Forward

KEY FOCUS AREAS FOR AFM Exams

Key topics to be conversant with to pass AFM.

 Cost of capital, for reconstruction, combined company, single company, gearing, re-gearing,
etc. Cost of Equity, you need asset Beta, equity Beta while cost of debt you need tax.
 Capital Investment- Cashflows
 Mergers and acquisitions, how to value company using PE Ratio, Assts based options, divided
methods.
 Financing options
 Reconstruction
 Risk management- Interest rates and exchange rates
 Emerging issues- read more of articles.
 Ethical consideration, always one question will come from any part of the syllabus.
 Behavioral finance- No so common, but you should understand the basics.
 Adjusted present value-Very important.

Important role of finance manager

- Maximization of shareholders. This rule is connected to all AFM Sylabus. E.g. The perform of
calculating PV, is to you choose project with positive npv.
- Risk management
- Efficient and effective use of resources
- Investment selection and capital resource allocation
- Raising finances & minimizing cost of capital
- Distribution and retention
- Financial planning and controls
- Communicating with stakeholders

Exchange traded options are traded through the clearing house, thus adding another layer of security
while OTC are traded over the counter

Treasury department role

- Short term cash management-Lending/Borrowing funds as required.

- Currency Management

3.3 Centralised v Decentralised

3.3.1 Advantages of Centralised Treasury Management

 Economies of scale – lower staff costs, increased power with financial institutions,
lower transaction costs.
  Bilateral and multilateral netting (i.e. between only two or more than two
companies) – finding the net position for group companies in different foreign
currencies. This can reduce the number of transactions and hence cash
transmission costs.
 Control over subsidiaries – for example regarding gearing levels.
 "Pooling" of short-term cash surpluses and deficits – to reduce interest expense.
 Netting of currency exposures to reduce the amount of external hedging required.
 Identification of the best investments available within the group.
 Transfer of cash from subsidiaries producing surpluses to those requiring project
finance.
 Effective global tax planning – by means of transfer pricing and offshore "dividend
mixer" companies.
 Minimising finance costs – perhaps through the use of Special Purpose Vehicles;
diverting low-risk cash flows into a separate entity which gains a high credit rating
and can issue bonds at low interest rates.

3.3.2 Disadvantages of Centralised Treasury Management

 Reduced autonomy of subsidiaries – may lead to demotivation.
 Lack of understanding of local conditions.
 Slow to react to opportunities at local level.
 Potentially dangerous to concentrate power in the hands of a few personnel.
 Some governments restrict the use of multilateral netting in order to protect the
fees generated by their banking system.

Long term maximization of shareholders wealth

- Raising long term finance, equity, or debt

- Investment decisions
- Dividend Policy
- Risk management- interest rates, assessing exposures, hedging fx

Those specific to international group

- Setting transfer prices

- Deciding currency exposures policies and procedures
- Transfer of cash across international borders
- Netting and matching currency obligations

When asked to assess the impact of financial managers’ decisions? You should consider the
following areas.

- Strategic impact, does the new project help enhance firms’ competitive advantage, does it fit
the environment, use of resources, stakeholders’ expectation.
- Financial impact
- Regulatory impact
- Ethical impact
- Environmental impact

Margin requirements
are used when exchange traded derivatives are bought or sold. It’s a practice used to minimize risk
of default,

If excahange rate move against the hedge, margin is used to settle the difference

These will be returned to the company when contracts are closed or the balance will be returned.

PROFESSIONAL SKILLS MARKS

Communication

- Appropriate format
- Proper wording
- Heading and subheading
- Conclusion

Scepticism

- You have to question/ challenge directives that are being given to you.

Commercial acumen

- Point out other risks associated with the industry. Risks that are not mentioned in the
question. e.g., if the question is on IT, you can point out risks like Cyber risks, etc
- Having broad knowledge of the industry

Analysis and Evaluation

- Evaluation- you give Pros and cons.

- Analysis- using the exhibit, you coordinate information from various exhibits in making your
presentation and conclusion.

Forms of synergy

- Financial
- Expertised manpower
- Economy of scale
- Economy of scope
-
Delta Hedge

Assume an investor holds shares and that the delta of call options on this share =
0.5.

 Number of call options to sell = (No. of shares/(N(d1))

INVESTMENT APPRAISAL DECISIONS

- Past paper history

- Exams focus, free cash flows, inflations, DCF, Taxation, Capital rationing, IRR, MIRR,
Discounted payback period, Duration, Financial reporting, and investment appraisal decision.
- NPV and APV are commonly tested topics.

NPV- Sum of PV OF cashflows minus initial investment

FCF- Cash that is not retained, and reinvested into the business. It can be calculated as FCFE or FCF

FCF- Value of the whole organization- we deduct value of debt, and discount using cost of capital. We
minus debt

FCFE- We discount cashflow using the cost of Equity not cost of capital, we don’t minus debt.

Relevant cashflows- future incremental cashflows arise as a result of direct result of the decision.

Uses of FCF

- Basis of evaluation using npv

- As indicator of NPV
- Calculating value of a firm
- Valuing potential share prices
- As a representation of capital available to all providers of finance.

EXAMS FOCUS

In exams you have to explain what happened one by one. Stating that you have ignored sunk cost will
gain your Marks.

When assessing Investment projects using FCFS, you should ignore financing cashflows (E.g. Interest
charges, loan repayment, dividend) and all their tax effects. E.g., Interest tax relief. Dividend has
nothing to do with Investment decisions, so you ignore it.

The interest, loans and dividends are already taken into account during calculation of discount rate
(Cost of Equity & cost of debt). In calculation of cost of debt, they are already taken into
consideration.
INFLATION

Exams focus.

Two approaches to inflation i.e.

- real method – Cashflow does not have impact of inflation. Uninflated, you have to inflate it.
- Money/ Nominal rate – Post inflation has been taken into account.

Real cashflows, you use real rate and nominal cashflows you use nominal rates.

DCF & Taxation

There are three important tax effects to consider.

- Tax payment on operating profit

- Tax benefit from TAD
- Tax relief on interest payment on debts

Real options

-The options are assumed to be European options, exercisable on due date

- A follow on project is a call option-

Types of call options

- Options to delay
- Option to abandon.
- Follow-on option
- Option to redeploy.

Option to abandon the project is a put option.

Limitations and assumptions

Many of the limitations and assumptions discussed below stem from the fact that a model developed
for financial products is used to assess flexibility and choice embedded within physical, long-term
investments.

European-style options or American-style options

The BSOP model is a simplification of the binomial model and it assumes that the real option is a
European-style option, which can only be exercised on the date that the option expires. An
American-style option can be exercised at any time up to the expiry date. Most options, real or
financial, would, in reality, be American-style options.

In many cases the value of a European-style option and an equivalent American-style option would
be largely the same, because unless the underlying asset on which the option is based is due to
receive some income before the option expires, there is no benefit in exercising the option early. An
option prior to expiry will have a time-value attached to it and this means that the value of an option
prior to expiry will be greater than any intrinsic value the option may have, if it were exercised.

However, if the underlying asset on which the option is based is due to receive some income before
the option’s expiry; say for example, a dividend payment for an equity share, then an early exercise
for an option on that share may be beneficial. With real options, a similar situation may occur when
the possible actions of competitors may make an exercise of an option before expiry the better
decision. In these situations, the American-style option will have a value greater than the equivalent
European-style option.

Because of these reasons, the BSOP model will either underestimate the value of an option or give a
value close to its true value. Nevertheless, estimating and adding the value of real options embedded
within a project, to a net present value computation will give a more accurate assessment of the true
value of the project and reduce the propensity of organisations to under-invest.

Estimating volatility

The BSOP model assumes that the volatility or risk of the underlying asset can be determined
accurately and readily. Whereas for traded financial assets this would most probably be the case, as
there is likely to be sufficient historical data available to assess the underlying asset’s volatility, this is
probably not going to be the case for real options. Real options would probably be available on large,
one-off projects, for which there would be little or no historical data available.

Volatility in such situations would need to be estimated using simulations, such as the Monte-Carlo
simulation model, with the need to ensure that the model is developed accurately and the data input
used to generate the simulations reasonably reflects what is likely to happen in practice.

Other limitations of real options

The BSOP model requires further assumptions to be made involving the variables used in the model,
the primary ones being:

(a) The BSOP model assumes that the underlying project or asset is traded within a situation of
perfect markets where information on the asset is available freely and is reflected in the asset value
correctly. Further it assumes that a market exists to trade the underlying project or asset without
restrictions (that is, that the market is frictionless)

(b) The BSOP model assumes that interest rates and the underlying asset volatility remain constant
until the expiry time ends. Further, it assumes that the time to expiry can be estimated accurately

(c) The BSOP model assumes that the project and the asset’s cash flows follow a lognormal
distribution, similar to equity markets on which the model is based

(d) The BSOP model does not take account of behavioural anomalies which may be displayed by
managers when making decisions, such as over- or under-optimism

(e) The BSOP model assumes that any contractual obligations involving future commitments made
between parties, which are then used in constructing the option, will be binding and will be fulfilled.
For example, in example three above, it is assumed that Swan Co will fulfil its commitment to
purchase the project from Duck Co in two years’ time for $28m and there is therefore no risk of non-
fulfilment of that commitment.
In any given situation, one or more of these assumptions may not apply. The BSOP model therefore
does not provide a ‘correct’ value, but instead it provides an indicative value which can be attached
to the flexibility of a choice of possible future actions that may be embedded within a project.

Conclusion

This article discussed how real options thinking can add to investment appraisal decisions and in
particular NPV estimations by considering the value which can be attached to flexibility which may be
embedded within a project because of the choice managers may have when making investment
decisions. It then worked through computations of three real options situations, using the BSOP
model. The article then considered the limitations of, and assumptions made when, applying the
BSOP model to real options computations. The value computed can therefore be considered
indicative rather than conclusive or correct.

The second article will consider how managers can use real options to make strategic investment
appraisal decisions.

Business Valuation

The purpose of business valuation is to estimate a company’s total value, its equity value or value of
an equity shares

Business valuation methods may be needed:

 To determine the value of a private company (e.g. for a Management Buy
Out (MBO) team).
 To determine the maximum price to pay when acquiring a listed company
(e.g. in a merger or takeover).
 To place a value on companies joining the stock market (i.e. Initial Public
Offerings – IPOs).
 To value subsidiaries/divisions for possible disposal or spinoff.

Business Valuation Methods

1. Assets based valuation

- Net book Value
- Net realizable value
- Placement cost
- Book value plus
2. Dividend Valuation Method
- Ordinary shares
- Preference shares
3. Free cashflow mode
- FCFE
- FCFF( Free cash flow to the firm)
4. Relative valuation models
- P/E
 - EPS
- Dividend yield

1) Assets based valuation

This method considers total Assets of an entity less its liability
NBV (Net book value)= Assets -Liability = Equity

2.1 Net Book Value (NBV)

The net book value method simply uses the "balance sheet" equation:

Equity = Assets − liabilities

Problems and weaknesses of this method include:
 Statement of financial position (balance sheet) values are often based on
historical cost rather than market values.
 Net book value (also called carrying amount) of assets depends on
depreciation/amortisation policies.
 Many key assets are not recorded on the balance sheet (e.g. internally
generated goodwill).
For these reasons a valuation based on balance sheet net assets is not likely to be
reliable

2.2 Net Realisable Value (NRV)

The net realisable method estimates the liquidation value of the business:

Equity = Estimated net realisable value of assets −

liabilities
This may represent the minimum price that might be acceptable to the present owner
of the business.
Problems and weaknesses of this method include:
 Estimating the NRV of assets for which there is no active market (e.g. a
specialist item of equipment).
 It ignores unrecorded assets (e.g. internally-generated goodwill).

3.1 Price/Earnings Ratios

Price earning ratios refers to= Market value of shares/ EPS

EPS= Net profit after interest and tax & Preference Dividend / No. of shares

Price of Ordinary shares = PE *EPS

3.1 Price/Earnings Ratios
The published P/E ratio of a quoted company takes into account the expected
growth rate of that company (i.e. it reflects the market's expectations for the
business).
Using published P/E ratios as a basis for valuing unquoted companies may indicate
an acceptable price to the seller of the shares.
This can be used for valuing the shares in an unquoted company. The steps required
are:

Step 1 Select the P/E ratio of a similar quoted company.

Adjust downwards to reflect the perceived trading risk of an unquoted

Step 2 company and the non-marketability of unquoted shares.

Step 3

Determine the maintainable earnings to use for the unquoted company's

EPS.

Multiply the earnings determined in Step 3 by the adjusted P/E from Step
2 to find the value of the unquoted company.
Step 4
The P/E ratio of a small unquoted company will be, on average, 50% lower than that
of a comparable quoted company in the same industry sector. Generally, the higher
the risk – the greater the discount. A 30% discount would infer a low average level of
risk with high growth potential, whilst a 70% discount would indicate above average
risk. However, the existence of unrecorded intangible assets may improve the
valuation.

Asset based valuation method is useful when liquidating a company and disposing of its assets

Discuss Advantages and Disadvantages of Organic Growth

Initial working capital= current Asset -Current Liability

Where growth rate is not given, use Historic Mean growth rate formula.

= (Current/Old) ^(1/2)-1
Where ungeared Equity Beta for similar company is given, you have to use Modigliani Proposition
with Tax to calculate the ungeared cost of equity for the other company in question.

Refer to MM Formula in the formula table.

DARK POOL NETWORK

Dark pool refers to a private network of trading shares in a listed company usually, not through the
public offerings- Public stock exchange.

Dark pool allows shares to be traded anonymously, away from public scrutiny,, the details of the
trading are revealed when trade has already been closed.

Benefits of dark pool-

Prevent traders from hiking share prices and

They result into reduced price because trading usually take place at mid-price between bid and offer
price

Selling through public offering may result in fall in the price of the shares, thus less value realized
from the sales, however, selling through Darkpool, one is able to keep price intact and largely save
transaction cost

Benefits of dark pool

- Saves transaction costs

- Price of the mid-point between offer and bid price
- Prevent traders from hiking prices.
- Protects from fall in price due to public offering through stock exchange.

How to determine treasury spot rate

((1+g)/MV-1

Year 1 is interest and year 2 Is interest plus redemption value.

Forward interest rate

Forward Rate for Year 2 = (Spot Rate for Year 2 )^2/ (Spot rate for year 1 )

Disadvantage of Swap

- Swaps represent long term commitment from the company at a time when interest
rate is still uncertain, interest rate may rise at lower than expected
- Liability for arrangement fees
- The benefit period may be delayed, depending on the changes in the yield curve.
Advantages of SWAP

- Annual interest liability is fixed. A certain figure can be used in budgeting.

- The company benefits, in case of significant rise in interest rates
- A short swap may be negotiated, given company opportunity to re-consider its
position at the end of the swap.
-

Ways of hedging translation risk is to match asset with liability.

Discuss Advantages and Disadvantages of hedging interest rate risks using Interest rate collar instead
of option

Advantages of hedging using interest rate collar

Collar vs options

The main advantage of using a collar instead of options to hedge interest rate risk is lower cost. A
collar involves the simultaneous purchase and sale of both call and put options at different exercise
prices. The option purchased has a higher premium when compared to the premium of the option
sold, but the lower premium income will reduce the higher premium payable. With a normal
uncovered option, the full premium is payable.

However, the disadvantage of this is that, whereas with a hedge using options the buyer can get full
benefit of any upside movement in the price of the underlying asset, with a collar hedge the benefit
of the upside movement is limited or capped as well.

INTEREST RATE FUTURES

- If you are borrowing money, you will sell futures now and buy back later,
- If you are depositing money, you will buy futures now, and sell later. You are worried
about interest going down, decrease in interest means price of futures will go high
and you will sell futures.
- Always choose the first one after the start of the loan
- Number of contracts= Length of the loan/3 its always length of the loan divide by 3
months because futures are quoted on quarterly basis
-

Interest rate options

- If you are borrowing money, you will always buy put options. Rights to sell option.
- Strike price, price at which we buy or sell futures.
-
KEY FOCUS AREAS FOR AFM Exams

Key topics to be conversant with to pass AFM.

Criteria used by Credit agencies to establish a company’s credit rating.

1. Industry risk- Resilience of the company’s industry factors to changes in in the

economy. Impact of economic changes on the industry, how the demand shift in the
industry,
2. Earning protection- Measures how well the company will be able to protect or
maintain its earnings in a changing circumstance, by looking at different ranges of
sources of earnings, diversification of customers base, profit margins and return on
capital
3. Financial flexibility- Measure how easily the company is able to raise finances
needed to pursue its investment goals. Evaluation of plans for financial needs and
relationships with financial providers and operating restrictions on debt covenant.

4. Evaluation of company’s management- this considers how well managers are

managing and planning for the future of the company. Its financing strategies,
Management succession plan, qualifications and experience of managers and
performance in achieving financial and non-financial targets.

Factors to consider in changing financing structures.

Having high equity increases a company’s debt financing capacity.

- Early redemption penalty

- Changes in capital structure.
- Accessibility to additional finance, due to increase in Equity level.
- Willingness of current shareholders to take on additional finance.
-

Multilateral netting

Government doesn’t allow multinational netting because it limits the fees that their local banks
would receive from these individual transactions.

Some countries allow multilateral trade as this would make companies more willing to operate in
those countries due to savings from Multilateral netting.