AFM Session A1

Intro on Page 6

1 Role of Senior Financial Advisor

Identify problems

Provide solutions appropriate for THIS situation

Communicate to other members of the Board (i.e. non accountants)

2 Advanced investment Appraisal – Chap 2 – 6

Builds on FM knowledge -so you need to revise it

3 and 4 Acquisitions , mergers and reconstructions Chap 7-10

Require similar skills

5 Risk mgmt. techniques

Knowing the details of hedging (Chap 11)

Exam structure

Do Q1 first

Most important is to USE the number we calculate to help THIS organisation

ANALYSE results

Appropriate Recommendations

Section A will include TWO syllabus areas

Look at the Formulae – Tables

Need to be able to do these in Excel

Only new ones are

 M and M situation 2
 MIRR
 Black Scholes (is now given a spreadsheet)
 Put Call options
 Std Normal distribution table

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What is objective of financial mgmt.

Maximise shareholder wealth

Risk /return payoff

Want to reduce risks due to poor financial management (i.e. taking too much risks)

Three Qs to look at

1.
2.
3.
1 Investment decision

Working Capital – not a big deal at AFM

2 Financing decision

Internally generated – Retained Earnings are not cash

Risk mgmt.

Identify risk – what is the impact – what is the likelihood

Transfer –

Accept –

Reduce impact –

Reduce likelihood –

Avoid –

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Centralised treasury may be better for looking at identifying overall risk and how to

Mitigate them

Behavioural finance

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Dividend policy – how much would we LIKE to pay out

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Signals how wealthy / liquid company is –

Clientele effect –

Dividend capacity –

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Stakeholders – mainly interested in shareholders

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Seen ethics at SBL – should do PER module

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May be tested as part of currency risk

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May be tested as part of currency risk

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Make sure you are happy with the tax area

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Dark pool

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Chap 2 Investment Appraisal

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You should remember

NPV

IRR

Payback

From the FM paper

All three have issues with them that mean they are good for investment appraisal, but all have
problems. The AFM exam will concentrate on new techniques that improve these methods

NPV – gives a clear decision – positive increase shareholder wealth

IRR is the discount rate at which you change your mind between yes / no (sensitivity analysis)

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Same as payback but using discounted cashflows

Remember relevant cash flows so you should ignore

 Non cash flows – depn

 Past cash flows – sunk
 Costs unaffected by a decision - rent on a factory
 Interest payments (in WACC)

Inflation can be dealt with by

 Inflating cash flows and use nominal rate of return

 Using non inflated cash flows and use real rate of return

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(1+m) = (1 +r) *(1 + i)

Capital allowances might be in overseas country (so need profits in that country)

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Example 1 Jato Co
Jato Co is considering a project – whether or not to commercialise an innovative muscle
toning device (MTD) that will be used in the treatment of sporting injuries. It is
expected that the commercial life of MTD will be four years after which technological
advances will bring more sophisticated devices to the market and the sales of MTD will
fall to virtually zero. $8,000,000 has been spent in developing and testing the device
over the past year. Initial market research has been conducted at a cost of $2,500,000
and is due to be paid shortly.
Information on future returns from the investment has been forecast to be as follows:
Year 1 2 3 4
Units demand 20,000 70,000 125,000 20,000
Selling Price in current price terms 2,000 2,200 1,600 1,500
($/unit)
Variable cost in current price terms ($/unit) 900 1,000 1,020 1,020
Fixed costs in current price terms
10 10 10 10
($million/year)
Selling price inflation and fixed costs inflation are expected to be 5% per year and
variable cost inflation is expected to be 4% per year. Fixed costs represent incremental
fixed production overheads which are wholly attributable to the project.
The production equipment for the new device would cost $120 million and an additional
initial investment of $20 million would be needed for working capital. The equipment is
expected to be sold at the end of four years for $10 million when the production and
sales cease. The average general level of inflation is expected to be 3% per year and
working capital would experience inflation of this level.
Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis could
be claimed on the cost of equipment. Profit tax of 30% per year will be payable one
year in arrears. A balancing allowance would be claimed in the fourth year of operation.
Jato Co has a real cost of capital of 7.8%.
Required: Calculate the NPV / IRR / Payback & Discounted payback

See Spreadsheet

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Adjustments that need to be made / considerations for AFM for investment appraisal

Adjustments that need to be made when we do international projects

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Reminders from FM

Requirements of an exam standard NPV

1 Inflation – Inflation could be specific or general
a) If specific-you MUST inflate specific cash flows and discount using the
specific inflation rate for each i.e. you have different inflation rates for
different cashflows
(e.g. labour is increasing at one rate and raw materials at a different one)
b) If general – you MAY ignore and discount using the real rate
c) You must apply inflation each year
d) If you are told the value “in current price terms” that means in Yr 0

Nominal rate = (1+ Real rate) * (1 + inflation) which is equivalent to

Real rate = (Nominal rate) / (1 + inflation)

2 Taxation
a) Save tax on Written Down Allowances
b) Pay tax on trading cash flows
c) Often paid a year in arrears

3 Working Capital – this is part of the initial investment

a) We must adjust each year by the INCREMENTAL change in the level of
working capital

4 Relevant cash flows – only future cashflows should be included

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FM Class Note Q4 (CNQ4)
SC Co. is evaluating the purchase of a new machine to produce Product P, which has a short
product lifecycle due to rapidly changing technology. The machine is expected to cost $1
million. Production and sales of Product P are forecast to be as follows:
Year 1 2 3 4
Production 35,000 53,000 75,000 36,000
and sales
(units/year)

The selling price of Product P (in current price terms) will be $20 per unit, while the variable
cost of the product (in current price terms) will be $12 per unit. Selling price inflation is
expected to be 4% per year and variable cost inflation is expected to be 5% per year. No
increase in existing fixed costs is expected since SC Co. has spare capacity in both space and
labour terms.

Producing and selling Product P will call for increased investment in working capital. Analysis
of historical levels of working capital within SC Co. indicates that at the start of each year,
investment in working capital for Product P will need to be 7% of sales revenue for that year.

SC Co. pays tax of 30% per year in the year in which the taxable profit occurs. Liability to tax
is reduced by capital allowances on machinery (tax-allowable depreciation), which SC Co.
can claim on a straight-line basis over the four-year life of the proposed investment. The new
machine is expected to have no scrap value at the end of the four-year period.

SC Co. uses a nominal (money terms) after-tax cost of capital of 12% for investment
appraisal purposes.
Required:
(a) Calculate and comment on the net present value of the proposed investment in
Product P. (7 marks)
(b) Discuss how the net present value method of investment appraisal contributes
towards the objective of maximising the wealth of shareholders.
(3 marks)
(c) Calculate the internal rate of return of the proposed investment in Product P.
(5 marks)
(d) Advise on the acceptability of the proposed investment in product P and discuss the
limitations of the evaluation you have carried out. (5 marks)

(20 marks)

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Part a) See spreadsheet Note that in exam this requirement is likely to be worth more like
10 marks

b) The NPV should be added to the value oof the firm. So if the NPV is positive, the
value of the firm increases and so the share price will rise. This leads to a capital gain for
shareholders.
Note in exam this requirement is more likely to be worth 1 or 2 marks
c) See spreadsheet
d) The IRR looks at how high the discount rate would need to go before the company
changed its mind (it is when the NPV goes from being positive to negative).
This has been calculated as 16% which is significantly higher than the 12% which will be
used. This indicated that as long as the figures used are reasonably accurate – the NPV will
still be positive
Having said that, all the above assumes that the company is able to sell product P for the
ENTIRE four-year period. The lifecycle is short due to rapidly changing technology and so
product P might not be able to achieve this level of sales in the later years
Similarly, it would be more likely that sales would peak in years 1 and 2 rather than year 3

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