F3 Course Notes

F3 Course note
Syllabus A: Financial policy decisions ...........................................2

Syllabus A1: Advise on strategic nancial objectives .................................................2
Syllabus A2. Financial policy decisions ..................................................................32
Syllabus A3. In uences on nancial strategic decisions ...........................................67
Syllabus B: Sources of long term funds ......................................74
Syllabus B1. Capital structure ..............................................................................74
Syllabus B2. Analyse long-term debt nance .........................................................90
Syllabus B3. Evaluate equity nance ...................................................................127
Syllabus B4. Evaluate dividend policy ..................................................................137
Syllabus C. Financial risks ........................................................149
Syllabus C1. The sources and types of nancial risks ...........................................149
Syllabus C2. Evaluate nancial risk .....................................................................151
Syllabus C3. Hedging techniques for foreign currency risk ....................................166
Syllabus C3. Hedging techniques for interest rate risk ..........................................181
Syllabus D. Business valuation .................................................191
Syllabus D1. Acquisition, merger and divestment .................................................191
Syllabus D2. Valuation methods .........................................................................204
Syllabus D4. Post-transaction issues ..................................................................267
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Syllabus A: Financial policy decisions
Syllabus A1: Advise on strategic nancial objective
Types of organisation
The organisatio
can be
1. Privat
Owned and operated by private individua
2. Publi
Owned by stat
PRIVATE SECTO
Motive of Private organisations can be
• For - Pro
Strategic nancial objectives is
maximising shareholder wealth (by paying dividends and increasing the share
price) o
- providing a surplus (e.g. additional cash in the bank
• Not-for-pro
Strategic nancial objectives is Value for mone
For - Pro t organisatio
Business organisations engage in commercial and industrial activities, with the
purpose of making a pro t
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1. Sole Trade
An individual sets up business on his ow
Sole traders are people who work for themselves.
Examples include:
- a hairdresse
- a local statione
- a plumbe
The owner has UNLIMITED LIABILITY for the debts of his business
It means that the law will not distinguish between the private assets and liabilities
of the owner to those of the organisation
In case of bankruptcy the owner can lose his personal assets
e.g. if the business has debts that it is unable to pay, the sole trader will become
personally liable for the unpaid debts and would be required, if necessary, to sell
his private possessions (e.g. his car or house) to repay them
2. Partnershi
Partnerships occur when two or more people decide to run a business together
Examples include
- an accountancy practic
- a legal practice
- a medical practic
The owners have UNLIMITED LIABILITY for the debts of their business
In general, the partners have unlimited liability although there may be
circumstances when one or more partners have limited liabilit
3. Incorporated entities (Companies

These companies have a LIMITED LIABILIT
This means that the maximum amount that an owner will lose in the event that
the company becomes insolvent and cannot pay off its debts, is his share of the
capital in the business
In all cases, we apply the separate entity concept, i.e. the business is regarded
as being separate from the owner (or owners) and the accounts are prepared for
the business itself
The shareholders cannot normally be sued for the debts of the business
Their risk is generally restricted to the amount that they have invested in the
company when buying the shares (limited liability)
The strategic nancial objective of a compan

Maximisation of shareholders wealt
Types of company
• Quoted compan
a company whose shares can be bought or sold on the Stock Exchang
• Unquoted compan
A company with previously issued securities that are no longer quoted or traded
on formal exchanges
Shares in these companies are available in the over-the-counter market (OTC
Summar
The entity can be
1. Incorporate
2. Unincorporate
Unincorporated entitie
are not incorporated as companies
They have Unlimited personal liability (joint & several
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They can be
• for pro
e.g. Sole trader, Partnership
The strategic nancial objective is to maximise pro
• not-for-pro
e.g. clubs and societie
The strategic nancial objective is to achieve value for mone
Not-for-pro t organisation
A non-pro t organisation (NFP) works with a prime intention (primary goal) of
providing a good or a service to different sectors of society for which they are set up
to provide a bene t
NFP has to be ef ciently managed so that their resources are used effectively to
meet the objectives of the organisation while not making a nancial los
• For example, a school is set up to provide education.
Charities, such as, the Red Cross is set up to provide a medical service
PUBLIC SECTO
Public Sector organisations are owned or run by the governmen
They are funded by and accountable to the government.
A major challenge that any government faces is that of balancing their limited
resources with a huge demand for public services
Examples of a public sector organisation are

1. Hospital
2. Armed Force
3. Centrally funded agencie
4. Most schools & Universitie
5. Government Department
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Non-Quanti able objective
Not-for-pro t organisatio
Its rst objective is to be involved in non-loss operations to cover its cost
For example
1. Charitie
2. Statutory bodies offering public transport or the provision of services such as
leisure, health or public utilities such as water or road maintenance
Objectives for not-for-pro t organisation

A major problem with many not-for-pro t organisations, particularly government
bodies, is that it is extremely dif cult to de ne their objectives at all
NFP objectives include
• Surplus maximisation (equivalent to pro t maximisation
• Revenue maximisation (as for a commercial business
• Producer satisfaction maximisation (satisfying the wants of staff and volunteers
• Client satisfaction maximisation (the police generating the support of the public
It is also dif cult to measure the performance of not-for-pro t organisations
As already said, it is sometimes very dif cult to de ne their objective at all, let alone
try to measure their performance
Example of NF
One of the objectives of the local council could be ‘to provide adequate street lighting
throughout the area’
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Its other objective could be to improve road safety
• How could the ‘adequacy’ of street lighting be measured
• What is the amount of money to pay for adequately lit streets and improved road
safety
Without information about what is being achieved (outputs) and what it is costing
(inputs), it is impossible to make ef cient resource allocations
These allocation decisions rely on a range of performance measures which, if

unavailable, may lead managers to allocate resources based on subjective
judgment
Without performance measures, managers will not know the extent to which
operations are contributing to effectiveness and ef ciency; when diagnostic
interventions are necessary; how the performance of their organisation compares
with similar units elsewhere; and how their performance has changed over time
Government may require performance information to decide how much to spend in

the public sector and where, within the sector, it should be allocated
In particular they will be interested to know what results may be achieved as a

consequence of a particular level of funding, or to decide whether or not a service
could be delivered more effectively and ef ciently in the private sector
Likewise people who provide funds for other kinds of not-for-pro t organisations are
entitled to know whether their money is being put to good use
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Value for Money (VFM
Not-for-pro t organisatio
Indicators to assess overall performanc
1. Effectivenes
• Financial indicator
o Quality of service/output measures; e.g. exam results; pupil/teacher
rati
o Utilisation of resources; e.g. hospital bed occupancy; are trained
teachers fully used to teach the subjects they have been trained for
o Flexibility; e.g. average waiting tim
• Non- nancial indicator
o Workplace moral
o Staff attitude to dealing with the publi
o Client satisfaction in the service being provide
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2. Ef cienc
Financial indicators to measure ef cienc
• Cost per unit of activity (e.g. cost per student
• Variance analysi
• Comparisons with benchmark informatio
• Cost component as a proportion of total cost
• Costs recovered as a proportion of costs incurred (eg payment received from
householders requesting collection of bulky/unusual items of refuse
3. Econom
A-value-for-money (VFM) audit will look also at the economy of the use of resources,
for e.g. in the case of state education, it will look into the cost wages of school
teachers, the cost of books, equipment
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Non- nancial objective
Non- nancial objectives such a
1. Quality measure
2. Innovation measure
3. Customer-based measure
A company's non- nancial objectives may include the followin
• Social and relationshi
Customer satisfactio
A key target, because of the adverse nancial consequences if businesses switch

supplier
Responsibilities to supplier
Not exploiting power as buyer unscrupulousl
• Natura
Welfare of societ
Concern for environmen
• Huma
Welfare of employee
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Competitive wages and salaries, comfortable and safe working conditions, good
training and career developmen
Welfare of managemen
High salaries, company cars, bonuse
• Intellectua
Leadership in research and developmen
Failure to innovate may have adverse long-term nancial consequences
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Non-Financial Performance Indicator
Non- nancial objectives such a
1. Quality measure
2. Innovation measure
3. Customer-based measure
In recent years, the trend in performance measurement has been towards a broader
view of performance, covering both nancial and non- nancial indicators
The most well-known of these approaches is the balanced scorecard proposed by

Kaplan and Norton, which we will be describing later
Areas to measure should relate to an organisation's critical success factors. Critical

success factors (CSFs) are performance requirements which are fundamental to an
organisation's success (for example innovation in a consumer electronics company)
and can usually be identi ed from an organisation's mission statement, objectives
and strategy
Key performance indicators (KPIs) are measurements of achievement of the chosen

critical success factors. Key performance indicators should be
• speci c (i.e. measure pro tability rather than ' nancial performance', a term which
could mean different things to different people
• measurable (i.e. be capable of having a measure placed upon it, for example, a
number of customer complaints rather than the 'level of customer satisfaction'
• relevant, in that they measure achievement of a critical success factor
The following table demonstrates critical success factors and key performance
indicators of a college training ACCA students
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Perspective Critical success factor Key performance indicators
Financia shareholder wealt

dividend yield; % increase in share price
success
cash o actual vs budge
debtor days
exam succes college pass rate vs national averag

Custome
premier college statu
satisfaction
tutor grading by students
average number of course variants pe

exibilit
subject (eg full-time, day release
evening)
proces % room occupanc

resource utilisatio
ef cienc average class siz
average tutor teaching load (days)
growt innovation product % of sales from < 1 year ol

information technology number of online enrolments
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Balanced Score card – Performanc
The Balanced Scorecar
The Balanced Scorecard was popularised by Robert Kaplan and David Norton in
1992
The rationale for the development of the Balanced Scorecard was a growing
dissatisfaction with traditional, nancial measures of performance.
The balanced scorecard approach emphasises the need to provide management
with a set of information which covers all relevant areas of performance in an
objective and unbiased fashion
The scorecard designed by Kaplan and Norton contains four key groupings of
performance measures
These four groupings, called ‘perspectives’ by Kaplan and Norton, were considered
suf cient to track the key drivers of both current and future nancial performance of
the rm
The perspectives focused on the achievements of the rm in four areas
1. The nancial perspectiv
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- concentrates on how the rm appears to its shareholders and considers what

the rm’s nancial objectives are
The measures used to assess whether these objectives are being achieved
typically include, pro t, sales, ROI, cash ow or economic value added (EVA)
2. The customer perspectiv
- focuses on the question, what must the rm do to satisfy its customers so as to

achieve its nancial objectives
Outcome measures for the customer perspective generally include measures of

customer satisfaction, market share, customer retention and customer
pro tability
These outcome measures can be sub-divided into driver measures, such as

measures relating to lead times, on-time delivery, product quality and product
cost
3. The internal business perspectiv
- considers the question, what must the rm do well internally in order to support
the product/market strategy and to achieve its nancial objectives
Typical outcome measures include those relating to innovation (product and

process) and operations (cycle times, defect rates)
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4. In the learning and growth perspectiv
- the measures focus on the question what infrastructure must the rm build to
create long-term growth and improvement
In other words, what capabilities must be improved or acquired to achieve the

long-term targets for the customer and internal business process perspectives
Outcome measures may include metrics on employee satisfaction, training, and

retention
Perspective Question Explanation
Gives rise to targets that matter

What do existing and
to customers: cost, quality,
Customer new customers value
delivery, inspection, handling
from us?
and more.
What processes must we

excel at to achieve our Aims to improve internal
Internal
nancial and customer processes and decision making.
objectives?
Considers the business's

Can we continue to capacity to maintain its
Innovation and
improve and create competitive position through the
learning
future value? acquisition of new skills and the
development of new products.
Covers traditional measures

such as growth, pro tability and
How do we create value shareholder value but set
Financial
for our shareholders? through talking to the
shareholder or shareholders
direct.
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The following is an example of a balanced scorecar
Advantage
The balanced scorecard approach to performance measurement offers several

advantages
1. it measures performance in a variety of ways, rather than relying on one gur
2. managers are unlikely to be able to distort the performance measure - bad

performance is dif cult to hide if multiple performance measures are use
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3. it takes a long-term perspective of business performanc
4. success in the four key areas should lead to the long-term success of the
organizatio
5. it is exible - what is measured can be changed over time to re ect changing

prioritie
6. 'what gets measured gets done' - if managers know they are being appraised on
various aspects of performance they will pay attention to these areas, rather than
simply paying 'lip service' to them
The main dif culty with the balanced scorecard approach is setting standards for
each of the KPIs. This can prove dif cult where the organisation has no previous
experience of performance measurement. Benchmarking with other organisations is
a possible solution to this problem
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Financial strategy - international operation
International in uence
Trading abroa
Compared with companies that trade entirely within one country, companies that
trade overseas will have to deal with a variety of international constraints
Foreign exchange in uence
A company that exports or imports faces the risk of higher costs or lower revenues
because of adverse movements in foreign exchange rates
A company that owns assets in different countries (subsidiaries abroad) faces the
risk of accounting losses due to adverse movements in exchange rates causing a fall
in the value of those assets, as expressed in domestic currency
Political issue
A company which trades abroad can face risks of economic or political measures
being taken by governments, affecting the operations of its subsidiaries abroad
An example was the import restrictions imposed by the USA on the British cashmere
industry during 1999, in retaliation for EU restrictions on banana imports
Geographical separatio
The geographical separation of the parent company from its subsidiaries adds to the
problems of management control of the group of companies as a whole
Separation may enhance problems caused by language and cultural differences
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Litigatio
The risk of litigation varies in different countries and to minimise this risk, attention
should be paid to legislation and regulations covering the products sold in different
countries
Care should be taken to comply with contract terms
Multinational
A MULTINATIONAL COMPANY or enterprise is one which owns or controls

production facilities or subsidiaries or service facilities outside the country in which it
is based
Thus, a company does not become 'multinational' simply by virtue of exporting or

importing products - ownership and control of facilities abroad is involved
Examples of multinational companies include
Food and Hospitality and Car

Technology Pharmaceuticals
Drink leisure manufacturers
Coca Cola Hilton Ford Apple GlaxoSmithKline
McDonald's Marriott Toyota Microsoft P zer
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Limitation of FS - non- nancial capita
Non-Financial Capita
The objective of nancial reporting i
to provide information about the nancial position that is useful to users in making
economic decisions
• However, the FSs provide only nancial information and therefore do not provide
a full picture
Non- nancial information (capital) is important in economic decisions
What is Non- nancial capita
1. People in your compan
2. Natural resouce
3. Trade mark
The objectives of non- nancial reporting are
1. to become more transparen
e.g. future plan
2. to understand the company's Responsibilit
e.g. Social and environmental responsibilities the company has
3. to reach out to more than just shareholder
e.g. wider stakeholder
Non- nancial information can be reported using the following guidance
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• GR
Global Reporting Initiative
• I
Integrated Reporting framewor
• These 2 give us the structure on how to report on non- nancial information
If we all use it, it will help us to compare the non- nancial information
Limitation of FS
They dont show us
• What will happen in the futur
• What's the competition doin
• What environmental changes have bee
• What our R+D results ar
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Sustainabilit
The Global Reporting Initiative (GRI
arose from the need to address the failure of the entities to respond changes in the
global economy
• GRI's mission is to make sustainability reporting standard practice by providing

guidance and support to organisations
• e.g. In case of incomplete disclosur
- if the information is omitted due to con dentiality, these should be explained
Sustainabilit
is a long-term programme involving developing strategies that balance

environmental, economic and social needs
The aim is that the organisation only uses resources at a rate that allows them to be
replenished, and that emissions of waste are at a level the environment is able to
absorb
Sustainable ef ciency practices for organisations are
1. Reducing wast
2. Using less energ
3. Recyclin
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There are 5 sustainability consideration
1. Sustainable for who
The issue concerns which species (other than humans) are to be sustained
2. Sustainable for how lon
This is about ensuring future generations can enjoy the same environmental
conditions as the current generatio
3. Sustainable at what cos
There is a balance between preserving the environment and natural resources

with the need to produce goods and services
4. Sustainable by who
Ideally the whole world will take responsibility for sustainability
The organisations should take on responsibility for sustainability themselves

rather than waiting for legal regulation.
5. Sustainable in what wa
This concerns what sustainability is about
- Ecological sustainabilit
- Social sustainabilit
- Economic sustainability
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Ecological sustainabilit
concerns the preservation of the environment
• The operations management issue is whether organisations should continue

production processes which are harmful to the environment
Social sustainabilit
is about personal growth and development
• For organisations, the issues are whether or not employees should be treated like
robots by requiring them to perform repetitive tasks
Economic sustainabilit
is about producing goods and services that people want while maximising the
organisation's pro tability
• The operations issue is to ensure the organisation produces products and

services that its customers want while minimising waste
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Framework for environmental and sustainability

reportin
The idea here is that everything must be able to continue in the futur
We must not use up resources, social or environmental, without replacing the
Any that is not replaced is called the social or environmental footprin
Reporting Sustainabilit
• Voluntar
• Increasingly popular (often put on website too
• Sometimes called ‘the triple bottom line’ (Pro ts, people and planet
Environmental Reportin
1. Can be in the published annual repor
2. Can be a separate repor
3. No mandatory standards to follo
4. Covers inputs (Using up of resources
5. Covers outputs (Pollution etc.
Its voluntary basis causes problems
Users can disclose the good but not the ba
No external in uence means less con dence in the repor
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Bene ts of an Environmental Repor
• Can highlight inef ciencie
• Identi es opportunities to reduce wast
• Can create a positive image as a good corporate citize
• Increased consumer con dence in i
• Employees like i
• Investors look for environmental concerns nowaday
• Reduces risk of litigation against i
• Can give competitive edg
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'CSR strategy' and 'strategic CS
Strategic CSR looks at those good corporate social responsibility activities that are
the KEY focus of a business and hence its strateg
If you buy clothes at Loft by design in France - they come with ethical concepts even
printed on their clothes such as “build community” or “keep money in the local
community
Not only is this an outward expression but also all purchases result in books being
made available in parts of the world without such resources
Consequently all materials and work is done locally and sustainably regardless of the
effect on cost. This is quite a big thing when your competition is say Primark who will
use the cheapest source of clothing
However this good CSR becomes a strategy. It gives a purpose to everything the
company does and therefore then gains a niche in the market where like minded
customers will b
The idea of strategic CSR is very speci c and goes beyond “we are green etc” it
permeates all KPIs and objective
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Purpose and content of an integrated repor
To explain to companies how to create value over tim
It bene ts all stakeholders interested in an organisation’s ability to create value over

time, includin
• Employee
• Customer
• Supplier
• Business partner
• Local communitie
• Legislator
• Regulators and policy-maker
The ‘building blocks’ of an integrated report are
• Guiding principle
These underpin the integrated repor
They guide the content of the report and how it is presente
• Content element
These are the key categories of informatio
They are a series of questions rather than a prescriptive lis
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Guiding Principle
1. Are you showing an insight into the future strategy..
2. Are you showing a holistic picture of the organisation's ability to create value over
time
Look at the combination, inter-relatedness and dependencies between the factors
that affect this
3. Are you showing the quality of your stakeholder relationships
4. Are you disclosing information about matters that materially affect your ability to
create value over the short, medium and long term
5. Are you being concise
Not being burdened by less relevant information
6. Are you showing Reliability, completeness, consistency and comparability when
showing your own ability to create value
Content Element
1. Organisational overview and external environmen
What does the organisation do and what are the circumstances under which it
operates
2. Governanc
How does an organisation’s governance structure support its ability to create

value in the short, medium and long term
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3. Business mode
What is the organisation’s business model
4. Risks and opportunitie
What are the speci c risk and opportunities that affect the organisation’s ability to
create value over the short, medium and long term? And how is the organisation
dealing with them
5. Strategy and resource allocatio
Where does the organisation want to go and how does it intend to get there
6. Performanc
To what extent has the organisation achieved its strategic objectives for the
period and what are its outcomes in terms of effects on the capitals
7. Outloo
What challenges and uncertainties is the organisation likely to encounter in

pursuing its strategy, and what are the potential implications for its business
model and future performance
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Syllabus A2. Financial policy decisions
Purpose of Financial Managemen
Financial management is getting and using nancial resources well to

meet objective
Financial objective
Pro t maximisation is often assumed, incorrectly, to be the main objective of a
business
Reasons why pro t is not a suf cient objective
1. Investors care about the futur
2. Investors care about the dividen
3. Investors care about nancing plan
4. Investors care about risk managemen
For a pro t-making company, a better objective is the maximisation of shareholder

wealth
this can be measured as total shareholder return (the dividend per share plus capital
gain divided by initial share price
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Key decisions
1. Investmen
(in projects or takeovers or working capital) need to be analysed to ensure that

they are bene cial to the investor
Investments can help a rm maintain strong future cash ows by the achievement
of key corporate objective
e.g. market share, quality
2. Financ
mainly focus on how much debt a rm is planning to use
The level of gearing that is appropriate for a business depends on a number of

practical issues
Life cycle - A new, growing business will nd it dif cult to forecast cash ows with
any certainty so high levels of gearing are unwise
Operating gearing- If xed costs are a high proportion of total costs then cash
ows will be volatile; so high gearing is not sensible
Stability of revenue- If operating in a highly dynamic business environment then

high gearing is not sensible
Security- If unable to offer security then debt will be dif cult and expensive to
obtain
3. Dividend
how returns should be given to shareholder
4. Risk managemen
mainly involve management of exchange rate and interest rate risk and project
management issues
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Key Objectives of Financial Managemen
Taking a commercial business as the most common organisational structure, the key
objectives of nancial management would be to
• Create wealth for the busines
• Generate cash, an
• Provide an adequate return on investment bearing in mind the risks that the
business is taking and the resources investe
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Internal, Connected and external Stakeholder
STAKEHOLDER
Internal Stakeholder
Internal stakeholders are intimately associated to the organisation and their
objectives are likely to have a strong in uence on how it is run.
The main two examples of internal stakeholders are

• Employee
• Managemen
Their interests to defend ar

jobs / careers, money, promotion prospects and bene ts
Response risk if interests are not recognise

Pursuit of individual goals rather than shareholder interest
Resignatio
Connected Stakeholder
Connected stakeholders can be viewed as having a contractual relationship with the
organisation.
The objective of satisfying the shareholders needs to be ful lled, however, customers
and nance objectives must be met if the company is to succeed.
Some examples of connected stakeholders may include
• Shareholders – interested in shareholders’ wealth measured by pro tability, P/E

ratios, market capitalizatio
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Sell shares (e.g. to predator) or vote against management (e.g. at AGM
• Customers – interested in the company’s product
Buy elsewher
Damage reputation (e.g. bad publicity
Legal actio
• Suppliers – interested in building long term relationship, on time payment of

goods and pro table sale
Refusal of credi
Stop supplyin
Legal action (e.g. for unpaid debts
• Finance providers - like banks interested in loan securit
Denial of credi
Higher interest charge
External Stakeholder
External stakeholders have quite diverse objectives and have varying ability to
ensure that the organisation meets its objectives.
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Some examples of external stakeholders may include

• Non-governmental organisation
Interests to defen
Human right
Legal actio
• Environmental pressure group
Interests to defen
Protecting the environmen
Human right
Publicit
Direct actio
Sabotag
Pressure on governmen
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• Government and regulatory agencies – interested in tax, compliance with

legislation and employment opportunitie
Tax increase
Regulatio
Legal actio
Tariff
• Trade unions – interested in protecting their members
Legal actio
Direct actio
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How different Stakeholder groups interac
STAKEHOLDERS GROUP
The needs/expectations of the different stakeholders may con ict.
Some of the typical con icts are shown below
Stakeholders Con ict
Employees versus managers Jobs/wages versus bonus (cost ef ciency)
Product quality / service levels versus pro t/

Customers versus shareholders
dividend
General public versus Effect on the environment versus pro t/

shareholders dividend
Vehicle for exposing managerial skills vs

Managers versus shareholders dividend stream and increase in the value of
shares.
Examples of common con icts of expectations
1. Managers prefer short-term decisions which bring them short-term pro t

(bonuses
howeve
Shareholders prefer Long-term decisions which bring them return in long-term
2. Business expansion may require additional share issues or loans, which will
reduce nancial independenc
Syllabus A2a. Financial management
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Cash ow Forecast
The principles of cash ow forecastin
Cash ow forecasting enables you to predict peaks and troughs in your cash balance
It helps you to plan borrowing and tells you how much surplus cash you’re likely to
have at a given time
Many banks require forecasts before considering a loan
The forecast is usually done for a year or quarter in advance and divided into weeks
or months
In extremely dif cult cash ow situations a daily cash ow forecast might be helpful
It is best to pick periods during which most of your xed costs - such as salaries - go
out
It is important to base initial sales forecasts on realistic estimate
Short term cash ow forecast
Cash Forecast for the Three Months Ended 31 March 20X
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This is the proforma that could be produced for a big, cash ow forecast question,
though there has not been one yet, it is a minor topic so fa
January February March
Cash Receipts
Sales
Issue of Shares
Cash Payments
Purchases
Dividends
Tax
Non Current Assets
Wages
Cash Surplus/defecit
Cash b/f
Cash c/f
Note that not all expenses in the income statement are cash eg depreciation/
accruals
Not all sales are cash - only put them in the table when cash is RECEIVED
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Not all purchases of NCA are cash eg Finance leases - just put in the cash PAID to
the lessor
When preparing cash ow forecasts make sure your work is clearly laid out and
referenced to workings
There is nothing dif cult just needs practic
Illustratio
• A lady decides to set her own business so needs to go to a bank with a cash ow
forecast
She has £6,000 to invest herself. She expects to buy some non current assets for
10,000, which have a 5 year life
These will be bought immediately
• Then she will need buffer stock of £1,000 acquired at the beginning of January
and subsequent monthly stock to meet her expected sales deman
• Forecast sales are 5,000 in February and rising by 10% per month
Selling price is calculated using a mark up of 50%. 1 months credit is allowed by
suppliers and 1 month given to customers also
Operating costs are 500 per month plus drawings of 500
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Prepare a cash ow for Jan, Feb, Marc
January February March
Cash Receipts
Sales 5,000
Issue of Shares
Cash Payments
Purchases -1,000 -3,333
Dividends
Operating Costs -500 -500 -500
Non Current Assets -10,000
Drawings -500 -500 -500
Cash Surplus/defecit -11,000 -2,000 667
Cash b/f 6,000 -5,000 -7,000
Cash c/f -5,000 -7,000 -6,333
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Gordon's growt
This presumes that you grow by investing what you keep in the busines
Therefore the more you give away (as dividends) the less you grow..
Return on Investment 12
Retained ratio 60
Growth would be
g=rx
g = 12% x 60% = 7.2
Of course the examiner could be Mr. Annoying and give you a dividend payout ratio
instead..
ROI = 10
Divdend Payout Ratio = 70
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What is the growth
Well if the payout ratio is 70%, therefore the retained ratio is 30
So, 10% x 30% = 3
Finally the examiner could be Captain Double Annoying and ask for the dividend to
be paid out... cheeky monke
ROI = 10
Growth = 4
Earnings = 10
Whats the dividend
So Retained ratio = 4/10 = 40
So Dividend payout ratio = 60
So Dividend is 60% x 100 = 6
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Financing requirement
Financing requirement
Cash de cits will be funded in different way
depending on whether they are short or long-term
Businesses should also have procedures for investing surpluses with appropriate
levels of risk and return
De ciencie
Any forecast de ciency of cash will have to be funded
• Borrowin
If borrowing arrangements are not already secured, a source of funds will have to
be found
If a company cannot fund its cash de cits it could be wound up
• The rm can make arrangements to sell any short-term marketable nancial

investments to raise cash
• The rm can delay payments to suppliers, or pull in payments from customers
This is sometimes known as leading and lagging
Because cash forecasts cannot be entirely accurate, companies should have

contingency funding available from a surplus cash balance and liquid investments, or
from a bank facility
Cash surpluse
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If a cash surplus is forecast, having an idea of both its size and how long it will exist
could help decide how best to invest it
In some cases, the amount of interest earned from surplus cash could be signi cant
for the company's earnings
The entity must have procedures for investing surpluses which consider both risk
and return
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Hedgin
Hedging is all about matching
Objectiv
To manage risk companies often enter into derivative contract
• e.g. Company buys wheat - so it is worried about the price of wheat rising (risk)
• To manage this risk it buys a wheat derivative that gains in value as the price of
wheat goes up
• Therefore any price increase (hedged item) will be offset by the derivative gains
(hedging item
So, the basic idea of hedge accounting is to represent the effect of an entity’s risk
management activitie
IFRS 9 change
• IFRS 9 has made hedge accounting more principles based to allow for effective
risk management to be better shown in the account
• It has also allowed more things to be hedged, including non- nancial item
• It has allowed more things to be hedging items also - options and forward
• There also used to be a concept of hedge effectiveness which needed to be

tested annually to see if hedge accounting could continue - this has now been
stopped
Now if its a hedge at the start it remains so and if it ends up a bad hedge well the FS
will show thi
Accounting Concep
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The idea behind hedge accounting is that gains and losses on the hedging
instrument and the hedged item are recognised in the same period in the income
statemen
It is a choice - it doesn’t have to be applie
There are 3 types of hedge
1. Fair value hedge
Here we are worried about an item losing fair value (not cash)
For example you have to pay a xed rate loan of 6%. If the variable rate drops to
4% your loan has lost value. If the variable rate rises to 8%, then you have
gained in fair val
Notice you still pay 6% in both scenarios - so the risk isn’t cash ow - it is fair
valu
2. Cash ow hedge
Here we are worried about losing cash on the item at some stage in the futur
For example, you agree to buy an item in a foreign currency at a later date. If the
rate moves against you, you will lose cas
3. Hedges of a net investment in a foreign operatio
This applies to an entity that hedges the foreign currency risk arising from its net
investments in foreign operation
Hedged item
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The hedged item is the item you’re worried about - the one which has risk (which
needs managing
A hedged item can be
• A recognised asset or liability ( nancial or not
• An unrecognised commitmen
• A highly probable forecast transactio
• A net investment in a foreign operatio
They must all be separately identi able, reliably measurable and the forecast
transaction must be highly probable
When can we use hedge accounting
The hedge must meet all of the following criteria: (replacing the old 80-125% criteria
• An economic relationship exists between the hedged item and the hedging
instrument – meaning as one goes up in FV the other will go dow
For example, a UK company selling to US customers - enters into a $100 to £

futures contract which ends when the UK company is expected to receive $10
Here - the future $ receipt will be the hedged item and the futures contract the
hedging ite
In the above example it is an obvious economic relationship as it’s the same

amount and same timin
However, sometimes the amounts and timings won’t be the same so you may
use judgement as to whether this is actually a proper hedge or not - here
numbers could be use
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• Credit risk doesn’t dominate the fair value change
So, after having established an economic relationship (above) - IFRS 9 just wants
to make sure that any credit risk to the hedged or hedging item wont affect it so
much as to destroy the relationshi
Accounting treatmen
• Fair Value Hedge
Gains and losses of both the Hedged and Hedging item are recognised in the
current period in the income statemen
• Cash ow hedge
Here the hedged item has not yet made its gain or loss (it will be made in the
future e.g. Forex
So, in order to match against the hedged item when it eventually makes its gain
or loss, the “effective” changes in fair value of the hedging instrument are
deferred in reserves (any ineffective changes go straight to the income
statement
These deferred gains/losses are then taken from reserves/OCI and to the income
statement when the hedged item eventually makes its gain or los
• Hedges of a net investment in a foreign entit
Same as cash- ow, changes in fair value of the hedging instrument are deferred
in reserves/OC
Normally individual company forex gains/losses are taken to the income

statement and foreign subsidiary retranslation gains/losses taken to the OCI/
Reserves
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So, lets say a UK holding company has a UK subsid and a Maltese subsid. The
Malta sub also has loaned the UK sub some cash in Euros
Normally the UK sub would retranslate this loan and put the difference to the
income statement. Also the Maltese sub is retranslated and the difference taken
to OCI. Here, it is allowed for the UK sub to hold the translation losses also is
reserves (like a cash ow hedge) as long as the loan is not larger than the net
investment in the Maltese su
Special cases of hedging items which reduce P&L Volatilit
1. Options - time value element when intrinsic value of option is the designated
hedging ite
If the hedging item is an option - then the time value changes in that option will be
taken to the OCI (and equity
When the hedged item is realised, these then get reclassi ed to P&
2. Forward points - when the spot element of a forward contract is the designated
hedging ite
If the hedging item is a forward contract then the forward points FV changes MAY
be taken to OCI, and again gets reclassi ed when the hedged item hits the I/
3. Currency basis ris
The spread from this can be eliminated from the hedge - and instead either be
valued as FVTPL or FVTOCI(with reclassi cation
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Illustration of a FV Hedg
5% 100,000 xed rate 5 year Receivable loan. (Current variable rates 5%)
Here we are worried that variable rates may rise above this - if they did then the FV
of this receivable would worsen
So we would have a FV loss
If the variable rates go lower, then we are happy (as we are receiving a xed rate)
and so the FV would improve
This company hedges against the variable rates going down - by entering into a
variable rate swap (This is the hedging item)
With this derivative, if variable rates rise we will bene t from receiving more but the
FV of our xed rate receivable loan will have lowered
These 2 should cancel themselves out
Market interest rates then increase to 6%, so that the fair value of the xed rate bond
has decreased to $96,535
As the bond is classi ed as a hedged item in a fair value hedge, the change in fair
value of the bond is instead recognised in pro t or loss
Dr Hedging loss Income Statement (hedged item) 3,465
Cr Fixed rate bond 3,465
At the same time, the company determines that the fair value of the swap has
increased by $3,465 to $3,465
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Since the swap is a derivative, it is measured at fair value with changes in fair value
recognised in pro t or loss. Therefore, Entity A makes this journal entry
Dr Derivative (FVTPL) (hedging item) 3,465
Cr Hedging gain Income statement 3,465
Since the changes in fair value of the hedged item and the hedging instrument
exactly offset, the hedge is 100% effective, and the net effect on pro t or loss is zero
Illustration Cash ow Hedg
Company has the euro as its functional currency. It will buy an asset for $20,000 next
year
It enters into a forward contract to purchase $20,000 a year´s time for a xed amount
(10,000)
Half way through the year (the company’s Year-end) the dollar has appreciated, so
that $20,000 for delivery next year now costs 12,000 on the market
Therefore, the forward contract has increased in fair value to 2,00
Solutio
Dr Forward Asset 2,000
Cr Equity / OCI 2,000
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When the company comes to pay for the asset, the dollar rate has further increased,
such that $20,000 costs 14,000 in the spot market
Therefore, the fair value of the forward contract has increased to 4,00
Dr Forward Asset 2,000
Cr Equity 2,000
The forward contract is settled
Dr Cash 4,000
Cr Forward Asset 4,000
The asset is purchased for $10,000 (14,000)
Dr Machine 14,000
Cr Accounts Payable 14,000
The deferred gain left in equity of 4,000 should eithe
Remain in equity and be released from equity as the asset is depreciated o
Be deducted from the initial carrying amount of the machine
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Impact of hedge accounting on stakeholder assessmen
Hedge accounting matches the hedged item and the hedged instrument
If a loss arises on a hedged item, if the hedging is effective, then an opposite gain
will arise on the hedging instrument and vice versa
Without hedge accounting, stakeholders (eg investors, lenders, customers and

suppliers) cannot see hedges entered into from nancial statements
Hedge accounting allows stakeholders to make more informed decisions about a

compan
e.g. to lend to, invest in, or do business with a company
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Disclosure of nancial ris
IFRS 7 Financial instruments: Disclosure
Users of nancial instruments need information abou
• an entity's exposures to risk
• how those risks are manage
as this information can in uence a user's assessment of the nancial position and
nancial performance of an entit
Classes of nancial instruments and levels of disclosur
The entity must group nancial instruments into classes appropriate to the nature of
the information presented
1. Statement of nancial positio
The following must be disclosed
• Carrying amount of nancial assets and liabilities
• Special disclosures about nancial assets and nancial liabilities designated to be

measured at fair value through pro t and loss including disclosures about credit
risk and market risk, changes in fair values attributable to these risks and the
methods of measurement
• Reason for any reclassi cation of nancial instruments from one category to
another
• The carrying amount of nancial assets the entity has pledged as collateral for
liabilities or contingent liabilities
• Reconciliation of movement in the allowance account for credit losses (bad

debts) by class of nancial assets
2. Statement of pro t or loss and other comprehensive incom
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The entity must disclose the following items of income, expense, gains or losses,
either on the face of the nancial statements or in the notes
• Net gains/losses on nancial instruments recognised in pro t or loss by lAS 39

category (broken down as appropriate: eg interest, fair value changes, dividend
income)
• Total effective interest income/expense (for items not held at fair value through
pro t or loss)
• Impairments losses by class of nancial asset
3. Other disclosure
• Accounting policy for the measurement of nancial instruments
• Credit risk management polic
• Aged debtor analysi
• The impact of adverse exchange rate movements on reported pro
• Description of each nancial instrument designated as hedging instruments and

their fair value at the reporting date
• The nature of the risks being hedged
• For cash ow hedges, periods when the cash ows will occur and when they will
affect pro t or loss
• For fair value hedges, details of fair value changes of the hedging instrument and
the hedged item
• The ineffectiveness recognised in pro t or loss arising from cash ow hedges and
net investments in foreign operations
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Financial objectives and corporate strateg
Shareholder wealth maximisation (share price
Maximisation of shareholder wealth is measured by the share price (if the company
is listed of course). This is because the share price is simply the value of all future
dividends coming to the shareholders
However, sometimes a business reports a pro t increase and the share price falls
due to the manner in which they made the pro t. This suggests that that pro t is not
suf cient as a business objectiv
Share price could also rise and fall due to potential investment decisions or the fact
that a new loan is being taken out or that dividends are to be increased or lowere
Corporate Strategie
Clearly corporate strategies are wider than purely nancial, they look at the business
as a whole. Once these are set appropriate nancial objectives can then be set and
measure
Examples include
• Return on investmen
Market shar
Growt
Customer satisfactio
Qualit
Financial Objective
Examples include
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1. Pro t Maximisatio
Focusing on pro ts could mean undue risk and short termism
Also there is the problem that pro ts can be manipulated using nancial
accounting, unlike cash
So maybe pro t maximisation focuses on nancial pro t too much and not
enough on cash generation
2. Earnings Per Share Growt
This still uses earnings (pro ts) rather than cash unfortunately
EPS looks at the amount of pro ts made in the year for each individual share
Remember it is the ORDINARY shareholders who are interested in EPS. Therefore

EPS is
(Pro t after tax - preference dividends) / Weighted average Ordinary share

Illustratio
What is the EPS in each year

Last year Current year
Pro ts before interest and tax 22,300 23,726
Interest 3,000 3,000
Tax 5,790 6,218
Pro ts after tax 13,510 14,508
Preference dividends 200 200
Number of ordinary shares issued 100,000 100,000

Solutio
• Last year
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Earnings (13,510 - 200) = 13,31
EPS = Earnings 13,310 / Shares 100,000 = 13.31
• Current yea
Earnings (14,508 - 200) = 14,30
EPS = Earnings 14,308 / Shares 100,000 = 14.31
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Changes in economic and business variable
Impact of changes in underlying economic and business variable
All entity's ability to meet its nancial objective
will be sensitive to the following changes in economic variables and business

variables
Economic variable
• Interest rate
When interest rates rise, consumer spending tends to fall because higher interest
rates mean higher costs of credit for customers, leading to less disposable
income for spending
Forecast sales gures should therefore be revised downwards for increases in

interest rates
Interest rate risk can be mitigated by hedging against interest rate rises with
derivatives such as interest rate swaps
• Exchange rate
If a company's domestic currency increases in value against currencies of

overseas customers, it will be harder for the company to export, since the cost to
the overseas customers is higher
This could cause sales to fall if exports are signi cant
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Furthermore, If a company's domestic currency increases In value against

currencies of overseas suppliers, costs will fall, since the cost of imports will be
lower
Currency risk can be mitigated by hedging against adverse changes in exchange

rates with derivatives such as currency swaps
• In atio
A low stable rate of in ation, eg up to 3%, enables businesses to increase their

prices on sales and potentially higher pro ts
Business variable
Sales volume
In addition to changes in economic variables having an impact on sales, sales can

be also affected by other factors such as
1. Weathe
2. Seasonal chance
3. Technolog
4. Locatio
5. Demographics
This can also affect costs and therefore pro t margins will be affected
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Ratios and Strateg
Accounting Ratio
In your exam, you may be required to calculate some ratios in order to support your
strategic analysis of the case.
This section shall only present a summary and list of ratios that could potential be
used in your exam for such purpose
Ratios may be divided into the following categories
• PROFITABILITY RATIO
These are measures of value added being generated by an organisation and

include the following
ROCE Operating Pro t (PBIT)/Capital Employed
Capital Employed Equity + LT liabilities
Capital Employed Non current assets + net current assets
Capital Employed Total assets - current liabilities
Gross margin Gross Pro t/Sales
Net Margin Net Pro t/Sales
Pro t After Tax - Preference dividends/Shareholders’ Funds

ROE
(Ordinary shares + Reserves)
RI Pro t After Tax - (Operating Assets x Cost of Capital)
• EFFICIENCY RATIO
These are measures of utilisation of Current & Non-current Assets of an

organisation. Ef ciency Ratios consist of the following
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Asset Turnover Sales/Capital Employed
ROCE Margin X Asset Turnover
Receivables Days (Receivables Balance / Credit Sales) x 365
Payables Days (Payable Balance / Credit Purchases) x 365
Inventory Days (Inventory / Cost of Sales) x 365
• LIQUIDITY & GEARING RATIO
Liquidity Ratios measure the extent to which an organisation is capable of

converting assets into cash and cash equivalents.
On the other hand, Gearing Ratios measure the dependence of an organisation

on external nancing as against shareholder funds.
Liquidity and Gearing Ratios are outlined below
Liquidity
Current Ratio Current Assets / Current Liabilities
Quick Ratio (Current Assets – Inventory) / Current Liabilities
Gearing
Financial Gearing Debt/Equity
Financial Gearing Debt/Debt + Equity
Operational gearing Contribution / PBIT
• INVESTOR'S RATIO
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These ratios measures return on investment generated by stakeholders. Such

ratios include
Dividend Cover Pro t After Tax / Total Dividend
Dividend Yield Dividends per share / Share price
Interest Cover PBIT / Interest
Interest yield (coupon rate / market price) x 100%
Pro t After Tax and preference dividends / Number of

Earnings Per Share
Shares
PE Ratio Share Price / EPS
• In the exam you have to act like a detective. You have to sift through evidence
and extract meaningful messages for effective business decisions. The starting
point is often the basic accounting documents that record the progress of any
business, the Income statement & SF
These are closely related and so need reading together
The balance sheet is a snapshot of a business at one point in time
The income statement is dynamic and describes the ow of money through the
business over a period of time
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Syllabus A3. In uences on nancial strategic decisions
Lenders’ assessment of creditworthines
People will lend money to us only if we are creditworth
We should think of
1. Business plan
People who will lend us money will want to see our business plan
Within that business plan, they will want to know
- How good the management are
- What assets you have
- What your gearing is
- SWOT analysi
2. Ratio
- Current ratio
- Interest cove
3. Cash ow Forecas
Can we provide the CF forecast
It will help them to forecast whether we will be able to nance the loan
They will be interested especially in the CF from Operating activities
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4. Credit ratin
What is our credit rating
The higher the credit rating, the better
It will effect the interest rate that we will be charged
5. Quality of managemen
Their experience, quali cation
Their integrity
Their commitment to pay off the loan
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Financial strategy - regulatory requirement
Competition regulatio
The government can in uence a market through regulation
eg using an industry regulator or a competition authority
Industry regulator
Where a market is not competitive, industry regulatory authorities have the role of
ensuring that consumers' interests are not subordinated to those of other
stakeholders) such as employees, shareholders and tax authorities
The main methods used to regulate monopoly industries are as follows
• Price contro
The regulator agreeing the output prices with the industry
Typically, the price is progressively reduced in real terms each year by setting
price increases at a rate below that of in ation
• Pro t contro
The regulator agreeing the maximum pro t which the industry can make
A typical method is to x maximum pro t at x% of capital employed, but this does

not provide any incentive to making more ef cient use of assets: the higher the
capital employed, the higher the pro t
• Service contro
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The regulator agreeing a minimum standard of service the industry should

provide customers
For example, for gas companies - the minimum standard of service may be to
restore customers supply within a speci c time period, following a network
interruption
The regulator will be concerned with
• Actively promoting competition by encouraging new rms in the industry and

preventing unreasonable barriers to entr
• Addressing quality and safety issues and considering the social implications of
service provision and pricin
Regulation of takeover
Competition authorities such as the UK Competition and Markets Authority aim to

protect competition with in a market
It will make in-depth enquiries into mergers and markets to ensure that one company
cannot dominate a marke
Where a potential merger is suf ciently large to warrant an investigation, the

competition authority will look at whether the merger will be against the public
interest in terms of
• Effective competition within the industr
• The interests of consumers, purchasers and users of the goods and services of
that industry in respect of quality, price and variet
• The reduction of costs and the introduction of new products and technique
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Consideration of taxation regulation
Impact of taxation on nancial strateg
Tax regulations are an important factor to consider in setting nancial strateg
As part of maximising shareholder wealth, companies can take advantage of tax

relief schemes, and have subsidiaries in countries with lower tax rates
Tax liabilities are an important factor in cash ow forecasts
Domestic tax consideration
• Payment of taxe
The deadlines for payment of taxes needs to be factored into cash ow forecasts
to ensure the entity has enough cash to meet the deadlines and avoid penalties
This will have an effect on a company's working capital management
• Tax relief incentive
Companies can reduce their tax bill by taking advantages of tax relief schemes
For example capital allowances (ie tax allowable depreciation) on purchases of

equipment are deductible from a company's taxable pro ts
Tax relief is also available for interest payments on debt nance, but not equity
nance. This will be a factor in a company's nancing decisions
International tax consideration
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Multinational companies will have the following tax considerations in setting nancial
strategy
• Tax regime and dividend payment
Tax considerations are thought to be the primary reason for the dividend policies
inside a multinational rm
For example, the parent company may reduce its overall tax liability by receiving
larger amounts of dividends from subsidiaries in countries where undistributed
earnings would otherwise be taxed
• Tax haven
Tax havens are countries with lenient tax rules or relatively low tax rates, which
are often designed to attract foreign investment
Multinational companies may choose to exploit these tax regimes through

transfer pricing or switching production from one country to another
Taxation issue
If a company makes investments abroad it will be liable to income tax in the home
country on the pro ts made, the taxable amount being before the deduction of any
foreign taxes. The pro ts may be any of the following
• Pro ts of an overseas branch or agenc
• Income from foreign securities, for example debentures in overseas companie
• Dividends from overseas subsidiarie
• Gains made on disposals of foreign asset
In many instances, a company will be potentially subject to overseas taxes as well as

to local income tax on the same pro ts
However, this can be reduced by double taxation relief (DTR)
Double taxation relief (DTR
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A DOUBLE TAXATION AGREEMENT is an agreement between two countries

intended to avoid the double taxation of income which would otherwise be subject to
taxation in both
Typical provisions of double taxation agreements based on the OECD Model

Agreement are as follows
• DTR is given to taxpayers in their country of residence by way of a credit for tax
suffered in the country where income arises
This may be in the form of relief for withholding tax only or, given a holding of
speci ed size in a foreign company, for the underlying tax on the pro ts out of
which dividends are paid
• Total exemption from tax is given in the country where income arises in the hands
of, for example
i) Visiting diplomat
ii) Teachers on exchange programme
• Preferential rates of withholding tax are applied to, for example, payments of rent,
interest and dividends. The usual rate is frequently replaced by 15% or less
• There are exchange of information clauses so that tax evaders can be chased
internationally
• There are rules to determine a person's residence and to prevent dual residence
(tie-breaker clauses)
• There are clauses which render certain pro ts taxable in only one rather than
both of the contracting states
• There is a non-discrimination clause so that a country does not tax foreigners

more heavily than its own nationals
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Syllabus B: Sources of long term funds
Syllabus B1. Capital structur
Capital structure theorie
These are 3 theories to see if there is a perfect capital structur
This simply means - is there a perfect Debt to Equity ratio
For example, 40% Debt and 60% Equity
Well there are 3 theories here we go
The Traditional Theor
suggests that using some debt will lower the WACC, but if gearing rises above an
acceptable level then the cost of equity will rise dramatically causing the WACC to rise
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The cheap cost of debt (as it is ranked before equity in terms of distribution of earnings and
on liquidation), combined with its tax advantage, will cause the WACC to fall as borrowing
increases
However, as gearing increases past a certain point, shareholders increase their required
return (i.e., the cost of equity rises)
This is because there is much more interest to be paid before they get their dividends
At high gearing the cost of debt also rises because the chance of the company defaulting on
the debt is higher (i.e., bankruptcy risk)
So at higher gearing, the WACC will increase
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The main problem with the traditional view is that there is no underlying theory to show by
how much the cost of equity should increase because of gearing worries or the cost of debt
should increase because of default risk
In the traditional view of capital structure, ordinary shareholders are relatively indifferent to
the addition of small amounts of debt in terms of increasing nancial risk and so the WACC
falls as a company gears up
As gearing up continues, the cost of equity increases to include a nancial risk premium and
the WACC reaches a minimum value
Beyond this minimum point, the WACC increases due to the effect of increasing nancial risk
on the cost of equity and, at higher levels of gearing, due to the effect of increasing
bankruptcy risk on both the cost of equity and the cost of debt
Although it is more or less realistic, the traditional view remains a purely descriptive theory
This view can be represented by a U shaped graph, where the vertical axis is the WACC and
the horizontal the amount of debt nance
Next, Modigliani and Miller (MM
the use of debt transfers more risk to shareholders, and this makes equity more expensive
so that the use of debt does not reduce nance costs ie does not reduce the WACC
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Modigliani and Miller view
In order to demonstrate a workable theory, MMs 1958 paper made a number of simplifying
assumptions
The capital market is perfect
There are therefore no transactions costs and the borrowing rate is the same as the lending
rate and equal to the so-called risk free rate of borrowing
Taxation is ignore
Risk is measured entirely by volatility of cash ows
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Main ide
Debt or Equity - it doesn’t matte
The WACC remains the same throughou
As a company takes on more debt, the equity holders take on a little more ris
The more debt brings the WACC down but the extra risk for equity holders, increases
Cost of Equity and so the WACC comes back up agai
M&M (with tax
If debt also saves corporation tax then it does reduce nance costs, which bene ts
shareholders ie it reduces the WACC
This suggests that a company should use as much debt nance as it can
Main ide
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• Taxatio
If Debt gets tax relief and equity doesn't then the straight line graph is wron
The tax will make debt cheaper than equity and so more debt is advantageous at all
level
However, this still presumes a perfect market where people don't worry about bankruptcy
risk - they do
Therefore at higher levels of debt, WACC would actually rise in the real, imperfect
marke
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Cost of equity and WACC (M&M
MODIGLIANI AND MILLER – TAX IGNORED (1958
Formula
1. Value of compan
Vg = V
2. Cost of equit
Keg = Keu+(Keu−Kd) Vd/V
3. WAC
WACCg = WACCu (Keu
MODIGLIANI AND MILLER – INCLUDING CORPORATION TAX (1963
Formulae - given in the exa
Where
Vg = value of geared compan
Vu = value of ungeared compan
TB = Tax on deb
Keg = cost of equity of a geared company,
Keu = cost of equity in an ungeared compan
Kd = cost of debt (pre-tax
Vd Ve = market value of debt & equit
t = ta
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Example
Cow plc (an all equity company) has on issue 10,000,000 $1 ordinary shares at market
value of $2.00 each
Milk plc (a geared company) has on issue
15,000,000 25p ordinary shares; and
$5,000,000 10% debentures (quoted at 120
Corporation tax at 30%
Assume that the companies are in all other respects identical
Calculate the value of Milk’s plc
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Solutio
Vg = Vu+D
D = $5,000,000 x 120/100 = $6
Vu = $10,000,000 x $2.00 = $20
Dt = $6m x 30% = $1.8
Vg = $20m + $1.8m = $21.8
Example
An ungeared company with a cost of equity of 15% is considering adjusting its gearing by
taking out a loan at 10% and using it to buy back equity
After the buyback the ratio of the market value of debt to the market value of equity will be
1:1
Corporation tax is 20%
Require
Calculate the new Ke, after the buyback
• Keg = Keu + (Keu - Kd) x [ VD (1 - t) / Ve

Keg = 15 + (15 - 10) x [1 (1 - 0.20) / 1
Keg = 15 + 5 x 0.8
Keg = 19
Example
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A Company has
- an ungeared cost of equity of 10
- market value of equity of $20
- market value of debt of $10
- a tax rate of 20%
Required
Calculate WACC using M&M formula
WACC = Keu x [1 - ( Vdt / (Ve + Vd))
WACC = 10% x [ 1 - ( 0.2 x 100 / ( 200 + 100))
WACC = 9.3
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Impact of capital structure on ratio
Gearin
The nancial risk of a company's capital structure can be measured b
1. gearing rati
2. debt/equity rati
3. interest cove
Financial gearin
measures the relationship between shareholders' capital plus reserves, and either prior
charge capital or borrowings
Commonly used measures of nancial gearing are based on the statement of nancial
position values of the xed interest and equity capital
They include
* Either including or excluding minority interests, deferred tax and deferred income
Generally, a company is neutrally geared if the ratio is 50%, low geared below that, and
highly geared above that
Gearing ratios based on market value
An alternative method of calculating a gearing ratio is one based on market values
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The advantage of this method is that potential investors in a company are able to judge the
further debt capacity of the company more clearly by reference to market values than they
could by looking at statement of nancial position values
The disadvantage of a gearing ratio based on market values is that it disregards the value of
the company's assets, which might be used to secure further loans
Changing nancial gearin
Financial gearing is an attempt to quantify the degree of risk involved in holding equity
shares in a company, both in terms of the company's ability to remain in business and in
terms of expected ordinary dividends from the company
The more geared the company is, the greater the risk that little (if anything) will be available
to distribute by way of dividend to the ordinary shareholders
The more geared the company, the greater the percentage change in pro t available for
ordinary shareholders for any given percentage change in pro t before interest and tax
This means that there will be greater volatility of amounts available for ordinary
shareholders, and presumably therefore greater volatility in dividends paid to those
shareholders, where a company is highly geared
Gearing ultimately measures the company's ability to remain in business. A highly geared
company has a large amount of interest to pay annually
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If those borrowings are 'secured' in any way then the holders of the debt are perfectly
entitled to force the company to realise assets to pay their interest if funds are not available
from other sources
Clearly, the more highly geared a company, the more likely this is to occur when and if pro ts
fall
Interest cove
Like gearing, interest cover is a measure of nancial risk which is designed to show the risks
in terms of pro t rather than in terms of capital values
As a general guide, an interest cover of less than three times is considered low, indicating
that pro tability is too low given the gearing of the company
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Capital structure of group companie
In multinational companie
The debt to equity pro le is structured to maximise shareholder wealth by reducing tax
Structuring the debt/equity pro le of group companie
In multinational groups of companies, parent companies can choose the mixture of debt and
equity to nance subsidiaries
Since interest payments on debt are tax deductible and dividend payments are not, it would
be more tax ef cient for a company to have higher levels of debt than equity
However, companies on their own are unlikely to have high levels of debt to equity as this
would be too risky for investors and lenders
Companies within a group, however, can have higher levels of debt to equity by borrowing
from 'other group companies
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Thin capitalisatio
A company that has a signi cantly higher level of debt compared to equity than it could
achieve on its own is described as thinly capitalised
Thin capitalisation can be tax: ef cient for both the lender and the borrower
The borrowing company within the group pays interest to the lending company
This allows the borrowing company to reduce its taxable pro ts by the amount of interest
paid
The lending company receives interest income from the borrowing company
However if the lending company is incorporated in a country with a low tax rate, or in a
country which does not tax interest income, it pays relatively low or zero tax on this income
By structuring the nancing and interest arrangements carefully, a multinational group can
therefore in uence the pro t it reports and the tax it pays
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Tax avoidance rule
To counteract companies exploiting thin capitalisation to reduce tax, some countries have
introduced tax legislation to place limits on the amount of interest that can be deducted from
taxable pro ts, for example
• Arms length limits

The maximum amount of debt on which interest is tax deductible is limited to the amount
that an independent arm's length lender would provide to a company
• Ratio limit
The maximum amount of debt on which interest is tax deductible is limited to a set ratio
such as the ratio of debt to equity
For example, in Australia, the maximum ratio of debt to equity is 60:40 for general
entities
• Earnings stripping approac

Some countries adopt a ratio approach which focuses on the amount of interest paid in
relation to some other variabl
e.g. the amount of interest to operating pro
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Syllabus B2. Analyse long-term debt nanc
Short term nanc
The following are short terms forms of nanc
- in the exam always remember to think about these when asked about possible ways of
raising nanc
1. Overdraf
This is the riskiest type of nance as the bank can call it in at any time
The bank has the right to be repaid overdrawn balances on demand, except where the
overdraft terms require a period of notice
The bank can use the customers’ money in any legally or morally acceptable way that it
choose
2. Short term Loa

Less risky than an overdraft but it will possibly need replacing and there’s a risk that it
would be on worse terms - if the economy change
3. Trade payable
Often seen as free nance - although you may actually be missing out on early
settlement discounts
Be careful also not to annoy your creditors by taking too long to pa
4. Operating Leas
When recommending though - also think about how much overdraft they already have -
what their short term commitments are alread
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Operating Lease
This is a useful source of nance for the following reasons
• Protection against obsolescenc

Since it can be cancelled at short notice without nancial penalty
The lessor will replace the leased asset with a more up-to-date model in exchange for
continuing leasing business
This exibility is seen as valuable in the current era of rapid technological change, and
can also extend to contract terms and servicing cove
• Less commitment than a loa

There is no need to arrange a loan in order to acquire an asset and so the commitment
to interest payments can be avoided, existing assets need not be tied up as security and
negative effects on return on capital employed can be avoide
Operating leasing can therefore be attractive to small companies or to companies who

may nd it dif cult to raise debt
• Cheaper than a loa

By taking advantage of bulk buying, tax bene ts etc the lessor can pass on some of
these to the lessee in the form of lower lease rentals, making operating leasing a more
attractive proposition that borrowing
• Off balance sheet nanc

Operating leases also have the attraction of being off-balance sheet nancing, in that the
nance used to acquire use of the leased asset does not appear in the balance sheet
The role of nancial intermediaries in providing short-term nance i

• to provide a link between investors who have surplus cash and borrowers who have
nancing needs
• to aggregate invested funds in order to meet the needs of borrowers
• to offer maturity transformation, in that investors can deposit funds for a long period of
time while borrowers may require funds on a short-term basis onl
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Money market instrument
The characteristics and role of the principal money market instrument
Money market instruments are short term and they can give interest, be discounted or be
derivative base
Interest Bearin
Any nancial instrument that earns interes
• Certi cates of deposit (CDs

A CD is a receipt for funds deposited in a bank for a speci ed term and for a set rat
With a CD - if they’re negotiable - they can be sold before maturity. Non-negotiable ones
just pay a set amount of interest (coupon) and is repaid as norma
• Repurchase Agreemen
A repo is where 2 parties agree to buy/sell an instrument at an agreed price and then
repurchase back at an agreed price a set time late
• Bank Deposit
Bank deposits are made to deposit accounts at a banking institution
The account holder has the right to withdraw any deposited funds, as set forth in the
terms and conditions of the account
The "deposit" itself is a liability owed by the bank to the depositor (the person or entity
that made the deposit)
• Government Securit
A bond (or debt obligation) issued by a government authority, with a promise of
repayment upon maturity that is backed by said government
These securities are considered low-risk, since they are backed by the government
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• Local authority bon

a xed- interest bond, repayable on a speci c date, used by a local authority in order to
raise a loan and similar to a Treasury bon
Non-interest-bearin
• Bill Of Exchang
Is an unconditional order in writing to pay the addressee a speci ed sum of money either
on demand or at a future date
Discount Instrument
These don’t pay interest as such. They are issued at a discount, which effectively means the
“interest” is all at the beginnin
Think of it from the lenders viewpoint. They wish to lend $100, but actually only need to lend
$80 (discounted at the start) but are paid back the full $100
• Treasury Bill
These are issued by governments with maturities from 1m to 12m. They are issued at a
discount to their face valu
• Commercial pape
These are unsecured with a typical term of 30days
There are issued by large organisations with good credit ratings - funding their short term
investment need
• Bankers Acceptanc
These again are issued by companies BUT are guaranteed by a ban
The banks will get a fee for this guarantee - and because the risk is low (for the lender
due to the bank guarantee) - the interest the companies offer on these will be lo
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Again these are offered at a discount however they are negotiable, meaning they can be
traded before maturit
These are normally issued by rms who do not have a good enough credit rating to offer
commercial pape
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Long term nanc
These are
1. Finance Leas
You will notice we have included both operating and nance leases as potential sources
of nance - don’t forget too to mention the possibility of selling your assets and leasing
them back as a way of getting cash
Be careful though - make sure there are enough assets on the SFP to actually do this -
or your recommendation may look a little silly ;
2. Bank loans and bonds/debenture

Bonds securities which can be traded in the capital markets
Bond holders are lenders of debt nance
Bond holders will be paid a xed return known as the coupon
Traded bonds raise cash which must be repaid usually between 5 and 15 years after
issue
Bonds are usually secured on non-current assets thus reducing risk to the lender
Interest paid on the bonds is tax-deductible, thus reducing the cost of debt to the issuing
compan
3. Equit
via a placing - does not need to be redeemed, since ordinary shares are truly permanent
nance
The return to shareholders in the form of dividends depends on the dividend decision
made by the directors of a company, and so these returns can increase, decrease or be
passed
Dividends are not tax-deductible like interest payments, and so equity nance is not tax-
ef cient like debt nance
4. Preference Shar
These are seen as a form of deb
5. Venture Capita
For companies with high growth and returns potentia
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This is provided to early/start up companies with high-potential
The venture capitalist makes money by taking an equity share and then realising this in
an IPO (Initial Public Offering) or trade sale of the compan
Equity as nanc
Rights Issue For existing shareholders initially No dilution of control
Placing Fixed price to institutional investors Low cost - good for small issues
Public Underwritten & advertised Expensive - good for large issue
Rights Issu
For existing shareholders initially - means no dilution of contro
A 1 for 2 at $4 (MV $6) right issue means…
The current shareholders are being offered 1 share for $4, for every 2 they already
own
(The market value of those they already own are currently $6
Calculation of TERP (Theoretical ex- rights price
Calculation of TERP (Theoretical ex- rights price
The current shareholders will, after the rights issue, hold
1 @ $4 = $
2 @ $6 =$1
So, they now own a total of 3 for a total of $16. So the TERP is $16/3 = $5.3
Effect on EP
Obviously this will fall as there are now more shares in issue than before, and the company
has not received full MV for the
To calculate the exact effect simply multiply the current EPS by the TERP / Market
value before the rights issu
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Eg Using the above illustratio
EPS x 5.33 /
Effect on shareholders wealt
There is no effect on shareholders wealth after a rights issue
This is because, although the share price has fallen, they have proportionately more
share
Equity issues such as a rights issue do not require security and involve no loss of
control for the shareholders who take up the righ
Methods of obtaining a listin
An unquoted company can obtain a listing on the stock market by means of a
1. Initial public offer (IPO

When a company issues shares to the public for the rst time
They are often issued by smaller, younger companies looking to expand, or large private
companies wanting to become public
For the individual investor it is tough to predict share prices on the initial day of trading as
there’s little past data about the company often, so it’s a risky purchase
Also expansion brings uncertainty in any cas
2. Placin
Is an arrangement whereby the shares are not all offered to the public
Instead, the shares are bought by a small number of investors, usually institutional
investors (such as pension funds and insurance companies)
This means low cost - so good for small issue
Placings are likely to be quick
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3. Public Issue
These are underwritten & advertised
This means they are expensive - so good for large issu
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Factors in uencing the choice of debt nanc
The criteria for choosing different types of long term debt nanc
e.g. bank borrowings, bonds, convertible
• Availabilit
Only listed companies will be able to make a public issue of bonds on a stock exchange
With a 'public issue' the bonds are listed on a stock market, although most bond trading
is off-exchange
Most investors will not invest in bonds issued by small companies
Smaller companies are only able to obtain signi cant amounts of debt nance from a
bank
• Credit ratin
Large companies may prefer to issue bonds if they have a strong credit rating
Credit ratings are given to bond Issues by credit rating agencies such as Standard &
Poofs and Moody's
The credit rating given to a bond issue affects the interest yield that investors will require
If a company's bonds would only be given a sub-investment grade rating ('junk bond'
rating), the company may prefer to seek debt nance from a bank loan as it will be less
expensive
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• Amoun
Bond issues are usually for large amounts
It a company wants to borrow only a small amount of money, a bank loan would be
appropriate
• Duratio
If loan nance is sought to buy a particular asset to generate revenues tor the business,
the length of the loan should match the length of time that the asset will be generating
revenues
• Fixed or oating rat

Expectations of Interest rate movements will determine whether a company chooses to
borrow at a xed or oating rate
Fixed rate nance may be more expensive, but the business runs the risk of adverse
upward rate movements if it chooses oating rate nance
Banks may refuse to lend at a xed rate for more than a given period of time
• Security and covenant

The choice of nance may be determined by the assets that the business is willing or
able to offer as security, also on the restrictions in covenants that the lenders wish to
impose
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Procedures for issuing debt securitie
How to get debt (issue debt securities
You can get it from
1. Bank
ST and MT loan
2. Bond marke
LT securitie
You will ask the public to lend you some money (to invest in you
3. Private placemen
It is a new issue to the institutional investors (e.g. Pension funds
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The role of advisor
Raising nance on the capital market requires input from a wide range of
experts
Sponso
A sponsor, typically an investment bank or large accountancy rm, acts as the lead advisor
in an Initial Public Offer (IPO) on the Main Market
Firms offering services as sponsors must be approved by the UK Listing Authority (UKLA)
which forms part of the UK’s Financial Conduct Authority (FCA)
The sponsor’s functions include
• Project managing the IPO proces
• Co-ordinating the due diligence and the drafting of the prospectus (the prospectus is the
document in which the company offers its share for sale
• Ensuring compliance with the applicable rule
• Developing the investment case, valuation and offer structur
• Managing the communication between the London Stock Exchange and the UKL
• Advising the company’s board both before the IPO and afte
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Bookrunne
Share issues in the primary market may be underwritten by a nancial institution, such as
investment bank
The issue of debt may be underwritten in the same way. The underwriter is referred to as the
bookrunner
The bookrunner undertakes to raise nance from investors on behalf of the company
In the process, it helps to determine the appropriate pricing for the share or debt
If the bookrunner is unable to nd enough investors, it will hold some of the share itself
In a public offering, shares are often underwritten by a syndicate of several bookrunners
Reporting accountan
The directors bear legal responsibility for the integrity of the listing documents (including the
prospectus)
The sponsor, as the company’s lead advisor, risks considerable damage to its reputation
should the prospectus be de cient
For this reason, the sponsor would usually require the company to engage a reporting
accountant to review and report on the company’s readiness for the transaction
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The reporting accountant would typically report on the following
• Financial reporting procedures - whether the company would be able to meet its
reporting obligations as a public compan
• Financial historical records - the equivalent of an audit opinion on the company’s entire
nancial track record
• Working capital - whether the basis for the directors’ working capital statement in the
prospectus is soun
• Other information - any other additional information provided in the prospectus, such as
pro t forecast and pro-forma nancial information (for example, to illustrate the effects of
an IPO
Lawye
The London Stock Exchange is governed by EU law, UK Acts of Parliament, the FCA’s
Listing Rules and the Exchange’s own rules
Lawyers therefore play an important part in ensuring that the company meets the eligibility
criteria for the listing, and continues to comply with the ongoing obligations of a public
company
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Target debt pro l
Managing the debt pro l
A company's debt pro le is its mix of different types or debt nance
Management will be responsible for structuring the debt pro le to reduce the risks of debt
nance, such as re nancing risk, currency risk and interest rate risk
Re nancing ris
This is the risk that a company cannot repay or re nance existing debts
This risk is reduced if its maturity pro le (ie the timing of maturity of debts) is spread so that
the debts mature at different times
This enables the company to put in place a schedule or re nancing and ensure there is
adequate cash available to pay off debts when they mature
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Currency ris
A company can face higher costs if it borrows in a currency for which exchange rates move
adversely against the company's domestic currency
Management should seek to match the currency of the loan with the currency or the
underlying operations / assets that generate revenue to pay interest / repay the loans
Currency risk can also be mitigated through the use of derivatives such as currency futures,
options or swaps
Interest rate ris
This is the risk of interest payments increasing due to uctuating interest rates
A company that has xed interest debt may end up paying more than it needs to if interest
rates fall
However the company runs the risk of adverse increases in interest rates if it chooses
oating rate debt
The risk of this can be mitigated through the use of derivatives such as interest rate futures,
options or swaps
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Types of foreign currency ris
Translatio
Risk that there will be losses when a subsidiary is translated into the parent company
currency when doing consolidated account
Transactio
Risk of exchange rates moving against you when buying and selling on credit, between the
transaction date and actual payment dat
Economi
Long term cash ow risk caused by exchange rate movements
For example a UK exporter will struggle if sterling appreciated against the euro
It is like a long term transaction ris
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Options to manage these risk
1. Only deal in home currency ! (commercially acceptable?
2. Do nothing ! (Saves transaction costs but is risky
3. Leading - Receive early (offer discount) - expecting rate to depreciat
4. Lagging - Pay later if currency is depreciatin
5. Matching - Use foreign currency bank account - so matching receipts with payments then
risk is against the net balanc
6. Another way of managing the risk is using
Hedging, options, futures, swaps and forward rates - more of these later
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Currency Swap
What are they
• The exchange of debt from one currency to anothe
• 2 companies agree to exchange payments on different terms (eg different currency
Advantage
1. Eas
2. Low transaction cost
3. Spread debt across different currencie
How to use the
Currency swaps are better for managing risk over a longer term (than currency futures or
currency options
A currency swap is an interest rate swap (between 2 companies) where the loans are in
different currencies
It begins with an exchange of principal, although this may be a notional exchange rather
than a physical exchange
During the life of the swap agreement, the companies pay each others’ foreign currency
interest payments. At the end of the swap, the initial exchange of principal is reversed
Exampl
Consider a US company X with a subsidiary Y in France which owns vineyards. Assume a
spot rate of $1 = €0.7062. Suppose the parent company X wishes to raise a loan of €1.6
million for the purpose of buying another French wine company
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At the same time, the French subsidiary Y wishes to raise $1 million to pay for new up-to-
date capital equipment imported from the US
The US parent company X could borrow the $1 million and the French subsidiary Y could
borrow the € 1.6 million, each effectively borrowing on the other's behalf. They would then
swap currencies
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Interest rate risk managemen
If the organisation faces interest rate risk, it can seek to hedge the risk
Alternatively where the risk is immaterial in comparison with the company's overall cash
ows or appetite for risks, one option is to do nothing
The company then accepts the effects of any movement in interest rates which occur
The company may also decide to do nothing if risk management costs are excessive, both in
terms of the costs of using derivatives and the staff resources required to manage risk
effectively
Interest Rate Ris
• Fixed rate borrowing - risk that variable rates dro
• Variable rate borrowing - risk that variable rates ris
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Methods of reducing interest rate risk include the following
1. Nettin
- aggregating all positions, assets and liabilities, and hedging the net exposur
2. Smoothin
- maintaining a balance between xed and oating rate borrowin
3. Matchin
- matching assets and liabilities to have a common interest rat
4. Forward rate agreement (FRA
- a binding contract that xes an interest rate for short-term lending/investing o
short-term borrowing, for an interest rate period that begins at a future dat
5. Interest rate future
- can be used to hedge against interest rate changes between the current date and the
date at which the interest rate on the lending or borrowing is set
Borrowers sell futures to hedge against interest rate rises. Lenders buy futures to hedge
against Interest rate falls
6. Interest rate option
- an interest rate option grants the buyer of it the right, but not the obligation, to deal at
an agreed interest rate (strike rate) at a future maturity dat
7. Interest rate swaps 
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Interest Swap
Interest Rate Option
Grants the buyer the right (no obligation) to deal at a speci c interest rate at a future date
At that date the buyer decides whether to go ahead or no
These protect against adverse movements in the actual interest rate but allow favourable
ones
Clearly, because of this, the option involves buying at a premium
Interest rate Swap
2 companies agree to exchange interest rate payments on different terms (eg xed and
variable)
For example one interest rate payment as a xed rate and the other at a oating rate
Interest rate swaps can act as a means of switching from paying one type of interest to
another, allowing an organisation to obtain less expensive loans and securing better deposit
rates
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Advantage
1. Eas
2. Low transaction costs (compared to getting a different loan
In the simplest form of interest rate swa
Party A agrees to pay the interest on party B's loan, while party B reciprocates by paying the
interest on A's loan
If the swap is to make sense, the two parties must swap interest which has different
characteristics
Assuming that the interest swapped is in the same currency, the most common motivation
for the swap is to switch from paying oating rate interest to xed interest or vice versa
This type of swap is known as a 'plain vanilla' or generic swap
Illustration
Company A
- has a loan at FLOATING rate (LIBOR + 0.8%) from Bank
- thinks that the interest rates go up so wants FIXED rat
Company
- has a loan at FIXED rate (8%) from Bank
- thinks that the interest rates go down so wants FLOATING rat
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Solutio
• Company A can use a swap to change from paying interest at a oating rate of LIBOR +
0.8% to one of paying xed interest of 8%
So the Company A will pay
8% to Company
Libor + 0.8% to Bank
And will receive LIBOR + 0.8% form Company B
Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - (LIBOR + 0.8%)) = 8%
(FIXED)
• Company B will pay
8% to Bank
Libor + 0.8% to Company
And will receive 8% form Company A
Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - 8% FIXED) = LIBOR +
0.8% (FLOATING
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LIBOR or the London Inter-Bank Offered Rate is the rate of interest at which banks borrow
from each other in the London inter-bank market
A swap may be arranged with a bank, or a counterparty may be found through a bank or
other nancial intermediary
Fees will be payable if a bank is used
However a bank may be able to nd a counterparty more easily, and may have access to
more counterparties in more markets than if the company seeking the swap tried to nd the
counterparty itself
Swaps are generally terminated by agreeing a settlement interest rate, generally the current
market rate
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Debt covenant
Debt nance often comes with certain debt covenants from the lender
Debt covenants are agreements between a lender and the borrower to not breach certain
limits of nancial ratios and to abide by other restrictions, for example
• Restrictions on dividend payments
This is to safeguard the company's future cash ows and ability to meets its debts
• Financial ratio limits
Certain nancial ratios cannot fall below speci ed levels, eg interest cover, net debt/
EBIDTA, debt/debt and equity
• Restrictions of additional debt
Lenders may restrict the type and amount of additional debt a company can take on or
the nature of charges over assets that the company can issue
Breaches of debt covenants usually entitle the lender to demand full repayment of the loan.
However in practice this is unlikely; rather, the debt is re-negotiated
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Leases – Introductio
There are 2 types of lease - an Operating and a Finance lease
In simple terms, a nance lease is where the LESSEE takes the majority of the risks and
rewards of the underlying asset
Therefore with a nance lease the lessee would show the asset on their SFP (and the
related nance lease liability)
When classifying look for substance rather than the form
Finance Lease Indicator
• The lessee gets ownership of the asset at the end of the lease ter
• The lessee can buy the asset at such a low price that it is reasonably certain that the
option will be exercised
• The lease term is for the major part of the economic lif
• The PV of the lease payments is substantially the fair value of the leased asset; an
• Only the lessee can use the asset as it is so specialize
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Other possible nance lease indicator
• If the lessee cancels the lease, he has to pay the lessor’s losse
• The lessee gets any residual value gains/losses an
• The lessee can lease for a secondary period at a cheap ren
Land & Building
Normally separately classi e
The minimum lease payments are allocated between the land and buildings elements in
proportion to their relative fair values
• Land = Operating lease (unless title passes to the lessee at the end of the lease term
• Buildings = Operating or nance lease (by applying the classi cation criteria in IAS 17
The classi cation of leases is a key issue in corporate reporting. From a lessees point of
view, classifying as a nance lease will increase gearing and decrease ROCE (as there’s
more capital employed due to the nance lease liability). Interest cover will also decrease
As the SFP shows more liability, future borrowing will be harder to come by and current loan
covenants may be breached. The level of perceived risk may increase, loan covenants may
be compromised and an entity’s future borrowing capacity may be restricted
UK studies have revealed that average operating lease commitments are over ten times that
of reported nance lease obligations
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Lease or Bu
Simply choose the one with the lowest NPV cost (as asset revenues will be the same for
both methods
Let’s have a look at what are the relevant costs her
LEASE BUY
Rental Payment Cost of item
(Tax relief on these) (Residual Value)
(WDAs)
Unless the company does not pay tax - use the after tax cost of borrowin
= Interest rate x 70% (if tax is 30%
*Note that the cost of the loan should not include the interest repayments on the loa
Illustratio
Machine cost $6,400 (UEL 5 years
Capital allowances 25% reducing balanc
Finance choice
5 year loan 11.4% pre tax cost o
5 year Finance Lease @ $1,420 pa in advanc
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Solutio
Buy using the Loa
Year WDA Tax bene t Timing
0 Cost 6,400
1 WDA 1,600 480 Year 2
2 WDA 1,200 360 Year 3
3 WDA 900 270 Year 4
4 WDA 675 203 Year 5
5 Balancing Allowance 2,025 608 Year 6
Post Tax borrowin
11.4% x 70% = 7.98% = 8
Cost = (4,984
Time 0 1 2 3 4 5 6
Cost (6400)
Tax Bene t 480 360 270 203 608
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Discount Factor 1 0.926 0.857 0.794 0.735 0.681 0.630
Discounted Cash ows (6400) 411 286 198 138 383
Option 2 - Leas
Cost (4,548
Cash Discount Factor Discounted Cash ows
0-4 Lease Payments (1,420) 1+3.312 (6,123)
2-6 Tax saving 426 4.623 - 0.926 1,575
The cheapest option is the leas
Leasing bene ts in genera
1. Allows company to get the asset if they can’t get a bank loa
2. Some taxation bene ts (Tax exhaustion
3. Avoids regulations that other lending can give such as covenants et
Operating Lease Feature
1. Possibility of short term renta

2. No initial capital outla
3. No risk of obsolescenc
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4. Often maintained & insured by the lesso

5. Off balance sheet nanc
6. Can be expensiv
Finance lease feature
1. Long term renta

2. No need for initial capital outla
3. Simply an alternative source of nanc
4. May be cheape
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Foreign Exchange Single compan
Transactions in a single compan
This is where a company simples deals with companies abroad (who have a different
currency)
The key thing to remember is that
ALL EXCHANGE DIFFERENCES TO INCOME STATEMEN
So - a company will buy on credit (or sell) and then pay or receive later. The problem is that
the exchange rate will have moved and caused an exchange difference
Step 1: Translate at spot rat
Step 2: If there is a creditor/debtor @ y/e - retranslate it (exch gain/loss to I/S
Step 3: Pay off creditor - exchange gain/loss to I/
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Illustration
On 1 July an entity purchased goods from a foreign country for Y$10,000.
On 1 September the goods were paid in full
The exchange rates were:
1 July $1 = Y$10
1 September $1 = Y$
Calculate the exchange difference to be included in pro t or loss according to IAS 21 The
Effects of Changes in Foreign Exchange Rates
Solutio
Account for Payables on 1 July: Y$10,000/10 = 1,00
Payment performed on 1 September: Y$10,000 / 9 = 1,11
The Exchange difference: 1,000 - 1,111 = 111 los
Illustration
Maltese Co. buys £100 goods on 1st June (£1:€1.2
Year End (31/12) payable still outstanding (£1:€1.1
5th January £100 paid (£1:€1.05
Solutio
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Initial Transactio
Dr Purchases 12
Cr Payables 12
Year En
Dr Payables 1
Cr I/S Ex gain 1
On paymen
Dr Payables 11
Cr I/S Ex gain
Cr Cash 10
Also items revalued to Fair Value will be retranslated at the date of revaluation and the
exchange gain/loss to Income statement
All foreign monetary balances are also translated at the year end and the differences taken
to the income statement
This would include receivables, payables, loans etc
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Syllabus B3. Evaluate equity nanc
Methods of otatio
Methods of obtaining a listing / otatio
Flotation means
The process of making shares available to investors by obtaining a quotation on a stock

exchange
An unquoted company can obtain a listing on the stock market by means of
1. Offer for sal

2. Prospectus issu
3. Placin
4. Introductio
Initial public offe
An Initial Public Offer (IPO) is a means of selling the shares of a company to the public at
large
When companies 'go public' for the rst time, a large issue will probably take the form of an
IPO
Subsequent issues are likely to be placings or rights issues
An IPO entails the acquisition by an issuing house of a large block of shares of a company,
with a view to offering them for sale to the public
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An issuing house is usually an investment bank (or sometimes a rm of stockbrokers)
It may acquire the shares either as a direct allotment from the company or by purchase from
existing members
In either case, the issuing house publishes an invitation to the public to apply for shares,
either at a xed price or on a tender basis
The issuing house accepts responsibility to the public, and gives the support of its own
reputation and standing to the issue
In May 2012 Facebook launched one of the largest IPOs ever on the Nasdaq stock
exchange at $38 per share, valuing the company at $104 billion
Many questioned whether this was overly ambitious, given that the company's previous year
net income gure was $1 billion
As a result the share price tell in early trading and fell further over the next four months to a
low of $17.55 per share in September 2012. Since then, the share price has recovered and
on 21 June 2014 it was $64.50
1. Offer for sale by tende

It is often very dif cult to decide upon the price at which the shares should be offered to
the general public
One way of trying to ensure that the issue price re ects the value of the shares as
perceived by the market is to make an offer for sale by tender
A minimum price will be xed and subscribers will be invited to tender for shares at
prices equal to or above the minimum
The shares will be allotted at the highest price at which they will all be taken up
This is known as the striking price
2. Prospectus issu
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Issues where the issuing rm sells shares directly to the general public tend to be quite
rare on many stock exchanges, and the issues that are made tend to be quite large
These issues are sometimes known as offers by prospectus
This type of issue is very risky, because of the lack of guarantees that all shares will be
taken up
3. A placin
A placing is an arrangement whereby the shares are not all offered to the public, but
instead the sponsoring market maker arranges for most of the issue to be bought by a
small number of investors, usually institutional investors such as pension funds and
insurance companies
The choice between an offer for sale and a placin
Is a company likely to prefer an offer tor sale of its shares, or a placing
• Placings are much cheaper

• Approaching institutional investors privately is a much cheaper way of obtaining
nance, and thus placings are often used for smaller issues
• Placings are likely to be quicker
• Placings are likely to involve less disclosure of information
• However, most of the shares will be paced with a relatively small number of
(institutional) shareholders, which means that most of the shares are unlikely to be
available for trading after the otation, and that institutional shareholders will have
control of the company
• When a company rst comes to the market in the UK) the maximum proportion of
shares that can be placed is 75%, to ensure some shares are available to a wider
public
4. An introductio
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By this method of obtaining a quotation, no shares are made available to the market, neither
existing nor newly created shares; nevertheless, the stock market grants a quotation
This will only happen where shares in a large company are already widely held, so that a
market can be seen to exist
A company might want an introduction to obtain greater marketability for the shares, a
known share valuation for inheritance tax purposes and easier access in the future to
additional capital
Flotation has an impact on stakeholders as follows
• Customers and suppliers will have more faith in a company that has gone through the
due diligence process and is governed by stock exchange rule
• Employees can bene t from receiving shares in the compan
• Existing shareholders can exit at otation
• Flotation is a very lengthy process and requires a lot of management time
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Rights issu
Issue of shares for cas
A rights issue is an issue of shares for cash
These shares are usually issued at a discount to the current market price
The 'rights' are offered to existing shareholders, who can sell them if they wish
This formulae is given in the exam
Legen
N = number of shares required to buy 1 shar
Cum rights price = the market value before the rights issue is mad
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Illustration 1 - TER
Cow Co. makes a 1 for 4 rights issue, at $3 (MV before issue made $5
What is the theoretical ex-rights price
Solutio
TERP
= 1 / (4 + 1) x [(4 x 5) + 3
= $4.6
Illustration
Cow Co. makes a 1 for 3 rights issue, at $5 (MV before issue made $6
Solutio
TERP
= 1 / (3 + 1) x [(3 x 6) + 5
= $ 5.7
Advantage
• Raises cas
• Reserves are available for future dividend distributio
Disadvantage
• If a shareholder sells his rights, he will be losing (diluting) his control in the compan
Syllabus B1c. Raising equity nanc
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Yield-adjusted TER
Yield adjusted ex-rights pric
So normally we presume that when we do a rights issue, the money from it generates the
same rate of return as existing funds
But, if the new money raised is likely to earn a different return from to the current return, the
yield-adjusted theoretical ex-rights price should be calculated
The yield-adjusted price demonstrates how the market will view the rights issue
This formulae is given in the exam
Legen
N = number of shares required to buy 1 shar
Cum rights price = the market value before the rights issue is mad
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Illustration 1 - TERP (simple
Cow Co. makes a 1 for 5 rights issue, at $2.50 (MV before issue made $3
This market value just before the issue is known as the cum rights price
Use the formulae
Solution
So the value per share after the rights issue (TERP) is
TERP
= 1 / (5 + 1) x [(5 x 3.00) + 2.50
= $ 2.9
Illustration 2 - Yield-adjusted TER
Cow Co. makes a 1 for 5 rights issue, at $2.50 (Cum-rights price $3
Rate of return on new funds = 15%, and on existing funds = 10%
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Require
Calculate the yield-adjusted theoretical ex-rights price
Solutio
Cum rights price =
N = 5 share
Issue price = 2.5
Yield on new funds = 15
Yield on existing funds = 10
Yield-adjusted theoretical ex-rights price
= 1/(5+1) x [(5 x 3) + 2.50 x 0.15/0.1)
= 18.75 /
= $3.1
Illustration 3 - Yield-adjusted TER
A Cow Co. currently has
WACC of 10
Current share price of $2.5
The company announces a 1 for 4 rights issue at a discount of 25% to the current share
price to nance a project that has a yield of 14%
The yield adjusted TERP is
Solutio
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Yield-adjusted theoretical ex-rights price
= 1/(4+1) x [(4 x 2.50) + 1.88 x 0.14/0.1)
= 12.632 /
= $2.5
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Syllabus B4. Evaluate dividend polic
Dividend Theorie
Dividend polic
A decision to increase capital investment spending will increase the need for financing,
which could be met in part by reducing dividends
In a perfect market - Miller and Modiglian
• Miller and Modigliani showed that, in a perfect capital market, the value of a company
depended only on its investment decision, and not on its dividend or nancing decisions
In a perfect market, the value of a company is maximised when all positive NPV projects
are invested in
This affects share price NOT dividend policy
• In a perfect market the share price re ects all future dividends, so shareholders who
were unhappy with the level of dividend declared by a company could gain a ‘home-
made dividend’ by selling some of their shares
This is possible since there are no transaction costs in a perfect capital market
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• M & M's dividend irrelevancy theory
Shareholders return can be measured as the aggregate of dividends plus growth in

share price
Bird in the hand vie
• Many say there is a clear link between dividend policy and share prices
For example, it has been argued that investors prefer certain dividends now rather than
uncertain capital gains in the future (the ‘bird-in-the-hand’ argument)
• Imperfect market
The real world markets are semi strong, not perfect
So information knowledge of managers and shareholders are not equal
Therefore a change in dividend policy could be seen by investors (with less information
than managers) as a ‘signal’ and so affect the share price
• Signalling effec
The size and direction of the share price change will depend on the difference between
the dividend announcement and the expectations of shareholders
This is referred to as the ‘signalling properties of dividends’
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Clientele Effec
• Apple shares have outperformed the market massively in the last few years
This means that Apple shareholders are enjoying huge share price increases (capital
growth)
These shareholders cannot get such returns by investing elsewhere so do not want their
money back from Apple yet
Consequently Apple’s dividend policy to date is zero dividends despite its huge cash
balance
• This is referred to as the ‘clientele effect’
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
Legal Constraint
Three general rules are followed when paying dividends
1. The Net Pro t Rul

dividends can only be paid from current and past earning
2. Capital Impairment Rul

prevents payment from the value of shares on the balance shee
3. Insolvency Rul
dividends cannot be paid when insolvent or if the payment makes the rm insolven
Forms of Dividend
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Types of payment
1. Cash dividend
2. Stock dividends: Corporations distribute dividends in the form of new shares to existing
shareholder
3. Stock split: Issue new shares to existing shareholders by splitting existing shares (E.g.,
2-for-1 split
4. Reverse split: Issue new shares to replace out shares but results in a reduction in
number of outstanding shares (E.g., 1-for-2 shares
5. A scrip (or share) dividend is an offer of shares in a company as an alternative to a cash
dividend
It is offered pro rata to existing shareholdings
Advantages of a Scrip dividen
• From a company point of view, it has the advantage that, if taken up by shareholders, it
will conserve cash, i.e. it will reduce the cash out ow from a company compared to a
cash dividend
This is useful when liquidity is a problem, or when cash is needed to meet capital
investment or other nancing needs
• Another advantage is that a scrip dividend will lead to a decrease in gearing, whether on
a book value or a market value basis, because of the increase in issued shares
This decrease in gearing will increase debt capacity
A disadvantage of a scrip dividend i
that in future years, because the number of shares in issue has increased, the total cash
dividend will increase, assuming the dividend per share is maintained or increased
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Dividends polic
Dividend policy is mainly a re ection of the investment decision and the

nancing decisio
Investment decisio
eg. Think about a young company (such as acowtancy.com
All our cash will be used for investments, so our shareholders expect low or zero
dividen
They are happy with that because they think we are fab and cool :) and will grow and
their shares will go up hugely in value as we gro
Financing decisio
• However, if a company can borrow to nance its investments, it can still pay dividends
This is sometimes called borrowing to pay a dividend. There are legal constraints over a
company’s ability to do this
it is only legal if a company has accumulated realised pro ts
• Dividend policy tends to change during the course of a business’s lifecycle

Young compan
Zero / Low dividen
High growth / investment needs
Wants to minimise deb
Mature compan
High stable dividen
Lower growt
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Able & willing to take on debt
Possibly share buybacks to
A Residual dividend polic
is a dividend policy company management uses to fund capital expenditures with available
earnings before paying dividends to shareholders
It is appropriate for a small company listed on a small stock exchange and owned by
investors seeking maximum capital growth on their investmen
A special dividen
is a payment made by a company to its shareholders that the company declares to be

separate from the typical recurring dividend cycl
Usually when a company raises its normal dividend, the investor expectation is that this
marks a sustained increase
The disadvantage can be that the company could not respond quickly to new
business opportunities
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What to look for when considering investing in other company
1. Are dividends growing at a stable rate
2. What is the company’s dividend payout ratio ( Divs / PAT)
A reduction in dividends paid is looked poorly upon by investors
3. What is the company’s dividend cover (PAT / dividends)
4. Are the company’s earnings growing steadily
5. What happen if pro ts will fall? Will the dividends be reduced
If so, it may cause unnecessary uctuations of the share price or result in a depressed
share price
6. You should take into account factor such as taxation implications
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Alternatives to a cash dividen
These methods include
Shareholder perk
Some companies (e.g. hotels) offer discounts to shareholders on room bookings and
restaurant meals
A number of transport companies offer reductions in fares
Some retailers provide discount vouchers, which are sent to shareholders at the same time
as the annual report and accounts
Scrip dividend
When the directors of a company consider that they must pay a certain level of dividend, but
would really prefer to retain funds within the business, they can introduce a scrip dividend
scheme
A scrip dividend enables the shareholders to choose whether to receive a cash dividend or
shares
Share repurchase
Companies with cash surpluses may choose to introduce a share buy-back scheme,
whereby the company’s shares are purchased at the company’s instructions on the open
market
Bene t of a share buyback schem
1. It helps to control transaction costs and manage tax liabilitie
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2. With the share buyback scheme, the shareholders can choose whether or not to sell
their shares back to the company
3. Share buybacks are normally viewed as positive signals by markets and may result in an
even higher share price
4. Increasing future EPS (because of the reduction in the number of shares in issue
5. Changing the gearing level of the compan
6. Reducing the likelihood of a takeove
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Share repurchas
Companies may purchase their own shares bac
Therefore if a company has surplus cash and cannot think of any pro table 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
So what will actually happen
1. The company's CASH will go DOWN
Becasue the company is buying the shares back
2. The number of SHARES will go DOWN
The effect on EP
EPS = Earnings / Share
• Earnings will stay as they ar
• But you will have less share
• Therefore EPS will INCREAS
Shares may be purchased either by
1. Open market purchase – the company buys the shares from the open market at the
current market price
2. Individual arrangement with institutional investors
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3. Tender offer to all shareholders
Reasons for share repurchas
• Readjustment of the company's equity bas
• Purchase of own shares may be used to take a company out of the public market and
back into private ownership
• Purchase of own shares provide an ef cient means of returning surplus cash to the
shareholders
• Purchase of own shares increases earning per share (EPS) and return on capital
employed (ROCE)
• To increase the share price by creating arti cial demand
Problems of share repurchas
1. Lack of new idea
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
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2. Cost
Compared with a one-off dividend payment, share repurchase will require more time and
transaction costs to arrange
3. Resolutio
Shareholders have to pass a resolution and it may be dif cult to obtain their consent
4. Gearin
If the equity base is reduced because of share repurchase, gearing may increase and
nancial risk may increase
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Syllabus C. Financial risks
Syllabus C1. The sources and types of nancial risk
Different types of interest rate ris
Gap Exposur
Let’s say you have some receivable loans (at variable rates) and some payable loans (at
variable rates). Ideally these would match each other and you wouldn’t worry about the
interest rate
However if they mature at different times, you are for going to be ‘exposed’ for a period - and
this may be good news (positive gap) or bad news (negative gap
• Positive Gap - the interest bearing assets are greater than the interest paying liabilities
maturin
• Negative Gap - more interest sensitive liabilities within the perio
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Basis Ris
This time lets presume that our variable rate receivable and payable loans are perfectly
matched (in size and maturity). Therefore there is no gap exposure
However the rates they pay may be different - as they may be BASED on different things -
for example one is based on LIBOR and the other no
It means they may be the same now but in the future they may not move in line with each
other 
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Syllabus C2. Evaluate nancial risk
Understanding Exchange Rate
£ : $1.
Here £ = Base Currency; $ = Counter Currenc
£0.67:
Here $ = Base Currency; £ = Counter currenc
Normally the “foreign” currency is the counter currenc
Banks BUY HIGH and SELL LO
Here we are referring to the foreign / counter currenc
If a company needs to make a foreign currency paymen
Banks SELL the foreign currency at the LOWER rat
If a company needs to make a foreign currency receip
Banks will BUY that foreign currency from them at the HIGHER rat
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Translating Currencie
1. If you are given the counter currency
DIVIDE the amount by the exchange rat
Eg A UK company has to pay $1,500
£ : $1.
Solution = $1,500 / 1.5 = £1,00
2. If you are given the Base currency
MULTIPLY the amount by the exchange rat
Eg A UK company has to pay £1,000 in $
£ : $1.
Solution = £1,000 x 1.5 = $1,50
If £ is strong (strengthening, appreciate
• UK exporters suffers because the $ is weak and their revenues is in $s
• If the £ appreciates relative to the $, the exchange rate falls:
it takes fewer £ to purchase $1.
($1 = £1.5 → $1= £1.4)
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If £ is weak (weakening, depreciate, devalue
• UK importers suffer because the $ is strong and their costs are in $s
Translation risk
- NCA and CA value - decreas
- NCL and CL value - increase
• For instance, if the £ depreciates relative to the $, the exchange rate rises:
it takes more £ to purchase $1.
($1= £1.5 → $1= £1.7). 
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Predicting Exchange Rate
Purchasing Power Parity (PPP theory
Why do exchange rates uctuate
“The law of one price
Illustratio
Item costs $1,00
$2:€ (base
However in ation in US is 5% and Europe is 3
According to law of one price what is the predicted exchange rate in 1 year
• Solutio
So next year - Item in US costs $1,050 and in Europe €51
“The law of one price” = $1,050 = €51
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So, forward exchange rate = 1,050 / 515 = $2.039:€
PPPT “High in ation leads to depreciation of currency
• Another way of calculating this is as follows
Exchange rate now (counter) x (1+ Inf (counter) / 1 + inf (base)
2 x 1.05 / 1.03 = 2.03
Limitation
1. Future in ation is an estimat
2. Market is ruled by speculative not trade transaction
3. Governments often interven
Interest Rate Parity (IRP theory
Why do exchange rates uctuate?
An investor will get the same amount of money back no matter where he deposits his mone
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Illustratio
US Interest rate = 10
European Interest rate = 8
Exchange rate = $2:
Investor has $1,000 to invest for 1 yea
What is the future exchange rate as predicted by IRPT
• Solutio
In US he will receive $1,100 in one years tim
In Europe he will receive €54
Forward rate will therefore be 1,100 / 540 = $2.037:
IRPT “High interest rates leads to depreciation of currency
• Another way of calculating this is as follows
Exchange rate now x (1+ Int (counter) / 1 + int (base)
2 x 1.10 / 1.08 = 2.03
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Limitation
1. Government interventio
2. Controls on currency tradin
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Interest Rate Ris
Fixed rate borrowing - risk that variable rates dro
Variable rate borrowing - risk that variable rates ris
Yield Curves (Return to debtholder
Norma
Long term loans - higher yields (more risk
Inverte
Longer term loans - Less yield (upcoming recession
Fla
Yields are same for short and long term loan
The shape of the curve depends on
In a bit more detail, the shape of the yield curve and thus the expectations of what the
interest rates will be depends on
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1. Liquidity preferenc
Investors want their cash back quickly therefore charge more for long term loans which tie
up their cash for longer and thus expose it to more ris
2. Expectation
Interest rates rise (like in ation) - so longer term more charge
NB. Recession expected means less in ation and less interest rates so producing an
inverted curv
3. Market segmentatio
If demand for long-term loans is greater than the supply, interest rates in the long-term loan
market will increase
Differing interest rates between markets for loans of different maturity can also explain why
the yield curve may not be smooth, but kinke
4. Fiscal polic
Governments may act to increase short-term interest rates in order to reduce in atio
This can result in short-term interest rates being higher than long-term interest rates
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Why is yield curve important
It predicts interest rates.
Normal curves are upward sloping
Therefore, in these circumstances, use short term variable rate borrowing and long term
xed rate
Gap Exposure?
The risk of an adverse movement in the interest rates reducing a company’s cash o
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Value at ris
Value at Risk is the amount potentially lost, at a given "con dence level"
VaR is measured by using normal distribution theory
Con dence levels are often set at either
95% (The VaR here shows the potential loss that has only a 5% chance of decline) o
99% (The VaR considers a 1% chance of loss of value)
Illustratio
Cow plc estimates the expected NPV of a project to be £100 million, with a standard
deviation of £9.7 million
Required
Establish the value at risk using both a 95% and also a 99% con dence level
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Solutio
• Using Z = (X - μ) / σ
wher
X = result we are considerin
μ = mea
σ = standard deviatio
• Establishing Z from the normal distribution tables
ie at a 95% (0.95) con dence level, 1.65 is the value for a one tailed 5% probability of
decline (i.e. 0.95 - 0.50 = 0.45 = 0.4505 from the normal distribution table)
and at a 99% (0.99) con dence level, 2.33 is the value for a one tailed 1% probability of loss
of NPV (i.e. 0.99 - 0.50 = 0.49 = 0.4901 from the normal distribution table)
• At 95% con dence level, Z = (X-100) / 9.7 = –1.65;
therefore X = (9.7x–1.65)+100 = 8
• At 99% con dence level, Z = (X-100) / 9.7 = –2.33
therefore X = (9.7x–2.33)+100 = 77.
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• 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
Value at risk can be quanti ed for a project using simulation to calculate the project’s
standard deviation
In this context, the standard deviation needs to be adjusted by multiplying by the square root
of the time period i
95% value at risk = 1.645 x standard deviation of project x √time period of the projec
Illustratio
A four-year project has an NPV of $2m and a standard deviation of $1m per annum
Require
Analyse the project’s value at risk at a 95% con dence level
The VAR at 95% is 1.645 x 1,000,000 x √4 = $3,290,000
ie worst case NPV (only 5% chance of being worse) = $2m – $3.29m = – $1.29
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Illustratio
A simulation has been used to calculate the expected value of a project and is deemed to be
normally distributed with the following results
Mean = $40,000 (positive
Standard deviation = $21,00
Calculate the following
a) The probability that the NPV of the project will be greater than 0
b) The probability that the NPV will be greater than $45,000
• a)
Using Z = (X - μ) / σ
μ = $40,00
σ = $21,00
X=
Z = (0 - 40,000) / 21,00
Z = 1.9
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• From normal distribution table
1.90 = 0.4713 + 0.50 = 0.9713 = 97% probability that NPV >
• b)
Using Z = (X - μ) / σ
Z = (45,000 - 40,000) / 21,00
Z = 0.2
• From normal distribution table
0.24 = 0.094
the
0.50 - 0.0948 = 0.4052 = 41% probability that the project's NPV > $45,000 
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Syllabus C3. Hedging techniques for foreign currency ris
Forward Rate
So, remember what we are looking at here are ways to negate the risk that, in the future, the
exchange rates may move against u
So we have bought or agreed a sale now in a foreign currency, but the cash won’t be paid
(or received) until a future dat
With a forward rate we are simply agreeing a future rate now
Therefore xing yourself in against any possible future losses caused by movements in the
real exchange rat
However - you also lose out if the actual exchange rate moves in your favour as you have
xed yourself in at a forward rate already 
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Illustratio
UK importer has to pay $1,000 in a months tim
He takes the forward rate of $1.8-1.9:
The bank then has agreed to SELL the dollars (counter currency) to the importer.
Remember the bank SELLS LO
The exchange rate would therefore be $1.8:
So, the bank will give the exporter $1,000 in return for £555.
The importer must pay £55
NOTE
If importer cannot ful ll the forward contract agreed (maybe because he didnt receive the
goods) the bank will sell the importer the currency and then buy it back again at the current
spot rate
This closes out the forward contrac
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Advantages of forward rat
1. Flexibl
2. Straightforwar
Disadvantages of forward rat
1. Contracted commitment (even if you haven’t received money
2. Cannot bene t from favourable movement
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Money Market Hedges - paymen
The whole idea of a money market hedge is to take the exchange rate NOW even though
the payment is in the future
By doing this we eliminate the future exchange risk (and possible bene ts too of course
So. the foreign payment is in the future, but we are going to get some foreign currency NOW
to pay for it
We do not need the full amount though, as we can put the foreign money into a foreign
deposit account to earn just enough interest to make the full payment when read
We, therefore, calculate how much is needed now by taking the full amount and discounting
it down at the foreign deposit rat
Now we know how much foreign currency we need NOW, we can convert that into home
currency using the spot rate 
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We now know how much home currency we need. This needs to be
borrowed. So, the cost to us will eventually be
Amount of home currency borrowed + interest on that until payment is made.
(Obviously here we use the home borrowing rate
Steps
1. Calculate how much foreign currency needed (discount @ foreign deposit rate
2. Convert that to home currenc
3. Borrow that amount of home currenc
4. The cost will be the amount borrowed plus interest on that (home currency borrowing rate
Illustratio
Let’s say we are a UK company and need to pay $100 in 1 year.
UK borrowing rate is 8% and US deposit rate is 10%.
Exchange rate now $2 - 2.2 :
• Need to pay $100 in 1 year so we borrow 100 x 1/ 1.10 = 9
• Borrow just $91 as we then put it on deposit and it attracts 10% interest - to pay off the
whole $100 at the en
• Convert $91 dollars now. We need dollars, so bank SELLS us them. They always SELL
LOW. So 91 / 2 = £45.
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• £45.5 is borrowed now. We will then have to pay interest on this in the UK for a year.
• So £45.5 x 1.08 = 49.1
• £49.14 is the total cost to u
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Money Market Hedge - Receip
The whole idea of a money market hedge is to take the exchange rate NOW even though
the receipt is in the future
By doing this we eliminate the future exchange risk (and possible bene ts too of course
The foreign receipt is in the future, we are going to get eliminate rate risk by getting that
foreign currency NOW
To do this we need to borrow it abroad
We do not borrow the full amount though, as the receipt will pay off this loan plus interest
We, therefore, calculate how much is needed now by taking the full amount and discounting
it down at the foreign borrowing rat
Now we know how much foreign currency we need NOW, we can convert that into home
currency using the spot rate
Here the bank are buying foreign currency off us and so will BUY HIG
We then take this home currency and put it on deposit at hom
The eventual receipt is the amount converted plus the interest earned at hom
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Steps
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate
3. Deposit that amount of home currenc
4. The receipt will be the amount converted plus interest on that (home currency deposit
rate
Illustratio
Will receive $400,000 in 3 month
Exchange rate now: $1.8250 - 1.8361:
Forward rates $1.8338 - 1.8452:
Deposit rates (3 months) UK 4.5% annual US 4.2% annua
Borrowing rates (3 months) UK 5.75% US 5.1% annua
1. Calculate how much foreign currency needed (discount @ foreign borrowing rate)
Interest = 5.1% x 3/12 = 1.275
$400,000 x 1/ 1.01275 = $394,96
The UK company now needs to sell $394,964 from the bank. The bank will BUY HIG
394,964 / 1.8361 = £215,11
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3. Deposit that amount of home currency
This amount will be deposited at home at 4.5% for 3/12 = 1.125% = 215,110 x 1.125% =
£217,530 
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Currency Future
What is this little baby all about then
• It’s a standard contract for set amount of currency at a set dat
• It is a market traded forward rate basicall
*Calculations of how these work are required only for P4 exam (not F9
Explanatio
When a currency futures contract is bought or sold, the buyer or seller is required to deposit
a sum of money with the exchange, called initial margin
If losses are incurred as exchange rates and hence the prices of currency futures contracts
change, the buyer or seller may be called on to deposit additional funds (variation margin)
with the exchang
Equally, pro ts are credited to the margin account on a daily basis as the contract is ‘marked
to market’
Most currency futures contracts are closed out before their settlement dates by undertaking
the opposite transaction to the initial futures transaction, ie if buying currency futures was the
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initial transaction, it is closed out by selling currency futures. A gain made on the futures
transactions will offset a loss made on the currency markets and vice versa
Advantage
1. Lower transaction costs than money marke
2. They are tradeable and so do not need to always be closed ou
Disadvantage
1. Cannot be tailored as they are standard contract
2. Only available in a limited number of currencie
3. Still cannot take advantage of favourable movements in actual exchange rates (unlike in
options…next!) 
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Currency Option
Features of Currency Options
A currency option gives its holder the right to
Buy (Call option) the contracted currency o
Sell (Put option) the contracted currenc
on or before a speci ed date, at a xed rate of exchange (the strike rate for the option)
If the exchange rate moves against you - then take the option which is more favourabl
If the exchange rate moves in your favour - then ignore the option (which would be
adverse)... You can't lose
Clearly, because of this, the option involves buying at a premium at the beginning 
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Disadvantage
1. The premiu
2. Must be paid up immediatel
3. Not available in every currenc
Advantage
1. Currency options do not need to be exercised if it is disadvantageous for the holder to do
so
2. Holders of currency options can take advantage of favourable exchange rate movements
in the cash market and allow their options to lapse. The initial fee paid for the options will still
have been incurred, however. 
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Currency Swap
What are they?
• The exchange of debt from one currency to anothe
• 2 companies agree to exchange payments on different terms (eg different currency
Advantage
1. Eas
2. Low transaction cost
3. Spread debt across different currencie
How to use the
Currency swaps are better for managing risk over a longer term (than currency futures or
currency options
A currency swap is an interest rate swap (between 2 companies) where the loans are in
different currencies
It begins with an exchange of principal, although this may be a notional exchange rather
than a physical exchange
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During the life of the swap agreement, the companies pay each others’ foreign currency
interest payments. At the end of the swap, the initial exchange of principal is reversed
Exampl
Consider a US company X with a subsidiary Y in France which owns vineyards. Assume a
spot rate of $1 = €0.7062. Suppose the parent company X wishes to raise a loan of €1.6
million for the purpose of buying another French wine company.
At the same time, the French subsidiary Y wishes to raise $1 million to pay for new up-to-
date capital equipment imported from the US.
The US parent company X could borrow the $1 million and the French subsidiary Y could
borrow the € 1.6 million, each effectively borrowing on the other's behalf. They would then
swap currencies. 
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Syllabus C3. Hedging techniques for interest rate ris
Market Value of Bond
Have a think (or even better) a look at when we calculated the cost of debt for Irredeemable
debts (bonds
You will see that we took the capital and interest and discounted it (at a guessed rate) then
compared it to the MV of the bond..and so o
This is because you calculate the MV of a loan or a bond by taking its Capital and Interest
and discounting it down by the cost of deb
Therefore the MV of Bonds is affected by
1. Amount of interest paymen
The market value of a traded bond will increase as the interest paid on the bond increases,
since the reward offered for owning the bond becomes more attractive
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2. Frequency of interest payment
If interest payments are more frequent, say every six months rather than every year, then
the present value of the interest payments increases and hence so does the market value
3. Redemption valu
If a higher value than par is offered on redemption, the reward offered for owning the bond
increases and hence so does the market value
4. Period to redemptio
The market value of traded bonds is affected by the period to redemption, either because
the capital payment becomes more distant in time or because the number of interest
payments increases
5. Cost of deb
The present value of future interest payments and the future redemption value are heavily
in uenced by the cost of debt, i.e. the rate of return required by bond investors.
This rate of return is in uenced by the perceived risk of a company, for example as
evidenced by its credit rating.
As the cost of debt increases, the market value of traded bonds decreases, and vice versa
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6. Convertibility
If traded bonds are convertible into ordinary shares, the market price will be in uenced by
the likelihood of the future conversion and the expected conversion value, which is
dependent on the current share price, the future share price growth rate and the conversion
ratio. 
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Interest Rate - Forwards & Future
Forward rate
This locks the company into one rate (no adverse or favourable movement) for a future loa
If actual borrowing rate is higher than the forward rate then the bank pays the company the
difference and vice vers
They are usually only available on loans of at least £500,00
Procedur
1. Get loan as norma
2. Get forward rate agreemen
3. Difference between 2 rates is paid/received from the ban
Illustratio
Company gets 6% 600,000 FR
Actual rate was 10
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Solutio
FRA receipt from bank (10%-6%) x 600 24,00
Payment made (10% x 600,000 (60,000
Net paymen 36,00
Interest Future
Standard contract for set interest rate at a set dat
It is a market traded forward rate basicall
Calculations of how these work are NOT required in the F9 exam. (ONLY REQUIRED IN
THE P4 EXAM
As interest rates rise - bond prices fal
Let’s say you are expecting interest rates to rise
You would sell a bond futures contract, and when the interest rate rises, the value of the
bond futures contract will fall
You would then buy the return of the contract at a normal price, making a pro t
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As interest rates fall - bond prices increas
Let’s say you are expecting interest rates to decline in the near future
You would buy a futures contract for bonds
When interest rates fall, the price of bonds increase, and so does the bonds futures contract
You then sell the bond futures contract at a higher price
Borrowers sell futures to hedge against rise
Lenders buy futures to hedge against falls 
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Interest Options and Swap
Interest Rate Options
Grants the buyer the right (no obligation) to deal at a speci c interest rate at a future date.
At that date the buyer decides whether to go ahead or no
These protect against adverse movements in the actual interest rate but allow favourable
ones
Clearly, because of this, the option involves buying at a premium
Interest rate Swap
2 companies agree to exchange interest rate payments on different terms (eg xed and
variable)
For example one interest rate payment as a xed rate and the other at a oating rate
Interest rate swaps can act as a means of switching from paying one type of interest to
another, allowing an organisation to obtain less expensive loans and securing better deposit
rates
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Advantage
1. Eas
2. Low transaction costs (compared to getting a different loan
In the simplest form of interest rate swa
Party A agrees to pay the interest on party B's loan, while party B reciprocates by paying the
interest on A's loan.
If the swap is to make sense, the two parties must swap interest which has different
characteristics.
Assuming that the interest swapped is in the same currency, the most common motivation
for the swap is to switch from paying oating rate interest to xed interest or vice versa.
This type of swap is known as a 'plain vanilla' or generic swap
Illustration
Company A
- has a loan at FLOATING rate (LIBOR + 0.8%) from Bank
- thinks that the interest rates go up so wants FIXED rat
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Company
- has a loan at FIXED rate (8%) from Bank
- thinks that the interest rates go down so wants FLOATING rat
Solutio
• Company A can use a swap to change from paying interest at a oating rate of LIBOR +
0.8% to one of paying xed interest of 8%
So the Company A will pay
8% to Company
Libor + 0.8% to Bank
And will receive LIBOR + 0.8% form Company B
Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - (LIBOR + 0.8%)) = 8%
(FIXED)
• Company B will pay
8% to Bank
Libor + 0.8% to Company
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And will receive 8% form Company A
Therefore will effectively pay (8% FIXED + (LIBOR + 0.8%) - 8% FIXED) = LIBOR + 0.8%
(FLOATING
LIBOR or the London Inter-Bank Offered Rate is the rate of interest at which banks borrow
from each other in the London inter-bank market
A swap may be arranged with a bank, or a counterparty may be found through a bank or
other nancial intermediary
Fees will be payable if a bank is used
However a bank may be able to nd a counterparty more easily, and may have access to
more counterparties in more markets than if the company seeking the swap tried to nd the
counterparty itself
Swaps are generally terminated by agreeing a settlement interest rate, generally the current
market rate. 
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Syllabus D. Business valuation
Syllabus D1. Acquisition, merger and divestmen
Interests of different stakeholder
Impact of mergers and takeovers on stakeholder
The effect of mergers and takeovers on stakeholders
• Acquiring company shareholder
There might be a decline in pro tability compared with industry averages
Returns to equity can often be poor relative to the market in the early years, particularly
for equity- nanced bids and rst time players
Costs of mergers frequently outweigh the gains
• Target company shareholder
Usually, it is the target shareholders who bene t most from a takeover
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Bidding companies have to offer a signi cant premium over the market price prevailing
prior to the bid in order to achieve the purchase
• Acquiring company managemen
The management of the newly enlarged organisation will often enjoy increased status
and in uence, as well as increased salary and bene ts
• Target company managemen
Whilst some key personnel may be kept on for some time after the takeover, a signi cant
number of managers will nd themselves out of a job
• Other employee
Commonly the economy of scale cost savings anticipated in a merger will be largely
achieved by the loss of jobs, as duplicated service operations are eliminated and loss-
making divisions closed down
However, in some instances, the increased competitive strength of the newly enlarged
enterprise can lead to expansion of operations and the need for an increased workforce
• Financial institution
These are perhaps the outright winners
The more complex the deal, the longer the battle, and the more legal and nancial
problems encountered, the greater their fee income, regardless of the end result
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Reasons for and against acquisitions, mergers and

divestment
Reasons for mergers and takeover
The main reason
why one company may wish to acquire the shares or the business of another may be
categorised as follows
• Operating economie
Elimination of duplicate facilities and many other ways
• Management acquisitio
Acquisition of competent and go-ahead team to compensate for lack of internal
management abilities
• Diversi catio
Securing long-term future by spreading risk through diversi cation
• Asset backin
Company with high earnings: assets ratios reducing risk through acquiring company with
substantial assets
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• Quality of earning
Reducing risk by acquiring company with less risky earnings
• Finance and liquidit
Improve liquidity/ability to raise nance through the acquisition of a more stable
company
• Growt
Cheaper way of growing than internal expansion
• Tax factor
Tax ef cient way of transferring cash out of the corporate sector. In some jurisdictions, it
is a means of utilising tax losses by setting them against pro ts of acquired companies
• Defensive merge
Stop competitors obtaining advantage
• Strategic opportunitie
Acquiring a company that provides a strategic t
• Asset strippin
Acquiring an undervalued company in order to sell off the assets to make a pro t
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• Big data acces
Big data refers to a collection of data sets too large and complex to analyse using
traditional database management tools
A technology company may want to acquire a company for the data it holds on users
which can be of great value to that company
FB and Instagra
Facebook acquired the photo-sharing app company lnstagram tor $1billion
Although lnstagram was not pro table, it had 30 million worldwide users before the
acquisition
Acquiring the data of lnstagram users is valuable to Facebook, for example, it could allow
Facebook to track the movements of users who upload a photo on a mobile device, and
place targeted advertisements to the user
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Acquisitions and mergers as a method of corporate

expansio
Merger or acquisitio
A merge
is the combining of two or more companie
Generally by offering the stockholders of one company securities in the acquiring company
in exchange for the surrender of their stock
An acquisitio
normally involves a larger company (a predator) acquiring a smaller company (a target)
A demerge
A demerger involves splitting a company into two separate companies which would then
operate independently of each other
The equity holders in the company would continue to have an equity stake in both
companies
An alternative approac
is that a company may simply purchase the assets of another company rather than acquiring
its business, goodwill, etc
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Identifying possible acquisition target
Suppose a company decides to expand
1. Its directors will produce criteria (size, location, nances, products, expertise,
management) against which targets can be judged
2. Directors and/or advisors then seek out prospective targets in the business sectors it is
interested in
3. The team then examines each prospect closely from both a commercial and nancial
viewpoint against criteria
In general businesses are acquired as going concerns rather than the purchase of speci c
assets
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Synerg
The combinations should be pursued if they increase the shareholder

wealt
Synergies can be separated into three types
1. Revenue synergy
- which result in higher revenues for the combined entity,
- higher return on equity and
- a longer period when the company is able to maintain competitive advantage
2. Cost synergy
- which result mainly from reducing duplication of functions and related costs, and from
taking advantage of economies of scale
Sources of which include
Economies of scale (arising from eg larger production volumes and bulk buying)
Economies of scope (which may arise from reduced advertising and distribution costs
where combining companies have duplicated activities)
• Elimination of inef ciency

• More effective use of existing managerial talent
3. Financial synergy
- which result from nancing aspects such as the transfer of funds between group
companies to where it can be utilised best, or from increasing debt capacity
Sources of which include
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• Elimination of inef cient management practices

• Use of the accumulated tax losses of one company that may be made available to
the other party in the business combination
• Use of surplus cash to achieve rapid expansion
• Diversi cation reduces the variance of operating cash ows giving less bankruptcy
risk and therefore cheaper borrowing
• Diversi cation reduces risk (however this is a suspect argument, since it only
reduces total risk not systematic risk for well diversi ed shareholders)
• High PE ratio companies can impose their multiples on low PE ratio companies
(however this argument, known as “bootstrapping”, is rather suspect)
Why is there a high failure rate of acquisitions
In practice, the shareholders of predator companies seldom enjoy synergistic gains,

whereas the shareholders of victim companies bene t from a takeover
The acquiring company often pays a signi cant 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
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Taxation implication
Tax issue
In some countrie
It is possible for an acquiring company to offset past losses of an acquired subsidiary

against the present pro ts of the parent company
However, in certain countries (eg the UK), there are stricter tax rules that prevent this
In cross-border acquisition
The impact of the acquisition on the acquirer's tax bill will need to be considered
For example an entity may try to exploit differences in taxation rates by merging with an
overseas company and re-incorporating in a low tax regime, eg Ireland
The impact of withholding tax on certain types of incomes from an overseas branch will have
to be carefully assessed, although the impact of this is reduced if a double taxation
agreement between the two countries is in place
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Acquisition by private equity or venture capitalis
Acquisition by Venture Capital or Private Equit
Acquisitions are often made or supported by private equity (PE) or venture capital (VC)
investors
The main differences between these types of investor are as follows
1. Nature of investmen
• Venture Capita
VC investors tend to invest in many companies, expecting some to fail, but a small
number to make huge returns to compensate for the companies that fai
• Private Equit
PE investors tend to invest large amounts in a small number of companies
2. Type of target companie
• Venture Capita
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VCs tend to invest in young companies especially start-up
• Private Equit
PEs tend to invest in mature established companie
3. Typical shareholdin
• Venture Capita
less than 50
• Private Equit
100
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Role and scope of competition authoritie
Competition legislatio
Takeovers and mergers may be investigated by competition authorities to ensure that one
company cannot dominate a market
In the UK this is the responsibility of the Competition and Markets Authority (CMA
Within the EU, the European Commission can review mergers that create turnover
concentrations with a "Community Dimension
The role of competition authoritie
• is to ensure healthy levels of competition and safeguard public interest
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"
Syllabus D2. Valuation method
Valuations – Introductio
When are Valuations needed
1. Takeovers (Price paid would be MV + a takeover premium
2. When setting a price for an I.P.O (Initial Public Offer
3. Selling ‘private’ share
4. When using shares as loan securit
5. When negotiating a sale of a private compan
6. For liquidation purpose
What information helps Valuation
• Financial statement
• Non current asset summarie
• Investments hel
• Working capital listing (debtors, creditors and stock
• Lease agreement
• Budget
• Current industry environmen
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What are the limitations of the information provided
• Does the PPE need a costly revaluation
• Are there any contingent liabilities not taken into account
• Has deferred tax been calculated appropriately
• How has stock been valued
• Are all debtors receivable
• Are there any redundancy costs
• Any prior charges on assets
• What shareholding is being sold? Does it mean the business carries on
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Market Capitalisatio
This is very straightforward and is often referred to as “Market Cap
It is calculated as follows
Share Price x Number of share
Illustratio
Share Price 96
Share Capital (nominal value 50c) $60millio
Solutio
96 x (60/.5) = $115.2 millio
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Asset Based Valuation
Valuing a business by looking at its assets only is a troublesome affair.
When is it a good technique then - cow face
oooh cheeky, anywhere here goes.
1. When looking to asset strip the compan
2. As a minimum pric
3. When valuing Investment companie
NB. If a company is quoted on a market AND is a going concern then the minimum valuation
is.
Market price + Acquisition premiu
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There are different ways of measuring assets
1. Book Value
This is poor as it uses Historic costs and not up to date values
It can give a ball park gure thoug
2. Net Realisable Valu

This would represent the minimum value of a private company - as it is what the assets
alone could be sold for
However, even here there is the problem of needing to sell quickly may mean the NRV
might be dif cult to valu
Another weakness of this is that this gives a value for the assets when SOLD not when
IN USE
Therefore, not good for a situation of partial disposal where business and hence assets
will carry o
3. Replacement Cos
Here the valuation dif cult - need similar aged assets value
It also ignores goodwil
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If assets are to be sold on an ongoing basi
Illustratio
NCA 450
Current Assets 150
Current Liabilities (50)

Share capital ($1) 200
Reserves 250
6% Loan 100
Loan is redeemable at 2% premiu
MV of property is $30,000 more than carrying valu
What is the value of an 80% holding using assets basis
Solutio
NCA 450+30 = 480
Current Assets 150
Current Liabilities (50)

6% Loan (100 x 1.02) = (102)
6% 478
X 80% = 382,400
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IAS 38 Intangible asse
What is an Intangible asset
Well, according to IAS 38, it’s an identi able non-monetary asset without physical substance,
such as a licence, patent or trademark
The three critical attributes of an intangible asset are
1. Identi abilit
2. Control (power to obtain bene ts from the asset
3. Future economic bene t
Whooah there partner, what´s identi able mean?
Well it just means the asset is one of 2 things
1. It is SEPARABLE, meaning it can be sold or rented to another party on its own (rather
than as part of a business) o
2. It arises from contractual or other legal rights
It is the lack of identi ability which prevents internally generated goodwill being recognised.
It is not separable and does not arise from contractual or other legal rights
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Example
• Employees can never be recognised as an asset; they are not under the control of the
employer, are not separable and do not arise from legal right
• A taxi licence can be an intangible asset as they are controlled, can be sold/exchanged/
transferred and arise from a legal righ
(The intangible doesn’t have to be separable AND arise from a legal right, just one or the
other is enough)
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Forms of intangible asset and methods of valuatio
The valuation of intangible assets and intellectual capital is dif cul
Valuation of intangible
The asset based valuation method speci cally excluded most intangible assets from the
computation
This rendered this method unsuitable for the valuation of most established businesses,
particularly those in the service industry
Historical cos
We are interested in any element of business that may have some value
Certain intangible assets can be recorded at their historical cost
Examples include patents and trademarks being recorded at registration value and
franchises being recorded at contract cost
However over time these historical values may become poor re ections of the assets' value
in use or of their market value
Intellectual capita
is knowledge which can be used to create value
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Intellectual capital includes
• Human resource
the collective skills, experience and knowledge of employee
• Intellectual asset
knowledge which is de ned and codi ed such as a drawing, computer program or
collection of dat
• Intellectual propert
intellectual assets which can be legally protected, such as patents and copyright
Types of Intangible assets and intellectual capital
• Patents, trademarks and copyright

• Franchises and licensing agreement
• Research and developmen
• Brand
• Technology, management and consulting processe
• Know-how, education, vocational quali catio
• Customer loyalt
• Distribution channel
• Management philosoph
Methods of Measurement of intangible asset
1. Market-to-book value
2. Tobin's 'q
3. Calculated intangible valu
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1. Market-to-book value
This method represents the value of a rms intellectual capital as the difference bein
the book value of tangible assets an
the market value of the rm
Value of IA = Market Capitalisation - Value of tangible N
For example, if a company's market value is $10 million and its book value is $8 million,
the $2 million difference is taken to represent the value of the rm's intangible (or
intellectual) assets
2. Tobin's 'q
Tobin's q is the ratio between a physical asset's market value and its replacement value
The formula for Tobin's Q is: Tobin's Q = Total Market Value of Firm / Total Asset Value of
Firm
3. Calculated intangible values (CIV
(CIV) is used for calculating the fair market value of a rm's intangible assets
CIV =[(Earnings - ROA) x Tax] / WAC
A step-by-step approach would be as follows
1. Calculate average pre-tax earning

2. Calculate the return on assets (ROA
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Industry average return on tangible asset / Company's Tangible asset
3. Adjust it by Ta
4. Divide it by the entity's cost of capital (WACC
Illustration
Cow Co. is using CIV method to value its intangible assets
Relevant data
Earnings = 10,00
Industry average return on tangible assets is 15
Cow Co's tangible assets are $20,00
Corporate income tax is 30
Cow Co's WACC is 10
Require
Value Cow Co's intangible assets
Solutio
CIV = [(Earnings - ROA) x Tax)] / WAC
CIV = [(10,000 - 15% x $20,000) x 0.70] / 0.1
CIV = $49,00
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CAP
The valuation of intangible assets and intellectual capital is dif cul
Valuation of intangible
The asset based valuation metho
This method also calculates the cost of equity (like dvm) but looks more closely at the
shareholder’s rate of return, in terms of risk
The more risk a shareholder takes, the more return he will want, so the cost of equity will
increase
For example, a shareholder looking at a new investment in a different business area may
have a different risk
The model assumes a well diversi ed (see later) investor
It suggests that any investor would at least want the same return return that they could get
from a “risk free” investment such as government bonds (Greece?!!)
This is called the risk free retur
On top of the risk free return, they would also want a return to re ect the extra risk they are
taking by investing in a market share
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They may want a return higher or lower than the average market return depending on
whether the share they are investing in has a higher or lower risk than the average market
ris
The average market premium is Market return - Risk free retur
The higher or lower requirement compared to the average market premium is called the beta
(β
Required Return = Rf + β(Rm - Rf
Rm = Average return for the whole marke
Rm - Rf = Average market risk premiu
Beta (β )= How much of the average market risk premium (Rm - Rf) is neede
Systematic and non-systematic ris
More technically Beta (β ) = Systematic risk of the investment compared to the marke
1. Systematic ris
Market wide risk - such as state of the econom
All companies, though, do not have the same systematic risk as some are affected more
or less than others by external economic factor
2. Non Systematic Ris

Risk that is unique to a certain asset or company
An example of nonsystematic risk is the possibility of poor earnings or a strike amongst a

company’s employees
Non-systematic risk can be diversi ed awa
One may mitigate nonsystematic risk by buying different securities in the same industry
or different industries
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For example, a particular oil company has the diversi able risk that it may drill little or no
oil in a given year
An investor may mitigate this risk by investing in several different oil companies as well
as in companies having nothing to do with oil
Nonsystematic risk is also called diversi able risk
An explanation of the grap
• If you have 1 share and this share does badly, then you DO BADLY
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• If you have 10 shares and 1 share does badly, you are sad about 1 share, but you are
still HAPPY about the other 9
• Therefore with 1 share you are taking more risk than if you have more shares
This risk is called UNSYSTEMATIC RIS
• So, we can buy more shares and therefore the UNSYSTEMATIC RISK should GET
SMALLE
• You will be always left with some risk that can't be diversi ed away
This risk is called SYSTEMATIC RISK
It is BETA (β) in the CAPM formula
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CAPM Continue
How risky is the speci c investment compared to the market as a whole
1. This is the ‘beta’ of the investment If beta is 1, the investment has the same risk as the
market overall
2. If beta > 1, the investment is riskier (more volatile) than the market and investors should
demand a higher return than the market return to compensate for the additional risk
3. If beta < 1, the investment is less risky than the market and investors would be satis ed
with a lower return than the market return
Illustratio
Risk free rate = 5
Market return + 14
What returns should be required from investments whose beta values are:
(i) 1
(ii) 2
(iii) 0.
• Cost of Equity = Rf +beta(Rm - Rf
(i) = 5 + 1(14 - 5) = 14%
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The return required from an investment with the same risk as the market, which is simply
the market return
• (ii) = 5 + 2(14 - 5) = 23
The return required from an investment with twice the risk as the market
A higher return than that given by the market is therefore required
• (iii) = 5 + 0.5(14 - 5) = 9.5
The return required from an investment with half the risk as the market
A lower return than that given by the market is therefore required
CAPM assumption
1. Diversi ed investor
2. Perfect market (in fact they are semi strong at best
3. Risk free return always available somewher
4. All investors expectations are the sam
Advantages of CAP
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1. The relationship between risk and return is market base
2. Correctly looks at systematic risk onl
3. Good for appraising speci c projects and works well in practic
Disadvantages of CAP
1. It presumes a well diversi ed investor
Others, including managers and employees may well want to know about the
unsystematic risk als
2. The return level is only seen as important not the way in which it is given
For example dividends and capital gains have different tax treatments which may be
more or less bene cial to individuals
3. It focuses on one period only
Some inputs are very dif cult to get hold of
For example beta needs a subjective analysi
4. Generally CAPM overstates the required return for high beta shares and visa vers
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Share prices (quoted and non-quoted entities
Valuation of quoted or unquoted compan
Quoted companie
A quoted (listed) company will have a current stock market value also known as its market
capitalisation
Where small holdings of shares are being traded, this is the relevant price for the
transaction
However, if one company is looking to purchase another by buying shares, this value will not
give a suitable price because the current shareholders will not have any extra incentive to
sell their holdings at the current market price
As a result a premium to the existing market price is normally offered
Unquoted companie
Since an unquoted company has no stock market price determining a valuation may be
more dif cult
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There is likely to be less available information to help a potential purchaser assess the value
of the company
Typically this process will involve using a similar quoted company (proxy company)
The techniques we are now going to cover produce a range of values which can be
summarised as follows
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Using PE rati
Take the earnings of the company you are trying to value and multiply it
by the average P/E ratio of their industr
Income based methods like this are best used whe
When taking control of a compan
When more interested in earnings than dividend polic
Price Earnings Rati
It essentially tells us is how long it would take the earnings to repay the share pric
Ok so this is how it is calculated..
But what we are more concerned with here is how to use this to calculate the value of a
business, again here is the formula to use to calculate the value of ONE share.
How to calculate the value of ONE shar
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How to calculate the value of the WHOLE busines
Or..
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Both of these give the value of the company as a whole.
HOWEVER, to value a target company you need to use THEIR earnings and our own P/E
ratio or at least a P/E ratio from their industr
Also note: The PE can be adjusted down by 10 - 20
If private company (as less liquid shares
If risky company (fewer controls etc
Share Capital (25c $100,00
Pro t before ta $260,00
Ta (120,000
Preference Dividen ($20,000
Ordinary Dividen ($36,000
Retaine $84,00
PE (for similar company) = 12.
What is the value of 200,000 shares
Solutio
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Value of Company = PE x Earnings (PAT - Pref divs
Total Earnings (of 200,000 shares
140,000 - 20,000 = 120,000 x 200/400 = 60,00
PE 12.
60,000 x 12.5 = $750,00
Use of predator's P/E ratio
A predator company may use their higher P/E ratio to value a target company
This use of a higher P/E ratio is known as bootstrappin
An illustration
Cow Co. (Predator) is valuing a potential acquisition target, Calf Co. (Target), using a
bootstrapping approach
The following items will be used in a valuation calculation
Calf's Earnin
Cow's P/
Drawbacks Of PE mode
1. Finding a quoted company that is similar in activity (most have a wide range
2. A single year’s PE ratio may not be representativ
3. The quoted company used to get the PE ratio from may have a totally different capital
structur
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Earnings Yiel
This is the inverse of the PE rati
Basically this is how much your earnings are as a % of your share pric
Value of Company using Earnings Yield = Total Earnings x 1/Earnings yiel
PAT 300,000; Earnings yield 12.5
What is the value of this company
Solutio
300,000 x 1/0.125 = $2,400,00
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Discounted Cash ow
Ok so this example is dif cult but let's take it one step at a time.
PB 80 (all cash
Capital Investment each yea 4
Deb 10 ($120
Tax = 30
WACC = 10
The pro ts are expected to continue for foreseeable future (perpetuity
What is the value of equity
First of all you need to know how to calculate the value of something that lasts forever (like
the pro ts here
Well this is called a perpetuit
And calculating its PV is easy! Just Divide it by the discount factor
So say it's a perpetuity of 60 at a discount rate of 4% = 60 / 0.04 = 1,50
In this question the income needs taxing remember
Solutio
Cash in ow 80 x 70% = 56 - 48 = 8 (in perpetuity
Value of business = 8 / 0.1 = 80
So the Equity is the value of all the cash ows less value of debt remembe
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Equity = 80m - (10 x 1.2) = 68
Advantages of DCF Metho
1. Theoretically best metho

2. Can value part of a compan
Disadvantages of DCF Metho
1. Need to estimate cash ows and discount rat

2. How long is PV analysis for
3. Assumes constant tax, in ation and discount rat
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Discounted Free cash ow basi
This method is based upon the PV of the free cash ow to equity of an

enterprise
Free cash ow to equity is the cash ow available to a company from operations after
1. Interest expense
2. Ta
3. Repayment of debt and lease obligation
4. Any changes in working capita
5. Capital spending on assets needed to continue existing operations (ie replacement
capital expenditure equivalent to economic depreciation
Remember
Discounted FCF is used for the calculation of the Value of Company attributable to equity
holders
Value of Company = PV of Free cash ows (FCF
How to calculate the PV of FCF using a CONSTANT annual growth rat
e.g. After four years, the annual growth rate of the FCF to the company will be 3%, for the
foreseeable future
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FCF in Y4 = 10
g=3
k = 11
PV of FCF ( rst 4 years) 50
PV of FCF, year 5 onwards
= [FCF (in Y4) x (1 + growth rate (g)) / (cost of capital (k) – g) ] x (1+k) (to the
negative power of the number of years before the g is consistent each year
= (100 x 1.03) / (0.11 - 0.03)] x 1.11 ^ -
= 1,287.5 x 0.658
= 84
Value of Compan
= PV of FCF ( rst 4 years) + PV of FCF, year 5 onward
= 500 + 84
= 1,34
Exampl
COW Co’s future sales revenue will increase by 7.5% for the next four years
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After the four years, the annual growth rate of the free cash ows to the company will be
3.5%, for the foreseeable future
Operating pro t margins are expected to be 15% in the future
Although it can be assumed that the current tax-allowable depreciation is equivalent to the
amount of investment needed to maintain the current level of operations, the company will
require an additional investment in assets of 30c per $1 increase in sales revenue for the
next four years
Tax rate is 25%
Cost of capital is 11%
Extract from COW Co's Statement of pro t or loss
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Solutio
Sales revenue in Y1 = $389.1 x 1.075 = $418.
Operating pro t in Y1 = $418.3 x 15% = $62.
Additional capital investment in Y1 = ($418.3 - $389.1) x $0.30 = $8.
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Dividend Valuatio
Essentially this model presumes that a share price is the PV of all future
dividend
Calculate this (with or without growth) and multiply it by the total number of share
It is similar to market capitalisation except it doesn’t use the market share price, rather one
worked out using DV
DVM can be with or without growth
DVM without Growt
Note
Cost of Equity will be given, or calculated via CAP
Take this share price and multiply it by the number of share
DVM with growt
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Note
Dividend + growth = Dividend end of year
Share Capital (50c) $2 millio
Dividend per share (just paid) 24
Dividend paid four years ago 15.25
Current market return = 15
Risk free rate = 8
Equity beta 0.
Solution
Dividend is growing so use DVM with growth model
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Calculating Growth
Growth not given so have to calculate by extrapolating past dividends as before
24/15.25 sq root to power of 4 = 1.12 = 12
So Dividend at end of year 1 = 24 x 1.1
Calculate Cost of Equity (using CAPM)
8 + 0.8 (15-8) = 13.6
So using DVM with Growth mode
Dividend + growth / Cost of Equity - growth (decimal
Share price = 24x1.12 / 0.136 - 0.12 = 1,680
Market cap = $16.8 x (2m / 0.5) = $67.
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Ef cient Market Hypothesis (EMH
Stock market ef ciency usually refers to the way in which the prices of
traded nancial securities re ect relevant informatio
Weak For
1. Share prices re ect past information onl
2. Investors cannot generate abnormal returns by analysing past informatio
3. Share prices appear to follow a ‘random walk’ by responding to new information as it

becomes availabl
Semi- Stron
Share prices re ect past and current public informatio
Investors cannot generate abnormal returns by analysing public information as share prices
respond quickly and accurately to new information as it becomes publicly availabl
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Stron
1. Share prices re ect public, past and private informatio
2. Even investors with access to insider information cannot generate abnormal returns in
such a marke
Stock markets are semi-stron
Managers will not be able to deceive the market by the timing or presentation of new
information, such as annual reports or analysts’ brie ngs, since the market processes the
information quickly and accurately to produce fair prices
Managers should therefore simply concentrate on making nancial decisions which increase
the wealth of shareholders
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Impact of government incentives on entity valu
Impact of government grants on entity valuation
Government incentives such as capital or revenue grants will have an impact on the
valuation of an entit
1. Capital grant
are often available in many countries to provide assistance with the cost of assets such
as plant and machinery
2. Revenue grant
are often available to assist with the costs of revenue expenditure, ie running costs
lAS 20 Accounting for Government Grant
requires grants to be credited to the statement of nancial position (SFP) and then
recognised as income on the same basis as the related expenditure on the asset, ie
depreciation
The method of recognition in the SFP can be
1. to deduct the grant from the carrying value of the asset, o

2. to credit the grant to deferred income
In a net assets valuatio
consideration should be given to the value of the asset to use, whether to us
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• the replacement cost o

• realisable value of the asset, rather tha
• the reduced carrying value of the asset
Furthermore, consideration should be given to any potential liability to pay back the grant in
the event that the conditions of the grant are not complied with
Revenue grant
are recognised as income on the same basis as the expenditure to which they relate is
incurred
This can either be in 'other income' or deducted from the related expenditure
This should be taken into account in the gures used in earnings valuations
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Syllabus D3. Pricing and bid issue
Forms of consideratio
Payment methods - how an acquisition can be nance
Methods of paymen
The takeover will involve a purchase of the shares of the target company fo
1. cas
If the purchase consideration is in cash, the shareholders of the target company will
simply be bought out
2. 'paper' (shares, or possibly convertible bonds

A purchase of a target company's shares with shares of the predator company is referred
to as a share exchange
3. Those choice will depend on
- available cash,
- desired level of gearing,
- shareholders' taxation position and
- change in control
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An Illustration: Cash purchase
Suppose that there are two companie
Cow Calf
Net assets (book value) $2,000 $300
Number of shares 100 10
Earnings $3,000 $90
Cow negotiates a takeover of Calf for $600 in cash
As a result, Cow will end up with
• Net assets (book value) of

$2,000 + $300- $600 cash = $1,70
• 100 shares (no change
• Expected earnings of $3,090 minus the loss of interest (net of tax) which would have
been obtained from the investment of the $600 in cash which was given up to acquire
Cal
A cash offer can be nanced from
• Cash retained from earning

This is a common way when the rm to be acquired is small compared to the acquiring
rm, but not very common if the target rm is large relative to the acquiring rm
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• The proceeds of a debt issu
That is the company may raise money by issuing bonds
This is not an approach that is normally taken, because the act of issuing bonds will alert
the markets to the intentions of the company to bid for another company and it may lead
investors to buy the shares of potential targets, raising their prices
• A loan facility from a ban

This can be done as a short term funding strategy, until the bid is accepted and then the
company is free to make a bond issue
• Mezzanine nanc
This may be the only route for companies that do not have access to the bond markets in
order to issue bonds
Mezzanine nancing is a hybrid of debt and equity nancing that gives the lender the
rights to convert to an equity interest in the company in case of default, after venture
capital companies and other senior lenders are paid
Purchases by share exchang
One company can acquire another company by issuing shares to pay for the acquisition
The new shares might be issued
• In exchange for shares in the target company

Thus, if A acquires B, A might issue shares which it gives to B's shareholders in
exchange for their shares
The B shareholders therefore become new shareholders of A
This is a takeover for a paper consideration
Paper offers will often be accompanied by a cash alternative
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• To raise cash on the stock market, which will then be used to buy the target company's
shares
To the target company shareholders, this is a cash bid
Sometimes, a company might acquire another in a share exchange, but the shares are
then sold immediately on a stock market to raise cash for the seller
An Illustration: Share consideratio
Cow has agreed to acquire all the ordinary shares in Calf and has also agreed a share-for-
share exchange as the form of consideration
The following information is available
Cow - $m Calf -$m
Net pro t after taxation 100 30
Share capital - $0.50 ordinary shares £25m £5m
Price/earnings ratio 11 14
The agreed share price for Calf will result in its shareholders receiving a premium of 25% on
the current share price
How many new shares must Cow issue to purchase the shares in Calf
Solutio
Market value Cow (11 x $100m) = $1,100
Value per share ($1,100m/50m) = $22 per shar
Market value Calf (14 x $30m) = $420
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Value of bid ($420m x 1.25) = $525
Number of shares issued ($525m/$22) = 24 million share
Use of bond
Alternative forms of paper consideration, including debentures, loan notes and preference
shares, are not so commonly used, due to
• Dif culties in establishing a rate of return that is attractive to target shareholder

• The effects on the gearing levels of the acquiring compan
• The change in the structure of the target shareholders' portfolio
• The securities being potentially less marketable, and lacking voting right
Issuing convertible bonds will overcome some of these drawbacks, by offering the target
shareholders the option of partaking in the future pro ts of the company if they wish
An Illustration: Loan consideratio
Cow offers to buy 100% of the equity shares of Calf
The purchase price will be $3 million in 10% bonds
The annual pro ts before tax of Calf have been $2 millions
Assuming no synergy as the result of the acquisition, by how much will the earnings of Cow
be expected to increase next year when the pro ts of Calf are taken into account
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Company tax is 30%
Solutio
$'000 $'000
Calf pro t before tax 2,000
Less: tax (30%) (600)
1,400
Interest on bonds 300
Less: tax reduction (90)
Net increase in interest 210
Increase in pro t after tax for Cow 1,190
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Earn-out arrangement
Earn-out arrangement
An earn-out arrangement is where the purchase consideration is structured such that an

initial payment is made at the date of acquisition and the balance is paid depending upon the
nancial performance of the target company over a speci ed period of time
The main advantages of earn-out arrangements are that
1. Initial payment is reduced
2. The risk to the predator company is reduced as it is less likely to pay more than the
target is worth
The price is limited to future performance
3. It encourages the management of the target company to work hard as the overall
consideration depends on future performance
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The conduct of a takeove
The target company may resist the takeove
Will the bidding company's shareholders approve of a takeover
When a company is planning a takeover bid for another company, its board of directors
should give some thought to how its own shareholders might react to the bid
A company does not have to ask its shareholders for their approval of every takeover
• When a large takeover is planned by a listed company involving the issue of a

substantial number of new shares by the predator company (to pay for the takeover),
Stock Exchange rules may require the company to obtain the formal approval of its
shareholders to the takeover bid at a general meeting (probably an extraordinary general
meeting, called speci cally to approve the takeover bid)
• If shareholders, and the stock market in general, think the takeover is not a good one the
market value of the company's shares is likely to fall
The company's directors have a responsibility to protect their shareholders' interests,

and are accountable to them at the annual general meeting of the company
A takeover bid might seem unattractive to shareholders of the bidding company because
• It might reduce the EPS of their company

• The target company is in a risky industry, or is in danger of going into liquidation
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• It might reduce the net asset backing per share of the company, because the target
company will probably be bought at a price which is well in excess of its net asset value
Will a takeover bid be resisted by the target company
Resistance comes from the target company's board of directors, who adopt defensive
tactics, and ultimately the target company's shareholders, who can refuse to sell their shares
to the bidding company
Resistance can be overcome by offering a higher price
• In cases where an unquoted company is the target company, if resistance to a takeover

cannot be overcome, the takeover will not take place, and negotiations would simply
break down
• Where the target company is a quoted company, the situation is different
The target company will have many shareholders, some of whom will want to accept the
offer for their shares, and some of whom will not
In addition, the target company's board of directors might resist a takeover even though
their shareholders might want to accept the offer
Because there are likely to be major differences of opinion about whether to accept a
takeover bid or not, companies in most jurisdictions are subject to formal rules for the
conduct of takeover bids
Contesting an offe
The directors of a target company must act in the interests of their shareholders, employees
and creditors
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They may decide to contest an offer on several grounds
• The offer may be unacceptable because the terms are poor

Rejection of the offer may lead to an improved bid
• The merger or takeover may have no obvious advantage
• Employees may be strongly opposed to the bid
• The founder members of the business may oppose the bid, and appeal to the loyalty of
other shareholders
When a company receives a takeover bid which the board of directors considers
unwelcome, the directors must act quickly to ght off the bid
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Defensive tactic
The steps that might be taken to thwart a bid or make it seem less attractive include
• Revaluing assets or issuing a forecast of attractive future pro ts and dividends to
persuade shareholders that to sell their shares would be unwise, that the offer price is
too low, and that it would be better for them to retain their shares
• Lobbying to have the offer referred to the competition authoritie
• Launching an advertising campaign against the takeover bi
• Finding a 'white knight', a company which will make a welcome takeover bi
• Making a counter-bid for the predator company (this can only be done if the companies
are of reasonably similar size
• Arranging a management buyou
• Introducing a 'poison-pill' anti-takeover devic
• Introducing a 'shark repellent' - changing the company's constitution to require a large
majority to approve the takeove
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Methods of raising cas
The predator company can raise cash from many sources to nance the
acquisition, some of the sources are
Borrowing to obtain cas
The predator company may not have enough cash immediately available to nance the
acquisition and may have to raise the necessary cash through bank loans and issuing of
debt instruments
Mezzanine nanc
Mezzanine nance is a form of nance that combines features of both debt and equity
It is usually used when the company has used all bank borrowing capacity and cannot also
raise equity capital
It is a form of borrowing which enables a company to move above what is considered as

acceptable levels of gearing
It is therefore of higher risk than normal forms of borrowing
Mezzanine nance is often unsecured
It offers equity participation in the company either through warrants or share options
If the venture being nanced is successful the lender can obtain an equity stake in the
company
Retained earning
This method is used when the predator company has accumulated pro ts over time and is
appropriate when the acquisition involves a small company and the consideration is
reasonably low
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This method may be the cheapest option of nance
Vendor placin
In a vendor placing the predator company issues its shares by placing the shares with
institutional investors to raise the cash required to pay the target shareholders
Leveraged buy-outs (LBO
is a takeover of a company by an investor (often private equity) using signi cant debt
Typically the debt used to fund the takeover is secured on the assets of the target company
The cash ow generated by the target company is then used to service and repay the debt
The target company would normally need to have low existing debt, stable cash ows and
good asset backing
This approach allows a private equity investor to acquire a large company with minimal cash
or risk, since they are borrowing against the acquired company's assets and earnings
A range of different debt is usually used and any short-term debt instruments may need re-
nancing soon after the deal
The overall aim is to improve the running of the target over a 3-5 year period, generate
additional pro ts, repay the debt and sell the company for a pro t
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Treatment of target entity deb
Many debt agreements carry a change of control clause which means

that when a company completes an acquisition it may well have to
re nance the target company's debt
The acquiring company will need to ensure that it has factored this into its nancial planning
This may require a short-term line of credit to act as a bridging loan while re- nancing is
being arranged
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Divestmen
Divestment is the process of selling an asset (business)
This can be achieved either by
- selling the whole business to a third part
- selling the assets piecemea
Reasons for divestmen
1. The principal motive for divestment will be if they either do not conform to group or
business unit strategy
2. A company may decide to abandon a particular product/activity because it fails to yield

an adequate return
3. Allowing management to concentrate on core business
4. To raise more cash possibly to fund new acquisitions or to pay debts in order to reduce
gearing and nancial risk
5. The management lack the necessary skills for this business secto
6. Protection from takeover possibly by disposing of the reasons for the takeover or
producing suf cient cash to ght it effectively
Syllabus C3. Pricing issues and post-transaction issue
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Spin-offs/demerger
This is where a new company is created and the shares in the new
company are owned by the shareholders of the original compan
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
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The main disadvantages of de-merger are
1. Economies of scale may be lost, where the de-merged parts of the business had
operations in common to which economies of scale applied
2. The ability to raise extra nance, especially debt nance, to support new investments
and expansion may be reduced
3. Vulnerability to takeovers may be increased
4. There will be lower revenue, pro ts and status than the group before the demerger
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Sell-off
A sell-off is a form of unbundling involve disposing the non-core parts of

the compan
A Sell-of
• Involves selling part of a company to a third party for an agreed amount of funds or valu
• This value may comprise of cash and non-cash based assets
The most common reasons for a sell-off are
1. To divest of less pro table and/or non-core business units
2. To offset cash shortages
The extreme form of sell-off is liquidation, where the owners of the company voluntarily
dissolve the business, sell-off the assets piecemeal, and distribute the proceeds amongst
themselves
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Management buy-out (MBO) and buy-i
A management buy-out is the purchase of a business from its owners by

its managers
For example, the directors of a company in a subsidiary company in a group might buy the
company from the holding company, with the intention of running it as proprietors of a
separate business entity
Reasons for MBO
1. A parent company wishes to divest itself of a business that no longer ts in with its
corporate objectives and strategy
2. A company/group may need to improve its liquidity. In such circumstances a buy-out
might be particularly attractive as it would normally be for cash
3. A company may decide to abandon a particular product/activity because it fails to yield
an adequate return
4. In administration a buy-out may be the management’s only best alternative to
redundancy
Advantages of MBOs to disposing compan
1. To raise cash to improve liquidity
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2. If the subsidiary is loss-making, sale to the management will often be better nancially
than liquidation and closure costs
3. There is a known buyer
4. Better publicity can be earned by preserving employer’s jobs rather than closing the
business down
5. It is better for the existing management to acquire the company rather than it possibly
falling into enemy hands
Advantages of buy-out to acquiring managemen
1. It preserves their jobs
2. It offers them the prospects of signi cant equity participation in their company
3. It is quicker than starting a similar business from scratch
4. They can carry out their own strategies, no longer having to seek approval from the head
of ce
Problems of MBO
1. Management may have little or no experience nancial management and nancial
accounting
2. Dif culty in determining a fair price to be paid
3. Maintaining continuity of relationships with suppliers and customers
4. Accepting the board representation requirement that many sources of funding may insist
on
5. Inadequate cash ow to nance the maintenance and replacement of assets
Sources of nance for MBO
Several institutions specialise in providing funds for MBOs
These include
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1. The clearing banks
2. Pension funds and insurance companies
3. Venture capital
4. Government agencies and local authorities, for example Scottish Development Agency
Factors a supplier of nance will consider before lendin
• The purchase consideration. Is the purchase price right or high
• The level of nancial commitment of the buy-out team
• The management experience and expertise of the buy-out team
• The stability of the business’s cash ows and the prospects for future growth
• The rate of technological change in the industry and the costs associated with the
changing technologies
• The level of actual and potential competition
• The likely time required for the business to achieve a stock market otation, (so as to
provide an exit route for the venture capitalist)
• Availability of security
Conditions attached to provision of nanc
• Board representation for the venture capitalist
• Equity options
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• A right to take a controlling equity stake and so replace the existing management if the
company fails to achieve speci ed performance targets
Management buy-i
- a company to an external management tea
• is a type of sell-off which involves selling a division or part of a company to an external
management team, who will take up the running of the new business and have an equity
stake in the business
• is normally undertaken when it is thought that the division or part of the company can
probably be run better by a different management team compared to the current one
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Liquidation
Liquidation
The extreme form of a sell-off is where the entire business is sold off in a liquidation
In a voluntary dissolution, the shareholders might decide to close the whole business, sell off
all the assets and distribute net funds raised to shareholders
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Going privat
A public company may occasionally give up its stock market quotation

and return itself to the status of a private company
The reasons for such move are varied, but are generally linked to the disadvantages of
being in the stock market and the inability of the company to obtain the supposed bene ts of
a stock market quotation
Other reasons are
• To avoid the possibility of takeover by another company
• Savings of annual listing costs
• To avoid detailed regulations associated with being a listed company
• Where the stock market undervalues the company’s shares
• Protection from volatility in share price with its nancial problems
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Syllabus D4. Post-transaction issue
Potential post-transaction valu
Valuation of mergers and takeover
Shareholders of both of the companies involved in a merger or acquisitio
will be aware of the effect on share prices and earning per share (EPS)
The market values of the companies' shares during a takeover bi
Share prices can be very important during a takeover bid
Suppose that Cow decides to make a takeover bid of Calf
Calf shares are currently quoted on the market at $3 each
Cow shares are quoted at $6.50 and Cow offers one of its shares for every two shares in
Calf, thus making an offer at current market values worth $3.25 (= $6.50 / 2) per share in
Calf
This is only the value of the bid so long as Cow's shares remain valued at $6.50
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If their value falls, the bid will become less attractive
E.g. if the the value is $5.80 so the offer would mean ($5.80 / 2 = $2.90) which is less than
$3.0
Companies that make takeover bids with a share exchange offe
are thus always concerned that the market value of their shares should not fall during the
takeover negotiations, before the target company's shareholders have decided whether to
accept the bid
If the market price of the target company's shares rises above the offer price during the
course of a takeover bid, the bid price will seem too low, and shareholders in the target
company might refuse to sell their shares to the bidder
EPS before and after a takeove
If one company acquires another by issuing shares, its EPS will go up or down according to
the P/E ratio at which the target company has been bought
• If the target company's shares are bought at a higher P/E ratio than the predator
company's shares, the predator company's shareholders will suffer a fall in EPS
• If the target company's shares are valued at a lower P/E ratio, the predator company's
shareholders will bene t from a rise in EPS
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Illustration 1: Share for share exchange
P acquired 80% of S shares via a 2 for 1 share exchange
At the date of acquisition, the following balances were in the books of P and S
P S
Share Capital $400 ($0.50) $400
Share Premium $100 $50
The share price of P was $2 at the date of acquisition
How much is the Cash of investment
P acquired 80% of S’s shares
The shares had a value of $400 but a nominal value of $0.50
This means S has 800 shares in total. P acquired 80% x 800 = 640 share
The share for share deal was 2 for 1
So P gives 1,280 of its shares in return for 640 of S’s shares
P’s shares have a MV of $2 at this date so the “cost of investment is 1,280 x $2 = $2,56
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Illustration 2: Share for share exchanges (2 for 1
Cow takes over Calf by offering two shares in Cow for one share in Calf
Details about each company are as follows
Cow Calf
Number of shares 3,000,000 200,000
Market value per share $5 -
Annual earnings $750,000 $100,000
EPS 25p 50p
P/E ratio 25
By offering two shares in Co
worth $5 each for one share in Calf, the valuation placed on each Calf share is $10, and with
Calf's EPS of 50p, this implies that Calf would be acquired on a P/E ratio of 20
This is lower than the P/E ratio of Cow, which is 25
If the acquisition produces no synergy, and there is no growth in the earnings of either Cow
or its new subsidiary Calf, then the EPS of Cow would still be higher than before, because
Calf was bought on a lower P/E ratio
The combined group's results would be as follows
Cow group
Number of shares (3,000,000 + 400,000) 3,400,000
Annual earnings (750,000 + 100,000) 800,000
EPS 23.53p
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Illustration 3: Buying companies on a higher P/E ratio but with pro t growth (2 for 3
Buying companies on a higher P/E ratio will result in a fall in EPS unless there is pro t
growth to offset this fall
For example, suppose that Cow acquires Calf, by offering two shares in Cow for three
shares in Calf
Details of each company are as follows
Cow Calf
Number of shares 7,500,000 6,000,000
Value per share $8 $6
Annual earnings
Current $3,000,000 $1,200,000
Next year $3,200,000 $2,000,000
EPS 40p 20p
P/E ratio 20 30
Cow is acquiring Calf on a higher P/E ratio, and it is only the pro t growth in the acquired
subsidiary that gives the enlarged Cow group its growth in EPS
Cow group
Number of shares (7,500,000 + 4,000,000) 11,500,000
Earnings
If no pro t growth (3,000,000 + 1,200,000) = $4,200,000 EPS would have been 36.52p
With pro t growth (3,200,000 + 2,000,000) = $5,200,000 EPS will be 45.22p
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If an acquisition strategy involves buying companies on a higher P/E ratio, it is therefore
essential for continuing EPS growth that the acquired companies offer prospects of strong
pro t growth
Valuation using post-merger dividends or cash ow
An alternative method to using the P/E ratios, is to consider the dividends or cash ows of
the merged company
Dividend metho
The steps are as follows
• Estimate the initial dividends of the combined company and the dividend growth rat
• Estimate the new cost of capital; if the cost of the two old companies differs signi cantly,
some sort of weighted average method wilI be require
• Calculate the value of the combined company using the dividend valuation mode
• Compare the value of the combined company with the pre-merger value of the acquiror
The excess is the value of the targe
Cash ow metho
The steps here are as follows
• Estimate the cash ows of the combined company, including the acquired's, the
acquiror's and the additional cash ows arising from the bene cial effects of the merge
• Estimate the new cost of capita
• Calculate the net present value of the combined cash ow
• Compare the value of the combined cash ows with the acquiror's cash ows if no
merger took place
The excess is the value of the target
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Integration of managemen
Post-acquisition integratio
 
Takeovers should pay attention to what happens after the takeove
Problem of integratio
Failures of takeovers often result from inadequate integration of the companies after the
takeover has taken place
There is a tendency for senior management to devote their energies to the next acquisition
rather than to the newly-acquired rm
Approaches to the post-acquisition integration
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Drucker's Golden Rule
P F Drucker has suggested ve Golden Rules for the process of post-acquisition integration
Remember the mnemonic 'MATCH'
1. Management in plac
Within a year, the acquiring company should put top Management with relevant skills in
place
2. Add value to the targe

The acquiring company must ensure It can Add value to the targe
(that is, ensure targets are set, communicated to customers and synergies are realised)
3. Target respec
The acquiring company must show respect to the products, management and track
record of the target
4. Common core of unit

Ensure there is a Common core of unit
(for example take actions to ensure systems are compatible)
5. Happy staf
Strategies should be developed for Holding onto existing staf
(for example, loyalty bonuses)
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Jones's Integration Sequenc
C S Jones has proposed a ve-step 'integration sequence'
1. Decide on and communicate initial reporting relationship

This will reduce uncertainty
2. Achieve rapid control of key factor

This will require access to the right accurate information
3. Resource audi
Both physical and human assets are examined in order to get a clear picture
This includes examining the roles of each of the main stakeholders (staff, customers and
suppliers) and evaluating the products sold
4. Re-de ne corporate objectives and to develop strategic plan

These should harmonise with those of the acquiror company as appropriat
5. Revise the organisational structur
Successful post-acquisition integration requires careful management of the 'human

factor' to avoid loss of motivation
If redundancies are felt to be necessary, voluntary redundancies should be offered rst
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Service contracts for key personne
When the target company employs certain key personnel, on whom the success of the
company has been based, the predator company might want to ensure that these key
people do not leave as soon as the takeover occurs
To do this, it might be necessary to insist as a condition of the offer that the key people
should agree to sign service contracts
Service contracts would have to be attractive to the employees concerned, perhaps through
offering a high salary or other bene ts such as share options in the predator company
Merging system
There are two extremes of integration
• Complete absorption of the target r

where the cultures, operational procedures and organisational structures of the two rms
are to be fused together
This approach is most suitable where signi cant cost reductions are expected to be
achieved through economies of scale, and/or combining marketing and distribution effort
can enhance revenues
• The preservation approac

where the target company is to become an independent subsidiary of the holding
company
This would be most bene cial for the merger of companies with very different products,
markets and cultures
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Exist strategie
An exit strategy is a way to terminate ownership of company or the operation of part of the
company
These are
1. Divestmen
2. Demerger
3. Sell-off
4. Spin-off
5. Management buy-outs
6. Liquidatio
7. Going privat
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Syllabus A: Financial policy decisions ...........................................2

Syllabus A: Financial policy decisions

Syllabus A1: Advise on strategic nancial objective

- providing a surplus (e.g. additional cash in the bank

3. Incorporated entities (Companies

The strategic nancial objective of a compan

Shares in these companies are available in the over-the-counter market (OTC

Examples of a public sector organisation are

Non-Quanti able objective

Its rst objective is to be involved in non-loss operations to cover its cost

Objectives for not-for-pro t organisation

NFP objectives include

• Surplus maximisation (equivalent to pro t maximisation

• Revenue maximisation (as for a commercial business

• Producer satisfaction maximisation (satisfying the wants of staff and volunteers

It is also dif cult to measure the performance of not-for-pro t organisations

Its other objective could be to improve road safety

• How could the ‘adequacy’ of street lighting be measured

These allocation decisions rely on a range of performance measures which, if

Government may require performance information to decide how much to spend in

In particular they will be interested to know what results may be achieved as a

Value for Money (VFM

Indicators to assess overall performanc

o Quality of service/output measures; e.g. exam results; pupil/teacher

o Utilisation of resources; e.g. hospital bed occupancy; are trained

o Flexibility; e.g. average waiting tim

• Non- nancial indicator

o Staff attitude to dealing with the publi

o Client satisfaction in the service being provide

• Cost per unit of activity (e.g. cost per student

• Comparisons with benchmark informatio

• Cost component as a proportion of total cost

• Costs recovered as a proportion of costs incurred (eg payment received from

householders requesting collection of bulky/unusual items of refuse

teachers, the cost of books, equipment

Non- nancial objective

Non- nancial objectives such a

A company's non- nancial objectives may include the followin

• Social and relationshi

A key target, because of the adverse nancial consequences if businesses switch

Not exploiting power as buyer unscrupulousl

Concern for environmen

High salaries, company cars, bonuse

Leadership in research and developmen

Failure to innovate may have adverse long-term nancial consequences

Non-Financial Performance Indicator

Non- nancial objectives such a

The most well-known of these approaches is the balanced scorecard proposed by

Areas to measure should relate to an organisation's critical success factors. Critical

Key performance indicators (KPIs) are measurements of achievement of the chosen

• relevant, in that they measure achievement of a critical success factor

Perspective Critical success factor Key performance indicators

Financia shareholder wealt

exam succes college pass rate vs national averag

average number of course variants pe

proces % room occupanc

growt innovation product % of sales from < 1 year ol

Balanced Score card – Performanc

The Balanced Scorecar

dissatisfaction with traditional, nancial measures of performance.

The balanced scorecard approach emphasises the need to provide management

with a set of information which covers all relevant areas of performance in an

objective and unbiased fashion