Revision Notes

ACCA
Advanced Financial Management (AFM)
Exams from September 2019

Tutor details
ii I n t ro d u c t i on A C C A A FM

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Contents
Page

1: Role of a senior financial adviser in the multinational organisation 1

1 The role and responsibility of senior financial executive/advisor 1

2 Financial strategy formulation 1
3 Ethical issues in financial management 13
4 Management of international trade and finance 15
5 Strategic business and financial planning for multinationals 19
6 Dividend policy in multinationals and transfer pricing 20

2: Advanced investment appraisal 21

1 Discounted cash flow techniques 21

2 Application of option pricing theory in investment decisions 27
3 Impact of financing on investment decisions and adjusted present value (APV) 29
4 Valuation and the use of free cash flows 33
5 International investment and financing decisions 33

3: Acquisitions and mergers 37

1 Acquisitions and mergers versus other growth strategies 37

2 Valuation for acquisitions and mergers 40
3 Regulatory framework and processes 44
4 Financing acquisitions and mergers 46

4: Corporate reconstruction and reorganisation 49

1 Financial reconstruction 49
2 Business re-organisation 51

5: Treasury and advanced risk management techniques 53

1 The role of the treasury function in multinationals 53

2 The use of financial derivatives to hedge against foreign exchange risk 56
3 The use of financial derivatives to hedge against interest rate risk 63

Formulae sheets 67
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 1

Role of a senior financial adviser

in the multinational organisation

1 The role and responsibility of senior financial executive/advisor

The Finance Director will be charged with setting goals which increase shareholder wealth and will set
the principles.
Directors should aim to maximise shareholder return.
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷+𝐴𝐴𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑖𝑖𝑖𝑖 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝×100
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑠𝑠 ′ 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 (%) =
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝

1.1 Development of financial targets

The board may use financial targets and movement in the share price to measure progress towards its
strategic goals. Non-financial objectives may be present which limit the achievement of financial
objectives. Many non-financial objectives arise from ethical considerations – how the company should
morally behave beyond its statutory requirements.

2 Financial strategy formulation

2.1 Assessing corporate performance
Performance ratios tend to be split into the following four categories:
 Profitability
 Liquidity
 Gearing/Debt
 Investor
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2.1.1 Profitability
PBIT
 Return on Capital Employed (ROCE) = TALCL
× 100%

(where TALCL = Total Assets Less Current Liabilities)

Gross profit
 Gross Profit margin = Revenue
× 100%

Profit after Tax

 Net Profit margin = × 100%
Revenue

Profit after tax and Pref dividends

 Return on Equity = Ordinary SC +Reserves
× 100%
Revenue
 Asset turnover = TALCL

2.1.2 Liquidity
Current assets
 Current ratio = Current liabilities

Current assets − Inventories

 Quick ratio (or acid test) = Current liabilities

Cost of sales
 Inventory turnover =
Inventories

Inventory
 Inventory days = COS
× 365 days

Trade receivables
 Receivables collection period = × 365 days
Credit turnover
Trade payables
 Payables payment period = × 365 days
Credit purchases or COS

Note: The working capital cycle includes receivables, inventories and payables.

2.1.3 Gearing/debt
The term ‘gearing’ refers to the extent to which a business is dependent on loans and preference
shares, as opposed to ordinary shares and reserves.
Gearing ratios indicate the degree of risk attached to the company and the sensitivity of earnings and
dividends to changes in profitability and activity level.
Long term debt
 Gearing = × 100%
Equity+Long term debt

PBIT
 Interest cover = Interest payable

2.1.4 Investor
Profit available to ordinary shareholders
 Earnings per share (EPS) = No of shares

Dividend per share

 Dividend yield = Market share price
× 100%

EPS
 Dividend cover = Dividend per share

P Market share price Market capitalisation


E
ratio = EPS
or PAT
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The P/E ratio is an indicator of the stock market’s confidence in the shares of a company. In general, a
high P/E suggests that the markets view the share favourably and that it is a safe investment. It reflects
the market’s anticipation of the growth potential of the business.
Equity value
 Share price =
No.of ordinary shares in issue

2.1.5 Earnings before interest, tax, depreciation and amortisation (EBITDA)

EBITDA gives a profit measure that roughly approximates to the operating cash flow generated by the
business.

2.2 Capital structure and the cost of capital

A company can raise its capital from shareholders (Equity finance) and from debt holders (loans). New
equity can be raised via a rights issue, a public offer (either an offer for sale or a public issue) or a
placing.
The annual cost to satisfy equity and debt investors via the payment of dividend and interest is known
as the company’s cost of capital (WACC).

2.3 Cost of Equity (Ke)

The cost of equity is the annual return required by the shareholders measured as a percentage. It
represents the annual cost to the company of paying out dividends and providing capital growth.
Two methods are available to calculate the annual cost of equity (Ke) as follows:
(1) The rearranged dividend growth model (DVM) which predicts the annual future return to
investors by measuring the past return delivered.
(2) Capital Asset Pricing Model (CAPM) – this method uses a measurement of risk to determine the
minimum required return of the shareholder.

2.3.1 Calculation of the cost of equity (Ke) using the rearranged dividend growth model
(DGM)
𝐷𝐷0 (1+𝑔𝑔)
𝑟𝑟𝑒𝑒 = + 𝑔𝑔
𝑃𝑃0

P0 = today’s ex-div share price D0 = current dividend g = annual dividend growth rate (%)
The following limitations significantly reduce the reliance on the Ke calculated by the DVM.
 The company must be listed and the quoted share price must not change
 The dividend growth rate must be constant – forever!!
 The dividend just paid must be indicative of the future dividend.
Often, the growth rate (g) is not provided so we can use one of two methods to estimate this:
(a) Annualising growth from analysing the historical dividend stream

(b) The earnings retention method g = b re GIVEN TO YOU IN THE EXAM

2.3.2 Calculation of the cost of equity (Ke) using the Capital Asset Pricing Model (CAPM)
The CAPM assumes that investors hold a diversified portfolio of investments.
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2.3.3 Beta factors

βe < 1.0 βe = 1.0 βe > 1.0

Investment < average risk Investment = average risk Investment > average risk
Ke < rm Ke = rm Ke > rm

𝐸𝐸(𝑟𝑟𝑖𝑖 ) = 𝑅𝑅𝑓𝑓 + 𝛽𝛽𝑖𝑖 �𝐸𝐸 (𝑟𝑟𝑚𝑚 ) − 𝑅𝑅𝑓𝑓 � GIVEN TO YOU IN THE EXAM
Where:
𝐸𝐸(𝑟𝑟𝑖𝑖 ) = Expected return on a share called ‘i’ or the cost of equity of share ‘i’
𝑅𝑅𝑓𝑓 = Risk free rate of return
𝛽𝛽𝑖𝑖 = Beta, which is a measure of the systematic risk in share ’i’
𝐸𝐸 (𝑟𝑟𝑚𝑚 ) = Expected return from the market
�𝐸𝐸 (𝑟𝑟𝑚𝑚 ) − 𝑅𝑅𝑓𝑓 � = Equity risk premium

2.3.4 Portfolios and business risk

CAPM measures the investors’ required return to compensate them for systematic risk only.

2.3.5 Alpha values

This is the amount by which a share’s returns are currently above or below the required return, the
level of systematic risk. Over time, the alpha value tends towards zero.

2.3.6 Limitations of CAPM

 𝑅𝑅𝑚𝑚 tends to be overstated.
 𝛽𝛽𝑒𝑒 is based on historic information.
 It can only be used when the investors are diversified.
 It assumes that investors can invest and borrow at the risk free rate.
 It assumes that the capital markets are perfect.

2.4 Cost of Preference Shares (Kp)

𝐷𝐷0
𝐾𝐾𝑝𝑝 = 𝑃𝑃0

2.5 Cost of Debt (Kd)

Companies can borrow from banks or some companies (listed large companies with a good credit
rating) can borrow directly from investors. Such loans are known as debentures and the process of
removing the bank from the transaction is called disintermediation.
The company pays interest net of tax reducing the cost of debt to the company.

2.5.1 Cost of bank loans

Take the quoted cost of the loan and multiply this by (1–T) to get the post-tax cost.
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2.5.2 Irredeemable debentures

Interest on this form of debt finance is paid indefinitely (in perpetuity).
𝐼𝐼 (1 − 𝑇𝑇)
𝐾𝐾𝑑𝑑 =
𝑃𝑃0

2.5.3 Redeemable debentures

The required return of the investor is the Internal Rate of Return on the investment.
Time $
0 (Market value)
1–n Annual Interest OR Annual Interest (1 – tax)
N Redemption value

𝑁𝑁𝑁𝑁𝑁𝑁𝐿𝐿
𝐼𝐼𝐼𝐼𝐼𝐼 ≈ 𝐿𝐿 +
𝑁𝑁𝑁𝑁𝑁𝑁𝐿𝐿 −𝑁𝑁𝑁𝑁𝑁𝑁𝐻𝐻
× (𝐻𝐻 − 𝐿𝐿) where, L% is the lowest rate chosen
H% is the highest rate chosen

2.5.4 Tax rules

Ignore corporation tax when calculating Kd Gross (Gross Redemption Yield) i.e. the required return of
the debt holder.
Include corporation tax when calculating Kd Net, the company’s Cost of Debt i.e. the annual cost to the
company of paying interest.

2.5.5 CAPM used to calculate Kd gross

As with shares, the risk on individual debentures can be measured against a market average and the
debt beta (βd). CAPM can be used to determine the return an investor would require on that bond in
compensation for that level of risk.

2.5.6 Convertible debentures

Convertible debentures give the holder the right to convert £100 of debt into a quoted number of
shares. If the conversion option is elected, then the return to the investor could be higher if the
equivalent shares are worth more than the loan redemption value.
Time
0 Market value
1–n Interest × [1 – tax]
N Expected value of the shares or redemption value (whichever is higher)

2.6 Islamic finance

In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channelled
into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in
that profit, after a management fee is deducted by the bank.

2.7 Initial coin offerings

A cryptocurrency is a digital or virtual currency. It is difficult to counterfeit as it uses cryptography (the
computerised encoding and decoding of information) for security.
An Initial Coin Offering (ICO) is the cryptocurrency equivalent of an Initial Public Offering (IPO). A
quantity of cryptocurrency is sold in the form of “tokens” to investors. These tokens are similar to
shares in a company. Investors provide finance for the company to invest in a new project or to start a
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new digital currency. In return investors hope the success of the project or new currency will provide
them with a good return on their tokens in the future.

2.7.1 Advantages of ICOs

 ICOs are decentralised and largely unregulated by any government. This creates opportunity for
companies. It allows access to a global market of investors when it can often be difficult to fund
projects from traditional equity investment such as VC’s, Angel investors for start-ups etc.
 They do not have the regulatory compliance requirements of venture capitalists, banks and
stock exchanges.

2.7.2 Disadvantages of ICOs

 As a result of the lack of regulation, some ICOs have been accused of basically being scams on
wealthy, under-informed investors.

2.8 The weighted average cost of capital (WACC)

The WACC represents the average cost to the company of paying dividends to its shareholders and
interest to its debt holders.
The weighted average cost of capital
e V d V
WACC = �V +V � K e + �V +V � K d (1 − T) GIVEN TO YOU IN THE EXAM
e d e d

Where:
Ve = Total value of the equity
Vd = Total value of the debt
K e = Equity cost of capital
K d = Debt cost of capital
T = Corporation tax rate

2.9 Why is Debt finance cheaper than Equity finance?

Debt holders face less risk than equity holders and interest is tax deductible where dividends are not.

2.10 Use of WACC in investment appraisal

The WACC is the annual cost of finance. A new project must generate at least this return to cover this
cost. The WACC therefore becomes the minimum acceptable return on a project.
 If the NPV > 0 then the investment is delivering a higher return than the WACC
 If the NPV < 0 then the investment is delivering a lower return than the WACC

So when can the WACC be used?

The WACC can only be used for project evaluation if
 There is no change in business risk
 There is no change in gearing
 The project is small relative to the size of the company
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Important
If the wrong WACC is used during investment appraisal, then there is a risk that a company:
 Accepts a project with a NPV < 0
 Rejects a project with a NPV > 0
Where there is a change in risk or gearing, the WACC needs to be recalculated at the new gearing and
risk levels. This new WACC is used specifically for project appraisal and is called the marginal cost of
capital.

2.11 Impact on a change in capital structure

Gearing measures the proportion of debt finance to market capitalisation (D/D+E).

KEY TERMS
 Financial risk: Financial risk is indicated by the gearing ratio and is defined as the risk a
company cannot pay the interest on its debt or repay the principle borrowed. Financial
risk increases with additional debt finance as the probability of default grows.
 Ungeared: An ungeared company has no debt and therefore no financial risk.
An ungeared company is financed 100% by equity finance and therefore its WACC = ke.

To help visualise the impact of financial risk, consider the following diagram:

Cost of capital
βe into the CAPM
formula gives (for
the relevant gearing
Ke
ratio)
βa into the CAPM
formula gives

K ie

𝐷𝐷
Gearing
𝐷𝐷+𝐸𝐸

When debt is introduced into the financial structure there are two major factors which will influence
the WACC. Debt is cheaper than equity due to the lower risk, but at the same time debt increases the
(financial) risk faced by the shareholders. The question is which one of the two factors dominates (i.e.
does the WACC actually go up or down when the level of debt rises).
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2.11.1 Traditional theory

Adding debt makes sense up to a certain gearing

level since it is cheaper and shareholders’ risks %
Ke
are not initially significantly affected.
WACC
Eventually, if gearing gets too high the cost of
debt and equity will rise such that WACC K ie Kd
eventually starts to rise.
Conclusion – There is an optimum WACC (lowest
point) where project and hence company value Gearing
will be maximised.

2.11.2 M&M (No TAX)

As the level of debt increases the benefits of %

debt (cheaper than equity) is exactly offset by Ke

the fact that the cost of equity (Keg) increases,

such that overall the WACC remains constant.
WACC
The two forces above are therefore equal and K ie
opposite.
Kd
Conclusion – WACC is not affected by gearing.
Financing has no impact on company value. Gearing

2.11.3 M&M (with TAX)

Debt finance is even cheaper due to the tax

relief on the interest payments. The lower cost %
Ke
of debt outweighs the increasing Ke such that
WACC falls as gearing increases.
Conclusion – WACC reduces as debt levels K ie
increase.
WACC
Theoretically, companies should use as much Kd
debt as possible to lower the WACC.
Gearing
In reality, at higher gearing levels the WACC
tends to rise due to the costs of financial distress
(higher Ke due to risk, higher Kd as banks get
nervous).
Therefore, managers should aim to find the
optimal capital structure where WACC is a
minimum.

M&M make a few fairly limiting assumptions including the assumption that debt is always risk free (big
assumption), perfect capital markets (perfect information, rational risk averse investors), individuals
and companies can borrow and invest at the same rate.
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2.11.4 Financial distress

Practically, at high gearing as company’s borrow large amounts of debt they will suffer costs of
‘financial distress’ which are costs associated with providing assurances to banks, debt holders, other
creditors and customers that they will remain solvent.
These costs will increase the WACC at high levels of gearing. Examples of costs of financial distress are:

Direct financial distress costs Higher interest payments imposed by the bank (credit risk premium).
Indirect financial distress costs Loss of sales / lack of credit from suppliers.
Agency costs Restrictive covenants preventing further borrowing/certain types of
investment.

2.11.5 Pecking order theory

Pecking Order theory suggests that, in general, firms will finance projects in the following order.
(1) Use of internal funds. They will use cash and adapt their target dividend payout ratios to fund
expansion opportunities. If cash generated is more than capital investment the firm will pay off
its debt. If cash generated is less than capital investment it will draw down on its cash and
reduce debt repayments rather than reduce dividends.
(2) Use of debt finance. If external financing is required, firms issue the safest security first. That is,
they start with debt, then possibly hybrid securities such as convertible bonds.
(3) Use of equity finance. Primarily reserved for very large investments, business acquisitions, or
significant changes in strategic direction.
In addition, issue costs are least for internal funds, low for debt and highest for equity. Exam advice
should be:
Keep gearing low if: High gearing is fine if:
Small, young enterprise, Mature company
Volatile cash flows Stable cash flows
Tax benefits < financial distress costs Tax benefits > financial distress costs

2.11.6 Static trade-off theory

In practice, managers will seek to achieve a target level of gearing, offsetting the costs of debt at
higher gearing levels (financial distress) against the benefits of debt (tax relief on interest). Companies
in a static position will seek to achieve a target level of gearing by adjusting their current gearing
levels.

2.11.7 Agency theory of debt

This relates to the potential conflict between shareholders and debt holders.
Consider expansion funded by debt finance. If expansion is successful then the benefits that arise will
flow principally to the shareholders. If the expansion fails and the debt is not repaid (loan default) and
the shareholders will have limited their exposure as the debt holder bears the loss of their principal.
The cost of debt will therefore rise as the probability of default rises. This will influence the optimal
capital structure as the benefits of new debt finance are balanced with the higher cost.

2.11.8 Agency theory of equity

This relates to the potential conflict between old and new shareholders on a public issue of shares.
New shareholders will want to monitor company activities such that old shareholders do not benefit at
the expense of new shareholders.
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2.12 Dividend policy

A listed company needs to have a published dividend policy which help investors make their
investment decisions based on the predicted level of future dividends. A dividend is paid from surplus
funds after interest, tax and preference dividend have been paid.
Dividend policy is shaped by the following factors:
 Investment decision – the level of business risk (βe) in the business with determine the
expectation of dividend (Ke).
 Financing decision – the proportion of debt finance in the business will determine a potential
dividend as interest payments must be made first.
 Investment opportunities – a company strategically focused on growth may prefer to reinvest
retained profits at the expense of a dividend payout to fund expansion. This may be useful if
access to debt finance is restricted (small, start-up company or highly geared).
 Poor liquidity – a company may choose to lower the dividend if recessionary fears and poor
liquidity are present.
 Investor preference – failure to adopt a policy that is consistent with what investors expect may
cause them to sell their holding and new investors may come along. A turbulent share price may
result for a period of time (Clientele effect).
 How will the market perceive the dividend announcement (i.e. what signal does it send out
about the likely future performance). If it is considered a positive signal there may be a period
of share price growth (Dividend signalling).
 Is there cash available to pay a dividend? If not, an alternative that could be considered is that
of a scrip dividend whereby additional shares are offered as an alternative to a cash dividend.
The choice can sometimes be popular with investors and relieve cash flow pressure on the
business.
 Tax implications. Payment of dividends will be subject to income tax in the hands of the
shareholder. An increase in the share price will generate potential capital gains tax for the
shareholder. Thus some investors may prefer reinvestment and growth in the share price.
 Is sufficient cash being retained within the organisation to meet the future demands existing or
new future projects?
 Are profits consistent/stable such that a policy of growing dividends can be sustained?
In the real world, investors dislike erratic dividends and so companies tend to use either of the
following policies:
 Growth year on year
 Constant dividend payout %
As a guideline for exam questions:

Small or young company Large or listed company

Zero / Low dividend High stable growing dividend
Use cash for reinvestment Borrow to expand
Zero or low debt Higher gearing (industry average)
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2.13 Capital investment monitoring systems

The seven stages in the capital investment process are as follows.
(1) Collecting ideas – product development, geographical expansion, organic growth, M&A,
diversification (innovation team).
(2) Strategic screening – ideas vs. strategic goals and risk criteria. Eliminate strategically
inconsistent, non-commercial/viable, loss making (fail payback target) or fail risk/return
evaluation.
(3) Financial analysis – include NPV, IRR, MIRR, Discounted Payback, project duration, value at risk,
probability of loss, sensitivity analysis, simulation and modelling, position audit, data gathering
and market research, resource requirements and availability.
(4) Evaluation – determine optimal investment plan vs. capital resource (debt and equity)
constraints.
(5) Authorisation – board consensus and investor/market communication.
(6) Monitoring – update investment forecasts with actual results and re-evaluate future potential
return vs. target required return. Develop plans to abandon project or redeploy assets to limit
future losses if the investment fails to deliver.
(7) Post-completion evaluation – review the investment appraisal process where capital
investment activity failed to meet forecast revenue and returns. Determine errors made and
change the process to prevent reoccurrence. This may require changes in management.

2.14 Risk definitions

Risk type Definition
Information Taking the wrong decision due to inadequate information. This includes
forecasting risk.
Operational or business This is the risk arising from the execution of business operations within a certain
sector from human error, failure of internal control, dealing with business
partners or external events.
Reputational This is the risk that stakeholders will no longer trust in the company’s ability to
deliver quality and behave ethically.
Non-systematic This is the business risk which can be eliminated by portfolio diversification. It is
(specific risk) the risks which are unique to a company.
Systematic This is the business risk which cannot be eliminated by the well diversified
investor and is measured by βe. It includes risks from operating in a specific
industry sector, risks from changes in national/global economic outlook, the
impact of natural disasters, political change and war.
Political This is the risk of government action which negatively impacts on trade and profit.
Cultural This is the risk that the company’s activities cause social or religious offence.
Economic This is a risk of loss from changes in the macroeconomic environment in which
the company operates.
Regulatory This is a risk that changes in regulation are ignored or costly to
implement/monitor.
Fiscal This is the risk that changes to tax law results in higher tax or more restrictive
trading criteria (i.e. trade embargoes/quotas).
Credit • The risk to the company that a customer fails to pay; or
• The risk to the lender that the borrower defaults on either the interest
payments or on the repayment of the principal on the due date.
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2.15 Risk mapping

Risk mapping involves considering various risks against criteria of severity and frequency. A risk
management strategy can then be considered.

Low Frequency/probability High

High Transfer Avoid (100% hedge)
Impact
severity Accept/Manage Reduce/Mitigate (< 100% hedge)
Low

2.16 Rationale for the management of risk

Risk can be defined as the volatility of returns/cash flows or profit.
Risk management involves identifying the key value drivers in a business and actively managing the
associated risks. This can lead to a reduction in earnings volatility which increases shareholder wealth.
The theoretical rationale for risk management
In order to maximise shareholder wealth companies should aim to limit earnings volatility through the
active management of risk if it results in an increase in value. Risk should be accepted where the potential
return is sufficient to reward the possibility of loss, and shareholders support the investment policy.
The practical rationale for risk management
Companies must be seen to be managing risk to maintain investor confidence in future operations.
Companies which appear ‘cavalier’ with shareholder funds will unnerve potential investors even if
greater than average returns are being delivered (too good to be true?)

How do managers behave?

Managers which have large equity stakes (owner managers) are more likely to take positive actions to
manage/mitigate risk. The danger is that risk is avoided which limits growth.
Managers who hold share options are incentivised to increase the value of the share options by
pursuing excessive growth/risk to boost the share price. The danger is that excessive risk is unlikely to
maximise shareholder wealth.

Does risk management work?

Research suggests that companies that have diversified themselves and reduce non-systematic risk do
not actually increase corporate value – this is because the market quote traded share prices assuming
all investors are well diversified and have already eliminated this risk.

2.17 Strategies for the management of risk

Risk mitigation is the process of minimising the probability and the financial impact should the risk
occur. Corporations should develop a strategy to achieve this and will include the following.
Strategy Explanation
Negotiation Contracts will define tasks and responsibilities and can be used to share/transfer
risk. Reporting of key performance indicators and use of targets will provide an
early warning system. The contract should set out procedures in the event of
specified problems.
Monitoring This use of ratio’s, key performance indicators, variance analysis and re-
forecasting all work as an early warning system allowing action to be taken
against problems before significant loss/damage is incurred.
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Strategy Explanation
Operational Hedging Real options give the possibility of delaying, abandoning, enhancing or switching
activities in the event of a risky scenario.
Financial Hedging This is the use of financial products and derivatives to reduce risk exposure.
Losses can be capped or gains generated which offset losses incurred.
Diversification Earnings volatility can be reduced through product or geographical
diversification.
Insurance In the UK, the Exports Credit Guarantee Department provides protection against
various threats including nationalisation, currency conversion restrictions and
war. Credit insurance.
Joint ventures/partners Risk can be spread across partners but of course returns are diluted.
Legal system Registering patents and intellectual property. A readiness to sue for breach of
contract.
Supply chain Broadening suppliers will limit risk of stock out. Managing suppliers will preserve
quality/service. Outsource key production elements to experts will limit error
and investment.

2.18 Behavioural Finance

Conventional financial theories generally rely on the assumption that investors act rationally.
Behavioural finance proposes psychology-based theories to explain stock market anomalies. Within
behavioural finance, it is assumed that the information structure and the characteristics of market
participants systematically influence individuals' investment decisions as well as market outcomes.
Behavioural finance uses the psychological factors behind investor decisions such as sentiment and
speculation to explain why irrational investor behaviour is likely to have a significant impact on share
prices.
Examples of these factors include:
 Investor over-confidence
 Cognitive dissonance (clinging onto long-held beliefs and ignoring evidence to the contrary)
 Availability bias (placing too much significance on the latest piece of available information and
losing sight of the bigger picture).

3 Ethical issues in financial management

3.1 Defining an ethical dilemma
To help, we might consider the following tests as a tool to help evaluate the issue?
 Are the company’s actions truthful?
 Do a particular group of stakeholders benefit at the expense of other stakeholders?
 Are any stakeholders harmed by the company's actions?
 If the action entered the public domain, would it damage the company’s reputation?
A firm should follow best practice to protect its reputation, market share and profitability as opposed
to simply implementing minimum legal requirements. As a general rule, directors should endeavour to
ensure ethical behaviour takes precedence over the pursuit of profit in all circumstances.
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3.2 Resolution of stakeholder conflict

Conflicts can arise between the objectives of the shareholders and those of management. The
resolution of this shareholder conflict is found by bringing about goal congruence between the
objectives of the two parties.

3.3 Ethics and the financing decision

A company should always consider the ethical implications of any decision, even if it is difficult to
quantify their direct financial impact.

3.4 The ethical framework

A company can then apply the following five-step ethical framework to a situation to ensure it applies
the highest ethical standards.
 Ensuring understanding. Gather information confirming the situation and gain and
understanding around the circumstances which created the problem.
 Compare against ethical principles. Ensure legal and regulatory compliance against published
frameworks and ensure compliance the company’s statement of ethical principles.
 Perform risk assessment. The Board of Directors should evaluate potential financial exposure,
damage to brand/reputation and harm to stakeholder groups.
 Mitigation – can counter measures be taken to limit harm to stakeholders?
 “Mirror test” – would disclosure of the issue by the press result in negative publicity or financial loss.

3.5 Code of Ethics and the Ethics Committee

Ideally, a company should publish a Code of Ethics against which it can be held accountable. As well as
providing guidance to employees when facing difficult decisions, it should also state its position on the
environment, discrimination, bribery and fraud, bullying and intimidation.
The Ethics Committee will monitor compliance with the code of ethics and are empowered to take
disciplinary action against unethical behaviour and insist on corrective action.

3.6 Sustainability and environmental issues

Sustainability is a target of zero impact that a company’s activities has on the Earth’s resources whilst
balancing growth.
Environmental risk is the potential damage to shareholder wealth resulting from any adverse public
reaction to company’s activities which adversely affect the environment.

3.7 The carbon-trading economy and emissions

Participants of the Paris Agreement are granted permits to emit carbon. Low emitters can sell the
right to emit CO2 to high emitting companies. This provides low emitting countries with additional
revenue which it can use to develop its economy and infrastructure.
The advantages are that overall emissions are reduced and low emitting countries have funds to
improve health, education and overall living standards.
The sceptics argue the existence of a trade in carbon permits discourages high emitters changing their
ways and developing countries becoming reliant on the income generated from carbon trading.
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3.8 The role of the Environment Agency

The Environment Agency (EA) has three official roles:

Action Prosecuting companies who breach waste disposal or pollution regulations.

Advice Businesses have access to government officials who can advise on specific waste
disposal issues and changes in environmental law.
Protection Beaches, forests, national parks, farm land, flood protection, restoring rivers and
protecting wildlife and fish, waste regulation, air quality management.

3.9 Environmental audits and the triple bottom line approach

An environmental audit seeks to measure and report the environment impact of a company’s policies.
The triple bottom line approach allows the formulation of clear objectives as follows.

Social justice Objective ensuring no discrimination on the grounds of ethnicity, gender, age,
disability, sexuality. Ensuring no human rights violations. For example, not
seeking to reduce the corporation tax burden by exploiting loopholes.
Environmental quality Impact on the physical environment (air, water and land) in the immediate, short,
medium and long term. For example, commitment to reduce energy
consumption.
Economic prosperity Impact the company’s activities have on the local community both positive and
negative. For example, assurance to use only local suppliers as opposed to
imports.

3.10 Integrated reporting

When making decisions regarding investment and financing strategies, the directors should always
consider the impact on the organisations stakeholders and particularly their shareholders. Integrated
reporting means that it is easier for stakeholders to see the full consequences of the directors’
decisions. This should hopefully reduce the agency problem of shareholder conflict.

4 Management of international trade and finance

4.1 Barriers to free trade
Free trade is a system of trade policy that allows traders to act or transact without interference from
government.
It is common for multinational companies to encounter barriers to trade outside these free trade
zones. Examples include the following.
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Trade barriers Description

Domestic subsidies Governments may subsidise domestic industries to provide a cost
advantage.
Import duties and tariffs Additional costs similarly improve the cost advantage of domestic
competitors.
Trade quotas Limit the quantity of goods that can be imported so excess demand is met
by local suppliers.
Trade embargoes This represents a total ban on certain imports, again aimed at protecting
domestic industry.
Import legislation and form Additional administration will increase the time to clear customs and may
filling. be designed to be cumbersome and pedantic. The aim here is to put off
imports. This is particularly effective where the goods are perishable.

Management of these will first involve a clear understanding of the barrier and options available.
Often, barriers can be negotiated around if benefits to the local population can be demonstrated.

4.2 Agreements encouraging free trade

Trade agreement Description
Free trade area No restrictions between members, each has own trade restrictions with
non-members.
Customs union No restrictions between members, common trade restrictions with
countries outside union.
Common market/economic In addition to trade, free movement of labour and capital between
community member states.
Economic union In addition, harmonisation of social and economic policies (i.e. single
currency).

4.3 How actions of the World Trade Organisation impact on a multinational

organisation
The World Trade Organisation (WTO) is an international body seeking to promote and liberalise free
trade between all countries by implementing the ‘Marrakech Agreement’. The WTO assists companies
in:
 Identifying and reducing existing trade barriers; and
 Acting as an intermediary between companies and member states with the objective to resolve
trade disputes.
The WTO has the power to impose fines on its members if they are deemed to be in breach of their
rules. The WTO will allow ‘safety valves’, in specific circumstances, where governments can restrict
trade.

4.4 Roles of other organisations in promoting global trade

The role of national and international financial institutions is aimed at ensuring global stability and
setting out a platform for economic growth.
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4.5 Role of financial markets in the management of global debt

Role of the international financial market
Management of global Governments issue debt to fund tax shortfalls against public spending plans.
debt The rating agencies have a role in providing such debt with a rating (i.e. AAA).
The raising of capital requires willing investors and if investors’ confidence is
shaken by events then the ability to raise additional finance diminishes.
Recently, concerns over the national debt levels in Greece resulted in rating
agencies reducing its credit rating to ‘junk status’. Spain and Portugal have
endured difficulties in raising debt.
This has prompted Eurozone members and the IMF to support Greece with
110bn Euros in financial aid on the condition that it slashes public spending and
boosts its tax revenues. In this way the markets place limits on the ability of
governments to borrow.
The financial development As emerging economies liberalise their economic policies, this facilitates a
of emerging economies significant flow of international capital into the region and demand for
international debt capital. The creation of jobs and wealth creates a need for
domestic financial institutions which in turn provide credit, facilitating further
economic growth. Deficiencies in financial reporting, insolvency law, corporate
governance and the likelihood of corruption remain obstacles.
The maintenance of global The rapid financial development of emerging economies has contributed to
financial stability financial instability. There is no single global financial regulator. The global debt
crisis in the late 20th century and the recent ‘credit crunch’ with the fall of
Lehman Brothers and the bail out of Bank of America, AIG and UK banks such as
RBS, cast doubt on the market’s ability to self-regulate and maintain its own
stability.

4.6 Developments in world financial markets

4.6.1 Securitisation
Securitisation is the process of packaging existing loans and mortgages and selling the future interest
cash flows to investors. These are rated by the rating agencies making the investments attractive to
the market. On sale, the banks use the cash flows generated to offer further loans and mortgages to
the market.
For example, a mortgage company could group together a bundle of its existing mortgages and sell the
package of cash flows known as collateralised debt obligations (CDOs). The cash generated could then
be used by the banks to finance further mortgages.

4.6.2 The Credit Crunch

Once the mortgage market reached saturation, the sub-prime market was targeted (high risk of
default). At the time default risk was considered irrelevant as expected rises in the housing market
meant that on mortgage default the proceeds from the sale of a mortgaged property would always
exceed the outstanding loan value.
However, when the concern about the levels of debt shook market confidence, as house prices fell
then so did the value of mortgage backed securities.
This resulted in a lack of debt availability in the market and reduced the ability of companies to fund
expansion, or individuals to obtain mortgages. This was caused by a lack of confidence in the banking
industry fuelled by years of liberal lending criteria and a rise in securitisation.
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4.6.3 Traunching
The structure of securitisation deals is referred to a traunching. Claims on cash flows are split into at
least three classes. Each class is called a tranche and has absolute priority in future interest
distributions over more junior ones. Junior tranches are more risky, and therefore command a higher
return.

4.6.4 Credit Default Swaps

Credit Default Swaps (CDS) are counterparty agreements which allow the transfer of third-party credit
risk to another party. These gained popularity alongside CDOs in an unregulated market. The speed
and volume of these transactions (over $45 trillion in 2007) resulted in large financial institutions
becoming unaware of their credit risk exposure and added to the 2007 economic downturn.

4.6.5 Dark pool trading

Dark pools are trading systems which allows market makers (traders) to trade without quoting prices
publicly on the exchange.
This system allows fund managers to buy/sell large orders anonymously to avoid influencing the
market price. The proportion of trading using alternative platforms or ‘dark pools’ is estimated at 25%
in UK/US.
The problems of dark pool trading are:
 The regulated exchange is not aware about large transactions until the trades are complete;
market pricing can be out of date as it excludes large transactions until disclosed.
 Dark pool transactions reduce transparency and market efficiency which reduce investor
confidence (and market liquidity).
 There is a danger with dark pool trading that the market under estimates risk; with CDOs and
CDSs there is a danger that this unregulated risk precipitates events which led to the last credit
crunch.
 A two-tier market may be seen as unfair undermining market confidence and development.
Both the US and European regulators are conducting a review of how dark pools affect price, market
stability and fairness before any regulatory reforms are proposed.

4.6.6 Money laundering

Globalisation has created more opportunities for money laundering (the process of moving the
proceeds of crime through legitimate business concealing the source and identity of parties involved)
with governments increasingly trying to co-operate to combat this with legislation.
In the UK, the Financial Services Authority (FSA) requires financial services professionals to warn the
authorities if they suspect/discover that illegal transactions have taken place. UK companies engaging
in financial services must:
 Assess risk of money laundering from the customer base,
 Check the identity/source of funds for new customers,
 Implement effective internal control to protect the business from money laundering, and
 Keep full and up-to-date records.

4.7 New developments in the macroeconomic environment

Use news websites and Internet searches to gain a current picture of market and macroeconomic
developments.
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5 Strategic business and financial planning for multinationals

5.1 Financial planning framework for multinationals
Multinational companies need to develop a financial planning framework in order to make sure that
the strategic objectives and competitive advantages are realised. A strategy will include:
 How to finance an overseas subsidiary (equity vs. debt, joint venture, local debt, list on local
stock exchange)
 The risks related to the overseas operations (political, cultural, foreign exchange)
 How to repatriate profit (restrictions on dividends, transfer pricing, management charges and
royalties, interest on loans)
 How to minimise local taxes and prevent double taxation
 Control of the business (local vs. central management)

5.2 UK listing requirements

Listing on the London Stock Exchange (LSE) requires
(a) Audited revenue earnings for a three-year period.
(b) A value of at least £700,000 at the time of listing.
(c) Working capital for at least twelve months following listing.
(d) A prospectus must be issued to potential shareholders. In addition to general business data,
financial forecasts and a summary of business risks must be included.
(e) Compliance with the UK corporate governance code (separate chairman and CEO; half the
board NED; independent nomination; remuneration and audit committees; excellent controls
and financial systems), the ‘City Code’ and other UKLA disclosure rules.

5.3 Eurocurrency markets

Eurocurrency is currency which is held or borrowed by individuals and institutions outside the country
of issue of that currency.

5.4 Obtaining a Eurobond

A Eurobond is a debenture issued outside the jurisdiction of the country in whose currency the bond is
denominated.
Local capital distortions can sometimes mean that local debt finance is attractive as it is potentially
cheaper. Additionally, the benefits of using local finance include the reduction of foreign exchange risk
and political risk.
Eurobond’s are issued following these steps:

STEPS
Step 1: A lead manager is appointed who liaises with credit rating agency and organises a credit
rating for the Eurobond.
Step 2: An underwriting syndicate is organised who agree the bond terms and buy it.
Step 3: The underwriting syndicate will then organise the sale of the bond.
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Advantages of Eurobonds
 Eurobonds are bearer instruments (so can be traded)
 Interest is paid gross. Overseas investors therefore avoid UK tax
 Hedging foreign exchange risk as a Eurobond liability will match a foreign currency asset
 Often cheaper than a foreign currency bank loan
 Can be fixed or floating
 Normally unsecured (but need excellent credit rating)
 Finance is quickly raised as Eurobonds are easy to place with institutional investors
Disadvantages of Eurobonds
 High issue costs (2% upward)
 Exchange rate risk if no foreign currency assets

5.5 Mapping global risks

Monitoring expected risks (and use of risk mapping) should be part of a multinational’s strategy.

5.6 Agency conflict

The potential conflict between management of an overseas subsidiary and the Board of Directors, is
simply another level of agency conflict to actively manage through corporate governance mechanisms,
performance appraisal, target setting, and on site visits.
Management compensation packages can be used to reduce agency costs in aligning the interests of
overseas executives with head office management and the ultimately interests of the shareholders.

6 Dividend policy in multinationals and transfer pricing

6.1 Factors affecting the dividend decision
Dividend policy represents the choice directors must make when setting the balance between capital
gain in the share price and the annual cash dividend. For a multinational apart from those factors
already covered in Section 2.11, the following factors should also be considered:
 Internationally, double tax relief will limit the extra tax payable on overseas dividends to the
difference between rate of tax overseas and the UK rate.
 Exchange controls reduce the ability of a company to pay dividends from an overseas subsidiary
and the value of the dividend reduces with the time value of money.
 A company may set a high transfer price on goods sold to an overseas subsidiary (high UK
income) or a low transfer price on goods bought from an overseas subsidiary (low UK cost) as an
alternative to a dividend. This is a useful tool where dividend remittance is restricted or
dividends are highly taxed. Management charges, royalties and interest on intercompany loans
will have the same effect.
 21

Advanced investment
appraisal

1 Discounted cash flow techniques

1.1 Net present value (NPV)
Using relevant cost theory, NPV is calculated by evaluating all the future cash flows which occur as a
consequence of the decision to proceed with a particular project.

KEY TERM
NPV = Present value of relevant cash inflows less present value of relevant cash outflows
discounted at the investors required rate of return.

NPV is a powerful investment appraisal tool as a positive result confirms the project has achieved
three things:
(1) Payback of project costs is achieved.
(2) The project delivers the required annual return of the investor (WACC%) represented by the
discount rate (%). Therefore loan interest and dividends are excluded from project cash flows as
the discounting process already includes these.
(3) The +NPV represent a surplus return in addition to the required annual return (WACC).
The company retains this and can use it for reinvestment. The +NPV represents an increase in
company wealth and therefore we would expect the value of the company to increase by this
amount in an efficient stock market.
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A company will accept a project with a positive NPV as it satisfies both the investor (it delivers the
required return), and the company (the +NPV can be used to fund further expansion). Consequently, a
+NPV avoids agency conflict.

NPV

FUTURE COST OF
CASHFLOWS CAPITAL

Tax on operating
Relevant costs &
cashflows & tax Expected Working Inflation (real or
revenues (incl Inflation
saved on capital values Capital money rate)
terminal values)
allowances

1.2 Relevant costs

Relevant costs are cash flows which are future cash flows which are incremental to a decision. For a
figure to be relevant it must pass three tests:
(1) Future: a decision being made today cannot change the past and so only future costs are
considered. Past costs are sometimes referred to as sunk costs and are not relevant and so are
ignored e.g. the price paid for something which is already owned.
(2) Incremental: only those costs that are affected by the decision are relevant. Some costs are
sometimes referred to as committed costs and are not relevant and so are ignored e.g. fixed
costs.
(3) Cash flow: these are factual and not based upon accounting conventions. Also organisations live
or die due to their cash position. So non-cash flows are not relevant e.g. depreciation.
Relevant costs include opportunity costs, which is income which has been sacrificed as a consequence
of making a decision. They exclude sunk costs, which are expenses which have already been incurred
and cannot change.

1.3 Discounting (the time value of money)

You must be able to confidently discount:
 Single future amounts back to the present – this is known as a present value.
 Annuities which are a series of equal amounts received/paid at regular intervals for a finite time
period.
 Perpetuities which are a series of equal amounts starting at a future point and continuing forever.
Discounting tables can be used where the discount rate is a whole number between 1% and 20%.
The following formulae will provide the discount factor for all other discount rates.
Single value = (1 + 𝑟𝑟)−𝑛𝑛 GIVEN TO YOU IN THE EXAM
1 − (1+𝑟𝑟)−𝑛𝑛
Annuity = 𝑟𝑟
GIVEN TO YOU IN THE EXAM
1
Perpetuity = 𝑟𝑟
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1.4 NPV layout

Time
0 1 2 3 4 5
Revenue X X X X
Relevant costs (X) (X) (X) (X)
Incremental cash before tax X X X X
Taxation (X) (X) (X) (X)
Capital expenditure (X)
Scrap value X
Tax benefit of CAs X X X X
Working capital (X) (X) (X) (X) X
Net cash flows (X) X X X X X
Discount factors @ WACC X X X X X X
Present value (X) X X X X X

1.5 Corporation tax

It is advisable to show two corporation tax cash flows in your workings.
(1) Corporation tax on operating cash flows
Be careful of tax timings and follow the guidance in the question (i.e. same year vs. one year in
arrears).
(2) Capital allowances on capital expenditure
This is tax allowable depreciation and the % allowance will be given in the questions. You might
be asked to calculate straight line, reducing balance and possibly first year allowance. Follow
these steps.

STEPS
Step 1: Calculate the amount of capital allowance claimed in each year.
Step 2: Calculate the tax saved by multiplying by the tax rate given.
Step 3: Be prepared to calculate the tax effect of any balancing charge or allowance which
crystallises when the asset is sold.

1.6 Terminal values

The Examiner may give you a few years of detailed cash flow information in relation to a project and
then tell you that “.. the cash flows from year 4 onwards will continue at the year 3 level forever and
ever”. You will need to estimate what this is worth as a lump sum using the perpetuity ideas seen
earlier.

1.7 Working capital

It is normal to assume that any funds needed to provide working capital (e.g. inventory) for a project is
needed up front (time 0 cash outflow). Each year from then on the relevant cash flow will be the
incremental movement between the total requirement one year and the next. At the end of the
project it is assumed that all amounts invested in working capital thus far are returned (cash inflow at
end of project).
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1.8 Inflation
There are two methods to deal with inflation. Both methods result in the same NPV.
(1) Real method (ignoring inflation)
 Cash flows are stated at current prices ignoring inflation. These are called real cash flows.
 Cash-flows are discounted at a real discount rate.
(2) Money/Nominal method (including inflation)
 Cash flows are inflated to the actual cash received or paid at a future date. These are
called nominal or money cash flows.
 The cash flows are discounted at a nominal or money discount rate.
Fisher’s equation may need to be used to determine the correct rate.
(1 + nominal rate) = (1 + real rate) × (1 + inflation rate)
(1 + i) = (1 + r) × (1 + h) GIVEN TO YOU IN THE EXAM

1.9 Cash flow classification

Investment phase – these are the initial cash flows during which capital investment is made.
Return phase – this is period from the commencement of operations to the end of the project (or last
cash flow, whichever is later).
These classifications are often required in the exam and are used in a number of follow on
calculations.

1.10 Single period capital rationing

Single period capital rationing describes the situation where an organisation does not have sufficient
funds to undertake all positive NPV projects at one particular point in time.
If the investment projects are divisible we need to rank the projects by identifying the Profitability
Index.
If the investment projects are non-divisible we need to identify all possible combinations of whole
projects that can be undertaken and then select the combination with the greatest total NPV.

1.11 Multi-period capital rationing

Ideally a company would like to invest in all projects with a positive NPV.
Often a company may be able to choose between different projects but will be unable to raise
sufficient capital to proceed with all opportunities. Deciding which projects to undertake is the capital
rationing problem.
We can use linear programming to solve the problem. In AFM you will be expected to set up in the
problem and interpret the output only.

1.12 Internal rate of return (IRR)

The Internal rate of return calculates the maximum % return given by a project assuming all returns
are paid to investors (and there is no surplus left for the company i.e. NPV = 0).
Companies should accept projects where the IRR > WACC, as the maximum return is greater than the
cost of finance and the return demanded by investors.
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IRR is calculated using the following formula which must be learned.

𝑁𝑁𝑁𝑁𝑁𝑁𝐿𝐿
𝐼𝐼𝐼𝐼𝐼𝐼 ≈ 𝐿𝐿 +
𝑁𝑁𝑁𝑁𝑁𝑁𝐿𝐿 −𝑁𝑁𝑁𝑁𝑁𝑁𝐻𝐻
× (𝐻𝐻 − 𝐿𝐿) where, L% is the lowest rate chosen
H% is the highest rate chosen

1.13 Relative merits of NPV and IRR

The relative merits of NPV over IRR are:
 It provides a clear decision i.e. accept if positive, reject if negative
 It always gives the correct decision
 It always gives a single answer (some projects have more than one IRR)
 It maximises the shareholders wealth
The relative merit of IRR over NPV is:
 It is much easier for non-accountants to accept
 It does not require the exact cost of funds to be known

1.14 The Modified Internal Rate of Return (MIRR)

Drawback of using Internal Rate of Return (IRR)
The IRR is not a reliable measure for two reasons:
(1) If the annual cash flows change from net inflow to net outflows more than once then there will
potentially be more than one IRR. Choosing the wrong IRR could result in:
 Accepting projects which should be rejected – accept negative NPV
 Rejecting projects which should be accepted – sacrifice positive NPV.
(2) The IRR% assumes project net cash inflows are reinvested by the company and will generate a
return of at least the IRR%. In reality, reinvestment must simply generate at least the WACC%,
which is lower. An IRR of 20% assumes any reinvestment will generate 20%, where investors
may be happy with a return on reinvestment at the WACC of 10%.
The Modified Internal Rate of Return (MIRR) solves both of these problems as:
 There is only ever one MIRR, therefore it can be relied upon as the maximum project return.
 MIRR assumes that any reinvestment generates only the minimum required return (WACC%)
and not the project maximum return (IRR%).
The MIRR is calculated using the following formula:
1
PVR n
MIRR = �
PVI
� (1 + re ) − 1 GIVEN TO YOU IN THE EXAM
Where n = the length of the project
The return margin is defined as the difference between the MIRR and the WACC

1.15 Techniques for dealing with risk

Before deciding to spend money on a project, managers will want to be able to make a judgement on
its risk (past experience provides a probability of failure) and uncertainty (no past experience,
probability of failure unknown).
26 2: A d v an c e d i n v e st me n t ap p ra i s al A C C A A FM

Key AFM techniques which allow you to build in risk and uncertainty into your analysis are as follows:
 Expected values (EV) – Probabilities are used to find a weighted average (e.g. of likelihood of
sales in year 1 being high, medium or low).
 Sensitivity analysis – Estimate the amount that a particular variable would need to change by
before a decision is reversed (i.e. from project acceptance to project refusal). If calculating the
sensitivity of a particular input variable, the calculation would be:
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑁𝑁𝑁𝑁𝑁𝑁
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑖𝑖𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡(%) = 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣𝑣 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟
× 100

Care needs to be taken over the treatment of taxation (i.e. does the variable affect the tax
figure?).
 Risk adjusted discount factor Using a higher WACC requires the project to achieve a higher
minimum return to compensate for additional risk.
 Payback period measures the time where a project recovers its initial investment. It ignores any
subsequent returns.
 Discounted payback period incorporates the time value of money and so compares early
investment cash flows with later return cash flows on a like for like basis.
 Project duration is a measure in years of how long it takes to recover approximately half of the
present value of the projects benefits. The longer the duration the more risky the project. It is
particularly useful where comparing different projects where a lower duration is preferred.
It works by amplifying risk on later cash flows by multiplying by a higher time factor.
∑(𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = ∑ 𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

 Value At Risk (VAR) determines a worst case scenario by predicting a fall from the NPV most of
the time (say, 95%). There will be a small chance (say, 5%) that the fall from average is greater.

Frequency

5% 45%

1.645
worse better

VAR is calculated using the following formula (which is not given.)

VAR = 1.645 × sd × time

Using the normal tables, 45% corresponds to Z=1.645, sd is the project annual standard
deviation (annual volatility) and time is the length of the project (or year of final cash flow if
later).
 Monte Carlo simulation
Simulation is an analysis of how changes in more than one variable may affect the NPV of a
project.
Monte Carlo simulation assumes uncertain variables follow a probability distribution, with
certain outcomes more likely than others. Commonly the normal distribution is incorporated
with assumptions regarding mean and standard deviation.
A C C A A FM 2: A d v a n c e d i n v e st me n t ap p ra i s al 27

The simulation can be run thousands of times using random number generators to generate
potential variable outcomes.
The results will generate a normal distribution of the NPV.
Consequently it is possible to generate a probability of achieving a NPV greater than a desired
value. i.e.

Prob = 30%

NPV = $1m

In its simplest form, Monte Carlo simulation assumes that the input variables are uncorrelated.
The technique can reduce the impact of spurious results occurring through chance in the
random number generation process.

2 Application of option pricing theory in investment decisions

2.1 Intrinsic and time value of an option
There are five main components which contribute to the value of an option which you must learn and
are listed below. To help with this, consider a share currently trading at $2 and you have the option to
buy the share for $1.50 in two years’ time.
Intrinsic value, the difference today (T0) between
 Pa = the current value of the asset = share price e.g. $2.00
 Pe = the exercise price of the option = option price e.g. $1.50
The difference is the intrinsic value of the option is 50c.
The time value of the premium reflects the uncertainty surrounding the intrinsic value. Over the next
year the share price could rise or fall, either increasing the intrinsic value, or reducing it.
The influencing factors are:
 s = volatility (standard deviation) in the value of the asset
 t = time to expiry of the option (in years)
 r = risk free interest rate (the London Inter Bank Offered Rate (LIBOR))
o An increase in volatility generally increases the value of the option.
o A decrease in time to expiry generally decreases the value of the option.
o A rise in interest rates increases the required return of the investor which generally increases
the value of the option.
28 2: A d v an c e d i n v e st me n t ap p ra i s al A C C A A FM

2.2 The Black-Scholes Option Pricing Model

Value of a call option at time 0

C = Pa N(d1 ) − Pe N(d 2 )e −rt GIVEN TO YOU IN THE EXAM

Value of a put option at time 0

P = C − Pa + Pe e −rt GIVEN TO YOU IN THE EXAM

N(dx) is the cumulative value from the normal distribution tables for the value dx

ln (Pa /Pe ) + (r + 0.5s 2 )t GIVEN TO YOU IN THE EXAM

d1 =
s t

d 2 = d1 − s t GIVEN TO YOU IN THE EXAM

Formula inputs
Pa = present value of volatile cash flows which result from exercising the option, valued at T0
Pe = non-volatile cash flows which result from exercising option, valued at the exercise date
r = risk free rate of return per annum (as a decimal)
t = time to expiry of option (in years)
s = volatility per annum i.e. standard deviation of the project

2.3 Value of Real Options

The existence of real options can be classified as follows:
OPTION TO DELAY OPTION TO EXPAND OPTION TO REDEPLOY OPTION TO ABANDON
CALL (buy assets) CALL (buy assets) PUT (sell assets) PUT (sell assets)
Avoid loss by rejecting if Create technology, Avoid loss by selling Avoiding future loss by
economy worsens. patent, brand, use assets from Project A and stopping project selling
Create extra wealth if elsewhere in the using the cash realised on assets to a third party.
proceed when economy business. Project B.
improves.

For option to delay

𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑵𝑵𝑵𝑵𝑵𝑵 = 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝒐𝒐𝒐𝒐 𝒄𝒄𝒄𝒄𝒍𝒍𝒍𝒍 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐
For options to expand, abandon and redeploy
𝑻𝑻𝑻𝑻𝑻𝑻𝑻𝑻 𝑵𝑵𝑵𝑵𝑵𝑵 = 𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷𝑷 𝑵𝑵𝑵𝑵𝑵𝑵 + 𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽𝑽 𝒐𝒐𝒐𝒐 𝒓𝒓𝒓𝒓𝒓𝒓𝒓𝒓 𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐𝒐
Note: The examining team has stated that candidates need to be able to explain the option to
redeploy but will not be required to calculate its value.

2.4 Drawbacks of the Black-Scholes Option Pricing Model

 Volatility of an asset is difficult to estimate and is unlikely to remain constant for the duration
of the option. In reality the standard deviation is based on judgement.
 The formulae assumes that the options are ‘European’ so only exercisable on a fixed date; often
we use Black-Scholes to value ‘American’ style options, which are exercisable at any date to
maturity.
A C C A A FM 2: A d v a n c e d i n v e st me n t ap p ra i s al 29

3 Impact of financing on investment decisions and adjusted present

value (APV)
3.1 Developments in Islamic financing
The growth and popularity of the use of Islamic finance has been exceptional since the Central Bank of
Bahrain issued the first sovereign sukuk bonds in 2001. Global Islamic banking assets held by
commercial banks are set to cross US$1.8 trillion in 2013, up from the US$1.3 trillion of assets held in
2011.
The basic principles of Islamic finance require all parties involved in a transaction to be allowed to
make informed decisions without being misled or cheated. The parties are also allowed to pursue
personal economic gain but without entering into those transactions that are forbidden (for example,
transactions involving alcohol, pork-related products, armaments, gambling and other socially
detrimental activities). Also, speculation is also prohibited (so Options and Futures are ruled out).
However, the most important principle from a financing perspective is the strict prohibition of interest
(riba = excess).
In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channelled
into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in
that profit, after a management fee is deducted by the bank.
In Islamic banking there are broadly two categories of financing techniques:‘fixed income’ modes of
finance – murabaha, ijara, sukuk and ‘equity’ modes of finance – mudaraba, musharaka.

3.2 Use of Macaulay Duration

Macaulay Duration measures the weighted average length of time to the receipt of a bonds’ benefits
(coupon and redemption value). Its benefit is that it allows the risk, expressed in years, to be
compared between bonds of different maturities.
By modifying the duration, we can determine the change in price of a bond if an investor requires an
increase or decrease in the gross yield.
We need to follow a three step process:

STEPS
Step 1: Calculate Duration on the bond
∑(𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = ∑ 𝑃𝑃𝑃𝑃𝑟𝑟𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒𝑒

Step 2: Calculate Modified Duration

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = 1+𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦

Step 3: Calculate the change in price

∆ 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = −𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 × ∆𝑌𝑌 × 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
Where ∆𝑌𝑌 = change in the investors’ required gross yield

Limitations of Macaulay Duration

In reality, the relationship between bond price and gross yield is convex (non-linear). As we have
assumed a linear relationship then the estimated change in bond price is a guide only. The more
convex the relationship then the less accurate the price change estimate.
30 2: A d v an c e d i n v e st me n t ap p ra i s al A C C A A FM

3.3 Credit risk measurement

A credit rating defines the financial strength of a borrower and helps the investor determine the
likelihood that the bond issuer will pay interest in a timely fashion and return the initial investment at
maturity.
There are two major credit rating agencies; they are Standard & Poors and Moody. They both conduct
extensive research on the bond issuer before assigning a credit rating to them.
The bond rating will affect the gross yield that the issuer will need to deliver to investors; the stronger
the credit rating, the lower the interest rate.
Rating Definition
AAA,AA+, AAA-, AA, AA-,A+  Excellent quality, lowest default risk
A, A-,BBB+  Good quality, low default risk
BBB,BBB-,BB+  Medium rating
BB or below  Junk bonds (high default risk)

3.3.1 Calculating a credit rating

The Kaplan-Urwitz model is used to calculate a credit rating and uses the following criteria:
 Firm size (F),
 Profitability (π, net income/total assets),
 Gearing (L, long term debt/total assets),
 Interest cover (C),
 Risk (σ, standard deviation/mean of the last five years of earnings) – likely to be given,
 Risk due to debt status (S, if subordinated = 1 if not = 0).
The final score is converted into a credit rating using the Kaplan-Urwitz model:
4.41 + 0.0014F + 6.4π – 2.56S – 2.72L + 0.006C – 0.53σ
If the score is > 6.76 a rating of AAA is given, if > 3.28 a rating of A is given and if > 1.57 a rating of BBB
is given.

3.3.2 Impact on WACC on change of credit rating

The cost of a bond (Kd gross) can be estimated by adding together the following two factors.
(a) The risk free rate ─ derived from the yield curve on governments bonds with increasing maturities.
(b) The credit risk premium (or credit spread) – the additional return required in compensation for
the risk of default.

% yield
Yield curve

Years to maturity
A C C A A FM 2: A d v a n c e d i n v e st me n t ap p ra i s al 31

The yield curve tends to be upwards sloping for the following reasons:
 Expectations theory – the curve reflects expectations that interest rates will rise in the future so
longer-dated bonds will need to pay out more interest.
 Liquidity preference theory – investors require compensation for sacrificing liquidity on long-
dated bonds.
 Market segmentation theory – short-dated bonds tend to be more abundant and popular with
investors so it is easier to sell these bonds at a lower coupon rate.
The credit risk premium is quoted and will be given in the exam as a yield spread in basis points (100
points = 1%).

3.3.3 Assessing the credit risk premium (spread)

The banks will use Value at Risk (VAR) to determine the potential probability of loan default and will
use it to determine the interest rate necessary to meet the banks minimum required return on its
investment (the loan). The rate over the risk free rate will determine the credit spread for this
company.

3.3.4 Using Black-Scholes to determine loan default risk

The role of the Black-Scholes option pricing model in the assessment of default risk is based on the
limited liability aspect of equity investments as follows:
If Value of assets > outstanding debt, then company exercises its option to repay its debt.
If Value of assets < outstanding debt, then the company defaults on its debt obligation.
The value of assets changes with volatility then we can use Black-Scholes to calculate the probability
that they fall below the value of outstanding debt.
If the company is successful, then the shareholders enjoy all of the upside. The shareholders will
exercise the option to repay the loan and retain the company’s equity (effectively exercising the
option to ‘buy’ the shares).
If the company defaults on the loan, the limited liability status of the company protects the
shareholders from a personal commitment to repay the loan. The shareholders therefore enjoy very
little downside risk as this is transferred to the debt holder.
We can use Black-Scholes to determine the probability of default using the Black-Scholes formula where
Pa = the market value of assets
Pe = the value of debt (loan default position)
N(d2) is the probability that a call option will be exercised (i.e. loan is repaid). Therefore 1 – N(d2)
represents the probability of default.

3.4 Investment appraisal and a change in gearing/risk

We have previously determined that you cannot use the existing WACC for investment appraisal if
there is a change in gearing. A new WACC must be calculated using the following methodology.

Type 1 No change in business risk or financial risk (i.e. no change in gearing). It is okay to use existing
WACC without adjustment.
Type 2 Change in financial risk only (change of gearing), no change in business risk .
Use Adjusted Present Value (APV) as an approximation to NPV; or
Recalculate the WACC at new gearing level.
Type 3 Change in business risk ─ determine a risk adjusted Ke and recalculate WACC at the gearing level.
32 2: A d v an c e d i n v e st me n t ap p ra i s al A C C A A FM

3.5 Adjusted Present Value (APV) – Type 2

Modigliani & Miller (1958) determined that in a perfect capital market the only difference in the value
of two identical companies will be the tax advantage of debt and therefore a geared company will be
worth more than an identical ungeared company.
From the M&M model with tax we can conclude that,
𝑀𝑀𝑀𝑀 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑐𝑐𝑐𝑐 > 𝑀𝑀𝑀𝑀 𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑢𝑑𝑑 𝑐𝑐𝑐𝑐
The question is by how much? M&M argued the extra MV should be the PV of the tax saved on debt
finance. Total value of the geared firm, Vg (based on MM):
𝑽𝑽𝒈𝒈 = 𝑽𝑽𝒖𝒖 + 𝑻𝑻𝑻𝑻
Where
Vg = MV of geared company (i.e. MV Debt + MV Equity)
Vu = MV of ungeared company (i.e. just MV Equity since it has no debt)
T = Tax rate
B = MV of debt
TB = is referred to as the “Tax shield”
This theory can be applied to investment appraisal. If we evaluate the NPV assuming no debt finance,
then under a TYPE 2 situation where a company finances a project via debt, the only difference should
be any tax saved on the debt finance. This is known as adjusted present value (APV).

APV = NPV @ Ke i + PV tax saved on interest @ Kd gross – issue costs

Other possible effects of debt finance are the benefits of government loan subsidies.
In order to calculate NPV, we may have to ‘degear’ or eliminate the effects of gearing (financial risk)
from Ke. We can use M&M’s formula to degear Ke and remove financial risk.

i i V
K e = K e + (1 − T )( K e − K ) d GIVEN TO YOU IN THE EXAM
d V
e
K e = cost of equity of a geared company
i
K e = cost of equity in an ungeared company

K = this is gross (before tax)

d
V , Ve = market value of debt & equity, respectively
d

3.6 Change in business risk – Type 3

Where a business proposes to diversify and undertake a project with a different business risk then a
risk adjusted WACC must first be calculated which reflects the actual business risk of the project
undertaken and the proposed level of gearing after the project commences.
A C C A A FM 2: A d v a n c e d i n v e st me n t ap p ra i s al 33

Follow a five-step process:

STEPS
Step 1: Find a listed company with the same risk as the proposed investment and determine
the quoted βe and gearing level. This is called a proxy company.
Step 2: Using the formula below to degear the proxy βe to determine the ungeared beta βa
(asset beta).
Step 3: Regear βa at OUR company’s gearing level.
Step 4: Use CAPM to determine the risk adjusted Ke.
Step 5: Find WACC at the new risk and gearing level.
Formula

 Ve   Vd (1 − T ) 
βa =   βe +  βd GIVEN TO YOU IN THE EXAM
 (Ve + Vd ( 1 − T))   (Ve + Vd (1 − T )) 
where, βa – ungeared beta - this is business risk only
βe – geared beta – this is business risk + financial risk
βd – is the credit risk on debt finance – assume βd=0 if not given
If Ke is given for a comparable quoted company, follow the same method using the following formula
to degear/regear.

i i V
K e = K e + (1 − T )( K e − K ) d GIVEN TO YOU IN THE EXAM
d V
e

3.7 Impact of gearing on reported financial performance

Funding a project using equity finance will decrease gearing whereas using debt finance will increase
gearing.
We would expect the project to generate additional profits which increase EPS. Because of the added
benefit of tax relief on debt interest we would expect the increase in EPS to be higher where the
company uses debt finance.

4 Valuation and the use of free cash flows

Covered in Chapter 3.

5 International investment and financing decisions

Companies invest overseas where the domestic market is saturated, where there is a product gap in an
overseas market and low competition or to secure a cheaper/more efficient/less volatile source of
supply.
However investing overseas presents further political, cultural, credit and foreign exchange risks.
34 2: A d v an c e d i n v e st me n t ap p ra i s al A C C A A FM

5.1 Understanding exchange risk

Exchange risk can be broken down into three components.
(1) Transaction risk is a realised cash loss as either we receive less on a specific foreign currency
receivable (export) or pay more on an overseas payable (import) at the settlement date.
(2) Translation risk is the foreign exchange loss on the translation of overseas assets and liabilities
into sterling for financial reporting purposes. This loss is unrealised as does not represent a cash
loss and it could reverse if the rate changes.
(3) Economic risk is the longer-term risk that an overseas project NPV falls as overseas cash flows
diminish in value.
Companies embarking on an overseas investment will increase risk exposure across all three areas.

5.2 Effect of changes in exchange rates on NPV

As the domestic currency appreciates the value of any overseas income will fall and therefore the
overseas NPV will fall.

5.3 Predicting exchange rates

Purchasing power parity
Purchasing power theory suggests that changes in exchange rates are caused by differences in the rate
of inflation between two countries i.e. relative purchasing power.
Interest rate parity
Interest rate parity assumes differences in the interest rates will cause movement in the exchange rate
as demand for capital will be affected (savers attracted to high rates, borrowers attracted to low
rates).
Formula
Based on parity theory, we can predict a movement in the exchange rate based on expected inflation
rates or interest rates using the following formula:
(1 + ℎ𝑐𝑐 ) (1 + 𝑖𝑖𝑐𝑐)
𝑆𝑆1 = 𝑆𝑆0 ×
1 + ℎ𝑏𝑏
𝐹𝐹0 = 𝑆𝑆0 × (1 + 𝑖𝑖𝑏𝑏)
GIVEN TO YOU IN THE EXAM

Where S1 = exchange rate in 1 year

Fo = forward rate today (spot)
S o = exchange rate today (spot)
hc = inflation rate and i c = interest rate, in the spot rate country
hb = inflation rate and i b = interest rate, in the non-spot rate country
A C C A A FM 2: A d v a n c e d i n v e st me n t ap p ra i s al 35

5.4 Overseas NPV

We can use parity theory to improve the accuracy of our overseas investment appraisal. When
calculating the NPV, we can use two methods. Each method results in the same NPV.

Method 1

STEPS
Step 1: Forecast foreign currency cash flows using overseas inflation.
Step 2: Forecast exchange rates and convert to £ cash flows.
Step 3: Discount at UK WACC.

Method 2

STEPS
Step 1: Adjust UK WACC to overseas WACC.
Step 2: Discount foreign currency cash flows using overseas WACC and calculate the foreign
currency NPV.
Step 3: Using the spot rate, convert into a £ NPV.

5.5 Exchange controls

If a country imposes a delay on the remittance of a dividend from an overseas investment to its UK
parent, then the cash received at a later time period will have a lower value due to the time value of
money. Furthermore, the exchange rate may have worsened.
In addition to creating liquidity problems for the UK parent, a worst case scenario is that the exchange
rate control changes an investment from viable (+NPV) to not viable (–NPV).

5.6 Using overseas debt

International debt market
In addition to UK loans and debentures a company may choose to finance its overseas investment
using overseas debt finance for the following three reasons:
(1) Reduction in transaction risk ─ $ Revenue can be used to pay $ loan interest. Only the net is
exposed to the foreign exchange market.
(2) Reduction in translation risk ─ $ Investment is hedged by $ loan on the statement of financial
position. The foreign exchange movement on the asset offsets the foreign exchange movement
on the liability.
(3) Reduction in political risk – local governments may be reluctant to take adverse actions against
investors where local banks hold a stake. In a worst case scenario, if the $ investment assets are
nationalised following a change in government then the assets taken are viewed as a repayment
of the principal loan hedging the loss.
However, often the cost of a UK company borrowing $ from an overseas bank is higher which may
offset the above benefits. Using a Eurocurrency loan may provide a cheaper solution.
36 2: A d v an c e d i n v e st me n t ap p ra i s al A C C A A FM

Euromarket loans
This obstacle can be managed by the use of the Euromarkets to borrow in any foreign currency using
unregulated markets organised by investment banks.
 Often the cost of debt is cheaper as UK banks are willing to lend out their surplus foreign
currency at preferential interest rates to avoid translating to sterling at a disadvantageous rate.
 This is an unregulated market as only sterling lending limits are within the control of the Bank of
England so often loan security or other banking covenants are not required by the banks.
 This facility is only available to very large or listed companies with excellent credit ratings.

International bond market - Eurobonds

This is a debenture issued by a UK company and used to raise foreign currency debt capital. Often the
Eurobonds are unsecured and carry a low coupon rate.

International equity market – dual listing

A company may seek a dual listing, where it is listed on two recognised share exchanges i.e. UKLA and
NYSE, in order to widen it exposure to potential investors. For example, a company with significant
UK/US operations will have a reputation in both countries, and will be able raise equity capital from
both UK and US investors if it issues new shares on both the London and New York stock exchanges.
There are two principal disadvantages:
 Listing fees will be paid to two listing authorities.
 Increase in costs of compliance as corporate governance and accounting rules in two separate
jurisdictions need to be observed. Two annual reports will be required under US and
International GAAP.

5.7 Double taxation

To prevent ‘double taxation’, most governments have agreed under international tax treaties to give a
tax credit for any foreign tax paid on overseas profits. This is known as double tax relief.
Where taxed profit is remitted to the parent company, the parent tax authority will charge the full tax
liability under its tax rules less the overseas tax already paid.

5.8 Capital allowances and the problem of tax exhaustion

Capital allowances are claimed which reduce a company’s profits chargeable to corporation tax.
Consider a situation where a company is generating potential cash flows on a project but its overall
trading is weak or loss making.
(a) Where the entire company generates a taxable profit lower than the project capital allowance,
the tax relief is limited to the profit generated.
(b) Where the entire company is making a loss, then the capital allowance increases the taxable
loss. It does not generate a cash tax saving in the period and must be ignored from the
investment appraisal until such a time the tax losses can be utilised.
 37

Acquisitions and mergers

1 Acquisitions and mergers versus other growth strategies

1.1 Evaluating growth objectives
To achieve its growth objectives, a company has three strategies that it can use:
Advantages Disadvantages
Internal or Organic A company can use its existing talent Failure to develop a competitive product
growth pool to expand whilst controlling its or launch successfully.
costs and growth rate. A competitor enters the market and claims
advantage before the company completes
its R&D.
Acquisitions / Instant access to new markets, products, It may cost a premium over organic
Mergers technology, patents, processes, brands, growth.
customers, supply chains or economies It may pay too much.
of scale which might be difficult for the It requires significant finance. This may be
company to otherwise obtain. new debt or equity to provide cash to fund
Could be cheaper than organic growth if the acquisition.
high set up/infrastructure costs, or A merger will see a dilution of control as
inexperienced. payment is with shares.
The company does not get what it thinks it
has bought.
Joint ventures Where competitors have a mutual goal Commercially sensitive information is
and are able to share the risks, costs and shared which can then be exploited by the
rewards of new products. competitors.
Particularly useful where the R&D costs The risk/return ratio is unfairly weighted in
are prohibitively expensive. the favour of the competitor.
Can reduce political risk when investing
overseas.
38 3: A c q u i s i ti o n s an d me rg e rs A C C A A FM

1.2 Synergy
Often where one company buys another company, it will have to pay a premium to the current fair
value to persuade shareholders of the target company (the Target) to sell.
It is the creation of synergy on acquisition which provides the increase in wealth required by the
Bidder. Synergy is additional wealth which is only created as a result of the combination of two
companies i.e.
𝑀𝑀𝑀𝑀𝐴𝐴+𝐵𝐵 = 𝑀𝑀𝑀𝑀𝐴𝐴 + 𝑀𝑀𝑀𝑀𝐵𝐵 + 𝑃𝑃𝑃𝑃 𝑜𝑜𝑜𝑜 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠
Synergy can be classified into three areas:
(1) Sales Synergy –
 Increase volumes (improved market reach, product visibility, technology)
 Increase prices on rebranding/include new technology
(2) Cost Synergy –
 Reduce overheads
 Increase production efficiencies
 Access to new economies of scale due to increased company size
 Reduce headcount
(3) Financial Synergy –
 Reduce bank interest due to economies of scale
 Reduce WACC due to perceived reduction in risk

1.3 Identifying potential synergies

If you are asked to identify potential synergies in the exam, read through the scenario
carefully and use sales, cost and financial as your sub-headings.

1.4 Criteria for choosing suitable acquisition targets

Every acquisition should be evaluated against a series of strategic objectives set out by the Board of
Directors. Examples are as follows:

Increase in debt Disposal of cash Underperrforming Access to key

Strategic Aims Diversification Tax savings
capacity surplus company technology
• Must be • Leads to a • Use of group • Acquisition of low • Ideally the target • Target is poorly • Where speed is
consistent with reduction in losses. geared target should have managed or vital, or
long term goals. earnings may increase potential but structured badly. intellectual
• Measureable volatility. ability to borrow. little cash to property is
synerygy. expand. protected.
A C C A A FM 3: A c q u i s i ti o n s a n d me rg e rs 39

1.5 Risks of acquisition

An acquisition strategy will fail if expected synergies fail to materialise. This may happen for the
following reasons.
Risk Explanation
Agency theory An over dominant director seeking status may desire to maximise revenue by
increasing market share as opposed maximising profit and building shareholder
wealth (Empire Building).
Pay too much A change in economic conditions renders the price paid as greater than the net
benefits purchased.
Cultures clash/post Failure to define a new ‘shared culture’ on day one following the takeover can
integration strategy lead to standoff between groups of employees and significantly impact on
effectiveness of the new group and morale.
Loss of talent Key staff may decide to leave rather than face the uncertainty of change in the
new structure.
Customer/Supplier Customers fear post-acquisition quality and delivery problems and may anticipate
uncertainty an increase in price. Failure to communicate results in loss of customers.
The supply chain fear potential liquidity issues and reduce quantity and credit
terms.
Due diligence errors Unexpected issues, costs and liabilities arise as the due diligence process failed to
accurately identify all costs, contingencies, assets, staff skills, capacity, data etc.
Pre-emptive theory An acquisition is hastily pursued out of fear that a competitor will gain large cost
savings or synergies from horizontal integration.

1.6 Post-integration strategy

To minimise these risks the company should be prepared to roll out, on day one following the
acquisition, a post-integration strategy which will address all the key risks above and will cover the
following:
 All due diligence is completed including legal and tax.
 A new shared vision, mission with goals and corporate values is communicated. This may wisely
include a new company name, logo and corporate colour.
 An operational structure is implemented aimed at realising planned synergies.
 Staff surplus to requirements are made redundant. This removes uncertainty and allows the
staff affected to move on and secure alternative employment quickly.
 Key positions and reporting lines are clear and communicated; control of key resources/capital
expenditure is clearly delegated.
 A new marketing/advertising campaign is delivered and key customer and supplier relationships
are protected.
 A position audit is performed once the new group is trading to identify further risks/potential
gains.

1.7 Reverse takeovers

A reverse takeover is usually the acquisition of a listed (quoted) target company by a private
(unquoted) acquirer company through a share-for-share exchange. This enables the private company
to obtain a listing without going through a lengthy Initial Public Offer (IPO) process. The term can also
be used to describe a smaller acquirer company taking over a larger target company.
40 3: A c q u i s i ti o n s an d me rg e rs A C C A A FM

Benefits of a reverse takeover

(a) A higher price can be obtained for future share issues of the acquirer, if it is now a listed
company
(b) The private acquirer company can become listed at a lower cost and more quickly than if it uses
an IPO
(c) There will be less dilution of control for existing shareholders of the acquirer company than
under an IPO.
(d) A reverse takeover is less susceptible to market conditions than an IPO, as the deal is between
the shareholders of the acquirer and target companies only

Disadvantages of a reverse takeover

(a) Private acquirer company management may lack experience of dealing with the stock markets
and the requirements of being a listed company
(b) Market interest in the acquirer company shares may be limited after listing, affect the liquidity
and value of the shares post takeover.
(c) The acquirer company management may lack experience and skills to manage the much larger
company after acquisition
(d) No new finance is raised with a reverse takeover. It often will be if the acquirer company listed
by IPO
(e) Under UK Listing Rules the listing and trading of the public listed company shares may be
suspended while the reverse takeover is undertaken. The new, larger company may then need
to reapply for a listing.

2 Valuation for acquisitions and mergers

2.1 Problems of over valuation
There is no such thing as accurate company valuation as the ultimate price is that negotiated between
the buyer and seller.
The problem of overvaluation can lead to a reduction in wealth which can be seen from both the buyer
and seller perspective:
 Buyer – pay too much if overvalued reducing shareholder wealth
 Seller – refuses to sell if overvalued rejecting potential increase in wealth

2.2 Estimating future growth

Internal measures ─ Use past growth to predict future growth or the growth model:

g = b re GIVEN TO YOU IN THE EXAM

External measures – Estimate a realistic company growth against published industry/economy growth
rates, competitor growth rates, and market research. In the exam, you may be given the results of an
analyst’s report providing growth data.
Often short-term growth rates can be predicted with greater certainty than later years. After which
point a lower conservative growth rate is applied to forecast cash flows and earnings to address the
potential problem of overvaluation.
A C C A A FM 3: A c q u i s i ti o n s a n d me rg e rs 41

There are generally considered to be three main groups of valuation techniques:

Asset based Earnings based Cash flow based

• Use of historic cost, • P/E ratios • Discounted cash flow

replacement cost or • Dividend yield
realisable value? • Dividend growth
• Black Scholes Options model
Pricing model

2.3 Asset basis – minimum valuation

Used to determine a minimum or base value, the net assets of the business are determined at
realisable value to establish an equivalent cash value should the business cease and the assets sold.
Essentially, this is a pre-goodwill valuation as it ignores the economic benefits the company is capable
of delivering from its future trade. Drawbacks to asset basis:
 Ignores goodwill and other intangibles not included on the statement of financial position;
 Difficult to determine realisable value without actually selling assets;
 Few circumstances where a sale at minimum value would be acceptable.

2.4 Using Black-Scholes to Value Equity

The role of the Black-Scholes option pricing model in company valuation is based on the limited
liability aspect of equity investments as follows:
If Value of assets > outstanding debt, then company exercises its option to repay its debt.
If Value of assets < outstanding debt, then the company defaults on its debt obligation.
If the company is successful, then the shareholders enjoy all of the upside benefit. The shareholders
will exercise the option to repay the loan and retain the company’s equity (effectively exercising the
call option to ‘buy’ the shares). The value of the option can be equated to the value of the equity.
If the company defaults on the loan, the limited liability status of the company protects the
shareholders from a personal commitment to repay the loan. The shareholders therefore enjoy very
little downside risk as this is transferred to the debt holder.

2.5 Earnings basis

Earnings basis is often used as a very quick method of generating a valuation as the company is valued
as a multiple of its current maintainable earnings (PAT – preference dividends).
It is useful when valuing an unlisted company using the P/E ratio of a proxy similar listed company.
Where valuing an unlisted company an adjustment of between 0.5 ─ 0.7 is required to reflect the
higher risk of investing in an unlisted company.
42 3: A c q u i s i ti o n s an d me rg e rs A C C A A FM

2.6 Discounted cash flow valuations

AFM will refer to these as free cash-flow valuations.
Free cash-flow valuation is considered to be the most accurate method of valuation as due diligence
can be performed to accurately predict a company’s future operating cash flows.

COMPANY
VALUE

Future Free WACC or Ke

Cash Flows
Usually use the WACC of the
company that is being valued
The cashflows will need to include any
synergies likely to be available to the
new owners

Free cash flow (FCF) is defined as operating cash flows after tax and after annual capital expenditure
(where, operating cash flows are defined as operating profit + depreciation + changes in working
capital), but before interest.
Free cash flow to equity (FCFTE) is defined as above but after interest.
FCFTE is also known as dividend capacity as this represents the cash available to be distributed to
ordinary shareholders as a dividend.

Free Cash Flow valuation (FCF) Free Cash Flow to Equity valuation (FCFTE)

1. Estimate Free Cash Flow 1. Estimate Free Cash Flow to Equity

(remember to deduct interest post-tax)

2. Discount at WACC 2. Discount at the cost of equity, Ke

3. PV = Vd + Ve 3. PV= Value of Equity, Ve (i.e. market cap)

4. Less: Value of Debt, Vd
5. Value of Equity, Ve

Different time horizons and growth rates

You need to be able to value companies under different time horizons:
𝐹𝐹𝐹𝐹𝐹𝐹 (1+𝑔𝑔) 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 (1+𝑔𝑔)
 Infinite timeframe, use Terminal value = or =
(𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊−𝑔𝑔) (𝐾𝐾𝐾𝐾−𝑔𝑔)

 Finite timeframe, constant cash flows can be valued using annuity factors
Valuations are very sensitive to changes in the annual growth rate. Generally, as the growth rate
increases, the value will increase.

2.7 Dividend yield basis

By extracting the dividend yield on a similar quoted company and using it as the required return, we
have a better understanding of Ke. This is particularly useful for unlisted, owner managed businesses
where the required return is unknown.
A C C A A FM 3: A c q u i s i ti o n s a n d me rg e rs 43

2.8 Dividend basis – useful for valuing minority interests

The value of a share is calculated as the present value of the future dividends that are expected to be
generated from time 1 to infinity evaluated as the shareholders’ required return. If growth is
overstated, it could significantly overvalue the company. Remember there are two ways of estimating
growth (past growth and g = b re ).

D0 ( 1 + g)
Value per share = P0 = GIVEN TO YOU IN THE EXAM
re − g
Where D0 = current dividend paid
re = cost of equity
g = estimated dividend growth rate
As minority shareholders have limited influence over the company’s strategy, they are not in a position
to make decisions which create synergy. Therefore, a minority valuation considers the PV of the future
returns only (i.e. the dividend stream).
Drawbacks to dividend valuation model:
 It is difficult to estimate future dividend growth;
 It is inaccurate to assume that growth will be constant to infinity;
 It will not create a value for companies which do not pay a dividend and reinvest retained
profits.

2.9 Valuations with changing risk

For a free cash flow valuation we must determine what type of valuation we dealing with (Type 1, 2, or
3) in order to generate the appropriate Ke or WACC.

Type 1 Acquisitions that do not When valuing own company.

change financial or Use existing gearing/betas to generate appropriate discount rate.
business risk
Type 2 Acquisitions that change Often if borrowing to fund acquisition.
financial risk only Degear and regear beta or Ke to determine appropriate discount
rates.
Use APV.
Type 3 Acquisitions that change When diversifying or using a comparable quoted company (CQC)
business risk or business to determine risk.
and financial risk Find buyer βe, target βe (or use CQC) βe and degear to βa. Degear
by division if each has a different risk.
Find weighted average βa based on proportions of
buyer/seller/division.
Regear at the new group gearing level to find group βe
Use group βe and CAPM to find group Ke.
Find new WACC and use to value FCFs (Group cash flows + synergy).
Deduct Vd to find Ve combined group.
Compare with value of bidder to find maximum price.

If you recall we determined the maximum price the bidder should pay was based on the following:

𝑀𝑀𝑀𝑀𝑀𝑀 𝑡𝑡𝑡𝑡 𝑝𝑝𝑝𝑝𝑝𝑝 𝑓𝑓𝑓𝑓𝑓𝑓 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡 𝐵𝐵 = 𝑀𝑀𝑀𝑀𝐴𝐴+𝐵𝐵 − 𝑀𝑀𝑀𝑀𝐴𝐴

There may be other non-trading one-off cash flows, such as pension and share option liabilities and
sales of surplus assets, for which the valuation will require adjusting for.
44 3: A c q u i s i ti o n s an d me rg e rs A C C A A FM

2.10 Valuing high cost/high growth start-up companies

Initial Research and Development costs, manufacturing set up costs, marketing, property and capital
expenditure costs will dwarf revenues in the early stages of a new business. So how do we value a
company which is currently delivering a net loss and negative free cash flows? The key is to value cash
flows which are expected to growth at different rates.
FCF Valuation = PV Inflows at high growth rate – PV outflows at low growth rate

3 Regulatory framework and processes

3.1 The City Code
The City Code on Takeovers and Mergers is a voluntary set of principles governing takeovers and
mergers of UK companies. It is issued and administered by the Takeover Panel, an independent body
of representatives from UK financial institutions with key members appointed by the Bank of England.
Directors of both bidding and target companies may aim to manipulate the bid process to their
advantage.
The Takeover Panel can block a company from making a bid for a listed company if it feels the rules
have not been followed. Furthermore, any listed company not complying with the Code may have the
membership of the London Stock Exchange suspended. Unlisted companies are encouraged to follow
the guidance.

3.1.1 Benefits of the City Code

 It sets out procedures which ensure the highest standard of conduct which companies and
directors must follow during the bid.
 It determines procedures governing the access to information.
 It sets out a time limit for making a formal bid declaration following market rumours/approach
to purchase. This removes share price uncertainty.
 It can prevent a company from repeatedly bidding and withdrawing offers which would
otherwise prevent a company from pursuing its own trade without distraction.
 It ensures shareholder approval is required for any sale of the business.
A C C A A FM 3: A c q u i s i ti o n s a n d me rg e rs 45

3.1.2 Timeline for a takeover offer

-28 days
• Announcement of intention to bid

0 days
• Last day for all shareholders to received offer document

14 days
• Last day for target company to issue defence document

21 days
• Earliest day for the offer to close

42 days
• Last date for offeror to revise its offer

95 days
• Last day for paying offer consideration

3.1.3 The Competition and Markets Authority

The Government created the Competition and Markets Authority allowing legal intervention to
prevent a merger that creates a combined market share of above 25% (either nationally or locally).
The principle behind this legislation is the protection of the consumer who can be exploited on price if
there is a lack of competition. Certain industries whose monopoly power cannot be curbed by this
legislation (for example, water, gas and electricity) are subject to price regulation by government
agencies.

3.1.4 Directors’ duties

Ethically, where the Board feels that a takeover is in the best interests of the shareholders then they
should issue a recommendation to shareholders to accept the bid. Usually 50% of shareholders must
vote to accept the bid for the sale to proceed.
The Board may genuinely believe a takeover is not in their shareholders’ best interest then they have
fourteen days from receiving the formal offer to issue a defence document to the shareholders.
In 2004, in response to a bid for the company M&S appointed a new MD who delivered a new strategy
to shareholders valuing M&S at £4.00 per share. The defence strategy was successful and shareholders
rejected the offer.

3.1.5 Defence strategies

These are pre-emptive strategies aimed at reducing the attractiveness of the company from a
potential bidder. Examples are:
 Golden parachute – Increasing bonus or redundancy/pensions terms for directors/employees
can be off-putting to a potential bidder.
 Poison Pill – Make the target less attractive by creating share options/deferred shares/ which
convert to equity on acquisition, thereby reducing the acquirer’s stake or selling new shares to
existing shareholders at a very low price.
 White Knight – seek an alliance with another company (or sale to), strengthening the
company's position against a potential bid.
46 3: A c q u i s i ti o n s an d me rg e rs A C C A A FM

 Crown Jewels – sell off assets/part of the business believed to be attractive to the bidder.
 Revaluation of assets – may increase the offer price required.
 Re-forecasting – may increase the offer price required.
 Reverse takeover (Pacman defence) – mount a counter-bid for the attacking company.
 Litigation or regulatory defence – seek investigation by the Takeover Panel or Competition
Commission which will cause delay.
Pre offer defence strategy – clear focus on wealth creation. Ensuring the dividend policy meets
the shareholders’ expectations and that the market is kept informed of positive developments
(market efficiency).
Remember, employment of any of these defences is unethical if not in the best interests of the
shareholders and directors have a duty to put aside their personal goals of remuneration and
continued service if shareholders get a better deal from a sale or merger.

4 Financing acquisitions and mergers

4.1 Cash based acquisitions
An acquisition is a sale of the business for cash. This results in 100% control being transferred to the
acquiring company. Cash bids are often offered at a premium to market price (20% as an approximate
guide).
A cash offer can be funded from

Retained •Requires surplus cash

earnings •May involve divestment of assets

•Debentures - can signal intention to bid to market

•Banks loan - can avoid signalling, can be short term prior to
Debt finance bond issue
•Eurobond for overseas acquisition
•May require security; amount may be prohibitive

•Convertible bonds and warrants

Mezzanine •Venture capital/private equity
finance •Maybe the only route for companies excluded from
traditional bond markets

4.2 Paper-based mergers

A merger (or paper bid) is the exchange of shares in the target company for new shares in the bidding
company. This results in control being shared between both sets of directors and shareholders.
As no cash changes hands this is attractive to companies without access to cash or debt; furthermore
target shareholders will receive shares as opposed to cash thereby delaying capital gains tax.
A C C A A FM 3: A c q u i s i ti o n s a n d me rg e rs 47

A deal could be mixed, meaning a combination of shares and cash. This provides target shareholders
with the certainty of some cash and the potential for higher dividends.
The most appropriate offer is the one which responds to the needs of the shareholders the most,
which often is the offer which maximises the increase in shareholder wealth.

4.3 Investor considerations between cash or paper

Bidder Target
• Dilution of EPS • Exit investment - cash
• Cost of finance • Need for future income
• Impact on gearing • Taxation impact
• Authorised share capital • Share price of bidder
• Impact on culture
48 3: A c q u i s i ti o n s an d me rg e rs A C C A A FM
 49

Corporate reconstruction
and reorganisation

1 Financial reconstruction
1.1 Causes of financial distress
There have been a number of high profile business failures including Woolworths, Lehman Brothers,
Furniture Village, Comet, HMV and BHS.

1.2 Financial reconstruction schemes

Often easing the burden on short term cash flow can significantly reduce the risk of insolvency where
there is cash generative potential in the core trade.
Following efforts to reduce trading expenditure, restructuring a company is a more radical and
permanent strategy to improve future trading prospects. Restructuring plans can include:
 The closure of unprofitable divisions and unnecessary departments;
 A redundancy programme to reduce staff to an operating minimum and eliminate non-value
adding overheads;
 A reduction in expensive R&D, marketing and IT projects;
 A refinancing of short-/medium-term debt to longer-term debt. Increased maturity reduces
annual loan repayments;
 A conversion of Loans and Debentures into shares (debt to equity). The advantage of lower
interest payments is balanced against the dilution of control to existing shareholders; or
 A cash call to investors; new debt or equity finance.
There is a risk that smaller creditors are financially disadvantaged by a reconstruction scheme.
To address this, UK insolvency legislation requires that each class of creditors should meet and vote
50 4: Co rp o rat e re c o n s t ru c t i o n an d re o rg an is at i o n A C C A A FM

whether they agree with the terms of the scheme. Every class of creditor must vote yes for the scheme
to succeed. A no vote by one group of creditors is sufficient to block the scheme.
For a scheme to be acceptable, each class of creditors must agree it is in a better position financially
compared to the position on liquidation of the company. This is the starting point to evaluate whether
the scheme is acceptable. The following steps are applied to a scheme which will be set out by the
Examiner.

1.3 Steps on financial reconstruction

STEPS
Step 1: Assess the financial position of each group of creditor on liquidation (restating assets to
realisable value).
Step 2: Assess the financial position of each group of creditor after the terms of reconstruction
scheme have been implemented.
Step 3: Discuss whether you believe each group of creditors will agree to the scheme.
Step 4: Determine whether the company will be economically viable and have sufficient
working capital following the scheme.

1.4 Order of settlement on liquidation

On liquidation, the assets of the business are converted into cash and this is then distributed to
creditors by the Insolvency Practitioner in the following order in compliance with UK legislation.
(1) Settlement of liquidation fees
(2) Amounts due to fixed charge holders – named property offered as loan security
(3) Amounts due to preference creditors (set out in the question)
(4) Amounts due to floating charge holders – all other assets offered as loan security
(5) Unsecured creditors
(6) Preference share capital – restricted to nominal value only
(7) Ordinary share capital – restricted to nominal value only
If available cash does not cover a particular class of creditor in full then a pro-rata payout (cents per $1
debt) is paid in settlement.
A C C A A FM 4: Co rp o rat e re c o n s t ru c t i o n a n d re o rg a n is at i o n 51

2 Business re-organisation

Sell Off

MBO Demerger

Exit
Strategy

Franchise Liquidation

IPO

2.1 Sell – off (divestment)

 Raise cash – where new debt/equity finance is restricted this is a method of raising capital to
fund a more profitable ventures or reduce financial risk (repayment of debt/overdraft).
 Strategic review – dispose of a non-core subsidiary/product which is underperforming or
absorbing a disproportionate amount of management time. The ethos here is that a company
can improve performance if it focuses its resources on doing what it does best.
 Take-over defence – the sale of an attractive asset/subsidiary as a pre-emptive measure against
takeover rumours.

2.2 Demerger (spin off)

A demerger is the opposite of an acquisition. A company spins off some business it owns into a
completely separate company. No cash is raised through a demerger.
Demergers can have beneficial effects:
 Allowing management of demerged companies to concentrate on their core business,
 Allowing the market to value each part of the business fairly increasing shareholder value.
British Gas demerged in the late 1990s into BG and Centrica. Zeneca was spun out of ICI and Argos was
spun out of BAT.

2.3 Liquidation
This is an extreme exit strategy whereby the business ceases to exist. A sell off may occur due to a
poor outlook for the company and it is felt liquidation and hence sale of the assets is the best way of
returning any value to the investors.
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2.4 Initial public offering (IPO)

An IPO occurs where there is a sale of the shares of the company to the public to be traded on a stock
exchange. Advantages may be that there is some realisation of cash for investors, major shareholders
usually maintain control and it can offer a high potential return. Disadvantages are that it is a costly
process with an uncertain outcome. Major shareholders may be limited as to how much, when, and
how they can sell their shares.

2.5 Franchise
In the case of a franchise the business concept is sold to others to replicate. There will usually be an upfront
cash receipt with an ongoing franchise fee. The arrangements are often legally very complicated.

2.6 Management buyout (MBO)

A team of managers (either from inside or outside the organisation) buy out the business or a part of
it. An MBO can be attractive for the managers (own and run their own business, potential equity gains)
and the company (dispose of non-core operations, raises cash, it may be quicker than a sale to a third
party).
The management team will need to make sure they have the relevant skills and expertise on board
(particularly in IT, HR and other head office functions that they can no longer utilise from the original
business).
The key players in an MBO situation will be:
 The management team
 Directors of the business selling to the MBO team
 The financiers

2.6.1 Financing an MBO

A typical financing structure in an MBO will often be driven by the fact that the MBO team want a
decent % of the equity but can only personally afford a small fraction of the amount payable. This may
result in the following approximate financing structure.
Management team 1-5%
Banks – Senior (secured) debt and subordinated (less secured) debt 30-40%
Banks/Investors – Mezzanine debt (unsecured, higher interest rate, shorter term) possibly 20-30%
with equity warrants
Venture capital 20-30%

2.6.2 The venture capitalist

Venture capital businesses are typically owned by the major banks but some large independents (e.g.
3i) do exist. They typically look to invest in businesses with high potential growth where the
management have a proven track record.
A VC firm may look for their investment to generate in the region of 25% to 30% average annual
return (generally seen as dividends plus capital gain), some sort of board presence and decision
making input plus a clear exit plan for a three- to seven-year timescale.
The exit plan could be; flotation, sale to third party, sale of shares to the management team or sale to
institutional investors.
To incentivise the management team to deliver the venture capitalist may agree a ‘ratchet system’ in
the agreement whereby the management team get a bigger % of the equity on sale if they exceed
their performance targets (this can work in reverse as well if performance is below expectations).
 53

Treasury and advanced

risk management techniques

1 The role of the treasury function in multinationals

1.1 The money market
When a company needs to borrow funds to address a short term liquidity problem (< 1 year) they may
be able to access the money markets if they satisfy the criteria of being listed with a good credit rating
(some large unlisted companies will also qualify). The ‘money market’ is simply a network of financial
institutions willing to lend to each other and to other companies. Contact with the ‘money market’ is
essentially communicating by telephone with a specific investment bank as opposed to a special
purpose institution, like the stock exchange.
Investment banks will also co-ordinate the issue of new government bonds (UK gilts) and target
specific investors, in return for a fee. This way, the government uses the money markets as a source of
public funds (UK debt).
The money market is also an active market in the trade of export invoices/promises to pay. These are
known as bills of exchange. An exporter will obtain a signed ‘promise to pay’ from its overseas
customer. The money markets will purchase these bills at a discount, thereby providing funding to
finance the production of the good/service.
We will also see the money markets provide forward contracts and futures and options (derivatives)
which allow companies to reduce foreign exchange risk and interest rate risk.

1.2 Role of banks in the money markets

Whilst banks can directly provide credit to companies, the market can also oversee the issue of new
bonds by introducing investors directly with borrowers. This is called disintermediation where the
investor is the provider of credit as opposed to the bank.
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The banks can also provide the framework for a secondary market in financial products. This provides
an exit route to investors and increases investor liquidity. This aspect of the market attracts investors
and therefore increases the available credit in the market.

1.3 Common money market instruments

Coupon bearing
Certificates of deposit Issued by banks which entitle the bearer to fixed interest and principal for a
(CDs) specified time period. These can be traded as ‘bearer only’ providing liquidity
for the investor.
Eurocurrency deposits Interest-bearing loans or deposits agreed in a country where the contract
currency is deemed a foreign currency. Interest is referenced to LIBOR in
London i.e. 3M US LIBOR.

Discount instruments
Treasury bills (Gilts) Government bonds issued to fund public sector services and deal with short
term shortfalls in tax receipts. These are sold at auction and carry a zero coupon
(i.e. non-interest bearing). The return is embedded as issued at a discount and
redeemed at face value.
Commercial paper (CP) These are debentures which redeem in less than one year. These are issued by
large or listed companies with an excellent credit rating with a minimum of
£500,000. The return is embedded as issued at a discount and redeemed at face
value. Debt is usually unsecured, with no restrictive covenants. Issue costs are
low and cash can be raised in less than one day.
Bills of exchange (BoE) This is an export customer’s ‘promise to pay’ with a minimum of £75,000 and
maturity 60-180 days. These are sold at a discount as non-interest bearing and
useful to the exporter where there are lengthy credit terms. The export
customer can be pursued in court for non-payment in the country of origin
under international treaty.

Derivatives
Futures contract A contract to buy and sell a standard quantity of a specified commodity at a
fixed future date at a price fixed today.
Options contract An option to exercise a futures contract to buy (call) and sell (put) a standard
quantity of a specified commodity at a fixed future date at a price fixed today.
The privilege of choice bears a cost called a premium.

1.4 Role of the treasury function

A large company or listed company will have a treasury function which will consolidate the cash and
debt position of all its divisions and subsidiaries and co-ordinate its activities on the money markets so
it benefits from the following advantages.
 Use cash surplus’s to provide short term finance to other subsidiaries thereby avoiding the cost
of external bank finance.
 Consolidate subsidiary borrowing requirements into a single loan at a lower interest rate due to
economies of scale and avoid multiple transaction fees.
 Reduce risk by requiring subsidiaries to justify parent financial support through the provision of
collateral, loan covenants and business plans, just like an external bank.
 Reduce foreign exchange risk exposure through the natural hedging currency assets and
liabilities.
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1.5 Centralised verses decentralised treasury function

The advantage of using a decentralised treasury function is that it encourages subsidiaries to be
financially independent by increasing profits and cash generation and it allows the rapid exploitation
of emerging opportunities as the process of parent company authorisation can lead to delay.

1.6 Longer term decisions of treasury function

In the longer term, the treasury function will seek to increase shareholder wealth by pursuing four key
decisions:
(1) Investment decision – Additional +NPV projects will increase shareholder wealth.
(2) Financing decision – Financing expansion and meeting the target capital structure.
(3) Dividend decision – Reinvesting retained profits vs. meeting dividend expectations.
(4) Risk management – The treasury function will seek to manage currency and interest rate risks
within acceptable limits by using a variety of hedging techniques and available products offered
by the money markets.

1.7 The Delta Hedge

One particular method treasury functions use to manage risk is the Delta Hedge, where Delta is
measured as N(d1) and calculated using the Black-Scholes Option Pricing Model.
Consider an investor holding a portfolio of shares which are falling in value. If the investor writes CALL
options, then the premiums earned will offset the fall in value of the portfolio. The number of options
is determined by the ‘delta hedge’ as follows:
𝐶𝐶𝐶𝐶𝐶𝐶𝐶𝐶 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤 = 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 ℎ𝑒𝑒𝑒𝑒𝑒𝑒/𝑁𝑁(𝑑𝑑1 )
𝑃𝑃𝑃𝑃𝑃𝑃 𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 𝑏𝑏𝑏𝑏𝑏𝑏𝑏𝑏ℎ𝑡𝑡 = 𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 ℎ𝑒𝑒𝑒𝑒𝑒𝑒 / 𝑁𝑁(– 𝑑𝑑1 )

1.8 Gamma
Gamma measures how much Delta changes as the underlying asset value changes. It is useful to
update the ‘delta hedge’ for changes in price. For example, if the gamma is 0.01 then for each 1% rise
in the underlying asset value the delta should increase by a factor of 0.01. (If gamma is 0.02, then for
each 1% rise in asset value delta should increase by 0.02.)

1.9 The ‘Greeks’

A summary of elements of the Black-Scholes Option Pricing Model, known as ‘the Greeks’ is as follows.
Note, only an awareness of these is required.

Delta This is the change in the value of the option as the value of underlying asset changes.
Gamma This is the change in delta value as the value of the underlying asset changes.
Theta Measures the change in an option’s value over time. Generally, the option value falls as we
move toward maturity.
Vega Measures the change in the option value as volatility change. Generally, the value increases as
volatility increases.
Rho Measures the sensitivity of option prices to changes in interest rates. Generally, the higher the
interest rate the higher the value of the call option.
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2 The use of financial derivatives to hedge against foreign exchange risk

2.1 Exchange risk
If you recall, exchange risk can be broken down into three components:
(1) Translation risk is the foreign exchange loss on the translation of overseas assets and liabilities
into sterling for financial reporting purposes. This is unrealised.
(2) Transaction risk is where foreign exchange payables increase or foreign exchange receivables
fall in value by the time the transaction is settled. This is realised.
(3) Economic risk is the longer term risk that an overseas investment NPV falls as a result of a
strengthening of the domestic currency.

2.2 Impact on changes in exchange rate and hedging

As the exchange rate moves, foreign exchange risk is created. We will see that this risk can be hedged
if the company holds both a foreign currency asset and liability.
 Imports create a foreign exchange payable. The foreign exchange loss is the extra amount paid
on settlement between the rate at the transaction date and the rate at settlement date.
 Exports create a foreign exchange receivable. The foreign exchange loss is the fall in cash
received on settlement between the rate at the transaction date and the rate at settlement
date.

2.3 Quoted rates

A spot rate is the rate available if buying or selling the currency today.
An expected spot rate is the expected rate prevailing at a future date.
A forward rate is a rate fixed today on a transaction converting currency at a fixed future date.
In the UK exchange rates are shown per £ e.g. $1.5350 $/£. i.e. it will cost $1.5350 to buy or sell £1.
Banks will quote a ‘spread’ of rates detailing the price which they will buy the currency on the left and
sell the currency on the right. The quote is always as a price per unit of currency. Consider the
following quote:
BUY SELL
$1.5250:£1 – $1.5450:£1
Bank: Buys £s low at $1.5250 Sells £s high at $1.5450 (bank earns $0.02 per £1)
The Company is the counterparty to the exchange of currency.
Company: Sell £s low at $1.5250 Buys £s high at $1.5450 (company pays $0.02 per £1)
OR
Company: Buys $ Sells $
The Spread can be shown in questions in three ways:
 1.5250 – 1.5450 $/£
 $/£ 1.5350 +/ – 0.0100
 $/£ 1.5350 bid/offer spread 250 ─ 450
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During question practice there are two ways to determine which rate to use:
 Use the worse rate. Calculate the £ equivalent using both rates. The company will ALWAYS
receive the lowest receivable OR pay the highest payable.
 Apply buy/sell to the first symbol. For example, 1.5250 – 1.5750 $/£. The first symbol is $ so
the company can Buy $ at $1.5250 and Sell $ at $1.5750.

2.4 Internal hedging methods

Internal methods do not involve the purchase of a financial product. Methods include:
 Evaluate exchange rate volatility and do nothing.
 Transfer the transaction risk to the customer or supplier by invoicing in the home currency.
 Leading – settle payables in advance / request early settlement of receivables.
 Lagging – delay payment until exchange rate improves.
 Bi-lateral netting ─ the netting of receivables and payables which settle in the same foreign
currency on the same date.
 Multilateral netting – the elimination of intercompany foreign currency payables and
receivables in a large group (may include other third party balances by agreement).

2.5 External hedging methods

External methods involve the purchase of a financial product from either a bank (OTC – over the
counter) or from a recognised currency exchange (Chicago, New York, Philadelphia only). Methods
include:
 Forward contract ─ A contract with a bank to buy or sell specific amount of foreign currency on
a specific future date at an exchange rate which is agreed now and specified in the contract.
The contract obligation must be fulfilled.
 Money Market Hedge (MMH) – Uses interest rate parity theory to fix the future rate.
A company will either lend or borrow foreign currency with a bank to generate interest to offset
the movement in exchange rates.
 Futures contract – A contract with a bank or currency exchange to buy or sell a standard
amount of foreign currency on a standard future date at an exchange rate which is agreed now.
The contract can be ‘nominal’ in that any gain or loss due to the movement in the exchange rate
is settled in cash as opposed to the physical delivery of currency. The gain or loss on the future
contract offsets the foreign exchange movement on the transaction.
 Option contract – An option to exercise a contract with a bank or currency exchange to buy or
sell a standard amount of foreign currency on a standard future date at an exchange rate which
is agreed now.
The option avoids a loss on a contract. The trader will require a fee called a premium for the
ability to exercise a gain and not exercise a loss.
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2.6 Forward contract

A bank will quote forward rates allowing a company to fix the future exchange rate to exactly match
the settlement date and amount. The bank will increase its ‘spread’ on forward rates to improve its
margin so often forward contracts do not carry a transaction fee. The spread can be quoted in
different ways:
Forward rate $/£ 1.5000 – 1.5400
Forward rate $/£ 1.5200 +/- 0.0200
Forward rate $/£ 1.5200 bid/offer spread 000-400
Additionally, the forward rate can be quoted as an adjustment to the Spot rate. The rule is subtract a
premium (pm) and add a discount (dis).
Notice how subtracting the premium from the spot rate increases in the spread (bank’s margin).
Spot 3 month forward Forward rate
US $/£ 1.5250 – 1.5450 0.0250 – 0.0050 premium 1.5000 – 1.5400

Advantages of Forwards Disadvantages of Forwards

Widely available and easy to arrange so limited Rate quoted may be poor.
specialist knowledge required. Good for SMEs.
No transaction fee (bank profit embedded in Mandatory agreement and difficult to reverse. May
increased spread). incur additional loss, for example, if a $ receivable is
late, a company must still sell $ on the due date,
which requires buying $ on the spot market.
Unique contracts which are bespoke to the Removes potential upside as future rate is fixed.
transaction’s requirements.

2.7 Synthetic agreements on foreign exchange (SAFEs)

These are like forward contracts, except no currency is delivered. Instead, the profit or loss on a
notional amount of currency is settled between the two counterparties.

2.8 Money market hedge

A money market hedge removes exchange rate volatility by employing interest rate parity theory.
Remember the formula for estimating the forward rate below; this rate is practically achieved using a
money market hedge.
(1 + 𝑖𝑖𝑐𝑐 ) Will be GIVEN TO YOU IN THE EXAM
𝐹𝐹0 = 𝑆𝑆0 ×
(1 + 𝑖𝑖𝑏𝑏 )
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Export (foreign exchange receivables)

A MMH will offset a foreign exchange loss due to a decreasing $ receivable by borrowing as interest
earned on a £ deposit asset will exceed the interest paid on a $ loan. We can use the following layout
to help control the problem.

EXPORTER
Now Future
$ Step 3 Strip out interest that will accrue Step 1 Receive $ from export (foreign
by discounting to calculate $ loan to be exchange asset).
borrowed today.
Step 2 Repay $ loan with $ export revenue.

£ Step 4 Translate $ loan into £. Step 5 Deposit £ in UK account and

compound (1+r).

Imports (foreign exchange payables)

A MMH will offset a foreign exchange loss due to an increasing $ payable by borrowing as interest
earned on a $ deposit asset will exceed the interest paid on a £ loan. The following layout can be used
in the exam.

IMPORTER
Now Future
$ Step 3 Strip out interest that will accrue Step 1 Receive $ on deposit.
by discounting to calculate $ to be
Step 2 Settle $ payable (foreign exchange
purchased today and put on deposit.
liability).

£ Step 4 Translate $ deposit into £. Step 5 Borrow £ in UK account and compound

(1+r).

2.9 Currency futures

Hedging using currency futures takes time to understand and practice before you will feel
comfortable.

DEFINITION
Currency futures are derivative contracts with a bank or currency exchange to buy or sell a
standard amount of foreign currency on a standard future date at an exchange rate which is
agreed now.

Derivative contract
The value derives from avoiding a disadvantageous rate on the foreign exchange markets.
Exchange traded currency futures and options can only be purchased in the US (Chicago, New York,
Philadelphia). Over the counter (OTC) contracts can be purchased from a UK bank but are less
common for currency.
A futures contract can be considered as a bet that your risk happens. The downside of the risk is offset
by the bet’s winnings. We use buy and sell terminology to define winning or losing the bet.
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Notional contracts
Two futures contracts are required to ‘close out’ and crystallise a gain or loss. The difference in price
generates the gain/loss (the Tick).
Now Future contract to Buy £ OR Future contract to Sell £
At Settlement date Future contract to Sell £ Future contract to Buy £
Generally the market will quote to fix the Future rate at 31 March, 30 June, 30 September or
31 December.

Setting up a hedge using Futures contracts

Do we ‘buy’ or ‘sell’ futures contracts to set up a hedge? The advice is to identify the contract currency
and match it to the transaction you want to hedge.
To hedge using Futures contracts you pay an initial margin to the exchange to cover potential trading
losses. Cash is credited or debited to the firm’s account each day as profits or losses accumulate. If the
initial margin drops below a certain safety level a variation margin is paid by the company to cover
further losses.

Number of Futures contracts

In order to hedge a foreign exchange transaction we need sufficient futures contracts to cover the
exposure as follows:
𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸𝐸
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 = 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 (× 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡′𝑠𝑠 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝)

Only a whole number of contracts can be acquired so always round your answer to the nearest whole
number.
Note: only use today’s Futures price if the exposure and standard contracts are different currencies.

Tick size
The tick size is the change in gain/loss on one Futures contract if the rate changes by $0.0001.
Tick size = Tick × Standard contract size

Gain/loss on a Futures contract

Gain/loss on Futures contract = Tick size × Number of Ticks × Number of Futures contracts

Basis
Basis is the assumption that the difference between the spot price and Futures price (known as the
‘basis’) falls over time. Typical movement of Futures price versus spot price through time are
illustrated as follows:

Price

Spot

Future

Delivery Time
date
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Basis is used in calculations to predict the Futures price at the settlement date as follows.

Predicting the closing Futures price at the settlement date.

Now Settlement date
Spot X X
Futures price X Balance figure price
𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆
Difference X × = X

𝑡𝑡𝑡𝑡
𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
𝑁𝑁𝑁𝑁𝑁𝑁

𝑡𝑡𝑡𝑡
𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
Basis risk
Basis risk is that risk that the difference between the future and spot price will not move in this
predictable way and the hedge is less effective than expected. Choosing a Futures contract which
matures after settlement date helps to minimises Basis Risk.

Exam question approach

STEPS
Step 1: Determine the hedging strategy using Futures Contracts (Buy or Sell).
Step 2: Calculate the number of Contracts required to hedge.
Step 3: Calculate the predicted gain or loss on Futures contracts at the settlement date using
basis.
Step 4: Determine the outcome of the hedge.
Futures calculations are very methodical, so take them step by step.
Advantages of Futures Disadvantages of Futures
Available for settlement dates at the quarter end Not good for SMEs, as product knowledge is vital and
BUT can be closed out early to match individual futures contracts are for large volumes of currency.
transaction settlement dates.
No transaction fee (traders actively managed Additional investment in talent and internal control
position so they generate a net profit from required due to the additional risks of operating on
trading). the derivatives market.
Creates an economy of scale for large companies as Initial and Variation margins are payable upfront and
the large volumes of trades at the currency during the life of the Future.
exchange improve prices and hedge efficiency.

2.10 Over the counter currency options (OTC)

An option is the right but not the obligation to a future rate.
 If option rate is preferred (strike or exercise price) then exercise the option
 If the market rate if preferred then do not exercise the option and take the market rate
OTCs can be purchased from a bank. OTC options are normally European style options meaning they
can only be exercised on the maturity date as opposed to American style options, which can be
exercised at any date up to the maturity date.
Do I need a Put or Call? From a UK bank’s perspective, a CALL is required if we want an option to Buy
foreign currency, and a PUT is required if we want an option to Sell foreign currency.
If the premium is quoted as a lump sum (as opposed to a price per £) then it is OTC.
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2.11 Exchange traded currency options

DEFINITION
A currency option is the right, but not the obligation, to exercise a contract with a bank or
currency exchange to buy or sell a standard amount of foreign currency on a standard future
date at an exchange rate which is agreed now.

The trader will require a fee called a premium for the ability to exercise a gain (in the money) and
avoid exercising a loss (out of the money). The premium is quoted as a cost per unit of currency
hedged.
Exchange traded currency options are also not available outside the US. They are available from the
large US derivative exchanges in Chicago, New York and Philadelphia and therefore the £ is the foreign
currency and contracts are quoted to buy/sell in blocks of £31,250.
Call option – a right to buy £ (or other contract currency)
Put option – a right to sell £ (or other contract currency)
A premium is quoted as a dollar price for each unit of foreign currency. For example:
Premium $/£ Options £31,250 (cents per £1).
Strike Calls Puts
Price Oct Nov Dec Oct Nov Dec
1.5200 1.96 2.44 2.78 0.58 1.08 1.48
1.5250 0.78 1.25 1.66 1.26 1.44 1.59
1.5300 0.33 0.64 0.87 2.24 2.56 2.76

Exam question approach

STEPS
Step 1: Determine the hedging strategy using Options Contracts (Buy or Sell).
Step 2: Calculate the number of Contracts required to hedge.
Step 3: Calculate the premium payable.
Step 4: Calculate the predicted gain.
Step 5: Determine the outcome of the hedge.
Advantages of Options Disadvantage of Options
• Remove downside risk. • Premiums can be prohibitively costly, such
• Retain upside, if rate creates a foreign that option premium cost outweighs option
exchange gain. benefits.

2.12 Calculating the option premium using Black-Scholes

A modified version of the Black-Scholes model is used by options traders to value currency options and
determine the premium to charge as follows.

For a call option [ ]

C = e − rt F0 N (d1 ) − XN (d 2 ) Will be GIVEN TO YOU IN THE EXAM

For a put option P = e −rt [XN (−d 2 ) − F0 N (−d1 )] Will be GIVEN TO YOU IN THE EXAM
A C C A A FM 5: T re a s u ry a n d a d v an c e d ri s k man ag e me nt t e ch n i q ue s 63

where

ln (Fo /X) + s 2 t / 2 Will be GIVEN TO YOU IN THE EXAM

d1 =
s t

d 2 = d1 − s t GIVEN TO YOU IN THE EXAM

where
F0 = Expected forward rate
X= Exercise/Strike price
r= Risk free interest rate (LIBOR)
t= Time to expiry of the option (in years)
s= Volatility (standard deviation) in the value of the asset

2.13 FOREX swaps

In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-
swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is
agreed between the parties in advance.

3 The use of financial derivatives to hedge against interest rate risk

3.1 Interest rate risk
Risk
Future Loans The rate rises prior to start of loan.
Future Deposits The rate falls prior to start of deposit.

Interest rate risk can be managed by netting interest bearing assets with interest bearing liabilities
(netting) or using a mix of fixed and variable rate finance (smoothing).
However, if finance is required at some point in the future, then the use of Interest Rate Forward
Contracts, Futures, Options, Collars and Swaps must be used to hedge the risk. You will require
knowledge of the following.
(a) Forward Rate Agreements (FRAs) – these fix the future rate on loans and deposits.
(b) Interest Rate Futures – these also fix the future rate on loans and deposits.
(c) Over the Counter (OTC) options and Exchange Traded options – these cap the loan cost at a
maximum rate, or set a floor on cash deposit income with a minimum rate.
(d) An Interest Rate Collar sets a minimum and maximum loan or deposit rate, the objective being
to reduce the overall cost of hedging.
(e) An Interest Rate Swap hedges by converting a variable rate loan into a fixed rate loan.

3.2 Forward Rate Agreements (FRAs)

An FRA is a contract with a bank to borrow or deposit a ‘notional’ amount of money to be
borrowed/deposited in the future for a set time period but at a fixed rate of interest agreed now.
Market terminology for a three-month £2m loan, starting in three months’ time and fixing the cost at
4.5% per annum is as follows:
£2m 3-6 FRA at 4.5%
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The FRA is a legal contract, in addition to the loan agreement. Should the interest rate rise and the
cost of the loan exceeds 4.5%, then the writer of the FRA will pay out the difference between the rate
paid and 4.5%. That way, the effective interest paid is fixed at 4.5%.
Advantages Disadvantages
• Easy to arrange, widely available. • The contract must be honoured, even if the
Suitable for SMEs, no transaction fees. company decides not to borrow/deposit.
• Bespoke to suit company requirements. • Rate quoted may be expensive compared with
the current loan rate.

3.3 Interest Rate Futures

Interest Rate Futures are contracts to borrow or deposit a standard amount on a standard future date
for a three-month period but at an interest rate agreed now.
The contract can be ‘nominal’ in that any gain or loss due to the movement in the interest rate is
settled in cash as opposed to the actual borrowing or lending of cash.
For a loan the hedging strategy is Sell, then to closeout you Buy
For a deposit the hedging strategy is Buy, then to closeout you Sell
Futures are quoted at a price equal to (100 – annual yield)
If a hedge is required on a loan or deposit longer than the standard contract length of three months,
then an adjustment to the number of contacts is required (see below). This is called maturity
mismatch
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 × 𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿 𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙ℎ
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 =
£500𝑘𝑘 × 3 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚ℎ𝑠𝑠

Advantages Disadvantages
• Flexibility – a Future can be ‘closed out’ • Only for large companies as available in large
when no longer required. contract sizes (£500,000).
• May get a better deal than an FRA due to • If bought at the LIFFE exchange, then Initial
market efficiencies on the London and Variation Margins are payable upfront
International Financial Futures and and during the life of the future.
Options Exchange (LIFFE).

3.4 Exchange Traded Interest Options

An Interest Rate Option is the right, but not the obligation, to exercise a Futures contract to borrow or
deposit a standard amount (£500k) on a standard future date for a three-month period but at an
interest rate agreed now. The trader will require a fee called a premium for the ability to exercise a
gain and not exercise a loss.
 To hedge increasing rates on a loan, use a Put option – a right to sell (borrow and pay interest).
This is known as a cap.
 To hedge falling rates on a deposit, use a Call option – a right to buy (deposit and receive
interest). This is known as a floor.
Advantages Disadvantages
Keep potential upside. Premium cost (which is paid upfront). Can be expensive.
Flexibility – an Option does not need to be Only for large companies as available in large contract
exercised so do not exercise if not needed. sizes (£500,000).
May get a better deal than an FRA due to market If bought at the LIFFE exchange, then Initial Margin is
efficiencies (LIFFE). required.
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3.5 Loan Collar

Here you want to hedge your loan but the option is too expensive. The aim of the collar is to make
hedging affordable. This is done by becoming a trader, writing an option and earning a premium as
follows:
(1) Set Cap: Hedge the loan using a PUT option and pay a premium
(2) Set Floor: Write a CALL option and earn a premium.
 As the interest rate rises, the PUT is exercised which hedges the loan. A maximum interest rate
on the loan is achieved.
 As the interest rate falls, there is a benefit as the cost of loan has fallen and the PUT is not
exercised. The holder will exercise the CALL option to hedge their deposit as the rate falls.
As the writer of the CALL option we pay out.

3.6 Deposit Collar

Here you want to hedge your deposit but the option is too expensive. A Collar will make the hedge
affordable and will work:
(1) Set Cap: Write a PUT option and earn a premium
(2) Set Floor: Hedge the deposit using a CALL option and pay a premium
 As the interest rate falls, the CALL is exercised which hedges the deposit. A minimum interest
rate on the deposit is achieved.
 As the interest rate rises, there is a benefit as the interest income on the deposit rises ─ the
CALL option is not exercised. The PUT option is exercised by the holder to hedge their loan as
the rate rises. As the writer of the PUT option we pay out.

3.7 Interest Rate Swaps

A Swap is where two companies agree to swap their interest payments on their respective loans.
A Swap agreement can deliver up to three objectives:
(1) To reduce the cost of borrowing (Kd).
(2) To hedge; a variable interest commitment is swapped to fixed.
(3) To take advantage of falling rates; a fixed interest commitment is swapped to variable.
Three conditions need to be in place for a SWAP to be effective:
(1) A counterparty must want to borrow the same amount for the same period.
(2) A counterparty must want to achieve an opposing objective.
(3) One of the parties must have a stronger credit rating and achieve competitive advantage in
finance costs.
The Swap will be achieved by the netting of three separate cash flows.
(1) Each party (A and B) pays the interest on its loan commitment to the bank.
(2) A pays variable rate interest to B, or vice versa.
(3) B pays fixed rate interest to A, or vice versa.
Usually a bank will organise the Swap and charge a fee. This is a finder’s fee as the banks will bring
together two of its customers who will benefit from a Swap arrangement.
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3.8 Currency Swaps

In addition to the benefits of a Swap agreement, a Currency Swap allows a company to manage its
currency risk when investing overseas, by swapping the amount borrowed for an amount of foreign
currency at a fixed rate to fund the investment. Only with a Currency Swap is the actual amount
borrowed also swapped.
At maturity, the amount borrowed is swapped back at the initial rate (regardless of the market rate),
therefore hedging currency risk on the amount borrowed.
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Formulae sheets
68 Fo rmu l ae s h e e t s A C C A A FM
A C C A A FM Fo rmu l ae s h e e t s 69
70 Fo rmu l ae s h e e t s A C C A A FM
A C C A A FM Fo rmu l ae s h e e t s 71
72 Fo rmu l ae s h e e t s A C C A A FM