank market, where one party agrees to deliver a
specified amount of one currency for another at a specified exchange rate at a designated date in the
future. The designated exchange rate and date are called the forward rate and settlement (delivery) date
respectively. Where an investor takes a position in the market by buying a forward contract, the investor
is said to be in a long- position, and where he takes a position to sell a forward contract we say the
investor is in a short-position.
A forward contract is a binding contract on both parties. This means that having made the contract, a
company must carry out the agreement, and buy or sell the foreign currency on the agreed date and at
the rate of exchange fixed by the agreement. If the spot rate moves in the company’s favour, that will be
bad for the company and vice versa.
Example 8
Consider the following exchange rate:
$/£
Bid Offer
Spot rate 1.5090 1.5600 2months forward
1.5060 1.5590 3 month forward 1.5000 1.5500
A UK company is expecting to receive $100,000 in three months time from the goods supplied to a USA
company.
Required:
What is the sterling receipt if the company decides to hedge using a forward exchange contract?
Solution 8
Guaranteed sterling receipts is = $100,000/1.5500 = £64,516.13
This is the guaranteed right from the outset when the contract was made, and it is irrelevant what the
exchange rate will be in three months.
Example 9
A company expects to receive $10m in two month time. Exchange rates are as follows:
Spot $1.6100 – 1.6400

1 month dis 200 - 300
2 months dis 400 - 600
3 months dis 800 - 120
Required:
Show how forward contract can be used to hedge the exposure.
Solution 9
Three month forward rate will be: $/£
Spot 1.6100 - 1.6400

2 month points (add) 0.0400 - 0.0600
2 months forward rate 1.6500 – 1.7000
The guaranteed sterling receipt is $10m / 1.7000 = £5,882,353

Example 10
The exchange rate for dollar and sterling: $/£
Spot 1.5100 – 1.5150

3 months forward (premium) 45 – 42
A UK company is expected to pay $1,000,000 in three months time and wish to fix a rate for the transaction.
Required:
Use forward market contract to hedge this exposure.
Solution 10
Spot rate 1.5100 -- 1.5150

Points (less) 0.0045 -- 0.0042 3 months forward rate
1.5055 1.5108
Guaranteed payment = 1,0 00,000/ 1.5055 = £ 664231.2
Implications of using forward contracts
Forward contracts are obligatory and both parties have legal obligation to fulfil their part of the contract.
This means that if one party, say the customer, is not able to satisfy the contract the other party (bank)
can legally force him to meet it.
However, the bank can also extend the contract at an extra cost to the customer.
Money market hedge

The money market is a market where companies and individuals lend and borrow money for a short
period of time. The period of time could be overnight or up to a year.
Steps in money market hedge are:
● Borrow an appropriate amount in foreign currency today.
● Convert it immediately to the home currency.
● Place it on deposit account in the home currency.
● Settlement.
Example 11
A UK company export goods to a number of companies in the USA and Europe. It is due to receive $100,000
in three month time from the goods supplied to a USA company. The three months forward rate is 1.4550 –
1.4600. The spot rate is
1.4960-1.4990
The interest rates available in the money market are:
UK US
Annual interest 6% - 9% 11% - 14%
Solution 11
Normally two interest rates will be given. Note that the lower rate is the rate for depositing or investing
your money in the bank and the higher rate is the borrowing/taking money from the bank.
Following the steps!
1. Borrow from a bank an appropriate amount
● this means that we will borrow in the US bank at an interest rate of 14%
● the appropriate amount to be borrowed now at 14% to get $100,000 in three month time
is:
$100,000/ 1.035 = $96618.4
14/4 = 3.5% = three months interest rate
The amount borrowed of $96618.4 will compound up to $100,000 in three month at the rate of 14%
per annum or 3.5% for three months.
2. Convert the amount borrowed into sterling at the spot rate
$96618.4/ 1.4990 = £64455.2
3. Invest the £64455.2 in UK at an interest rate of 6% for three months
64455.2 x (1.015) = £65422.028
This amount is less than the amount given by the forward contract hence the company can hedge the
exposure by using the forward contract.
Example 12
Assume the same facts as example one above except that the UK company is making payment of $1,000,000.
Solution 12
Step 1
The UK company should buy dollars now and put them into a deposit account for three months in order to
get $1,000,000.
= $1,000,000 / (1+ (0.11/4) = $973,236.01
Step 2
Convert this amount to sterling at the spot rate, = 973,236.01/ 1.4960

= £650,558.83
Step 3
This means the company has to borrow £650558.83 in the UK for three months at an interest rate of 9%. The
total amount payable in sterling is:
650,558.83 x (1 + (0.09/4) = £665,196.40
Example Rates and Risk
(a) Structure of Exchange Rates
The following information on exchange rates was extractedCHAPTER

from the15Financial
– HEDGING FOREIGN
Times EXCHANGE
several years RISK
ago
Pound spot - forward against the pound:
Days spread Close Three months

United States 1.7545 – 1.7710 1.7680 – 1.7690 1.56 – 1.51 cpm Switzerland 2.2669 – 2.2770
2.2693 – 2.2714 3.39 – 3.73 cdis
Required:
(i) Identify the bank’s buying and selling rates.
(ii) Calculate the three months rates for the US dollar and the Swiss franc.
(b) Determinants of Forward Rates
The spot rate for the $/£ exchange is $1.77. Interest rates in London are 14% p.a. and in New
York 12% p.a.
Required:
Ignoring transaction costs calculate the best rate (for the customer) at which a bank will sell the
US $ twelve months forward.
(c) Hedging ‘Forex’ Risk
The following information is available with respect to the $/£ exchange rate and interest rates in
London and New York.
$/£
Spot 1.7680 − 1.7690
Three months 1.56 − 1.51 cpm
Interest rates:
Borrow Lend
London 15% p.a 13% p.a.
New York 10.5% p.a. 8.5% p.a.
Required:
(i) An American customer will pay $3m in three months’ time. Show how foreign exchange
risk can be eliminated using:
(1) forward market cover, and
(2) money market cover.
(ii) You must pay an American supplier $3m in three months’ time. Show how foreign
exchange risk can be eliminated using:
(1) forward market cover, and
(2) money market cover.

Solution to Rates and Risk
(a) The spot and the three month forward rates are:
US Dollars Swiss Francs

(i) Spot 1.7680 – 1.7690 2.2693 – 2.2714
(Prem)/dis (0.0156) – (0.0151) cpm 0.0339 – 0.0373 cdis
(ii) 3 month rates 1.7524 – 1.7539 2.3032 – 2.3087
BANK Sell $ Buy $ Sell SF Buy SF WE Buy $ Sell $ Buy SF Sell SF
(b) This exchange rate can be calculated from first principles as follows:
Bank borrows at 14% (say) £1,000 Buys $ spot at $1.77 =

$1,770 Invests $ at 12% for twelve months
In one year, the bank has:
$ asset $1,770 x 1.12 = $1,982.4
£ liability £1,000 x 1.14 = £1,140.0
Therefore the bank cannot sell $ forward for more than $1.7389 (ie $1,982.4 ÷ £1,140).
However the interest rate parity theory can alternatively be used.
Interest rate parity theory (IRPT)

Proponents of this theory claim that the difference between current spot rates and forward rates is based
upon interest rate differentials between the two countries concerned. Therefore the principle of
interest rate parity links the international money markets with the foreign exchange markets.
1 + foreign int erest rate 

Forward rate (Fo) = Current Spot rate x1 = S0 × 11++iibc  
+ home int erest rate 
Forward rate = $1.77 × = $1.7389
In this instance the current spot rate is $1.77 = £1, whereas the one year forward rate is $1.7389 = £1. Thus
there is a premium of $0.0311!!
Accordingly, provided this theory holds, where:
Foreign interest rates < UK interest rates, the forward rate is quoted at a premium,
and where:
Foreign interest rates > UK interest rates, the forward rate is quoted at a discount.
(c) (i) (1) Forward market hedge
The selling rate in the 3 month forward market (ie the banks buying rate) is $1.7539 (see part
a))
By selling forward you will receive $3,000,000 ÷ 1.7539 = £1,710,474 in three months’ time.
(2) Money market hedge : exporter case Has a $ asset

therefore must create $ liability
(1) Borrow in USA $3,000,000 ÷ 1.02625* = $2,923,264
(2) Sell $ spot $2,923,264 ÷ 1.7690 = £1,652,495
(3) Invest in UK £1,652,495 x 1.0325# = £1,706,201 proceeds
(4) Repay $ loan with receipts from customer = $3,000,000
*10.5%
= 2.625%
#13%
= 3.25%
It is more effective to hedge in the forward market.
(ii) (1) Forward market hedge
Buy $ forward : $3,000,000 ÷ 1.7524 = £1,711,938
(2) Money market hedge : importer case Has $

liability therefore must create $ asset
(3) Borrow in UK
= £1,661,525
(2) Convert to $ £1,661,525 x 1.7680 = $2,937,577
(1) Invest in USA $2,937,577 x 1.02125* = $3,000,000
(4) Repay £ loan £1,661,525 x 1.0375# = £1,723,832 cost
* 8.5%
= 2.125%
#15%
= 3.75%
Chapter 16
Hedging interest rate risk
CHAPTER 16 – HEDGING INTEREST RATE RISK
CHAPTER CONTENTS
INTEREST RATE RISK -------------------------------------------------- 257
TERM STRUCTURE OF INTEREST RATES ------------------------------ 258

THE NORMAL YIELD CURVE 258
THE INVERSE YIELD CURVE 259
BOND VALUATION AND BOND YIELDS ------------------------------- 261

VALUATION OF BONDS 261
GROSS REDEMPTION YIELD OR YIELD TO MATURITY OR REQUIRED RATE OF RETURN 261
VALUING BONDS BASED ON THE YIELD CURVE 262
ESTIMATING THE YIELD CURVE 263
HEDGING/PROTECTING INTEREST RATE RISK ---------------------- 264

FORWARD RATE AGREEMENTS (FRA) 264
INTEREST RATE RISK

Interest rate risk is the risk of incurring losses or higher costs due to an adverse movement in interest
rates or gains as a result of favourable movement in interest rates. The interest rate exposure can arise
due to many reasons including the following:
● The company has an asset whose market value changes whenever market interest rates changes.
● The company is expected to make some payment in the future, and the amount of the payment
will depend on the interest rate at that time.
● The company is expecting some income in the future, and the amount of income received will
depend on the interest rate at that time.
LIBOR and LIBID

LIBOR means the London inter-bank offered rate. It is the rate of interest at which a top-level bank in
London can borrow wholesale short-term funds from another bank in London money markets.
LIBID means the London inter-bank bid rate. It is the rate of interest that a toplevel bank in London
could obtain short-term deposits with another bank in London money markets. The LIBID is always
lower than the LIBOR
TERM STRUCTURE OF INTEREST RATES

The “term structure of interest rates” reflects the manner in which the gross redemption yield on
government bonds varies with the term to maturity, ie the period of time before the stock is to be
redeemed. For example, government bonds may be short-dated (eg repayment within 5 years),
medium-dated (repayment between 5 and 20 years) or long-dated (redemption in excess of 20 years).
Of course, some government bonds e.g. 2½% Consols are undated (ie irredeemable).
Gross
Redemption
Yield Bond
% Yield Curve
This data is often presented in the form of a graph to illustrate the “bond yield curve”, which is created
by plotting the gross redemption yield of the bond against the term to maturity. In normal
circumstances the yield curve is upward sloping.
The gross redemption yield reflects the internal rate of return on the cash flows associated with the
bond, ie it incorporates the effect of the current market value of the bond, the gross interest payments
and the redemption value of the bond – in other words it measures not only the gross interest yield but
also the capital gain or loss to maturity. The calculation of the gross redemption yield is very similar to
the calculation of the cost of redeemable debt for the company – the notable difference is that interest
payments are included gross (as opposed to net of corporation tax as is used in arriving at Kd).
The normal yield curve

The general shape of the normal upward sloping yield curve appears as follows:
0 5 10 15 20 25
Term to maturity (years)
A normal yield curve slopes upwards because the yield on longer dated bonds is normally higher than
the yield on shorter dated bonds. If you are confused by this point, remember that your mortgage is
only cheaper than your overdraft because the mortgage is secured on the property, whereas the
overdraft is unsecured. The reason for the upward sloping shape of the yield curve is thought to be
based on the following theories:
● liquidity preference theory
● expectations theory
● market segmentation theory.
Liquidity preference theory
Lenders have a natural preference for holding cash rather than securities − even low risk government
securities. They therefore need to be compensated for being deprived of their cash for a longer period
of time – hence the higher yield on longdated securities and the lower yield on short-dated securities.
There is a greater risk in lending long-term than in lending short-term. To compensate lenders for this
risk they would require a higher return on longer dated investments.
Expectations theory
This theory states that the shape of the yield curve will vary dependent upon a lender’s expectations of
future interest rates (and therefore inflation levels). A curve that rises from left to right indicates that
rates of interest are expected to increase in the future to reflect the investors fear of rising inflation
rates.
Market segmentation theory

The slope of the yield curve is thought to reflect conditions in different segments of the market. In other
words lenders and borrowers tend to confine themselves to a particular segment of the market and thus
it is probably futile to compare shortterm with long-term lending and borrowing. Thus, companies
typically finance working capital with short-term funds and non-current assets with long-term funds.
This leads to different factors affecting short-term and long-term interest rates leading to irregularities
which cause humps, dips or wiggles in the shape of the yield curve.
The inverse yield curve

A yield curve may occasionally slope downwards, since short-term yields may be higher than long-term
yields for the following reasons:
● Expectations. ie if interest rates are currently high, but the market anticipates a steep fall in the
near future, the resultant yield curve will be downward sloping.
● Government intervention. ie a policy of keeping interest rates relatively high might have the
effect of forcing short-term yields higher than long-term yields.
An inverse yield curve is downwards sloping and its general shape is as follows:
Gross
Redemption
Yield
%
Bond
Yield Curve
0 5 10 15 20 25
Term to maturity (years)
Significance of the yield curve to financial managers

Financial managers should inspect the current shape of the yield curve when deciding on the term of
borrowings or deposits, since the curve shows the market expectations of future movement in interest
rates.
If the yield curve slopes steeply upwards, it suggests increase in interest rate in the future. In this case
the financial manager should avoid borrowing long-term on variable rates, since the interest rate charge
may increase over the term of the loan. It would be better to either borrow on long-term fixed rate or
short-term variable rate.
BOND VALUATION AND BOND YIELDS
Valuation of bonds
A ‘plain vanilla’ bond will make regular interest payments to the investors and pay the capital to buy
back the bond on the redemption date when it reaches maturity. Therefore the value of a redeemable
bond is the present value of the future income stream discounted at the required rate of return (or yield
or the internal rate of return) as seen in chapter 9.
Example
A company has issued some 9% bonds, which are redeemable at par in three years’ time. Investors
require an interest yield of 10%.
What will be the current market value of £100 of bond?
Solution
10%
Year Cash flow discount factor PV
1-3 net interest 9.0 2.487 22.38
3 redemption value 100 0.751 75.10
Market value 97.48
This means that £100 of bonds will have a market value of £97.48
Remember that there is an inverse relationship between the yield of a bond and its price or value. The
higher rate of return (or yield) required, the lower the price of the bond, and vice versa.
Gross redemption yield or yield to maturity or required rate of return
The cost of redeemable bond is the internal rate of return or required rate of return or redemption yield
or yield to maturity of the cash flows of the bond.
Example
A 5.6% bond is currently quoted at £95 ex-int. It is redeemable at the end of 5 years at par. Corporation
tax is 30%.
Calculate gross cost of the bond.
Solution
Year CF DF10% PV DF5% PV
0 MP (95) 1 (95) 1 (95)
1-5 gross interest 5.6 3.791 21.23 4.329 24.24
5 Redemption value 100 0.621 62.1 0.784 78.4
NPV (11.67) 7.64
IRR = 5% + (7.64 / 7.64 + 1 1.67) X (10 % - 5%) = 7 %
Valuing bonds based on the yield curve

The spot yield curve can be used to estimate the price or value of a bond. Normally these rates are
published by the central banks or in financial press.
Example
A company wants to issue a bond that is redeemable in four years for its par value or face value of $100,
and wants to pay an annual coupon of 5% on the par value.
Estimate the price at which the bond should be issued and the gross redemption yield.
The annual spot yield curve for a bond of this risk class is as follows:
Year Rate
1 3.5%
2 4.0%
3 4.7%
4 5.5%
Solution
The market price of the bond should be the present value of the cash flows from the bond (interest and
redemption value) using the relevant year’s yield curve spot rate as the discount factor.
Year 1 2 3 4
Cash flows 5 5 5 105
Df 1.035-1 1.04-2 1.047-3 1.055-4
Present value 4.83 4.62 4.36 84.76
The market price = $98.57.
Given a market price of $98.57, the gross yield to maturity is calculated as follows:
Year CF DF10% PV DF5% PV

0 MP (98.57) 1 (98.57) 1 (98.57)
1-4 gross interest 5 3.170 15.85 3.546 17.73
4 Redemption value 100 0.683 68.3 0.823 82.3
NPV (14.42) 1.46
IRR or to maturity = 5% + (1.46 / 1.46 + 14.42) X(10% - 5%) = 5.46%
Note that the yield to maturity of 5.46% is not the same as the four year spot yield curve rate of 5.5%.
The reasons for the difference are as follows:
● The yield to maturity is a weighted average of the term structure of interest rates.
● The returns from the bond come in earlier years, when the interest rates on the yield curve are
lower, but the largest proportion comes in Year 4.
Estimating the yield curve

There are different methods used to estimate a spot yield curve, and the iterative process based on
bootstrapping coupon paying bonds is perhaps the simplest to understand. The following example
demonstrates how the process works.
Example
A government has three bonds in issue that all have a face or par value of $100 and are redeemable in
one year, two years and three years respectively. Since the bonds are all government bonds, let’s
assume that they are of the same risk class. Let’s also assume that coupons are payable on an annual
basis.
Bond A, which is redeemable in a year’s time, has a coupon rate of 7% and is trading at $103.
Bond B, which is redeemable in two years, has a coupon rate of 6% and is trading at $102.
Bond C, which is redeemable in three years, has a coupon rate of 5% and is trading at $98.
Determine the yield curve. (ACCA 2011 student article)
Solution
To determine the yield curve, each bond’s cash flows are discounted in turn to determine the annual
spot rates for the three years, as follows:
Bond A: $103 = $107 x (1+r1)-1 r1 = 107/103 –

1 = 0.0388 or 3.88%
Bond B: $102 = $6 x 1.0388-1 + 106 x (1+r2)-2 r2 = [106 / (102 –

5.78)]1/2 - 1= 0.0496 or 4.96%
Bond C: $98 = $5 x 1.0388-1 + $5 x 1.0496-2 + 105 x (1+r3)-3 r3 = [105 / (98 – 4.81 –

4.54)]1/3 – 1 = 0.0580 or 5.80%
The annual spot yield curve is therefore:
Year
1 3.88%
2 4.96%
3 5.80%
HEDGING/PROTECTING INTEREST RATE RISK
There are several methods of hedging interest rate risk including the following:
● forward rate agreements
● interest rate options
● interest rate swaps
● interest rate futures.
Forward rate agreements (FRA)

A forward rate agreement for interest rate is similar to forward foreign exchange contract.
A forward rate agreement offer companies the facility (with a bank) to fix future interest rates today on
either borrowing or lending for a specified future period.
If the actual interest rate proves to be higher than the rate agreed, the bank pays the company the
difference. If the actual rate is less than the rate agreed, the company pays the difference. This is called
compensation payment.
If a company knows for instance that it will take a loan in few months at a floating rate of interest it may
worry what the interest rate will be and try to manage it by using FRA. The company arranges FRA with
a third party (the bank) at a mutually agreed interest rate for a specified period in advance.
The company then takes the loan on the due date and pays interest at the prevailing (actual) rate. At
the end of the specified period the interest actually paid is compared with the rate agreed under the
FRA and adjustments are made accordingly between the two parties.
No premium or commission is paid on FRAs.
FRA quotations or prices

FRAs are over-the counter transaction between a bank and a company. The bank quotes two-way prices
for each FRA period for each notional borrowing (loan) or lending (deposit).
Examples of bank quotations for FRA are:
● 2v5 5.75 - 6.00
Means forward rate agreement that start in 2 months and last for 3 months at a borrowing rate
of 6% and lending rate of 5.75%.
● 3v5 5.78 - 6.13
of 6.13% and lending rate of 5.78%.
● 3v6 5.95 - 6.45
of 6.45% and lending rate of 5.95%
Example
A bank has quoted the following FRA rates:
2 v6 5.75 - 6.00
3 v5 5.78 - 6.13
4 v7 5.95 - 6.45
Assume that now is 1st November 2008.
Required:
Determine the FRA interest applicable to the following situations:
1. A company wants to borrow on 1st February 2009 and repay the loan on 1st of April 2009.
2. A company wants to deposit money on 1 st January 2009 and expect to with draw the amount for
an investment on 1st of May 2009.
3. A company wants to borrow on 1st March 2009 and repay the loan on 1st of June 2009.
Solution
1. 3 v 5 at a borrowing rate of 6.13%
2. 2 v 6 at lending rate of 5.75%
3. 4 v 7 at a borrowing rate of 6.45%
Compensation payment
Compensation period is calculated as the difference between the FRA rate fixed and the LIBOR rate at
the fixing date (actual LIBOR) multiplied by the amount of the notional loan/deposit and the period of
the loan/deposit.
The FRA therefore protects against the LIBOR but not the risk premium attached to the customer.
The settlement of FRA is made at the start of the loan period and not at the end and therefore
compensation payment occurs at start of the loan period. As a result the compensation payment should
be discount to it present value using the LIBOR rate at the fixing date over the period of the loan.
Example
A company will have to borrow an amount of £100 million in three month time for a period of six
months. The company borrow at LIBOR plus 50 basis points. LIBOR is currently 3.5%. The treasurer
wishes to protect the short-term investment from adverse movements in interest rates, by using
forward rate agreement (FRAs).
FRA prices (%)
3v9 3.85 – 3.80 4 v 9 3.58 3.53

5v9 3.55 3.45
Required:
Show the expected outcome of FRA:
(a) If LIBOR increases by 0.5%.
(b) If LIBOR decreases by 0.5%.
Solution
The FRA will be 3 v 9 as the money will be needed in three months time and will last for six months. The
applicable interest rate will be 3.85%.
(a) If LIBOR increases by 0.5%
LIBOR (Actual) at fixing date = 3.5 + 0.5 = 4.0%
Actual interest paid on the loan

= 4.5% x 100m x 6/12 (4 + = £2.25m
50/100)
Compensation received from the bank
= 0.15% x100m x 6/12 = (£0.075m)
(4 – 3.85)
Net interest payment £2.175m
Effective rate = (2.175/100) x (12/6) x 100% = 4.35%
Same as FRA rate + spread = 3.85 + 50/100 = 4.35%
(b) If LIBOR decreases by 0.5%

LIBOR (Actual) at fixing date = 3.5 - 0.5 = 3.0%
Actual interest paid on the loan
= 3.5% x 100m x 6/12 = £1.75m
(3 + 50/100)
Compensation received from the bank
= (£0.425m)
= -0.85% x100m x 6/12 (3 – 3.85)
Net interest payment £2.175m
Effective rate = (2.175/100) x (12/6) x 100% = 4.35%
Same as FRA rate + spread = 3.85 + 50/100 = 4.35%

Example
Assume that it is now 1 June. Your company expects to receive £7.1 million from a large order in five
months’ time. This will then be invested in high-quality commercial paper for a period of four months,
after that it will be used to pay part of the company’s dividend. The treasurer wishes to protect the
short-term investment from adverse movements in interest rates, by using forward rate agreement
(FRAs).
FRA prices (%)
4v5 3.85 – 3.80

4v9 3.58 3.53
5v9 3.50 3.45
The current yield on the high-quality commercial paper is LIBOR + 0.60%. LIBOR is currently 4%.
Required:
If LIBOR falls or increase by 0.5% during the next five months, show the expected outcome of FRA.
Solution
The FRA will be 5 v 9 as the money will be invested in five month time and will last for four months. The
applicable interest rate will be 3.45%.
If LIBOR falls by 0.5%
LIBOR (Actual) at fixing date = 4 - 0.5 = 3.5%
Actual interest received on

= 4.1% x 7.1m x 4/12 = £97,033.33
investment (3.5 + 0.6)
Compensation paid to the bank
= 0.05%x 7.1m x 4/12 = (£1,183.33)
(3.5 – 3.45)
Net interest payment £95,850
If LIBOR increases by 0.5%
LIBOR (Actual) at fixing date = 4 + 0.5 = 4.5%

Actual interest received on
= 5.1% x 7.1m x 4/12 = £120,700
investment (4.5 + 0.6)
Compensation paid to the bank
= 1.05%x 7.1m x 4/12 = (£24,850)
(4.5 – 3.45)
Net interest payment £95,850
Chapter 17
Futures
CHAPTER 17 – FUTURES
CHAPTER CONTENTS
DERIVATIVES ----------------------------------------------------------- 271
FUTURES ----------------------------------------------------------------- 272
CURRENCY FUTURES --------------------------------------------------- 276
INTEREST RATE FUTURES---------------------------------------------- 278

PRICING FUTURES CONTRACTS 278
TICKS AND TICK VALUES 278
DIFFERENCES BETWEEN FORWARD AND FUTURES CONTRACTS -- 281

ADVANTAGES OF USING FUTURES CONTRACTS 281
DISADVANTAGES OF FUTURES CONTRACTS 282
DERIVATIVES
A derivative is a financial instrument that derives its value from the price or rate of an underlying item.
A company can enter into Derivative position for one of two reasons:
● To hedge against exposure to a particular risk, or
● To speculate, and hope to make a profit from favourable movements in rate or price.
Examples of derivatives are forward contracts, futures contracts, options and swaps .
FUTURES
A futures is a legal binding contract between two parties to buy or to sell a standardised quantity of an
underlying item at a future date, but at a price agreed today, through the medium of an organised
exchange.
Future contracts are forward contracts traded on a future and options exchange.
Underlying item
Underlying item is the quantity of the item which is to be bought or sold under the futures contract.
Each futures contract has a standardised quantity of this underlying items and the futures contract
cannot be undertaken in fractions.
The underlying item may include agricultural products, like meat, cocoa, maize, energy products, like
crude oil gas, financial products, like currency and interest rate, and stock index futures on shares.
Delivery dates
Financial futures are normally traded on a cycle of three months, March, June, September and
December of each year.
The clearing house

Each futures exchange has a clearing house. When a futures deal has been made the clearing house
assumes the role of counterparty to both the buyer and the seller. Thus the buyer has effectively
bought from the clearing house whilst the seller is treated as having sold to the clearing house, thus
removing the risk of default on the futures contract. The clearing house imposes upon its members the
requirement to pay “margins”, which effectively acts as a security deposit.
Closing a future position

If you entered the futures contract by buying, then that contract will be closed by selling and if you
entered by selling futures contract, you close by buying. That is, a position is closed by reversing what
you did to enter the futures contract.
A person who bought a futures contract will close by selling and is said to hold a long position.
A person who sold a futures contract will close by buying and is said to hold a short position.
Ticks
A tick is the minimum price movement permitted by the exchange on which the future contract is
traded. Ticks are used to determine the profit or loss on the futures contract. The significance of the
tick is that every one tick movement in price has the same money value.
Example 1
If the price of a sterling futures contract changes from $1.4523 to $1.4555, then price has risen by
$0.0032 or 32 ticks.
If you entered/bought into 50 contracts the profit on the futures contract will be calculated as:
Number of contracts x ticks x tick value

50 x 32 x $6.25 = $10,000
Ticks are used to calculate the value of a change in price to someone with a long or a short position in
futures.
If someone has a long position, a rise in the price of the future represents a profit, and a fall in price
represents a loss.
If someone has a short position, a rise in the price of the future represents a loss, and a fall represents a
profit.
Margins
When a deal has been made both buyer and seller are required to pay margin to the clearing house.
This sum of money must be deposited and maintained in order to provide protection to both parties.
Initial margin
Initial margin is the sum deposited when the contract is first made. This is to protect against any
possible losses on the first day of trading. The value of the initial margin depends on the future market,
risk of default and volatility of interest rates and exchange rates.
Variation margin
Variation margin is payable or receivable to reflect the day-to-day profits or losses made on the futures
contract. If the future price moves adversely a payment must be made to the clearing house, whilst if
the future price moves favourably variation margin will be received from the clearing house. This
process of realising profits or loss on a daily basis is known as “marking to market”.
This implies that margin account is maintained at the initial margin as any daily profit or loss will be
received or paid the following morning. Default in variation margins will result in the closure of the
futures contract in order to protect the clearing house from the possibility of the party providing cash to
cover accumulating losses.
Example 2
Contract size £62,500
3 months future price $1. 3545
Number of contract entered 50 contracts
Tick value $6.25 Tick size 0.0001
Required:
Calculate the cash flow if the future price moves to in day one $1.3700 and 1.3450 day two (variation
margin). Assume a short position.
Solution 2
Day One
Selling price 1.3545

Buying price 1.3700
Loss 0.0155 = 155 ticks
Variation margin = payment of the loss
= 155 x 50 x $6.25 = $48,437
Day 2
Selling price 1.3700 Buying price 1.3450

Profit 0.025 = 250 ticks
Variation margin = receipt of the profit
= 250 x 50 x $6.25 = $78,125
Basis and basis risk

Basis is the difference between the futures price and the current cash market price of the underlying
security. In the case of exchange rates, basis is the difference between the current market price of a
future and the current spot rate of the currency. At final settlement date itself, the futures price and the
market price of the underlying item ought to be the same otherwise speculators would be able to make
an instant profit by trading between the futures market and spot cash market.
Most futures positions are closed out before the contract reaches final settlement, hence a difference
between the close out future price and the current market price of the underlying item.
Basis risk may arise from the fact that the price of the futures contract may not move as expected in
relation to the value of the underlying item which is being hedged.
Futures hedge
Hedging with a future contract means that any profit or loss on the underlying item will be offset by any
loss or profit made on the future contract. A perfect hedge is unlikely because of:
● Basis risk.
● The “round sum” nature of futures contracts, which can only be bought or sold in whole number.
CURRENCY FUTURES
A currency futures is an exchange traded agreement between two parties to buy/sell a particular
quantity of one currency in exchange of another currency at a particular rate on a particular future date.
Typical available futures contracts are as follows:
quantity of currency per value of one

Futures price quotation tick size
contract tick
£/ $ £62,500 $ per £1 $0.0001 $6.25
€/ $ €125,000 $ per €1 $0.0001 $12.50
€/£ €100,000 £ per €1 £0.0001 £10
Example Franco plc
Assume that it is now 30 June. Franco plc is a company located in the USA that has a contract to
purchase goods from Japan in two months time on 1 st September. The payment is to be made in yen
and will total 140 million yen.
The managing director of Franco plc wishes to protect the contract against adverse movements in
foreign exchange rates, and is considering the use of currency futures. The following data are
available.
Spot foreign exchange rate: Yen/$

128.15
Yen currency futures contracts on SIMEX (Singapore Monetary Exchange).

Contract size 12,500,000 yen. Contract prices are in US$ per yen.
Contract prices:
September 0.007985 December
0.008250
Assume future contract matures at the end of the month.
Assuming the spot exchange rate is 120 yen/$1 on 1 st September and that basis risk decreases steadily
in a linear manner.
Required:
Calculate what the result of the hedge is expected to be. Briefly discuss why this result may not occur.
Solution to Franco plc
● What contract. The most suitable contract will be the contract that matures at the nearest date
after the transaction date 1st September. This is the September contract, which matures at the
end of September.
● Buy or sell. To protect against the risk of the yen strengthening against the US$, Franco plc
should buy yen future contracts, hoping to sell at a higher price if the yen strengthens.
● Number of contracts. Each contract size is 12.5m yen and the amount involved is 140m yen.
Therefore the number of contracts to be bought are = 140/12.5 = 11.2 contracts. However,
contracts cannot be bought or sold in fractions (it should be whole number), therefore it can
enter into 11 whole contracts. This means 0.2 x 12.5 = 2.5 million yen is left unhedged under the
futures contract. The company can either hedge this 2.5m yen by using forward contract or leave
it unhedged.
● Calculation of closing price. This can be done, by using the basis and basis risk. Basis is the
difference between current spot rate and the future price.
Yen
Spot rate 128.15
Future price (September) = $ 0.007985 to yen = 1/ 0.007985 125.23
Basis 2.92 yen
Basis will be zero at maturity date of the future contract, 30 th September. If it reduces in a linear
manner over the three months period (30/6 to 30/9), the expected basis on 1 st September, when
there is still one month to maturity = (2.92 x1)/3 = 0.973 yen.
The expected futures price on 1 st September is therefore 0.973 yen below the spot price of 120
yen/$1
Closing price
Yen
Spot rate = 120 Basis 0.973
Future price 1 Sept = 119.027 or $0.008401 (1/119.027) ● Calculation of profit or loss:
$
Entered by buying 11 future contract each at 0.007985 Will close by selling
the 11 contracts each at 0.008401
Profit on futures position for each contract 0.000416
Total profit on future position = 0.000416 x 11 x 12.5m

= $57,200
● Expected result of the hedge or outcome
$
1st September- spot market (140/120) 1,166,667 Profit from the future position
57,200
Net payment 1,109,467
● Hedge efficiency. This is to check whether the hedge is a perfect hedge.
Spot market
30th June – spot market (140/128.15) 1,092,470

1st September – spot market (140/120) 1,166,667
Loss in the spot market 74,197
Hedge efficiency = 57,200/74,197 = 77%
● This result may not occur as basis is not likely to decrease in a linear manner .
INTEREST RATE FUTURES
Interest rate futures are futures contracts and similar to currency futures. They are standardised
exchange-traded contract agreement now between buyers and sellers, for settlement at a future date,
normally in March, June, September and December.
Pricing futures contracts
The pricing of an interest rate futures contract is determined by the three months interest rate (r %)
contracted for and is calculated as (100 – r). For example if three months Eurodollar time deposit
interest rate is 8%, a three months Eurodollar futures contract will be priced at (100-8) = 92; and if
interest rate is 11%, the future price = 89= (100-11).
The decrease in price or value of the contract reflects the reduced attractiveness of a fixed rate deposit
in times of rising interest rates.
Ticks and tick values

Examples of ticks and tick values are:
1. For 3 months Eurodollar futures, the amount of the underlying instrument is a deposit of
$1,000,000. With a tick of 0.01%, the value of the tick is:
0.01% x $1m x 3/12 = $25
2. For 3 months sterling, the underlying instrument is a 3 months deposit of £500,000. With a tick of
0.01%, the value of tick is:
500,000 x 0.01% x 3/12 = £12.5
Basis and basis risk

Example
If three months LIBOR is 7% and the September price of three months sterling future is 92.70 now, at
the end of March (let’s say), the basis is:
LIBOR (100 - 7) 93.00

Futures 92.70
0.30%
30 basis points
Maturity mismatch
Maturity mismatch occurs if the actual period of lending or borrowing does not match the notional
period of the futures contract (three months). The number of futures contract used has to be adjusted
accordingly. Since fixed interest is involved, the number of contracts is adjusted in proportion to the
time period of the actual loan or deposit compared with three months.
Number of contracts =
amount of actual loan/deposit time period required for loan/deposit 
  × 
 futures contrat size  3 months 

Example AA plc
The monthly cash budget of AA plc shows that the company is likely to need £18m in two months time
for a period of four months. Financial markets have recently been volatile, and the finance director fears
that short term interest rates could rise by as much as 150 ticks (ie 1.5%). LIBOR is currently 6.5% and AA
plc can borrow at LIBOR plus 0.75%.
LIFFE £500,000 3 months futures prices are as follows:
December 93.40
March 93.10 June
92.75
Required:
Assume that it is now 1 st December and that exchange traded futures contract expires at the end of the
month, estimate the result of undertaking an interest rate futures hedge on LIFFE if LIBOR increases by
150 ticks (1.5%).
Solution to AA plc
● What contract = 3 months contract = March futures contract.
● What type = sell as interest rates are expected to rise.
● Number of contracts
18m× 4
= = 48 contracts.
0.5m× 3
● Tick size = 0.01% x 500,000 x 3/12 = 12.5
● Calculate the closing future price using basis and basis risk.
Calculate opening basis as
Current LIBOR 6.5% = (100 –6.5) 93.50

Future price 93.10
Basis 0.40
This will fall to zero when the contract expires, and it is assumed that it will fall at an even or
linear manner.
There are four months until expiry and the funds are needed in two month time, therefore the
expected basis at the time of borrowing is:
0.4 x 2/4 = 0.2
Closing future price:
LIBOR = 6.5% + 1.5% = 8% = (100 –8) 92.0

Basis 0.2 Future price 91.8 ● Calculate profit or loss

Gain per contract 1.3 = 130 ticks
Total profit 130 x 0.01% x 500,000 x 3/12 x 48 = £78,000
OR
130 x 12.5 x 48 = £78,000
● Overall outcome (total cost)
£
Interest cost (8 +0.75) = 8.75% x 4/12 x 18m 525,000
Profit on future position (78,000)
Net cost 447,000
Effective rate of interest = (447,000/18m) x 12/4 x 100%
= 7.45%
DIFFERENCES BETWEEN FORWARD AND FUTURES

CONTRACTS
Futures contracts differ from forward contracts in a number of ways including the following:
● Size of the contract
Futures contracts are for multiples of standard-size contracts whereas forward contracts with a
bank can be negotiated for any size desired.
● Maturity
Futures contracts are available only for a set of fixed maturities, the longest of which is typically
for less than a year. A bank will write a forward contract for maturity up to a year and
occasionally for longer than a year.
● Location
Futures trading is conducted by brokers on the flow of an organised exchange, where orders from
all buyers and sellers compete in one central place. Forward contracts are negotiated with banks
at any location in person or by telephone.
● Price
Futures prices are determined through an open outcry process at the ’pit’ in which the particular
contract is traded. Forward contracts prices are quoted by the bank in the form of bid and offer.
● Counter parties
Purchasers and sellers of futures contracts are unknown to each other, since the opposite party
to every trade is the exchange clearing house. Purchasers and sellers of forward contracts deal
with the bank where they are known, either personally or by reputation.
● Margin
Futures contracts require payment of margin while no payments are made under forward
contract apart from settlement payment.
Advantages of using futures contracts

1. Futures could be used to hedge both interest rates and foreign currency risk
2. Default risk is minimal as contracts are marked to market daily by the clearing house, with the
protection of the margin payment.
3. There is single specified price, which is transparent. No bid and offer.
Disadvantages of futures contracts

1. Futures prices might not move by exactly the same amount as the cash market due to basis risk,
and perfect hedges are rare.
2. An initial margin (deposit) is required, and further variation margins may be necessary.
3. Futures contracts are not very flexible. Contracts are only on standardised size.
4. It is more complex than forward contract.
5. Futures contract is not available in every currency.
Chapter 18
Options
CHAPTER 18 – OPTIONS
CHAPTER CONTENTS
OPTIONS ----------------------------------------------------------------- 285
TERMINOLOGIES OF OPTIONS ---------------------------------------- 286
OVER-THE-COUNTER AND TRADED OPTIONS------------------------ 288
PRICING OF OPTIONS -------------------------------------------------- 289

FACTORS DETERMINING THE VALUE(PRICE) OF OPTION 289
THE BLACK-SCHOLES OPTION PRICING MODEL 291
PUT-CALL PARITY: PRICING A PUT OPTION 292
LIMITATIONS OF THE BLACK-SCHOLES MODEL 293
DIVIDEND PAID BEFORE DATE OF EXPIRY 293
REAL OPTIONS ---------------------------------------------------------- 294
OPTION TO DELAY OR DEFER 294
OPTION TO EXPAND 294
OPTION TO ABANDON 295
OPTION TO REDEPLOY OR SWITCH 295
VALUATION OF REAL OPTIONS 295
APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE THE VALUE OF
EQUITY ------------------------------------------------------------------ 299
THE GREEKS ------------------------------------------------------------- 305
1. DELTA 305
2. GAMMA 305
3. VEGA 306
4. THETA 306
5. RHO 306
SUMMARY OF THE GREEKS 306
HEDGING WITH OPTIONS --------------------------------------------- 307
CURRENCY OPTIONS --------------------------------------------------- 308
INTEREST RATE OPTIONS --------------------------------------------- 312

INTEREST RATE GUARANTEES OR OPTIONS ON FORWARD RATE AGREEMENTS 312
OPTIONS ON INTEREST RATE FUTURES 313
CAPS, COLLARS AND FLOORS 316
OPTIONS
An option is a contract giving it holder the right, but not an obligation to buy or sell a specific quantity of
a specific asset at a fixed price on or before a specific future date.
Options can be bought and sold over a wide range of assets from coffee beans to pork bellies and
financial assets such as amount of currency, an interest bearing security or bank deposit, and company’s
shares.
TERMINOLOGIES OF OPTIONS
The holder or buyer

The holder or buyer of the option is an investor or speculator who pays the option money as
consideration for the right to buy or sell at a fixed price over a limited period.
The writer or seller

The writer or seller of the option is an organisation or individual who will grant the option and take the
option money in payment for the services. Unlike the holder, the writer has an obligation to the deal, if
the holder is to exercise the right under the option.
Call option
A call option is the option that gives its holder the right, but not an obligation to buy the underlying item
at the specific price on or before the specific expiry date of the option. For example, a call option on
shares of central college, gives its holder the right to buy that number of shares in central college at the
fixed price on or before the expiry date of the option.
Put option
A put option is the option that gives its holder the right to sell the underlying item at the specific price
on or before the specific expiry date of the option. For example, a put option in central college shares,
gives its holder the right to sell that number of shares at the specific price on or before the specific
expiry date of the option.
Note that options are contractual agreements, so when the holder of the option exercises the option,
the seller or writer of the option must fulfil his side of the contract by selling (call option) or buying (put
option) the underlying item at the specified price.
American and European options

European options only allow the option holder to exercise the right on the expiry date itself and not
before.
American options allow the holder to exercise the right at any time up to and including the expiry date
of the option.
Striking or exercise price

This is the predetermined price at which the underlying item would be bought or sold if the holder of
the option decides to exercise the right under the option contract.
At, in, and out of the money

If the exercise price is more than the market price of the underlying item, a call option will be out of
money and a put option will be in the money.
If the exercise price is less than the market price of the underlying item, a call option will be in the
money and a put option will be out of the money.
If the exercise price is equal to the market price of the underlying item both call and put options will be
at the money.
Option money or premium

Option premium or money is the fee payable by the holder to the writer. It is the writers return for the
risks they are accepting. The premium will vary in value according to the market expectations of future
values of the underlying assets.
Intrinsic value
Intrinsic value is the difference between the strike price for the option and the current market price of
the underlying item. However, an in-the-money option has an intrinsic value; but because intrinsic value
cannot be negative, an out of the money option has an intrinsic value of zero.
OVER-THE-COUNTER AND TRADED OPTIONS

Over-the-counter options are options bought and sold in off-exchange transactions, negotiated directly
between the buyer (company) and seller (bank), tailored to the customer’s specific requirements.
Traded options are options bought and sold in a recognised exchange such as the LIFFE, and like futures,
have standardised contract terms.
Advantages of traded options over-the-counter options

1. There is greater price transparency, with current price on the market immediately available and
would be disseminated, which facilitates the management of option position.
2. It offers greater liquidity, with easy sale or purchase of options of a known standard quality.
3. Lower counter party risk. Contracts are marked to the market on a daily basis, and a central
clearing house monitors the ability of all counter parties to meet their obligations.
4. Better regulations. Most options exchanges are subject to stringent regulation by government
authorities.
5. Market traded options are normally American style options and may be exercised at any time.
OTC options are often European style, and can only be exercised at their maturity date.
Advantages of OTC options

1. OTC options offer a much larger choice of contract size and maturity which allows the purchaser
of the option to tailor the option much more specifically to individual needs.
2. Option sizes are typically much larger on the OTC market.
3. Options may be arranged for longer periods than is possible with traded options.
PRICING OF OPTIONS
Writers of options need to establish a way of pricing them. This is important because there has to be a
method of deciding what premium to charge to the buyers.
The pricing model for call options are based on the Black-Scholes model.
Factors determining the value(price) of option

The major factors determining the price of options are as follows:
The price of the underlying item

For a call option, the greater the price for the underlying item the greater the value of the option to the
holder. For a put option the lower the share price the greater the value of the option to the holder.
The price of the underlying item is the market prices for buying and selling the underlying item.
However, mid-price is usually used for option pricing, for example, if price is quoted as 200–202, then a
mid-price of 201 should be used.
The exercise price

For a call option the lower the exercise price the greater the value of the option. For a put option the
greater the exercise price, the greater the value of the option.
The exercise price will be stated in terms of the option contract.
Time to expiry of the option

The longer the remaining period to expiry, the greater the probability that the underlying item will rise
in value. Call options are worth more the longer the time to expiry(time value) because there is more
time for the price of the underlying item to rise. Put options are worth more if the price of the
underlying item falls over time.
The term to expiry will also be stated in the terms of the option contract.
Prevailing interest rate

The seller of a call option will receive initially a premium and if the option is exercised the exercise price
at the exercised date. If interest rate rises the present value of the exercise price will diminish and he
will therefore ask for a higher premium to compensate for his risk.
The risk free rate such as treasury bills is usually used as the interest rate.
Volatility of underlying item
The greater the volatility of the price of the underlying item the greater the probability of the option
yielding profits.
The volatility represents the standard deviation of day-to-day price changes in the underlying item,
expressed as an annualized percentage.
The following steps can be used to calculate volatility of underlying item, using historical information:
● Calculate daily return = Pi/Po, where Pi = current price and Po = previous day’s price
● Take the ‘In’ of the daily return using the calculator
● Square the result above to get, say, X
● Calculate the standard deviation as
= (∑ X /n)− (∑ X /n)
2 2
● Then annualise the result using the number of trading days in a year.
The formula = daily volatility x √trading days
Example
Day Price Pi/Po In(Pi/Po) X X2
Monday 100 - - -
Tuesday 103 1.03 0.0296 0.000874
Wednesday 106 1.0291 0.0287 0.000823
Thursday 105 0.9906 -0.0094 0.000089
Friday 108 1.0282 0.0282 0.000795
Total 0.0771 0.00251
n 4 4
Average 0.019275 0.0006275
Solution
Standard deviation = Daily volatility = 0.0006275 − (0.019275)2
= 0.016
= 2%
Since there are five trading days in a week and 52 weeks in a year, we assume the trading days in a year
is 52 x 5 = 260 days.
Annualised volatility = 2% x √260 = 32.2%.

The Black-Scholes option pricing model
Black-Scholes model is a model for determining the price of a call option. The model considers the
factors discussed above and states that the market value of a call option at a particular time can be
calculated as:
Option price = PaN(d1) – Pe(Nd2) e-rt
(
ln(Pa/Pe)+ r + 0.5s2 t d1 )
= s t
d2 = d1 – s√t
ln = natural log
Nd1 and Nd2 are the normal distribution function of d1 and d2 respectively.
Where:
Pa = current market price of the underlying item

Pe = the exercise price
R = the annual risk free rate in decimals
T = time to expiry of option in years, so six months will be 0.5 years.
S = the standard deviation of the underlying instrument returns. This
measures the volatility of underlying item.
Example
The current share price of AA plc is £2.90.
Estimate the value of a call option on the share of the company, with an exercise price of £2.60, and 6
months to run before it expires.
The risk free rate of interest is 6% and the variance of the rate of return on the shares has been 15%.
Solution
ln(2.9/2.6)+ (0.06×0.5×0.15) d1
= 0 . 15 × 0 . 5
d1 = 0.6452, approximate to two decimal places = d2 = 0.65
0.65 – (√0.15 x√0.5)
= 0.3713 rounded to 0.37
Using the normal distribution table:

Nd1 = N( 0.65) = 0.5 + 0.24 = 0.74
Nd2 = N(0.37) = 0.5 + 0.14 = 0.64
Using calculator e-rt = e-0.03
= 0.97
Call option price = (2.90 x 0.74) – (2.60 x 0.97 x 0.64)
= £0.53
Put-call parity: pricing a put option
The Black-Scholes model is used to price call options. The price of a put option can be derived from the
price of a call option using the put-call parity.
The relationship between the value of call option, C, and that of its associated put option, P, is given by
the following put-call parity equation as:
P = c – Pa + Pe e-rt
P = 0.53 – 2.9 + 2.60 (0.97)
P = £0.15
Limitations of the Black-Scholes model

The model has a number of limitations including the following:
● It assumes that no dividends are paid in the period of the option.
● It applies to European call options only, and not to American options.
● It assumes that the risk free rate is known and constant throughout the option life.
● It assumes that there is no transaction costs and tax effects involved in buying or selling the
option or its underlying item.
● The difficulty of estimating the standard deviation of the returns of the underlying item to which
the model is sensitive, and the use of this historical measure to estimate future movements.
Dividend paid before date of expiry

One of the main limitations of the Black-Scholes model is the assumption that no dividends are paid in
the period of the option. However, the formula can be adjusted to reflect a situation where dividend is
paid before the expiry date.
The only and simple adjustment is to calculate the dividend-adjusted share price, which is the difference
between the current share price and the present value of dividend to be paid.
PV of dividend = De-rt Where D = dividend.
Example
The following information relates to a call option:
Current share price £60 Exercise price

£70
Dividend to be paid in 3 month time £1.5
Risk free rate 5%
Expiry date is 5 months.
The dividend-adjusted share price for Black-Scholes option pricing model can be calculated as:
PV of dividend = De-rt
r = 0.05
t = 3/12 = 0.25 of a year.
PV of dividend = 1.5 e-(0.05 x 0.25)
= £1.48
Dividend-adjusted price = 60 –1.48 = £58.52 and this will replace the price of the underlying item in the
formula.
REAL OPTIONS
Real options are concerned with options related to operational and strategic decisions, in particular
those concerned with investment in projects.
Conventional DCF analysis looks at whether a project is going to add value for shareholders. In practice,
managers of a business are unlikely to consider net present values of projects alone. Investing in a
particular project might lead to other opportunities that may have been ignored in a DCF analysis.
Managers could take action to help boost a project’s NPV if it falls behind forecast. They can create and
take advantage of options in managing projects.
The flexibility provided by real options in investments appears in many guises. Busby and Pitts identify
the following types:
● Timing options – options to embark on an investment, to defer it or abandon it.
● Scale options – options to expand or contract an investment.
● Staging options – option to undertake an investment in stages.
● Growth options – options to make investments now that may lead to greater opportunities later,
sometimes called ‘toe-in-the-door’ option.
● Switching option – options to switch input or output in a production process.
Based on the P4 syllabus, we have to consider option to delay, expand, redeploy and withdraw.
Option to delay or defer

An option to delay gives the company the right to undertake the project in a later period without losing
the opportunity creating a call option on the future investment. This is more applicable if a company
has exclusive rights to a project or product for a specific period.
Option to expand
The option to expand exists when firms invest in projects which allow them to make further investments
in the future or to enter new market. The initial project may be found in terms of its NPV as not worth
undertaking. However, when the option to expand is taken account, the NPV may become positive and
the project worthwhile.
Expansion will normally require additional investment creating a call option.
Option to abandon
The option will be exercised only when the present value from the expansion is higher than the extra
investment.
An abandonment options is the ability to abandon the project at a certain stage in the life of the project.
Whereas traditional investment appraisal assumes that a project will operate in each year of its lifetime,
the firm may have the option to cease a project during its life.
Abandon options gives the company the right to sell the cash flows over the remaining life of the project
for a salvage/scrape value therefore like American put options. Where the salvage value is more than
the present value of future cash flows over the remaining life, the option will be exercised.
Option to redeploy or switch

The option to redeploy or switch exist when the company can use it productive assets for activities other
than the original one. The switching from one activity to another will be exercised only when the
present value of cash flows from the new activity will exceed the cost of switching. This could result to a
put option if there is a salvage value for the work already performed, together with a call option arising
on the right to commence the new investment at a later stage.
Valuation of real options

The Black-Scholes model can be used to value real options just as financial options seen earlier, but the
following should be noted:
● The exercise price will be replaced by the capital investment (initial investment).
● The price of the underlying item will be replaced by the present value of future cash flows from
the project.
● Time to expiry is replaced by the life of the project.
● Interest rate is still the risk free rate.
● Volatility of cash flows can be measured using typical industry sector risk.
Illustration of an option to expand

Winter plc has investigated the opening of a new restaurant in the Isle of Man. The initial capital
expenditure is estimated at £12 million, whilst the present value of the net cash inflows is expected to
be £12.005 million. Since the resulting NPV of £0.005 million is a very small positive amount, this
appraisal suggests that the project is extremely marginal.
However, if this first restaurant is opened, Winter plc would gain the right, but not the obligation to
open a second restaurant in five years time at a capital cost of £20 million. The present value of the
associated future net cash inflows is estimated at £15 million, with a standard deviation of 28.3%.
If the risk free rate of interest is 6%, determine whether to proceed with the restaurant projects.
Solution to illustration
t = 5; Pe = 20; Pa = 15; s = 0.283; r = 0.06
d1 =
= = = 0.3358
d =
2 0.3358 − 0.283× 5 = –0.297
Using the standard normal distribution tables:
d1 = 0.3358 gives 0.1331; thus N(d 1) = 0.5 + 0.1331 = 0.6331 d 2 = –0.297 gives –0.1179; thus N(d 2) = 0.5 –
0.1179 = 0.3821
c= (15 x 0.6331) – (20 x 0.3821 x e-0.06 x 5)
= 9.4965 – (20 x 0.3821 x 0.7408)
= 9.4965 – 5.6613
= £3.8352m
Conclusion:
£m
NPV of first restaurant 0.005
Value of call option (to expand) on second restaurant 3.8352
Value of combined projects +3.8402
Therefore the project should be accepted, since the additional value (which incorporates the option to
expand), allows Winter plc to avoid the downside element of risk.
Illustration of an option to abandon

Summer plc is undertaking a brewing joint venture with Autumn Inc. This project requires an initial
outlay by Summer plc of £250 million. The present value of the net cash inflows is expected to be £254
million, with a variance of 9%. The arrangement thus provides an extremely small positive NPV of £4
million. Summer plc, however, has the right but not the obligation to sell its share of the joint venture to
Autumn Inc for £150 million at the end of the first five years of the venture.
If the risk free rate of interest is 7%, calculate the value of this abandonment option.
Solution to illustration
Pa = 254; Pe = 150; s2 = 0.09; t = 5; r = 0.07
Firstly, calculate the value of the call option:
1
ln(254 ÷150)+ (0.07 + 0.5× 0.09)5 d
=
0 . 09 × 5
0.
= = 1.6423
d2 = 1.6423 − 0.6708 = 0.9715
Using the standard normal distribution tables:
d1 = 1.6423 gives 0.4495; thus N(d1) = 0.5 + 0.4495 = 0.9495 d2 = 0.9715
gives 0.3340; thus N(d2) = 0.5 + 0.3340 = 0.8340
c= (254 x 0.9495) – (150 x 0.8340 x e-0.07 x 5)
= 241.173 – (150 x 0.8340 x 0.7047)
= 241.173 – 88.156 = 153.017
Secondly, using the put call parity relationship, calculate the value of the put option p = c - P a + Pe e-rt
= 153.017 – 254 + (150 x 2.7183-0.07 x 5)
= 153.017 – 254 + 105.703
= £4.72m
Alternatively, it is possible to directly calculate the value of the put option using the following modified
Black-Scholes formula, but this is not provided on the ACCA formula sheet:
p = Pe N(−d2)e-rt – Pa N(−d1)
where:
N(−d1) = 0.5 – 0.4495 = 0.0505 N(−d2) =
0.5 − 0.3340 = 0.166
p = (150 x 0.166 x 2.7183-0.35) – (254 x 0.0505)
= (150 x 0.166 x 0.7047) – 12.827
= 17.547 – 12.827
= £4.72m
Conclusion:
£m
NPV of joint venture project 4
Value of put option (to abandon joint 4.72 venture)
Total NPV with the abandonment option +8.72
Therefore Summer plc should go ahead with the joint venture, since the additional value, which
incorporates the option to abandon allows Summer plc to avoid the downside element of risk.
APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE THE VALUE OF EQUITY

A major aspect of the P4 syllabus is the emphasis on corporate valuation. There may, of course, be some
companies that cannot realistically be valued by conventional techniques.
The Black Scholes Option Pricing (BSOP) model provides a basis for corporate valuation in cases where
traditional methods are either inappropriate, or where they fail to fully reflect the risks involved. Some
authors refer to the Black Scholes Merton model to reflect the work performed by Robert Merton (a key
member of the research team which developed the model).
The usual determinants in the valuation of options need to be redefined, when the valuation of equity is
treated as a call option:
Determinants Possible appropriate measures
Valuation of the underlying The fair value of the assets of the company
Exercise price Settlement values of outstanding liabilities
Volatility of the underlying Standard deviation of underlying assets
Risk-free rate of interest Current yield on company debt
Time to expiry Average period to settlement of company liabilities

Where the assets of the company are actively traded and easily liquidated, their current market value
would be appropriate. In the case of most companies, fair value will normally be based upon the
present value of the future cash flows that the company’s assets are expected to generate over their
useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to estimate accurately.
One approach is to estimate the probabilities of the likely future cash flows of the company and generate
a distribution of their present values from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the company’s liabilities
consist entirely of debt in the form of a zero coupon bond. If the company’s debt includes other types of
bond, adjustments are necessary as shown in the following illustration.
Illustration 1
A company has on issue a 5% bond with five years to redemption with a gross yield to maturity of 8%.
Required:
Estimate the market value of that bond and that of an equivalent zero coupon bond.
Solution 1
The market value of the debt is estimated as follows:

Year 1 2 3 4 5
Annual interest and redemption payments (£) 5 5 5 5 105
Discount factors @ 8% 0.926 0.857 0.794 0.735 0.681
Present values (£) 4.63 4.29 3.97 3.67 71.50
Present value of debt = £88.06
The redemption value of a zero coupon bond of the same market value is calculated by establishing the
unknown future value which (when discounted at 8% p.a. for a five year period) provides a present value
of £88.06, ie:
Future value = £88.06 x 1.085 = £129.39
Therefore £129.39 is treated as the exercise price (ie the redemption value of a zero coupon bond with
the same features as the debt currently in issue, which has a yield to maturity of 8%).
Assuming that acceptable estimates of the input variables have been established, the next step is to
incorporate them into the BSOP model. The model does have a number of restricting assumptions, but it
can be used to produce an acceptable valuation of a company.
Illustration 2
In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair values of £113.2 billion
and £110.7 billion respectively. The average term to maturity on the liabilities of the bank (which
consisted of short-term money market borrowing and deposits) was 100 trading days, whilst the annual
number of trading days was 250 approximately. At that time the risk-free rate of interest was 3.5% and
the company had 495.6 million equity shares in issue.
Required:
(a) Using the BSOP (sometimes referred to as the Black Scholes Merton) model, estimate the share
price of Northern Rock in each of the following situations: (i) Assuming that the standard
deviation of the bank’s assets was 5%; and (ii) Assuming that the volatility of the bank’s assets was
10%.
(b) Using the Black Scholes Merton model, recalculate an estimate of the share price of Northern Rock
if the fair value of the company’s assets fell to £110.7 billion and their volatility was 5%.
(c) Comment upon the results and consequences of the calculations performed in parts (a) and (b)
above.
Solution 2
This entire procedure is based on the notion that if equity shareholders pay off the liabilities at “expiry
date”, they are effectively paying the “exercise price” of a call option and thus “exercising their right to
buy” the underlying assets of the company at their fair value.
Taking the data provided and converting to the ACCA symbols:
(a)
Pa = 113.20; Pe = 110.70; r = 0.035; t = (100 ÷ 250) = 0.4 (since the annual number of trading days
is 250); s is initially taken as 0.05 and, subsequently as 0.1
(i) If volatility (s or σ) = 0.05:
d1 =
0.
=
= = 1.16474
d2 = 1.16474 - 0.0316227 = 1.13312
From Normal Distribution tables: d1 =
1.16474, by interpolation:
1.16 gives 0.3770

1.17 gives 0.3790 1.16 gives
0.3770
(474 ÷ 1000) x 0.0020 = 0.00095
0.37795
d2 = 1.13312, by interpolation:
1.13 gives 0.3708

1.14 gives 0.3729 1.13 gives
0.3708
(312 ÷ 1000) x 0.0021 = 0.00065
0.37145
Of course, in an exam it is quicker to round up or down to the two decimal places provided by the ACCA
tables. In this case, 1.16 (giving 0.3770) and
1.13 (giving 0.3708) would be used!
N(d1) = 0.5 + 0.37795 = 0.87795

N(d2) = 0.5 + 0.37145 = 0.87145
c = (113.20 x 0.87795) – (110.70 x 0.87145 x e -0.035 x 0.4)

= 99.384 – (110.70 x 0.87145 x 0.98610)
= 99.384 – 95.128 = £4.258bn
Price = (£4.258 bn ÷ 495.6 m shares) = £8.59 per share
(ii) If volatility (s or σ) = 0.1:
d1 =
0.
=
= = 0.60609
d2 = 0.60609 – 0.0632455 = 0.54284
From Normal Distribution tables:
0.60 gives 0.2257

0.61 gives 0.2291
0.60 gives 0.2257
(609 ÷ 1000) x 0.0034 = 0.00207
0.22777
0.54 gives 0.2054
0.55 gives 0.2088
0.54 gives 0.2054
(284 ÷ 1000) x 0.0034 = 0.00097
0.20637
Again, in an exam it is quicker to round up or down to the two decimal places provided by the
ACCA tables. In this case, 0.61 (giving 0.2291) and 0.54 (giving 0.2054) would be used!
N(d1) = 0.5 + 0.22777 = 0.72777 N(d2) = 0.5

+ 0.20637 = 0.70637
c = (113.20 x 0.72777) – (110.70 x 0.70637 x e -0.035 x 0.4)
= 82.3836 – (110.70 x 0.70637 x 0.98610)
= 82.3836 – 77.1082 = £5.2754 bn

(b)
In this instance, the asset value (Pa) falls and is now equal to the liability value (at a volatility of 0.05), so
that both Pa and Pe become 110.70. All other facts are unchanged.
The calculations are:
d1 =
= = 0.45853
0.
d2 = 0.45853 – 0.0316227 = 0.42691
From Normal Distribution tables:

0.45 gives 0.1736
0.46 gives 0.1772
0.45 gives 0.1736
(853 ÷ 1000) x 0.0036 = 0.0031
0.1767
0.42 gives 0.1628
0.43 gives 0.1664
0.42 gives 0.1628

(691 ÷ 1000) x 0.0036 = 0.0025
0.1653
Once more, in an exam it is quicker to round up or down to the two decimal places provided by the ACCA
tables. In this case, 0.46 (giving 0.1772) and 0.43 (giving
0.1664) would be used!
N(d1) = 0.5 + 0.1767 = 0.6767

N(d2) = 0.5 + 0.1653 = 0.6653
c = (110.70 x 0.6767) – (110.70 x 0.6653 x e -0.035 x 0.4)
= 74.9107 – (110.70 x 0.6653 x 0.98610)
= 74.9107 – 72.6250 = £2.29 bn
(c) Comments
As can be seen from the calculations in part (a), the value of an option increases as the level of risk rises.
At a standard deviation of 5%, the share price is £8.59, whilst at a volatility of 10%, the share price rises
to £10.64. The actual share price of Northern Rock in March 2007 fluctuated around £9.50 per share.
In part (b) of this illustration, the fair value of the bank’s assets fell to £110.7 billion to be equal to the fair
value of its liabilities. Accordingly, the Statement of financial position would show an equity value of zero.
However, the BSOP model shows a quite different result, at a volatility of 5% the total value of the equity
is still worth £2.29 billion, that is £4.62 per share – almost precisely its value in September 2007!
At this date, the information being released from the company suggested that its assets had fallen in
value as the bank’s mortgage receivables were written down in line with falling house prices and
potential defaults.
It was only when the threat of nationalisation became a real possibility (during the final months of 2007)
that the equity value began to collapse - and this can be explained within the framework of the BSOP
model. Nationalisation eliminates the possibility of asset recovery for the shareholders. This deprives
them of the “time value” on their call option on the underlying assets of the business.
The rationale for this rather strange result is that the equity of a business can still have a substantial
positive value (despite the Statement of financial position showing a zero equity value) because of the
presence of limited liability!
Limited liability protects shareholders from a loss - and in fact they have everything to gain if the fair
value of the assets should recover! When the equity of a company is “at or near the money”, ie when its
gearing levels approach 100%, the equity investors will become increasingly risk aggressive (i.e. risk-
seeking). Agency theory suggests they will provide management with incentives to increase risk, rather
than reduce it. Hence, the very high levels of reward offered to bank employees, particularly those
employed in the risk-taking departments of the business.
The work of Black, Scholes and Merton provides a framework to value those companies that are
financed, in part, by borrowing. Where shareholders are protected by limited liability, they have a call
option on the underlying business assets. Employing the BSOP model, an estimate can be made of the
value of a company’s equity on the basis of the value of its assets and their volatility.
For companies that are deep “in-the-money”, time value is small and the intrinsic value of the business
(i.e. the present value of the net assets) will dominate the value of the equity. In this case, normal risk
aversion can be expected to apply as that intrinsic value will be exposed to equal positive and negative
movements in the value of the company’s assets.
This situation dramatically changes when companies are “near-the-money”. This occurs with high growth
start-ups financed by debt, leveraged buyouts and companies that are in risk of default.
One class of company (banks) always operate “near-the-money”, and in valuing such businesses, time
value would be more significant than intrinsic value in equity valuation.
When time value dominates, shareholders become risk-seekers and they will grant management
incentives to take greater risk, which will cause the company to be pushed closer and closer “to-the-
money”, by expanding assets and liabilities without increasing the equity capital.
THE GREEKS
In principle, an option writer could sell options without hedging his position. If the premiums received
accurately reflect the expected pay-outs at expiry, there is theoretically no profit or loss on average. This
is analogous to an insurance company not reinsuring its business. In practice, however, the risk that any
one option may move sharply in-the-money makes this too dangerous. In order to manage a portfolio of
options, the dealer must know how the value of the options he has sold and bought will vary with
changes in the various factors affecting their price. Such assessments of sensitivity are measured by the
“Greeks”, which can be used by options traders in evaluating their hedge positions.
1. Delta
For each option held, the delta value can be established i.e.
Change in option price

Delta =
Change in price of underlying security
Delta is a measure of how much an option premium changes in response to a change in the security
price. For instance, if a change in share price of 5p results in a change in the option premium of 1p, then
the delta has a value of (1p/5p) 0.2.
Therefore, the writer of options needs to hold five times the number of options than shares to achieve a
delta hedge. The delta value is likely to change during the period of the option, and so the option writer
may need to change his holdings to maintain his delta hedge position.
Accordingly a writer can hedge a holding of 300,000 shares using options with a delta value estimated by
N(d1) of 0.6, by holding the following number of LIFFE contracts (each on 1,000 shares).
Number of shares 300,000

= = 500 contracts.
Delta value × Contract size0.6×1,000
A delta value ranges between 0 and +1 for call options, and between 0 and -1 for put options. The actual
delta value depends on how far it is in-the-money or outof-the-money.
The absolute value of the delta moves towards 1 (or -1) as the option goes further in-the-money and
shifts towards 0 as the option goes out-of-the-money. At-themoney calls have a delta value of 0.5, and
at-the-money puts have a delta value of -0.5.
2. Gamma
Gamma measures the amount by which the delta value changes as underlying security prices change. This
is calculated as the:
Change in the delta value

Change
in the price of the underlying security
3. Vega
Vega measures the sensitivity of the option premium to a change in volatility. As indicated above higher
volatility increases the price of an option. Therefore any change in volatility can affect the option
premium. Thus:
Change in the option price

Vega =
Change in volatility
N.B. Vega is the name of a star, not a letter of the Greek alphabet!!
4. Theta
Theta measures how much the option premium changes with the passage of time. The passage of time
affects the price of any derivative instrument because derivatives eventually expire. An option will have a
lower value as it approaches maturity. Thus:
Change in the option price (due to changes in value)

Theta =
Change in time to expiry
5. Rho
Rho measures how much the option premium responds to changes in interest rates. Interest rates affect
the price of an option because today’s price will be a discounted value of future cash flows with interest
rates determining the rate at which this discounting takes place. Thus:
Change in the option price

Rho =
Change in the rate of interest
Summary of the Greeks
Changes in In response to changes in
DELTA Option premium Value of underlying security

GAMMA Delta value Value of underlying security
VEGA Option premium Volatility
THETA Time value in option premium Time to expiry
RHO Option premium Risk free rate of interest
HEDGING WITH OPTIONS

An option contract is bought by paying premium in order to have the right to buy (call option) or sell (put
option) the underlying item (currency) such that, if the underlying cash market rate moves in an adverse
direction, the holder of the option will exercise the right to take advantage of the option. However if the
underlying cash market rate moves in favour of the holder of the option, the holder will let the option
lapse and take advantage of the more favourable cash market rate as options are not obligatory.
Options involve the payment of premium, often upfront, which is payable whether or not the option is
exercised.
CURRENCY OPTIONS
A currency option is the right, but not an obligation, to buy (a call option) or sell (put option) a particular
currency at a specified exchange rate on a particular date
Solution to Diano plc
Receipts Payments Net exposure

3 month time £4.8 million £7.6 million £2.8 million
Forward contract
Guaranteed payment = 2.8 x 5.6190 = GHC 15,733,200
Currency options
What date contract - The most suitable contract will be the contract that matures at the nearest date
after the transaction date 1st September. This is the September contract, which matures at the on 15th
September.
Call or put option. Select call option to give right to buy or put option to give the right to sell the contract
size currency. In this case, since the contract size is denominated in Ghana Cedi, the company will need
to sell GHC for Sterling, therefore it needs to buy a put option to get the right to sell GHC, hence
September put option should be selected.
Calculate the number of contracts
a b c = b/a d e = c/d
Exercise Contract Number of
£ GHC
price size contracts
0.175 2.8 16,000,000 125,000 128 exact hedge

0.18 2.8 15,555,556 125,000 124.4 125 over hedge
0.185 2.8 15,135,135 125,000 121.08 121 under hedge
Calculate premium
a b c d e f g d
Number of Premium Premium in Premium
Exercise Contract Spot Premium in
contracts per contract £ plus
price size rate GHC
=bxcxd interest
0.175 125,000 128 0.143 22,880 5.591 127,922 130,161
0.18 125,000 125 0.314 49,063 5.591 274,311 279,111
0.185 125,000 121 0.691 104,514 5.591 584,338 594,564
We assume that Diano plc will borrow to finance the premium at 7% per annum, therefore three month =
7 x 3/12 = 1.75%.
Forward contract for under/over hedge
Number Amount
Exercise Contract Amount (Over)/ Forward Outcome
of hedged GHC Exposure £
price size hedged £ under rate GHC
contracts =bxc
0.18 125 125,000 15,625,000 2,812,500 2,800,000 (12,500) 5.5880 (69,850)

0.185 121 125,000 15,125,000 2,798,125 2,800,000 1,875 5.5880 10,535
a b c d e f g h i
Overall outcome if the option is exercised
(a) (b) (c) (d) e = b+c+d

Exercise Basic cost Premium cost (Over)/under hedge Total cost (GHC)
Price (GHC) (GHC) outcome (GHC)
0.175 16,000,000 130,161 0 16,130,161
0.180 15,625,000 279,111 (69,850) 15,834,261
0.185 15,125,000 594,564 10,536 15,730,100
It is recommended that Diano plc should use 0.185 currency option to hedge against the sterling exposure
as it is the cheapest.
Example Canta plc
Canta plc a UK based company is to build a large factory block in the USA. This will involve an initial
payment of $300m in 5 months time and the management of Canta plc are worried about adverse
movement in exchange rate, and has decided to protect this risk by currency options. Upon investigation
the following information was made available:
The exercise price of call option £0.54 = $1
5 months interest rate in UK 5.79%

5 months interest rate in USA 4.83%
Spot rate $1.8234/£1
Annual $/£ volatility during recent past was 10%
Required:
Calculate the value of the call option.
Solution to Canta plc
Using Spot rate ‘S’ basis
Spot rate in direct quote = 1/1.8234 = £0.5484/$1

T = 5/12 = 0.4167
ln(0.5484/0.54)
+
[0.0579 − 0.0483 + 0.5×0.1 ]0.4167 d
2
1 =
0 . 1 × 0 . 4167
= 0.02152/0.06455
d1 = 0.3334 = 0.33
d2 = 0.3334 - 0.1 x√0.4167 = 0.2688 = 0.27

Reading from normal distribution table:
N(d1) = 0.5 + 0.1293 = 0.6293
N(d2) = 0.5 + 0.1064 = 0.6064
Value of call option = e-rf x T S N(d1) – e-rT XN(d2)
= e-(0.0483 x 0.4167) x 0.5484 x 0.6293 – e-(0.0579 x 0.4167) x 0.54 X0.6064
= £0.0185799 = 1.858 pence
Using forward rate ‘F’ basis
Forward rate can be calculated using interest rate parity.
1.0201 5/12 x 4.83% = 2.01%

F5 months = 1.8234 × 
1.0241
1.0201
F5 months = 1.8234 ×  5/12 x 5.79% = 2.41%
1.0241
= $1.8163
Direct quote = 1/1.8163 = £0.5506/$1
ln (F / X ) + 0 . 5 s T
2
d1 =
s T
ln (0 . 5506 / 54 ) + 0 . 5 × 0 .1 × 0 . 4167
2
d1 =
0 . 1 × 0 . 4167
= 0.3334
d2 = 0.3334 - 0.1 x√ 0.4167 = 0.2688 = 0.27
Reading from normal distribution table:
N(d1) = 0.5 + 0.1293 = 0.6293

N(d2) = 0.5 + 0.1064 = 0.6064
Value of a currency call option = e-rT [F N(d1) – XN(d2)]
Value of a currency call option
= e-(0.0579 x 0.4167) [0.5506 x 0.6293 – 0.54 x 0.6064]
= 0.01858 = 1.858 pence
INTEREST RATE OPTIONS
Interest rate guarantees (IRGs) or options on forward rate agreements (FRAs)

Interest rate guarantees (IRA) are short-term interest-rate options, usually with a maximum maturity of
one year. If a company wants longer term guarantees it can use caps, collars or floors.
IRGs allow a borrowing company to hedge against adverse movements in interest rates and to take
advantage of favourable movement. The company can do this without losing (other than the cost of the
guarantee) if there is a favourable movement interest rate.
IRG involves the payment of a premium to the seller of the guarantee, which has to be paid whether or not
the guarantee is exercised.
IRGs are similar to FRA with the following differences:
● IRG involves the payment of a premium to the seller of the guarantee, which has to be paid
whether or not the guarantee is exercised. No premium is payable with FRA
● Unlike an FRA the interest rate included in the IRG only comes into play if it is in the customer’s
favour.
Example A plc
A plc needs to borrow £100m in four months time, 1/4/2003, but is worried about interest rate changes in
the intervening period. Its bankers are prepared to enter into a IRG with it. The terms of the IRG are that
it will last for six months and include an interest rate of 8% per annum. Initial premium payment is
£1,000,000
Required:
Show how IRG could be used, if on 1/4/2003 interest rate is 11%.
Solution
The interest rate in the IRG is 8% and this is lower than the open market rate of 11%, hence the bank will
operate the IRG on the company’s behalf at 8% per annum.
Interest payment £100m x 8% x 6/12 4,000,000

Premium payment 1,000,000
Total payment £5,000,000
If the IRG has not been bought the total interest would have been
11% x £100m x 6/12 = £5,500,000
Therefore the premium of £1m has saved interest of 5,500,000- 4,000,000 = 1,500,000, with a net savings
of £500,000.
The IRG allows the company to participate in favourable interest rate movements, but this flexibility is paid
for through the premium.
IRG like FRA cannot normally be arranged for periods of longer than one year but successive IRG can be
arranged so the maximum interest cost is always known one period in advance.
IRG and FRA are all over the counter hedging techniques.
Options on interest rate futures

Interest rate option is a right, but not obligation, to either borrow or lend a notional amount of principal
for a given interest period, starting on or before a date in the future (expiry date for the option), at a
specified rate of interest (exercise price of the option).
It is simply options to buy or sell futures. This is one of the challenging aspects of hedging interest rate
and the following example will be used to illustrate how it works.
Example Shawter
Assume that it is now mid-December.
The finance director of Shawter plc has recently reviewed the company’s monthly cash budgets for the
next year. As a result of buying new machinery in three months’ time, the company is expected to
require short-term finance of £30 million for a period of two months until the proceeds from a factory
disposal become available. The finance director is concerned that, as a result of increasing wage
settlements, the Central Bank will increase interest rates in the near future.
LIBOR is currently 6% per annum and Shawter can borrow at LIBOR + 0.9%.
Derivative contracts may be assumed to mature at the end of the month.
Three types of hedge are available:
Three months sterling Future (£500,000 contract size, £12.50 tick size)
December 93.870 March

93.790
June 93.680
Options on three months sterling futures (£500,000 contract size, premium cost in annual %)
Calls Puts
December March June December March June
93750 0.120 0.195 0.270 0.020 0.085 0.180
94000 0.015 0.075 0.115 0.165 0.255 0.335
94250 0.000 0.030 0.085 0.400 0.480 0.555
FRA prices
3v6 7.01 – 6.91

3v5 7.08 – 7.00
3v8 7.28 – 7.20
Required:
Illustrate how the short-term interest risk might be hedged, and the possible results of the alternative
hedges if interest rates increase by 0.5%.
Solution Shawter
Futures
● What contract = 3 months contract = March futures contract
● What type = sell interest rate futures as interest rates are expected to rise. If interest rate rises,
future price will fall, and we can close the position by buying futures.
● Number of contracts
30m×2
= = 40 contracts
0.5m× 3
● Tick size = 0.01% x 500,000 x 3/12 = 12.5
● Calculate the closing future price using basis and basis risk.
Calculate opening basis as:
Current LIBOR = 6% = (100 –6) = 94.00

Future price 93.790
Basis 0.21
This will fall to zero when the contract expires, and it is assumed that it will fall at an even or linear
manner
There are three and half months until expiry and the funds are needed in three months time,
therefore the expected basis at the time of borrowing is:
0.21 x 1/7 = 0.03
Closing future price
LIBOR = 6.5% (100 –6.5) 93.5

Basis 0.03
Future price 93.47
● Calculate profit or loss

Gain per contract 0.32 = 32 ticks
Total profit 32 x 0.01% x 500,000 x 3/12 x 40 = £16,000
OR
32 x 12.5 x 40 = £16,000
● Overall outcome (total cost)
£
Interest cost (6.5 +0.9) = 7.4% x 2/12 x 30m = 370,000
Profit on future position (16,000) Net cost
354,000
Option
● What date contract = March contract
● Call or put = buy put option to have the right to sell sterling futures
● Calculate premium
Exercise price Premium cost

93750 30,000,000 x 0.085% x 2/12 = £4,250
94000 30,000,000 x 0.225% x 2/12 = £12,750
94250 30,000,000 x 0.480% x 2/12 = £24,000
The premium cost is annual % so it should be expressed to 2/12, to reflect period of borrowing.
● Calculate profit or loss
If interest rate increases, the option will be exercised and the futures contract sold at the exercise
price.
Exercise price Profit

93750 (93.75 – 93.47) x 100 x 40 x12.5 = £14,000 94000 (94.00 – 93.47) x 100 x 40 x
12.5 = £26,500
94250 (94.25 – 93.47) x 100 x 40 x 12.5 = £39,000
● Calculate total cost
Cost of
Exercise Premium Profit on
borrowing at Net cost
price cost future
7.4%, 2 months
93750 370,000 4,250 (14,000) = 360,250
94000 370,000 12,750 (26,500) = 356,250
94250 370,000 24,000 (39,000) = 355,000
FRA
As the company wants to borrow funds in three months time for a period of two months, the
appropriate FRA would be the 3 v 5 contract.
The effective lock in rate would be 7.05% as borrowing carries more rate than investing.
The overall cost is 30,000,000 x 7.08% x 2/12 = £354,000
Conclusion
The future and FRA have the same expected total cost. However, future contract require margin
payments and the associated basis risk makes the future cost uncertain, therefore the FRA would be
preferable. However, if there is any belief of a chance of interest rate falling, then the best alternative
would be the option with exercise price of 94,250.
Caps, collars and floors

These are hedging techniques that can be used to cover risk on long term borrowing. As the name
implies, a ‘cap’ is the upper-level interest rate, and a ‘floor’ a lower-level interest rate. With collar a
company enters into an arrangement such that it will borrow for a period of time with a floating interest
rate, but it knows it will not have to pay more than the ‘cap’ rate, but on the other hand it will not be
able to pay less than the ‘floor rate.
Interest rate
10% CAP
op en market rate
5% floor
0 time
The open market rate will be applied to the loan as long as it remains between 5% and 10%. If the open
market interest rate goes outside these parameters (say 12% or 4%) the bank will activate the ‘cap’ or
‘floor’ as appropriate to keep the loan interest cost between the agreed limits.
The advantage of the collar compared to a normal cap is that the collar has a lower overall premium
cost, due to the potential benefit of floor to the bank.
Interest rate option is a right, but not obligation, to either borrow or lend a notional amount of principal
for a given interest period, starting on or before a date in the future (expiry date for the option), at a
specified rate of interest (exercise price of the option).
Chapter 19
Swaps
CHAPTER 19 – SWAPS
CHAPTER CONTENTS
SWAPS-------------------------------------------------------------------------------------------------------------------------- 307
INTEREST RATE SWAPS----------------------------------------------------------------------------------------------------- 308
Reasons for interest rate swaps---------------------------------------------------------------------------------------------------------------------310
CURRENCY SWAPS----------------------------------------------------------------------------------------------------------- 311
Benefits of currency swaps---------------------------------------------------------------------------------------------------------------------------312
FOREX SWAP (FX SWAP)---------------------------------------------------------------------------------------------------- 312
TYPES OF RISK ASSOCIATED WITH SWAPS-----------------------------------------------------------------------------314
SWAPTIONS------------------------------------------------------------------------------------------------------------------- 315
SWAPS
A swap is an agreement between two parties to exchange cash flows related to specific underlying
obligations for an agreed period of time. It is the exchange of one stream of future cash flows for
another stream of future cash flows with different characteristics.
INTEREST RATE SWAPS

Interest rate swap allows a company to exchange either: ● Fixed rate interest
payments into floating rate payment, or
● Floating rate interest payment into fixed rate payments.
Here a company worried about interest rate volatility on a floating rate loan finds a swap partner with a
fixed interest loan who is unworried by interest rate volatility.
The parties swap their interest rate commitments to obtain the interest style they want. This is
operative over the duration of the loans and so provides long-run hedging. Normally a financial
intermediary is employed to find a suitable swap partner for the arrangement and is paid a fee.
Example 1 Fred plc

Fred plc has a loan of £20m repayable in one year. Fred plc pays interest at LIBOR plus 1.5% and could
borrow fixed at 13% per annum. Martin plc also has a £20m loan and pays fixed interest at 12% per
annum. It could borrow at a variable rate of LIBOR plus 2.5%.
The companies agree to swap their interest commitments with Fred plc paying Martin plc fixed rate plus
0.5% and Martin plc paying Fred plc LIBOR plus 2%. An arrangement fee of £10,000 is charged on each
company.
Required:
Calculate the total interest payments of the two companies over the year if LIBOR is 10% per annum
Solution
LIBOR at 10%
Fred plc
£
Interest on own loan (10% + 1.5%) x 20m (2,300,000) (11.5%)
Interest received from Martin (10%+2%) x 20m 2,400,000 12%
Interest paid to Martin (12%+0.5%) x 20m (2,500,000) (12.5%)
Total interest payment (2,400,000) (12%)
Martin plc
£
Interest on own loan (12% x 20m) (2,400,000 12%)
Interest received from Fred (12% + 0.5%) x 20 2,500,000 12.5%
Interest paid to Fred (10% +2%) x 20m (2,400,000) (12%)
Total interest payment (2,300,000) 11.5%

Calculation of arbitrage gains from the swap
Fixed rate Floating rate

Fred 13% LIBOR + 1.5
Martins 12% LIBOR + 2.5
--------- --------------
Difference 1% -1%
---------- -----------
Arbitrage gains = 1% - (-1%) = 2%
Example 2
A company wants to borrow £6 million at a fixed rate of interest for four years, but can only obtain a
bank loan at LIBOR plus 80 basis points. A bank quotes bid and ask prices for a four year swap of 6.45% -
6.50%.
Required:
(a) Show what the overall interest cost will become for the company, if it arranges a swap to switch
from floating to fixed rate commitments.
(b) What will be the cash flows as a percentage of the loan principal for an interest period if the rate
of LIBOR is set at 7%?
Solution 2
(a)
%
Actual interest floating rate (LIBOR + 0.8)
Swap
Receive floating rate interest from bank LIBOR
Pay fixed rate (higher-ask price) (6.50)
Overall cost (7.3)
(b)
%
Actual interest floating rate (7 + 0.8) (7.8)
Swap
Receive floating rate interest from bank 7
Pay fixed rate (higher-ask price) (6.50) 0.5 Overall cost (7.3)
Reasons for interest rate swaps

Interest rate swaps have several uses including:
1. Long-term hedging against interest rate movements as swaps may be arranged for periods of
several years.
2. The ability to obtain finance at a cheaper cost than would be possible by borrowing directly in the
relevant market.
3. The opportunity to effectively restructure a company’s capital profile without physically

redeeming debt.
4. Access to capital markets in which it is impossible to borrow directly, for example because the
borrower is relatively unknown in the market or has a relatively low credit rating.
CURRENCY SWAPS
Currency swaps are similar to interest rate swaps, but the underlying obligations are in different
currencies.
Currency swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Exchange of regular interest payment during the life of the swap.
● Final exchange of principal currencies at maturity of the swap.
When currencies are exchanged at the commencement and maturity of the swap, the same exchange
rate is used. In other words, the amounts exchanged at the start of the swap and at the end are exactly
the same.
Example 3 DD plc
DD plc needs to borrow $50m to finance it US subsidiary. DD plc is not well known in US and can only
borrow in US at US basic rate + 3%. DD plc contacts a US company it has known for many years, FFK plc.
FFK plc is in a similar position to DD plc in that it requires a sterling loan to finance its UK operations. FFK
plc can borrow sterling at 11% per annum fixed and floating rate in US at US base rate + 1%.
The two companies come into a swap arrangement where:
● DD plc will borrow sterling at 9% per annum fixed and FFK plc will borrow dollars at US base rate +
1%
● DD plc will pay FFK plc US base rate + 1.5% per annum and FFK plc will pay DD plc sterling 9.5%
per annum
● There will be an exchange of principal now and in five years time at the current spot rate of $8 =
£1
● UK base rate is currently 7% and US base rate is 5% per annum.
Required:
Show whether the suggested swap would benefit the two companies.
Solution 3
DD plc borrows = $50/ 8 = £6.25m at 9%
FFK plc borrows = $50 at base rate + 1% = 6%
The currencies borrowed will then be swapped so that each company obtains the currency they
require.
The swap arrangement results in the following interest rates:
DD plc FFK plc

% %
Actual cost of loan (9) (6)
Swap arrangement:
FFK to DD 9.5 (9.5)
DD to FFK (6.5) 6.5
Overall cost of foreign currency finance 6% 9%
Cost without swap 8% 11%
Savings 2% 2%
At the end of the swap arrangement both companies have benefited considerably, not only they have
managed to get the currencies they wanted, but also have obtained them at a lower interest rate than
they could have achieved by borrowing overseas directly.
Benefits of currency swaps

1. Hedging against foreign exchange risk. Swaps can be arranged for up to ten years which provide
protection against exchange rate movements for much longer periods than forward contracts. It
is very useful when dealing with countries with exchange controls and/or volatile exchange rates.
2. The ability to obtain finance at a cheaper cost than would be possible by borrowing directly in the
relevant market.
3. The opportunity to effectively restructure a company’s capital profile without physically

redeeming debt.
4. Access to capital markets in which it is impossible to borrow directly, for example because the
borrower is relatively unknown in the market or has a relatively low credit rating.
5. Swaps can be arranged for any sum typically $5m to $50m over varying time periods, and may be
reversed by re-swapping with other counter parties. Hence it is flexible.
6. There may be low transaction cost, as cost may be limited to the legal fees in agreeing the
documentations and arrangement fees.
FOREX SWAP (FX SWAP)
A forex swap is an agreement between two parties to exchange equivalent amount of currency for a
period and then re-exchange them at the end of the period at a predetermined agreed rate.
Forex swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Final exchange of principal currencies at maturity of the swap normally at a different rate.
The purpose of forex swap are to hedge against foreign exchange risk for longer period, say more than
one year, and where it is difficult to raise money directly.
TYPES OF RISK ASSOCIATED WITH SWAPS
1. Credit Risk
This is the risk that the counter party to the swap will default before the end of the swap and fail to
carry out their agreed obligation. Such risk is reduced if a reputable bank is used as an intermediary to
the deal
2. Market Risk
This is the risk that interest rates or exchange rates will move unfavourably against the company after it
has committed itself into the swap.
3. Sovereign Risk
This is the risk associated with the country in whose currency a swap is being considered. It covers
political instability or the possibility of exchange controls being introduced.
4. Liquidity Risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to meet its payment
obligations when these are due.
SWAPTIONS
Swaption may also be referred as swap option, options on swap or option swap. Swaptions are
combination of swap and option.
In return for the payment of premium by the holder, a swaption gives the right, but not an obligation, to
enter into swap on or before a particular date.
Swaptions are available on an over-the-counter market and are therefore tailored to the exact
specifications of the holder. They may be American or European style.
Swaptions are example of financial engineering. Financial engineering is the construction of a financial
product from a combination of existing derivative products.
Illustration 3 Swaptions
Noswis plc borrowed two million Euros (€) in four year floating rate notes funds nine months ago at an
interest rate EURIBOR plus 1%, in an attempt to reduce the level of interest paid on its loans. At that
time EURIBOR was 6%. Unfortunately EURIBOR interest rates have increased since that time to 7.2%.
The company wishes to protect itself from further interest rate volatility, but does not wish to lose the
benefit of possible interest rate reductions that might occur in a few months time. An adviser has
suggested the use of a six month American style Euro swaption at 8.5% with a premium of €50,000,
commencing in three months time and with a maturity date the same as the floating rate Euro loan.
Required:
Briefly explain what is meant by a swaption, and illustrate under what circumstances this proposed
swaption would benefit Noswis. The time value of money may be ignored.
Solution 3
Swaptions are hybrid derivative products that integrate the benefits of swaps and options. The buyer of
a swaption has the right, but not the obligation, to enter into an interest rate or currency swap during a
limited period of time and at a specified rate.
Swaptions are available on the over-the-counter market and involve the payment of a premium,
normally in advance. They may be ‘European style’, exercisable only on the maturity date, or ‘American
style’, exercisable on any business day during the exercise period.
Noswis is interested in protection against interest rate volatility, but wishes to maintain the flexibility to
benefit from falls in interest rates. A swaption would offer the opportunity to do this.
Noswis is currently paying 8.2% on its Euro loan. The swaption offers a swap from floating rate to fixed
rate finance for the remaining three year period of the Euro loan. (N.B. the four year loan was raised
nine months ago and the swaption will not commence until another three months have elapsed).
The fixed rate is 0.3% per annum above the current floating rate payable by Noswis.
The premium payable of €50,000 is 2.5% of the total value of the loan, or, ignoring the time value of
money, 0.833% per year over the remaining three year period of the loan.
If Euro interest rates rise during the next nine months by more than 0.3% the swaption is likely to be
exercised. For the swaption to be beneficial to Noswis, the average floating rate payable by Noswis
without the swap over the three year period would have to exceed:
8.2% + 0.3% + 0.833% = 9.333%
This is a 13.8% increase on the current EURIBOR payable rate (ie over 8.2%)
If interest rates fall then the swaption would not be exercised and Noswis would benefit from borrowing
at the lower floating rates. If the swaption is not exercised the premium is still payable, and Noswis
would be worse off by the amount of the premium than if no swaption had been agreed.
However, this premium is the price that must be paid for the flexibility of being able to take advantage
of any lower interest rates in the future.
Furthermore it should be noted that once the swaption is exercised this action cannot be reversed.
Therefore if interest rates subsequently fall, Noswis will continue to pay the fixed rate of interest set out
in the agreement.
Chapter 20
Principles of islamic
finance
PRINCIPLES OF ISLAMIC FINANCE
CHAPTER CONTENTS
INTRODUCTION TO ISLAMIC FINANCE ------------------------------- 331

ISLAMIC BANKING HAS THREE MAIN PRINCIPLES: 332
SHARIA’A IMPOSES THE FOLLOWING THREE PROHIBITIONS: 333
IN ADDITION TO THE ABOVE PROHIBITIONS: 334
TYPES OF TRANSACTIONS IN ISLAMIC FINANCE ------------------- 335
PROFIT AND LOSS SHARING PARTNERSHIP METHODS 335
LEASING AND DEFERRED PAYMENT SALES 336
HIRE PURCHASE (IJARA WA-IQTINA) 337
DIRECT INVESTMENT 338
QARD HASAN OR BENEVOLENT LOANS 338

INTERNATIONAL ACCOUNTING STANDARDS FOR ISLAMIC FINANCE339
INTRODUCTION TO ISLAMIC FINANCE

The rapid growth of Islamic Banking has received considerable attention in international financial circles
and its growth potential for the future is being widely acknowledged.
Social and economic forces operating in modern day commerce have ensured that economic and
financial activities are given prominence in the Islamic world. It has therefore become necessary to
question whether the growing Islamic Banking sector will be able to compete with the traditional
commercial banks in the area of international trade and finance.
The growing importance levied on Islamic banking is also attributed to the fact that unlike conventional
banking, it is concerned about the viability of the project and the profitability of the operation and does
not focus on the size of the collateral. Shareholder value maximizing projects that might be rejected by
conventional banks due to lack of collateral would be financed by Islamic banks on a profit-sharing basis.
This ensures that Islamic banks can play a significant role in stimulating economic development.
The Islamic Development Bank (IDB) is an international financial institution with 46 member countries
established in 1973. The IDB is primarily a development assistance agency rather than a commercial
bank, but one of its major roles has been to promote Islamic banking worldwide through its co-
sponsorship with the Accounting Organization for Islamic Financial Institutions (AAOIFI) of conferences,
seminars and research.
Since the creation of the IDB, a number of Islamic banking institutions have been formed and countries
have taken measures to organise their banking systems along Islamic principles. The first private Islamic
commercial bank, the Dubai Islamic Bank, was founded in 1975.
Among private Islamic commercial banks, a number of banks belong to certain holding companies.
Today, the ‘Al-Baraka' group, operates banks, investment companies, financial advisory and management
companies in more than a dozen countries. It launched its activities in 1982 and is today considered to
be one of the fastest growing Islamic enterprises. The group has operations in Tunisia, Sudan, Bahrain,
Turkey, and Malaysia. It is the first group to obtain a license to launch Islamic banking in London.
The primary intention behind establishing Islamic banks was the desire to reorganize financial activities in
a way that do not contradict the principles of Sharia’a which is the code of law derived from the Koran
and from the teachings and example of Prophet Mohammed.
The authority of Sharia is drawn from four sources. The first source is specific guidance laid down in the
Qur’an, and the second source is the Sunnah, literally the 'Way', ie the way that Muhammad (the Prophet
of Islam) lived his life. The third source is Qiyas, which is the extension by analogy of existing Sharia law
to new situations. Finally Sharia law is based on ijma, or consensus. Justification for this final approach is
drawn from the Hadith where Muhammad states: "My nation cannot agree on an error." The umma, or
community of Muslims, comes together with each applying his ijtihad, or independent thought and
judgment, to achieve this consensus. The comprehensive nature of Sharia law is due to the belief that
the law must provide all that is necessary for a person's spiritual and physical wellbeing. All possible
actions of a Muslim are divided (in principle) into five categories: obligatory, meritorious, permissible,
reprehensible, and forbidden.
In theory, there is no conflict between the process as outlined by Prophet Mohammed and very
progressive and consultative political movements. The consensus-driven process ensures that the whole
community arrives at a wellreasoned conclusion compatible with science and scholarship. In practice,
however, there is often incredible tension between conservative, liberal or secular forces.
Islamic banking or interest-free banking came into existence because borrowing from the banks and
depositing their savings with the bank are strictly avoided in order to keep away from dealing in interest
which is prohibited by religion. Islamic banking is also referred to as Profit-Loss-Sharing Banking (PLS). It
is based on the principle that factors of production, goods and services are provided for deferred
payment. Transactions are based on the sharing of risk and reward between the provider of the funds
(the investor) and the user of the funds. Money is treated as a medium of exchange and therefore
Islamic scholars do not allow payment of interest on it. In addition, payment of interest stifles
entrepreneurship and passes on the risk of any venture solely on the entrepreneur and creates a moral
hazard where the owner of capital is guaranteed return as against the other party, which has to take all
the risk.
Islamic banking has three main principles:
1. It is interest-free
The Western concept of the transaction between individuals and institutions rests on the basis of time
value of money, whereby someone borrowing money has to repay the lender a higher amount in return
for the satisfaction of using that money today. Western societies reward capitalism and private
enterprise through interest. Islamic societies are founded on the concept of welfare and equitable
distribution of income, whereby growth will be collective, and societal welfare will be prioritized over
individual enterprise. Interest is, hence, considered illegal, and all the tools and mechanisms for growth
will have a profit sharing component instead of an interest component where one segment in society
gains at the expense of the other.
Thus, in an Islamic society, everyone will share in the profits of an enterprise, and everyone will bear a loss
equally.
2. It is multi-purpose dealing with both Central Bank functions as well as

commercial banking functions
This multi-purpose character of Islamic banking creates difficulties in relation to the skills required to
handle diverse and complex transactions. Islamic banking does not provide capital guarantee in all its
deposit accounts. In many countries, this is one of the two main objections to permitting the
establishment of Islamic banks.
3. It is equity-oriented
Lending and investing are separate functions as loans are interest-free but carry a service charge, while
investing is on a profit-and-loss-sharing (mudaraba) basis. Commercial banks only grant loans and do not
engage in investment-financing. Investment-financing is conducted through investment banks and
investment companies. Value erosion of capital due to inflation is compensated.
Overall
Therefore, the difference between Islamic banking and finance and conventional banking lies in the social
concept of sharing responsibility, risk, and property. Consequently, fixed interest transactions where risk
is entirely assigned to the borrower are avoided.
Sharia’a imposes the following three prohibitions:
1 Prohibition on riba and interest

There are two forms of riba:
● riba al naseeyah which is the interest or monetary compensation paid to the lender.
● riba al fadl or excess compensation without consideration.
The rate of interest in the conventional banking mechanism is considered to be synonymous to Riba. The
Islamic prohibition on interest does not mean that capital is costless in an Islamic banking system. Islam
recognizes capital as a factor of production but it does not allow the factor to make a prior or pre-
determined claim on the productive surplus in the form of interest. Profit-sharing is the alternative. In
Islam, the owner of capital can legitimately share the profits made by the entrepreneur. Profit sharing is
permissible while interest is not, because in profit sharing, it is only the profit-sharing ratio, not the rate of
return itself that is predetermined. Even the rate of return on financial assets held in financial institutions
is not known and not fixed prior to undertaking of the transaction. The rate of return is determined after
actual profits are derived from the use of assets within the economy.
It has been argued that profit-sharing can help allocate resources efficiently, as the profit sharing ratio
can be influenced by market forces so that capital will flow into those sectors which offer the highest
profit- sharing ratio to the investor, other things being equal.
2 Prohibition on gharar or risk and uncertainty

This includes transactions involving speculation.
Gharar occurs when consequences of a contract are unknown. In this case, what happens to asset
managers who have to take a number of decisions based upon incomplete information? Decisions often
need to be based on what the market is doing instead of basing actions on rational factors. Examples of
irrational decisionmaking include investing in familiar assets, excessive trading based on overconfidence
with respect to market knowledge.
Islamic finance spreads risk over society as a whole as profit and loss need to be shared equally by all as
would be the profits.
3 Prohibition on dealing with businesses which involve forbidden activities such

as gambling
In addition to the above prohibitions:
The transaction must be associated with an asset or an enterprise

This means that the asset should have the following characteristics:
● It should be permissible under sharia’a – and therefore excludes alcohol, arms, tobacco.
● The asset should exist at the time the contract was entered into.
● The asset must be owned by the seller. Constructive ownership is acceptable where the goods are
under the direct control of the owner even if the owner does not have physical possession.
● The subject should be specific and determined without uncertainty.
Due to the above prohibitions, majority of the conventional financial instruments are not suitable to
Islamic finance. The prohibition on riba means that Islamic banks can not lend at interest but can provide
financing on a profit and loss sharing basis and take ownership of the underlying asset.
The prohibition on gharar means that forward contracts and derivatives are not allowed. Short selling is
prohibited because the seller needs to own the asset.
TYPES OF TRANSACTIONS IN ISLAMIC FINANCE
Profit and loss sharing partnership methods
Musharaka or joint venture

Where all parties provide capital as well as skills and expertise and share the profits and losses on agreed
basis. Partners have unlimited liability.
A musharaka transaction arises when one or more entrepreneurs approach an Islamic bank for the
finance required for a project. The bank, along with other partners, provides complete finance. All
partners, including the bank, have the right to participate in the project. They can also waive this right.
The profits are to be distributed according to an agreed ratio, which need not be the same as the capital
proportions. However, losses are shared in exactly the same proportion in which the different partners
have provided the finance for the project.
Most Islamic banks participate in the equity of companies. There are different types of musharaka. In
permanent musharaka the bank participates in the equity of a company and receives an annual share of
the profits on a pro rata basis. The period of termination of the contract is not specified. This financing
technique is also referred to as continued musharaka.
Diminishing musharaka is a special form of musharakah, which ultimately results in the ownership of the
asset or the project by the client. The bank participates as a financial partner, in full or in part, in a
project with a given income forecast. An agreement is signed by the partner and the bank through
which the bank receives a share of the profits as a partner. However, the agreement also provides
payment of a portion of the net income of the project as repayment of the principal financed by the
bank. The partner is entitled to keep the rest. In this way, the bank's share of the equity is progressively
reduced or diminished and the partner eventually becomes the full owner. The Islamic banks finance real
estate projects and the construction of commercial buildings and housing projects through diminishing
partnership. The bank finances the projects, fully or partially, and the bank obtains a proportion of the
net profits as a partner and receives another payment toward the final payment of the principal
advanced. When the original amount is fully repaid, the ownership is fully transferred to the partner and
the bank has no claim whatsoever.
Mudaraba or passive partnership

Only one of the partners contributes capital and the other contributes skill and expertise.
One of the partners is providing the capital and the other is running the business, the relationship is
based on trust. The partner contributing capital is liable to the extent of the capital provided. The
contract can be terminated at any time with reasonable notice.
Mudaraba transactions are appropriate for private equity investments. In the case of financial
institutions and banks, the mudaraba method become applicable as the bank is a lender to a business it
can share in the profits that the business makes instead of charging an interest on the loan. The result is
that risk is shared equally between lender and borrower. Similarly, if the bank is a borrower, the lender’s
deposit is treated as an equity investment, and he or she shares in the profit that the bank makes
through its investments. Conventional banks make a profit on the spread between the interest rate
charged to borrowers and paid to depositors – Islamic banks make a profit on the investments that they
make or their borrowers make.
There are various limitations on the use of mudaraba as a viable basis of financial intermediation in an
interest-free framework. The legal system operating in the country should provide legal safeguards to
the provider of capital so that he can finance projects on the basis of mudaraba. As a result, the number
of banks providing finance on the basis of mudaraba is not very large. Even among those banks that use
mudaraba as a financing technique, the frequency of its use is not very high. An Islamic financial
institution (IFI) will perform the functions of financial intermediation through appraising profitable
projects and monitoring the performance of projects on behalf of the investors who deposit their funds
with the IFI. Therefore, the mudaraba contract becomes the cornerstone of financial intermediation and
thus banking.
Leasing and deferred payment sales
Leasing or ijara transaction

A lease contract has to fulfill all of the essentials of a valid contract stipulated by the shariah. The
contract should be clear, should be by mutual agreement, the responsibilities and benefits of both parties
should be clearly spelled out, the agreement should be for a known period and against a known price.
These conditions become more important in a lease contract because there is more room for uncertainty
or gharar. Hence, it is necessary that the benefits and costs of each party are clearly stated in the
contract.
Leasing is emerging as a popular technique of financing among Islamic banks. Under this scheme of
financing, the bank purchases a real asset and leases it to the client. The period of lease may be from
three months to five years or more, and is determined by mutual agreement according to the nature of
the asset. During the period of lease, the asset remains in the ownership of the bank but the physical
possession of the asset and the right of use is transferred to the lessee. After the expiry of the leasing
period these revert to the lessor. A lease payment schedule is agreed by the bank and the lessee based
on the amount and terms of financing is agreed upon by the bank and the lessee. The agreement may or
may not include a grace period.
According to the Islamic principles, the maintenance of the asset during the leasing period is the
responsibility of the owner of the asset, as the benefit or rental is linked to the responsibility of
maintenance. Some Islamic banks may invite other investors to participate in the leasing operation. For
example, some investors and an Islamic bank may participate in an income yielding real asset leasing
project. All participants in this venture take their share of profit out of the rental income. The bank also
has the right to repurchase participation according to the agreed terms. The main recipient of leasing
based finance is the agricultural sector where all kinds of equipment, such as tractors, trailers, fishing
boats, solar energy plants, other farm machinery and transport equipment are leased. The Al Baraka
Investment Company uses the technique of ‘ijarah wa iqtina’ to finance the purchase of large capital items
such as property, industrial plants and heavy machinery. It involves direct leasing where investors in the
scheme receive regular monthly payments that represent an agreed rental. At the expiry of the lease, the
lessee purchases the equipment.
Murabaha or deferred payment sale or instalment credit sale
If a consumer wishes to purchase an asset, the bank can buys the asset for the individual on an agreed
upon price between the individual and the seller. The individual then purchases the asset from the bank
at the purchase price plus a mark-up. However, critics have pointed out that the mark-up has the same
connotation as interest, and this similarity with traditional banking is perhaps one of the reasons why
murabaha contracts are widely accepted.
Murabaha contracts are applied to financing of raw materials, machinery, equipment and consumer
durables as well as short-term trade financing.
One application of murabaha sale is in the issuing of a letter of credit:
● The customer requests the bank to open a letter of credit to import goods from abroad through an
application which includes a pro-forma invoice and other necessary details and information.
● After securing the necessary guarantee and scrutinizing the application, the bank opens a letter of
credit in favour of the client and sends copies to the correspondent bank abroad and to the exporter.
● The customer endorses a "Promise to Buy" the merchandise.
● The cost of the goods and the conditions of delivery are negotiated.
● The exporter makes arrangements to export the goods and delivers the documents to the
correspondent bank abroad.
● The shipment of the goods takes place and the correspondent bank advises the bank and sends the
documents.
● After the confirmation of the bank's ownership of the goods in question through the acquisition of
related documents an “Agreement of Sale” is signed with the client.
Hire purchase (ijara wa-iqtina)
Advance purchase financing, (istisna)

Long term production finance or a purchase contract for future delivery of an asset and is exempt from the
conditions of ownership and existence.
The payment to the producer or contractor of the asset does not have to be in full in advance. Payment is
made in instalments depending on the progress made.
Salam contract
Salam contract is a short term production contract or a purchase contract in which payment is made
today against future delivery of an asset. (Sale with deferred delivery).
Salam contracts are exempted from criteria of existence and ownership.
In istisna and salam contracts, the buyer takes a business risk and is therefore not subject to the prohibitions
of gambling and uncertainty.
Direct investment
In direct investment, the Islamic bank performs the role of an investment company.
The option of direct investment gives Islamic banks an opportunity to invest in priority projects in chosen
sectors. In this way, banks can channel their funds in the direction they think most desirable.
There are several ways in which Islamic banks undertake direct investment. A number of Islamic banks
have taken the initiative in establishing and managing subsidiary companies.
The general method of undertaking direct investment includes establishing a company dealing with
investment, insurance and reinsurance, trade, construction and real estate. Another method of
undertaking direct investment is participation in the equity capital of other companies. The companies
are established by the Islamic banks themselves and the public subscription of shares are invited or banks
participate in the equity capital of companies established by others.
Qard Hasan or benevolent loans

A loan given in accordance with the Islamic principles has to be a benevolent loan (qard hasan), without
interest. It has to be granted on the grounds of compassion, to remove the financial distress caused by
the absence of sufficient money in the face of dire need.
Since banks are profit-oriented organizations, it would seem that there is not much scope for the
application of this technique. However, Islamic banks also play a socially useful role. Hence, they make
provisions to provide qard hasan besides engaging in income generating activities.
Islamic banking is sophisticated in respect of financing techniques and hence permits Islamic banks to
compete in international trade and finance. Islamic banking has been able to offer various kinds of
financial products. It is in the area of assets rather than liabilities that the practices of Islamic banks are
more diverse and complex than those of conventional banks. There is a near-consensus that Islamic
banks can function well without interest.
INTERNATIONAL ACCOUNTING STANDARDS FOR

ISLAMIC FINANCE
An area that is gaining global importance is that of International Accounting Standards. There has been
an emphasis to develop international accounting standards in response to the increasing globalisation of
markets and economies. It is argued that international standards will increase comparability and
understandability of financial statements, save time and money, ease interpretation and improve the
credibility of the financial reporting process.
The process of international standard setting is dominated by western accounting practices that are not
always applicable to Islamic purposes, as Islamic economics is based on completely different
considerations than is Western economics. International Accounting Standards and Practices would be
particularly inapplicable to zakat and interest-free banking. Islamic countries should have a greater input
into the international standard-setting process if they are to compete in the area of international trade
and finance.
Those with a certain level of accumulated wealth are obliged to pay zakat in an effort to eradicate
poverty and redistribute wealth from the rich to the poor and needy. Thus zakat keeps wealth constantly
circulating in society. It creates a society based on mutual assistance and ensures that a minimum
standard of living is available to all people in the Islamic society.
The rules for zakat are inconsistent with the generally accepted accounting practice (GAAP) of
international accounting. The two primary assets in the context of international trade would be
inventories and accounts receivables. Discrepancies arise in the valuation of inventories, accounts
receivable and the concept of conservatism.
According to GAAP, inventories are to be valued at the lower of cost or market value. Market value can be
either replacement cost or net realisable value. However, for zakat purposes, only the selling price is
relevant. This means that Islamic organizations cannot apply GAAP valuation for inventories as by doing
so they would not be complying with the rules for zakat.
Zakat is payable on net receivables or accounts receivable net of expected bad debts minus accounts
payable. However, Islamic economics does not provide for an estimated provision for bad debts.
Accounts are assessed one-by-one to determine whether and to what extent they are expected to be
collected.
The accounting concept of conservatism is also is inconsistent with the concept of zakat. Conservatism
requires that assets and revenues are not overstated and liabilities and expenses are not understated.
Understating assets would mean less zakat liability. However, paying zakat is one of the most important
religious duties of Muslims, and Islam encourages Muslims to be generous with their wealth. Therefore,
they must be careful not to understate their assets or overstate their liabilities, and thus the concept of
conservatism is not applicable for assessing zakat.
The AAOIFI standards attempt to take into account many transactions that occur in international trade
and finance such as documentary credit. For example, it is not permissible for an Islamic bank to secure
obligations arising out of documentary credit or to provide documentary credit as security for payment in
favour of institutions and banks dealing with it.
ACCA STUDY
GUIDE
ACCA STUDY GUIDE
ACCA STUDY GUIDE
Can I rely on these Class Notes to cover the syllabus?
The answer is YES!

To quote ACCA:
This is the main document that students, tuition providers and publishers should use as the
basis of their studies, instruction and materials. Examinations will be based on the detail of
the study guide which comprehensively identifies what could be examined in any
examination sitting. The study guide is a precise reflection and breakdown of the syllabus.
Below I have set out ACCA’s Study Guide in detail for you.
A Role and responsibility towards stakeholders

1. The role and responsibility of senior financial executive/ advisor
a) Develop strategies for the achievement of the company’s goals in line with its agreed policy
framework.
b) Recommend strategies for the management of the financial resources of the company such that
they are utilised in an efficient, effective and transparent way.
c) Advise the board of directors of the company in setting the financial goals of the business and in
its financial policy development with particular reference to:
i) Investment selection and capital resource allocation.
ii) Minimising the company’s cost of capital.
iii) Distribution and retention policy.
iv) Communicating financial policy and corporate goals to internal and external stakeholders.
v) Financial planning and control.
vi) The management of risk.
2. Financial strategy information

a) Assess corporate performance using methods such as ratios, trends, EVA TM and MVA.
b) Recommend the optimum capital mix and structure within a specified business context and
capital asset structure.
c) Recommend appropriate distribution and retention policy.
d) Explain the theoretical and practical rationale for the management of risk.
e) Assess the company’s exposure to business and financial risk including operational, reputational,
political, economic, regulatory and fiscal risk.
ACCA STUDY GUIDE
f) Develop a framework for risk management comparing and contrasting risk mitigation, hedging
and diversification strategies, and demonstrate risk diversification through the application of
portfolio theory.
g) Establish capital investment monitoring and risk management systems.
3. Conflicting stakeholder interests

a) Assess the potential sources of the conflict within a given corporate governance/stakeholder
framework informed by an understanding of the alternative theories of managerial behaviour.
Relevant underpinning theory for this assessment would be:
i) The Separation of Ownership and Control.
ii) Transaction cost economics and comparative governance structures. iii)

Agency Theory.
b) Recommend, within specified problem domains, appropriate strategies for the resolution of
stakeholder conflict and advise on alternative approaches that may be adopted.
c) Compare the emerging governance structures and policies with respect to corporate governance
(with particular emphasis upon the European stakeholder and the US/UK shareholder model) and
with respect to the role of the financial manager.
4. Ethical issues in financial management

a) Assess the ethical dimension within business issues and decisions and advise on best practice in
the financial management of the company.
b) Demonstrate an understanding of the interconnectedness of the ethics of good business practice

between all of the functional areas of the company.
c) Establish an ethical financial policy for the financial management of the company which is
grounded in good governance, the highest standards of probity and is fully aligned with the ethical
principles of the Association.
d) Recommend an ethical framework for the development of a company’s financial policies and a
system for the assessment of their ethical impact upon the financial management of the company.
e) Explore the areas within the ethical framework of the company which may be undermined by
agency effects and/or stakeholder conflicts and establish strategies for dealing with them.
5. Impact of environmental issues on corporate objectives and on governance
a) Assess the issues which may impact upon corporate objectives and governance from:
i) Sustainability and environmental risk.
ii) The carbon-trading economy and emissions.

iii) The role of the environment agency. iv) Environmental audits and the triple bottom line
approach.
ACCA STUDY GUIDE
iv)B Economic environment for multinationals

1. Management of international trade and finance
a) Advise on the theory and practice of free trade and the management of barriers to trade.
b) Demonstrate an up to date understanding of the major trade agreements and common markets
and, on the basis of contemporary circumstances, advise on their policy and strategic implications
for a given business.
c) Discuss the objectives of the World Trade Organisation.
d) Discuss the role of international financial institutions within the context of a globalised economy,
with particular attention to the International Monetary Fund, the Bank of International
Settlements, The World Bank and the principal Central Banks (the Fed, Bank of England, European
Central Bank and the Bank of Japan).
e) Assess the role of the international financial markets with respect to the management of global
debt, the financial development of the emerging economies and the maintenance of global
financial stability.
2. Strategic business and financial planning for multinationals
a)
Advise on the development of a financial planning framework for a multinational taking into
account:
i) Compliance with national governance requirements (for example the London Stock
Exchange admission requirements).
ii) The mobility of capital across borders and national limitations on remittances and transfer
pricing.
iii) The pattern of economic and other risk exposures in the different national markets.
iv) Agency issues in the central coordination of overseas operations and the balancing of local
financial autonomy with effective central control.
C Advanced investment appraisal

1. Discounted cash flow techniques and the use of free cash flows
a) Evaluate the potential value added to a company arising from a specified capital investment
project or portfolio using the net present value model.
Project modelling should include explicit treatment and discussion of:
i) Inflation and specific price variation.
ii) Taxation including capital allowances and tax exhaustion.

iii) Multi-period capital rationing to include the formulation of programming methods and the
interpretation of their output.
iv) Probability analysis and sensitivity analysis when adjusting the risk and uncertainty in
investment appraisal.
b) Outline the application of Monte Carlo simulation to investment appraisal.
ACCA STUDY GUIDE
Candidates will not be expected to undertake simulations in an examination context but will be
expected to demonstrate an understanding of:
i) Simple model design.
ii) The different types of distribution controlling the key variables within the simulation.
iii) The significance of the simulation output and the assessment of the likelihood of project
success.
iv) The measurement and interpretation of project value at risk.
c) Establish the potential economic return (using internal rate of return and modified internal rate
of return) and advise on a project’s return margin.
d) Forecast a company’s free cash flow and its free cash flow to equity (pre and post capital
reinvestment).
e) Advise, in the context of a specified capital investment programme, on a company’s current and
projected dividend capacity.
f) Advise on the value of a company using its free cash flow and free cash flow to equity under
alternative horizon and growth assumptions.
2. Application of option pricing theory in investment decisions and valuation
a) Apply the Black-Scholes Option Pricing (BSOP) model to financial product/ asset valuation:
i) Determine, using published data, the five principal drivers of option value (value of the
underlying, exercise price, time to expiry, volatility and the risk-free rate).
ii) Discuss the underlying assumptions, structure, application and limitations of the BSOP
model.
b) Evaluate embedded real options within a project, classifying them into one of the real option
archetypes.
c) Assess and advise on the value of options to delay, expand, redeploy and withdraw using the BSOP
model.
d) Apply the BSOP model to estimate the value of equity of a company and discuss the implications
of the change in value.
3. Impact of financing on investment decisions and adjusted present values
a) Assess the appropriateness and price of the range of sources of finance available to a company
including equity, debt, hybrids, lease finance, venture capital, business angel finance, private
equity, asset securitisation and sale.
b) Assess a company’s debt exposure to interest rate changes using the simple Macaulay duration
method.
c) Discuss the benefits and limitations of duration including the impact of convexity.
ACCA STUDY GUIDE
d) Assess the company’s exposure to credit risk, including:
i) Explain the role of, and the risk assessment models used by the principal rating agencies.
ii) Estimate the likely credit spread over risk free.
iii) Estimate the company’s current cost of debt capital using the appropriate term structure
of interest rates and the credit spread.
e) Explain the role of BSOP model in the assessment of default risk, the value of debt and its
potential recoverability.
f) Assess the impact of financing and capital structure upon the company with respect to:
i) Pecking order theory. ii)

Static trade-off theory. iii)
Agency effects.
g) Apply the adjusted present value technique to the appraisal of investment decisions that entail
significant alterations in the financial structure of the company, including their fiscal and
transactions cost implications.
h) Assess the impact of a significant capital investment project upon the reported financial position
and performance of the company taking into account
alternative financing strategies.
4. International investment and financing decisions

a) Assess the impact upon the value of a project of alternative exchange rate assumptions.
b) Forecast project or company free cash flows in any specified currency and determine the
project’s net present value or company value under differing exchange rate, fiscal and
transaction cost assumptions.
c) Evaluate the significance of exchange controls for a given investment decision and strategies for
dealing with restricted remittance.
d) Assess the impact of a project upon a company’s exposure to translation, transaction and
economic risk.
e) Assess and advise upon the costs and benefits of alternative sources of finance available within
the international equity and bond markets.
D Ac quisitions and mergers

1. Acquisitions and mergers versus other growth strategies
a) Discuss the arguments for and against the use of acquisitions and mergers as a method of
corporate expansion.
b) Evaluate the corporate and competitive nature of a given acquisition proposal.

c) Advise upon the criteria for choosing an appropriate target for acquisition.
d) Compare the various explanations for the high failure rate of acquisitions in enhancing
shareholder value.
e) Evaluate, from a given context, the potential for synergy separately classified as:
ACCA STUDY GUIDE
i) Revenue synergy. ii) Cost

synergy.
iii) Financial synergy.
2. Valuation for acquisitions and mergers

a) Outline the argument and the problem of overvaluation.
b) Estimate the potential near-term and continuing growth levels of a company’s earnings using both
internal and external measures.
c) Assess the impact of an acquisition or merger upon the risk profile of the acquirer distinguishing:
i) Type 1 acquisitions that do not disturb the acquirer’s exposure to financial or business risk.
ii) Type 2 acquisitions that impact upon the acquirer’s exposure to financial risk.
iii) Type 3 acquisitions that impact upon the acquirer’s exposure to both financial and business
risk.
d) Advise on the valuation of a type 1 acquisition of both quoted and unquoted entities using:
i) ‘Book value-plus’ models. ii) Market

relative models. iii) Cash flow models, including
EVATM, MVA.
e) Advise on the valuation of type 2 acquisitions using the adjusted net present value model.
f) Advise on the valuation of type 3 acquisitions using iterative revaluation procedures.
g) Demonstrate an understanding of the procedure for valuing high growth startups.
3. Regulatory framework and processes

a) Demonstrate an understanding of the principal factors influencing the development of the
regulatory framework for mergers and acquisitions globally and, in particular, be able to compare
and contrast the shareholder versus the stakeholder models of regulation.
b) Identify the main regulatory issues which are likely to arise in the context of a given offer and:
i) Assess whether the offer is likely to be in the shareholders’ best interests.

ii) Advise the directors of a target company on the most appropriate defence if a specific
offer is to be treated as hostile.
iii) 4. Financing acquisitions and mergers
a) Compare the various sources of financing available for a proposed cash-based acquisition.
ACCA STUDY GUIDE
b) Evaluate the advantages and disadvantages of a financial offer for a given acquisition proposal
using pure or mixed mode financing and recommend the most appropriate offer to be made.
c) Assess the impact of a given financial offer on the reported financial position and performance of
the acquirer.
E Corporate reconstruction and reorganisation

1. Financial reconstruction
a) Assess a company situation and determine whether a financial reconstruction is the most
appropriate strategy for dealing with the problem as presented.
b) Assess the likely 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.
c) Recommend a reconstruction scheme from a given business situation, justifying the proposal in
terms of its impact upon the reported performance and financial position of the company.
2. Business reorganisation
a) Recommend, with reasons, strategies for unbundling parts of a quoted company.
b) Evaluate the likely financial and other benefits of unbundling.

c) Advise on the financial issues relating to a management buy-out and buy-in.
F Treasury and advanced risk management techniques

1. The role of the treasury function in multinationals
a) Describe the role of the money markets in:
i) Providing short-term liquidity to industry and the public sector.
ii) Providing short-term trade finance.
iii) Allowing a multinational company to manage its exposure to FOREX and interest rate risk.
b) Explain the role of the banks and other financial institutions in the operation of the money
markets.
c) Explain the characteristics and role of the principal money market instruments:
i) Coupon bearing.
ii) Discount instruments.
iii) Derivative products.
d) Discuss the operations of the derivatives market, including:
i) The relative advantages and disadvantages of exchange traded versus OTC agreements.
ii) Key features, such as standard contracts, tick sizes, margin requirements and margin
trading.
iii) The source of basis risk and how it can be minimised.
ACCA STUDY GUIDE
iv) Risks such as delta, gamma, vega, rho and theta, and how these can be managed.
e) Explain the role of the treasury management function within:
i) The short term management of the company’s financial resources.
ii) The longer term maximisation of shareholder value. iii) The management of risk
exposure.
2. The use of financial derivatives to hedge against FOREX risk
a) Assess the impact on a company to exposure in translation, transaction and economic risks and
how these can be managed.
b) Evaluate, for a given hedging requirement, which of the following is the most appropriate
strategy, given the nature of the underlying position and the risk exposure:
i) The use of the forward exchange market and the creation of a money market hedge.
ii) Synthetic foreign exchange agreements (SAFEs).
iii) Exchange-traded currency futures. iv) Currency swaps.
v) FOREX swaps.
vi) Currency options.
c) Advise on the use of bilateral and multilateral netting and matching as tools for minimising FOREX
transactions costs and the management of market barriers to the free movement of capital and
other remittances.
3. The use of financial derivatives to hedge against interest rate risk
a) Evaluate, for a given hedging requirement, which of the following is the most appropriate given the
nature of the underlying position and the risk exposure:
i) Forward Rate Agreements.
ii) Interest Rate Futures. iii)

Interest rate swaps.
iv) Options on FRAs (caps and collars), interest rate futures and interest rate swaps.
4. Dividend policy in multinationals and transfer pricing
a) Determine a company’s dividend capacity and its policy given:
i) The company’s short- and long-term reinvestment strategy.
ii) The impact of any other capital reconstruction programmes on free cash flow to equity
such as share repurchase agreements and new capital issues.
iii) The availability and timing of central remittances. iv) The corporate tax regime within the
host jurisdiction.
ACCA STUDY GUIDE
b) Develop company policy on the transfer pricing of goods and services across international
borders and be able to determine the most appropriate transfer pricing strategy in a given
situation reflecting local regulations and tax regimes.
G Em erging issues
1. Developments in world financial markets
Discuss the significance to the company, of latest developments in the world financial markets such as
the causes and impact of the recent financial crisis, growth and impact of dark pool trading systems, the
removal of barriers to the free movement of capital, and the international regulations on money
laundering.
2. Developments in international trade and finance

Demonstrate an awareness of new developments in the macroeconomic environment, establishing their
impact upon the company, and advising on the appropriate response to those developments both
internally and externally.

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ACCA Paper P4

© Interactive World Wide Ltd. January 2013.

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: ISSUES IN CORPORATE GOVERNANCE 13

CHAPTER 2: ADVANCED INVESTMENT APPRAISAL – SECTION 1 25

CHAPTER 3: ADVANCED INVESTMENT APPRAISAL – SECTION 2 51

CHAPTER 4: COST OF CAPITAL 69

CHAPTER 6: CAPITAL ASSET PRICING MODEL 103

CHAPTER 7: ADJUSTED PRESENT VALUE 117

CHAPTER 8: INTERNATIONAL INVESTMENT APPRAISAL 129

CHAPTER 9: VALUATIONS, ACQUISITIONS AND MERGERS – SECTION 1 145

CHAPTER 10: VALUATIONS, ACQUISITIONS AND MERGERS – SECTION 2 169

CHAPTER 11: VALUATIONS, ACQUISITIONS AND MERGERS – SECTION 3 179

CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION 197

CHAPTER 13: CORPORATE DIVIDEND POLICY 211

CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE 221

CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK 237

CHAPTER 16: HEDGING INTEREST RATE RISK 255

CHAPTER 17: FUTURES 269

CHAPTER 18: OPTIONS 283

CHAPTER 19: SWAPS 317

CHAPTER 20: PRINCIPLES OF ISLAMIC FINANCE 329

ACCA STUDY GUIDE 341

Aim of the paper

Outline of the syllabus

B. Economic environment for multinationals

C. Advanced investment appraisal

D. Acquisitions and mergers

E. Corporate reconstruction and re-organisation

F. Treasury and advanced risk management techniques

G. Emerging issues in finance and financial management

Format of the exam paper

Section A will contain a compulsory question, comprising of 50 marks.

Formulae & tables

Modigliani and Miller Proposition 2 (with tax)

The Capital Asset Pricing Model

E(rj) = Rf + βj (E(rm) – Rf)

The asset beta formula

 Ve βe  +  Vd(1- T) βd 

(Ve + Vd(1- T))  (Ve + Vd(1- T)) 

The Growth Model

Gordon’s growth approximation

The weighted average cost of capital

WACC =   Ve   ke + VeV+dVd  kd(1–T)

The Fisher formula

Purchasing power parity and interest rate parity

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER

Modified Internal Rate of Return

The Black Scholes Option Pricing Model

d1 = ln(P a/Pe) + (r + 0.5s2)t

The Put Call Parity relationship p = c − Pa +

Present value of 1 ie (1 + r)-n

Where r = discount rate n = number of periods until

Discount rate (r)

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER

Where r = discount rate

Discount rate (r)

Standard normal distribution table

If di > 0, add 0.5 to the relevant number above.

If di < 0, subtract the relevant number above from 0.5

FINANCIAL OBJECTIVES ------------------------------------------------ 15

THE UK CORPORATE GOVERNANCE CODE ----------------------------- 16