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ACCA Paper AFM
Advanced Financial
Management
Class Notes
December 2022
© Interactive World Wide Ltd August 2022
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,
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Contents
PAGE
INTRODUCTION TO THE PAPER 5
FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7
CHAPTER 1: FINANCIAL STRATEGY FORMULATION 13
CHAPTER 2: DISCOUNTED CASH FLOW TECHNIQUES 25
CHAPTER 3: APPLICATION OF OPTION PRICING IN INVESTMENT DECISIONS 35
CHAPTER 4: IMPACT OF FINANCING ON INVESTMENT DECISIONS 43
CHAPTER 5: ADJUSTED PRESENT VALUE 57
CHAPTER 6: INTERNATIONAL INVESTMENT APPRAISAL 63
CHAPTER 7: ACQUISITIONS AND MERGERS 71
CHAPTER 8: BUSINESS VALUATIONS 75
CHAPTER 9: FRAMEWORK 85
CHAPTER 10: CORPORATE RECONSTRUCTION AND REORGANISATION 91
CHAPTER 11: HEDGING FOREIGN EXCHANGE RISK 99
CHAPTER 12: HEDGING INTEREST RATE RISK 111
SOLUTIONS TO EXAMPLES 119
CLASS NOTES QUESTIONS 165
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Introduction to the
Paper
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Aim of the paper
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 in private and public sectors.
Outline of the syllabus

A. Role of senior financial adviser in the multinational organisation (Chapter 1)
B. Advanced investment appraisal (Chapters 2 – 6)
C. Acquisitions and mergers (Chapters 7 – 9)
D. Corporate reconstruction and re-organisation (Chapter 10)
E. Treasury and advanced risk management techniques (Chapters 11 – 12)
F. Professional skills
Format of the exam paper

The Advanced Financial Management exam builds upon the skills and knowledge
examined in the Financial Management exam. At this stage candidates will be
expected to demonstrate an integrated knowledge of the subject and an ability to
relate their technical understanding of the subject to issues of strategic importance
to the organisation. The study guide specifies the wide range of contextual
understanding that is required to achieve a satisfactory standard at this level.
Examination Structure
The syllabus is assessed by a three-hour 15 minutes examination.
Section A
Section A will always be a single 50 mark case study. The 50 marks will comprise of
40 technical marks and 10 professional skills marks. All of the professional skills will
be examined in Section A.
Financial managers are required to look across a range of issues which affect an
organisation and its finances, so candidates should expect to see the case study focus
on a range of issues from at least two syllabus sections from A - E. These will vary
depending on the business context of the case study.
Section A questions will ask candidates to produce a response in a specific format,
for example a report to the Board of Directors.
Section B
Section B will consist of two compulsory 25 mark questions. All section B questions
will be scenario based and contain a combination of calculation and narrative marks.
There will not be any wholly narrative questions. The 25 marks will comprise of 20
technical marks and 5 professional skills marks. Section B questions will contain a
combination of professional skills appropriate to the question. Each question will
contain a minimum of two professional skills from Analysis and Evaluation, Scepticism
and Commercial Acumen.
All topics and syllabus sections will be examinable in either section A or section B of
the exam.
Formulae & Tables
Provided in the
Examination Paper
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F O R M U L A E & T A B L E S P R O V I D E D I N T H E E X A M I N A T I O N P A P ER
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   Vd (1 - T) 
βa =   e  +  (V + V (1 - T))  d 
 (Ve + Vd (1- T ))   e d 
The Growth Model
D0 (1 + g)
P0 =
(re - g)
Gordon’s growth approximation

g = bre
The weighted average cost of capital
 Ve   Vd 
WACC =   ke +  
  V + V  kd(1–T)
 Ve + Vd   e d
The Fisher formula

(1 + i) = (1 + r) (1 + h)
Purchasing power parity and interest rate parity
(1 + hc )
(1 + ic )
S1 = S0  Fo = So 
(1 + hb ) (1 + ib )
Modified Internal Rate of Return
1
 PVR  n
MIRR =   (1 + re) – 1
 PVI 
F O R M U L A E & T A BL ES P R O V I D ED I N T H E E X A M I N A T I O N P A P ER
The Black Scholes Option

Pricing Model
-rt
c = Pa N(d1) − Pe N(d 2 ) e
Where:
ln(Pa /Pe ) + (r + 0.5s2 )t
d1 =
s t
and
d2 = d1 – s t
The Put Call Parity relationship

-rt
p = c − Pa + Pe e
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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
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F O R M U L A E & T A BL ES P R O V I D ED I N T H E E X A M I N A T I O N P A P ER
Annuity table
1 - (1 + r)-n
Present value of an annuity of 1 ie
r
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 10.368 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.255 10.575 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.134 11.348 10.635 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.004 12.106 11.296 10.563 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.865 12.849 11.938 11.118 10.380 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
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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(di), 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
12 w w w . l s b f. o r g . u k
Chapter 1
Financial Strategy
Formulation
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C H A P T E R 1 - F I N A N C I A L S T R A T EG Y F O R M U L A T I O N
Primary financial management objective

Shareholder wealth maximisation which is achieved by;
● increasing the value of the entity and the share price
● providing a cash flow to investors via a dividend
Core financial management decisions

Financial management is often described in terms of the three basic decisions to be
made:
● the investment decision,
● the financial decision,
● the dividend decision.
Each of these decisions have to be looked at in far greater detail later on in the course
but as an outline these are the basic considerations:
1. The investment decision

A company may invest its funds in one of three basic areas:
1. Capital assets
2. Working capital
3. Financial assets
The investment decision will be covered in significant detail in Chapters 2 - 6
2. The financing decision

When looking at the financing of a business there are 4 basic questions to consider:
1. total funding required,
2. internally generated vs externally sourced,
3. debt or equity,
4. long-term or short-term debt.
The financing decision will be covered in Chapter 4.
3. The dividend decision

The amount of return to be paid in cash to shareholders. This is a critical measure
of the companies’ ability to pay a cash return to its shareholders.
The dividend decision will be covered later in this chapter
14 w w w . l s b f. o r g . u k
C H A P T ER 1 – F I N A N C I A L S T R A T EG Y F O R M U L A T I O N
Other financial management responsibilities
1. Risk management
All elements of risk need be identified and mitigated including;
1. Operational
2. Reputational
3. Political
4. Economic
5. Regulatory
6. Fiscal
Risk management strategy
Whilst a level of risk is accepted, a company will aim to identify, assess and protect
against risk. The risk management strategy involves taking decisions on which risks
to avoid, which to retain and which to transfer.
Risk mitigation
This is the process of transferring risks out of a business through, for example,
hedging or insurance, or avoiding certain risks altogether.
Risk diversification
This is the process of risk reduction by limiting the exposure to a particular element.
This can be achieved by diversifying into different products and services, different
geographical areas and different industries.
Tara Framework
Substantial risk should be transferred away from the operation via adopting the
required insurance policies, avoiding excessive risk, accepting ordinary risk and
reducing non-controllable risk. The cost of such action should always be compared
to the benefit derived, prior to authorising any action.
Risk management will be evident across the entire syllabus, with specific coverage of
interest rate and foreign exchange risk covered in Chapters 11 and 12.
2. Communication of financing decisions

Communication has far reaching implications to all stakeholders and as such careful
dialogue must be maintained with both internal and external stakeholders
3. Incorporate adequate financial planning and control

To ensure objectives are adhered to and necessary corrective action is taken to
pursue primary objective.
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Treasury Management Function

Often the risks that the entity is exposed to are managed by the treasury department
and will include:
● Liquidity management
● Funding management
● Currency management
● Corporate finance (acquisitions and divestments)
1. Centralised treasury
A centralised treasury function has a better view of the firm’s overall position and
thus is able to ensure cash is correctly allocated between divisions, and has greater
purchasing power, in turn reducing cost of borrowing and also avoiding duplication.
In addition, it facilitates superior currency management.
2. Regional treasury
A regional treasury department is better equipped to respond in a time conscious

manner to issues that arise as opposed to waiting for approval to act. They will
reduce the workload of head office and have greater expertise in the local banking
environment.
BEHAVIOURAL FINANCE
Financial management theory assumes that decisions will always be made in a
rational manner, however this make not be the case and as such irrational decisions
and systematic errors will occur.
This theory undermines the efficient market hypothesis which suggests that no
excessive gains can be made, as information is effectively absorbed in to the share
price. However examples of such irrationality which creates opportunity for arbitrage
include;
Overconfidence
Where investors overestimate the forecasted financial performance, and as a
consequence make inaccurate decisions.
Confirmation Bias
Where investors pay consideration only to information which supports their view and
overlook anything that suggests an error has been made
Conservatism
Where investors are immune to positive information and do not believe that the
outcome is likely to be repeated, as such the information is not absorbed into the
share price.
16 w w w . l s b f. o r g . u k
DIVIDEND POLICY
The owners of profit-making organisations look for reward from their investment in
two ways: the growth of the capital invested (capital gains), and the cash paid out
as income (dividend).
The dividend decision thus has two elements: the amount to be paid out and the
amount to be retained to support the growth of the entity, the latter being a financing
decision; the level and regular growth of dividends represent a significant factor in
determining a profit-making company’s market value, that is the value placed on its
shares by the stock market.
POSSIBLE APPROACHES TO DIVIDEND POLICY

There are four major possibilities a company could adopt as to the pattern of dividend
pay-out over time. These are:
1. Constant Pay-out Ratio

The company pays a constant proportion of earnings available to equity shareholders
as dividend hence dividend per share will fluctuate from year to year in line with
earnings.
2. Stable Dividend Policy

The company pay out a fixed dividend per share irrespective of the earnings available
to equity shareholders.
3. Residual Dividend Policy

Retained earnings are used to fund all profitable projects. Remaining funds (if any)
are used to pay dividends. This policy leads to a very volatile dividend stream over
time.
4. Zero Pay-out
The company chooses not to pay a dividend as they wish to retain the funds for
reinvestment. This would usually occur in fast growing companies, or those in
financial distress.
DIVIDEND POLICY AND SHAREHOLDERS’ WEALTH

Does the dividend policy adopted by a company have an influence on its shareholders’
wealth? There are broadly two schools of thought in relation to this question. These
theories are the dividend relevance theory and dividend irrelevance theory as
discussed below:
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Dividend relevance theory – traditional theory

This argument is that dividends pay-out influences the market value of the company
because of the following practical influences:
1. Signalling effect
In a semi-strong form efficient market, information available to directors is more
substantial than that available to shareholders, so that information asymmetry exists.
Investors perceive dividend announcements as signals of future prospects for the
company. The signalling effect also depends on the dividend expectations in the
market.
2. Clientele effect
The clientele effect states that shareholders are attracted to particular companies as
a result of being satisfied by their dividend policies. A company with an established
dividend policy is therefore likely to have an established dividend clientele. The
existence of this dividend clientele implies that the share price may change if there
is a change in the dividend policy of the company, as shareholders sell their shares
in order to reinvest in another company with a more satisfactory dividend policy.
Dividend irrelevance theory – Modigliani and Miller (M&M)

M&M began by examining the effects of differences in dividend policy on the current
price of shares in an ideal economy characterised by perfect capital markets, no tax,
rational behaviour and perfect certainty.
Under these assumptions, M&M argued that a change in the dividend policy, per say,
would not affect the shareholders’ wealth as the value of a company depends on its
investment decision alone, and not on its dividend or financing decisions.
Since investors have perfect information, they will be indifferent between dividends
and capital gains.
Dividend capacity
The maximum dividend a company is able to pay without resorting to borrowing is
equivalent to the free cash flow to equity that we explore in Chapter 8.
To calculate this we start with the profit after tax (earnings) generated by the
business and adjust as follows:
Add back: Non-cash expenses, cash received from asset disposals
Deduct: Investment in non-current assets and working capital, debt repaid.
18 w w w . l s b f. o r g . u k
Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a business.
A more comprehensive view would be to consider a wider range of interested parties
or stakeholders.
Stakeholders are any party that has both an interest in and relationship with the
company. The basic argument is that the responsibility of an organisation is to
balance the requirements of all stakeholder groups in relation to the relative
economic power of each group.
Conflict between stakeholder groups

The very nature of looking at stakeholders is that the level of ‘return’ is finite within
an organisation. There is a need to balance the needs of all groups in relation to
their relative strength.
Agency theory
Agency relationships occur when one or more people employ one or more persons as
agent. The persons who employ others are the principals and those who work for
them are called the agent
In an agency situation, the principal delegate some decision-making powers to the
agent whose decisions affect both parties. This type of relationship is common in
business life. For example shareholders of a company delegate stewardship function
to the directors of that company. The reasons why an agents are employed will vary
but the generally an agent may be employed because of the special skills offered, or
information the agent possess or to release the principal from the time committed to
the business.
Goal Congruence
Goal congruence is defined as the state which leads individuals or groups to take
actions which are in their self-interest and also in the best interest of the entity.
For an organisation to function properly, it is essential to achieve goal congruence at
all level. All the components of the organisation should have the same overall
objectives, and act cohesively in pursuit of those objectives.
In order to achieve goal congruence, there should be introduction of a careful
designed remuneration packages for managers and the workforce which would
motivate them to take decisions which will be consistent with the objectives of the
shareholders.
Money as a prime motivator

The most direct use of money as a motivator is payment by results schemes whereby
an employee’s pay is directly linked to his results. However, research has shown that
money is not a single motivator or even the prime motivator.
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Ethics
Consideration of ethical implications which may impede shareholder wealth
maximisation as consideration must be given to other stakeholder groups.
Modern thinking recognises the link between an ethical approach and enhanced
revenue, by contrast unethical behaviour may have consequences such as customer
and supplier boycotts which impact upon financial and business performance.
Ethical framework for decision making
• Integrity
• Objectivity
• Professional competence
• Confidentiality
• Professional behaviour
Environmental Issues
Exam questions may require you to consider environmental issues and their impact
upon corporate objectives.
Ensure that you consider a decision with the potential conflict and damage to the
business reputation
Triple bottom line reporting

Requires the reporting of performance from three perspectives
1. Economic
2. Social
3. Environmental
Environmental indicators could include carbon emissions, renewable energy
consumed as a percentage of total, quantity of waste recycled etc.
20 w w w . l s b f. o r g . u k
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.
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 blocs
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.
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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.
• 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.
• Credit risk – this is the risk of non-payment for the goods/services involved in
an export transaction.
• 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.
22 w w w . l s b f. o r g . u k
TRANSFER PRICING WITHIN MULTINATIONALS

Essentially a transfer price is an internal recharge which is not an actual cash flow.
However it will in effect redistribute income and cost within an organisation and as a
consequence adjust the profit reported by separate divisions.
Whilst this has an internal consequence in the evaluation of divisional management,
it is of particular significance within multinational organisations due to the tax
implications.
Performance evaluation
Divisional managers are often sensitive to the transfer price used as it directly
impacts upon their financial performance. Where remuneration is linked to financial
results of the division, incongruent behaviour could arise, with decisions taken which
are not in the best interest of the group.
This can be circumvented by adjusting the financial results, or alternatively removing
autonomy so that divisional managers have to accept the transfer price and utilise
internal capacity rather than sourcing goods and services from external suppliers
where a better price can be achieved.
Fund remittance
Transfer pricing can be used in international investments as a way to circumvent any
restrictions relating to blocked funds. The parent company will charge the foreign
subsidiary an inflated amount to ensure a cash flow that might have otherwise not
been possible to obtain.
Tax implications
Transfer pricing can also be used to minimise the global tax payable, by adjusting
the transfer price to ensure that a low profit is declared in nations of high tax rates
and a larger profit is declared in nations where the rate is more favourable.
This may need the approval of the respective governments who may not take kindly
to such blatant attempts to avoid paying tax. They may enforce that the transaction
is carried out at “arm’s length” using a price that would be applied to an external
customer to ensure that the transaction is fair and tax is collected as it should be.
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DARK POOL TRADING

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.
24 w w w . l s b f. o r g . u k
Chapter 2
Discounted Cash
Flow techniques
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CHAPTER 2 – DISCOUNTED CASH FLOW TECHNIQUES
DISCOUNTED CASH FLOW TECHNIQUES

Discounting cash flow techniques are investment appraisal techniques which take into
account both the time value of money and also total profitability over the project life.
It is therefore superior to both the ARR and the payback as methods of investment
appraisal.
The discounting methods include:
• Net present value (NPV)
• Internal rate of return (IRR)
• Modified internal rate of return (MIRR)
• Discounted payback period
• Duration
• Adjusted present value (APV)
The assumed objective is to maximise the shareholders’ wealth.
Net present value (NPV)

The NPV of a project is the value obtained by discounting all the cash outflows and
inflows at a chosen target rate of return or cost of capital and taking the net total.
That is the present value of inflows minus present value of outflows.
NPV = PV of future cash flows – initial investment.
Decision rule
1. If he NPV is positive, then the cash inflows from the investment will yield a
return in excess of the cost of capital and so the project should be undertaken.
2. If the NPV is negative, the cash inflows from the investment will yield a return
below the cost of capital, and the project should not be undertaken.
Internal Rate of Return (IRR)

Internal rate of return is that discount rate which gives a net present value of zero.
Alternatively, the IRR can be described as the maximum cost of capital that can be
applied to finance a project without causing harm to the shareholders.
The IRR is found approximately using interpolation. This is given as:
 NPVL 
IRR = L% +    H% − L%
 NPVL − NPVH 
Decision rule
If the expected (calculated) IRR exceeds the cost of capital, the project should be
undertaken.
26 w w w . l s b f. o r g . u k
C H A P T ER 2 – D I S C O U N T ED C A S H F L O W T E C H N I Q U E S
Discounted payback period (DPB)

It is the length of time the present values of cash flows from an investment recover
the original cash outlay required by the investment. Through DPB method, the
normal payback period problem of time value of money is resolved.
Relevant cash flows

A relevant cash flow is a future cash flow arising as a result of a decision. The cash
flows that should be included are those specifically generated or incurred as a result
of the accepting or non-accepting of the project.
Relevant cash flows should be judged on the basis of:
• Incremental cash flows,
• Avoidable cash flows, and
• Opportunity cost.
Irrelevant cash flows include:
• Depreciation – not a cash flow item. If profit is given after depreciation, the
depreciation should be added back to get the cash flows.
• Apportioned fixed cost. Fixed costs may appear in a DCF calculation only if it is
known that they will increase as a result of accepting a project.
• Interest payments – this is factored into the discount rate.
• Sunk or past costs.
Working capital
Some capital investment involves an investment in working capital as well as fixed
assets. An increase in working capital reduces cash flows and a reduction in working
capital improves the cash flow in the year that it happens
By convention, in DCF analysis, if a project will require an investment in working
capital, the investment is treated as a cash outflow at the beginning of the year in
which it occurs. The working capital is eventually released or recouped at the end of
the project, when it becomes a cash inflow.
INFLATION AND PROJECT APPRAISAL

Inflation is a general increase in prices leading to a general decline in the real value
of money.
‘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%).
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‘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
1. Money or Nominal rate is used to discount the nominal cash flows.
2. Real rate is used to discount the real cash flows.
3. Because inflation affect financing needs, is also likely to affect gearing and so
cost of capital.
The relationship between money rate (m), real rate (r) and inflation (i) is given as:
(1 + m) = (1 + r)(1 + i)
Taxation and Project Appraisal

• Tax charged on net trading revenue
• Tax saved on capital allowances (tax allowable depreciation)
• Timing of the cash flows
Capital allowance
The capital allowances are used to reduce the taxable profits and the consequence
reduction in a tax payment should be treated as a cash savings arising from the
acceptance of a project.
The cash savings on the capital allowance = capital allowance

x tax rate
When the asset is eventually sold, the difference between the sale proceeds and the
written down amount at the time of sale will be treated as:
• A balancing charge (taxable profit) if the sale price exceed the written down
balance.
• A balancing allowance (taxable loss) if the sale price is less than written down
balance.
28 w w w . l s b f. o r g . u k
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.
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Modified internal rate of return (MIRR)

An assumption underlying the NPV method is that any net cash flows generated
during the life of the project will be reinvested elsewhere at the cost of capital (the
discount rate). The IRR method assumes that the net cash flows are reinvested
elsewhere at the IRR.
If the IRR is considerably higher than the cost of capital this is an unlikely assumption.
If the assumption is not valid the IRR method overestimates the projects return.
To help overcome the problem of IRR, a recent innovation is the development of the
modified IRR, which has the following benefits:
• It eliminates multiple IRR rates.
• It addresses the reinvestment rate issue and reduces over optimism.
• It produces a result which, when ranking projects, is consistent with the NPV rule.
• Provides a % rate of return for project evaluation.
Using this method (MIRR) all cash flows after investment are converted, by assuming
that the cash flows can be reinvested at the cost of capital, to a single cash inflow at
the end of the final year of the project.
Calculating modified internal rate of return (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.
This is referred to as PvI in the provided formula
• All net cash flows generated by the project after the initial investment (ie the
return phase cash flows) are discounted back to time 0 using the company’s cost
of capital and added together to give the PvR.
• The MIRR can then be calculated using the formula provided in the exam.
Example 2 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 over the 5 years of the
project are expected to have a present value of £23,272.
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%.
30 w w w . l s b f. o r g . u k
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.
Example 3 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:
Calculate the duration to recover the present value of the project (at an 8%
hurdle rate).
RISK AND UNCERTAINTY
Risk
Future events might not be certain, because there are several possible outcomes.
However, it might be possible to predict the likelihood that each possible outcome
will occur. The predictions of risk in the future might be based on statistical
assessment of what has occurred in the past.
With risk analysis, the probabilities might be obtained from analysing what has
happened in the past.
Uncertainty
Uncertainty exist where there are several possible outcomes, but there is little
previous statistical evidence to enable the possible outcomes to be predicted.
Methods of treating risk

The methods of treating risk include:
• sensitivity analysis
• probability estimate of cash flows
• certainty equivalent
• adjusting the discount rate
• simulation modelling.
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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.
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).
Annual VAR = Std Dev x Tail Value
Projects Life VAR = (Project Life^0.5) x Std Dev x Tail Value
Example 4
Andrews plc estimates the expected NPV of a project lasting for a single year to be
£100 million, with a standard deviation of £9.7 million.
In addition they have a further project which is scheduled to last 4 years with an
expected NPV £200m, with a standard deviation of £5.8.
Required:
(a) Establish the value at risk using both a 95% and also a 99% confidence
level for the single year project
(b) Establish the value at risk using both a 90% and also a 95% confidence
level for the 4-year project.
32 w w w . l s b f. o r g . u k
CAPITAL RATIONING
Capital rationing occurs whenever there is a budget ceiling or a market constraint on
the amount of funds which can be invested during a specific period of time. It is a
situation where there are insufficient funds to finance all profitable projects.
Causes of capital rationing

There are two causes of capital rationing:
1. Soft or internal capital rationing

Soft capital rationing is often used to refer to situation where, for various reasons,
the firm internally imposes a budget ceiling on the amount of capital expenditure.
It occurs due to internal factors such as:
• Management may be reluctant to issue additional share capital because of the
concern that this may lead to a dilution in control.
• Management may be unwilling to issue share capital if it will lead to a dilution in
earnings per share.
• Management may not want to raise additional debt capital because they do not
want to be committed to large fixed interest payment or due to the concern of
gearing.
• There may be a desire within the company to limit investment to a level that can
be financed solely from retained earnings.
2. Hard or external capital rationing

Hard capital rationing occurs whenever there is a market constraint on the amount
of funds which can be invested during a specific period of time.
This occurs due to external factors such as:
• Raising money through the stock market is not possible because share prices are
depressed.
• There may be restriction on bank lending due to government controls.
• Lending institutions may consider an organisation to be too risky to be granted
further loan facility.
• The cost associated with making small issues of capital may be too great.
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Types of capital rationing

The two types of capital rationing are single period and multi period capital rationing.
1. Single period capital rationing

Single period capital rationing is where there are shortages of funds now, but funds
are expected to be freely available in all later periods.
2. Multi-period capital rationing

This is where available finance is limited not only during the current period, but also
during subsequent periods.
Projects may be:
1. 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.
2. Indivisible
In this event, integer programming would be required to determine the optimal
combination of investments.
34 w w w . l s b f. o r g . u k
Chapter 3
Application of Option
Pricing in Investment
Decisions
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C H A P T E R 3 – A P P L I C A T I O N O F O P T I O N P R I C I N G I N I N V E S T M EN T D E C I S I O N S
Terminology 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.
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.
36 w w w . l s b f. o r g . u k
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.
Factors determining the value (price) of option

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

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 price for the underlying
item 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
The exercise price (Pe)

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 (t)

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 (r)

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 (s)

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 annualised percentage.
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REAL OPTIONS IN INVESTMENT APPRAISAL

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.
Based on the AFM syllabus, we have to consider option to delay, expand and abandon.
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 markets. The initial project may be
found in terms of its NPV as not worth undertaking. However, when the option to
expand is taken into account, the NPV may become positive and the project
worthwhile.
Expansion will normally require additional investment creating a call option.
The option will be exercised only when the present value from the expansion is higher
than the extra investment.
Example 1 - option to expand – CALL OPTION

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.
38 w w w . l s b f. o r g . u k
Option to abandon
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.
Example 2 - option to abandon – PUT OPTION

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 standard deviation of 30%.
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.
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.
Example 3 – option to delay – CALL OPTION

Digunder, a property development company, has gained planning permission for the
development of a housing complex at Newtown which will be developed over a three-
year period.
The resulting property sales less building costs have an expected net present value
of $4 million at a cost of capital of 10% per annum. Digunder has an option to acquire
the land in Newtown, at an agreed price of $24 million, which must be exercised
within the next two years. Immediate building of the housing complex would be risky
as the project has a volatility attaching to its net present value of 40%.
One source of risk is the potential for development of Newtown as a regional
commercial centre for the large number of professional firms leaving the capital,
Bigcity, because of high rents and local business taxes. Within the next two years,
an announcement by the government will be made about the development of
transport links into Newtown from outlying districts including the area where
Digunder hold the land option concerned. The risk-free rate of interest is 6% per
annum.
Required:
Estimate the value of the option to delay the start of the project for two
years using the Black and Scholes option pricing model and comment upon
your findings.
Assume that the government will make its announcement about the potential
transport link at the end of the two-year period.
www.lsbf.org.uk 39
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.
40 w w w . l s b f. o r g . u k
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(d 1) 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 size 0.6  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 out-of-
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-the-
money 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
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3. 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
4. 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
THETA Time value in option premium Time to expiry
42 w w w . l s b f. o r g . u k
Chapter 4
Impact of Financing
on Investment
Decisions
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C H A P T E R 4 – I M P A C T O F F I N A N C I N G O N I N V E S T M EN T D E C I S I O N S
SOURCES OF FINANCE
External finance is raised with the agreement of lenders or investors who will bring
to the arrangement their own set of goals, preferences and investment strategies.
Internal finance is raised through management decision-making, such as making
changes to working capital and dividend policy
External Sources
Equity
Equity finance allows companies to raise large amount of finance. However,
although small, each share represents a part transfer of ownership to an external
shareholder.
There is no fixed rate of return (dividends) for equity shareholders and they will
only receive a return when there are enough profits available after other
financing costs, such as interest payments and preference share dividends, have
been met.
Debt
To obtain finance an organisation may borrow from a lender. A lender will loan an
agreed sum based upon a contract where the amount of interest, date of interest
payment, security and capital repayment are agreed and stated. There are a
number of different types of debt instruments, all with subtly different
characteristics.
Hybrids
Hybrids are financial instruments that combine both the characteristics of debt and
equity finance. There are several types of hybrid finance: preference share capital,
convertible debentures and warrants.
Leases
The main advantage of using leases is that the organisation does not have to
finance the initial capital costs of the asset or factor in its depreciation. Instead it
only has to finance the leasing cost, which is spread over an extended period with
relatively small regular payments.
In a financing lease, the lessee has legal ownership of the asset, but pays the third
party of the use of the asset. Whereas in an operating lease, the lessee does not
have legal ownership of the asset and pays the third party of the use of the asset.
Venture capital
Venture capital is finance provided to a start-up company during concept proving,
start up or expansion especially where there are high initial costs which cannot be
met through normal debt financing. It is a high-risk approach to investment and a
very selective financing strategy often applied in innovative technological,
biotechnology and IT industries, subject to potential rapid growth (and possible
failure), but where the return on investment may be several years into the future.
44 w w w . l s b f. o r g . u k
Business angel
This is where an affluent individual will provide finance to an organisation which
may have difficulties attracting finance from more traditional routes during the
business start-up phase or new product development phase. The ‘business angel’
is taking a greater risk with their capital than traditional investment so expects a
significantly greater return for their support in terms of convertible debt or
ownership equity.
Private equity
An organisation might raise finance through offering equity via a private sale (eg
not publicly traded on a stock exchange) to a private equity firm. This often
involves selling a majority stake or controlling stake in the organisation.
Asset securitisation
This is a specialised and complex method of financing which involves an
organisation selling some of its money-earning assets in a consolidated package
as ‘pass through securities’. Investors then receive appropriate returns on
investment from these assets having paid for the right to do so.
Islamic finance
Sharia Law does not allow for the earning of interest on money. It considers the
charging of interest to be ‘usury’ or ‘compensation without due consideration’. This
is called Riba and underpins all aspects of Islamic financing.
Instead of interest a return may be charged against the underlying asset or
investment to which the finance is related. Another way of describing it is as the
sharing of profits arising from an asset between lender and user of the asset. The
prohibition on ‘gharar’ means that forward contracts and derivatives are not allowed.
Initial Coin Offerings

An Initial Coin Offering (ICO) is an IPO using cryptocurrencies. The business sells
tokens (“coins”) to investors who pay using cryptocurrency. The tokens become
currency when, or if, the funding goal is achieved and the business successfully
launches.
By using an ICO rather than a traditional stock exchange listing a business can
reduce the costs associated with dealing with established financial intermediaries
such as banks, listing authorities etc, and avoid the regulations that accompany
these forms of finance. However that leaves investors with little protection, and
are thus exposed to failure and irregularities.
Factors influencing choice

• Prevailing and forecast economic conditions
• Level of interest rates
• Taxation
• Cost of capital
• Risk
• Control of the company
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Cost of capital
The cost of capital is the return that investors expect to be paid for putting funds into
the company. In order words, it is the cost incurred by a company for raising money
to finance its activities.
The elements of cost of capital are:
• The risk-free rate of return – return required from an investment which is
completely free from risk, example return on government securities.
• The risk premium – return to compensate for financial risk (having debts in capital
structure) and business risk (return to compensate for uncertainty about the
future and about a firm’s business prospects).
WEIGHTED AVERAGE COST OF CAPITAL (WACC)

The Weighted Average Cost of Capital (WACC) is the average cost of the different
elements within the capital structure of a company, using the market value of each
of the different elements as the basis of the weightings.
Although book values are often easier to obtain they are of doubtful economic
significance, that is, it is more meaningful to use market values.
Assumptions in the use of WACC

WACC can be used as a cut-off or discount rate for calculating NPVs of projected cash
flows for new investments, but the following criteria should be met.
• There is no significant change in capital structure of the company as a result of
the investment.
• The operating risk of the company does not change as a result of the investment.
• The project to appraise is small relative to the size of the company. It represents
a marginal investment.
46 w w w . l s b f. o r g . u k
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.
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.
Thus a standard deviation ( 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.
Total UNSYSTEMATIC RISK

portfolio
risk(s)
SYSTEMATIC RISK
11 5 9 13 17 21 25
Number
Number of
of different
different companies
companies in
in which
which shares
shares are
are held
held
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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 acquires debt levels its equity
shareholders will also have to accept 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 systematic
financial risk.
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.
The theoretical relationship between βa and βe is commonly expressed by the

following formulae:
 Ve   Vd (1 − T ) 
βa =  β + β 
 (V + V (1 − T ))   (V + V (1 − T )) 
e d
 e d   e d 
Asset Beta Financial

(β asset) + Gearing
Re-gear
De-gear
Equity beta
(β equity)
Key formula
 asset (ungeared) =  equity (geared)  Ve / Ve + Vd(1-t)
 equity (geared) =  asset (ungeared)  Ve + Vd(1-t) / Ve
48 w w w . l s b f. o r g . u k
Project specific cost of capital

Discount rates for capital investment appraisal should be consistent with the risk that
go with the project and as such should take into account both the systematic risk and
the company’s gearing level.
This approach is appropriate where a company is diversifying into another industry
or is undertaking a major new investment which will affect business and financial
risks significantly.
The stages of establishing the specific cost of capital for appraising such investments
are:
• Identify a proxy beta. This is the average equity beta (Be) of the industry in
which the project is to be undertaken.
• Ungear the proxy equity beta to remove the financial risk to establish the asset
beta or ungeared equity beta (Ba) using the above formula.
• Regear the asset beta (Ba) to establish the geared equity beta by including the
financial risk that reflects the method of financing the new project. This is the
debt equity ratio of financing the new project or the company’s existing
debt/equity proportion if will not change as a result of the new project.
• Use the re-geared beta (Be) from above to calculate the project specific cost of
equity using the CAPM formula.
• The project specific WACC can be calculated based on the weighted average of
cost of equity and cost of debt. This WACC will be used to discount the project
cash flows to determine the net present value.
Example 1
Casio produces educational electronic devices though is about to invest in a
diversification into the pharmaceutical industry. Their current market value of equity
and debt is $140m and $60m respectively. They have an equity beta of 1.8. The
average equity  of pharmaceutical firms is 1.3. Gearing in the pharmaceutical
industry averages 40% debt, 60% equity. The pre-tax cost of debt is 4%.
Rm = 14%, Rf = 4%, corporation tax rate = 30%.
Required:
What would be a suitable discount rate for the new investment?
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WACC of combined activities

This occurs when the company is involved in two or more activities in different
industries.
The stages for calculating the WACC of combined activities are:
1. Un-gear each entity’s equity beta to determine the asset beta for each.
2. Find the weighted average of the asset betas using the respective market value
of equity of each entity. This represents the combined asset beta of the
company.
3. Re-gear the combined asset beta using the debt-equity proportion of the
company to determine the equity beta.
4. Using CAPM, calculate the combined cost of equity.
5. Finally, calculate the combined WACC.
Example 2 – Combined Asset Beta
Company A Company B Combined

Equity Beta 1.6 1.3
Value Equity $750m $250m $1,000m
Value Debt $150m $125m $ 275m
Total Market Value $900m $375m $1,275m
Tax = 20% / Risk Free rate = 3% / Risk Premium = 7.5% / Cost of Debt = 6%
Calculate the combined cost of capital if Company A was to merge with Company B
50 w w w . l s b f. o r g . u k
Example 3 Edwards plc – Combined Asset Beta

Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order to
achieve backward vertical integration. 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.
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 equity 0.97 2.52
The risk free rate of interest is to be taken at 5% and the expected return on a
market portfolio is 9%. The cost of debt post acquisition is expected to be 7% and
the forecast rate of corporation tax is expected to remain at 30%.
Advise the directors of Edwards of a suitable cost of capital to evaluate the

proposed acquisition.
Deconstruction of combined entity WACC

This occurs in the exam when a company is seeking to divest part of their operations
or using a diversified organisation as a proxy in project specific discount factor.
The stages for deconstructing the combined asset beta are:
1. De-gear the entity to convert equity beta into combined asset beta.
2. Reconstruct the original computation of the combined asset beta.
3. Use the information provided to identify the asset beta of the relevant element
to be divested or used as a proxy.
4. Re-gear the asset beta as appropriate.
5. Using CAPM, calculate the appropriate cost of equity.
6. Calculate the post-tax cost of debt.
7. Finally, calculate the combined WACC.
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Example 4 – Separating Combined Asset Beta

Startup Plc is seeking to diversify operations into a new business sector,
telecommunications, and is unsure of an appropriate discount factor to evaluate the
projects cash flows. Established Ltd already operates in the telecom sector, though
this only accounts for 40% of their operations. The rest of their business relates to
satellite television broadcasting, which has an asset beta of 1.045.
The respective details of each firm are shown below:
Startup Established
Equity Beta 1.6 1.5
Value Equity $50m $360m
Value Debt $25m $90m
Total Market Value $75m $450m
Pre-tax Cost of Debt 8.0% 6.0%
Tax = 20% / Risk Free rate = 4% / Risk Premium = 9%
Required:
Calculate the appropriate discount factor to be used for the diversification into
Telecommunications for Startup Plc based upon the asset beta of Established.
Credit rating agencies

Assess the credit risk by using financial ratios and other financial information. Most
common considerations include maturity period of the debt, debt to asset ratio,
volatility of asset value, cash flow generation, industry and competitive position,
quality of management, capital structure and profitability.
Rating Risk of Default
AAA High Quality – zero risk
AA High Quality – very little risk
A Upper Medium Grade – minimal risk
BBB Medium Grade
BB Lower Medium grade – speculative risk
B Speculative
CCC Poor Quality – considerable risk exposure
CC Highly speculative
C Lowest grade – very high default risk
52 w w w . l s b f. o r g . u k
Credit spread & cost of debt

Credit spread is the premium over the equivalent return on risk free bond to
compensate the investor for credit risk. The higher the risk the higher the spread.
Cost – risk free return + spread
This is likely to be adjusted for the tax implications when determining cost of capital
Rating 1 Year 2 Year 3 Year 4 Year
AAA 8 16 24 32
A 32 52 72 92
BB 78 128 188 248
B 102 194 274 346
1 basis point = 0.01%

Note the lower the rating the higher the spread, further the yield to maturity
increases with time.
1 year = 2%
2 year = 4%
3 year = 6%
4 Year = 7%
Thus a four year A rated bond will cost 7 + 0.92 = 7.92% whereas a 3 year B rated
bond will cost 6.0 + 2.74 = 8.74%
www.lsbf.org.uk 53
MODIGLIANI AND MILLER FORMULAE

Proposition 1: value of company
Vg = Vu + Dt
Proposition 2: cost of equity
Vd
Keg = or kie +(1-T)(k ie -k d )
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 AFM Formulae sheet.
Proposition 3: WACC
 Dt 
WACCg = Keu  1 − 
 E +D 
Example 5 - 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:
Using the assumptions of Modigliani and Miller, explain and demonstrate how this
change in capital structure will affect:
(i) The total value of FF
(ii) The geared cost of equity
(iii) The WACC
54 w w w . l s b f. o r g . u k
The Frederick Macaulay duration method

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
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.
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
investors’ required yield (ie the gross yield to maturity) of the security.
Incidentally, the sum of these figures must be the current price of the bond.
3. Multiply the present values by the year in which it arose.
4. Duration will equal the sum of the present value x year column divided by the
sum of the present values.
Significance of the calculation of duration

Bonds with higher durations may have greater price volatility than similar bonds with
lower durations.
Changes in the value of a bond are inversely related to changes in the rate of return;
Long-term bonds have higher interest rate risk than shorter term bonds,
High coupon bonds have less interest rate sensitivity than low coupon bonds
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.
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Example 6 – Interest Only or Equal Instalments

A company has just issued a new bond at its par value, paying an annual coupon of
4.2%, which is also the investors’ required yield. Repayment is at par on the maturity
date. They were also considering repayment of capital and interest in equal annual
instalments. Maturity is in 4 years.
Required:
Using the Macaulay duration method, calculate the duration using the
repayment at maturity date and based upon the equal instalments.
Modified Duration
Modified duration looks at how sensitive the value of a security is in relation to the
changes in interest rates, measuring the percent change in a bond’s price for a 1%
change in its yield to maturity.
The formula is - Macauley Duration / (1+ Yield to Maturity /N)
This recognises the inverse relationship that occurs between bond price and interest
rates. This is effectively the price sensitivity.
56 w w w . l s b f. o r g . u k
Chapter 5
Adjusted Present
Value
www.lsbf.org.uk 57
CHAPTER 5 – ADJUSTED PRESENT VALUE
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, though
this fails to recognise the implications of how the project is financed.
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 THE 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
(ii) Present value of issue costs incurred
(iii) Present value of interest saved post tax on subsidised loans.
58 w w w . l s b f. o r g . u k
C H A P T ER 5 – A D J U S T ED P R E S EN T V A L U E
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.
Example 1
A project requires immediate capital expenditure of £20m. Issue costs are 5% of the
amount raised, and is paid at the start of the project. Assume a normal cost of
borrowing of 10%.
Required: Calculate the issue cost using both a NET and GROSS method.
Tax savings on interest paid

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 shield.
The calculation of the tax shield depends on whether the interest is payable on a
fixed amount every year or there is equal repayment on the loan.
Example 2
A project requires immediate capital expenditure of £20m. The amount will be raised
through a 10% bank loan, which is the firms normal cost of borrowing, over a period
of 5 years. Tax is paid at a rate of 30%.
Calculate the present value of tax shields assuming:
(a) The loan is repaid at the maturity date;
(b) The loan is repaid in equal instalments over 5 years
Interest saved on subsidised loans

The reduction in interest payments due to the acquisition of a subsidised loan is a
benefit that should be considered, though we must also reflect that paying less
interest will lead to an increase in tax.
Example 3
A project requires immediate capital expenditure of £20m. The company has a

normal cost of borrowing of 8% but a government loan will be available to finance
the project at 6%. The project is expected to last for 5 years. Tax rate is 30%.
Required: Calculate the present value of the interest saved post tax.
www.lsbf.org.uk 59
Discount Factor for the Base Case NPV

As we assume the company is all equity financed we need to use the cost of equity
as if there was no debt in the capital structure. To calculate we normally use the
CAPM formula though based upon the de-geared asset beta rather than the re-geared
equity beta. Alternatively we can use the MM formula in reverse when we are given
the cost of equity in a geared firm.
Example 4
A firm has a Cost of Equity of 12%, their total entity value is $240m and the Value
of equity is $180m. Tax is charged at the rate of 25% and the pre-tax cost of debt
is 6%.
Required: Calculate a suitable ungeared cost of equity to use for the base case NPV.
Complete APV Computation
Example 5 - Strayer
The managers of Strayer Inc are investigating a potential $24 million investment.
The investment would be a diversification away from existing mainstream activities
and into the printing industry. The investment would be financed by a $10 million
rights issue and $14 million of 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 $8 million out of the total $14 million is available. This will cost
2% below the company's normal cost of long-term 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. 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)
60 w w w . l s b f. o r g . u k
C H A P T ER 5 – A D J U S T ED P R E S EN T V A L U E
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.
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62 w w w . l s b f. o r g . u k
Chapter 6
International
Investment
Appraisal
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CHAPTER 6 – INTERNATIONAL INVESTMENT APPRAISAL
Introduction
In essence capital budgeting for overseas investments is similar to domestic
investment appraisal, and you may be required to calculate an NPV or an APV.
However there are additional steps that need to be incorporated into an overseas
computation, and are likely to include the following;
Estimating future exchange rates (spot rates).
Dealing with loss relief and double taxation arrangements.
Dealing with inter-company transactions, such as management charges and royalties
and cash flow remittance restrictions.
Estimating the appropriate cost of capital (discount factor).
Forecasting exchange rates

Exchange rates can be estimated using parity theory or simply adjusting by a given
%
Adjusting by a given percentage

Ensure that you are clear on the inverse relationship between the exchange rate and
the percentage change.
If Counter Currency strengthens the FX rate will fall, though if the counter currency
weakens then the FX rate will rise.
If Base Currency strengthens the FX rate will rise, though if the base currency
weakens then the FX rate will fall.
Adjusting using Parity Theory

The Purchase Power Parity Theory is used when inflation rates are given and the
Interest Rate Parity Theory is used when interest rates are given.
The formula is simply stated as:
Purchasing power parity and interest rate parity
(1 + hc ) (1 + ic )
S1 = S0  Fo = So 
(1 + hb ) (1 + ib )
Example 1 – Base Currency Strengthens

The current spot rate between the US$ and UK £ is $1.350 per £1. The predicted
inflation rates in the two countries are as follows;
UK US
Year 1 3% 5%
Year 2 4% 6%
Year 3 4% 7%
Required:
Calculate the future predicted spot rates for the next three years.
64 w w w . l s b f. o r g . u k
Example 2 – Base Currency Weakens

The current spot rate between the Europe € and UK £ is €1.125 per £1. The predicted
interest rates in the two nations are as follows;
UK Euro
Year 1 6% 3%
Year 2 5% 2%
Year 3 4% 2%
Required:
Calculate the future predicted spot rates for the next three years.
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Taxation and international investment appraisal
Loss Relief on Foreign Investment

In a domestic investment, any losses incurred during the life of the project, can be
offset against other trading activities, thus calculated tax is shown as a cash inflow.
However in an overseas investment, the assumption is that there are no other
operations taking place, thus losses cannot be offset, unless the host government
allows these loss to be carried forward and offset against future years profits.
If this is the case the exam question will explicitly state this to be the case. The
requirement is that the taxable profit is calculated as a separate working and a loss
memo be created.
Example 3 – Loss Relief

A new investment in a foreign nation has been predicted to produce the following net
trading revenue.
Year 1 2 3 4 5
NTR $m 250 550 1500 2500 8000
The initial investment cost $5,500m and has a residual value of $500m. Capital
allowances are available on a straight-line basis. The host government allows any
losses to be carried forward to reduce future tax payable. The rate of tax charged is
20%.
Required:
Calculate the tax charged during the life of the project and show the loss relief taken
in a separate loss memo.
Double Tax Treaties

When undertaking an overseas investment, a company may be exposed to having to
pay tax twice if no treaty exists between the host nation and the domestic nation.
Consider the following:
Italy tax UK tax Total Tax
(1) 20% 20% 40%
(2) 20% 30% 50%
(3) 20% 18% 38%
However, if a double taxation treaty exists between the two countries, then the tax
paid in the host nation will be offset against the tax charged in the domestic nation.
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.
66 w w w . l s b f. o r g . u k
Example 4 - Stella
Stella Plc is a UK based firm that plans to invest $120m in a project in the United
States, which will generate pre-tax net operating cash flows for 3 years as follows:
Year 1 Year 2 Year 3
$100m $120m $130m
The corporation tax rate in the US is 25%, and is 30% in the UK. There is a double
taxation treaty in place between the two countries and all tax is paid in the year after
the liability arises. No capital allowances are available on the initial investment.
The current $/£ spot rate is $2/£, and the US dollar is expected to weaken by 10%
per annum against sterling.
Stella uses a sterling cost of capital of 10% for all projects.
Required: Calculate the net present value of US investment.
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.
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.
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Example 5 - Bella
Bella Ltd is a UK based firm that plans to invest $80m in a project in the United
States, which will generate pre-tax net operating cash flows for 3 years as follows:
Year 1 Year 2 Year 3
$60m $72m $95m
The corporation tax rate in the US is 30%, and is 20% in the UK. There is a double
taxation treaty in place between the two countries and all tax is paid in the year after
the liability arises. Bella intends to charge the project a fixed annual fee of £5m which
will be subject to UK tax. No capital allowances are available on the initial investment.
The current $/£ spot rate is $1.80/£, and the US dollar is expected to strengthen by
10% per annum against sterling.
Stella uses a sterling cost of capital of 8% for all projects.
Required: Calculate the NPV of the investment.
68 w w w . l s b f. o r g . u k
Example 6 - Brookday plc

Brookday plc is considering whether to establish a subsidiary in the USA. The
investment would require $16m for non-current assets and a further $4 million for
working capital.
A suitable existing factory and machinery have been located and production could
commence quickly. 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 after-tax realisable
value of the non-current assets in 4 years’ time will be $8 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.
Tax is charged in the US at 20% whilst in the UK tax is 30% both payable one year
in arrears. A double taxation treaty exists between the UK and the USA, and any
losses incurred can be carried forward and offset against future profits.
Tax allowable ‘depreciation’ is available on a 25% written down allowance basis with
a balancing allowance or charge received in the final year.
Working Capital would need to be adjusted by the local inflation rate in each year of
trading. Brookday believes that the appropriate discount factor for the project would
be 13%.
The current spot exchange rate is US $1.300/£1. The exchange rate will move in line
with the purchase power parity theory, expected inflation of 8% will occur in the UK.
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?
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Further Considerations of Foreign Investments
Exchange Rate Risk

Changes in exchange rates can cause considerable variation in the amount of funds
received by the parent company. If the host currency devalues then the domestic
proceeds will fall and could result in a seemingly positive NPV becoming negative.
Political Risks
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;
• Changes to local laws and regulations.
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.
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
• Changes in tax law relating to allowable and disallowable tax expenses.
• Imposition of excise duties on imported goods or services.
• Imposition of indirect taxes.
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Chapter 7
Acquisitions and
Mergers
71 w w w . l s b f. o r g . u k
C H A P T E R 7 – A C Q U I S I T I O N S A N D M ER G ER S
Merger v Acquisition
There are distinct differences which you must be aware of;
Merger – the joining of two separate entities
Acquisition – where one entity buys a controlling interest in another entity.
Acquisition v Organic Growth

As a strategic decision there are reasons for pursuing an acquisition as opposed to
organic growth which include;
• Instant access into new markets
• Overcomes barriers to entry
• Expertise of the acquired entity
• Reduced competition
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. However the cost which will include a large premium and post-
acquisition integration issues can lead to problems which invariably reduce
shareholder wealth.
Revenue synergy: Sources of which include:
o Economies of vertical integration
o Market power and the elimination of competition
o Cross selling and enhanced marketing of new entities products
Cost synergy: Sources of which include:
o Economies of scale (ie bulk buying)
o Economies of scope (removing duplicated activities)
o Elimination of inefficiency
Financial synergy: Sources of which include:
o Use of the accumulated tax losses of one company by the other
o Use of surplus cash to invest in acquired entity
o Diversification reduces risk and therefore cheaper borrowing
o Bootstrapping - High PE ratio entity impose their multiples on lower entity
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C H A P T ER 7 – A C Q U I S I T I O N S A N D M ER G ER S
High failure rate of acquisitions

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, who are in pusuit of status and
job security.
• 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.
• Insufficient efforts to integrate and yield the anticipated synergy post acquisition,
often the directors become fixated with their next acquisition.
• Directors of the predator company become so obsessed with the success of their
bid that they often over-pay thus transferring all the benefit to investors in the
acquired company.
Reverse takeover
A reverse takeover is where a smaller listed company acquires a larger unlisted
company. However the shares used to acquire the larger company effectively give
control to the company that has been acquired.
The driving force for the acquisition is to enable the larger unlisted company to gain
the benefits of being a listed organisation, though avoiding the long complicated
process to gain such a listing.
Benefits
1. Easier access to capital markets
2. Higher company valuation
3. Ability to undertake further acquisitions
Problems
1. Lack of expertise
2. Adherence to stock market regulations
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C H A P T E R 7 – A C Q U I S I T I O N S A N D M ER G ER S
Post-acquisition integration
Often the main cause of failure with business combinations. To avoid this problem it
has been suggested that the following rules be applied
• The individual entities must share more than financial interest, i.e. technology
and market
• Consideration must be given to what we can do for acquired business
• Do not disregard products, markets and customers post acquisition
• Aim to share human resources and promote across entities
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Chapter 8
Business Valuations
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CHAPTER 8 – BUSINESS VALUATIONS
METHODS OF EQUITY VALUATIONS

The main approaches are:
• The discounted cash flow basis (Free cash flow method)
• The PE ratio
• The dividend valuation model (dividend growth model)
• Net assets and calculated intangible value
• Black Sholes Option Pricing Model
FREE CASH FLOWS TO ENTITY

Free cash flow is cash that is not retained and reinvested in the business.
The free cash flow to the entity (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.
From prepared accounting information, free cash flow to entity can be calculated as:
Profit before interest and tax (PBIT) xxxxx
Less taxation (PBIT x Tax rate) (xxx)
Add non-cash items such as depreciation xxxx
Less capital expenditure (xxxx)
Less increase or add decrease
in net working capital (xxxx)
Free cash flow to entity xxxxx
FREE CASH FLOW TO EQUITY (dividend capacity)

An alternative to the free cash flow to entity is to remove the debt investors, thus
the free cash flow to equity represents the funds available for distribution to only
ordinary shareholders of the company.
Where a company finance a project by issuing debts, then the shareholders are
entitled to the residual cash flows after meeting interest and principal payments.
This residual cash flow is called free cash flow to equity and is calculated as:
Profit before interest and tax (PBIT) xxxxx
Less interest (xxx)
Profit before tax (PBT) xxxxx
Less taxation (Profit before tax x tax rate) (xxx)
Add non-cash items such as depreciation xxxx
Less capital expenditure (xxxx)
Less increase or add decrease
in net working capital (xxxx)
Add cash raised from debt issue xxxx
Less debt repayments (xxxx)
Free cash flow to equity xxxxx
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C H A P T ER 8 – B U S I N E S S V A L U A T I O N S
Example 1 – Free Cash Flows
Forecast statement of profit or loss for next year
£m
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 £29 million, depreciation
charges to £30 million, and capital expenditure to £60 million. The dividend payable is
£30 million.
Required:
Calculate:
(a) Free cash flow to entity
(b) Free cash flow to equity
DISCOUNTING FREE CASH FLOW TO VALUE A FIRM

This method values a business as the present value of future free-cash flows.
Free Cash Flow to Entity – use the WACC
Free Cash Flow to Equity – use the Cost of Equity (Ke)
Note Value of Entity (Vt) = Value of equity (Ve) + Value of debt (Vd)
Therefore:
Value of equity (Ve) = Value of Entity (Vt) – Value of debt (Vd)
Example 1 – Continued
The firm has a WACC of 10% and a Cost of equity of 12%. The market value of debt
is $650m, and there is no growth anticipated in either of the free cash flow to entity
or equity.
Calculate the value of equity using both approaches.
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Example 2 - Free Cash Flow to Entity Valuation

The finance team of Talto Ltd has produced the following forecasts of financial data:
Financial year X1 X2 X3 X4
Revenue 230 261 281 298
Cost of goods sold (50%) 115 131 141 149
Selling and distributive expenses 32 34 36 38
Tax allowable depreciation 40 42 42 42
Interest paid 18 16 14 12
Cash flow needed for asset replacement 50 52 55 58
Corporation tax is at the rate of 30% per year, payable in the year that the taxable cash
flow occurs.
Assume that the company’s weighted average cost of capital is 14%. The market value of
debt is £30 million.
Required:
Calculate the value of the company if:
(a) Cash flows are expected to remain at X4 level into infinity.
(b) Cash flows are expected to grow by 4% per annum into infinity.
Note: A perpetuity that commences after the first year must be discounted back to year 1
PV Delayed Perpetuity
Free Cash Flow x (1+Growth)
Discount Factor – Growth) x Discount Factor to return to year 1
PRICE EARNINGS RATIO

The P/E ratio produces an earnings-based valuation of shares. This is done by
deciding a suitable P/E ratio and multiplying by the EPS for the shares to be valued.
Value per share = EPS x P/E ratio
Total value = Earnings x P/E ratio
For a given EPS, a higher P/E ratio will result in a higher price. A higher P/E ratio may
indicate:
(a) Expectations that the earnings will grow rapidly in the future, so that a high price
is being paid for future profit prospects.
(b) That the company is a low risk company than a company with a lower P/E ratio.
78 w w w . l s b f. o r g . u k
Example 3 – PE Ratio Valuation

ABC is a private company operating in the pharmaceutical industry. The current
average PE ratio of the pharmaceutical industry is 16·4 times and it has been
estimated that ABC’s PE ratio is 10% higher than this. VATA Co, a publicly listed
company and has decided to acquire ABC.
The following information is available:
VATA Co ABC
£m £m
Earnings before tax 1,980 397
Share capital (25p/share) 600 300
The current share price of VATA Co is $9·24 per share. The annual after tax earnings
will increase by $140 million due to synergy benefits resulting from combining the
two companies. However, it is thought that the PE ratio of the combined company
would fall to 14·5 times after the acquisition.
Both companies pay tax at 20% per annum
Required
Calculate the Individual values of Vata and ABC / The value of the combined entity /
and the enhanced value derived.
Discuss the maximum price that VATA should pay to acquire ABC indicating the
acquisition premium payable.
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.
Example 4 – Constant Growth

Thorsvedt has just paid a dividend of 30p per share. The market expects dividends
to grow at the rate of 5% per annum and equity investors have a required rate of
return of 20%.
Estimate the share price.
Example 5 – Fluctuating Growth

Wright plc has just paid a dividend of 15p per share. The directors’ forecast a 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.
www.lsbf.org.uk 79
Valuing intangible assets/intellectual capital
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. Multiply the industry-average ROA by the company’s average tangible assets to
calculate the average the company would earn from that amount of tangible
assets.
4. Subtract this figure from the firm’s average pre-tax earnings from step 1 to
produce the pre-tax value spread, and then multiply by 1-tax rate.
5. The post-tax value spread is then discounted as a perpetuity, without growth,
using the firm’s cost of capital to derive the calculated intangible value.
This is the CIV of the company’s intangible assets – the one that does not
appear on the balance sheet.
Example 6 - CIV
The summarised extracted financial information about Emboss plc for the last three
years is provided below:
Statement of profit or loss for the years ended 31 March:
2016 2017 2018
£millions £millions £millions
Pre-tax earnings 67.5 74.2 56.9
Total Assets 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) Tax is charged at the rate of 30%.
Required:
Calculate the CIV.
80 w w w . l s b f. o r g . u k
APPLYING THE BLACK SCHOLES MODEL TO EQUITY

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. 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.
Example 7
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:
Using the BSOP model, estimate the share price of Northern Rock in each of the
following situations assuming that the standard deviation of the bank’s assets was
5%.
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VALUATION OF DEBT AND PREFERENCE SHARES
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.
Redeemable
Example 8 – Constant Yield

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?
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. The gross
redemption yield is the average return to investors over the life of the bond,
calculated using the IRR methodology pre tax
Example 9 – Fluctuating Yield

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 1 2 3 4
Rate 3.5% 4.0% 4.7% 5.5%
82 w w w . l s b f. o r g . u k
Adjusting the yield curve

Often the examiner will provide the yield curve though expect you to adjust for the
credit spread as seen in Chapter 4.
Example 10
A firm has a 4-year bond with a coupon rate of 4.5% that redeems at its par value.
Required
Using the provided yields what is the impact on the market value of the bond if the
firms credit rating was to improve from B to A rating.
Government Bond Yield Curve
Year 1 2 3 4
1.25% 1.65% 2.15% 2.75%
Yield Spread (in basis points)

A 30 50 75 115
B 45 85 110 145
Estimating the Coupon Rate

Estimating the required coupon rate requires you to establish what the interest must
be if the discounted cash flows are to equal the desired issue price of debt.
Example 11
A firm hopes to issue a new 4-year bond at its par value of $100. The firm is currently
rated at B, and will redeem the loan note at a 2% premium to its par value.
Required
What is the required coupon rate that would entice investors to purchase at the par
value?
Government Bond Yield Curve
Year 1 2 3 4
1.25% 1.65% 2.15% 2.75%
Yield Spread (in basis points)

A 30 50 75 115
B 45 85 110 145
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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 12
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.
84 w w w . l s b f. o r g . u k
Chapter 9
Framework
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CHAPTER 9 – FRAMEWORK
Mode of Offer
Cash consideration
The offer is made to purchase the shares of the target company for cash. This method
is appropriate for relatively small acquisitions, unless the acquirer has a significant
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.
The disadvantages to target entity’s shareholders of receiving cash are that:
• If the price that they receive on sale is more than the price paid when purchasing
the shares, they may be liable to capital gains tax.
• They have no further involvement in the combined entity thus having to forego
any future capital gains or dividends
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.
• It will put pressure on the firm to obtain additional long term capital.
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 to the target 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.
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C H A P T ER 9 – F R A M E W O R K
• 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 authorised share capital to issue the
additional shares required.
Debentures
Very few companies use debentures as a means of paying a purchase consideration
on acquisitions.
The advantages of a debenture to target shareholders include:
• Capital gains tax is delayed.
• The return will be greater than if cash or share exchange were used.
The main disadvantage is that:
• Default risk will arise as there is no certainty that repayment of the debentures
will take place.
The main advantages to the predator are that:
• Interest payments are a tax allowable expense.
• Cost of debt is cheaper than equity, and it reduces the need to obtain funds.
• Does not dilute control.
The main disadvantages 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.
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Example 1
Simon Plc is considering a bid to acquire Denis Co, a rival firm in the IT sector, though
is unsure of which payment method to use. Simon’s current share price is $7.80 and
they have 3m shares in circulation. Denis has an EPS of $0.60 and their PE ratio is
10% greater than the industry average PE ratio of 8. Dennis has 1.5m shares in
circulation.
They have three potential payment options:
• A cash offer of $5.70 per share
• 2 Shares in Simon in exchange for 3 Denis shares
• A $100 Debenture that will be redeemed in 4 years, that has an estimated market
value of $93.75 in exchange for 15 Denis shares.
It is anticipated that post acquisition the value of the combined entity will rise by
$4m due to revenue and cost synergy
Required:
Estimate the percentage gain for both Simon and Denis investors under each
of the suggested three payment methods.
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C H A P T ER 9 – F R A M E W O R K
Strategic defences against hostile bids
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,
by suggesting that either the cash offer is too low, or that a share for share
exchange will fail to enhance their wealth.
• Lobbying the office of fair trading and or the department of trade and industry
to have the offer referred to the competition commission.
• 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.
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, which comes in many guises.
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;
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• 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.
Protecting shareholders
MANDATORY BID CONDITION – SELL OUT RIGHTS
This allows shareholders to dispose of their holding and exit the business at a fair
price. After a business is acquired the acquirer must make a mandatory bid for the
remaining shares at a price that matches that previously paid during the acquisition.
This is designed to prevent the exploitation of those minority investors that remain
post acquisition.
PRINCIPLE OF EQUAL TREATMENT

Again this is designed to protect the minority shareholders who remain in the
business post acquisition, and states that the same terms must be offered to all
investors rather than a select few.
SQUEEZE OUT RIGHTS

In order to restrict future problems, this condition forces the minority stakeholders
to sell their stake at a fair price. This is designed to allow 100% ownership to be
achieved, and prevent future dissent in the stewardship of the entity
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Chapter 10
Corporate
Reconstruction and
Reorganisation
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C H A P T E R 1 0 – C O R P O R A T E R E C O N S T R U C T I O N A N D R EO R G A N I S A T I O N
BUSINESS REORGANISATION
The aim of any change to a business is to enhance value and increase shareholder
wealth. Therefore you may be required to establish the impact of any change on the
financial performance using ratio analysis and forecasting or the impact upon the
share price and debt valuations using the techniques acquired in Chapter 8.
Portfolio Restructuring
Portfolio restructuring (also known as 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 (MBO)
• Management buy-ins (MBI)
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.
92 w w w . l s b f. o r g . u k
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 de-
merger.
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.
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.
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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.
Management buy-in
A management buy-ins occurs when a group of outside managers buys a controlling
stake in a business.
Organisational Restructuring
This is where a company changes the way in which it is organised and has many
guises. It may simply mean adjusting the reporting lines of internal divisions, to
amalgamating departments or realigning the entity on a regional or national basis.
94 w w w . l s b f. o r g . u k
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.
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.
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Share Repurchase
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 repurchased:
• In order to buy out dissident shareholders.
• To adjust the gearing ratio towards an optimal capital structure.
• To reduce the size of the company.
• So that the repurchase can be used to take a company out of the public market
and back into private ownership.
• To provide an efficient means of returning surplus cash to the shareholders.
• To increase earning per share and return on capital employed.
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 a 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, as well as avoiding the possibility of takeover
by another company.
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Forecasting & Ratio Analysis

To establish the success of a capital or physical reconstruction you may be required
to build upon your Financial Reporting and Financial Management papers from
fundamentals where the construction of future financial statements is required.
Key Financial Ratios
Profitability – ROCE, Asset Turnover, Margin

Liquidity – Current Ratio
Solvency – Gearing and Interest Cover
Earnings – ROE, PE Ratio, EPS
Dividends – DPS, Dividend Cover, Dividend Yield
Other – Total Shareholder Return
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98 w w w . l s b f. o r g . u k
Chapter 11
Hedging Foreign
Exchange Risk
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CHAPTER 11 – HEDGING FOREIGN EXCHANGE RISK
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.
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.
TYPES OF RISK
Foreign exchange risk is the possibility of making profit or loss as a result of changes
in exchange rate. The foreign exchange risk exposures are divided broadly into three
categories as follows:
Transaction
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. There is a risk of an adverse movement in exchange rates
prior to the settlement of the transaction.
Translation
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.
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
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
change in exchange rates. A depreciation of the firms currency will erode their
competitiveness.
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C H A P T ER 1 1 – H ED G I N G F O R EI G N E X C H A N G E R I S K
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 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. Unless management believes that translation losses will greatly affect
shareholders there would seem little point in protecting against them.
PROTECTION AGAINST ECONOMIC EXPOSURE
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.
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.
Currency swaps
Please see later in the chapter for currency swaps.
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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 external and internal
hedging techniques.
External hedging techniques

External hedging techniques means using the financial markets to hedge foreign
currency movements.
Forward exchange 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.
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.
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.
Example 1
FRT is a company in the UK that trades frequently with companies in the USA.
Transactions to be completed within the next six months are as follows:
Receipts Payments
Three months $350,000 $250,000
Six months £100,000 $1,000,000
Foreign exchange rates ($/£)
Spot 1.4960 – 1.4990
Three months forward 1.4550 – 1.4600
Six months forward 1.4490 – 1.4560
The annual interest rates available in the money market are:
UK USA
Borrowing 4.8% 8.4%
Investing 2.4% 5.4%
Required:
Using the forward contract and money market hedge, devise a foreign exchange
hedging strategy that is expected to maximise the cash flows of FRT.
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FOREIGN CURRENCY FUTURES

A futures contract 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.
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 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.
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”.
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.
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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.
Forward Exchange Contracts v 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.
104 w w w . l s b f. o r g . u k
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.
Disadvantages of using 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, with standardised maturity & size.
4. Futures contract is not available in every currency.
FOREIGN 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 or at
any time up to a particular date.
Exchange-traded v over-the-counter options

Option contracts are frequently traded on an exchange, though can also be acquired
over the counter (OTC).
Exchange-traded have greater transparency, with the price and contract details
communicated clearly in advance, though these are for standardised with fixed sizes
and maturity dates, typically for a three-month period, restricting a perfect hedge.
They are not available in all currencies, though they can be closed in advance of
expiry as they are often American style. Further the default risk and transaction
costs are lower.
OTC options are generally only closed at their maturity date as they are frequently
European. These are tailored to the exact needs of the party buying the option,
provide a neater hedge, and can be used for longer time periods and in a greater
range of currencies.
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Example 2 - Payment
Today is 1st August
BMB Ltd is a large listed company based in UK and uses Pounds Sterling (£) as its
currency. It is due to make a payment to an American supplier in 3 months’ time
of US$4,000,000.
Spot = $1.4385 - $1.4545

3 month forward = $1.4145 - $1.4450
Currency Futures (Contract size £125,000, Quotation: US$ per £1
Sept: 1·4482
Dec: 1·4285
March: 1.4225
Currency Options (Contract size £125,000, Exercise price quotation:
US$ per £1, cents per Pound
CALLS PUTS
Sept Dec March Strike Sept Dec March
Price
2.35 2.75 2.95 1.42 1.75 1.95 2.05
1.88 2.24 2.44 1.44 3.25 3.55 3.85
It can be assumed that futures and option contracts expire at the end of the month
and transaction costs related to these can be ignored.
Required:
Advise BMB Ltd on whether a forward exchange contract, currency future
or options on currency futures would be preferred as an appropriate
hedging strategy to manage the foreign exchange exposure of the US$
payment in three months’ time. Show all relevant calculations.
106 w w w . l s b f. o r g . u k
Example 3 - Receipt
Today is 1st August
Casanova Co is based in the United Kingdom and uses Sterling £ as its domestic
currency. It has just completed a major project in the USA and is due to receive a
payment of US$12 million in 6 months. The current exchange rates are quoted
below:
Spot = $1.4185 - $1.4345
6 month forward = $1.4345 - $1.4650
Currency Futures (Contract size £125,000, Quotation: US$ per £1
Sept: 1·4482
Dec: 1·4598
March: 1.4625
Currency Options (Contract size £125,000, Exercise price quotation: US$
per £1, cents per Pound
CALLS PUTS
Sept Dec March Strike Sept Dec March
Price
2.35 2.75 2.95 1.45 1.75 1.95 2.05
1.88 2.24 2.44 1.47 3.25 3.55 3.85
It can be assumed that futures and option contracts expire at the end of the month
and transaction costs related to these can be ignored.
Required:
Advise Casanova Co whether a forward, future or option should be used to

hedge against the US$ income it is due to receive in six months.
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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 4 DD plc
DD plc is based in the UK and needs to borrow $50m to finance it US subsidiary. DD
plc is not well known in US and can only borrow in US at Base rate + 3% or
domestically in the UK at 9%.
FFK plc is based in the US, and is in a similar position to DD plc in that it requires a
£37m loan to finance its UK operations. FFK plc can borrow sterling at 11% per
annum or domestically at Base rate + 1%.
A financial intermediary has put the companies in contact and has arranged for a
currency swap to take place where for a fee of 1.0%, the benefit and cost of the swap
will be shared equally between the two firms
There will be an exchange of principal now and in five years’ time at the current spot
rate of $1.351 = £1
Required:
Show the net saving to be made by the suggested swap.
Benefits of currency swaps

1. 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. 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.
4. 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.
5. There may be low transaction cost, as cost may be limited to the legal fees in
agreeing the documentations and arrangement fees.
108 w w w . l s b f. o r g . u k
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.
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.
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.
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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 5
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
Owed by Owed to 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 €0.880
Required:
Calculate the net payment to be made between the subsidiaries after netting of inter-
company balances.
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.
110 w w w . l s b f. o r g . u k
Chapter 12
Hedging Interest
Rate Risk
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C H A P T E R 1 2 - H E D G I N G I N T E R ES T R A T E R I S K
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:
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 top-level
bank in London could obtain short-term deposits with another bank in London money
markets. The LIBID is always lower than the LIBOR
HEDGING AGAINST INTEREST RATE RISK

There are several methods of hedging interest rate risk including the following:
• forward rate agreements
• interest rate futures
• interest rate options & collars
• interest rate swaps
Forward rate agreements (FRA)

A forward rate agreement offers companies the facility 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.
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%.
112 w w w . l s b f. o r g . u k
C H A P T ER 1 2 - H E D G I N G I N T E R ES T R A T E R I S K
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.
Example 1
A company will have to borrow an amount of £100 million in three months’ 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 – 3.10
3v6 3.58 2.93
6v3 3.55 2.85
Required:
Show the expected outcome of FRA:
(a) If LIBOR increases by 0.5%.
(b) If LIBOR decreases by 0.5%.
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).
Ticks and tick values

Examples of ticks and tick values are:
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 or;
0.0001 x $1m x 3/12 = $25
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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 contract size   3 months 
INTEREST RATE OPTIONS & COLLARS
1. 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.
2. Interest Rate Collars

This is a process where a company will obtain an interest rate option, whilst
simultaneously placing an opposite option on the exchange in order to minimise the
volatility of the final interest payable / received. A premium is thus both paid and
received, and should result in a reduction in both the upside and downside risk.
114 w w w . l s b f. o r g . u k
Example 2 – Borrowing (Protection against Rising Rates)

Assume that it is now 1st September.
The finance director of APB plc has recently reviewed the company’s monthly cash
budgets for the next year. As a result of buying new machinery in six 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 APB can borrow at LIBOR + 0.9%.
Derivative contracts may be assumed to mature at the end of the month.
The company is considering using interest rate futures, options on interest rate
futures or interest rate collars.
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 Strike Puts
December March June Price December March June
0.120 0.195 0.270 93.75 0.020 0.085 0.180
0.010 0.030 0.085 94.25 0.400 0.480 0.555
Required:
Illustrate how the short-term interest risk might be hedged, and the possible results
of the alternative hedges if interest rate increase or decrease by 0.5%.
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Example 3 – Investing (Protection against Falling Rates)

Assume that it is now 1st November.
Alpha PLC has recently agreed to the sale of one of their subsidiaries and is seeking
to invest the £24m proceeds for a period of 4 months until the money is needed for
a new investment project. The divestment will be completed in 3 months’ time when
the cash will be received. The finance director is concerned that interest rates may
fluctuate in this period, with an increase of 0.4% or potentially a 0.6% decrease.
LIBOR is currently 4.2% per annum and APB can invest cash at LIBOR minus 20 basis
points.
Derivative contracts may be assumed to mature at the end of the month.
The company is considering using interest rate futures, options on interest rate
futures or interest rate collars to protect against any such fluctuations.
Three months sterling Future (£1,000,000 contract size, £25.00 tick size)
December 95.950
March 96.200
June 96.480
Options on three months sterling futures (£1,000,000 contract size,

premium cost in annual %)
Calls Strike Puts
December March June Price December March June
0.250 0.475 0.505 95.50 0.120 0.185 0.240
0.150 0.230 0.285 96.25 0.375 0.445 0.555
Required:
Illustrate how the short-term interest risk might be hedged, and the possible results
of the alternative hedges if interest rate increase or decrease as stated above.
116 w w w . l s b f. o r g . u k
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 4 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%.
A financial intermediary has offered to arrange an interest rate swap, where Fred
would receive 60% of the benefit, though also pay 60% of the fee of 1.0%
Required:
Calculate the net saving made by each party.
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. 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.
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118 w w w . l s b f. o r g . u k
Solutions to
Examples
www.lsbf.org.uk 119
SOLUTIONS TO EXAMPLES
Chapter 2 – Discounted Cash Techniques
Example 1 Jato
1. Sales
Years 1 2 3 4
Selling price 2,000 2,200 1,600 1,500
Inflation 1.05 1
1.05 2
1.05 3
1.054
Inflated selling price 2,100 2,426 1,852 1,823
Units (000) 20 70 125 20
Sales ($000) 42,000 169,820 231,500 36,460
2. Variable costs
Years 1 2 3 4
Variable cost per unit 900 1,000 1,020 1,020
Inflation 1.041 1.042 1.043 1.044
Adjusted 936 1,082 1,147 1,193
Units (000) 20 70 125 20
Total ($000) 18,720 75,740 143,375 23,860
3. Fixed costs
Years 1 2 3 4
Fixed costs ($000) 10,000 10,000 10,000 10,000
Inflation 1.05 1
1.05 2
1.05 3
1.054
Inflated fixed cost 10,500 11,025 11,576 12,155
4. Tax Allowable Depreciation
Years 1 2 3 4
OB ($000) 120,000 90,000 67,500 50,625
Tax Allowable Dep’n 30,000 22,500 16,875 40,625
CB 90,000 67,500 50,625 10,000
5. Tax Charged
Years 1 2 3 4
NTR ($000) 12,780 83,055 76,549 445
Tax Allowable Dep’n 30,000 22,500 16,875 40,625
Taxable Profit (17,220) 60,555 59,674 (40,180)
Tax @ 30% 5,166 (18,167) (17,902 12,054
6. Working capital
Years 0 1 2 3 4
Required WC 20,000 20,600 21,218 21,855
Relevant WC (20,000) (600) (618) (637) 21,855
120 w w w . l s b f. o r g . u k
S O L U T I O N S T O E X A M P L ES
7. Nominal/money discount factor

(1 + M) = (1 + R)(1 + I)
Money discount factor = (1.078)(1.03) – 1 = 11.034% say 11%
Net present value
Years 0 1 2 3 4 5
$000 $000 $000 $000 $000 $000
Sales 42,000 16,9820 23,1500 36,460
Variable cost (18,720) (75,740) (14,3375) (23,860)
Fixed costs (10,500) (11,025) (11,576) (12,155)
Net Trad. Rev. 12,780 83,055 76,549 445
Tax 30% 5,166 (18,167) (17,902) 12,054
Equipment cost (120,000)
Resale value 10,000
Working capital (20,000) (600) (618) (637) 21,855
Net cash flows (140,000) 12,180 87,603 57,745 14,398 12,054
DF (11%) 1 0.901 0.812 0.731 0.659 0.593
Present values (140,000) 10,974 71,134 42,212 9,488 7,148
Net present
value $956
Since the net present value is positive the project is financially acceptable.
IRR
Net cash flows (140,000) 12,180 87,603 57,745 14,398 12,054

DF (13%) 1 0.885 0.783 0.693 0.613 0.543
Present values (140,000) 10,779 68,593 40,017 8,826 6,545
NPV = (5,240)
IRR = 11% + (956/956 + 5240) x (13% -11%) = 11.31%
The IRR is marginally higher than the cost of capital and the project is financially
acceptable.
Discounted payback period
Net cash flows (140,000) 12,180 87,603 57745 14,398 12054

DF (11%) 1 0.901 0.812 0.731 0.659 0.593
Present values (140,000) 10,974 71,134 42,212 9,488 7,148
cumulative (140,000) (129,026) (57,892) (15,680) (6,192)
6,192/7,148 = 0.87
Discounted payback = 4.87 years
Whether or not the project should be acceptable will depend on the company’s target
discounted payback period.
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Example 2 Carter plc

Single equivalent payment discounted to year 0 at an 8% discount rate:
Year £
0 15,000
1 (£5,400 x 0.926) _5,000
Present Value (PV) of investment cash flows (PvI) 20,000
 £23,271 
MIRR =   1.08  - 1 = 11.3%
 5 20,000 
 
Decision Rule and MIRR

The decision rule of MIRR is the same as IRR. That is if
• MIRR is more than cost of capital, accept
• MIRR is less than cost of capital, reject.
Example 3 FCF plc
Duration taken to recover the present value of the project
Year Cash Flow DF @ 8% DCF Year DCF x Year
1 7,600 0.926 7,038 1 7,038
2 16,500 0.857 14,141 2 28,282
3 13,000 0.794 10,322 3 30,966
4 6,600 0.735 4,851 4 19,404
36,352 85,690
The duration = 85,690/36,352 = 2.36 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!
122 w w w . l s b f. o r g . u k
Example 4 Andrews plc
Single Year Project

Tail Value @ 95% = 1.65 (0.4505 is found in row 1.6 column 0.05)
Value at Risk
At 95% confidence level, = $16.0m (9.7 x 1.65)
At 99% confidence level, = $22.6m (9.7 x 2.33)
Expected Proceeds
At 95% confidence level, = $84.0m ($100m - $16.0m)
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.
4 Year Project
Value at Risk
At 90% confidence level, = $14.8m (Sq-root 4) x 5.8 x 1.28))
At 95% confidence level, = $19.1m (Sq-root 4) x 5.8 x 1.65))
Expected Proceeds
There is a 10% chance of the expected NPV falling to £185.2 million or less and a 5%
probability of it falling to £180.1 million or below.
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Chapter 3 – Black Scholes Option Pricing Model
Example 1 – option to expand
t = 5; Pe = 20; Pa = 15; s = 0.283; r = 0.06
d1 = (
ln(15  20) + 0.06 + 0.5  0.2832 5)
0.283 5
−0.2877 + 0.3 + 0.2002 0.2125

= = = 0.3358
0.6328 0.6328
d2 = 0.3358 − 0.283  5 = –0.297
Using the standard normal distribution tables:
d1 = 0.3358 gives 0.1331; thus N(d1) = 0.5 + 0.1331 = 0.6331
d2 = –0.297 gives –0.1179; thus N(d2) = 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.
124 w w w . l s b f. o r g . u k
Example 2 – Option to Abandon
Pa = 254; Pe = 150; s = 0.30; t = 5; r = 0.07
Firstly, calculate the value of the call option:

d1 = In (254 /150) + (0.07+0.5x 0.30^2) x 5 = 0.5267 + 0.575 = 1.1017
Bottom Half: 0.30 x square root 5 = 0.6708
Combine: 1.1017 / 0.6708 = 1.642
d2 = 1.642 − 0.672 = 0.970
Using the standard normal distribution tables:
d1 = 1.642 gives 0.4495; thus N(d1) = 0.5 + 0.4495 = 0.9495
d2 = 0.970 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 - Pa + Pe e-rt
= 153.017 – 254 + (150 x e-0.07 x 5)
= 153.017 – 254 + 105.703
= £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.
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Example 3 – Option to delay
Pa = As NPV $4m thus PA must be $28m ($24m + $4m) however as this is delayed
for two years this must be discounted back to year 0 and will be $23.13m (28 x
0.826)
Pe = $24m / T = 2 / R = 6% / S = 40%
D1 = ln(23.13 / 24) + (0.06 + 0.5 x 0.40^2)2
0.40 x Sq Root 2
= -0.037 + 0.280
0.566
= 0.429
D2 = 0.429 – 0.566 = - 0.137
d1 = 0.429 (say 0.43) gives 0.1664

d2 = -0.137 (say -0.14) gives 0.0557
N(d1) = 0.5 + 0.1664 = 0.6664
N(d2) = 0.5 - 0.0557 = 0.4443
c = (23.13 × 0.6664) – (24 × e–0.06 × 2 × 0.4443)
= 15.414 – (24 × 0.8869 × 0.4443)
= 15.414 – (21.286 × 0.4443)
= 15.414 – 9.457
= 5.957 ($5.96m)
Final Project value = $4m + $5.96m = $9.96m
126 w w w . l s b f. o r g . u k
Chapter 4 – Impact of Financing
Example 1
Ignore current equity beta since it reflects a different business risk to the investment.
1 - Proxy beta = 1.3
2 – Degear to find Asset beta = 1.3 x [60 ÷ (60 + 40(1-0.3))] = 0.886
3 – Regear to produce Equity beta = 0.886 x (140 + 60(1 - 0.3) / 140) = 1.152
4 - Ke = 4 + 1.152 x (14 – 4) = 15.52%
5 – Kd = 4 x (1 – 0.30) = 2.8%
6 – Discount Factor = (15.52 x 140/200) + (2.8% x 60/200) = 11.70%
Example 2
Step 1 – Degear
• Company A = 1.60 x 750 / 750 + (150 x 0.80) = 1.38
• Company B = 1.30 x 250 / 250 + (125 x 0.80) = 0.93
Step 2 – Combined Asset Beta – Based upon total equity value

• 1.27 (1.38 x 750/1000) + (0.93 x 250/1000)
Step 3 – Regear – based upon post acquisition capital structure

• 1.55 (1.27 x (1,000 + (275 x 0.80)) / 1,000)
Step 4 – Calculate cost of equity

• 14.63% (3 + (1.55 x 7.5))
Step 5 – Cost of debt

• 4.8% (6% x (1 – 0.20)
Step 6 – WACC
• 12.5% (14.63 x (1000/1275) + (4.8 x (275/1275)
Example 3
β asset of combined company

Step 1 – Degear
• Edwards = 0.97 x 900 / 900 + (100 x 0.70) = 0.90
• Colman = 2.52 x 280 / 280 + (20 x 0.70) = 2.40
Step 2 – Combined Asset Beta – Based upon total equity value

• 1.26 (0.9 x 900/1180) + (2.4 x 280/1180)
β equity of combined company
Revised gearing levels are: £m

E = 900 + 280 = 1,180
D = 100 + 20 + 380 = 500
1,680
Step 3 – Regear – based upon post acquisition capital structure
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• 1.63 (1.26 x (1,180 + (500 x 0.70)) / 1,180)
Cost of equity
Ke = 5% + (9% − 5%) 1.63 = 11.52%
Weighted average cost of capital

1,180 500
WACC =  11.48% +  7%  (1 − 0.3) = 9.52%
1,680 1,680
Example 4 - Startup
Step 1 – Locate Proxy firm (Established Ltd) and Degear their Equity Beta
Established Ltd = 1.50 x 360 / 360 + (90 x 0.8) = 1.250
Step 2 – Reconstruct the calculation for the combined asset beta

Telecoms Unknown though represents 40% of the business 0.623
Balancing Figure
Television 1.045 x 60% 0.627
Combined Asset Beta 1.250
Step 3 – working in reverse establish the asset beta for the unknown aspect
0.623 / 0.40 = 1.558
Step 4 – Asset beta of telecoms regeared according to Startup Plc capital structure
1.558 x 50 + (25 x 0.8) / 50 = 2.181
Step 5 – cost of equity

Rf + (Be x Rp) = 4 + (2.181 x 9) = 23.63%
Step 6 – Post tax cost of debt

8% x (1 – 0.20) = 6.4%
Step 7 – Discount Factor

(23.63% x 50/75) + (6.4% x 25 / 75) = 17.9%
Example 5 - Canalot
(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
128 w w w . l s b f. o r g . u k
The market value of equity becomes

£34.25 million − £5 million = £29.25 million
(ii) The cost of equity
Using the MM formula for Ke:
18 + (1-0.35)(18-13)(5/29.25) = 18.56%
(iii) Weighted average cost of capital
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.
Example 6 - Macaulay Duration Method
(i) Repayment at Maturity

DF
Year CF 4.2% DCF FX
1 4.2 0.960 4.03 4.03
2 4.2 0.921 3.87 7.74
3 4.2 0.884 3.71 11.14
4 104.2 0.848 88.39 353.55
100.00 376.46
The bond duration is 3.77 years (376.46 / 100.00)
(ii) Equal Instalments

Annuity Factor @ 4.2% = 3.613 (1-(1.1042)^-4)/0.042
www.lsbf.org.uk 129
Equal Installment Payment = 100 / 3.613 = 27.68
DF
Year CF 4.2% DCF FX
1 27.68 0.960 26.56 26.56
2 27.68 0.921 25.49 50.99
3 27.68 0.884 24.47 73.40
4 27.68 0.848 23.48 93.92
100.00 244.87
The bond duration is 2.45 years (244.87 / 100.00)
130 w w w . l s b f. o r g . u k
Chapter 5 – Adjusted Present Value
Example 1
Net approach = $20m x 5% = $1m
Gross approach = $20m x 5/95 = $1.05m
Example 2
(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 1 to Year 5 as tax is one year in
arrears:
£0.6m x 3.791 = £2.275m
(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 0.60 0.909 0.545
2 1.7 0.51 0.826 0.421
3 1.3 0.39 0.751 0.293
4 0.9 0.27 0.683 0.184
5 0.5 0.15 0.621 0.093
PV Tax shield 1.536
Example 3
Present value of subsidy

Subsidy = 8% - 6% = 2%
Total subsidy per annum = 2% x £20m = £0.4m
PV of net subsidy = £0.4m x (1-0.3) x 3.993 = £1.12m
www.lsbf.org.uk 131
Example 4
As Value of Entity = $240m then Vd = $60m ($240m - $180m)
Keg = Keu + (1-t)(Keu-kd)(Vd/Ve)
12 = ? + (1-0.25)(?-6)(60/180)
0.75 x 6 x 0.33 = 1.5
0.75 x 0.33 = 0.25
? x 1.25 = 12 + 1.5
? = 10.8%
Example 5 - 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 = e 
E + D(1 − t )
50
Βa = 1.2  =0.71
50 + 50(1 − 0.3)
• 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 (24) 1 (24)
Y 1 –10 (5 x 0.7) 3.5 6.145 21.508
Y10 5 0.386 1.93
Base case NPV (0.562)
132 w w w . l s b f. o r g . u k
Present value of financing effects

Issue cost
$
Rights issue = 10m x 4% = 0.40
Debts = 6m x 1% = 0.06
PV of issue cost 0.46m
Tax savings on debt interest
8% loan of $6m
Annual interest = $6m x 8% = 0.48m
Tax saved per annum = $0.48 x 30% = 0.144m
$8m subsidised loan
Annual interest = $8m x 6% = 0.48m
Tax saved per annum = $0.48 x 30% = 0.144m
PV of tax savings on interest using normal cost of borrowing of 8% as discount factor
Total tax saving on interest = 0.144m + 0.144m = $0.288m

PV of tax savings = $0.288 x 6.710 = $1.932m
Present value of Subsidy

After tax interest saved as a result of subsidy = 2% x $8m = $0.160m x (1 – 0.3)
= $0.112m
Present value of subsidy at risk-free rate = $0.112m x 6.710 = $0.751
APV calculation $
Base case NPV (0.562)
Present value of tax savings on interest 1.932
Present value of subsidies 0.751
Present value of issue cost (0.460)
Adjusted present value 1.661
Since the APV is positive, the project is financially 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.
www.lsbf.org.uk 133
Chapter 6 – International Investment Appraisal
Example 1 – Base Currency Strengthens

As the predicted inflation rate is lower in the UK then the £ strengthens and it
becomes more expensive to buy a £1 thus the rate rises
Year 1 = 1.350 x 1.05 / 1.03 = $1.376 per £1
Year 2 = 1.376 x 1.06 / 1.04 = $1.402 per £1
Year 3 = 1.402 x 1.07 / 1.04 = $1.442 per £1
Example 2 – Base Currency Weakens

As the predicted interest rate is higher in the UK then the £ strengthens and it
becomes cheaper to buy a £1 thus the rate falls
Year 1 = 1.125 x 1.03 / 1.06 = €1.093 per £1
Year 2 = 1.093 x 1.02 / 1.05 = €1.062 per £1
Year 3 = 1.062 x 1.02 / 1.04 = €1.042 per £1
134 w w w . l s b f. o r g . u k
Example 3 – Loss Relief

The annual capital allowance will be $1,000m which is calculated as
$5,500 - $500m / 5
$m’s 1 2 3 4 5
NTR 250 550 1,500 2,500 8,000
Cap All (1,000) (1,000) (1,000) (1,000) (1,000)
Taxable Profit / (loss) (750) (450) 500 1,500 7,000
Loss Relief 750 450 (500) (700) Nil
Revised Taxable Profit Nil Nil Nil 800 7,000
Tax Charged @ 20% Nil Nil Nil 160 1,400
Loss Memo
Loss Incurred in Year 1 750
Loss Incurred in Year 2 450
Total Loss 1,200
Loss Relief taken in Year 3 (500)
Available Relief carried forward 700
Loss Relief taken in Year 3 (700)
Available Relief carried forward Nil
www.lsbf.org.uk 135
Example 4 - Stella
Year 0 1 2 3 4
NTR $m (120.00) 100.00 120.00 130.00
Tax $m 25% (25.00) (30.00) (32.50)
NCF $m (120.00) 100.00 95.00 100.00 (32.50)
$:£ Rate 2.00 2.20 2.42 2.66 2.93
NCF £m -60.00 45.45 39.26 37.57 -11.10
UK Tax £m -2.07 -2.25 -2.22
NCF £m -60.00 45.45 37.19 35.31 -13.32
DF 10% 1 0.909 0.826 0.751 0.683
DCF £m -60.00 41.32 30.72 26.52 -9.10
NPV £m 29.46
Add Tax in $ -5 -6 -6.5

Convert £ -2.07 -2.25 -2.22
136 w w w . l s b f. o r g . u k
Example 5
0 1 2 3 4
NTR $m (80.00) 60.00 72.00 95.00
Royalty $m (8.18) (7.44) (6.76)
Adjusted NTR $m (80.00) 51.82 64.56 88.24
Tax $m 30% (15.55) (19.37) (26.47)
NCF $m (80.00) 51.82 49.02 68.87 (26.47)
FX Rate $/£ 1.80 1.64 1.49 1.35 1.23
NCF £m (44.44) 31.67 32.95 50.93 (21.53)
Royalty £m 5.00 5.00 5.00
Tax 20% £m (1.00) (1.00) (1.00)
NCF £m (44.44) 36.67 36.95 54.93 (22.53)
DF 8% 1 0.926 0.857 0.794 0.735
DCF £m (44.44) 33.95 31.68 43.60 (16.56)
NPV £m 48.22
Annual Charge £ 5 5 5
Convert $ 8.18 7.44 6.76
www.lsbf.org.uk 137
Example 6 - Brookday plc

(a)
YEAR 0 1 2 3 4 5
Contribution $ 3,000 6,300 6,615 6,946
Fixed Cost $ (1,000) (1,050) (1,103) (1,158)
Royalty $ (316) (614) (597) (581)
Net Trad Rev $ 0 1,684 4,636 4,915 5,207
Investment in NCA $ (16,000)
Residual Value $ 8,000
Working Capital $ (4,000) (200) (210) (221) 4,631
Tax in US at 20% (397) (1,291)
Net Cash Flow $ (20,000) 1,484 4,426 4,695 17,441 (1,291)
FX Rate $ per £ 1.300 1.264 1.229 1.195 1.161 1.129
Remitted £ (15,385) 1,174 3,602 3,930 15,016 (1,144)
Royalty Receipt £ 250 500 500 500
Royalty Tax @ 30% (75) (150) (150) (150)
Extra UK Tax £ (166) (556)
Net Cash Flow £ (15,385) 1,424 4,027 4,280 15,200 (1,850)
D @ 13% 1 0.885 0.783 0.693 0.613 0.543
Discounted CF (15,385) 1,260 3,153 2,966 9,318 (1,004)
NPV 308
138 w w w . l s b f. o r g . u k
WORKINGS
Year 0 1 2 3 4 5
$ per £ 1.300 1.264 1.229 1.195 1.161 1.129
Sales Units 000's 50 100 100 100
Contribution per Unit 60 63 66 69
Total Contribution 3,000 6,300 6,615 6,946
Royalty per Unit 5 5 5 5
Sterling Value £000's 250 500 500 500
$ Value 316 614 597 581
Required Working Capital 4,000 4,200 4,410 4,631

Relevant cash flow (4,000) (200) (210) (221) 4,631
Non-current Asset Book

Value 16,000 12,000 9,000 6,750
25% WDA (4,000) (3,000) (2,250)
Carried Forward 12,000 9,000 6,750
Residual Value (8,000)
Balancing Charge (1,250)
Tax charged in United

States
Net Trading Revenue $ 1,684 4,636 4,915 5,207
Cap Allowance / Charge $ (4,000) (3,000) (2,250) 1,250
Taxable Profit $ (2,316) 1,636 2,665 6,457
Loss relief $ 2,316 (1,636) (680)
Revised Taxable Profit $ 0 0 1,985 6,457
Tax charged in US $ @
20% 0 0 397 1,291
Revised Taxable Profit £ 1,662 5,560
Additional Tax charged in UK $ @
10% 166 556
Loss Memo
Year 1 Loss (2,316)
Year 2 relief 1,636
Carried Down (680)
Year 3 relief 680
Nil
www.lsbf.org.uk 139
(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.
(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?
140 w w w . l s b f. o r g . u k
Chapter 8 – Business Valuations
Example 1
(a) Free cash flow

EBIT 313.50
Less: Corporation tax (@ 35% thereon) (109.72)
203.78
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Free cash flow 173.78
(b) Free cash flow to equity

£m
Profit after tax 188.18
Add back: Depreciation (non-cash amount) 30.00
Deduct: Capital expenditure (60.00)
Loan repayments (29.00)
Free cash flow to equity 129.18
Example 1 Continued
(a) Free cash flow to Entity

Value of Entity = $173.78m / 0.10 = $1,737.8m
Value of Equity = $1,737.8m - $650m = $1,087.8m
(b) Free cash flow to Equity

Value of Equity = $129.18m / 0.12 = $1,076.5m
www.lsbf.org.uk 141
Example 2
(a) Cash flows are expected to remain at X4 level into infinity

Financial year X1 X2 X3 X4
Revenue 230 261 281 298
Cost of goods sold (50%) 115 131 141 149
Selling and distributive expenses 32 34 36 38
Capital allowance 40 42 42 42
187 207 219 229
Taxable profit 43 54 62 69
Taxation (30%) 13 16 19 21
30 38 43 48
add back capital allowance 40 42 42 42
Less cash flow needed for assets
(50) (52) (55) (58)
replacement
Free cash flow 20 28 30 32
Discount factor (14%) 0.877 0.769 0.675 0.592
Present value 17.54 21.532 20.25 18.944
Total present value X1 - X4 = 78.266
Total PV X5 to infinity = (32/0.14) x 0.592 = 135.31
Total present value is 78.266 + 135.31 = £213.58
Corporate value = 213.58
Value of equity = 213.58 –30 = £183.58
(b) Cash flows are expected to grow at a rate of 4% per year after X4 into
infinity.
(32 x1.04)
Total PV 2005 to infinity = = 199
(0.14 − 0.04)
Total present value is 78.266 + 199 = £277.266
Corporate value = 277.266
Value of equity = 277.266 –30 = £247.266
Example 3
The maximum premium is the difference between the value of the combined business
and the sum of the current values of the individual companies.
Value of combined business: combined P/E ratio x combined earnings.

Combined earnings:
VATA Co profit after tax = $1,980m x 0·8 = $1,584·0m
Profit after tax ABC: $397m x 0·8 = $317·6m
Synergy earnings after tax = $140·0m
Earnings of combined business = $2041.6
Combined P/E ratio = 14.5
Value of combined business = (14.5 x 2041.6) = $29,603·2m
142 w w w . l s b f. o r g . u k
Value of individual companies:
Current market value of ABC

PE ratio of ABC = 1·10 x 16·4 = 18·0 times
Profit after tax of ABC: $397m x 0·8 = $317·6m
Current market value of ABC = $317·6m x 18·0 = $5,716·8m
Current market value of VATA = $9·24 x 2,400 shares = $22,176·0m
Maximum premium = $29,603·2m – ($22,176·0m + $5,716·8) = $1,710·4m
Example 4
D1
P0 = = £0.30 x 1.05 / 0.20 – 0.05 = £2.10
Ke − g
Example 5
For years 1 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
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
www.lsbf.org.uk 143
Example 6
Valuing intellectual capital/intangible assets

Based on the information in the question the following methods can be used to value
intellectual capital:
Calculated intangible value (CIV) method

67.5 + 74.2 + 56.9
Average pre-tax earnings =
3
= £66.2 million
198 + 229 + 263
Average tangible assets =
3
= £230 million
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) = £22.19m
Net present value of premium (value of intellectual capital) = 22.19 x 1/0.1
= £221.9 million.
144 w w w . l s b f. o r g . u k
Example 7
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:
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, volatility (s or σ) = 0.05:
d1 = (
ln(113.20  110.70) + 0.035 + 0.5  0.052 0.4 )
0.05 0.4
0.0223323 + 0.014 + 0.0005

=
0.0316227
0.0368323
= = 1.16474
0.0316227
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
www.lsbf.org.uk 145
Example 8
Discount Present
End of year
factor value
£ 10% £
1–3 Gross annual interest 9 2.487 22.38
3 Redemption value 100 0.751 75.10
97.48
Example 9
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.
Example 10
A Rating
% Yield
Year CF Base Spread Adj DF DCF
1 4.5 1.25 0.3 1.55 0.985 4.43
2 4.5 1.65 0.5 2.15 0.958 4.31
3 4.5 2.15 0.75 2.9 0.918 4.13
4 104.5 2.75 1.15 3.9 0.858 89.67
MARKET VALUE AT A RATING 102.55
146 w w w . l s b f. o r g . u k
B Rating
% Yield
Year CF Base Spread Adj DF DCF
1 4.5 1.25 0.45 1.7 0.983 4.42
2 4.5 1.65 0.85 2.5 0.952 4.28
3 4.5 2.15 1.1 3.25 0.909 4.09
4 104.5 2.75 1.45 4.2 0.848 88.64
MARKET VALUE AT B RATING 101.44
Change in
Value 1.11
% Change 1.1%
Example 11
B Rating
% Yield
Year Base Spread Adj DF
1 1.25 0.45 1.7 0.983
2 1.65 0.85 2.5 0.952
3 2.15 1.1 3.25 0.909
4 2.75 1.45 4.2 0.848
Notional annuity factor 3.692
Present value of redemption value in year 4

$102 x 0.848 86.50
Required Present value of Interest 13.5
Notional annuity factor 3.692
Annual Coup rate % 3.66
Example 12
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%
www.lsbf.org.uk 147
CHAPTER 9 – Framework
Example 1
Pre-Acq. Value
Simon = 3m x $7.80 = $23.4m
Denis value per share = $0.60 x 8 x 110% = $5.28
Total Value = $5.28 x 1.5m = $7.92m
Post Acquisition
Value of Combined Entity = $35.32m ($23.4m + $7.92m + $4m)
1. Cash Offer
Denis Investors
Value Received $5.70
Current Value $5.28
Premium Received $0.42
% of current value 8.0% $0.48 / $5.28
Simon Investors
Total acquisition premium paid = 1.5m x $0.42 = $0.63m
Value of synergy retained = $3.37m ($4m - $0.63m)
% for Simon Investors = 14.4% ($3.37m / $23.4m)
2. Share for Share Exchange

New shares issued = 1.5m x 2/3 = 1m
Post-acquisition in circulation = 4m (3m + 1m)
Post-acquisition value per share = $35.32m / 4m = $8.83
Denis Investors
Value Received $17.66 (2 x $8.83)
Current Value $15.84 (3 x $5.28)
Total Premium Received $1.82
Per Share $0.61 ($1.82 / 3)
% of current value 11.5% ($0.61 / $5.28)
Note that 25% of the combined entity will be owned by Denis Investors
Simon Investors
Increase in value per share = $1.03 ($8.83 - $7.80)
% increase = 13.2% ($1.03 / $7.80)
3. Debenture Issue
Denis Investors
Value received per $6.25 $93.75 / 15
share
Current value $5.28
Premium received $0.97
% of current value 18.4% $0.97 / $5.28
148 w w w . l s b f. o r g . u k
Simon Investors
Total acquisition premium paid = 1.5m x $0.97 = $1.46m
Value of synergy retained = $2.54m ($4m - $1.46m)
% for Simon Investors = 10.8% ($2.54m / $23.4m)
Summary
Method Denis Simon
Cash Offer 8.0% 14.4%
Share exchange 11.5% 13.2%
Debenture Issue 18.4% 10.8%
www.lsbf.org.uk 149
CHAPTER 11 – Foreign Exchange Risk
Example 1
Net exposure:
Receipts Payments Net exposure
Three months $350,000 $250,000 =$100,000 receipt
Six months £100,000 $1,000,000 =$1,000,000 payment
The £100,000 is in FRT’s home currency (£), hence no transaction risk.
Forward contract
Three months:
The guaranteed net receipt = $100,000/1.4600 = £68,493
Money market hedge
Three months:
1. Borrow from a bank an appropriate amount
• this means that we will borrow in the US bank at an interest rate of 8.4%
• the appropriate amount to be borrowed now at 8.4% to get $100,000 in
three months’ time is:
$100,000/ 1.021 = $97,943
8.4/4 = 2.1% = three months interest rate
The amount borrowed of $97,943 will compound up to $100,000 in three
months at the rate of 8.4% per annum or 2.1% for three months.
2. Convert the amount borrowed into sterling at the spot rate
$97,943/ 1.4990 = £65,339
3. Deposit the £65,339 in UK at an interest rate of 2.4% for three months
£65,339 x (1.006) = £65,731
This amount is less than the amount given by the forward contract hence the
company can hedge the three months exposure by using the forward contract.
Forward contract
Six months:
The guaranteed payment = $1,000,000/1.4490 = £690,131
Net payment = £690,131 - £100,000 = £590,131
Money market hedge
Six months:
Step 1
The UK company should buy dollars now and put them into a deposit account for six
months in order to get $1,000,000.
= $1,000,000 / (1+ (0.054/2) = $973,710
150 w w w . l s b f. o r g . u k
Step 2
Convert pounds into this amount at the spot rate = $973,710/ 1.4960
= £650,876
Step 3
This means the company has to borrow £650,876 in the UK for six months at an
interest rate of 4.8%.
The total amount payable in sterling is: £650,876x (1 + (0.048/2) =£666,497
Net payments = £666,497 - £100,000 = £566,497

The net payment with money market is cheaper than with forward contract, hence
the company should hedge the six-month exposure using the money market.
Example 2 - Payment
FORWARD EXCHANGE CONTRACT
• Will fix rate that is used to exchange and thus provide certainty of income.
• Inflexible and must be settled regardless of receipt
• Company will buy $ at the LOW rate of $1.4145 per £
• Actual payment = $4m / 1.4145 = £2,827,854
FX FUTURES
• A tradeable contract that must be completed
• Follow a 5-step approach as below
1. Date – December
• As the first available after expiry of requirement on 1st November
2. Closing Position – SHORT

• As this is a payment in a foreign currency = we sell £ to buy $
• As the derivative is in £ (Domestic) we buy domestic
3. Basis – Difference between spot rate and future rate

• Note that future is lower than spot
• Current basis is 1.4385 – 1.4285 = 0.0100
• Assume this reduces in a linear fashion over 5 months to zero

• 2 months will remain at exercise date = 0.0100 x 2/5 – 0.0040
4. Lock in Rate – Futures rate + or – unexpired basis

• As future is lower than spot the unexpired basis will be added
• 1.4285 + 0.0040 = 1.4325
5. Net cost
• Actual income = $4m / 1.4325 = €2,792,321
www.lsbf.org.uk 151
FX OPTIONS
• A tradeable contract that does not have be completed, will only exercise if
beneficial
1. Date – December
• As the first available after expiry of requirement
2. Option Type – PUT OPTION

• As this is a payment in a foreign currency we will aim to sell FX
• Opposite to reality which is to buy FX
3. Number of contracts – Receipt / strike price / contract size (round

down)
Strike Price 1.42 1.44

Dollar Payment $4,000,000 $4,000,000
Convert 1.42 1.44
Sterling £2,816,901 £2,777,777
Equivalent
Contract Size £125,000 £125,000
Contracts 22 22
4. Calculate premium - Contracts x option contract size x price / Spot

rate (to buy)

Contracts 22 22
Contract Size £125,000 £125,000
Premium (cents per 0.0195 0.0355
£)
Total $ Cost $53,625 $97,625
Spot rate $1.4385 per $1.4385 per £
£
Total € cost £37,278 £67,868
5. Forward Contracts Required – due to under hedge

Contracts 22 22
Contract Size £125,000 £125,000
Convert 1.45 1.44
$’s protected $3,905,000 $3,960,000
To protect $95,000 $40,000
Forward rate $1.4145 per £ $1.4145 per £
Total £ cost £67,162 £28,279
6. Overall outcome (Net cost / Receipt)

Contracts 22 22
Contract Size £125,000 £125,000
£ payment 2,750,000 2,750,000
Plus premium 37,278 67,866
Plus Forward 67,162 28,279
Total € receipt 2,854,440 2,846,145
152 w w w . l s b f. o r g . u k
Example 3 - Receipt
FORWARD EXCHANGE CONTRACT
• Will fix rate that is used to exchange and thus provide certainty of income.
• Inflexible and must be settled regardless of receipt
• Company will sell $ at the high rate of $1.4560 per £
• Actual income = $12m / 1.4650 = £8,191,126
FX FUTURES
• A tradeable contract that must be completed
1. Date – March
• As the first available after expiry of requirement on 1st February
2. Closing Position – LONG

• As this is a receipt in foreign currency = we sell $ to buy £
• As the derivative is in £ (Domestic) we sell domestic
3. Basis – Difference between spot rate and future rate

• Note that future is higher than spot
• Current basis is 1.4625 – 1.4345 = 0.0280
• Assume this reduces in a linear fashion over 8 months to zero
• 2 months will remain at exercise date = 0.0080 x 2/8 – 0.0070
4. Lock in Rate – Futures rate + or – unexpired basis

• As future is higher than spot the unexpired basis will be deducted
• 1.4625 – 0.0070 = 1.4555
5. Net cost
• Actual income = $12m / 1.4555 = €8,244,589
FX OPTIONS
• A tradeable contract that does not have be completed, will only exercise if
beneficial
1. Date – March
• As the first available after expiry of requirement
2. Option Type – CALL OPTION

• As this is a receipt in a foreign currency we will aim to buy FX
• Opposite to reality which is to sell FX
3. Number of contracts – Receipt / strike price / contract size (round

down)

Dollar Receipt $12,000,000 $12,000,000
Convert 1.45 1.47
Sterling £8,275,862 £8,163,265
Equivalent
Contract Size £125,000 £125,000
Contracts 66 65
www.lsbf.org.uk 153
4. Calculate premium - Contracts x option contract size x price / Spot

rate (to buy)

Contracts 66 65
Contract Size £125,000 £125,000
Premium (cents per 0.0295 0.0244
£)
Total $ Cost $243,375 $198,250
Spot rate $1.4185 per £ $1.4185 per £
Total € cost £171,572 £139,760
5. Forward Contracts Required – due to under hedge
Strike Price
Contracts
Contract Size £125,000 £125,000
Convert 1.45 1.47
$’s protected $11,962,500 $11,943,750
To protect $37,500 $56,250
Forward rate $1.4650 per £ $1.4650 per £
Total £ Income £25,597 £38,396
6. Overall outcome (Net cost / Receipt)

Contracts 66 65
Contract Size £125,000 £125,000
£ Receipt £8,250,000 £8,125,000
Less premium (£171,572) (£139,760)
Plus Forward £25,597 £38,201
Total € receipt £8,104,025 £8,023,636
154 w w w . l s b f. o r g . u k
Example 4
DD plc borrows = $50m / 1.35 = £37.0m at 9%
FFK plc borrows = $50m at base rate + 1%
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 Combined
% %
Foreign cost Base +3.0 11 Base + 14
Domestic Cost 9 Base +1 Base + 10
Arbitrage Gain 2.0 2.0 4.0
Bank Fee (0.5) (0.5) (1.0)
Net Benefit 1.5 1.5 3.0
Swap arrangement:
Obtain 9.0 Base + 1.0
DD to FFK Base (Base)
FFK to DD (8.0) 8.0%
Cost before Bank Fee Base + 1.0 9.0%
Bank Fee 0.5 0.5%
Net Cost Base +1.5% 9.5%
Saving against Foreign Cost 1.5% 1.5%

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.
Example 5 - Netting
Step 1: Convert the balance into a common currency, the US dollar.
Owed
By To Amount Currency Rate $ Conversion
UK SA 1,200,000 Rand 6.126 195,886
UK FR 480,000 Euro 0.880 545,455
FR SA 800,000 Rand 6.126 130,591
SA UK 74,000 Sterling 0.680 108,824
SA FR 375,000 Euro 0.880 426,136
www.lsbf.org.uk 155
Paying subsidiaries
UK SA FR TOTAL
$ $ $ $
Receiving subsidiary
UK 108,824 - 108,824
SA 195,886 130,591 326,477
FR 545,455 426,136 971,591
Total payments 741,341 534,960 130,591 1,406,892
Total receipts 108,824 326,477 971,591 1,406,892
Net
(632,517) (208,483) 841,000 0
receipts/(payments)
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.
Its 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 weakened
in the sustained period.
156 w w w . l s b f. o r g . u k
CHAPTER 12 – Interest Rate Risk
Example 1
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 = £2.25m
(4 + 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 paid to the bank
= -0.85% x100m x 6/12 = £0.425m
(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%
www.lsbf.org.uk 157
Example 2 - Borrowing
Interest Rate Futures

1. What contract = March futures contract as it expires immediately after 1st March
transaction date.
2. What type = SHORT 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.
3. Number of contracts
30m  2
= = 40 contracts
0.5m  3
4. Tick Size = £500,000 x 0.0001 x 3/12 = £12.50
5. Calculate the closing future price using basis and basis risk.
Calculate opening basis as:
Current LIBOR = 6% = (100 –6) = 94.00
Future price 93.79
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 seven months until expiry and the funds are needed in six months’
time, therefore one month will remain at the time of borrowing, thus the
remaining basis is:
0.21 x 1/7 = 0.03
Closing future price
If LIBOR increase If LIBOR decrease
by 0.5% by 0.5%
LIBOR = 6% + 0.5% = 6.5% =
100 -6.5 93.5
LIBOR = 6% - 0.5% = 5.5% =
100 -5.5 94.5
Unexpired basis 0.03 0.03
Futures closing price 93.47 94.47
6. Profit or loss
by 0.5% by 0.5%
Selling 93.79 93.79
Buying 93.47 94.47
Profit/(loss) 0.32 (0.68)
Total profit = (0.32 x 100) x £12.50 x 40 = £16,000

Total loss = (0.68 x 100) x £12.50 x 40 = £34,000
158 w w w . l s b f. o r g . u k
7. Net outcome
by 0.5% by 0.5%
Actual interest: (6.5% + 0.9%)
= 7.4% x 2/12 x 30 million 370,000
(5.5% + 0.9%) =
6.4% x 2/12 x 30 million 320,000
Profit/loss (16,000) 34,000
Net payment 354,000 354,000
8. Effective Rate 354,000 /
30,000,000 x 12/2 7.08% 7.08%
Options on interest rate futures

1. What contract = as futures calculation above March
2. Call or put = buy PUT option to have the right to sell sterling futures as interest
is expected to increase.
3. Number of contracts – as futures calculation above 40 contracts
4. Tick Size = as futures calculation above £12.50
5. Closing future price as futures calculation above 93.47 & 94.47
6. Calculate premium
Exercise price Computation Premium
93.75 (0.085 x 100) x 40 contracts x $12.50 £4,250
94.25 (0.480 x 100) x 40 contracts x $12.50 £24,000
7. Calculate profit or loss
Rates Rise Fall
Sell at strike 93.75 94.25 93.75 94.25
Buy 93.47 93.47 94.47 94.47
Profit / (Loss) 0.28 0.78 (0.72) (0.22)
Exercise Yes Yes No No
If interest rate increases, the option will be exercised and the futures contract
sold at the exercise price, thus profit will be;
93.75 = (0.28 x 100) x 40 Contracts x £12.50 = £14,000
94.25 = (0.78 x 100) x 40 Contracts x £12.50 = £39,000
If interest rate decrease, the option will not be exercised.

8. Net outcome
Rates Rise Fall
Strike Price 93.75 94.25 93.75 94.25
Interest Paid 370,000 370,000 320,000 320,000
Premium Paid 4,250 24,000 4,250 24,000
Profit (14,000) (39,000) 0 0
Net Cost 360,250 355,000 324,250 344,000
9. Effective Rate 7.21% 7.10% 6.49% 6.88%
www.lsbf.org.uk 159
Interest rate collars

2. Call or put = Obtain a PUT option at 93.75 to create a ceiling / Place a CALL
option at 94.25 to create a floor
6. Calculate net premium
93.75 Pay (0.085 x 100) x 40 contracts x $12.50 £4,250
94.25 Receive (0.030 x 100) x 40 contracts x $12.50 (£1,500)
£2,750
Obtain PUT 93.75 Place CALL 94.25
Rise Fall Rise Fall
Sell 93.75 93.75 3rd Party Buy 94.25 94.25
Buy 93.47 94.47 3rd Party Sell 93.47 94.47
Profit / (Loss) 0.28 (0.72) Profit / (Loss) (0.78) 0.22
Exercise Yes No Exercise No Yes
If interest rate increases, our company will exercise the option, though if rates fall
the 3rd party who acquired the CALL will exercise;
Our profit 93.75 = (0.28 x 100) x 40 Contracts x £12.50 = £14,000
3rd Party profit = Our cost 94.25 = (0.22 x 100) x 40 Contracts x £12.50 = £11,000
8. Net outcome
Rates Rise Fall
Interest Paid 370,000 320,000
Premium Paid 2,750 2,750
(Profit) / Loss (14,000) 11,000
Net Cost 358,750 333,750
9.Effective Rate 7.18% 6.68%
SUMMARY
Rates Rise Fall
% %
Futures 7.08 7.08
Option @ 93.75 7.21 6.49
Option @ 94.25 7.10 6.88
Collar 7.18 6.68
160 w w w . l s b f. o r g . u k
Conclusion
From the above it can be deduced that if LIBOR should increase by 0.5% then the
hedging using interest rate futures contract gives the cheapest net interest payment
at 7.08%. Though where rates rise, this would in fact be the most expensive option.
However, if LIBOR should decrease by 0.5% the option at strike price of 93.75
provides the lowest cost, though conversely the highest cost were the rates to rise.
Thus a decision must be made based upon the attitude of management, risk adverse
will select the futures, whilst those comfortable with risk will select the 93.75 option.
Example 3 - Investing
Interest Rate Futures

1. What contract = March futures contract as it expires immediately after 1st
February.
2. What type = LONG buy interest rate futures as interest rates are expected to
fall. If interest rate fall, future price will rise, and we can close the position by buying
futures.
3. Number of contracts = £24m / £1m x 4/3 = 32 Contracts
4. Tick Size = £1,000,000 x 0.0001 x 3/12 = £25.00
5. Calculate the closing future price using basis and basis risk.
Calculate opening basis as:
Current LIBOR = (100 –4.2) = 95.80
Future price 96.20
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 five months until expiry and the funds are invested in three months’
time, therefore two months remain at the time of investing and the remaining
basis is expected to be:
0.40 x 2/5 = 0.16
Closing future price
by 0.4% by 0.6%
LIBOR = 100 – (4.2 – 0.4) 95.40
LIBOR = 100 – (4.2 + 0.6) 96.40
Unexpired basis 0.16 0.16
Futures closing price 95.56 96.56
6. Profit or loss
by 0.4% by 0.6%
Buying 96.20 96.20
Selling 95.56 96.56
Profit/(loss) (0.64) 0.36
www.lsbf.org.uk 161
Total profit = (0.36 x 100) x £25 x 32 = £28,800

Total loss = (0.64 x 100) x £25 x 32 = £51,200
7. Net outcome
by 0.5% by 0.5%
Actual interest: (4.6% - 0.2%)
= 4.4% x 4/12 x £24m 352,000
(3.6% - 0.2%) =
3.4% x 4/12 x £24m 272,000
Profit/loss (51,800) 28,800
Net payment 300,800 300,800
8. Effective Rate 300,800 /
24,000,000 x 12/4 3.76% 3.76%
Options on interest rate futures

1. What contract = March as above
2. Call or put = buy CALL option to have the right to buy sterling futures as
interest is expected to fall.
3. Contracts = 32 as above
4. Tick Size = £25 as given
5. Closing Price = 95.56 / 96.56 as above
6. Calculate premium
95.50 (0.475 x 100) x 32 contracts x $12.50 £38,000
96.25 (0.230 x 100) x 32 contracts x $12.50 £18,400
7. Exercise Contract
If LIBOR increase by If LIBOR decrease by

0.4% 0.6%
Strike Strike Strike Strike

95.50 96.25 95.50 96.25
Buying 95.50 96.25 95.50 96.25
Selling 95.56 95.56 96.56 96.56
Profit/(loss) 0.06 (0.69) 1.06 0.31
Exercise Yes No Yes Yes
Profit £4,800 n/a £84,800 £24,800
162 w w w . l s b f. o r g . u k
Note – Profit = Ticks x Tick Size x Contracts

(0.06 x 100) x £25 x 32 = £4,800
(1.06 x 100) x £25 x 32 = £84,800
(0.31 x 100) x £25 x 32 = £24,800
8. Net Receipt
If LIBOR increase by If LIBOR decrease by

0.4% 0.6%
Strike Strike Strike Strike

95.50 96.00 95.50 96.00
Interest £352,000 £352,000 £272,000 £272,000
Premium (£38,000) (£18,400) (£38,000) (£18,400)
Profit £4,800 n/a £84,800 £24,800
Net Receipt £318,800 £333,600 £318,800 £278,400
Effective Rate 3.99% 4.17% 3.99% 3.48%
Interest rate collars

2. Call or put = Obtain a CALL option at 96.25 to create a floor (minimum interest
received) / Place a PUT option at 95.50 to create a ceiling
6. Calculate net premium
96.25 Pay (0.230 x 100) x 32 contracts x £25 £18,400
95.50 Receive (0.185 x 100) x 32 contracts x £25 (£14,800)
£3,600
Obtain CALL 96.25 Place PUT 95.50
Rise Fall Rise Fall
Buy 96.25 96.25 3rd Party Sell 95.50 95.50
Sell 95.56 96.56 3rd Party Buy 95.56 96.56
Profit / (Loss) (0.69) 0.31 Profit / (Loss) (0.06) (1.06)
Exercise No Yes Exercise No No
If interest rate falls, our company will exercise the option, though if rates rise the
3rd party who acquired the PUT will not exercise;
Our profit = (0.31 x 100) x 32 Contracts x £25 = £24,800
www.lsbf.org.uk 163
8. Net outcome
Rates Rise Fall
Interest received 352,000 272,000
Premium Paid (3,600) (3,600)
(Profit) / Loss 24,800
Net Cost 358,750 293,200
9.Effective Rate 4.36 3.67%
SUMMARY
Rates Rise Fall
% %
Futures 3.76 3.76
Option @ 95.50 3.99 3.99
Option @ 96.25 4.17 3.48
Collar 4.36 3.67
Conclusion
From the above it can be deduced that if LIBOR should increase by 0.4% then the
collar would yield the highest return, though the second lowest return if rates were
to fall. The futures contract provides certainly, though so does the option at 95.50,
which appears to be the best option.
Example 4 - Fred
Fred Martin Combined
Worst Case 13% Libor + 2.5% Libor + 15.5%

Best Case Libor + 1.5% 12% Libor + 13.5%
Arbitrage Gain 60:40 1.2 0.8 2.0
Bank Fee (0.6) (0.4) (1.0)
Net Benefit 0.6% 0.4% 1.0
Swap arrangement:
Obtain Libor + 1.5% 12.0%
Martin to Fred (Libor) Libor
Fred to Martin 10.3% (10.3%)
Cost before Bank Fee 11.8% Libor + 1.7%
Bank Fee 0.6% 0.4%
Net Cost 12.4% Libor + 2.1%
Saving against worst case 0.6% 0.4%
164 w w w . l s b f. o r g . u k
Class Notes
Questions
www.lsbf.org.uk 165
CLASS NOTES QUESTIONS
Kilenc Co (June 2012)
Kilenc Co, a large listed company based in the UK, produces pharmaceutical
products which are exported around the world. It is reviewing a proposal to set
up a subsidiary company to manufacture a range of body and facial creams in
Lanosia. These products will be sold to local retailers and to retailers in nearby
countries.
Lanosia has a small but growing manufacturing industry in pharmaceutical
products, although it remains largely reliant on imports. The Lanosian
government has been keen to promote the pharmaceutical manufacturing
industry through purchasing local pharmaceutical products, providing
government grants and reducing the industry’s corporate tax rate. It also imposes
large duties on imported pharmaceutical products which compete with the ones
produced locally.
Although politically stable, the recent worldwide financial crisis has had a
significant negative impact on Lanosia. The country’s national debt has grown
substantially following a bailout of its banks and it has had to introduce economic
measures which are hampering the country’s ability to recover from a deep
recession. Growth in real wages has been negative over the past three years, the
economy has shrunk in the past year and inflation has remained higher than
normal during this time.
On the other hand, corporate investment in capital assets, research and
development, and education and training, has grown recently and interest rates
remain low. This has led some economists to suggest that the economy should
start to recover soon. Employment levels remain high in spite of low nominal
wage growth.
Lanosian corporate governance regulations stipulate that at least 40% of equity
share capital must be held by the local population. In addition at least 50% of
members on the Board of Directors, including the Chairman, must be from
Lanosia. Kilenc Co wants to finance the subsidiary company using a mixture of
debt and equity. It wants to raise additional equity and debt finance in Lanosia in
order to minimise exchange rate exposure. The small size of the subsidiary will
have minimal impact on Kilenc Co’s capital structure. Kilenc Co intends to raise
the 40% equity through an initial public offering (IPO) in Lanosia and provide the
remaining 60% of the equity funds from its own cash funds.
Required:
(a) Discuss the key risks and issues that Kilenc Co should consider when setting
up a subsidiary company in Lanosia, and suggest how these may be mitigated.
(15 marks)
(b) The directors of Kilenc Co have learnt that a sizeable number of equity trades
in Lanosia are conducted using dark pool trading systems.
Required:
Explain what dark pool trading systems are and how Kilenc Co’s proposed
Initial Public Offering (IPO) may be affected by these. (5 marks)
(20 marks)
166 w w w . l s b f. o r g . u k
Lamri Co (December 2010)
Lamri Co (Lamri), a listed company, is expecting sales revenue to grow to $80

million next year, which is an increase of 20% from the current year. The
operating profit margin for next year is forecast to be the same as this year at
30% of sales revenue. In addition to these profits, Lamri receives 75% of the
after-tax profits from one of its wholly owned foreign subsidiaries – Magnolia Co
(Magnolia), as dividends. However, its second wholly owned foreign subsidiary –
Strymon Co (Strymon) does not pay dividends.
Lamri is due to pay dividends of $7·5 million shortly and has maintained a steady
8% annual growth rate in dividends over the past few years. The company has
grown rapidly in the last few years as a result of investment in key projects and
this is likely to continue.
For the coming year it is expected that Lamri will require the following capital
investment.
1. An investment equivalent to the amount of depreciation to keep its non-
current asset base at the present productive capacity. Lamri charges
depreciation of 25% on a straight-line basis on its non-current assets of $15
million. This charge has been included when calculating the operating profit
amount.
2. A 25% investment in additional non-current assets for every $1 increase in

sales revenue.
3. $4·5 million additional investment in non-current assets for a new project.
Lamri also requires a 15% investment in working capital for every $1 increase in
sales revenue.
Strymon produces specialist components solely for Magnolia to assemble into
finished goods. Strymon will produce 300,000 specialist components at $12
variable cost per unit and will incur fixed costs of $2·1 million for the coming year.
It will then transfer the components to Magnolia at full cost price, where they will
be assembled at a cost of $8 per unit and sold for $50 per unit. Magnolia will incur
additional fixed costs of $1·5 million in the assembly process.
Tax-Ethic (TE) is a charitable organisation devoted to reducing tax avoidance
schemes by companies operating in poor countries around the world. TE has
petitioned Lamri’s Board of Directors to reconsider Strymon’s policy of
transferring goods at full cost. TE suggests that the policy could be changed to
cost plus 40% mark-up. If Lamri changes Strymon’s policy, it is expected that
Strymon would be asked to remit 75% of its after-tax profits as dividends to
Lamri.
Other Information
1. Lamri’s outstanding non-current liabilities of $35 million, on which it pays

interest of 8% per year, and its 30 million $1 issued equity capital will not
change for the coming year.
2. Lamri’s, Magnolia’s and Strymon’s profits are taxed at 28%, 22% and 42%
respectively. A withholding tax of 10% is deducted from any dividends
remitted from Strymon.
www.lsbf.org.uk 167
3. The tax authorities where Lamri is based charge tax on profits made by
subsidiary companies but give full credit for tax already paid by overseas
subsidiaries.
4. All costs and revenues are in $ equivalent amounts and exchange rate
fluctuations can be ignored.
Required:
(a) Calculate Lamri’s dividend capacity for the coming year prior to implementing
TE’s proposal and after implementing the proposal.
(14 marks)
(b) Comment on the impact of implementing TE’s proposal and suggest possible
actions Lamri may take as a result. (6 marks)
(20 marks)
Arbore Co (December 2012)
Arbore Co is a large listed company with many autonomous departments

operating as investment centres. It sets investment limits for each department
based on a three-year cycle. Projects selected by departments would have to fall
within the investment limits set for each of the three years. All departments would
be required to maintain a capital investment monitoring system, and report on
their findings annually to Arbore Co’s board of directors.
The Durvo department is considering the following five investment projects with
three years of initial investment expenditure, followed by several years of positive
cash inflows. The department’s initial investment expenditure limits are
$9,000,000, $6,000,000 and $5,000,000 for years one, two and three
respectively. None of the projects can be deferred and all projects can be scaled
down but not scaled up.
Investment required at start of year
Project Year one Year two Year three Project net

(Immediately) present value
PDur01 $4,000,000 $1,100,000 $2,400,000 $464,000
PDur02 $800,000 $2,800,000 $3,200,000 $244,000
PDur03 $3,200,000 $3,562,000 $0 $352,000
PDur04 $3,900,000 $0 $200,000 $320,000
PDur05 $2,500,000 $1,200,000 $1,400,000 Not provided
PDur05 project’s annual operating cash flows commence at the end of year four
and last for a period of 15 years. The project generates annual sales of 300,000
units at a selling price of $14 per unit and incurs total annual relevant costs of
$3,230,000. Although the costs and units sold of the project can be predicted with
a fair degree of certainty, there is considerable uncertainty about the unit selling
168 w w w . l s b f. o r g . u k
price. The department uses a required rate of return of 11% for its projects, and
inflation can be ignored.
The Durvo department’s managing director is of the opinion that all projects which
return a positive net present value should be accepted and does not understand
the reason(s) why Arbore Co imposes capital rationing on its departments.
Furthermore, she is not sure why maintaining a capital investment monitoring
system would be beneficial to the company.
Required:
(a) Calculate the net present value of project PDur05. Calculate and comment on
what percentage fall in the selling price would need to occur before the net
present value falls to zero. (6 marks)
(b) Formulate an appropriate capital rationing model, based on the above

investment limits, that maximises the net present value for department
Durvo. Finding a solution for the model is not required. (3 marks)
(c) Assume the following output is produced when the capital rationing model in
part (b) above is solved:
Category 1: Total Final Value $1,184,409 -
Category 2: Adjustable Final Values

Project PDur01: 0·958
Category 3:
Constraints Utilised: Slack

Year one: $9,000,000: Year one: $0
Year two: $6,000,000: Year two: $0
Year three: $5,000,000: Year three: $0
Required:
Explain the figures produced in each of the three output categories. (5 marks)
(d) Provide a brief response to the managing director’s opinions by:
(i) Explaining why Arbore Co may want to impose capital rationing on its
departments; (2 marks)
(ii) Explaining the features of a capital investment monitoring system and

discussing the benefits of maintaining such a system. (4 marks)
(20 marks)
www.lsbf.org.uk 169
Fernhurst Co (September/December 2016)

Fernhurst Co is a manufacturer of mobile communications technology. It is about
to launch a new communications device, the Milland, which its directors believe
is both more technologically advanced and easier to use than devices currently
offered by its rivals.
Investment in the Milland
The Milland will require a major investment in facilities. Fernhurst Co’s directors
believe that this can take place very quickly and production be started almost
immediately.
Fernhurst Co expects to sell 132,500 units of the Milland in its first year. Sales
volume is expected to increase by 20% in Year 2 and 30% in Year 3, and then be
the same in Year 4 as Year 3, as the product reaches the end of its useful life.
The initial selling price in Year 1 is expected to be $100 per unit, before increasing
with the rate of inflation annually.
The variable cost of each unit is expected to be $43·68 in year 1, rising by the
rate of inflation in subsequent years annually. Fixed costs are expected to be
$900,000 in Year 1, rising by the rate of inflation in subsequent years annually.
The initial investment in non-current assets is expected to be $16,000,000.
Fernhurst Co will also need to make an immediate investment of $1,025,000 in
working capital. The working capital will be increased annually at the start of each
of Years 2 to 4 by the inflation rate and is fully recoverable at the end of the
project’s life. Fernhurst Co will also incur one-off marketing expenditure of
$1,500,000 post inflation after the launch of the Milland. The marketing
expenditure can be assumed to be made at the end of Year 1 and be a tax
allowable expense.
Fernhurst Co pays company tax on profits at an annual rate of 25%. Tax is
payable in the year that the tax liability arises. Tax allowable depreciation is
available at 20% on the investment in non-current assets on a reducing balance
basis. A balancing adjustment will be available in Year 4. The realisable value of
the investment at the end of Year 4 is expected to be zero.
The expected annual rate of inflation in the country in which Fernhurst Co is
located is 4% in Year 1 and 5% in Years 2 to 4.
The applicable cost of capital for this investment appraisal is 11%.
Other calculations
Fernhurst Co’s finance director has indicated that besides needing a net present
value calculation based on this data for the next board meeting, he also needs to
know the figure for the project’s duration, to indicate to the board how returns
from the project will be spread over time.
Failure of launch of the Milland
The finance director would also like some simple analysis based on the possibility
that the marketing expenditure is not effective and the launch fails, as he feels
that the product’s price may be too high. He has suggested that there is a 15%
chance that the Milland will have negative net cash flows for Year 1 of $1,000,000
or more. He would like to know by what percentage the selling price could be
reduced or increased to result in the investment having a zero net present value,
assuming demand remained the same.
Assessment of new products
Fernhurst Co’s last board meeting discussed another possible new product, the
Racton, and the finance director presented a range of financial data relating to
170 w w w . l s b f. o r g . u k
this product, including the results of net present value and payback evaluations.
One of the non-executive directors, who is not a qualified accountant, stated that
he found it difficult to see the significance of the different items of financial data.
His understanding was that Fernhurst Co merely had to ensure that the
investment had a positive net present value and shareholders were bound to be
satisfied with it, as it would maximise their wealth in the long term. The finance
director commented that, in reality, some shareholders looked at the performance
of the investments which Fernhurst Co made over the short term, whereas some
were more concerned with the longer term. The financial data he presented to
board meetings included both short and long-term measures.
Required:
(a) Evaluate the financial acceptability of the investment in the Milland and,
calculate and comment on the investment’s duration. (15 marks)
(b) Calculate the % change in the selling price required for the investment to have
a zero net present value, and discuss the significance of your results.
(5 marks)
(c) Discuss the non-executive director’s understanding of net present value and
explain the importance of other measures in providing data about an
investment’s short and long-term performance. (5 marks)
(25 marks)
MesmerMagic Co (June 2011)

MesmerMagic Co (MMC) is considering whether to undertake the development of
a new computer game based on an adventure film due to be released in 22
months. It is expected that the game will be available to buy two months after
the film’s release, by which time it will be possible to judge the popularity of the
film with a high degree of certainty. However, at present, there is considerable
uncertainty about whether the film, and therefore the game, is likely to be
successful. Although MMC would pay for the exclusive rights to develop and sell
the game now, the directors are of the opinion that they should delay the decision
to produce and market the game until the film has been released and the game
is available for sale.
MMC has forecast the following end of year cash flows for the four-year sales
period of the game.
Year 1 2 3 4
Cash flows ($ million) 25 18 10 5
MMC will spend $7 million at the start of each of the next two years to develop
the game, the gaming platform, and to pay for the exclusive rights to develop
and sell the game. Following this, the company will require $35 million for
production, distribution and marketing costs at the start of the four-year sales
period of the game.
It can be assumed that all the costs and revenues include inflation. The relevant
cost of capital for this project is 11% and the risk free rate is 3·5%. MMC has
estimated the likely volatility of the cash flows at a standard deviation of 30%.
www.lsbf.org.uk 171
Required:
(a) Estimate the financial impact of the directors’ decision to delay the production
and marketing of the game. The Black-Scholes Option Pricing model may be
used, where appropriate. All relevant calculations should be shown.
(12 marks)
(b) Briefly discuss the implications of the answer obtained in part (a) above.
(5 marks)
(17 marks)
Tisa Co (June 2012)

Tisa Co is considering an opportunity to produce an innovative component which,
when fitted into motor vehicle engines, will enable them to utilise fuel more
efficiently. The component can be manufactured using either process Omega or
process Zeta. Although this is an entirely new line of business for Tisa Co, it is of
the opinion that developing either process over a period of four years and then
selling the productions rights at the end of four years to another company may
prove lucrative.
The annual after-tax cash flows for each process are as follows:
Process Omega
Year 0 1 2 3 4
After-tax cash flows (3,800) 1,220 1,153 1,386 3,829

($000)
Process Zeta Year 0 1 2 3 4
After-tax cash flows (3,800) 643 546 1,055 5,990

($000)
Tisa Co has 10 million 50c shares trading at 180c each. Its loans have a current
value of $3·6 million and an average after-tax cost of debt of 4·50%. Tisa Co’s
capital structure is unlikely to change significantly following the investment in
either process.
Elfu Co manufactures electronic parts for cars including the production of a
component similar to the one being considered by Tisa Co. Elfu Co’s equity beta
is 1·40, and it is estimated that the equivalent equity beta for its other activities,
excluding the component production, is 1·25. Elfu Co has 400 million 25c shares
in issue trading at 120c each. Its debt finance consists of variable rate loans
redeemable in seven years. The loans paying interest at base rate plus 120 basis
points have a current value of $96 million. It can be assumed that 80% of Elfu
Co’s debt finance and 75% of Elfu Co’s equity finance can be attributed to other
activities excluding the component production.
Both companies pay annual corporation tax at a rate of 25%. The current base
rate is 3·5% and the market risk premium is estimated at 5·8%.
172 w w w . l s b f. o r g . u k
Required:
(a) Provide a reasoned estimate of the cost of capital that Tisa Co should use to
calculate the net present value of the two processes. Include all relevant
calculations. (8 marks)
(b) Calculate the internal rate of return (IRR) and the modified internal rate of
return (MIRR) for Process Omega. Given that the IRR and MIRR of Process
Zeta are 26·6% and 23·3% respectively, recommend which process, if any,
Tisa Co should proceed with and explain your recommendation. (8 marks)
(c) Elfu Co has estimated an annual standard deviation of $800,000 on one of its
other projects, based on a normal distribution of returns. The average annual
return on this project is $2,200,000.
Required:
Estimate the project’s Value at Risk (VAR) at a 99% confidence level for one
year and over the project’s life of five years. Explain what is meant by the
answers obtained. (4 marks)
(20 marks)
Fubuki Co (December 2010)
Fubuki Co, an unlisted company based in Megaera, has been manufacturing

electrical parts used in mobility vehicles for people with disabilities and the
elderly, for many years. These parts are exported to various manufacturers
worldwide but at present there are no local manufacturers of mobility vehicles in
Megaera. Retailers in Megaera normally import mobility vehicles and sell them at
an average price of $4,000 each. Fubuki Co wants to manufacture mobility
vehicles locally and believes that it can sell vehicles of equivalent quality locally
at a discount of 37·5% to the current average retail price.
Although this is a completely new venture for Fubuki Co, it will be in addition to
the company’s core business. Fubuki Co’s directors expect to develop the project
for a period of four years and then sell it for $16 million to a private equity firm.
Megaera’s government has been positive about the venture and has offered
Fubuki Co a subsidised loan of up to 80% of the investment funds required, at a
rate of 200 basis points below Fubuki Co’s borrowing rate. Currently Fubuki Co
can borrow at 300 basis points above the five-year government debt yield rate.
A feasibility study commissioned by the directors, at a cost of $250,000, has
produced the following information.
1. Initial cost of acquiring suitable premises will be $11 million, and plant and
machinery used in the manufacture will cost $3 million. Acquiring the premises
and installing the machinery is a quick process and manufacturing can
commence almost immediately.
2. It is expected that in the first year 1,300 units will be manufactured and sold.
Unit sales will grow by 40% in each of the next two years before falling to an
annual growth rate of 5% for the final year. After the first year the selling
price per unit is expected to increase by 3% per year.
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3. In the first year, it is estimated that the total direct material, labour and
variable overheads costs will be $1,200 per unit produced. After the first year,
the direct costs are expected to increase by an annual inflation rate of 8%.
4. Annual fixed overhead costs would be $2·5 million of which 60% are centrally
allocated overheads. The fixed overhead costs will increase by 5% per year
after the first year.
5. Fubuki Co will need to make working capital available of 15% of the

anticipated sales revenue for the year, at the beginning of each year. The
working capital is expected to be released at the end of the fourth year when
the project is sold.
Fubuki Co’s tax rate is 25% per year on taxable profits. Tax is payable in the
same year as when the profits are earned. Tax allowable depreciation is available
on the plant and machinery on a straight-line basis. It is anticipated that the value
attributable to the plant and machinery after four years is $400,000 of the price
at which the project is sold. No tax-allowable depreciation is available on the
premises.
Fubuki Co uses 8% as its discount rate for new projects but feels that this rate
may not be appropriate for this new type of investment. It intends to raise the
full amount of funds through debt finance and take advantage of the
government’s offer of a subsidised loan. Issue costs are 4% of the gross
finance required. It can be assumed that the debt capacity available to the
company is equivalent to the actual amount of debt finance raised for the project.
Although no other companies produce mobility vehicles in Megaera, Haizum Co,
a listed company, produces electrical-powered vehicles using similar technology
to that required for the mobility vehicles. Haizum Co’s cost of equity is estimated
to be 14% and it pays tax at 28%. Haizum Co has 15 million shares in issue
trading at $2·53 each and $40 million bonds trading at $94·88 per $100. The five-
year government debt yield is currently estimated at 4·5% and the market risk
premium at 4%.
Required:
(a) Evaluate, on financial grounds, whether Fubuki Co should proceed with the
project. (17 marks)
(b) Discuss the appropriateness of the evaluation method used and explain any
assumptions made in part (a) above. (8 marks)
(25 marks)
174 w w w . l s b f. o r g . u k
Burung Co (June 2014)
You have recently commenced working for Burung Co and are reviewing a four-
year project which the company is considering for investment. The project is in a
business activity which is very different from Burung Co’s current line of business.
The following net present value estimate has been made for the project:
All figures are in $ million

Year 0 1 2 3 4
Sales revenue 23·03 36·60 49·07 27·14
Direct project costs (13·82) (21·96) (29·44) (16·28)
Interest (1·20) (1·20) (1·20) (1·20)
Profit 8·01 13·44 18·43 9·66

Tax (20%) (1·60) (2·69) (3·69) (1·93)
Investment/sale (38·00) 4·00
Cash flows (38·00) 6·41 10·75 14·74 11·73

Discount factors 1 0·935 0·873 0·816 0·763
(7%)
Present values (38·00) 5·99 9·38 12·03 8·95
Net present value is negative $1·65 million, and therefore the recommendation is
that the project should not be accepted.
In calculating the net present value of the project, the following notes were made:
(i) Since the real cost of capital is used to discount cash flows, neither the sales
revenue nor the direct project costs have been inflated. It is estimated that
the inflation rate applicable to sales revenue is 8% per year and to the direct
project costs is 4% per year.
(ii) The project will require an initial investment of $38 million. Of this, $16
million relates to plant and machinery, which is expected to be sold for $4
million when the project ceases, after taking any taxation and inflation
impact into account.
(iii) Tax allowable depreciation is available on the plant and machinery at 50%
in the first year, followed by 25% per year thereafter on a reducing balance
basis. A balancing adjustment is available in the year the plant and
machinery is sold. Burung Co pays 20% tax on its annual taxable profits.
No tax allowable depreciation is available on the remaining investment
assets and they will have a nil value at the end of the project.
(iv) Burung Co uses either a nominal cost of capital of 11% or a real cost of
capital of 7% to discount all projects, given that the rate of inflation has
been stable at 4% for a number of years.
(v) Interest is based on Burung Co’s normal borrowing rate of 150 basis points
over the 10-year government yield rate.
www.lsbf.org.uk 175
(vi) At the beginning of each year, Burung Co will need to provide working
capital of 20% of the anticipated sales revenue for the year. Any remaining
working capital will be released at the end of the project.
(vii) Working capital and depreciation have not been taken into account in the
net present value calculation above, since depreciation is not a cash flow
and all the working capital is returned at the end of the project.
It is anticipated that the project will be financed entirely by debt, 60% of which
will be obtained from a subsidised loan scheme run by the government, which
lends money at a rate of 100 basis points below the 10-year government debt
yield rate of 2·5%. Issue costs related to raising the finance are 2% of the gross
finance required. The remaining 40% will be funded from Burung Co’s normal
borrowing sources. It can be assumed that the debt capacity available to Burung
Co is equal to the actual amount of debt finance raised for the project.
Burung Co has identified a company, Lintu Co, which operates in the same line of
business as that of the project it is considering. Lintu Co is financed by 40 million
shares trading at $3·20 each and $34 million debt trading at $94 per $100. Lintu
Co’s equity beta is estimated at 1·5. The current yield on government treasury
bills is 2% and it is estimated that the market risk premium is 8%. Lintu Co pays
tax at an annual rate of 20%.
Both Burung Co and Lintu Co pay tax in the same year as when profits are earned.
Required:
(a) Calculate the adjusted present value (APV) for the project, correcting any
errors made in the net present value estimate above, and conclude whether
the project should be accepted or not. Show all relevant calculations.
(15 marks)
(b) Comment on the corrections made to the original net present value estimate
and explain the APV approach taken in part (a), including any assumptions
made. (10 marks)
(25 marks)
176 w w w . l s b f. o r g . u k
UW Plc – BASED UPON WASHI FROM SEPT 2018 EXAM
UW Plc is a clothing label based in Europe. They are looking to open an outlet in
Japan to capitalise on a surge in demand for their garments from the country,
having witnessed a significant proportion of their online sales coming from
Japanese locations over the last 18 months. A distribution centre will be
established for online sales, and a retail outlet opened in Tokyo.
The marketing department have forecasted that 25,000 items will be sold in the
first year, with an increase of 4% in year 2 and 10% each year thereafter.
In the first year of trading the average price of each item sold is expected to be
Y12,400, whilst the annual direct costs will be Y250m. Both of these figures will
increase by the rate of inflation in Japan each year. To generate increased
awareness of the brand, a one-off cost of Y40m will be incurred at the end of year
1.
The investment in non-current assets will total Y120m, with a residual value at
the end of year 4 of Y40m. Additional investment in working capital equivalent to
12% of revenue will be required and should be in place at the start of each year.
This will be released in full at the end of year 4, when the project is expected to
end.
UW will charge a fixed fee of €3.50 per unit sold in Japan for the licensing of their
garments, this will be payable at the end of each year by the Japanese subsidiary.
It is anticipated that European online orders will reduce as a consequence of the
expansion, resulting in a lost contribution of €50,000 in the first year, and then
rising in line with European inflation.
Tax is charged in Japan at the rate of 22% whilst in Europe the rate is 30% both
payable a year in arrears. A double taxation treaty exists between Europe and
Japan, and loss relief is available if required. Tax allowable ‘depreciation’ is
available on non-current assets on a 25% written down allowance basis with a
balancing allowance or charge received in the final year.
The current spot rate is Y124 per €1. The predicted exchange rates will move in
line with purchase power parity theory, with Japan anticipating annual inflation of
2% whilst in Europe it will be 3%. The converted € cash flows will be discounted
using the company’s cost of capital of 12%.
Required:
Calculate the value of the proposed expansion into the Japanese market.
Show the Yen (Y) figures in Millions, and the Euro (€) figures in €000’s.
(15 marks)
www.lsbf.org.uk 177
Vogel Co (June 2014)

Vogel Co, a listed engineering company, manufactures large scale plant and
machinery for industrial companies. Until ten years ago, Vogel Co pursued a
strategy of organic growth. Since then, it has followed an aggressive policy of
acquiring smaller engineering companies, which it feels have developed new
technologies and methods, which could be used in its manufacturing processes.
However, it is estimated that only between 30% and 40% of the acquisitions
made in the last ten years have successfully increased the company’s shareholder
value.
Vogel Co is currently considering acquiring Tori Co, an unlisted company, which

has three departments. Department A manufactures machinery for industrial
companies, Department B produces electrical goods for the retail market, and the
smaller Department C operates in the construction industry. Upon acquisition,
Department A will become part of Vogel Co, as it contains the new technologies
which Vogel Co is seeking, but Departments B and C will be unbundled, with the
assets attached to Department C sold and Department B being spun off into a
new company called Ndege Co.
Given below are extracts of financial information for the two companies for the
year ended 30 April 2014.
Vogel Co Tori Co
$ million $ million
Sales revenue 790·2 124·6
Profit before depreciation, interest and tax (PBDIT) 244·4 37·4

Interest 13·8 4·3
Depreciation 72·4 10·1
Pre-tax profit 158·2 23·0
Vogel Co Tori Co
$ million $ million
Non-current assets 723·9 98·2
Current assets 142·6 46·5
7% unsecured bond – 40·0
Other non-current and current liabilities 212·4 20·2
Share capital (50c/share) 190·0 20·0
Reserves 464·1 64·5
Share of current and non-current assets and profit of Tori Co’s three departments:
Department Department Department

A B C
Share of current and non-current assets 40% 40% 20%

Share of PBDIT and pre-tax profit 50% 40% 10%
178 w w w . l s b f. o r g . u k
Other information
(i) It is estimated that for Department C, the realisable value of its non-current
assets is 100% of their book value, but its current assets’ realisable value
is only 90% of their book value. The costs related to closing Department C
are estimated to be $3 million.
(ii) The funds raised from the disposal of Department C will be used to pay off
Tori Co’s other non-current and current liabilities.
(iii) The 7% unsecured bond will be taken over by Ndege Co. It can be assumed
that the current market value of the bond is equal to its book value.
(iv) At present, around 10% of Department B’s PBDIT come from sales made to
Department C.
(v) Ndege Co’s cost of capital is estimated to be 10%. It is estimated that in

the first year of operation Ndege Co’s free cash flows to firm will grow by
20%, and then by 5·2% annually thereafter.
(vi) The tax rate applicable to all the companies is 20%, and Ndege Co can claim
10% tax allowable depreciation on its non-current assets. It can be assumed
that the amount of tax allowable depreciation is the same as the investment
needed to maintain Ndege Co’s operations.
(vii) Vogel Co’s current share price is $3 per share and it is estimated that Tori
Co’s price-to-earnings (PE) ratio is 25% higher than Vogel Co’s PE ratio.
After the acquisition, when Department A becomes part of Vogel Co, it is
estimated that Vogel Co’s PE ratio will increase by 15%.
(viii) It is estimated that the combined company’s annual after-tax earnings will
increase by $7 million due to the synergy benefits resulting from combining
Vogel Co and Department A.
Required:
(a) Discuss the possible reasons why Vogel Co may have switched its strategy of
organic growth to one of growing by acquiring companies. (4 marks)
(b) Discuss the possible actions Vogel Co could take to reduce the risk that the
acquisition of Tori Co fails to increase shareholder value. (7 marks)
(c) Estimate, showing all relevant calculations, the maximum premium Vogel Co
could pay to acquire Tori Co, explaining the approach taken and any
assumptions made. (14 marks)
(25 marks)
www.lsbf.org.uk 179
Pursuit Co (June 2011)
Pursuit Co, a listed company which manufactures electronic components, is

interested in acquiring Fodder Co, an unlisted company involved in the
development of sophisticated but high risk electronic products. The owners of
Fodder Co are a consortium of private equity investors who have been looking for
a suitable buyer for their company for some time. Pursuit Co estimates that a
payment of the equity value plus a 25% premium would be sufficient to secure
the purchase of Fodder Co. Pursuit Co would also pay off any outstanding debt
that Fodder Co owed. Pursuit Co wishes to acquire Fodder Co using a combination
of debt finance and its cash reserves of $20 million, such that the capital structure
of the combined company remains at Pursuit Co’s current capital structure level.
Information on Pursuit Co and Fodder Co
Pursuit Co
Pursuit Co has a market debt to equity ratio of 50:50 and an equity beta of 1·18.
Currently Pursuit Co has a total firm value (market value of debt and equity
combined) of $140 million.
Fodder Co, Income Statement Extracts
Year Ended 31 May 2011 31 May 2010 31 May 2009 31 May 2008
All amounts are in $’000
Sales revenue 16,146 15,229 14,491 13,559
Operating profit (after 5,169 5,074 4,243 4,530

operating costs and tax
allowable depreciation)
Net interest costs 489 473 462 458
Profit before tax 4,680 4,601 3,781 4,072
Taxation (28%) 1,310 1,288 1,059 1,140
After tax profit 3,370 3,313 2,722 2,932
Dividends 123 115 108 101
Retained earnings 3,247 3,198 2,614 2,831
Fodder Co has a market debt to equity ratio of 10:90 and an estimated equity
beta of 1·53. It can be assumed that its tax allowable depreciation is equivalent
to the amount of investment needed to maintain current operational levels.
However, Fodder Co will require an additional investment in assets of 22c per $1
increase in sales revenue, for the next four years. It is anticipated that Fodder Co
will pay interest at 9% on its future borrowings.
For the next four years, Fodder Co’s sales revenue will grow at the same average
rate as the previous years. After the forecasted four-year period, the growth rate
of its free cash flows will be half the initial forecast sales revenue growth rate for
the foreseeable future.
Information about the combined company
Following the acquisition, it is expected that the combined company’s sales

revenue will be $51,952,000 in the first year, and its profit margin on sales will
180 w w w . l s b f. o r g . u k
be 30% for the foreseeable future. After the first year the growth rate in sales
revenue will be 5·8% per year for the following three years. Following the
acquisition, it is expected that the combined company will pay annual interest at
6·4% on future borrowings.
The combined company will require additional investment in assets of $513,000
in the first year and then 18c per
$1 increase in sales revenue for the next three years. It is anticipated that after
the forecasted four-year period, its free cash flow growth rate will be half the
sales revenue growth rate.
It can be assumed that the asset beta of the combined company is the weighted
average of the individual companies’ asset betas, weighted in proportion of the
individual companies’ market value.
Other information
The current annual government base rate is 4·5% and the market risk premium
is estimated at 6% per year. The relevant annual tax rate applicable to all the
companies is 28%.
SGF Co’s interest in Pursuit Co
There have been rumours of a potential bid by SGF Co to acquire Pursuit Co.
Some financial press reports have suggested that this is because Pursuit Co’s
share price has fallen recently. SGF Co is in a similar line of business as Pursuit
Co and until a couple of years ago, SGF Co was the smaller company. However,
a successful performance has resulted in its share price rising, and SGF Co is now
the larger company.
The rumours of SGF Co’s interest have raised doubts about Pursuit Co’s ability to
acquire Fodder Co. Although SGF Co has made no formal bid yet, Pursuit Co’s
board is keen to reduce the possibility of such a bid. The Chief Financial Officer
has suggested that the most effective way to reduce the possibility of a takeover
would be to distribute the $20 million in its cash reserves to its shareholders in
the form of a special dividend. Fodder Co would then be purchased using debt
finance. He conceded that this would increase Pursuit Co’s gearing level but
suggested it may increase the company’s share price and make Pursuit Co less
appealing to SGF Co.
Required:
Prepare a report to the Board of Directors of Pursuit Co that:
(i) Evaluates whether the acquisition of Fodder Co would be beneficial to Pursuit

Co and its shareholders. The free cash flow to firm method should be used to
estimate the values of Fodder Co and the combined company assuming that
the combined company’s capital structure stays the same as that of Pursuit
Co’s current capital structure. Include all relevant calculations; (16 marks)
(ii) Discusses the limitations of the estimated valuations in part (i) above;
(4 marks)
(36 marks)
www.lsbf.org.uk 181
Levante Co (December 2011)
Levante Co has identified a new project for which it will need to increase its long-
term borrowings from $250 million to $400 million. This amount will cover a
significant proportion of the total cost of the project and the rest of the funds will
come from cash held by the company.
The current $250 million borrowing is in the form of a 4% bond which is trading
at $98·71 per $100 and is due to be redeemed at par in three years. The issued
bond has a credit rating of AA. The new borrowing will also be raised in the form
of a traded bond with a par value of $100 per unit. It is anticipated that the new
project will generate sufficient cash flows to be able to redeem the new bond at
$100 par value per unit in five years. It can be assumed that coupons on both
bonds are paid annually.
Both bonds would be ranked equally for payment in the event of default and the
directors expect that as a result of the new issue, the credit rating for both bonds
will fall to A. The directors are considering the following two alternative options
when issuing the new bond:
(i) Issue the new bond at a fixed coupon of 5% but at a premium or discount,
whichever is appropriate to ensure full take up of the bond; or
(ii) Issue the new bond at a coupon rate where the issue price of the new bond
will be $100 per unit and equal to its par value.
The following extracts are provided on the current government bond yield curve
and yield spreads for the sector in which Levante co-operates:
Current Government Bond Yield Curve
Years 1 2 3 4 5
Yield 3.2% 3.7% 4.2% 4.8% 5.0%

spreads (in
basis points)
Bond Rating 1 year 2 years 3 years 4 years 5 years
AAA 5 9 14 19 25
AA 16 22 30 40 47
A 65 76 87 100 112
BBB 102 121 142 167 193
182 w w w . l s b f. o r g . u k
Required:
(a) Calculate the expected percentage fall in the market value of the existing bond
if Levante Co’s bond credit rating falls from AA to A. (3 marks)
(b) Advise the directors on the financial implications of choosing each of the two
options when issuing the new bond. Support the advice with appropriate
calculations. (7 marks)
(c) Among the criteria used by credit agencies for establishing a company’s credit
rating are the following: industry risk, earnings protection, financial flexibility
and evaluation of the company’s management.
Briefly explain each criterion and suggest factors that could be used to assess
it. (8 marks)
(18 marks)
Sigra Co (December 2012)
Sigra Co is a listed company producing confectionary products which it sells

around the world. It wants to acquire Dentro Co, an unlisted company producing
high quality, luxury chocolates. Sigra Co proposes to pay for the acquisition using
one of the following three methods:
Method 1
A cash offer of $5·00 per Dentro Co share; or

Method 2
An offer of three of its shares for two of Dentro Co’s shares; or

Method 3
An offer of a 2% coupon bond in exchange for 16 Dentro Co’s shares. The bond
will be redeemed in three years at its par value of $100.
www.lsbf.org.uk 183
Extracts from the latest financial statements of both companies are as

follows:
Sigra Co Dentro Co
$’000 $’000
Sales revenue 44,210 4,680
Profit before tax 6,190 780
Taxation (1,240) (155)
Profit after tax 4,950 625
Dividends (2,700) (275)
Retained earnings for the year 2,250 350
Non-current assets 22,450 3,350
Current assets 3,450 247
Non-current liabilities 9,700 873
Current liabilities 3,600 436
Share capital (40c per share) 4,400 500
Reserves 8,200 1,788
Sigra Co’s current share price is $3·60 per share and it has estimated that Dentro
Co’s price to earnings ratio is 12·5% higher than Sigra Co’s current price to
earnings ratio. Sigra Co’s non-current liabilities include a 6% bond redeemable in
three years at par which is currently trading at $104 per $100 par value.
Sigra Co estimates that it could achieve synergy savings of 30% of Dentro Co’s
estimated equity value by eliminating duplicated administrative functions, selling
excess non-current assets and through reducing the workforce numbers, if the
acquisition were successful.
Required:
(a) Estimate the percentage gain on a Dentro Co share under each of the above
three payment methods. Comment on the answers obtained.
(16 marks)
(b) In relation to the acquisition, the board of directors of Sigra Co are considering
the following two proposals:
Proposal 1
Once Sigra Co has obtained agreement from a significant majority of the
shareholders, it will enforce the remaining minority shareholders to sell their
shares; and
Proposal 2
Sigra Co will offer an extra 3 cents per share, in addition to the bid price, to
30% of the shareholders of Dentro Co on a first-come, first-serve basis, as an
added incentive to make the acquisition proceed more quickly.
184 w w w . l s b f. o r g . u k
Required:
With reference to the key aspects of the global regulatory framework for
mergers and acquisitions, briefly discuss the above proposals. (4 marks)
(20 marks)
Ennea Co (June 2012)

Three proposals were put forward for further consideration after a meeting of the
executive directors of Ennea Co to discuss the future investment and financing
strategy of the business. Ennea Co is a listed company operating in the haulage
and shipping industry.
Proposal 1
To increase the company’s level of debt by borrowing a further $20 million and
use the funds raised to buy back share capital.
Proposal 2
To increase the company’s level of debt by borrowing a further $20 million and
use these funds to invest in additional non-current assets in the haulage strategic
business unit.
Proposal 3
To sell excess non-current haulage assets with a net book value of $25 million for
$27 million and focus on offering more services to the shipping strategic business
unit. This business unit will require no additional investment in non-current
assets. All the funds raised from the sale of the non-current assets will be used
to reduce the company’s debt.
Ennea Co financial information
Extracts from the forecast financial position for the coming year
$m
Non-current assets 282

Current assets 66
Total assets 348
Equity and liabilities

Share capital (40c per share par value) 48
Retained earnings 123
Total equity 171
Non-current liabilities 140

Current liabilities 37
Total liabilities 177
Total liabilities and capital 348
www.lsbf.org.uk 185
Ennea Co’s forecast after tax profit for the coming year is expected to be $26
million and its current share price is $3·20 per share. The non-current liabilities
consist solely of a 6% medium term loan redeemable within seven years. The
terms of the loan contract stipulates that an increase in borrowing will result in
an increase in the coupon payable of 25 basis points on the total amount
borrowed, while a reduction in borrowing will lower the coupon payable by 15
basis points on the total amount borrowed.
Ennea Co’s effective tax rate is 20%. The company’s estimated after tax rate of
return on investment is expected to be 15% on any new investment. It is
expected that any reduction in investment would suffer the same rate of return.
Required:
(a) Estimate and discuss the impact of each of the three proposals on the forecast
statement of financial position, the earnings and earnings per share, and
gearing of Ennea Co. (20 marks)
(b) An alternative suggestion to proposal three was made where the non-current
assets could be leased to other companies instead of being sold. The lease
receipts would then be converted into an asset through securitisation. The
proceeds from the sale of the securitised lease receipts asset would be used
to reduce the outstanding loan borrowings.
Required:
Explain what the securitisation process would involve and what would be the
key barriers to Ennea Co undertaking the process. (5 marks)
(25 marks)
Tillinton Co (September 2018)
Tillinton Co is a listed company which has traditionally manufactured children’s

clothing and toys with long lives. Five years ago, it began manufacturing
electronic toys and has since made significant investment in development and
production facilities. The first electronic toys which Tillinton Co introduced into the
market were received very well, partly as it was seen to be ahead of its
competitors in making the most of the technology available.
The country where Tillinton Co is listed has seen a significant general increase in
share prices over the last three years, with companies in the electronic goods
sector showing particularly rapid increases.
Statement by Tillinton Co’s chief executive
Assume it is now September 20X3. Tillinton Co’s annual report for the year ended
31 March 20X3 has just been published. Its chief executive commented when
announcing the company’s results:
‘I am very pleased to report that revenue and gross profits have shown bigger
increases than in 20X2, resulting in higher post-tax earnings and our company
being able to maintain increases in dividends. The sustained increase in our share
186 w w w . l s b f. o r g . u k
price clearly demonstrates how happy investors are with us. Our cutting-edge
electronic toys continue to perform well and justify our sustained investment in
them. Our results have also benefited from improvements in operational
efficiencies for our older ranges and better working capital management. We are
considering the development of further ranges of electronic toys for children, or
developing other electronic products for adults. If necessary, we may consider
scaling down or selling off our operations for some of our older products.’
Steph Slindon represents an institutional investor who holds shares in Tillinton

Co. Steph is doubtful whether its share price will continue to increase, because
she thinks that Tillinton Co’s situation may not be as good as its chief executive
suggests and because she believes that current share price levels generally may
not be sustainable.
Financial information
Extracts from Tillinton Co’s financial statements for the last three years and other
information about it are given below.
Tillinton Co statement of profit or loss in years ending 31 March

(all amounts in $m)
www.lsbf.org.uk 187
Tillinton Co statement of financial position in years ending 31 March

(all amounts in $m)
Note: None of Tillinton Co’s loan finance in 20X3 is repayable within one year.
Required:
(a) Evaluate Tillinton Co’s performance and business prospects in the light of the
chief executive’s comments and Steph Slindon’s concerns. Provide relevant
calculations for ratios and trends to support your evaluation.
Note: 10 marks are available for the calculations. (20 marks)
(b) Discuss how behavioural factors may have resulted in Tillinton Co’s share price
being higher than is warranted by a rational analysis of its position.
(5 marks)
(25 marks)
188 w w w . l s b f. o r g . u k
Chawan Co (June 2015)
The treasury department of Chawan Co, a listed company, aims to maintain a

portfolio of around $360 million consisting of equity shares, corporate bonds and
government bonds, which it can turn into cash quickly for investment projects.
Chawan Co is considering disposing 27 million shares, valued at $2·15 each, which
it has invested in Oden Co. The head of Chawan Co’s treasury department is of
the opinion that, should the decision be made to dispose of its equity stake in
Oden Co, this should be sold through a dark pool network and not sold on the
stock exchange where Oden Co’s shares are listed. In the last few weeks, there
have also been rumours that Oden Co may become subject to a takeover bid.
Oden Co operates in the travel and leisure (T&L) sector, and the poor weather
conditions in recent years, coupled with a continuing recession, has meant that
the T&L sector is under-performing. Over the past three years, sales revenue fell
by an average of 8% per year in the T&L sector. However, there are signs that
the economy is starting to recover, but this is by no means certain.
Given below are extracts from the recent financial statements and other financial
information for Oden Co and the T&L sector.
Oden Co
Year ending 31 May (all amounts in $m) 2013 2014 2015
Total non-current assets 972 990 980

Total current assets 128 142 126
Total assets 1,100 1,132 1,106
Equity
Ordinary shares ($0·50) 300 300 300
Reserves 305 329 311
Total equity 605 629 611
Non-current liabilities
Bank loans 115 118 100
Bonds 250 250 260
Total non-current liabilities 365 368 360
Current liabilities
Trade and other payables 42 45 37
Bank overdraft 88 90 98
Total current liabilities 130 135 135
Total equity and liabilities 1,100 1,132 1,106
www.lsbf.org.uk 189
Oden Co
Year ending 31 May (all amounts in $m) 2013 2014 2015
Sales revenue 1,342 1,335 1,185

Operating profit 218 203 123
Finance costs (23) (27) (35)
Profit before tax 195 176 88
Taxation (35) (32) (16)
Profit for the year 160 144 72
Other financial information (Based on annual figures till 31 May of each year)
2012 2013 2014 2015
Oden Co average share price ($) 2·10 2·50 2·40 2·20

Oden Co dividend per share ($) 0·15 0·18 0·20 0·15
T&L sector average share price ($) 3·80 4·40 4·30 4·82
T&L sector average earnings per share ($) 0·32 0·36 0·33 0·35
T&L sector average dividend per share ($) 0·25 0·29 0·29 0·31
Oden Co’s equity beta 1·5 1·5 1·6 2·0
T&L sector average equity beta 1·5 1·4 1·5 1·6
The risk-free rate and the market return have remained fairly constant over the
last ten years at 4% and 10% respectively.
Required:
(a) Explain what a dark pool network is and why Chawan Co may want to dispose
of its equity stake in Oden Co through one, instead of through the stock
exchange where Oden Co’s shares are listed. (5 marks)
(b) Discuss whether or not Chawan Co should dispose of its equity stake in Oden
Co. Provide relevant calculations to support the discussion.
Note: Up to 10 marks are available for the calculations. (20 marks)
(25 marks)
190 w w w . l s b f. o r g . u k
Lirio Co (March/June 2016)
Lirio Co is an engineering company which is involved in projects around the world.

It has been growing steadily for several years and has maintained a stable
dividend growth policy for a number of years now. The board of directors (BoD)
is considering bidding for a large project which requires a substantial investment
of $40 million. It can be assumed that the date today is 1 March 2016.
The BoD is proposing that Lirio Co should not raise the finance for the project
through additional debt or equity. Instead, it proposes that the required finance
is obtained from a combination of funds received from the sale of its equity
investment in a European company and from cash flows generated from its
normal business activity in the coming two years. As a result, Lirio Co’s current
capital structure of 80 million $1 equity shares and $70 million 5% bonds is not
expected to change in the foreseeable future.
The BoD has asked the company’s treasury department to prepare a discussion
paper on the implications of this proposal. The following information on Lirio Co
has been provided to assist in the preparation of the discussion paper.
Expected income and cash flow commitments prior to undertaking the
large project for the year to the end of February 2017
Lirio Co’s sales revenue is forecast to grow by 8% next year from its current level
of $300 million, and the operating profit margin on this is expected to be 15%. It
is expected that Lirio Co will have the following capital investment requirements
for the coming year, before the impact of the large project is considered:
1. A $0·10 investment in working capital for every $1 increase in sales revenue;
2. An investment equivalent to the amount of depreciation to keep its non-

current asset base at the present productive capacity. The current
depreciation charge already included in the operating profit margin is 25% of
the non-current assets of $50 million;
3. A $0·20 investment in additional non-current assets for every $1 increase in

sales revenue;
4. $8 million additional investment in other small projects.
In addition to the above sales revenue and profits, Lirio Co has one overseas
subsidiary - Pontac Co, from which it receives dividends of 80% on profits. Pontac
Co produces a specialist tool which it sells locally for $60 each. It is expected that
it will produce and sell 400,000 units of this specialist tool next year. Each tool
will incur variable costs of $36 per unit and total annual fixed costs of $4 million
to produce and sell.
Lirio Co pays corporation tax at 25% and Pontac Co pays corporation tax at 20%.
In addition to this, a withholding tax of 8% is deducted from any dividends
remitted from Pontac Co. A bi-lateral tax treaty exists between the countries
where Lirio Co is based and where Pontac Co is based. Therefore corporation tax
is payable on profits made by subsidiary companies, but full credit is given for
corporation tax already paid.
It can be assumed that receipts from Pontac Co are in $ equivalent amounts and
exchange rate fluctuations on these can be ignored.
Sale of equity investment in the European country
It is expected that Lirio Co will receive Euro (€) 20 million in three months’ time
from the sale of its investment. The € has continued to remain weak, while the $
has continued to remain strong through 2015 and the start of 2016. The financial
www.lsbf.org.uk 191
press has also reported that there may be a permanent shift in the €/$ exchange
rate, with firms facing economic exposure. Lirio Co has decided to hedge the €
receipt using one of currency forward contracts, currency futures contracts or
currency options contracts.
The following exchange contracts and rates are available to Lirio Co.
Per €1
Spot rates $1·1585-$1·1618

Three-month forward rates $1·1559-$1·1601
Currency futures (contract size $125,000, quotation: € per $1)
March futures €0·8638

June futures €0·8656
Currency options (contract size $125,000, exercise price quotation € per

$1, premium € per $1)
Calls Puts
Exercise price March June March June
0·8600 0·0255 0·0290 0·0267 0·0319
It can be assumed that futures and options contracts expire at the end of their
respective months.
Dividend history, expected dividends and cost of capital, Lirio Co
Year to end of February 2013 2014 2015 2016
Number of $1 equity shares in 60,000 60,000 80,000 80,000

issue (000)
Total dividends paid ($000) 12,832 13,602 19,224 20,377
It is expected that dividends will grow at the historic rate, if the large project is
not undertaken. Expected dividends and dividend growth rates if the large project
is undertaken
Year to end of February 2017 Remaining cash flows after the investment in the
$40 million project will be paid as dividends.
Year to end of February 2018 The dividends paid will be the same amount as
the previous year.
Year to end of February 2019 Dividends paid will be $0·31 per share.
In future years from February Dividends will grow at an annual rate of 7%.
2019
Lirio Co’s cost of equity capital is estimated to be 12%.
192 w w w . l s b f. o r g . u k
Required:
(a) With reference to purchasing power parity, explain how exchange rate
fluctuations may lead to economic exposure. (6 marks)
(b) Prepare a discussion paper, including all relevant calculations, for the
board of directors (BoD) of Lirio Co which:
(i) Estimates Lirio Co’s dividend capacity as at 28 February 2017, prior
to investing in the large project;
(9 marks)
(ii) Advises Lirio Co on, and recommends, an appropriate hedging

strategy for the Euro (€) receipt it is due to receive in three months’
time from the sale of the equity investment;
(14 marks)
(iii) Using the information on dividends provided in the question, and from
(b) (i) and (b) (ii) above, assesses whether or not the project would
add value to Lirio Co; (8 marks)
(iv) Discusses the issues of proposed methods of financing the project

which need to be considered further.
(9 marks)
Professional marks will be awarded in part (b) for the format, structure and
presentation of the discussion paper. (4 marks)
(50 marks)
www.lsbf.org.uk 193
Kenduri Co (June 2013)

Kenduri Co is a large multinational company based in the UK with a number of
subsidiary companies around the world. Currently, foreign exchange exposure as
a result of transactions between Kenduri Co and its subsidiary companies is
managed by each company individually. Kenduri Co is considering whether or not
to manage the foreign exchange exposure using multilateral netting from the UK,
with the Sterling Pound (£) as the base currency. If multilateral netting is
undertaken, spot mid-rates would be used.
The following cash flows are due in three months between Kenduri Co and three
of its subsidiary companies. The subsidiary companies are Lakama Co, based in
the United States (currency US$), Jaia Co, based in Canada (currency CAD) and
Gochiso Co, based in Japan (currency JPY).
Owed by Owed to Amount
Kenduri Co Lakama Co US$ 4·5 million

Kenduri Co Jaia Co CAD 1·1 million
Gochiso Co Jaia Co CAD 3·2 million
Gochiso Co Lakama Co US$ 1·4 million
Jaia Co Lakama Co US$ 1·5 million
Jaia Co Kenduri Co CAD 3·4 million
Lakama Co Gochiso Co JPY 320 million
Lakama Co Kenduri Co US$ 2·1 million
Exchange rates available to Kenduri Co
US$/£1 CAD/£1 JPY/£1
Spot 1·5938-1·5962 1·5690–1·5710 131·91–133·59

3-month forward 1·5996-1·6037 1·5652–1·5678 129·15–131·05
Currency options available to Kenduri Co

Contract size £62,500, Exercise price quotation: US$/£1, Premium: cents
per £1
Call Options Put Options

Exercise 3-month 6-month 3-month 6-month
price expiry expiry expiry expiry
1·60 1·55 2·25 2·08 2·23
1·62 0·98 1·58 3·42 3·73
It can be assumed that option contracts expire at the end of the relevant month
194 w w w . l s b f. o r g . u k
Annual interest rates available to Kenduri Co and subsidiaries
Borrowing rate Investing rate
UK 4·0% 2·8%
United States 4·8% 3·1%
Canada 3·4% 2·1%
Japan 2·2% 0·5%
Required:
(a) Advise Kenduri Co on, and recommend, an appropriate hedging strategy for
the US$ cash flows it is due to receive or pay in three months, from Lakama
Co. Show all relevant calculations to support the advice given. (12 marks)
(b) Calculate, using a tabular format (transactions matrix), the impact of

undertaking multilateral netting by Kenduri Co and its three subsidiary
companies for the cash flows due in three months. Briefly discuss why some
governments allow companies to undertake multilateral netting, while others
do not. (10 marks)
(c) When examining different currency options and their risk factors, it was
noticed that a long call option had a high gamma value. Explain the possible
characteristics of a long call option with a high gamma value.
(3 marks)
(25 marks)
Alecto Co (December 2011)

Alecto Co, a large listed company based in Europe, is expecting to borrow
€22,000,000 in four months’ time on 1 May 2012. It expects to make a full
repayment of the borrowed amount nine months from now. Currently there is
some uncertainty in the markets, with higher than normal rates of inflation, but
an expectation that the inflation level may soon come down. This has led some
economists to predict a rise in interest rates and others suggesting an unchanged
outlook or maybe even a small fall in interest rates over the next six months.
Although Alecto Co is of the opinion that it is equally likely that interest rates
could increase or fall by 0·5% in four months, it wishes to protect itself from
interest rate fluctuations by using derivatives. The company can borrow at LIBOR
plus 80 basis points and LIBOR is currently 3·3%. The company is considering
using interest rate futures, options on interest rate futures or interest rate collars
as possible hedging choices.
The following information and quotes from an appropriate exchange are provided
on Euro futures and options. Margin requirements may be ignored.
Three month Euro futures, €1,000,000 contract, tick size 0·01% and tick value
€25:
• March 96·27
• June 96·16
• September 95·90
www.lsbf.org.uk 195
Options on three month Euro futures, €1,000,000 contract, tick size 0·01% and
tick value €25. Option premiums are in annual %.
Calls Strike Puts
March June September March June September
0.279 0.391 0.446 96.00 0.006 0.163 0.276
0.012 0.090 0.263 96.50 0.196 0.581 0.754
It can be assumed that settlement for both the futures and options contracts is
at the end of the month. It can also be assumed that basis diminishes to zero at
contract maturity at a constant rate and that time intervals can be counted in
months.
Required:
(a) Briefly discuss the main advantage and disadvantage of hedging interest rate
risk using an interest rate collar instead of options. (4 marks)
(b) Based on the three hedging choices Alecto Co is considering and assuming
that the company does not face any basis risk, recommend a hedging strategy
for the €22,000,000 loan. Support your recommendation with appropriate
comments and relevant calculations in €. (17 marks)
(c) Explain what is meant by basis risk and how it would affect the
recommendation made in part (b) above. (4 marks)
(25 marks)
Awan Co (December 2013)

Awan Co is expecting to receive $48,000,000 on 1 February 2014, which will be
invested until it is required for a large project on 1 June 2014. Due to uncertainty
in the markets, the company is of the opinion that it is likely that interest rates
will fluctuate significantly over the coming months, although it is difficult to
predict whether they will increase or decrease.
Awan Co’s treasury team want to hedge the company against adverse movements
in interest rates using one of the following derivative products:
Forward rate agreements (FRAs);
Interest rate futures; or
Options on interest rate futures.
Awan Co can invest funds at the relevant inter-bank rate less 20 basis points. The
current inter-bank rate is 4·09%. However, Awan Co is of the opinion that interest
rates could increase or decrease by as much as 0·9% over the coming months.
196 w w w . l s b f. o r g . u k
The following information and quotes are provided from an appropriate exchange
on $ futures and options. Margin requirements can be ignored.
Three-month $ futures, $2,000,000 contract size
Prices are quoted in basis points at 100 – annual % yield
December 2013: 94·80

March 2014: 94·76
June 2014: 94·69
Options on three-month $ futures, $2,000,000 contract size, option premiums are

in annual %
Calls Strike Puts
December March June December March June
0·342 0·432 0·523 94·50 0·090 0·119 0·271

0·097 0·121 0·289 95·00 0·312 0·417 0·520
Voblaka Bank has offered the following FRA rates to Awan Co:
1–7: 4·37%
3–4: 4·78%
3–7: 4·82%
4–7: 4·87%
It can be assumed that settlement for the futures and options contracts is at the
end of the month and that basis diminishes to zero at contract maturity at a
constant rate, based on monthly time intervals. Assume that it is 1 November
2013 now and that there is no basis risk.
Required:
(a) Based on the three hedging choices Awan Co is considering, recommend a

hedging strategy for the $48,000,000 investment, if interest rates increase or
decrease by 0·9%. Support your answer with appropriate calculations and
discussion. (19 marks)
(b) A member of Awan Co’s treasury team has suggested that if option contracts
are purchased to hedge against the interest rate movements, then the number
of contracts purchased should be determined by a hedge ratio based on the
delta value of the option.
Required:
Discuss how the delta value of an option could be used in determining the number
of contracts purchased.
(6 marks)
(25 marks)
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ACCA Paper AFM

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: FINANCIAL STRATEGY FORMULATION 13

CHAPTER 2: DISCOUNTED CASH FLOW TECHNIQUES 25

CHAPTER 3: APPLICATION OF OPTION PRICING IN INVESTMENT DECISIONS 35

CHAPTER 4: IMPACT OF FINANCING ON INVESTMENT DECISIONS 43

CHAPTER 5: ADJUSTED PRESENT VALUE 57

CHAPTER 6: INTERNATIONAL INVESTMENT APPRAISAL 63

CHAPTER 7: ACQUISITIONS AND MERGERS 71

CHAPTER 8: BUSINESS VALUATIONS 75

CHAPTER 10: CORPORATE RECONSTRUCTION AND REORGANISATION 91

CHAPTER 11: HEDGING FOREIGN EXCHANGE RISK 99

CHAPTER 12: HEDGING INTEREST RATE RISK 111

SOLUTIONS TO EXAMPLES 119

CLASS NOTES QUESTIONS 165

Outline of the syllabus

Format of the exam paper

Modigliani and Miller Proposition 2 (with tax)

The Capital Asset Pricing Model

The asset beta formula

The Growth Model

Gordon’s growth approximation

The weighted average cost of capital

The Fisher formula

Purchasing power parity and interest rate parity

Modified Internal Rate of Return

The Black Scholes Option

The Put Call Parity relationship

Present value table

Discount rate (r)

Where r = discount rate

Discount rate (r)

Standard normal distribution table

Primary financial management objective

Core financial management decisions

1. The investment decision

2. The financing decision

3. The dividend decision

Other financial management responsibilities

2. Communication of financing decisions

3. Incorporate adequate financial planning and control

Treasury Management Function

A regional treasury department is better equipped to respond in a time conscious

POSSIBLE APPROACHES TO DIVIDEND POLICY

1. Constant Pay-out Ratio

2. Stable Dividend Policy

3. Residual Dividend Policy

DIVIDEND POLICY AND SHAREHOLDERS’ WEALTH

Dividend relevance theory – traditional theory

Dividend irrelevance theory – Modigliani and Miller (M&M)

Conflict between stakeholder groups

Money as a prime motivator

Triple bottom line reporting

Free trade and protectionism

Risks of foreign trade

TRANSFER PRICING WITHIN MULTINATIONALS

DARK POOL TRADING

DISCOUNTED CASH FLOW TECHNIQUES

Net present value (NPV)

Internal Rate of Return (IRR)

Discounted payback period (DPB)