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P4 ACCA Workbook
Questions &
Solutions
Lecture 1
Financial Strategy
Shareholder Wealth - Illustration 1
Year Share Price Dividend Paid
2007 3.30 40c
2008 3.56 42c
2009 3.47 44c
2010 3.75 46c
2011 3.99 48c
There are 2 million shares in issue.

! ! ! ! ! ! ! ! ! ! ! !
Calculate the increase in shareholder wealth for each year:
II. Per share
III. As a percentage
IV. For the business as a whole
Solution
Year Share Share Price Div Increase As a Total

Price Growth Paid in Percentage Shareholder
Sholder Return
Wealth
2007 3.30 40c
2008 3.56 (3.56 - 3.30) = 26c 42c (26 + 42) = (68 / 330) = 2m x 68c =
68c 20.6% $1.36m
2009 3.47 (3.47 - 3.56) = -9c 44c (-9 + 44) = (35 / 356) = 2m x 35c =
35c 9.8% $0.70m
2010 3.75 (3.75 - 3.47) = 28c 46c (28 + 46) = (74 / 347) = 2m x 74c =
74c 21.3% $1.48m
2011 3.99 (3.99 - 3.75) = 24c 48c (24 + 48) = (72 / 375) = 2m x 72c =
72c 19.2% $1.44m
EPS - Illustration 2
2010 2011
$000 $000
PBIT 2000 2100
Interest 200 300
Tax 300 400
Profit After Tax 1500 1400
Preference Dividend 300 400
Dividend 800 900
Retained Earnings 400 100
Share Capital (50c) 5000 5000
Reserves 3000 3100
Share Price $2.50 $2.80
Calculate the EPS for 2010 and 2011.
Solution
2010 2011
Profit After Tax 1500 1400
Preference Dividend 300 400
Earnings 1200 1000
No. Ordinary Shares (5000 / 0.50) 10,000 10,000
EPS (Earnings / No. Ordinary Shares) 12c 10c

Lecture 2
Performance
Measurement
Performance Analysis Illustration
X1 X2 X3
Non Current Assets 500 700 1000
Current Assets 150 200 300
650 900 1300
Ordinary Shares ($1) 300 300 300
Reserves 100 280 430
Loan Notes 150 200 300
Payables 100 120 270
650 900 1300
Revenue 3000 3500 4200
COS 2000 2400 3200
Gross Profit 1000 1100 1000
Admin Costs 300 350 400
Distribution Costs 200 250 300
PBIT 500 500 300
Interest 100 150 220
Tax 120 90 50
Profit After Tax 280 260 30
Dividends 100 110 30
Retained Earnings 180 150 0
Share Price $3.30 $4.00 $2.20
Using the information calculate and comment on the following Ratios:
I. Return on Capital Employed

II. Return on Equity
III. Gross Margin
IV. Net Margin
V. Operating Margin
VI. Revenue Growth
VII. Gearing
VIII. Interest Cover
IX. Dividend Cover
X. Dividend Yield
XI. P/E Ratio
Solution
ROCE
X1 X2 X3
Equity + LT Shares 300 300 300

Liabilities
LT Loan Notes 150 200 300
Capital Employed 550 780 1030
Non Current Assets Non Current Assets 500 700 1000

+ Net Current
Assets
Net Current Assets (150 - 100) = 50 (200 - 120) = 80 (300 - 270) = 30

(Current Assets -
Current Liabilities)
Total Assets - Total Assets 650 900 1300

Current Liabilities
Current Liabilities 100 120 270
PBIT 500 500 300
Return on Capital PBIT / Capital (500 / 550) = (500 / 780) = (300 / 1030) =
Employed Employed 90.91% 64.10% 29.13%
X1 X2 X3
Return on Capital Employed (ROCE) 90.91% 64.10% 29.13%
In the first year the ROCE was 90.91%. At first glance this would appear to be a good return, however
without industry averages or prior period information we are unable to tell if this is the case.
In year X2 the ROCE is 64.10%. This is a fall of 29.5% from the previous year indicating that the business
in not able to make the same return on its assets that it has previously been able to do.
In the year X3 the ROCE is 29.13%. This is a fall of 54.55% indicating that there may be some serious
underlying problems which are affecting the ability of the business to generate the return on capital
previously generated.
ROE
X1 X2 X3
Ordinary Shares 300 300 300
Total 400 580 730
Return on Equity (PAT / Ord Shares + (280 / 400) = (260 / 580) = (300 / 730) =
Reserves) 70% 44.8% 41%
In the first year the ROE was 70%. At first glance this would appear to be a good return, however without
industry averages or prior period information we are unable to tell if this is the case.
In year X2 the ROE is 44.8%. This is a fall of 36% from the previous year indicating that the business in
not able to make the same return on the shareholders funds that it has previously been able to do.
In the year X3 the ROE is 41%. This is a fall of 8.4% indicating that the business may be having difficulty
generating the returns it was able to do previously.
Margins
X1 X2 X3
Revenue 3000 3500 4200
PAT 280 260 30
PBIT 500 500 300
Gross Margin (Gross Profit / Revenue) (1000 / 3000) = (1100 / 3500) = (1000 / 4200) =
33.33% 31.42% 23.89%
Net Margin (PAT / Revenue) (280 / 3000) = (260 / 3500) = (30 / 4200) =
9.3% 7.4% 0.7%
Operating Margin (PBIT / Revenue) (500 / 3000) = (500 / 3500) = (300 / 4200) =
16.66% 14.28% 7.1%
The Gross Margin is 33.33% in X1 and holds reasonably steady in X2 at 31.42%. However in X3 the
Gross Margin falls to 23.89% indicating that the business has either had to cut prices to sell the greater
volume it has, or the cost of its purchases have gone up.
The Net Margin is 9.3% in X1 but begins to fall in X2 with 7.4% achieved, before falling dramatically to
0.7% in X3. The main reason for this is the fall in Gross Profit as other costs have risen in line with
expectations given the increase in sales. However another point to note is that interest costs have risen
with the increase in long term loans. The extra interest costs have put pressure on the business.
The Operating Margin dropped slightly in X2 to 14.28% from 16.66% the previous year - a fall of almost
15%. In X3 the Operating Margin fell away to 7.1%, a decrease of over 50%. This is due to the decreasing
Gross Margin achieved as well as rises in the other expenses.
Gearing
X1 X2 X3
Debt 150 200 300
Equity Number of 300 300 300

Shares
Share Price 3.30 4 2.20
Market Value (300 x 3.30) = (300 x 4) = (300 x 2.20) =

990 1200 660
Gearing (Debt / Equity) (150 / 990) = (200 / 1200) = (300 / 660) =

15% 16.66% 45.45%
Gearing levels in year X1 are 15%. Without industry averages or prior year data we are unable to assess
this level although at first glance it does not seem excessive.
In year X2 gearing increases slightly to 16.66%, an increase of 11% from year X1. This is due to debt
levels increasing to 200 from 150, although this is offset by the increase in the share price from $3.30 to
$4.
In year X3 gearing increases dramatically to 45%, an increase of over 180%. This is due to debt levels
rising to 300 from 200 and the share price dropping to $2.20 due to the deteriorating results of the
business.
Interest Cover
X1 X2 X3
PBIT 500 500 300
Interest Cover (PBIT / Interest) (500 / 100) = 5 (500 / 150) = 3.33 (300 / 220) = 1.36
times times times
Interest coverage in year X1 is 5 times. Without industry averages or prior year data we are unable to
assess this level although at first glance it does not seem unreasonable.
In year X2 interest coverage falls to 3.33 times. This has occurred due to the interest charge increasing in
the period while PBIT has remained constant.
In year X3 interest coverage has decreased again to 1.36 times. This is caused by the PBIT achieved
decreasing to 300 combined with the increase in the interest charge to 220. The increase in interest is
caused by the increase in the long term debt of the company as shown by the gearing ratios calculated
above.
Dividend Cover
X1 X2 X3
PAT 280 260 30
Dividend Cover (PAT / Dividends) (280 / 100) = 2.8 (260 / 110) = 2.36 (30 / 30) = 1 time
times times
Dividend coverage in year X1 is 2.8 times. Without industry averages or prior year data we are unable to
assess this level although at first glance it does not seem unreasonable.
In year X2 dividend coverage falls to 2.36 times. This would not concern investors as although coverage
has gone down slightly, the dividend paid this year is greater than last.
In year X3 dividend coverage has decreased to 1 time. This is caused by the decrease in profit achieved
by the company restricting the level of dividend payable. This will be of concern to investors and their
concern is reflected in the fall in the share price from $4 in year X2 to $2.20 in year X3.
Dividend Yield
X1 X2 X3
Number of Shares (300 / 1) 300 300 300
Dividends Per Share (100 / 300) = 33c (110 / 300) = 36c (30 / 300) = 10c
Dividend Yield (Dividends Per Share / (33 / 330) = 10% (36 / 400) = 9% (10 / 220) = 4.5%
Share Price)
The Dividend Yield is 10% in year X1. Whilst we do not have comparatives, this seems a reasonable
return.
In year X2 the Dividend Yield falls to 9%. This will not be overly concerning to investors as the increase in
share price over the year will have more than made up for the slightly lower yield.
In year X3 the Dividend Yield has fallen to 4.5% which is 50% lower than the previous year. This,
combined with the fall in share price and reduced profitability will be a major concern to investors.
P/E Ratio
X1 X2 X3
Share Price $3.30 $4 $2.20
No. Ordinary Shares 300 300 300
EPS (280 / 300) = 93c (260 / 300) = 86c (30 / 300) = 10c
P/E Ratio (Share Price / EPS) (330 / 93) = 3.54 (400 / 86) = 4.65 (220 / 10) = 22
The P/E Ratio in year X1 is 3.54. We don not have industry comparatives or prior year information with
which to compare this.
In year X2 the P/E Ratio increases to 4.65. This indicates that the market expectations for this share have
risen since X1 and that investors are now willing to pay 4.65 times what the business earns in a year to
own the share.
In year X4 the P/E ratio has increased dramatically to 22. This is unusual as the earnings have decreased
to 12% of the previous year. The share price has fallen to reflect this, but not by as much as would be
expected. This may indicate that the market feels that the results in year X3 were perhaps a one-off and
that next years results will improve.
Lecture 3
Finance Sources
Rights Issue - Illustration 1
XYZ Ltd. intends to raise capital via a rights issue.
The current share price is $8.
They are offering a 1 for 4 issue at a price of $6.
Calculate the Theoretical Ex-rights Price.
Solution
Number of Shares Share Price Total
4 $8 (4 x $8) = 32
1 $6 (1 x $6) = 6
5 38
We now have 5 shares in issue at total value of $38 so the THERP is (38 / 5) = $7.60
Rights Issue - Illustration 2
ABC Ltd. has decided to raise capital via a rights issue.
The share price is currently $5.50 and ABC intends to raise $5m.
There are currently 6.25m shares in issue and ABC is offering a 1 for 5 rights issue.
Calculate the Theoretical Ex-Rights Price.
Solution
Amount of Capital to raise $5m
No. of shares issued (6.25m / 5) 1.25m
Share issue price ($5m / 1.25m) $4
Number of Shares Share Price Total
5 $5.50 (5 x 5.50) = 27.5
1 $4 (1 x 4) = 4
6 31.5
We now have 6 shares in issue at total value of $31.5 so the THERP is (31.5 / 6) =
$5.25
Lecture 5
Investment
Appraisal I
ARR - Illustration 1
ABC Ltd are considering expanding their internet cafe business by buying a business
which will cost $275,000 to buy and a further $175,000 to refurbish.
They expect the following cash to come in:
Year Net Cash Profits ()
1 45,000
2 75,000
3 80,000
4 50,000
5 50,000
6 60,000
The equipment will be depreciated to a zero resale value over the same period and,
after the sixth year, they can sell the business for $200,000
Calculate the ARR or ROCE of this investment

Solution
Total Profit over 6 years 45,000 + 75,000 + 80,000 + 50,000 + 360,000

50,000 + 60,000
Total Depreciation Equipment of $175,000 fully 175,000

depreciated
Total Profits 185,000
Average Profits $185,000 / 6 years 30,833
Average Investment (Capital (450,000 + 200,000) / 2 325,000

Investment + Residual Value) / 2
ROCE (Ave. Profit / Ave 30,833 / 325,000 9.5%

Investment)
Relevant Cash Flow Criteria - Illustration 2
A business is considering investing in a new project. They have already spent $20,000 on
a feasibility study which suggests that the project will be profitable.
The headquarters of the company has spare floor space which will be allocated to the
project with $7,000 of the current monthly rent allocated to the project.
New equipment costing $2.5m will have to be bought and will be depreciated on a straight
line basis over 10 years.
A manager who earns $30,000 per year and currently runs a similar project will also
manage the new project taking up 25% of his time.
State whether each of the following items are relevant cash flows and explain your answer.
I. The cost of the feasibility study.
II. The rent charged to the project.
III. The new equipment.
IV. The depreciation on the new equipment.
V. The Managers salary.
Item Relevant Explain

Cash Flow?
Feasibility Study No This is a sunk cost as it has already been paid.
Rent No The rent is not relevant as it must be paid whether

the project goes ahead or not. It is not incremental.
New Equipment Yes This is a relevant cash flow.
Depreciation No Depreciation is not a cash-flow but an accounting

entry.
Managers Salary No The managers salary must be paid whether the

project goes ahead or not so is not relevant.
Payback Period - Illustration 3
Initial Investment of $5.8m.
Annual Cash Flows of $400,000.
Calculate the Payback Period.
Solution
Payback Period (Initial Investment / $5.8m / $400,000 14.5 years

Annual Cash Flows)
Payback Period - Illustration 4
Initial Investment of $6.2m.
Cash Flows of:
Year 1: ! $1,200,000
Year 2:! $2,200,000
Year 3:! $2,500,000
Year 4:! $1,700,000
Calculate the Payback Period.
Solution
Year Cash Flows Cumulative Cash Flows
1 1,200,000 1,200,000
2 2,200,000 3,400,000
3 2,500,000 5,900,000
4 1,700,000 7,600,000
Payback period is between 3 and 4 years
Additional amount required to return capital (6,200,000 - 5,900,000) = 300,000
Total cash flows in year 4 of 1,700,000 so it will take (300,000 / 1,700,000) x 12 = 2.11
months
Discounted Cash-flows - Illustration 5
An investor wants a real return of 10%. Inflation is 5%
What is the MONEY/NOMINAL rate required?
Solution
Use Formula: 1+m = (1+r) x (1+inf)
We are looking for m, therefore:
1+m = (1+0.10) x (1+0.05)
1+m = 1.155
m = 0.155 = 15.5%
A company undertakes a project with the following cash-flows:
Year Cash-Flows
1 5,000
2 7,000
3 8,000
4 10,000
5 11,000
6 9,000
The company has a cost of capital of 10%.
Calculate the present value of the cash flows for each of the six years and in total.
Solution
Year Cash-Flows Discount Rate Present Value

(From Tables)
1 5,000 0.909 4,545
2 7,000 0.826 5,782
3 8,000 0.751 6,008
4 10,000 0.683 6,830
5 11,000 0.621 6,831
6 9,000 0.564 5,076
Total 35,072
A company undertakes a project with the following cash-flows:
Year Cash-Flows
1 5,000
2 5,000
3 5,000
4 5,000
5 5,000
6 5,000
The company has a cost of capital of 10%.
Calculate the present value of the total cash flows for the six years
Solution
Year Cash-Flows Discount Rate Present Value

(From Tables)
1 5,000 0.909 4,545
2 5,000 0.826 4,130
3 5,000 0.751 3,755
4 5,000 0.683 3,415
5 5,000 0.621 3,105
6 5,000 0.564 2,820
Total 21,770
Years Cash-flow Discount Rate (Annuity Present Value

Tables)
1-6 5,000 4.355 21,775

A company expects to receive $100,000 per year forever.
Their cost of capital is 10%.
Calculate the present value of the perpetuity.
Solution
Annual Cash Flow $100,000
Cost of Capital (10%) 0.10
Perpetuity (Cash-Flow / Cost of Capital) 100,000 / 0.10 = $1m

Lecture 6
Investment
Appraisal II
WDA - Illustration 1
A business buys a piece of equipment for $100.
Capital allowances are available at 25% reducing balance.
The tax rate is 30%
After the 4 year project the equipment can be sold for $25.
Solution
Period Balance 25% WDA 30% Tax Period

Saving
1 100.00 25.00 7.50 2
2 75.00 18.75 5.63 3
3 56.25 14.06 4.22 4
4 42.19
Sale of Item -25.00
17.19 5.16 5
Period 0 1 2 3 4 5
Tax - - 7.5 5.63 4.22 5.16

Saving
Working Capital - Illustration 2
A business requires the following working capital investment into a four year project:
Initial Investment:! ! 30,000
Year 1!! ! ! 35,000
Year 2!! ! ! 45,000
Year 3!! ! ! 32,000
Show the working capital line in the NPV calculation.
Solution
Period 0 1 2 3 4
Total Invested 30,000 35,000 45,000 32,000
Movement to NPV -30,000 -5,000 -10,000 13,000 32,000

Calculation
NPV - Illustration 3
A business is evaluating a project for which the following information is relevant:
I. Sales will be $100,000 in the first year and are expected to increase by 5% per year.
II. Costs will be $50,000 and are expected to increase by 7% per year.
III. Capital investment will be $200,000 and attracts tax allowable depreciation of the full
value of the investment over the 5 year length of the project.
IV. The tax rate is 30% and tax is payable in the following year.
V. Working Capital invested will be 20% of projected sales for the following year.
VI. General inflation is expected to be 3% over the course of the project and the business
uses a real discount rate of 9%.
Calculate the NPV for the project.
Solution
Working 1 - WDAs
Initial Investment WDAs Tax Saving Periods
200,000 (200,000 / 5) = (40,000 x 30%) = 2-6

40,000 12,000
Working 2 - Inflation
Period 1 2 3 4 5
Sales 100,000 100,000 100,000 100,000 100,000
Inflation - 1.05 1.05 to 1.05 to 1.05 to

power of 2 power of 3 power of 4
Inflated 100,000 105,000 110,250 115,763 121,551

Sales
Costs 50,000 50,000 50,000 50,000 50,000
Inflation - 1.07 1.07 to 1.07 to 1.07 to

power of 2 power of 3 power of 4
Inflated 50,000 53,500 57,245 61,252 65,540

Costs
Working 3 - Discount Rate
Working
Real Discount Rate In Question 9%
Inflation In Question 3%
Nominal Discount Rate 1 + m = (1 + 0.09) x (1 + 12%

0.03)
1 + m = 1.12
m = 0.12
Working 4 - Working Capital
Period 0 1 2 3 4 5
Inflated Sales 100,000 105,000 110,250 115,763 121,551
Working Capital 20,000 21,000 22,050 23,153 24,310

Required (20%)
Movement -20,000 -1,000 -1,050 -1,103 -1,158 24,310
NPV
Period 0 1 2 3 4 5 6
Inflated Sales 100,000 105,000 110,250 115,763 121,551

(W2)
Inflated Costs -50,000 -53,500 -57,245 -61,252 -65,540

(W2)
Profit 50,000 51,500 53,005 54,510 56,011
Tax at 30% -15,000 -15,450 -15,902 -16,353 -16,803
Tax Saving 12,000 12,000 12,000 12,000 12,000

(W1)
Capital -200,000
Investment
Working Capital -20,000 -1,000 -1,050 -1,103 -1,158 24,310

(W4)
Total Cash -220,000 49,000 47,450 48,452 49,451 75,968 -4,803

Flows
Discount Rate 1 0.893 0.797 0.712 0.636 0.567 0.507

12% (W3)
Discounted -220,000 43,757 37,818 34,498 31,451 43,074 -2,435

Cash Flows
NPV -31,838
Lecture 7 -
Investment
Appraisal III
Illustration 1
ABC has evaluated a project and come to the following conclusions.
At a discount rate of 10% the NPV will be $100,000
At a discount rate of 15% the NPV will be -$75,000
What is the IRR?
Solution
10 + (100,000/(100,000 +75,000) 5 = 12.85%
Illustration 2
Initial Investment(5,000)
Period Cash Flows
12,000
2(1,000)
33,500
43,800
Cost of Capital 10%
NPV = 1,216
IRR = 19%
Calculate the MIRR.

Solution
Terminal Value of Inflows
Period Inflow Inflate Value
1 2,000 (1.10)3 2,662
3 3,500 (1.10)1 3,850
4 3,800 1.10 3,800
Terminal Value 10,312
Present Value Outflows
Period Outflow Discount Rate PV
0 5,000 1 5,000
2 1,000 0.826 826
Present Value of Outflows 5,826
Discount Factor where 10,312 x DF (P4) = 5,826
5,826/10,312 = 0.565
Look at tables for Period 4 and find closest to 0.565.
MIRR = 15%
Lecture 8 - Foreign
NPV
Illustration 1
Item costs $1,000
/$ 1 : 2
However inflation in US is 5% and Eurozone 3%
Calculate the exchange rate in one years time.
Solution
Future exchange rate calculation
Exchange rate now x 1+ Inf (counter) / 1 + inf (base)
2 x 1.05 / 1.03 = 2.039

Illustration 2 (i)
US Interest rate = 10%
UK Interest rate = 8%
Exchange rate= /$ 1 : 2
Predict the exchange rate in 1 year
Solution
Future exchange rate calculation
Exchange rate now x 1+ Int (counter) / 1 + int (base)
2 x 1.10 / 1.08 = 2.037

Illustration 2 (ii)
Current spot rate $/ 1 : 1
The dollar is expected to strengthen by 7% per anum
Forecast the $: rate for the next 4 years.
Solution
Period 0 1 2 3 4
FX Rate 1 1.07 1.145 1.225 1.310

Illustration 3
ABC Ltd. is a UK company intending to undertake a project in Foreignland where the

currency is the Franc (FR).
ABC uses a discount rate of 10% to evaluate projects in the UK and the current spot rate
is / FR 2.000.
The risk free rate of interest in Foreignland is 5% with the UK rate being 7%.
The initial investment in the project will be FR 400,000 with net cash inflows over a 5 year
project of FR 150,000 per year.
Ignore Tax.
Calculate the NPV of the project.

Solution
FX Calculations
Period 1 2 3 4 5
Rate at start of period 2.000 1.963 1.926 1.890 1.855
(1.05 / (1.05 / (1.05 / (1.05 / (1.05 /

IRP
1.07) 1.07) 1.07) 1.07) 1.07)
FX Rate to use 1.963 1.926 1.890 1.855 1.820
NPV Calculations
Period 0 1 2 3 4 5
Investment -400
Cash Flows (FR) 150 150 150 150 150
FX Rate 2 1.963 1.926 1.890 1.855 1.820
Cash Flows () -200.00 76.41 77.88 79.37 80.86 82.42
Discount Rate (10%) 1 0.909 0.826 0.751 0.663 0.621
PV Cash Flows () -200.00 69.46 64.33 59.60 53.61 51.18
NPV 98.19
Illustration 4

is / FR 2.000.
Solution
so....
(1 + DRFoR) / (1 + 0.16) = (1 + 0.07) / (1 + 0.09)
(1 + DRFoR) / (1 + 0.16) = 0.982
(1 + DRFoR) = (1.16 x 0.982)
(1 + DRFoR) = 1.138
DRFoR = 13.8%
Illustration 5

is / FR 2.000.
Sterling is expected to appreciate against the Franc by 10% per year.
Solution
so....
If appreciates by 10% it will be able to buy 10% more FR which makes one
worth (2 x 1.1) = 2.2FR
(1 + DRFoR) / (1 + 0.20) = 2.2 / 2
(1 + DRFoR) / (1 + 0.20) = 1.1
(1 + DRFoR) = (1.20 x 1.1)
(1 + DRFoR) = 1.32
DRFoR = 32%
Illustration 6

is / FR 2.000.
The initial investment in the project will be FR 400,000 with net cash inflows over a 5 year
project of FR 150,000 per year.
Ignore Tax.
Calculate the NPV of the project by adjusting the discount rate.

Solution
(1 + DRFoR) / (1 + 0.10) = (1 + 0.05) / (1 + 0.07)
(1 + DRFoR) / (1 + 0.10) = 0.981
(1 + DRFoR) = (1.10 x 0.982)
(1 + DRFoR) = 1.079
DRFoR = 7.9%...say 8%
NPV Calculations
Period 0 1 2 3 4 5
Investment -400
Cash Flows (FR) 150 150 150 150 150
Discount Rate (8%) 1 0.926 0.857 0.794 0.735 0.681
PV Cash Flows (FR) -400.00 138.90 128.55 119.10 110.25 102.15
NPV (FR) 198.95
Spot Rate 2.00
NPV() 99.48
This is the same as the NPV in illustration 3 with a slight rounding difference.
Lecture 9
WACC I
Cost of Equity using DVM - Illustration 1
ABC Company has just paid a dividend of 35c.
The current share price is $3.25.
Calculate the Cost of Equity (Ke) using DVM.
Solution
Dividend 35
Share Price 325
Cost of Equity (Dividend / Share Price) (35 / 325) = 10.76%

Cost of Equity using DVM - Illustration 2
ABC Company has just paid a dividend of 35c.
The dividend paid has grown by 4% per year for the past 5 years.
Calculate the Cost of Equity (Ke) using DVM.
Solution
Dividend 35
Share Price 325
Dividend Growth 4%
Cost of Equity ((35 x 1.04) / 325) + 0.04 = 0.152

(Dividend (1+g) / Share Price) +g = 15.2%
Cost of Equity using CAPM - Illustration 3
Company A has a Beta of 1.2.
Government bonds are currently trading at 4%.
The average return than investors in the market can expect is 15%.
Calculate the Cost of Equity using CAPM.
Solution
Rf (Risk Free Rate) 4
Rm (Ave Return on the Market) 15
Beta 1.2
Ke = Rf + (Rm - Rf) (4 + 1.2(15 - 4)) = 17.2%

Cost of Equity using CAPM - Illustration 4
Company B has a Beta of 1.
The average return than investors in the market can expect is 12%.
Calculate the Cost of Equity using CAPM for each company.
Solution
Company A Company B
Rf (Risk Free Rate) 5 5
Rm (Ave Return on the 12 12

Market)
Beta 1.2 1
Ke = Rf + (Rm - Rf) (5 + 1.2(12 - 5)) = 13.4% (5 + 1(12 - 5)) = 12%
Notice that when Beta is 1 (Company B) Ke is 12% which is the same as the average
return on the market.
Also notice that a higher Beta of 1.2 gives a higher Ke of 13.4% showing that a higher
Beta means higher risk.
Cost of Equity using CAPM Illustration 5
Company B has a Beta of 1.2.
The average market risk premium is 6%.
Calculate the Cost of Equity using CAPM for each company.
Solution
Company A Company B
Rf (Risk Free Rate) 5 5
Rm - Rf (Ave Market Risk 6 6

Premium)
Beta 1.3 1.2
Ke = Rf + (Rm - Rf) (5 + 1.3(6) = 12.8% (5 + 1.2(6)) = 12.2%
Remember to look out for the market risk PREMIUM as this is always (Rm - Rf) rather
than Rm (Average return on the market)
Again notice that a higher Beta leads to a higher Ke i.e. more risk.
Lecture 10
WACC II
Irredeemable Debt - Illustration 1
A company has issued 10% irredeemable debt.
The market value of the debt is $90.
The tax rate is 30%
Calculate the cost of debt (Kd).
Solution
Interest paid (Per $100 nominal) $10
Tax Rate 30%
After tax interest (Amount Paid (1 - t)) $10 x (1 - 0.30) = $7
Market Value of Debt (Per $100 nominal) $90
Cost of Debt (After tax interest / Market Value of Debt) (7 / 90) = 7.7%
Redeemable Debt - Illustration 2
A Company has issued debt which is redeemable in 5 years time.
Interest is payable at 8%.
The current market value of the debt is $102.
Ignore taxation.
Calculate the Cost of Debt (Kd).
Solution
Perio Item $ DR 5% PV DR 15% PV

d
1 -5 Interest 8 4.329 34.63 3.352 26.82
5 Capital 100 0.784 78.40 0.497 49.70
Market Value -102 -102
11.03 -25.48
IRR Calculation: 5 + (11.03 / (11.03 - (25.48)) (15 - 5) = 8.02%

Redeemable Debt - Illustration 3
A Company has issued debt which is redeemable in 5 years time.
Tax is payable at 30%.
Solution

d
1 -5 Interest (10 x (1 7 4.329 30.30 3.352 23.46

- 0.3)
5 Capital 100 0.784 78.40 0.497 49.70
4.70 -30.84
IRR Calculation: 5 + (4.7 / (4.7 - (30.84)) (15 - 5) = 6.32%

Convertible Debt - Illustration 4
A Company has issued debt which is convertible in 5 years time.
On conversion, investors will have a choice of either:
I. Cash at a 15% premium; or
II. 18 shares per loan note.
The current share price is $6 and it is expected to grow in value by 4% per year.
Tax is payable at 30%.
Solution
Working 1 - Cash or Convert?
Working
Cash (15% Premium) 100 x 1.15 $115
Shares
Current Value $6
Value in 5 years with 4% 6 x (1.04 to the power of 5) $7.30

growth
Number of shares per $100 18
Conversion Value 7.30 x 18 $131.40
The conversion value is higher than the cash so the investors will choose to convert.
Do an IRR the same as for redeemable but filling $131.40 into the capital repaid
Cost of Debt

d
1 -5 Interest (10 x (1 - 0.3) 7 4.329 30.30 3.352 23.46
5 Conversion Value 131.4 0.784 103.02 0.497 65.31
13.32 -31.23
IRR Calculation: 5 + (13.32 / (13.32 - (31.23)) (15 - 5) = 8%
Preference Shares - Illustration 5
A company has issued 8% preference shares with a nominal value of $1.
The market value of the shares is 80c.
The tax rate is 30%.
Calculate the cost of the preference shares (Kd).
Solution
Interest Paid 8
Market Value of share 80
Cost (Kd) (Interest Paid / Market Value) (8 / 80) = 10%

Bank Debt - Illustration 6
A company has a bank loan of $2m at an interest rate of 10%.
Calculate the cost of debt (Kd).
Solution
Interest Rate before Tax 10
Tax Rate 30%
After Tax Cost of Debt (10 x (1 - 0.3)) 7%

WACC - Illustration 7
Company A is funded as follows:
Item Capital Structure Cost
Equity 85% 15%
Debt 15% 7%
Calculate the Weighted Average Cost of Capital.
Solution
Item Capital Structure Cost Ave
Equity 85% 15 12.75
Debt 15% 7 1.05
WACC 13.8
Balance Sheet Extract
Ordinary Shares (50c) 3000
Loan Notes 2000
Bank Loan 1000
The cost to the company of each of the above items has been calculated as:
Ordinary Shares 13%
Loan Notes 8%
Bank Loan 5%
The Loan notes are currently trading at $94.
The current share price is $1.50
Solution
Working 1 - Calculate Cost of Capital for each item.
Given in the Question
Ordinary Shares 13%
Loan Notes 8%
Bank Loan 5%
Working 2 - Calculate the Market Value of Debt and Equity.
SFP Market Value
Ordinary 3000 No. of shares (3000 / 0.50) = 6000 (6000 x $1.50) =

Shares (50c) Share Price = $1.50 9000
Loan Notes 2000 Loan Notes nominal value (on (2000 x (94 / 100)
SFP) = 100 = 1880
Market Value = 94
Bank Loan 1000 No market for this so use SFP 1000

value
Working 3 - Calculate the weighting of each item.
Item Market Value Weighting
Equity 9000 (9000 / 11,880) = 75.75%
Loan Notes 1880 (1880 / 11,880) = 15.82%
Bank Loan 1000 (1000 / 11,880) = 8.41%
11880
Working 4 - Weighted Average Cost of Capital
Item Market Weighting Cost Ave

Value (W1)
Equity 9000 (9000 / 11,880) 13 (9000 / 11,880) x 13 =

9.85
Loan Notes 1880 (1880 / 11,880) 8 (1880 / 11,880) x 8 =

1.27
Bank Loan 1000 (1000 / 11,880) 5 (1000 / 11,880) x 5 =

0.42
11880 WACC 11.54%

Balance Sheet Extract
Ordinary Shares (50c) 2000
12% Loan Notes 1500
8% Preference Shares ($1) 500
Bank Loan 750
Details on these are as follows.
The company has an equity beta of 1.2. Government bonds are currently trading at 6%
and the average market risk premium is 7%.
The Loan notes are currently trading at $106 and are redeemable at par in 5 years time.
The preference shares are trading at 92c.
The bank loan has an interest rate of 10%.

Solution
Working 1 - Calculate Cost of Capital for each item.
Cost of Equity using CAPM
(Rm - Rf)(Ave market risk premium) 7
Beta 1.2
Ke = Rf + (Rm - Rf) (6 + 1.2(7)) = 14.4%
Cost of 12% Loan Notes

d
1 -5 Interest (12 x (1 8.4 4.329 36.36 3.352 28.16

- 0.3)
5 Capital 100 0.784 78.40 0.497 49.70
8.76 -28.14
IRR Calculation: 5 + (8.76 / (8.76 - (28.14)) (15 - 5) = 7.37%
Cost of Preference Shares
Interest Paid 8
Market Value of share 92
Cost (Kd) (Interest Paid / Market Value) (8 / 92) = 8.7%

Cost of Bank Debt
Interest Rate before Tax 10
Tax Rate 30%
After Tax Cost of Debt (10 x (1 - 0.3)) 7%
Working 2 - Calculate the Market Value of Debt and Equity.
SFP Market Value
Ordinary 2000 No. of shares (2000 / 0.50) = 4000 (4000 x $1.25) =

Shares (50c) Share Price = $1.25 5000
12% Loan 1500 Loan Notes nominal value (on (1500 x (106 /
Notes SFP) = 100 100) = 1590
Market Value = 106
8% Preference 500 Preference shares nominal value (500 x (92 / 1)) =

Shares ($1) (on SFP) = $1 460
Market Value = 92c
Bank Loan 750 No market for this so use SFP 750

figure
Working 3 - Calculate the weighting of each item.
Item Market Value Weighting
Equity 5000 (5000 / 7800)
Loan Notes 1590 (1590 / 7800)
Preference Shares 460 (460 / 7800)
Bank Loan 750 (750 / 7800)
7800
Working 4 - Weighting & Weighted Average Cost of Capital
Item Market Weighting Cost Ave

Value (W1)
Equity 5000 (5000 / 7800) 14.4 (5000 / 7800) x 14.4 =

9.23
Loan Notes 1590 (1590 / 7800) 7.37 (1590 / 7800) x 7.37 =

1.50
Preference 460 (460 / 7800) 8.7 (460 / 7800) x 8.7 =

Shares 0.51
Bank Loan 750 (750 / 7800) 7 (750 / 7800) x 7 = 0.67
7800 WACC 11.91%

Lecture 11
Capital Structure
Capital Structure - Illustration 1
A company has total capital of $1,000 with debt making up $300 and equity making up
$700 of the total. The companys cost of debt is 5% and cost of equity is 14%.
I. Calculate the companys current WACC.

II. Calculate the WACC if the company substitutes $200 of equity for $200 of debt
causing their cost of equity to rise to 16%.
III. Calculate the WACC if the company substitutes $300 of equity for $300 of debt
causing their cost of equity to rise to 25%.
Solution
I.
Item Market Value Weighting Cost WACC
Debt 300 300 / 1000 5% 1.5
Equity 700 700 / 1000 14% 9.8
1000 11.3
II.
Debt 500 500 / 1000 5% 2.5
Equity 500 500 / 1000 16% 8
1000 10.5
III.
Debt 600 600 / 1000 5% 3
Equity 400 400 / 1000 25% 10
1000 13
Lecture 12
M & M Formulae
Illustration 1
ABC Ltd has a share price of 350c and 1m shares in issue. It currently has no debt.
Current cost of capital is 13%.
The directors have decided to replace $2m of equity with 10% debt. The tax rate is 30%.
Required
(i) Calculate the new value of the geared firm.
(ii)Calculate the value of the Equity in the geared firm.
Value of Ungeared Firm (1m x 350c) 3,500
Market Value of Debt 2,000
Tax Rate 30%
Fill into Formula (Vg = Vu + TB) Vg = (3500 x (30% x 2000) 4,100
Value of Debt (In Question) 2,000
Value of Equity (4,100 - 2,000) 2,100

Illustration 2
ABC Co. and CD Co. operate in the same industry and are identical in their ability to
generate cash flows.
ABC Co. is financed by Equity only of 3m shares with current value of $1 and has a cost of
equity calculated at 15%.
CD Co. has the same total capital but within it has irredeemable debt with a market value
of $0.9m.
Required
(i) Calculate the value of CD Co.
(ii)Calculate the value of the Equity in CD Co.
Solution
Value of Ungeared Firm (3m x 100c) 3,000
Market Value of Debt 900
Tax Rate 33%
Fill into Formula (Vg = Vu + TB) Vg = (3,000 x (33% x 900) 3,297
Value of Debt (In Question) 900
Value of Equity (3,297 - 900) 2,397

Illustration 3
of $0.9m and cost of debt of 8%.
Required
(i) Calculate the Cost of Equity for CD Co.
Solution
Keg = Keu + (Keu - Kd) Vd(1-t)/Ve
Keg = 15 + (15 - 8) 900(1-0.33) / 2397
Keg = 16.76%
Illustration 4
of $0.9m and cost of debt of 8%.
Required
(i) Calculate the WACC for CD Co.
Solution
Kadj = Keu (1 - tL)
Kadj = 15 (1 - (0.33 x (900 / 3,297)))
Kadj = 13.65
Lecture 14
Risk Adjusted WACC
Risk Adjusted WACC - Illustration 1
Company A intends to undertake a project in an unrelated industry.
The following details are relevant:
Item Company A Proxy Company
Equity Beta (e) 1.2 1.4
Value of Equity 1000 800
Value of Debt 400 500
The risk free rate is 4%.
The average return on the market is 12%.
The post tax cost of debt is 7%.
Calculate the risk adjusted WACC to be used in evaluating the project.
Ignore Tax
Solution
Working 1 - Un-gear the proxy e to get a.
Proxy Equity Beta 1.4
Value of Equity of Proxy 800
Value of Debt of Proxy 500
u = g(Ve / (Ve + Vd)) 1.4 (800 / (800 + 500)) = 0.86

Working 2 - Re-gear a with our capital structure
a 0.86
Value of Equity of Company A 1000
Value of Debt of Company A 400
g = u + (u -d) (Vd / Ve) 0.86 + (0.86 x (400 / 1000) = 1.20
Working 3 - Fill into CAPM
Rm (Ave return on the market) 12
Beta 1.2
Ke = Rf + (Rm - Rf) (4 + 1.2(12 - 4)) = 13.6%
Working 4 - Risk Adjusted WACC
Market
Item Weighting Cost Ave
Value
Equity 1000 (1000 / 1400) 13.6 9.71
Debt 400 (400 / 1400) 7 2.00
1400 WACC 11.71

Risk Adjusted WACC - Illustration 2
Company A intends to undertake a project in an unrelated industry.
The following details are relevant:
Item Company A Proxy Company
Equity Beta (e) 1.1 1.3
Value of Equity 1200 900
Value of Debt 500 450
The average return on the market is 12%.
The post tax cost of debt is 8%.
Calculate the risk adjusted WACC to be used in evaluating the project.
Solution
Working 1 - Un-gear the proxy e to get a.
Proxy Equity Beta 1.3
Value of Equity of Proxy 900
Value of Debt of Proxy 450
u = g(Ve / (Ve + Vd x 1-t)) 1.3 (900 / (900 + (450 x 0.7)) = 0.96

Working 2 - Re-gear a with our capital structure
a 0.96
Value of Equity of Company A 1200
Value of Debt of Company A 500
g = u + (u -d) (Vd (1-t)/ Ve) 0.96 + (0.96 x 500/1200) = 1.24
Working 3 - Fill into CAPM
Rm (Ave return on the market) 12
Beta 1.24
Ke = Rf + (Rm - Rf) (4 + 1.24(12 - 4)) = 13.92%
Working 4 - Risk Adjusted WACC
Market
Item Weighting Cost Ave
Value
Equity 1200 (1200 / 1700) 13.92 9.83
Debt 500 (500 / 1700) 8 2.35
1700 WACC 12.18

Illustration 3
Company ACompany B
Debt/Equity 1/31/4
Equity Beta 1.2
Debt Beta 0.3
Assume that the Asset Beta and the Debt Beta of each firm is the same.
Calculate the Equity Beta for Company B.
Solution
Ungear Equity Beta Company A:
Ba = (1.2 (3/4)) + (0.3 (1/4) = 0.9 + 0.075 = 0.975
Regear Asset Beta for Company B:
Be = 0.975 + ((0.975 -0.3) 1/4) = 1.14
or
0.975 = Be (4/5) + 0.3 (1/5)
0.975 - (0.3 x 1/5) = Be (4/5)
0.915 = Be (4/5)
Be = 0.915 x 5/4
Be = 1.14
Lecture 15
APV
Illustration 1
Cost of Equity in Geared Firm = 12%
Cost of Debt = 8%
Debt/Equity ratio = 1/2
Tax rate = 30%
Calculate the cost of equity in an ungeared firm.
Solution
12% = Keu + (Keu - 8%) (1(1 - 0.3) / 2)
12% = Keu + 0.35Keu - 2.8%
14.8% = 1.35 Keu
Keu = 10.96%
Illustration 2
Company AB has used $5m of 10% debentures to finance a project lasting

for 4 years. The tax rate is 35%.
Issue costs are 3% and are tax deductible.
What is the PV of the issue costs for APV purposes?
Solution
Issue Costs:! $5m x 3% = $150,000
Tax Relief:! ! $150,000 x 35% = $52,500
Post Tax Cost:! $150,000 - $52,500 = $97,500

Illustration 3

Issue costs are 3% and are tax deductible. These are to be raised along with
the finance.
What is the PV of the issue costs for APV purposes?
Solution
Required Finance: ! $5m is 97% of total to raise
! ! ! ! ...so ($5m / 0.97) $5,154,639 must be raised.
Issue Costs:! ! $5,154,639 x 3% = $154,639
Tax Relief:! ! ! $154,639 x 35% = $54,124
Post Tax Cost:! ! $154,639 - $54,124 = $100,515

Illustration 4

What is the PV of the tax relief available for APV purposes?
Solution
Annual Interest = $5m x 10% = $500,000
Annual Tax relief = $500,000 x 35% = $175,000
PV Tax relief = $175,000 x 3.170 = $554, 750

Illustration 5
Company AC needs to raise $10m in debt finance for 4 years.
Company AB has raised $7m of 10% debentures and the rest is provided by
a subsidised government loan of $3m at 5%.
Calculate the financing effects of the debt for APV purposes.
Solution
PV Tax Shield
Annual Interest = ($7m x 10%) + ($3m x 5%) = $850,000
PV Tax relief = $255,000 x 3.170 = $808,350
Cheap Loan
Interest Saved = ($3m x (10% - 5%)) = $150,000
Tax Relief Lost = ($150,000 x 30%) = $45,000
Net Saving = ($150,000 - $45,000) = $105,000
Discount at the cost of debt as even though discounted it has the same risk
as a normal loan...
PV Interest Saved = ($105,000 x 3.170) = $332,850

Illustration 6
ABC Co. is considering a project which is expected to generate cash inflows

of $500,000 per year for 5 years and cost $500,000 of initial investment.
Costs have been estimated at $350,000 per year.
ABC has a current cost of equity of 14% and a cost of debt of 7% and a
current debt to equity ratio of 1/3.
To undertake the the project the $500,000 will be raised through a bond issue
of 8% with issue costs of 4% to be raised in addition to the finance.
Solution
Un-gear the cost of equity
14% = Keu + (Keu - 7%) (1(1 - 0.3) / 3)
14% = Keu + 0.23Keu - 1.63%
15.63% = 1.23 Keu
Keu = 12.71% say 13%
Base Case NPV
Discount at un-geared Ke of 13%
PV Cash Inflows = ($500,000 x 3.517) = $1,758,500
PV Outflows = ($350,000 x 3.517) = $1,230,950
Net Cash Inflow = $527,550
Initial Investment = $500,000
Base Case NPV = ($527,550 - $500,000) = $27,550

Issue Costs
Required Finance: ! $500,000 is 96% of total to raise
! ! ! ! ...so ($500,000 / 0.96) $520,833 must be raised.
Issue Costs:! ! $520,833 x 4% = $20,833
Tax Relief:! ! ! $20,833 x 30% = $6,250
Post Tax Cost:! ! $20,833 - $6,250 = $14,583
PV Tax Shield
Annual Interest = ($520,833 x 8%) = $41,666
PV Tax relief = $12,500 x 3.993 = $49,912
APV
Base Case NPV! = ! $27,550
PV Issue Costs ! = ($14,583)
PV Tax Shield ! = $38,040
APV! ! ! = $51,007
Lecture 16
More Risk
Illustration 1
ABC Ltd is undertaking a project costing $900m with expected net cash flows of $400m in
years 1 & 2 then $600m in year 3.
The FD considers that these cash flows may be overestimated by as much as 10% in year
1, 15% in year 2 and 20% in year 3.
The risk free rate is 5%
Required
Using certainty equivalents calculate the expected NPV of the project.
Solution
0 1 2 3
Cash Flows -900 400 400 600
Certainty Equivalents 1 0.9 0.85 0.80
CE Cash Flows -900 360 340 480
Discount Rate (5%) 1 0.952 0.907 0.864
Present Value -900 343 308 415
NPV 166
Lecture 17
Options Pricing I
Illustration 1
Current Share Price:! ! $120

Exercise Price:! ! ! $100
Risk Free Interest Rate:! ! 10%
Variance of Shares:!! ! 25%
Time to Expiry:! ! ! 3 months
Solution
Time in Years to Expiry
3 months = 0.25 Years so 0.25 for formula
Standard Deviation of Share Price
Variance is 25% so thats...0.25
To get SD we need to take square root of this which is 0.5
We work out d1 later but lets say its 0.95 when we calculate it....
Find 0.95 on Normal Distribution table.
Read table to find applicable number....0.3289.
0.95 is greater than 0 so add 0.5 to number from the table...
0.3289 + 0.5 = 0.8289....this is N(d1).
Find d1 first...
In(Pa/Pe) + (r + 0.5s2)t
st
In(120/100) + (0.1 + 0.5 x 0.52)0.25

0.5 0.25
0.1823 + 0.05625
0.25
d1 = 0.95
0.3289 + 0.5 = 0.8289....this is N(d1).
Now d2...
d2 = d1- st
d2 = 0.95 - 0.5 0.25
d2 = 0.7
0.2580 + 0.5 = 0.7580....this is N(d2).
Fill into Black-Scholes model...
Call Option Value = PaN(d1) - PeN(d2)e-rt
Call Option Value = (120 x 0.8289) - 100 x 0.7580e-(0.1 x 0.25)
Call Option Value = (99.46 - 73.53) = 25.53
Intrinsic Value: (120 - 100) = $20
Time Value: (25.53 - 20) = $5.53

Illustration 2

Standard Deviation Shares:! 30%
Solution
Time in Years to Expiry
3 months = 0.25 Years so 0.25 for formula
Standard Deviation of Share Price
This is given to us as 30%....so 0.3.
Find d1 first...
In(Pa/Pe) + (r + 0.5s2)t
st
In(110/97) + (0.08 + 0.5 x 0.32)0.25

0.3 0.25
0.126 + 0.03125
0.15
d1 = 1.05
0.3531 + 0.5 = 0.8531....this is N(d1).

Now d2...
d2 = d1- st
d2 = 1.05 - 0.3 0.25
d2 = 0.9
Read table to find applicable number....0.3159
0.3159 + 0.5 = 0.8159....this is N(d2).
Call Option Value = (110 x 0.8531) - 97 x 0.8159 x e-(0.08 x 0.25)
Call Option Value = (93.84 - 77.58) = 16.26
Intrinsic Value: (110 - 97) = $13
Time Value: (16.26 - 13) = $3.26

Lecture 18
Options Pricing II
Illustration 1

Variance of Shares:!! ! 25%
We already calculated in the last lecture that the call option value is $25.53.
Calculate the value of the corresponding put option.
Solution
Put Option Valuation is...
P = c - Pa + Pe x e-rt
P = 25.53 - 120 + 100 x e-(0.1 x 0.25)
P = 25.53 - 120 + 97.53
P = $2.53
Illustration 2
ABC Ltd. has an option in CD Ltd. which is due to expire in 6 months.
A dividend of 55 cents is due to be paid in 3 months time and the current share price is
$15.
Calculate the dividend-adjusted share price.
Solution
We need the present value of the dividends so...
Divs x e-rt
55 x e-(0.1 x 0.25)
= 53.64c
Subtract this from the share price...
$15 - $0.54 = $14.46

Illustration 3
ABC Co. is planning to expand into Foreignland by opening a new distribution centre
there.
The project would cost $20m and the present value of the cash flows are forecasted to be
$17m leading to a negative NPV of $3m.
However, by undertaking the investment they could expand further into Foreignland with a
second distribution centre.
The second centre is expected to have the following details:
Estimated Cost (Pe):! ! ! $30m
PV Expected Net Receipts (Pa):! ! $23m
Timing (t):! ! ! ! ! 5 years
Risk Free Rate (r):! ! ! ! 8%
Volatility (s):! ! ! ! ! 30%
Calculate the value of the call option on the second distribution centre (this is an
option to expand).
Solution
Find d1 first...
In(Pa/Pe) + (r + 0.5s2)t
st
In(23/30) + (0.08 + 0.5 x 0.32)5

0.3 5
-0.266 + 0.625
0.67
d1 = 0.54
Read table to find applicable number....0.2054
0.2054 + 0.5 = 0.7054....this is N(d1).

Now d2...
d2 = d1- st
d2 = 0.54 - 0.3 5
d2 = -0.13
-0.13 is less than 0 so subtract number on the table from 0.5...
0.5 - 0.0517 = 0.4483....this is N(d2).
Call Option Value = (23 x 0.7054) - 30 x 0.4483 x e-(0.08 x 5)
Call Option Value = (16.22 - 9) = $7.22m
So...
NPV of first centre:! ! -$3m

Call Option on 2nd:!! $7.22m
Total:! ! ! ! $4.22m
Lecture19
More on Cost of Debt
Illustration 1
ABC Co. has 5 year bonds in issue with a BBB credit rating which have a credit spread of
115.
5 year treasury bonds have a current return of 3.4%
What is the expected yield on ABCs bonds?
Solution
A credit spread of 115 = 1.15%.
3.4% + 1.15% = 4.55%

Illustration 2
A government has three bonds in issue that all have a face or par value of $100 and are
redeemable in one year, two years and three years respectively. Since the bonds are all
government bonds, lets assume that they are of the same risk class. Lets also assume
that coupons are payable on an annual basis. Bond A, which is redeemable in a years
time, has a coupon rate of 7% and is trading at $103. Bond B, which is redeemable in two
years, has a coupon rate of 6% and is trading at $102. Bond C, which is redeemable in
three years, has a coupon rate of 5% and is trading at $98.
To determine the yield curve, each bonds cash flows are discounted in turn to determine
the annual spot rates for the three years, as follows:
Bond A:
$103 = $107 / (1+r1)
r1 = (107/103 1) = 0.0388 or 3.88%
Bond B:
$102 =
$6 / 1.0388! = 5.78
106 / (1+r2)2! = (102 - 5.78) = 96.22
r2 = [106 / 96.22]1/2 - 1= 0.0496 or 4.96%
Bond C:
$98 =
$5 / 1.0388 ! = 4.81
$5 / 1.04962 != 4.54
105 / (1+r3)3 != (98 - 4.81 - 4.54) = 88.65
r3 = [105 / (88.65)]1/3 1 = 0.0580 or 5.80%
The annual spot yield curve is therefore:
Year
1 3.88%
2 4.96%
3 5.80%
Illustration 3
ABC Co. has 3 yr 8% bonds in issue which are redeemable at par after the 3 year term.
The yield to maturity is 10% and they are trading at $95.
Calculate the Macauley Distribution.
Solution
Step 1 - PV of each future receipt:
Year DR = 10% Cash PV
1 0.909 8 7.27
2 0.826 8 6.61
3 0.751 108 81.11
Bond Price 95
Step 2 - Time to Maturity x PV Cashflow
Time Cash PV
1 7.27 7.27
2 6.61 13.22
3 81.11 243.33
SUM 263.82
Step 3 - SUM / Bond Price
263.82 / 95 = 2.78 Years

Lecture 20
Corporate Failure I
No Illustrations
Lecture 21
Corporate Failure II
Illustration 1
$000
Assets 500
500
Equity & Liabilities
Issued Equity Shares @ $1 each 600
Share Premium 100
Retained Earnings -300
Liabilities 100
500
Dividends cannot be paid while accumulated losses exist.
Equity of $600,000 is only backed by assets of $500,000.
Loan finance cannot be raised due to the current financial position.
Required
Apply a capital reduction and restate the statement of financial position.

Solution
DR CR
Share Premium 100
Equity Share Capital 200
Retained Earnings 300
$000
Assets 500
500
Issued Equity Shares 400
Share Premium 0
Retained Earnings 0
Liabilities 100
500
Illustration 2
$000
Intangible Asset (Brand) 50,000
Non Current Assets 220,000
270,000
Inventory 20,000
Receivables 30,000
320,000
Issued Equity Shares @ $1 each 100,000
Share Premium 75,000
Retained Earnings -100,000
75,000
Debenture Loan 125,000
Overdraft 20,000
Payables 100,000
320,000
A reconstruction scheme is to take place under the following conditions:
(i) The equity shares of $1 nominal currently in issue will be written off and will be replaced
on a one-for-one basis by new equity shares with nominal value of $0.25.
(ii)The debenture loan will be replaced by the issue of new equity shares - four new shares
with nominal value of $0.25 each for every $1 debenture loan converted.
(iii)New shares with a nominal value of $0.25 will be offered to the existing equity holders
in the ratio of three new shares for every one currently held. All current equity holders
are expected to take this up.
(iv)Share premium account to be eliminated.
(v)Brand to be written off as it is impaired.
(vi)Deficit on the retained earnings to be eliminated.
Prepare the revised SFP and show any workings undertaken to achieve this.
Solution
Reconstruction Account
DR CR
New Equity Shares 25,000 Remove Equity Shares 100,000

(100,000 x 0.25) Note (i) Note (i)
Conversion of Debenture 125,000 Remove Debenture Loan 125,000

(125,000 x 4 x 0.25) Note (ii) Note (ii)
Brand Impairment 50,000 Share Premium Removed 75,000

Note (v) Note (iv)
Retained Earnings 100,000

Note (vi)
300,000 300,000
$000
Intangible Asset (Brand) 0
220,000
Bank (-20,000 + 75,000) Note (iii) 55,000
Inventory 20,000
Receivables 30,000
325,000
Issued Equity Shares (125,000 + 25,000 + 75,000) 225,000
Share Premium 0
Retained Earnings 0
225,000
Debenture Loan 0
Overdraft 0
Payables 100,000
325,000
Lecture 22
Business Valuations
I
Net Assets Valuation Method Illustration 1
Current Assets 170,000
Current Liabilities -80,000
Share Capital 300,000
Reserves 200,000
10% Loan Notes 150,000
The Market Value of property in the Non Current Assets is $50,000 more than the book
value.
The Loan Notes are redeemable at a 5% premium.
What is the value of a 70% holding using the net assets valuation basis?
Solution
Working $
Non Current Assets 550,000 + 50,000 (Property value) 600,000
Current Assets 170,000
Current Liabilities -80,000
10% Loan Notes 150,000 x 105% -157,500
532,500
Value of 70% 532,500 x 70% 372,750

DVM - Illustration 2
ABC pays a constant dividend of 45c. It has 3m ordinary shares.
The shareholders require a return of 15%.
What is the Value of the business?
Solution
Working
Constant Dividend In Question 45c
Required Return (Cost of Equity or Ke) In Question 15%
Share Price (Dividend / Ke) 45 / 0.15 300c
No. Ordinary Shares In Question 3m
Value of the business 300c x 3m $9m

DVM - Illustration 3
A business has Share Capital made up of 50c shares of $3 million

Dividend per share (just paid) 30c
Dividend paid four years ago 22c
Required Return = 12%
Calculate the Value of the business using the dividend valuation method.
Solution
Working 1 - Dividend Growth
Dividend Paid Now 30c
Dividend Paid 4 Years Ago 22c
Dividend Growth (4(30 / 22))

=1.08
=8%
Working 2 - Business Valuation
Dividend Paid 30c
Required Return (Ke) 12%
Dividend Growth 8%
Share Price (Dividend (1+g)) / (Ke - g) (30 x 1.08) / (0.12 - 0.08) = 810c
No Ordinary Shares ($3m / 0.5) = 6m
Value of business (6m x 810c) = $48.6m

P/E Ratio Method - Illustration 4
X1 X2 X3
$000 $000 $000
Revenue 3000 3500 4200
COS 2000 2400 3200
PBIT 500 500 300
Tax 120 90 50
Industry P/E Average 13 12 14
Calculate the Value of the Company for each of the 3 years using the P/E Ratio
method.
Solution
Year Industry P/E Ratio Total Earnings Value of Company
1 13 280,000 (13 x 280,000) = $3.64m
2 12 260,000 (12 x 260,000) = $3.12m
3 14 30,000 (14 x 30,000) = $420,000

P/E Ratio Method - Illustration 5
X1 X2 X3
$000 $000 $000
Revenue 3200 3800 4800
COS 2000 2400 3200
PBIT 700 800 900
Tax 120 90 50
Industry P/E Average 17 15 18
Number of Shares 3m 3m 3m
Calculate the Earnings Per Share for each of the 3 years
Calculate the Value of the Company for each of the 3 years using the EPS you
calculate.
Solution
Year Earnings No. Shares EPS (Earnings / No.

Ordinary Shares)
1 480,000 3m 16c
2 560,000 3m 18.66c
3 630,000 3m 21c
Year Industry P/E EPS Share Price Value of Company

Ratio (EPS x P/E Ratio)
1 17 16c $2.72 (2.72 x 3m) =

$8.16m
2 15 18.66c $2.80 (2.80 x 3m) =

$8.4m
3 18 21c $3.78 (3.78 x 3m) =

$11.34m
Earnings Yield - Illustration 6
X1 X2 X3
$000 $000 $000
Revenue 3100 3700 4600
COS 2000 2400 3200
PBIT 600 700 700
Tax 120 90 50
Earnings Yield 0.15 0.18 0.17
Number of Shares 4m 4m 4m
Calculate the Earnings Per Share for each of the 3 years and the share price using the
earnings yield.
Solution
Year Earnings No. EPS (Earnings / Earnings Share Price

Shares No. Ordinary Yield (EPS / Earnings
Shares) Yield)
1 380,000 4m 9.5c 0.15 63.33c
2 460,000 4m 11.5 0.18 63.88c
3 430,000 4m 10.75 0.17 63.23c

Present Value of Future Cash Flows - Illustration 7
ABC Company earned $100,000 in cash inflows this year.
They expect this to increase in each of the next 5 years by 5% and after that to increase
by 2% forever.
The company uses a cost of capital of 10%.
Calculate the value of the company using the present value of future cash flows method.
Solution
Period 0 1 2 3 4 5
Cash Inflows 100,000 105,000 110,250 115,763 121,551 127,628
Discount Rate 1 0.909 0.826 0.751 0.683 0.621

10%
PV Cash 100,000 95,445 91,067 86,938 83,019 79,257

Flows
Total 535,725
Period Working $
Years 0 - 5 From Above 535,725
Post Year 5 (127,628 x (1+g)) / (Ke - g) 1,627,257

(127,628 x 1.02) / (0.10 - 0.02)
Total Value of Company 2,162,982

Lecture 23
Business Valuations
II
Illustration 1
Company A has 100m shares at 3 each. Company B has 50m shares of

1 each.
Company A makes an offer of 1 new shares for every 5 held in B and has
worked out that the synergies available are valued at 20m
Calculate the expected value of a share in the combined company.
Solution
1. Value of Company A = (100m x 3) = 300m
2. Value of Company B = (50m x 1) = 50m
3. Value of Combination = (300 + 50 + 20*) = 370m
*Synergies
4. No. Shares = 100 + (1/5)x50 = 110m
5. Value of one share = 370/110 = 3.45
Illustration 2
Post Tax Profit P/E Ratio Pre Aq. Value

Company A 150m 10 1500m
Company B 10m7 70m
Estimating the post acquisition value of the combined business is done by

applying the P/E ratio of Company A to the combined earnings of the new
combination.
Solution
Value of individual companies = (1,500 + 70) 1,570
Value of Combination = 10 x (150m + 10m) = 1,600m
Value of Synergies = 1,600m - 1,570m = 30m
Lecture 24
Advanced Business
Valuations
Illustration 1
ABC Ltd. uses a time horizon of 12 years to forecast free cash flows.
They use a planning horizon of 3 years after which they expect cash flows to remain at a
steady level.
The cash flows projected are as follows:
Year $
1 3m
2 5m
3 7m
The stock market value of debt is $6m and the cost of capital is 10%.
Calculate the value of the firm and the value of the equity.
Solution
Discount
Year $ PV
Rate (10%)
1 3m 0.909 2.73
2 5m 0.826 4.13
3 7m 0.751 5.26
4 to 12 7m 5.335 x 28.05
0.751
Value of the Firm 40.16
Value of Debt -6.00
Value of Equity 34.16

Illustration 2
The following figures are relevant:
$m
Operating Profit 400
Depreciation 150
Increase in Working Capital 40
Capital Expenditure to replace assets 8
New Capital expenditure 18
Interest Paid 7
Loans Repaid 30
Tax Paid 120
Calculate the free cash flows before interest and dividends and then the free cash
flows to equity.
Solution
$m
Less Tax -120
Add Depreciation 150
Operating Cash Flow 430
Replacement Capital Expenditure -8
Incremental Capital Expenditure -18
Incremental Working Capital -40
Free Cash FLows 364
Interest Paid -7
Loans Repaid -30
Free Cash FLows to Equity 327

Illustration 3
A company has NOPAT which has been adjusted for EVA purposes of $700m. Its capital
employed is $5,000m and its WACC is 8%. The total debt of the company is $1,000m.
Calculate the EVA for the company and use it to value the firm and the firms equity.
Solution
EVA = NOPAT - rC
EVA = 700 - (0.08 x 5000) = $300m
Firm Value = C + EVA/WACC
Firm Value = 5000 + 300/.08 = $8,750m
Value of Equity = 8750 - 1000 = $7,750m

Illustration 4
ABC Co. wants to value their company in order to raise more capital. They have a lot of
intangible assets so wish to use the CIV method to put a value to these.
ABC has operating profit of $250m and has a WACC of 9% and an asset base of $700m.
CD Co. is a larger but similar firm which made an operating profit of $1,000m on an asset
base of $5,500m.
Calculate the value of ABC Co. incorporating the CIV.
Solution
Proxy Firm ROA
1,000 / 5,500 = 18%
Value Spread
$m
Less
Proxy POA x Asset Base 18% x 700 126
Value Spread 124
Calculate CIV
Discount Value Spread at Cost of Capital = 124 / 0.09 = $1,377m
Value Firm
Assets (Capital Employed) + CIV
700 + 1,377 = $2,077m

Lecture 25
Multinational
Companies
Illustration 1
Figures from the cash flow statement of ABC Ltd. are as follows:
20X1 20X0
$m $m
Operating Cash Inflows 1,500 1,000
Capital Expenditure 250 200
Dividends from Joint Venture 130 100
Taxation Paid 200 170
Interest Paid 75 60
Disposal of Subsidiary 500 -
New Shares Issued 300 -
Calculate the free cash flows to equity or dividend capacity of ABC Ltd. for the year ended
20X1.
Solution
20X1
$m
Operating Cash Inflows ADD 1,500
Capital Expenditure SUBTRACT 250
Dividends from Joint Venture ADD 130
Taxation Paid SUBTRACT 200
Interest Paid SUBTRACT 75
Disposal of Subsidiary ADD 500
New Shares Issued ADD 300
Dividend Capacity 1905

Lecture 26
F9 FX Risk Revision
Buy or Sell Currency - Illustration 1
You have an invoice to pay to a US business of $1250 and you are a UK business.
The rate offered by the bank is $: 1.2500 - 1.3500
How many will it take to pay the $125?
Solution
Bank sells low We want to buy $ with our and the bank will sell them to
us at the low rate of 1.2500
For a receipt use the rate We are making a payment so we use the rate on the left i.e.
on the right 1.2500
Cost of $ (Amount of $ / ($1250 / 1.25) = 1,000

FX Rate)
Buy or Sell Currency - Illustration 2
You have issued an invoice to a US customer of $2000 and you are a UK business.
The rate offered by the bank is $: 1.4500 - 1.5500
How many will you receive for the $2000?
Solution
Bank sells low We want to sell the $ we will receive. The bank will buy them
from us at the high rate of 1.5500
For a receipt use the This is a receipt so use the rate on the right of 1.5500
rate on the right
Value of $ (Amount of ($2000 / 1.55) = 1,290

$ / FX Rate)
Purchasing Power Parity Theory - Illustration 3
The current exchange rate is 2$ per .
Inflation in the US is 6%.
Inflation in the UK is 8%.
What will the FX rate be in 1 years time?
Solution
Current Spot Rate 2
Inflation in Counter (US) 6%
Inflation in Base (UK) 8%
Forecast (Spot Rate Counter x (1 + Inf in Counter / 1 2 x ((1 + 0.06) / (1 + 0.08)) = 1.96
+ Inf in Base)
Interest Rate Parity Theory - Illustration 4
The current exchange rate is 2$ per .
The interest rate in the US is 3%.
The interest rate in the UK is 2%.
What will the FX rate be in 1 years time?
Solution
Current Spot Rate 2
Interest rate in Counter (US) 3%
Interest rate in Base (UK) 2%
Forecast (Spot Rate Counter x (1 + Int in Counter / 1 2 x ((1 + 0.03) / (1 + 0.02)) = 2.02
+ Int in Base)
Forward Rate - Illustration 5
ABC Company has entered into a contract whereby they will receive $500,000 from a
US customer in 3 months.
ABC is a UK company.
A 3 month forward rate is available at $: 1.6000 +/- 0.0500.
Calculate the amount of ABC would receive under the forward contract.
Solution
A rate quoted at $: 1.6000 +/- 0.0500 is the same as saying $: 1.5500 - 1.6500
Rate to use (For a receipt use the one on the 1.6500

right)
Convert ($ amount / Forward rate) (500,000 / 1.6500) = 303,030

Money Market Hedge - Illustration 6
A UK business needs to pay $350,000 to a US supplier in 3 months time.
Exchange rate now: $: 1.6500 - 1.7000
Deposit rates UK 4% annual US 6% annual
Borrowing rates UK 5% annual US 6.5% annual
How much will the transaction cost using a money market hedge?
Solution
Step 1 - How much Foreign Currency?
Amount of $ to pay 350,000
We will deposit the money in the US where it will earn interest so that in 3 months we
have $350,000.
Deposit Rate in US per year 6%
Deposit Rate for 3 months (Annual rate x 6 x (3/12) = 1.5%

3/12)
Amount to deposit (Total $ discounted at 350,000 x (100 / 101.5) = $344,827

1.5%)
We will deposit $344,827 in the US where it will earn interest of 1.5% over the 3 months
making it worth $350,000 when the payment becomes due.
We transfer the money now so that there is no more FX risk. The transfer is made at the
spot rate.
Step 2 - Convert using the Spot Rate
Amount to Transfer (Step 1) $344,827
spot rate.
Spot rate (We are making a payment) 1.6500
Convert ($ Amount / Spot Rate) (344,827 / 1.6500) = 208,986
Step 3 - Borrow the Home Currency
Amount to Borrow (Step 2) 208,986
We will have to pay interest on the amount we have borrowed for 3 months.
Borrowing Rate per year in UK 5%
Borrowing Rate for 3 months (Annual Rate (5 x 3/12) = 1.25%

x 3/12)
Total Cost of transaction
Amount transferred to US 208,986
Interest on borrowings in UK ( amount x 3 (208,986 x 1.25%) = 2,612

month UK borrowing rate)
Total Cost (Amount transferred + interest (208,986 + 2,612) = 211,589

incurred)
Money Market Hedge Illustration 7
A UK business will receive $350,000 from a US supplier in 3 months time.
Exchange rate now: $: 1.6500 - 1.7000
Deposit rates UK 4% annual US 6% annual
Borrowing rates UK 5% annual US 6.5% annual
How much will the business receive using a money market hedge?
Solution
Step 1 - How much foreign currency?
Amount of $ to receive 350,000
We will borrow the money in the US now and transfer it home.
Borrowing Rate in US per year 6.5%
Borrowing Rate for 3 months (Annual rate 6.5 x (3/12) = 1.625%

x 3/12)
Amount to borrow (Total $ discounted at 350,000 x (100 / 101.625) = $344,403

1.625%)
We will borrow $344,403 in the US where it will earn interest of 1.625% over the 3
months making it worth $350,000 when the receipt becomes due.
We will pay off the loan in the US when we receive the $350,000 in 3 months.
spot rate.
Step 2 - Convert into home currency using spot rate.
Amount to Transfer (Step 1) $344,403
spot rate.
Spot rate (We are receiving the foreign 1.7000

currency)
Convert ($ Amount / Spot Rate) (344,403 / 1.7000) = 202,590
Step 3 - Place the money on deposit in the UK
Amount to Deposit (Step 2) 202,590
We will receive interest on the money we deposit.
Deposit Rate per year in UK 4
Deposit Rate for 3 months (Annual Rate x (4 x 3/12) = 1%

3/12)
Total Receipt
Amount transferred to UK 202,590
Interest on deposit in UK ( Amount x 3 (202,590 x 1%) = 2,026

month UK borrowing rate)
Total Receipt (Amount transferred + interest (202,590 + 2,026) = 204,616

received)
Lecture 27
FX Risk: Futures
Illustration 1
A UK company will receive $2.5m from an american customer in 3 months time in

February.
The following information is relevant:
Futures: (contract size 62,500)
December 1.5830 $/
March 1.5796 $/
Forward Rates: Spot 1.5842 - 1.5851
1 month 0.0056 - 0.0053 pm
3 month 0.0172 - 0.0164 pm
28 February:
Assume that the spot rate moves to 1.6490 - 1.6510
March futures have a price of 1.6513
Required
Assess whether a future or forward currency hedge would have been better with hindsight.
Solution
Future
Step 1. Buy or sell
The contract currency is .
We will buy with the $ receipt.
Therefore we will buy futures.
Step 2. Choose Expiry
We will get the money in February so we choose the March futures rate of 1.5796
Step 3. How many contracts?
Foreign Amount Future Price Base Amount
$2,500,000 1.5796 1,582,679
Base Amount Contract Size No. Contracts
1,582,679 62,500 25
Step 4. Profit or Loss on future?
Action Future Price Contract Size Amount
Bought at 1.5796 62,500 98,725
Sold at 1.6513 62,500 103,206
Profit 4,481
No. Contracts 25
Total Profit 112,031

Step 5. Total Receipt
Amount
Receipt of Dollars 2,500,000
Profit on future contract 112,031
Total Dollar Receipt 2,612,031
Spot rate on transaction day 1.6510
Total Sterling received 1,582,090
Forward Rate
$2.5m / (1.5851 - 0.0164) = 1,593,676 received
Using the forward rate would be better.

Illustration 2
MNO is a UK based company that has delivered goods, invoiced at $1,800,000 US dollars
to a customer in Singapore. Payment is due in three months time, that is, in February
2007. The finance director of MNO is concerned about the potential exchange risk
resulting from the transaction and wishes to hedge the risk in either the futures or the
options market.
The current spot rate is $1695/. A three month futures contract is quoted at $1690/,
and the contract size for $/ futures contracts is 62,500.
Assuming that the spot rate and the futures rate turn out to be the same in February 2007,
indicating that there is no basis risk, identify the cost of hedging the exchange rate risk
using futures where the exchange rate at the time of payment is:
(i) $1665/
(ii) $1720/
Solution
Step 1. Buy or sell
The contract currency is .
We will buy with the $ receipt.
Therefore we will buy futures.
We receive the money in Feb 2007 so choose 3 month future.
1,800,000 1.690 1,065,089
1,065,089 62,500 17
Bought at 1.6900 62,500 105,625
Sold at 1.6650 62,500 104,063
Profit/Loss -1,563
No. Contracts 17
Total Profit/Loss -26,563

Bought at 1.6900 62,500 105,625
Sold at 1.7200 62,500 107,500
Profit/Loss 1,875
No. Contracts 17
Total Profit/Loss 31,875
1.665 1.720
Receipt of Dollars 1,800,000 1,800,000
Profit/Loss on future contract -26,563 31,875
Total Dollar Receipt 1,773,437 1,831,875
Spot rate on transaction day 1.665 1.72
Total Sterling received 1,065,127 1,065,044

Illustration 3
ABC Co. is a sterling based company that expects to receive $250m in 4 months time.
The spot rate is /$ 0.6690
Futures are available in $250,000 contracts as follows:
2 month expiry 0.6666
5 month expiry 0.6645
Estimate the result of the hedging transaction given that the spot rate is predicted to be
0.6674 in 4 months time and that basis risk reduces in a linear manner.
Solution
Basis Workings
Now
Spot now 0.6690
Future (5 month) 0.6645
Basis (Difference) 0.0045
Basis reduces to zero over 5 months so by 4 months time it will be (0.0045 / 5 x 1) =

0.0009
Spot rate in 4 months 0.6674
Basis remaining at that time -0.0009
Futures Price in 4 months 0.6665
Step 1. Buy or sell
The contract currency is $.
We will sell the $ when we receive the money.
Therefore we will sell futures.

We will use the 5 month expiry of 0.6645
250,000,000 250,000 1,000

(in )
Bought at 0.6665 250,000 166,625
Sold at 0.6645 250,000 166,125
Profit -500
No. Contracts 1,000
Total Loss -500,000
Amount
Receipt of Dollars in 4 months (250m x 0.6674) 166,850,000
Loss on future contract in -500,000
Total Receipt 166,350,000

Illustration 4
Using the information in illustration 3 calculate the total receipt using the lock-in rate.
Solution
Lock in rate = Opening Futures Price + Unexpired Basis (on transaction date)
Lock in rate = 0.6645 + 0.0009 = 0.6654 / $
Total Receipt = $250,000,000 x 0.6654 = 166,350,000

Lecture 28
FX Risk: Options &
Swaps
Illustration 1
A German company expects to receive $15m from a US company in December.
The spot rate is $1.4850 $1.4860.
The premiums for $/ Options of 32,500 are:
Strike CALLS PUTS

Price Oct Nov Dec Oct Nov Dec
1.4860 0.71 1.35 2.40 0.86 1.90 2.20

1.4870 0.71 1.35 2.30 0.86 1.90 2.25
The company is concerned that the $ may weaken.
(i) Show how traded $/ options may be used to hedge this risk.
(ii) Assume the spot rate moves to either 1.600 or 1.400
Solution
The Contract Currency is .
We will buy with our $ receipt...so we need the option to buy ...
...we therefore want to buy a call option.
Cheapest strike price is one of 1.4860 which will cost 2.4 cents per .
How many Contracts?
$15,000,000 1.4860 10,094,213
10,094,213 32,500 311
Calculate Premium.
No. Contracts Contract Size Price per / Premium
311 32,500 $0.024 $242,580
Convert to .
$242,580 / 1.4850 = 163,353
Exercise?
10,094,212 - 163,353 = 9,930,859
If the spot rate moves to 1.600 (15/1.6 = $9.375m) the company should exercise the
option.
If the spot rate is 1.400 then the spot rate should be used for conversion.
Uncovered Amount
Base Amount Contract Size No. Contracts Covered Uncovered
10,094,213 32,500 311 10,107,500 13,287

Illustration 2
Evans Co. is an Australian firm looking to expand in France and is thus looking to raise
24m it can borrow at the following fixed rates:
A$ 7.0%
5.6%
Portmoth is a Spanish Co. looking to acquire an Australian firm and wants to borrow A
$40m. It can borrow at the following rates:
A$7.2%
5.5%
The current spot rate is A$1 = 0.60
Show how a currency swap for 1 yr with interest paid at the end of the year would work.
Solution
! ! ! ! ! Evans Co Portmoth
Borrow from bank nowA$40m at 7.0% 24m at 5.5%
Exchange principles A$40m to Portmoth 24m to Evans Co.
Pay interest to Bank A$2.8m1.32m
Exchange Interest 1.32 to Portmoth A$2.8m to Evans Co.
Swap back principle 24m to Portmoth A$40m to Evans Co
Illustration 3
ABC Co. is a German company considering a project in Zancar, a foreign country where
the currency is the Franc (Fr). The investment in the project would be Fr250m and they
expect to sell out of the project after 1 year for Fr350m.
The current exchange rate is 25Fr/ and the government in Zancar has offered a forex
swap at this rate. The borrowing rate in the Eurozone is 5% and it is expected that the FX
rate in one year will be 40Fr/.
Show the effect if ABC Co.
i. Undertakes the forex swap.
ii.Does not undertake the forex swap
Solution
i. Undertake Swap
Now One Year
Borrow money to buy Francs (250 / 25) -10m
Swap back Francs at end of project (250 / 25) 10m
Convert Profit at Spot Rate (350 - 250) / 40 2.5m
Interest on Loan in Euros (10m x 5%) -0.5m
-10m 12m
Net result is a profit of 2m
ii. No Swap
Now One Year
Borrow money to buy Francs (250 / 25) -10m
Convert Sale Proceeds at Spot Rate (350 / 40) 8.75m
Interest on Loan in Euros (10m x 5%) -0.5m
-10m 8.25m
Net result is a net loss of 1.75m

Illustration 4
Companies A, B and C are within the same group whereas company D is an external
company. The following liabilities have been identified between the 4 companies:
Amount
Owed Form Owed to
(Millions)
A B 20
B C 30
C D $45
C A 100
C B 35
D B 20
D C $30
Mid-market spot rates are:
1 = $1.45
1 = 1.20
1 = 200
Establish the net indebtedness that would require external hedging.
Solution
Set up Table
Owed to A Owed to B Owed to C Owed to D
Owed From A 20
Owed From B 30
Owed From C 100 35 $45
Owed From D 20 $30

Convert to
Amount
Owed Form Owed to Rate
(Millions) (Millions)
A B 20 - 20.00
B C 30 1.2 25
C D $45 1.45 31.03
C A 100 200 0.50
C B 35 - 35.00
D B 20 1.2 16.67
D C $30 1.45 20.69
Fill in Table
Owed to A Owed to B Owed to C Owed to D Total
Owed From A 20 20
Owed From B 25 25
Owed From C 0.5 35 31.03 66.53
Owed From D 16.67 20.69 37.36
Total To 0.5 71.67 45.69 31.03
Total From 20 25 66.53 37.36
Net Total -19.5 46.67 -20.84 -6.33
Solution
Both A and C Pay the net amounts owed to B (19.5 + 20.84) 40.34
This leaves the amount outstanding to be paid by D to B 6.33
Total Paid to B 46.67
The amounts from A and C were in in any case and the 6.33 payable from D to B can
be converted back to at the spot rate (6.33 x 1.2 = 7.6).
Diagrammatical Method
Convert to base
Amount
Owed Form Owed to Rate
(Millions) (Millions)
A B 20 - 20.00
B C 30 1.2 25
C D $45 1.45 31.03
C A 100 200 0.50
C B 35 - 35.00
D B 20 1.2 16.67
D C $30 1.45 20.69

Lecture 29
Interest Rate Risk I
Illustration 1
ABC Ltd. has entered into a commitment to borrow $10m in 3 months time for a period of 3
months.
The bank has offered a 3v6 FRA at 6.00% - 5.65%.
Calculate the effect if the market rate in 3 months is
i. 7%
ii.4%
Solution
7% 4%
Interest Payable (10m x 7% x 3/12) 175,000 (10m x 4% x 3/12) 100,000
FRA Compensation
10m x (7% - 6%)

Receivable -25,000
x 3/12
10m x (4% - 6%) x

Payable 50,000
3/12
Net Interest Payable 150,000 150,000

Illustration 2
ABC Ltd. has entered into a commitment to borrow $10m in 3 months time for a period of 3
months.
The bank has offered an IRG at 6% for a premium of 0.075% of the loan capital.
Calculate the effect if the market rate in 3 months is
i. 7%
ii.4%
Solution
7% 4%
(Exercise) (Lapse)
Interest Payable (10m x 6% x 3/12) 150,000 (10m x 4% x 3/12) 100,000
Premium (10m x 0.075%) 7,500 7,500
Total Payable 157,500 107,500

Illustration 3
Company A is considering an interest rate swap with Company B. They can borrow at the
following rates:
! ! FixedFloating
A 10%LIBOR +1%
B12% LIBOR +1.5%
Show the effect of using an interest rate swap.
Solution
Working 1
Fixed Floating
Company A 10 L+1
Company B 12 L + 1.5
Difference 2 0.5
The largest difference is on Fixed with a total of 2%
Total Saving (2 - 0.5) 1.5%
A B
Split Saving 0.75% 0.75%
Working 2
Co. A Co. B
Borrow -10 (L + 1.5)
Swap 10 -10
Swap (L + 0.25) L + 0.25
Total (L + 0.25) -11.25
Could have borrowed (L + 1) -12
Saving 0.75% 0.75%

Lecture 30
Interest Rate Risk II
Illustration 1
ABC Ltd. wants to borrow $100m for 2 months with the current interest rate being 3%. It is
currently January 31st.
They decide to hedge their risk by using interest rate futures which are currently quoted at:
March Price = 94.50
June Price = 94.85
The contract size is $500,000.
By the date of the transaction the futures price has moved to 94.25 and the base rate of
interest has risen to 3.25%
Solution
Buy or Sell?
We learnt that borrowing is the same as selling bonds so we therefore sell the futures.
Number of Contracts
Number of Contracts = Loan/Deposit Amount X Term in Months

! ! ! ! Contract Size Contract Duration
Number of Contracts = (100,000,000 / 500,000) x 2/3 = 133
Profit or Loss on Future
Bought at 94.25
Sold at 94.50
No. Ticks 25
Tick Value (500,000 x 0.0001 x 3/12) $12.50
Profit Per Contract $312.50
Total Profit (133 x 312.5) $41,562.50

Extra Interest on Loan
100,000,000 x 0.25% x 2/12 = $41,666
Net Effect
Gain on Futures = $41,563
Extra Interest = $41,666
Net Cost = $103

Illustration 2
LTG Co. decides on the 1st January to hedge $30m of borrowings that will start on 30th
April and last for 3 months. The rate on the loan will be fixed at the LIBOR rate on that
date.
A $500,000 futures contract is available for June at 94.80 with the LIBOR rate being 5.5%.
i. Assuming that the basis reduces in a linear manner and that LIBOR is 4.5% on 30 April
calculate the financial result of the hedge.
ii.Calculate the lock-in rate for the transaction and the effect of using that rate.
Solution
Basis Workings
Now
LIBOR rate now 5.5%
Translates to (100 - 5.5) 94.50
Future (6 month) 94.80
Basis (Difference) 0.30
Basis reduces to zero over 6 months so by 4 months time it will be (0.30 / 6 x 2) = 0.10
LIBOR in 4 months 4.5%
Basis remaining at that time 0.10
Implied Interest Rate 4.4%
Futures Price in 4 months (100 - 4.4) 95.60

Buy or Sell?
We learnt that borrowing is the same as selling bonds so we therefore sell the futures.
Number of Contracts

Bought at 95.60
Sold at 94.80
No. Ticks -80
Tick Value (500,000 x 0.0001 x 3/12) $12.50
Profit Per Contract -$1000
Total Loss (60 x $1000) -$60,000
Net Interest on Loan
30,000,000 x 4.5% x 3/12 = $337,500
Loss on Future = $60,000
Net Payment = $397,500
Lock-In Rate
Implied Interest Rate (100 - Current Futures Price) + Unexpired Basis on Transaction Date
= (100 - 94.80) + 0.10% = 5.3%
Total Interest Payment = (5.3% x 30m x 3/12) = $397,500

Illustration 3
ABC Co. is borrowing $20m for 6 months with current market rate of 4%. They need the
loan for 6 months beginning in 1 months time.
Interest rate options are available in $500,000 contracts for 3 month December interest
rate futures. Today is the 30th September.
The following premiums are offered (quoted in %):
Exercise Price Call Put
95.50 1.35 -
95.75 1.06 0.16
96.00 0.56 0.56
96.25 0.17 1.07
Calculate the effect of an options hedge if the interest rate moves to 6% and if the
December futures price moves to 95.00 in one months time.
Solution
Call or Put Options
Were borrowing here so that means that we want the option to sell a future i.e. we want a
Put Option.
Number of Contracts

Exercise Price
Exercise Price Implied Rate Premium Total Cost
95.75 4.25 0.16 4.41
96.00 4 0.56 4.56
96.25 3.75 1.07 4.82
The cheapest rate to use will be the 95.75 option.
Premium Payable
0.16% x 80 x $500,000 x 3/12 = $16,000

The interest rate has moved to 6% so we will exercise our option on the future.
Bought at 95.00
Sold at 95.75
No. Ticks 75
Tick Value (500,000 x 0.0001 x 3/12) $12.50
Profit Per Contract $937.50
Total Profit (80 x $937.50) $75,000
Net Interest on Loan
20,000,000 x 6% x 6/12 = $600,000
Gain on Option = $75,000
Premium = $16,000
Total Payment = $509,000

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Shareholder Wealth - Illustration 1

Year Share Price Dividend Paid

2007 3.30 40c

2008 3.56 42c

2009 3.47 44c

2010 3.75 46c

2011 3.99 48c

There are 2 million shares in issue.

Year Share Share Price Div Increase As a Total

2007 3.30 40c

PBIT 2000 2100

Interest 200 300

Tax 300 400

Profit After Tax 1500 1400

Preference Dividend 300 400

Dividend 800 900

Retained Earnings 400 100

Share Capital (50c) 5000 5000

Reserves 3000 3100

Share Price $2.50 $2.80

Calculate the EPS for 2010 and 2011.

Profit After Tax 1500 1400

Preference Dividend 300 400

Earnings 1200 1000

No. Ordinary Shares (5000 / 0.50) 10,000 10,000

EPS (Earnings / No. Ordinary Shares) 12c 10c

Performance Analysis Illustration

Non Current Assets 500 700 1000

Current Assets 150 200 300

650 900 1300

Ordinary Shares ($1) 300 300 300

Reserves 100 280 430

Loan Notes 150 200 300

Payables 100 120 270

650 900 1300

Revenue 3000 3500 4200

COS 2000 2400 3200

Gross Profit 1000 1100 1000

Admin Costs 300 350 400

Distribution Costs 200 250 300

PBIT 500 500 300

Interest 100 150 220

Profit After Tax 280 260 30

Dividends 100 110 30

Retained Earnings 180 150 0

Share Price $3.30 $4.00 $2.20

Using the information calculate and comment on the following Ratios:

I. Return on Capital Employed

Equity + LT Shares 300 300 300

Reserves 100 280 430

LT Loan Notes 150 200 300

Capital Employed 550 780 1030

Non Current Assets Non Current Assets 500 700 1000

Net Current Assets (150 - 100) = 50 (200 - 120) = 80 (300 - 270) = 30

Capital Employed 550 780 1030

Total Assets - Total Assets 650 900 1300

Current Liabilities 100 120 270