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ACCA P4 Advanced Financial Management notes

Exam
Section A contains two compulsory questions with aggregate marks of 50 to 70, each question
with 25 to 40 marks. Section B contains three questions and you are required to answer two,
each with 15 to 25 marks. You are expected to demonstrate an integrated knowledge of the
subject and an ability to relate your technical understanding of the subject to issues of strategic
importance to the company. Therefore, understand the syllabus and practice past year
questions are the key to success.
Note
You are assumed to have F9 knowledge and also other knowledge from earlier papers. It is
advised that you go through with your F9 notes again before reading this note. Also, read
through articles published for P4 in ACCA website. It is advised that you study according to this
sequence: C, D, E, F, A, B and finally G, although it is fine to study sequentially if you remember
your F9 well.

Syllabus areas
A: Role and responsibility towards stakeholders

Page numbers
2-17

B: Economic environment for multinationals

18-22

C: Advanced investment appraisal

23-48

D: Acquisitions and mergers

49-61

E: Corporate reconstruction and re-organisation

62-67

F: Treasury and advanced risk management techniques

68-98

G: Emerging issues in finance and financial management

99-103

Underlining has been used to help you focus.

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Role and responsibility towards stakeholders


1. The role and responsibility of senior financial executive/advisor
As a senior financial executive/advisor or financial manager, you should develop strategies for
the achievement of companys goals (maximise shareholder wealth) in line with its agreed
policy framework. Strategy can be at three levels: corporate (what business are we in), business
(how strategic business units, SBUs compete in individual markets) and operational (what to do
in day-to-day operations).
Furthermore, you should recommend strategies for the management of the financial resources
of the company such that they are utilised in an efficient, effective and transparent way. This
consists of the management of balance sheet items to achieve the desired balance between risk
and return. In other words, this is about working capital management where we are dealing
with cash, receivables, inventory and payables. Financial strategy determines the means for
achieving stated objectives and management of financial resources is a short-term financial
strategy.
Advice the board of directors (BODs)
You might also be advising the BODs in setting the financial goals of the business and in its
financial policy development. The following factors are considered (many are brought forward
from F9):
Investment selection and capital resource allocation (investment decision)
You need to identify investment opportunities, evaluate them (maybe using net present value,
NPV) and decide on the optimum allocation of scarce funds (maybe using profitability index, PI)
available between investments.
Minimising the companys cost of capital (financing decision)
This relates to capital structure decision. Optimal financing mix is where weighted average cost
of capital (WACC) is minimised. You should be aware of Modigliani and Miller (MM)s view on
capital structure brought forward from F9. The feasibility of the mix of finance must also be
considered.
Distribution and retention policy (dividend decision)
This relates to dividend decision, how much to distribute and how much to retain as retained
earnings. A mature company may have a high stable dividend policy compared to young
company. Although pecking order theory suggests that companies generally prefer to use

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retained earnings first to finance investments, most adopted constant dividend payout policy.
Factors such as liquidity will be considered before distributing dividends.
Communicating financial policy and corporate goals to internal and external stakeholders
For financial strategy to be successful it needs to be communicated and supported by
stakeholders. Each stakeholder may have different goals and sometime conflict with each
other, this is where the influence of stakeholders will be considered, influence = power x
interest (Mendelows matrix).
Financial planning and control
Financial planning is a long-term profit planning aimed at generating greater return on assets,
growth in market share, and at solving foreseeable problem. This includes strategic cash flow
planning and strategic fund management (consider the dealings with unforeseen problems with
cash flows as well).
Financial control includes management control/tactical planning and operational control.
Management control is where managers assure that resources are well-utilised to achieve
organisations objectives. Operational control is the process of assuring that specific tasks are
carried out effectively and efficiently.
The management of risk
Investors that persuaded higher risk should be compensated with higher returns. Risk can be
managed by:
1. Hedging taking actions to make an outcome more certain.
2. Diversifying dont put all eggs in one basket; hold a portfolio of different investments. This
may reduce unsystematic risk/business risk.
3. Risk mitigation putting control procedures to avoid investments in projects whose risk is
above the shareholders required level.
2. Financial strategy formulation
Assessing corporate performance
Corporate performance can be measured using ratios, trends, economic value added (EVA)
and market value added (MVA).
Ratios
Ratio analysis is covered in many earlier papers, be sure you know the ratios. In addition to
calculating ratios, you should compare ratios in order to determine whether the business is
improving or declining. Other information such as revaluation of non-current assets, financial
obligations, events after the reporting period, contingencies and so on must also be considered

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together with ratios. Limitations of ratio analysis must also be noted. Review notes for earlier
paper regarding ratios if you have forgotten.
Trends
This involves looking at the difference of financial information from year to year. This allows
users to quickly spot significant changes.
EVA
TM represents trademark registered by Stern Steward and you need to write it whenever you
use the acronym. EVA is similar to the calculation of residual income with the exception of the
profit figure. EVA = NOPAT (cost of capital x capital employed) where NOPAT is net
operating profit after tax adjusted for non-cash expenses. Adjustments to be made to NOPAT
and also capital employed include:
1. We convert accrual accounting to cash accounting, eg. provisions are eliminated.
2. Spending on market building items such as research, staff training and advertising costs will
be capitalised.
3. Unusual items of profit or expenditure should be ignored.
4. Economic depreciation replaces accounting depreciation (sometime assume the same).
5. Interest on debt is added back to profit.
6. Impairment of goodwill is added back to profit and also goodwill.
If EVA is positive, organisation is providing a return greater than required by providers of
finance, ie. creating wealth.
Example: Division A of King Co has operating profits and assets as below:
$000
Gross profit
156
Less: non-cash expenses
(8)
Less: Impairment of goodwill
(5)
Less Interest @ 10%
(15)
Profit before tax
128
Tax @ 30%
(38)
Net profit
90
Total equity
350
Long-term debt
150
500
King Co has a target capital structure of 25% debt/75% equity. The cost of equity is 15%. The
capital employed at the start of the period amounted to $450000. The division had noncapitalised leases of $20000 throughout the period. Goodwill previously written off against

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reserves in acquisitions in previous years amounted to $40000. Calculate EVA for Division A
and comment on your results.
Solution: Remember that the adjustments you did in NOPAT can affect capital employed.
$000
Net profit
90
Add back:
Non-cash expenses
8
Impairment of goodwill
5
Interest (net of 30% tax) (15 x 0.7)
10.5
NOPAT
113.5
Capital employed at start of period
450
Non-capitalised leases
20
Impaired goodwill
40
Capital employed at end of period
510
WACC = (75 x 15% + 25 x 10% x 0.7)/100 = 13%
EVA = 113.5 510 x 13% = 47.2
EVA is positive, the business is creating value as its return is greater than groups WACC.
Advantages of using EVA include:
1. Keeps the focus on shareholder value an increase in EVA should lead to an increase in
company value and therefore increase in shareholder value.
2. Motivate managers to invest in projects where returns exceed cost of capital.
3. Easy to understand as the calculation starts with the familiar operating profit and deducts a
capital charge.
4. Results are consistent with NPV.
Disadvantages of using EVA include:
1. Adjustments to profits and capital can become cumbersome, especially if performed every
year.
2. Estimating WACC can be difficult.
3. EVA is an absolute measure, so it cannot be used to compare companies of different sizes.
4. Short-term focus EVA focuses only on current accounting period, whilst ideally
performance measures should have a longer-term focus.
MVA
MVA = market value of equity and debt book value of equity and debt. It is not a performance
measure but a wealth measure. The higher the MVA, the more wealth the company has
generated for its shareholders. It is also the discounted sum of EVA.

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Optimum capital structure


You need to be able to recommend the optimum capital mix and structure within a specified
business context and capital asset structure. The decisions on how to finance the acquisition of
assets are based on the cost of the various sources of finance. Revise business finance and cost
of capital area of F9 before continue as only some brief ideas will be given here.
The main sources of finance for companies are:
1. Debt.
2. Preference shares
3. Retained earnings.
4. Proceeds from the issue of new ordinary shares.
5. Proceeds from a flotation (going public) of a company.
Debt vs equity
(i) Cost the cost of equity is higher than the cost of debt. This is because an equity investor
takes a greater risk. If the company goes into liquidation, an equity investor is the last person to
be paid any money. Therefore, an equity investor expects a higher return to reflect the risk he is
taking. Debt finance is cheaper as interest payments are tax deductible but dividends (for
equity finance) are not.
(ii) Control of the business equity is normally invested into the business through the issue of
ordinary shares. Shareholders will share the ownership of the business and carry voting rights.
Hence, a shareholder can participate in business decisions. Debt finance avoids the dilution of
control (company will still have full control).
(iii) A significant difference between debt and equity is that debt has to be repaid, whereas
equity does not.
(v) Effect on gearing The more debt finance is raised, the higher is the gearing level. The
higher equity finance is raised, the lesser is the gearing level. Gearing = debt/equity or
debt/(equity + debt). Higher gearing level increases financial risk due to more interest
payments.
Preference shares
Preference shares have priority over ordinary shareholders in dividend payments and capital
repayment. They carry a fixed rate of dividends and they are an example of prior charge capital.
There are three types of preference shares:
1. Cumulative preference shares any arrears of dividend are carried forward.
2. Participating preference shares additional entitlement to dividend over and above their
specified rate.
3. Convertible preference shares shares that can be converted into ordinary shares.

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Cost of preference shares calculation is similar to cost of bonds with exception that dividend is
normally not allowable for tax.
Retained earnings
Although financing through retained earnings seems to involve no cost, there is actually an
opportunity cost for shareholders because if shareholders receive dividends (rather than
company retains to finance), shareholders can use the cash to invest elsewhere to earn a
return. Cost of retained earnings can be calculated through:
1. Theoretical Valuation Models such as capital asset pricing model (CAPM) or Arbitrage Pricing
Theory (APT).
2. Bond yield-plus-premium approach (used when analysts do not have confidence in CAPM or
APT approach).
3. Market implied estimates.

CAPM
CAPM is covered in F9. CAPM is the risk-free return adds a risk premium for systematic risk. The
formula is given in exam as
=
where
is the cost of equity,
is the risk-free rate of return, is the equity beta of the individual security (eg. shares),
is the rate of return on a market portfolio. Equity or market risk premium is therefore
represented by
and the risk premium is represented by
.

APT
This theory assumes that the return on each security is based on a number of independent
factors such as interest rates and industrial production. The cost of equity formula is shown as
where
is the risk
premium on factor A,
is the risk premium on factor B and so on. The formula is
similar to CAPM formula, with the exception that it takes into account more factors. With APT,
CAPMs problem of identifying the market portfolio (to determine market rate of return) is
avoided. However, there is a problem of identifying the macroeconomic factors and their
sensitivities.

Bond-yield-plus-premium approach
The idea is that return on equity is higher than the yield on bonds. This approach simply
involves adding a judgemental risk premium to the bond yields to determine cost of retained
earnings.

Market implied method


This is based on particular assumption on the growth rate of earnings or dividends of a
company. The dividend growth model approach can be used to derive the cost of retained

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earnings. The formula is


annual growth rate,

where

is the current dividend and

is the cost of retained earnings, g is


is the market value of shares ex-div.

Issue of new ordinary shares


Certain factors such as administrative costs, tax and effect on control should be considered
before any new share issue. All companies can use rights issue (issue to existing shareholders at
discount).
Methods for obtaining a listing
Unquoted companies can obtain listing through:
1. Direct offer by subscription to general public this type of issue is very risky because all
shares may not be taken up. These issues are sometimes known as offers by prospectus.
2. Offer for sale invitation to apply for shares in a company based on information contained in
a prospectus. An issuing house (usually merchant bank) will acquire a large block of shares of a
company and offer them for sale in the public either at fixed price or on tender basis. When
companies go public for the first time, a large issue will probably take the form of an offer for
sale.
3. Placing private invitation of a small number of investors to subscribe the shares.
Company needs to take into account the flotation cost involved with the new share. Cost of
equity can take it into account by adjusting the dividend growth model formula to
.
Conclusion
Business should consider carefully the feasibility (eg. maturity of current debt, availability of
stock market funds), suitability (minimisation of cost of capital, financial position, cost and
flexibility) and acceptability (risk attitudes, dilution of control) of the capital structure.
Distribution and retention policy (dividend policy)
A number of issues arise when we look at dividend policy, for example should we pay dividend
(as retained earnings can be used to finance investment), how should we pay dividend (in cash,
in the form of shares/scrip dividend or share buyback), signaling effect of changes in dividend
policy and our dividend capacity.

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Dividend capacity
This is the ability at any given time of a company to pay dividends to its shareholders. Legally,
the companys dividend capacity is determined by the amount of accumulated distributable
profits (retained earnings). More practically, dividend capacity can be calculated as the Free
Cash Flow to Equity (FCFE). FCFE is covered later.
Signaling effect
When company reduces its dividends, investors may read it as bad news. However, according
to MM (who assumed perfect capital market exists), dividend policy is irrelevant.
Residual theory
This suggests that company should invest any project with positive NPV and dividends should
be paid only when these investment opportunities are exhausted.
In practice, company tends to adopt a stable dividend policy or ratchet pattern (paying out a
table but rising dividend per share).
Rationale for risk management
Theoretical rationale
Companies should be looking to limit uncertainty and to manage speculative risks and
opportunities in order to maximise positive outcomes and hence shareholder value.
Practical rationale
Companies must be seen to be managing risk to maintain confidence of the shareholders in
their business operations.
Firms exposure to different types of risks
Most firms are exposed to business and financial risk. Assessing business and financial risk is a
skill learnt in F9, eg. calculating operational gearing and financial gearing.
Business risk
Business risk is a mixture of systematic (market risk) and unsystematic risk. It refers to the
possibility of changes in level of profit before interest as a result of changes in turnover or
operating costs. Business risk relates to the nature of business operations. Business risk can be
assessed using operational gearing.

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Financial risk
Financial risk is the systematic risk borne by the equity shareholders. It refers to the possibility
of changes in level of distributable earnings as a result of the need to make interest payments
on debt finance or prior charge capital. The ultimate financial risk is that the organisation will
be unable to continue to function as a going concern. Financial risk can be assessed using
financial gearing.
Other specific risks
1. Operational risk the risk arising from the operation of an organisations business functions.
For example, human error, fraud, systems failures.
2. Reputational risk the risk related to the way in which a business is viewed by others
(perceived value of the business).
3. Political risk the risk that political action will affect the position and value of a company.
Government stability is one key factor to be considered in assessing political risk.
4. Economic risk arises from changes in economic policy in the host country that affect the
macroeconomic environment in which the multinational company operates. For example,
changes in the monetary policy will affect aggregate demand.
5. Regulatory risk the risk that arises from the change in the legal and regulatory environment
which determines the operation of a company. For example, a new law that makes the firing of
workers more difficult may increase cost of production.
6. Fiscal risk the risk that changes in government fiscal policy will affect the present value of
investment projects and thus the value of the company. For example, an increase in the
corporate tax rate will affect the profitability of the company.
Framework for risk management
A risk management framework needs to cover:
1. Risk awareness. A formal risk assessment is needed for all estimates that are material,
looking at the potential risks that could affect the project and the probability they may occur.
2. Risk monitoring. A monitoring process is needed to alert management should the risks occur.
3. Strategies for dealing with risk. These include accepting the risk, mitigating the risk, hedging
the risk and diversification.
Risk mitigation
Risk mitigation is the process of minimising the probability of a risks occurrence or the impact
of the risk should it occur. A comprehensive set of controls help mitigate risks by working to
prevent, or identify and deal with risks before they become problematic. Management should
implement controls for the more material risks provided that the costs of doing so are less than

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the potential loss. For non-routine events, it is more common to have a strategy for dealing
with risks which actually arise.
Hedging the risk/exposure
This means taking measures to eliminate or reduce a risk. Hedging is often in the form of the
purchase or sale of a derivative security (financial hedging). Operational hedging involves using
non-financial instruments and the main way is through real options (covered later).
A perfect hedge will eliminate all risk, but also all future gains.
Diversification
This is chosen where reliance on a single customer, supplier or location has been identified as a
potential risk, and involves having a portfolio of clients, suppliers, operating in different
locations etc. The impact of one outcome is reduced by the impact of the others. This can only
reduce unsystematic risk (diversifiable risk).
Portfolio theory can be applied in diversification. The theory is concerned with the construction
of investment portfolios with the objective of reducing unsystematic risk. In order to diversify
effectively, investors should ensure that, in the event of a particular incident that affects the
market, some of the shares in the portfolio should move in the direction of the market (positive
correlation) and some should move in the opposite direction (negative correlation).
An important element of portfolio theory is that expected return of the investment portfolio is
the weighted average of the returns on the individual investments in the portfolio. However,
the risk of the portfolio (measured by standard deviation) should be less than weighted average
of the risks of the individual investments.
The formula of two-asset portfolio is given in exam as
where is the standard deviation of returns in the portfolio, is the proportion of portfolio
funds invested in share a, is the standard deviation of share a,
is the correlation coefficient
of returns in shares a and b. Correlation coefficient lies between -1 (perfect negative
correlation) and +1 (perfect positive correlation).
Example: Fire Co is planning to undertake two investment projects with the following risk and
return information.
Investment a
Investment b
Risk
8%
12%
Return
15%
25%
70% of the total portfolio funds will be invested in a and the remainder in b. The correlation
coefficient between a and b has been estimated as 0.25.

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Calculate the return and risk of the portfolio and comment on the risk-reducing effects of
diversification.
Solution: Return on portfolio = weighted average return on individual investments = 0.7 x 15 +
0.3 x 25 = 18%.
Risk of the portfolio = standard deviation of return on portfolio =
= 7.38%.
Weighted average risk on individual investments = 0.7 x 8 + 0.3 x 12 = 9.2%. Risk of the portfolio
is lower than this, implying that reduction in risk has been achieved and this is due to the
correlation coefficient of two investments being far from +1. The nearer the correlation
coefficient toward -1, the better the effect of reduction in risk as this will mean that returns of
the two shares move in opposite direction.
Capital investment monitoring and risk management system
As capital investment involves large amount of resources, the implementation of it must be
monitored to ensure that risks are being taken into account and controls are set to deal with
them. Monitoring process is closely linked to periodic risk assessment of the project. The
monitoring functions of the implementation stage seek to ensure that:
1. Project expenses are within the budgeted limits.
2. Budgeted revenues are achieved.
3. Completion time schedule is adhered to.
4. Risk factors identified during the appraisal stage remain valid.
3. Conflicting stakeholder interests
As it is common that interests of various stakeholders often conflict, company needs to ensure
that the problems are resolved before undertaking any financial decisions.
Potential sources of stakeholder conflict
In assessing the potential sources of stakeholder conflict, relevant underpinning theories should
be taken into account:
Separation of Ownership and Control
Equity shareholders are the owners of the company, but the company is managed by its board
of directors (BOD). The central source of shareholder conflict is the difference between the
interests of managers and those of owners. A good example is short-termism. This means that
managers try to achieve short-term rewards but their actions (eg. manipulate profits, cut costs)
can affect the long-term performance of the company.

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Transaction cost economics and comparative governance structure


Transaction cost economics theory suggests that the governance structure of a company is
determined by transaction costs. Transaction costs include search and information costs,
bargaining costs and policing and enforcement costs. To minimise transaction costs, managers
may try to do things in-house as much as possible. Managers will be acting with bounded
rationality and opportunistically to minimise such costs. Stakeholders may not like this, for
example because of losing business.
Agency theory
This theory concerns the relationship between principal (shareholder) and agent
(management). Agency problem arises when agents do not act in the best interests of their
principals.
Strategies for the resolution of stakeholder conflict
To resolve agency problem, goal congruence should be achieved, ie. organisationals goals =
managers goals. Goal congruence may be achieved by:
1. Giving performance-based rewards.
2. Rewarding managers with shares.
3. Giving share options this may encourage managers to focus on long-term performance as
share options will be valuable for them if share price goes up.
Alternative approaches include:
1. Adopting sound corporate governance.
2. Providing more information in annual report. This reduces information asymmetry and so
there will be less doubt on the company.
Corporate governance
You should be familiar with corporate governance from P1. Make sure you still remember some
key ideas.
Cadbury Report defines corporate governance as the system by which companies are directed
and controlled. For your information, Combined Code was renamed as UK Corporate
Governance Code in 2010. You should be able to compare UK and US approach (Sarbones-Oxley
Act 2002), ie. principle-based vs rule-based. We can also compare internationally, looking at
Germany, Japan and South Africa.
In Germany, two-tier board is common, with one supervisory board and one executive board.
Workers representatives and shareholders representatives are in supervisory board, but this

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board has no executive function. Executive board will be composed of managers, responsible
for the running of business.
In Japan, shareholders dont rule. Long-term interests of the company are stressed. There are
three boards: policy board (concerned with long-term strategic issues), functional board (made
up of main senior executives with a functional role) and monocratic board (few responsibilities,
have a more symbolic role). Stock market also imposes less regulation.
In South Africa, there is a King report. The report advocates an integrated approach to
corporate governance in the interest of a wide range of stakeholders, embracing the social,
environmental and economic activities of a companys activities.
4. Ethical issues in financial management
Ethical dimension in business
Business ethics deal with the behaviour of firms and the norms they should follow so that their
behaviour is judged as ethical. However, there is no universally acceptable framework of
business ethics principles that all companies should follow. Code of corporate governance
would ensure a minimum degree of ethical commitment by firms. Although key objective of
financial management is to maximise shareholders wealth, ethical consideration is important
and forms part of non-financial objectives. Stakeholders should be taken into account in any
financial decisions.
Interconnectedness of ethics between functional areas of the firm
Business ethics should govern the conduct of corporate policy in all functional areas of a
company such as:
1. Human resources management prevent conflict between financial objectives and the rights
of the employees. This can arise due to low wages and discrimination.
2. Marketing marketing is a way of communicating with customers and this communication
should be truthful and sensitive to social and cultural impact of society. It should not, for
example, target vulnerable groups, create dissatisfaction etc.
3. Market behaviour if company dominates the market, it should not use this dominant
position to exploit suppliers or customers. It should exercise restraint in their pricing policies.
4. Product development product should be safe to use.
Ethical financial policy for financial management
Ethical policy can be implemented through measures that ensure that the company takes into
account the concerns of its stakeholders. Ethical framework should be developed first where
company should develop an ethical corporate philosophy.

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Ethical framework
Ethical framework should be developed as part of the overall corporate social responsibility
(CSR) which according to Carroll includes PEEL:
1. Philanthropic responsibility include all actions that company needs to take in order to
improve the life of its employees, to contribute to the local community and to make a
difference to society as a whole.
2. Economic responsibility company is responsible to satisfy the required return of
shareholders. As discussed before, financial objective may conflict with stakeholders
objectives, strategies have to be established to deal with them.
3. Ethical responsibility ethical responsibilities arise in situations where there is no explicit
legal or regulatory provision and the company needs to exercise judgement as to what is right
and fair. There are many elements of business ethics management, including incorporating
ethics in mission statement, developing codes of ethics which are followed, providing ethics
education and so on.
4. Legal responsibility company is responsible to comply with all the legal and regulatory
provisions, and to ensure that employees are aware of this policy.
5. Impact of environmental issues on corporate objectives and on governance
Sustainability and environmental risk
Sustainability refers to the concept of balancing growth with environmental, social and
economic concerns. This is linked to triple bottom line approach which is discussed later.
Environmental risk is an unrealised loss or liability arising from the effects of an organisation
from the natural environment or the actions of that organisation upon the natural
environment. Environmental impacts on business may be direct (eg. impact on demand,
changes affecting costs or resource availability, effect on power balances between competitors
in a market) or indirect (eg. legislative change, pressure from customers or staff as a
consequence of concern over environmental problems).
Recently, many companies are now producing environment report for external stakeholders,
covering:
1. What the business does and how it impacts on the environment.
2. An environmental objective.
3. Companys approach to achieving and monitoring these objectives.
4. An assessment of its success towards achieving the objectives.
5. An independent verification of claims made.

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Also, companies are acknowledging the advantages of having an environmental policy. These
include reduction/management of risk to the business, motivating staff, saving more costs and
enhancement of corporate reputation.
Carbon-trading economy and emissions
Carbon trading allows companies which emit less than their allowed amount of emission to sell
the right to emit
to another company. Placing a cost on carbon emissions encourages
organisations to reduce them eg. through renewable energy, improved energy efficiency or
carbon offsets.
Emissions trading is becoming a key part of strategy both within European Union (EU) and
globally to reduce the emission of greenhouse gases. EU governments are addressing the
challenge of reducing carbon emissions through a combination of increased regulation and
market mechanisms.
Countries under Kyoto Protocol are allocated quotas for maximum pollution (to reduce
greenhouse gas emissions to stable level in order to prevent climate changes.
The role of environment agency
The role of environment agency is to protect or enhance environment, so as to promote the
objective of achieving sustainable development. The responsibilities of environment agency
include:
1. Flood risk management create/maintain flood defences.
2. Waste regulation grant licenses for handling special waste (eg. ratioactive).
3. Pollution control regulate discharges to aquatic environment, air and land.
4. Air quality management regulate the release of air pollutants into atmosphere.
5. Water quality management maintain and improve the quality of surface and ground water.
6. Water resource management manage use and conservation of water through water
abstraction licenses.
7. Fisheries maintain and improve quality of fisheries.
Environmental audits
Environmental audit is an audit that seeks to assess the environmental impact of a company's
policies. Auditor will check whether the company's environmental policy:
1. Satisfies key stakeholder criteria.
2. Meets legal requirements.
3. Comply with standards or local regulations.

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Triple bottom line approach


A triple bottom line (TBL) report provides a quantitative summary of a corporation performance
in terms of its economic or financial impact, its impact on environmental quality and its impact
on social performance. The principle of TBL reporting is that a corporation true performance
must be measured in terms of a balance between 3P: economic (profits), environmental
(planet) and social (people) factors; with no one factor growing at the expense of the others.
A corporation sustainable development is about how these three factors can grow and be
combined so that a corporation is building a reputation as being a good citizen. The contention
is that a corporation that accommodates the pressures of all the three factors will enhance
shareholder value by addressing the needs of its stakeholders.
Whereas TBL reporting is a quantitative summary of the corporation performance in the three
factors over a previous time period, say a year, sustainable development tends to be forward
looking and qualitative. Therefore, TBL provides the measurement tool to assess a corporation
performance against its stated aims.
Each factor can be assessed or measured using a number of proxies. The economic impact can
be measured by considering proxies such as operating profits, dependence on imports and the
extent to which the local economy is supported by purchasing locally produced goods and
services. Social impact can be measured by considering proxies such as working conditions, fair
pay, using appropriate labour force (not child labour), ethical investments, and maintenance of
appropriate food standards. Environmental impact can be measured by considering proxies
such as ecological footprint, emissions to air, water and soil, use of energy and water,
investments in renewable resources.

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Economic environment for multinationals


1. Management of international trade and finance
Multinational enterprises undertake foreign direct investment (FDI) for reasons including
obtaining cost and revenue advantages, tax considerations (Tax havens are countries with
lenient tax rules or relatively low tax rates) and process specialisation. There are many strategic
reasons for engaging in foreign investment which include seeking new markets for goods, new
sources of raw materials, production efficiency, expertise and political safety. Types of overseas
operations include joint ventures, branches, subsidiary, management contracts (sell
management skills), exporting, licensing and franchising.
Free trade and the management of barriers to trade
International trade takes place due to the law of comparative advantage. Two countries will
trade with each other if the opportunity cost of producing one unit of a product is the lowest
for both countries. The law of comparative advantage operates when there is a difference in
the relative prices of products in the two countries.
Free trade means international trade without restrictions on imports or exports such as tariffs
or customs duties (taxes on imported goods), import quotas (restrictions on quantity of product
allowed to trade), embargos (total ban, ie. zero quota) and so on. All these restrictions are
protectionist measures which act as barriers to trade.
Free trade can lead to greater competition and efficiency, and achieve better economic growth
worldwide. However, there are arguments in favour of protectionism:
1. Protection against cheap imports.
2. Protection against dumping other country may dump surplus production into the country
at uneconomically low price and this will cause a reduction in domestic output and employment
in the long-term.
3. Protection through retaliation any country that does not take protectionist measures when
other countries are doing so is likely to find that it suffers all of the disadvantages and none of
the advantages of protection.
4. Protection for infant industries/developing nations.
Major trade agreements and common markets
Common markets impose common rules of trading for all the member countries, thereby
promoting free and fair trade. There are a number of common markets:
1. Free trade areas eg. North American Free Trade Agreement (NAFTA), European Free Trade
Area (EFTA).
2. Customs unions erect common external tariffs, eg. Mercosur.

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3. Economic communities promoting economic integration and development, eg. Economic


Community of West African States (ECOWAS).
4. Economic and monetary unions free trade with common currency, eg. Eurozone.
5. European Union and single European market political and economic community.
The differences between these common markets include the wealth of member states,
infrastructural set-up, tax structure and skilled labour.
Objectives of World Trade Organisation (WTO)
WTO is a global international organisation dealing with the rules of trade between nations.
WTO replaced General Agreement on Tariffs and Trade (GATT). The objectives of WTO include:
1. Supervise and liberalise international trade.
2. Negotiate and implement new trade agreements eg. Trade Related Aspects of Intellectual
Property Rights (TRIPS) agreement (asked in June 2009 question 4(iv), try to understand the
answer) which introduced global minimum standards for protecting and enforcing nearly all
forms of intellectual property rights (IPR), including those for patents.
3. Monitor adherence to all WTO agreements.
4. Encourage free trade and reduce barriers to trade.
5. Resolve disputes between trading nations.
WTO encourages free trade by applying the most favoured nation principle where one country
(which is a member of GATT) that offers a reduction in tariffs to another country must offer the
same reduction to all other member countries of GATT.
Role of international financial institutions
We will look into those identified in the study guide one by one.
International Monetary Fund (IMF)
IMF was set up partly with the role of providing finance for any countries with temporary
balance of payments deficits. Other roles include:
1. Help to ensure stability in exchange rates.
2. Develop system for international payments.
3. Promote international financial cooperation.
4. Manage growth of liquidity and financial system.
5. Carry out appraisal of economic condition of member nations.
6. Assist in fiscal, monetary and exchange rate policies.
7. Impose and monitor strict economic policies.

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Bank of International Settlements (BIS)


The main roles of BIS are to promote cooperation between central banks and to provide
facilities for international cooperation. They do monitor international banking system and assist
countries in financial difficulties. Furthermore, they supervise member central banks.
World Bank (WB) or International Bank for Reconstruction and Development (IBRD)
WB is a multinational institution which provides long-term finance for the reconstruction of
member nations (lend money for capital projects). Therefore, they help countries reform and
develop under-developed sectors. International Development Association (IDA) is a subsidiary
of WB which provides loan at low cost with easy repayments terms to less developed countries.
Principal Central Banks
Central bank is the lender of last resort, which means that it is responsible for providing its
economy with funds when commercial banks cannot cover a supply shortage. In other words,
the central bank prevents the country's banking system from failing. Principal central banks
include:
1. The Fed Federal Reserve System, central bank of United States.
2. Bank of England central bank of United Kingdom.
3. European Central Bank central bank for European nations.
4. Bank of Japan central bank of Japan.
Role of international financial markets
International financial markets include international capital markets and international money
markets. Study guide requires us to assess the role of the international financial markets with
respect to the management of global debt, the financial development of the emerging
economies and the maintenance of global financial stability.
Management of global debt
This is to resolve the global debt crisis and a number of approaches can be used:
1. Some of the debt may be converted into equity, giving foreign companies a stake in local
industries and reducing the level of interest payments.
2. Writing off the debt.
3. Debt may be rescheduled in order to allow the government a longer time to repay the loan.
4. Giving short-term loan to solve temporary crisis.
Financial development of the emerging economies
Emerging economies are those on the path of development and whose trade and industry are
slowly flourishing. Private capital flows are important for emerging economies, and the transfer

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of flows has increased significantly as a result of the development in international capital


markets. The capital flows to emerging markets take three forms:
1. Foreign direct investment (FDI) by multinational companies.
2. Borrowing from international banks. With this, it is possible to obtain better terms and in
currencies which may be more appropriate in term of the overall risk exposure of the company.
3. Portfolio investment in international bond and equity market.
Maintenance of global financial stability
Financial crises are normally associated with weak economic fundamentals, low growth in gross
domestic product (GDP), high short-term debt, balance of payments deficits and high real
interest rates. Development of IFM has resulted in more liquidity and free movement of capital
between various countries. This helps in maintaining a global financial stability.
2. Strategic business and financial planning for multinationals
Development of financial planning framework for a multinational
Financial planning framework will include ways of raising capital and risks related to overseas
operations and the repatriation of profits. There are a number of issues to consider in
developing the financial planning framework and we will consider each of them one by one.
Compliance with national governance requirements
This includes compliance with local laws and regulations, listing requirements and corporate
governance requirements. For example, the key listing requirements of the London Stock
Exchange cover the areas of track record requirements, market capitalisation and publicly
traded shares, future prospects, audited financial information, corporate governance
requirements, acceptable jurisdiction and accounting standards, and other considerations
regarding disclosure rules.
Mobility of capital
Exchange controls (barrier to repatriation of profit) block the flow of foreign exchange into and
out of a country, usually to defend the local currency or to protect reserves of foreign
currencies. These controls resulted in blocked funds. Remittance of profit may also be
restricted. There are a number of ways to deal with blocked funds from oversea subsidiary such
as transfer pricing (setting high transfer price for goods sold to the oversea subsidiary), charging
royalty, make loan with high interest rate and management charges.
Risk exposures in different national markets
1. Economic risk this arises from the differences in economic policies. It can be reduced if a
company operates in several different economies (less reliance on any one currency).

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2. Political risk the risk that political action will affect the position and value of a company.
This arises mainly from the different government policies employed.
3. Litigation risk the possibility that legal action will be taken because of the companies
actions, inactions, products, services or other events. Litigation risks can be reduced by keeping
abreast of changes, acting as a good corporate citizen and lobbying.
4. Cultural risk this arises from the cultural differences in different national markets. Cultural
risks affect the products and services produced and the way organisations are managed and
staffed. Businesses should take cultural issues into account when deciding where to sell abroad,
and how much to centralise activities.
Agency issues
Agency issues can arise in the central coordination of overseas operations. Agency problems
arise from different agency relationships. Agency relationships exist between:
1. Management of the parent multinational corporations (principals) and managers of the
subsidiaries (agents).
2. Managers of various subsidiaries.
3. Managers and shareholders of a subsidiary.
Managers (agents) may not always act in the best interest of the principals. This is especially
when managers of oversea subsidiaries are normally given local financial autonomy. There is a
need of balancing of local financial autonomy with effective central control.
One way of reducing agency costs is to separate the ratification and monitoring of managerial
decisions from their initiation and implementation. BODs should carry out the role of ratifying
and monitoring the managerial decisions with the help of their non-executive outside
members. Managerial compensation packages can also be used to reduce agency costs by
aligning the interests of top executives with shareholders and the interests of subsidiary
managers to those of head office.

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Advanced investment appraisal


1. Discounted cash flow techniques and the use of free cash flows
You should be familiar with investment appraisal in F9. Now it is time to extend the knowledge.
Net present value (NPV)
NPV of a project is the sum of the discounted cash flows less the initial investment. NPV can be
used to evaluate the potential value added to a company arising from a specified capital
investment project or portfolio. Only relevant cash flows are taken into account when
calculating NPV. Positive NPV means that the project will add value to the company. Now, we
shall discuss a number of concepts.
Inflation and specific price variation
Fisher equation is relevant and is given in exam: (1 + i) = (1 + r)(1 + h) where i = nominal
(money) rate, r = real rate and h = inflation rate. You should normally use nominal rate unless
the cash flows are expressed in value at time 0, then use real rate. However, this only takes into
account the general inflation level. If there are specific price variations, for example variable
costs increase by 5% per annum, this must be reflected separately.
Taxation including capital allowances and tax exhaustion
Tax paid or saved is a relevant cash flow. Take note that in capital allowances, the cash flows
are not the capital allowance itself, but it is the tax savings on capital allowance (ie. tax rate x
capital allowance). Also note that when taxation is included in the cash flows, a post-tax
required rate of return should be used in NPV computation.
If capital allowances in a particular year equal or exceed before tax earnings, the company will
pay no tax (tax exhaustion situation). In most tax systems, unused capital allowances can be
carried forward indefinitely, so that the capital allowance that is set off against the tax liability
in any one year includes not only the writing down allowance for the particular year but also
any unused allowances from previous years.
Example: Suppose that a company has invested $10m in a plant. The first year allowance is
60%, whereas remaining amount is written down over a period of four years. Tax rate is 30%.
Earnings before tax over a five year period are as follows:
Year 1
Year 2
Year 3
Year 4
Year 5
$m
$m
$m
$m
$m
3
2.5
3.5
3.8
4.2
Calculate the tax liability every year.

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Solution:
Year 1
$m
3
6

Year 2
$m
2.5

Earnings before tax


First year allowance
Writing down allowance
1
Unused allowance b/f
3
Total allowance
6
4
Tax liability
0
0
In year 3, total allowance is lower than earnings before
which are taxable at 30%.

Year 3
$m
3.5
1
1.5
2.5
0.3
tax, so there

Year 4
$m
3.8

Year 5
$m
4.2

1
1
0
0
1
1
0.84
0.96
will be positive earnings

Multi-period capital rationing


You learnt single-period capital rationing in F9 where you use profitability index (NPV per
investment cost) to rank divisible projects and use trial and error to decide the combination of
non-divisible projects. Multi-period capital rationing arises when capital rationing is present
across multiple periods. In P4, the projects are divisible in the case of multi-period capital
rationing. Linear programming can be used to identify which combination maximises NPV
within the annual investment constraints. However, you dont need to solve everything like you
did in F5, just know how to formulate the linear programming problem and interpret the
output. The steps you need are as follows:
1. Define the variables, eg. X1 is the investment in project 1, X2 is the investment in project 2.
2. Define objective function, eg. maximise 5000X1 + 2000X2 + 3000X3. The 5000, 2000 and
3000 are the NPV of each project.
3. List the annual investment constraints (include non-negativity constraint if applicable), eg.
3000X1 + 1000X2 + 1000X3 15000 (year 1 constraint). There will be investment constraints in
the following years as this is a multi-period capital rationing situation. 3000, 1000 and 1000
represent the investment cost of each project.
4. Interpret the output. The output will be given by examiner as this is generated from
computer. Output should look like X1 = 1, X2 = 0, X3 = 1. This means that project 2 should not
be selected.
Risk and uncertainty
Before deciding whether or not to undertake a project, financial managers will want to assess
the projects risk (which can be predicted), and uncertainty (which is unpredictable). Probability
analysis and sensitivity analysis are stated in the study guide and you have learnt these in F9.
In probability analysis, you will calculate the expected values (EV) and the lower the EV, the
higher the risk. This is used to incorporate risk into project appraisal.

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In sensitivity analysis, you will look for variables which are sensitive and attention needs to be
paid to such variables. The sensitivity of the variable is calculated as NPV/PV of the variable. To
calculate sensitivity of the cost of capital (discount rate), internal rate of return (IRR) is used to
compare against cost of capital. This is used to incorporate uncertainty into project appraisal.
Monte Carlo simulation
You will not be expected to undertake simulations in an examination context but you need to
demonstrate an understanding of certain things. Simulation is a quantitative procedure used to
describe a process. Monte Carlo simulation is a technique of spreadsheet simulation.
This method adopts a particular probability distribution for the uncertain (random) variables
that affect the NPV and then using simulations to generate values of the random variables.
To deal with uncertainty, the Monte Carlo method assumes that the uncertain parameters
(such as the growth rate or the cost of capital) or variables (such as the free cash flow) follow a
specific probability distribution. Random number generator (from EXCEL) is used to generate
random numbers for each variable. The basic idea is to generate through simulation thousands
of values for the parameters or variables of interest and use those variables to derive the NPV
for each possible simulated outcome. From the resulting values we can derive the distribution
of the NPV.
Statistical measures such as standard deviation and mean can be useful in assessing the
likelihood of project success.
Project Value at Risk (VaR)
Project VaR is the potential loss of a project with a given probability. VaR is the minimum
amount by which the value of an investment or portfolio will fall over a given period of time at
a given level of probability. Alternatively it is defined as the maximum amount that it may lose
at a given level of confidence. For example, VaR is $100000 at 5% probability (5% chance that
loss will exceed $100000), or $100000 at 95% confidence level (95% chance that loss will not
exceed $100000). Most common probability levels are 1, 5 and 10 percent.
VaR is equal to kN where k is determined by the probability level, is the standard deviation
and N is the periods over which we want to calculate the VaR. If probability level is 5% (ie.
confidence level of 95%), look at standard normal distributable table, find 0.45 (0.95 0.5), it is
near to 1.65 (1.645 to be exact). If probability level is 1% (ie. confidence level of 99%), find 0.49
(0.99 0.5), it is near to 2.33. 1.645 is k for 5% probability and 2.33 is k for 1% probability.
Example: Annual cash flows from a project are expected to follow the normal distribution with
a mean of $50000 and standard deviation of $10000. The project has a 10 year life. It is
determined that at 5% probability level, k is 1.645. What is the project VaR?

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Solution: Project VaR that takes into account the entire project life is 1.645 x $10000 x 10 =
$52019, that is the maximum amount by which the value of the project will fall at a confidence
level of 95%.
Projects margin of safety
A projects margin of safety can be indicated by internal rate of return (IRR) or modified internal
rate of return (MIRR). You learnt IRR in F9 that it is the discount rate at which NPV is equal to
zero and accept the project if IRR is greater than the cost of capital (or target rate of return).
IRR = A + [(a/a b) x (B A)] Where A is the lower discount rate and B is the higher rate, a is the
NPV at the lower rate and b is the NPV at the higher rate. However, IRR has some problems:
1. Multiple IRR this will occur when the cash flows are unconventional (eg. investment in time
0, cash inflows in time 1, investment in time 2).
2. Mutually exclusive projects these are a set of projects which only one can be accepted.
Decision on IRR and decision on NPV may conflict in this case, for example, IRR is higher for
project A but NPV is higher for project B. In this case, we should base our decision on NPV.
3. Reinvestment rate IRR assumes that cash flows can be reinvested at IRR rate over the life of
the project. NPV assumes that cash flows can be reinvested at cost of capital rate over the life
of the project. The better reinvestment rate assumption will be the cost of capital rate.
MIRR attempts to solve IRRs problems. MIRR is the IRR that would result if it was not assumed
that project proceeds were reinvested at the IRR. MIRR uses cost of capital as the reinvestment
rate. MIRR = (PV of return phase/PV of investment phase)^(1/n) x (1 + reinvestment rate) 1.
This formula is given in exam. MIRR will be lower than IRR and this reflects better measure.
MIRR also solves the problem of multiple IRR. MIRR will give the same indication as NPV.
Example: The calculations of PV for a project are done and as follows, cost of capital is 10%,
calculate IRR and MIRR.
Year Cash flow Discount factor@10% PV
Discount factor@25% PV
0
(24500)
1.000
(24500)
1.000
(24500)
1
15000
0.909
13635
0.800
12000
2
15000
0.826
12390
0.640
9600
3
3000
0.751
2253
0.512
1536
4
3000
0.683
2049
0.410
1230
5827
(134)
Solution: IRR = 10% + [(5827/5827 + 134) x (25% - 10%)] = 24.7%.
PV of return phase = 13635 + 12390 + 2253 + 2049 = $30327.
PV of investment phase = $24500.
MIRR = (30327/24500)^(1/4) x (1 + 0.1) 1 = 16%. Both show that project is acceptable.

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Alternatively, MIRR = (Terminal value of return phase/PV of investment phase)^n 1. You need
to calculate the values of the inflows if they were immediately reinvested at 10%. For example
the $15000 received at the end of year 1 could be reinvested for three years at 10% per annum
(multiply by 1.1 x 1.1 x 1.1 = 1.331). Same example will be used to illustrate.
Solution:
Year Cash flows
1
15000
2
15000
3
3000
4
3000

Interest rate multiplier


1.1^3 = 1.331
1.1^2 = 1.21
1.1^1 = 1.1
1.1^0 = 1.0

Amount when reinvested


19965
18150
3300
3000
44415

MIRR = (44415/24500)^4 1 = 16%.


The problem of MIRR is that it may lead an investor to reject a project which has a lower rate of
return but, because of its size, generates a larger increase in wealth. A high-return project with
a short life may be preferred over a lower-return project with a longer life.
Forecasting free cash flow (FCF) and free cash flow to equity (FCFE)
FCF is the actual amount of cash that a company has left from its operations that could be used
to pursue opportunities that enhance shareholder value. FCF is before net debt cash flows and
can be used to service shareholders and lenders.
Profit before interest and tax (PBIT)
X
Less tax on PBIT
(X)
Plus non-cash charges (eg. depreciation)
X
Less capital expenditures
(X)
Less net working capital increases
(X)
Plus net working capital decreases
X
Plus salvage value received
X
Free cash flow
X
FCFE is after net debt cash flows and is the cash flow generated by investment project for
equity investors. There are two methods to calculate this. The first method is a direct method:
Net income (PBIT net interest tax paid)
Add depreciation
Less total net investment (change in capital investment + change in working capital)
Add net debt issued (new borrowings less any repayments)

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X
(X)
X

Page 27

Add net equity issued (new issues less any equity repurchases)
Free cash flow to equity
Second method is an indirect method:
Free cash flow
Less (net interest + net debt paid)
Add tax benefit from debt (net interest x tax rate)
Free cash flow to equity

X
X

X
X
X
X

Dividend capacity
Dividend capacity of a company is measured by its FCFE. In theory, the entire FCFE can be paid
as dividends as this is the amount that is available for this purpose. In practice, only a portion of
this figure will be given to the shareholders as dividends as the management team tends to
prefer a smooth dividend pattern. In the context of specific capital investment programme, if
the project is acceptable, dividend that can be paid will be FCFE investment cost.
Valuation of company using FCF and FCFE
First, you need to understand terminal value. Terminal value of a project or a stream of cash
flows is the value of all the cash flows occurring from period N + 1 onwards, ie. beyond the
normal prediction horizon of periods 1 to N. When we refer to a project, terminal value is
equivalent to the salvage value remaining at the end of the expected project horizon.
Value the company using FCF
This is similar to carrying out a NPV calculation. The value of the company is simply the sum of
the discounted FCF over the appropriate horizon. If the FCF is constant, the value of the firm is
simply FCF/cost of capital. If the FCF is growing at a constant rate every year, value of the firm
can be calculated using Gordon Model (or Constant Growth Model), which is like dividend
growth model; PV = [FCF x (1 + g)]/(k g).
Example: Ice Co currently has FCF of $5m per year and a cost of capital of 12%. Calculate the
value of Ice Co if FCF are expected to grow at a constant rate of 4% per annum.
Solution: Value of Ice Co = (5 x 1.04)/(0.12 0.04) = $65m.
When the growth of FCF is expected to start after the horizon considered, calculating terminal
value will be useful. The value of the company will be calculated as the sum of the discounted
FCF plus the discounted terminal value. The following example illustrates how to calculate
terminal value.

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Example: g = 0.05, FCF in the last year of the horizon considered is $2m, cost of capital = 0.10.
Solution: Terminal value = (2 x 1.05)/(0.1 0.05) = $42m. Therefore, this is the value in N + 1 (N
represents the normal horizon and +1 means over the horizon by 1 time).
Now we can look at an example of incorporating terminal value.
Example: Fire Co considers 8 years of FCF for valuation of the business. FCF are expected to
grow at 3% beyond the eighth year. Cost of capital is 12%. It is calculated that present value of
FCF is $9680 and the FCF of eighth year is $2070. Value Fire Co.
Solution: Terminal value = (2070 x 1.03)/(0.12 0.03) = $23690.
Discounted terminal value = 23690 x 0.404 (based on discount rate of 12% and n = 8) = $9751.
Value of Fire Co = $9680 + $9751 = $19431.
Valuation using FCFE
If you use FCFE, you are valuing the equity of the company. The approach is similar to the
above. In normal case, value of equity = present value of FCFE discounted at cost of equity.
In the case where growth starts after the horizon considered, value of equity = present value of
FCFE discounted at cost of equity + terminal value discounted at cost of equity.
If you want to value the company, value of the company = value of equity + value of debt.
2. Application of option pricing theory in investment decisions
This topic is a bit technical so we will start from some basic concepts about option. Later we will
consider something called real option which we need to value it as part of investment appraisal.
Basic concepts
An option is the right (but not an obligation), to buy (call option) or sell (put option) a particular
good at an exercise price, at or before a specified date. A premium is the cost of the option.
Exercise/Strike price is the fixed price at which the good may be bought or sold. An option
(whether call or put) is purchased by the buyer from the option seller or writer.
European-style options can be exercised on their expiry date only, and not before. Americanstyle options can be exercised at any time up to and including their expiry date. Therefore,
American options are more expensive since you are buying more rights.
The intrinsic value looks at the exercise price compared to the price of the underlying asset.
If the exercise price for an option is more favourable for the option holder than the current
market price of the underlying item, the option is said to be in-the-money.

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If the exercise price for an option is less favourable for the option holder than the current
market price of the underlying item, the option is said to be out-of-the-money. The intrinsic
value is zero and it will not be exercised.
If the exercise price for an option is exactly the same as the current market price of the
underlying item, the option is said to be at-the-money.
On the expiry date, the value of an option is equal to its intrinsic value.
Application of Black-Scholes Option Pricing (BSOP) model to financial product/asset valuation
BSOP model formula takes into account the five principal drivers of option value:
1. Value of the underlying ( ) if for example stock price goes up, call price will increase
(exercise price more favourable for call option holder) and put price will decrease.
2. Exercise price ( ) if exercise price increases, call price will decrease and put price will
increase (since put option holder can receive more if exercise price increases).
3. Time to expiry (t) both calls and puts will benefit from increased time to expiration as there
is more time for a big move in, for example, stock price.
4. Volatility (s) this is measured by standard deviation. Both the call and put will increase in
price as the underlying asset becomes more volatile as the buyer of the option receives full
benefit of favourable outcomes but avoids the unfavourable ones.
5. Risk-free rate (r) if risk-free interest rate increases, present value of exercise price
decreases, so value of the call will increase and value of the put will decrease.
Before using BSOP model to value options, there are a number of issues to consider:
1. It assumes that there are perfect markets with no taxes, no transaction costs, perfect security
divisibility, and no restrictions on short selling.
2. It assumes that interest rates are constant over the options life.
3. It assumes that no dividends are paid in the period of the option.
4. It assumes that rate of return on a share is log normally distributed.
5. It applies to European call options only. It cannot be used to accurately price American
options.
BSOP model is used first to value call option and if the option is a put option, the value of put
option depends on the value of the call option. Note that option value means the option
premium payable. The following formula is given in exam:
C = N(d) N(d)
d = [ln( / ) + r + 0.5s^2)t]/st
d = d - st
P=C +

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Where C = value of call option, P = value of put option, N( ) = the probability that a normal
distribution is less than the standard deviation above the mean, ln = natural logarithms, e =
base of the natural logarithms, ie. exponential. The ln and e can be found in scientific calculator.
Since this is an investment appraisal topic, we will apply BSOP model to relevant example later.
Embedded real options within a project
Real options theory attempts to classify and value flexibility that we have in a project. They are
actual options that a business can make in relation to investment opportunities. There are four
types of real options:
1. Option to delay this is a call option on NPV of the project.
2. Option to expand this is a call option on NPV of the project with an exercise price equals to
the additional investment cost.
3. Option to redeploy company can use its productive assets for activities other than the
original one. This is a put option to sell assets.
4. Option to withdraw/abandon this is a put option to sell the cash flows over the remainder
of the projects life for some salvage value.
Considering only NPV is not enough. NPV fails to consider the extent of managements
flexibility to respond to uncertainties surrounding the project. We may attempt to value real
option and incorporate it to NPV. Therefore, strategic NPV = conventional NPV + value of real
options and it is possible that NPV becomes positive after incorporating value of real options.
Valuation of real options using BSOP model
Real options can be valued using BSOP model, but there are certain limitations to bear in mind.
The main one is that BSOP assumes the option is European style but real option may be
exercised over any set period of time, like an American style option. In reality, the use of this
type of modelling is more appropriate for financial securities that are actively traded. Valuing
real option takes into account the uncertainty of the project but company does not actually
receive the value of the real option. The following example illustrates the use of BSOP model to
value real option:
Example: Leaf Co is considering taking a 20-year project which requires initial investment of
$250m in a real estate partnership to develop time share properties with a Spanish real estate
developer, and where the PV of expected cash flows is $254m. While the NPV of $4m is small,
assume that Leaf Co has the option to withdraw this project anytime by selling its share back to
the developer in the next 5 years for $150m. A simulation of the cash flows on this time share
investment yields a variance in the PV of the cash flows from being in the partnership of 0.09.
The 5 year risk-free rate is 7%. Calculate the total NPV of the project, including the option to
withdraw.

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Solution: C = N(d) N(d)


d = [ln( / ) + r + 0.5s^2)t]/st
d = d - st
P=C +
= PV of cash flows = $254m
= Salvage value from withdrawal = $150m.
s = 0.09 = 0.3
t = life of the project = 5 years (this is quoted in years).
r = 0.07 (this is quoted in decimal number).
d = [ln(254/150) + (0.07 + 0.5 x 0.3^2)5]/(0.35) = 1.6424.
d = 1.6424 0.35 = 0.9716.
Using normal distribution table (provided in exam), N(d) = 0.9495, N(d) = 0.8340.
C = 254 x 0.9495 150 x 0.8340 x e^(-0.07 x 5) = $153.02m.
P = 153.02 254 + 150 x e^(-0.07 x 5) = $4.72m.
Total NPV with withdrawal option = $4m + $4.72m = $8.72m.
Estimate the value of equity using BSOP model
BSOP provides a useful framework for valuing companies that are partly debt financed. Value of
the equity of the company can be estimated on the basis of value of its assets and their
volatility. We base on the premise that equity shareholders in effect hold a call option on the
underlying asset of the company and debt holders can be considered to have written the
option. This time, the data required to apply BSOP will be:
1. Value of underlying asset equity share price.
2. Exercise price contract price for settlement.
3. Time to expiry as agreed between the parties.
4. Volatility of the underlying asset value standard deviation of continuously generated share
returns.
5. Risk-free rate risk-free rate of return.
In the case of valuing company, it is assumed that:
1. Value of assets of a company change randomly around an increasing trend and hence are log
normally distributed.
2. Option is a European style option.
3. Assets are traded in frictionless markets and the holding can be continuously adjusted.

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3. Impact of financing on investment decisions and adjusted present values


Appropriateness and price of the range of sources of finance
You had the idea of sources of finance from F9. In general, factors to take into account when
deciding the source of finance include cost, tax, control, gearing, urgency, covenants, amount
needed, size of the company, availability etc. We will consider each type of finance.
Equity
This may be through new issue or rights issue of shares. Cost of equity is always higher than
cost of debt and it is at the bottom of pecking order. Equity finance can reduce gearing level.
Debt
This may be through issue of debentures/bonds/loan notes. This is cheaper but will increase
gearing ratio and therefore financial risk.
Hybrids
Hybrids are means of finance that combine debt and equity, for example convertible bonds,
debt with attached warrants and preference shares. These are often used either because the
companys ordinary share price is considered to be particularly depressed at the time of issue
or because the issue of equity shares would result in an immediate and significant drop in EPS.
Lease finance
This can be either operating or finance lease. Lease or buy decision will be needed to determine
whether it is cheaper to buy the asset or lease it and pay interests (with tax savings).
Venture capital
This is risk capital which is generally provided in return for an equity stake in the business and
most suited to private companies with high growth potential. Also venture capital is an
important source of finance for management buyouts (discussed later). Venture capitalists seek
a high return (usually at least 20%), although their principal return is achieved through an exit
strategy (where they sell off the shares after company became listed).
Business angel finance
Business angels are wealthy individuals who invest in start-up and growth businesses in return
for an equity stake. These individuals are prepared to take high risks in the hope of high
returns. As a result, business angel finance can be expensive for the business.

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Private equity
Private equity consists of equity securities in companies that are not publicly traded on a stock
exchange. In Europe, private equity funds tend to invest in more mature companies with the
aim of eliminating inefficiencies and driving growth. They might require 20-30% shareholding,
special rights to appoint a number of directors and also company to seek their prior approval
for new issues or acquisitions.
Asset securitisation
This involves aggregation of assets into pool, then issuing new securities backed by these assets
and their cash flows. The securities are then sold to investors who share the risk and reward
from these assets. New investors receive a premium (usually in the form of interest) for
investing in the success of failure of the segment. Most securitisation pools consist of
tranches. Higher tranches carry less risk of default (and therefore lower returns) whereas
junior tranches offer higher returns but greater risk. Securitisation is expensive due to
management costs, legal fees and continuing administration fees.
Assessing companys debt exposure to interest rate changes
Debt exposure to interest rate changes can be assessed using simple Macaulay duration
method. Duration is the weighted average length of time to the receipt of a bonds benefits
(coupon and redemption value), the weights being the PV of the benefits involved.
Example: Calculate the duration of 10% five year annual coupon bond trading at $97.25 (par
value of bond is normally assumed to be $100) with a gross redemption yield (GRY) of 10.743%.
Solution:
Time
1
2
3
4
5
Total
Cash flows
10
10
10
10
110
PV @ GRY
9.03
8.15
7.36
6.66
66.05
97.25
Duration = (9.03 x 1 + 8.15 x 2 + 7.36 x 3 + 6.66 x 4 + 66.05 x 5)/97.25 = 4.157 years. The longer
the duration, the higher is the sensitivity of debt price ($97.25) to the interest rate changes.
Basic features of sensitivity to interest rate risk will all be mirrored in the duration calculation.
1. Long-dated bonds will have longer durations.
2. Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zerocoupon bond where the duration will be the maturity.
3. Lower yields will give longer durations. In this case, the PV of cash flows in future will risk if
the yield falls, extending the point of balance, therefore lengthening the duration.

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Benefits and limitations of duration


The main benefits of duration are:
1. Duration allows bonds of different maturities and coupon rates to be directly compared. This
makes decision-making regarding bond finance easier and more effective.
2. If a bond portfolio is constructed based on weighted average duration, it is possible to
determine portfolio value changes based on estimated changes in interest rates.
3. Managers may be able to modify interest rate risk by changing the duration of the bond
portfolio, for example by adding shorter maturity bonds or those with higher coupons (which
will reduce duration).
The main limitation of duration is that it assumes a linear relationship between interest rates
and price. However, as interest rates change the bond price is unlikely to change in a linear
fashion. Rather it will have some kind of convex relationship with interest rates and the more
convex the relationship the more inaccurate duration is for measuring interest rate sensitivity.
Relationship between bond price and yield

Price

Duration
line

Difference captured
by convexity
measure

However used in conjunction with each other, convexity and duration can provide a more
accurate approximation of the percentage change in price resulting from a percentage change
in interest rates. It can also be used to compare bonds with the same duration but different
levels of convexity. For example, if Bond X has a higher convexity than Bond Y, its price would
fall by a lower percentage in the event of rising interest rates.
Assessing companys exposure to credit risk (default risk)
Credit risk of an individual loan or bond is determined by the following two factors:
1. Probability of default.
2. Recovery rate the fraction of the face value of an obligation that can be recovered once the
borrower has defaulted.
Loss given default (LGD) is the difference between the amount of money owed by the borrower
less the amount of money recovered. For example, a bond has a face value of $100 and the
recovery rate is 80%. LGD = 100 80 = $20.

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Expected loss (EL) from credit risk shows the amount of money the lender should expect to lose
from the investment in a bond or loan with credit risk. EL is the product of LGD and probability
of default (PD). Using the above example, if PD is 10%, EL = 10% x $20 = $2.
Principal rating agencies
The oldest and most common approach is to assess the probability of default using financial
and other information on the borrowers and assign a rating that reflects the expected loss from
investing in the particular bond. Credit rating agencies will assign credit ratings to issuers of
certain types of debt obligations. For example, AAA means lowest default risk and C means
lowest grade quality. However, lower rating will result in higher yields on bonds (higher cost of
debt) because the investment is more risky.
Another approach to credit risk assessment is called structural models. Structural models rely
on an assessment of the underlying riskiness of a firms assets or its cash generation, and the
likelihood the firm will not be able to pay interest or repay capital on the due date.
To reduce credit risk, credit enhancement may be undertaken which is the process of reducing
credit risk by requiring collateral, insurance, or other agreements to provide the lender with
reassurance that it will be compensated if the borrower defaulted. Credit enhancement is a key
part of the securitisation transaction in structured finance and is important for credit rating
agencies when raising a securitisation.
Credit spread and cost of debt capital
Credit spread is the premium required by an investor in a corporate bond to compensate for
the credit risk of the bond. Therefore, cost of debt = (risk-free rate + credit spread)(1 T).
Credit spread can be represented by basis point (1 basis point = 0.01%).
Example: Consider a corporate bond with a maturity of 4 years and a credit rating of BBB. The 4
year risk-free rate is 5% and credit spread is 200 basis points. The corporate tax rate is 30%.
Calculate the cost of debt capital.
Solution: Cost of debt = (5% + 2%)(1 0.3) = 4.9%.
However, for exam you need to have much wider knowledge than this. As a lender, we need to
know the amount above LIBOR (London Inter-Bank Offered Rate) that they should charge to
cover the loss on default and as compensation for the risk involved, ie. estimating credit spread.
The first step is to estimate the probability of default.
Example: A firm has assets with current value of $1m and outstanding debt of $0.4m. The
volatility of those assets (as given by the standard deviation of monthly asset values) is 10%.
Estimate probability of default.

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Solution: From the volatility measure, we can calculate the likelihood that within the next 12
months those assets will fall in value to less than $0.4m, thereby triggering default. A 10%
monthly volatility can be converted to an annual volatility (s) as follows:
s = 10% x 12 = 34.64%.
Standard deviation = 34.64% x $1m = $346400.
The distance to default in value terms is $1m less $0.4m = $0.6m. Dividing this by the standard
deviation tells us the number of standard deviations (z) below the average asset value the
default level lies.
z = 600000/346400 = 1.732. Using standard normal distributable table, the proportion
represented by 1.732 is near 0.4582 (to be exact, 0.4584). Adding this to the probability of an
asset value being above the mean (0.5) gives a total probability of not defaulting of 0.9584 or,
conversely, a probability of defaulting of 0.0416.
The second part of the default assessment is to estimate the potential recoverability of the
debt. A number of issues influence recoverability such as the nature of the firms assets and
their saleability, any covenants which impose restrictions on their disposal, the priority of the
lender, and any directors guarantees that may be in place. From this it is easy to see why banks
often proceed with unseemly haste when they foreclose. For a bank, at that point, the priority
is to protect the recoverability of the assets which support its loan. The following example
continues the above example:
Example: Assume bank assesses the recoverability of the debt as 80% and that it, in turn, pays
LIBOR of 5% to raise finance on the financial market. On a loan of $400,000, the bank would
expect to receive LIBOR plus the premium it wishes to charge at the end of the year, giving an
overall rate of i%. It is assumed that bank is risk neutral. Estimate credit spread.
Solution: Drawing a simple decision tree will be useful to show the main idea.
[400000 x (1 + i%)]/(1 + LIBOR)
P = 0.9584
Non-default
$400000
Default
P = 0.0416

[400000 x 80% x (1 + i%)]/(1 +


LIBOR)

From the tree we can see that there are two possible outcomes. Either the lender receives its
principal sum back, plus interest at i%, or it receives just 80% of that value. We have discounted
at LIBOR on the assumption that the lender is neutral towards risk.

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400000 = 0.9584 x [400000 x (1 + i%)]/(1 + 0.05) + 0.0416 x [400000 x 80% x (1 + i%)]/(1 + 0.05)
Rearranged: i = 1.05/(0.9584 + 0.0416 x 0.8) 1 = 0.0588, ie. 5.88%.
This means that it is 88 basis points above LIBOR and this is the credit spread.
Banks, however, are not neutral towards risk. The potential loss of 20% of the loan is more
significant to them than the potential gain if the lender remains solvent. To compensate, a bank
will add a percentage to the discount rate to cover its aversion to risk, and any other charges it
may wish to make. The following example continues the above example.
Example: Assume that bank requires an additional 50 basis points. Estimate credit spread.
Solution:
400000 = 0.9584 x [400000 x (1 + i%)]/(1.055) + 0.0416 x [400000 x 80% x (1 + i%)]/(1.055)
Rearranged: i = 1.055/(0.9584 + 0.0416 x 0.8) 1 = 0.0639, ie. 6.39% which is 1.39% above
LIBOR.
A problem with this type of analysis is how to estimate the asset value of the firm and the
volatility of that asset value. The solution comes from the theory of options.
Role of BSOP model in the assessment of default risk, the value of debt and its potential
recoverability
The role of option pricing models in the assessment of default risk is based on the limited
liability property of equity investments. The equity of a company can be seen as a call option on
the assets of the company with an exercise price equal to outstanding debt. The variables in the
BSOP formula in the case of valuation of the firm will be:
1. Value of underlying asset value of firm assets in use.
2. Volatility of the underlying asset standard deviation of asset value.
3. Exercise price redemption value of outstanding debt.
4. Time term to maturity of debt.
5. Risk-free rate term of debt.
The volatility of assets is probably the most difficult variable to estimate accurately. One
approach implies the asset value and the volatility from the BSOP model. Another approach is
to project and simulate the expected future cash flows of the business, generating a
distribution of present values from which the volatility can be obtained.
The value of N(d) shows how the value of equity changes when the value of the assets change.
This is the delta of the call option. The value of N(d) is the probability that a call option will be
in the money at expiration (value of asset will exceed outstanding debt). The probability of

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default is therefore given by 1 N(d). From the BSOP formula, it can be seen that probability of
default depends on three factors:
1. Debt/asset ratio.
2. Volatility of the company assets.
3. Maturity of debt.
A higher debt/asset ratio increases the probability of default. Similarly, an increase in volatility
will also increase the probability of default. The longer the maturity, the lower the probability
of default.
Example: Market value of assets is $100 and face value of the 1 year debt is $70. Risk-free rate
is 5% and volatility of asset value is 40%. Find the probability of default using BSOP model.
Solution: d = [ln( / ) + r + 0.5s^2)t]/st
d = d - st
= 100
= 70
r = ln (1 + 0.05) = 0.0488 (it is not wrong to use 5%)
s = 0.4
d = [ln(100/70) + (0.0488 + 0.5 + 0.4^2)1]/0.4 = 1.213.
d = 1.213 0.4 = 0.813.
N(d) = 0.792 so probability of default = 1 0.792 = 0.208, ie. 20.8%.
BSOP model can also be used to measure the expected loss associated with a corporate bond.
Expected losses are a put option on the assets of the firm with an exercise price equal to the
value of the outstanding debt. If you turn the equation of call option around, it becomes the
equation of put option.
Put option = Losses = N(-d)
- N(-d), also equal to N(-d)[
- x N(-d)/ N(-d)].
Note that N(-d) = 1 N(d). The term x N(-d)/ N(-d) shows the recovery value of the asset.
Example: Market value of assets is $100, and face value of the 1 year debt is $70. Risk-free rate
is 5% and volatility of asset value is 40%. What is the recovery value and the expected loss?
Solution: This example is the same as above so we already have some data.
r = 0.0488.
d = 1.213, so N(d) = 0.888, so N(-d) = 1 0.888 = 1.112.
N(-d) = 0.208.
Recovery value = 1.112/0.208 x 100 = $53.846.
Expected loss = 0.208 x [70e^(-0.0488 x 1) 53.846] = $2.667.

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Assessing the impact of financing and capital structure upon the company
Here we will look at a number of capital structure theories briefly, some you have learnt in F9.
Traditional view
WACC will initially fall with the increase in gearing because debt is cheaper. But after a certain
level, cost of debt will rise. There is an optimal capital structure where weighted average cost of
capital (WACC) is at a minimum.
Note: Maximising market value and minimising WACC are identical concepts.
Modigliani and Miller (MM) view
MM assumes there is a perfect capital market exists where investors have the same
information and will act rationally.
1. MM model without tax no optimal capital structure as cheaper cost of debt is countered by
increase in cost of equity, keeping WACC constant.
2. MM model with tax cost of debt will reduce further because of tax relief, so optimal capital
structure is where company chooses a 99.9% gearing level. In this case, cost of equity formula is
given as:

where

is ungeared cost of equity (without

financial risk),
is pre-tax cost of debt, is market value of debt, is geared cost of equity
(included financial risk). The formula is given in exam.
However, market is imperfect and so such viewpoint ignored:
1. Bankruptcy costs high gearing level causes bankruptcy risk to increase.
2. Agency costs as gearing increases, more covenants could be imposed by debt holders.
3. Tax exhaustion company is tax exhausted when taxable profit is not enough to cover the
interest payments (tax shield is broken).
Pecking order theory
This theory is based on the idea that shareholders have less information (information
asymmetry) about the firm than directors do. Shareholders and other investors will use
directors actions as signals to indicate what directors believe about the firm, given their
superior information. Order of preference for sources of finance is as follow:
1. Retained earnings (internally generated funds).
2. Straight debt.
3. Convertible debt.
4. Preference shares.
5. Equity shares.

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Static trade-off theory


There is a trade-off between the tax shield which increases the firms value and the reduction in
value caused by the costs of financial distress, bankruptcy and agency costs. Firms assess this
trade-off in an attempt to find the optimal capital structure. Costs of financial distress may be:
1. Direct legal and administrative costs associated with bankruptcy or reorganisation.
2. Indirect higher cost of capital, lost sales due to fear of impaired services, trouble to keep
highly skilled managers and employees etc.
This theory states that firms in a static position will seek to achieve a target level of gearing by
adjusting their current gearing levels. Company should gear up to take advantage of any tax
benefits available, but only to the extent that marginal benefits exceed the marginal costs of
financial distress. After this point, market value of the firm will start to fall and WACC will rise.
Agency effects
When the level of gearing is high, the interests of management and shareholders may conflict
with those of creditors. Management and creditors may both act in a way which is detrimental
to the company, for example, lenders imposing covenants. The optimal capital structure will be
formed at the particular level of debt and equity where the benefits of the debt that can be
received by the shareholders balance equal the costs of debt imposed by the debt holders.
Cost of capital revision
Before moving on, lets have a look at some basic cost of capital concepts briefly which you
have learnt most of them in F9. Make sure you know your F9 before coming to P4.
Cost of equity
This can be calculated in three ways:
1. Dividend valuation/growth model
2. Capital asset pricing model (CAPM)
=
this is given in exam.
Remember that the beta in the formula is equity beta if you want to calculate geared cost of
equity.
3. MM proposition 2

this is given in exam.

In exam, you have to look at the information available and select the correct formula.
Cost of debt
If exam only mentions cost of debt, it means pre-tax cost of debt unless otherwise stated. There
are three ways to calculate cost of debt.
1. For irredeemable debt,

and for redeemable debt,

is the IRR of

MV, post tax interest and redemption amount.

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2. CAPM
debt beta.
3. Use credit spread

and cost of debt is

. The beta should be

= (Risk-free rate + credit spread)(1 T).

WACC
WACC is the average cost of companys finance weighted by the total market value or book
value of each source of finance. WACC =

. When evaluating a

project, it is important to use a cost of capital which is appropriate to the risk of the new
project. The existing WACC will therefore be appropriate as a discount if:
1. New project has the same level of business risk as the existing operations.
2. Undertaking new project will not alter the firms capital structure (financial risk).
3. Size of the project is relatively small compared to the size of the company.
If new project has different business risk, risk adjusted WACC or project-specific cost of capital
needs to be calculated using the concept of CAPM. This involves the following steps:
1. Find a proxy company with similar operations as the proposed investment.
2. Equity beta of proxy company will be ungeared to get asset beta through this formula:
and we normally assume debt to be risk-free.
3. Asset beta will be regeared to include financial risk of investing company. Here we amend
the above formula to

(assume debt to be risk-free).

4. Then, by applying CAPM formula we got the cost of equity.


Example: Two companies are identical in every respect except for their capital structure. Water
Co has a debt to equity ratio of 1:3 and its equity has a value of 1.20. Fire Co has a debt to
equity ratio of 2:3. Currently Fire Co is considering a project with risk-free rate of return of 4%
and equity risk premium of 6%. Calculate the specific-project cost of equity for Fire Cos project.
Solution: We will start with ungearing the equity beta of Water Co. Note that it is not necessary
to put market value of equity or debt in $ inside the formula.

Next we regear this to equity beta for Fire Co.

We can now apply this to the CAPM formula to determine specific-project cost of equity.
Cost of equity =
= 4 + 1.427 x 6 = 12.6%.

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However, there are some problems with beta formula:


1. Difficult to identify a proxy company with identical operating characteristics.
2. Estimates of beta values from share price information are not wholly accurate as they are
based on statistical analysis of historical data.
3. There may be differences in beta values between firms caused by different size of the
organisation and debt capital not being risk-free.
You will still need to make sure you know the limitations of each technique.
Adjusted present value (APV)
APV technique can be used for investment decisions that entail significant alterations in the
financial structure of the company. This means where financial risk will alter. APV approach is
to evaluate the project and the finance package separately. APV = base case NPV + PV of
financing side-effects. If APV is positive, the project is financially acceptable.
Example: Fire Co is evaluating a telecoms project. Ice Co is a quoted telecoms company with an
equity beta of 1.5 and a debt beta of 0.1. The companys gearing ratio (D:E) is 1:2 and corporate
tax is at 30%. Treasury bill yield was 7% and the market return was 15%.
Solution:

= 1.137.

Base-case discount rate (ungeared cost of equity) = 7% + 1.137 x (15% - 7%) = 16.1%.
This discount rate can be used to discount the project cash flows to get base case NPV.
Example: A project is financed by $1m of retained earnings, $2m rights issue of new equity,
$4m 3-year loan from Regional Development Council at 4% and $2m 3-year bank loan at 10%.
The administration costs associated with the rights issue total 5% of the finance raised. Riskfree interest rate is 10%. The bank loan involves a $60000 arrangement fee. Assume that tax is
paid at 30%, one year in arrears. Calculate the PV of financing side-effects.
Solution: Tax savings on interest payments will all be considered.
CF ($000) Timing DF@10%
PV ($000)
Admin costs (5/95 x $2m)
(105)
0
1.000
(105)
Arrangement fee
(60)
0
1.000
(60)
Bank loan tax relief (2m x 10% x 30%)
60
2-4
2.261
136
RDC loan tax relief (4m x 4% x 30%)
48
2-4
2.261
109
RDC loan gross interest saved (4m x 6%) 240
1-3
2.487
597
RDC loan tax relief lost on interest
saved (4m x 6% x 30%)
(72)
2-4
2.261
(163)
PV of financing side-effects
514

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Note:
1. Admin costs are not calculated as 5% x $2m because $2m is the amount left after such costs
are paid, so $2m is 95%.
2. In this example we discount the cash flows at risk-free rate. However, it is possible to use
different rates to discount, such as cost of debt. In exam, you should make clear the reasons for
choosing the discount rate to discount the tax relief, and add comment that an alternative rate
might be used.
In APV analysis, the PV of the tax relief on interest should not be calculated on the basis of the
actual amount of debt but on the project debt capacity because tax relief on interest (tax
shield) is valuable, and to avoid a cross-subsidisation of one project with another projects debt
capacity. If a $10m project has a 60% debt capacity, this indicates that the project is capable of
acting as security for a $6m loan.
Issue costs/transaction costs are another thing to consider. Debt issue costs are tax deductible
(often with 1 years delay) but equity issue costs are not tax deductible.
We can see a number of benefits that APV can bring, such as able to evaluate the effect of
financing separately and no need to adjust WACC using assumptions of perpetual risk-free debt.
However, there are a number of practical problems:
1. The process of ungearing/degearing the industry beta to obtain a beta for an all-equity firm
does not include market imperfections such as bankruptcy costs.
2. The discount rates used to evaluate the various side effects can be difficult to determine.
3. Only appropriate where the project does not affect the firms exposure to business risk.
4. In complex investment decisions, the calculations can be extremely long.
Assessing the impact of a significant capital investment project upon the reported financial
position and performance taking into account alternative financing strategies
The source of finance chosen to finance the capital investment project will have an effect on
the reported financial position and performance. Gearing affects the volatility of EPS. The
higher the level of gearing, the higher the volatility of EPS. This is the case because the high
gearing level means that interest payments will also increase, thus affecting the net profits.
Therefore, if the project is financed mainly through debt, gearing level will rise and EPS can
easily change.
4. International investment and financing decisions
Now we are looking at overseas projects and there are certain issues to consider.

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Exchange rate assumptions


In a project, we need to forecast the exchange rates for future timing in order to, for example,
calculate NPV. This is because overseas projects take place at overseas so we need to know
about foreign currency. We can use two ways to forecast exchange rates: purchasing power
parity (PPP) theory and interest rate parity (IRP) theory.
PPP theory
Expected spot rate is forecast from the current spot rate by multiplying the ratio of expected
inflation rates in the two countries being considered. Therefore, the formula is:
, this formula is given in exam. Country c depends on

. If

is given as 8.00

kroner/1, then country C will be Denmark.


Example: The spot exchange rate between UK sterling and Danish krone is 1 = 8.00 kroner.
Assuming there is now purchasing parity, an amount of a commodity costing 110 in the UK will
cost 880 kroner in Denmark. Over the next year, price inflation in Denmark is expected to be 5%
while inflation in UK is expected to be 8%. Calculate the expected spot exchange rate at the end
of the year.
Solution: Expected spot exchange rate = 8 x 1.05/1.08 = 7.78. This amount can also be found by:
UK price = 110 x 1.08 = 118.80, Denmark price = Kr880 x 1.05 = Kr924.
New spot exchange rate = 924/118.80 = 7.78.
IRP theory
Forward rate is forecast from the current spot rate by multiplying the ratio of interest rates in
the two countries being considered. Therefore, the formula is:
, this formula is given in exam as well. Again, country c depends on

Example: Exchange rates between two currencies, the Northland florin (NF) and Southland
dollar ($S) are as follow:
Spot rates
$S1 = NF4.7250
NF1 = $S0.21164
90 days forward rates NF4.7506 per $S1
$S0.21050 per NF1
Money market interest rate for 90 day deposits in Northland florins is 7.5% annualised.
Estimate the interest rates in Southland.
Solution: Since we are given the 90 days forward rates, the interest rate of 7.5% should be
adjusted to 90 days.
Northland interest rate on 90 day deposit = 0.075 x 90/365 = 1.85%.

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There is a need to adjust the formula so that forward rate/spot rate = ratio of interest rates. If
we take $S0.21164 as spot rate, country c is Southland.
0.21050/0.21164 = (1 + )/1.0185, 1 + = 0.21050/0.21164 x 1.0185, 1 + = 1.013, so = 1.3%
OR
4.7506/4.7250 = 1.0185/1 + , 1 + = 1.0185 x 4.7250/4.7506, 1 + = 1.013 so = 1.3%.
In annual rate, 0.013 x 365/90 = 5.3%.
The fluctuations in exchange rate will affect the NPV of the overseas project.
International investment appraisal
In calculating overseas projects NPV, there are two ways and both result in same NPV:
First way
1. Estimate the projects cash flows post-tax in the overseas currency.
2. Convert the cash flows to home currency this involves forecasting exchange rates.
3. Add any home country cash flows, for example tax.
4. Discount the net home currency cash flows at the companys cost of capital to get NPV.
Second way
1. Estimate the projects cash flows post-tax in the overseas currency.
2. Convert the companys cost of capital to an overseas equivalent this can involve the use of
International Fisher effect,

where i = nominal interest rate and h = inflation rate.

3. Use adjusted cost of capital to find NPV in overseas currency.


4. Convert the NPV into home currency at spot exchange rate.
5. Add in the PV of any additional home country cash flows, for example tax.
It is the parent companys cash flows that should be converted into parents currency terms and
discounted to NPV. The NPV of an overseas project is done in the same way as a domestic NPV
appraisal. However, a number of issues must be considered:
1. Taxation question will always assume a double-taxation treaty. Therefore, projects profits
get taxed at whatever is the highest rate between the two countries.
2. Inter-company cash flows in the exam assume such cash flows are allowable for tax (and
state it) unless the question says otherwise. If an inter-company cash flow is allowable for tax
relief in one country, there will be a corresponding tax liability in the other.
3. Working capital assume (unless told otherwise) that the working capital requirement for
the overseas project will increase by the annual rate of inflation in that country.
4. Transaction costs this can be incurred due to currency conversion or other administrative
expenses. This should also be taken into account in the appraisal.

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5. Restricted remittance only the proportion of cash flows that are expected to be repatriated
should be included in the calculation of the NPV.
Exchange controls and strategies for dealing with restricted remittance
Exchange controls restrict the flow of foreign exchange into and out of a country, usually to
defend the local currency or to protect reserves of foreign currencies. Government may be
restricting the supply of foreign exchange or restricting the types of transaction. These
exchange controls can impact the NPV of the project because we only include cash flows that
are expected to be repatriated.
To deal with restricted remittance, there are a number of strategies:
1. Transfer pricing parent can set high price to the foreign subsidiary, however tax authorities
will try to prevent this from happening.
2. Royalty payment parent grants subsidiary the right to make goods protected by patents
and require royalty payments from subsidiary. The size of royalty can be adjusted.
3. High interest loan to subsidiary.
4. Management charges can be charged to subsidiary.
Impact of a project upon a companys exposure to translation, transaction and economic risk
You learnt the three terms in F9 but we will talk about them again.
1. Translation risk (historical) this is the risk that when company consolidates accounts, there
will be exchange losses when the accounting results of foreign subsidiary are translated into
home currency. (IAS 21 requires holding company to translate the account of foreign subsidiary
to home currency in consolidation).
2. Transaction risk (current) this is the risk of adverse exchange rate movements between the
date the price is agreed and the date cash is received/paid, arising during normal international
trade.
3. Economic risk (future) this is the risk that exchange rate movements might reduce the
international competitiveness of a company. It is the risk that the PV of companys future cash
flows might be reduced by adverse exchange rate movements.
These three types of risks will be exposed by any companies dealing with foreign currencies.
Costs and benefits of alternative sources of finance available within the international equity
and bond markets
Companies are able to borrow short and long-term funds on the Eurocurrency (money) markets
and on the markets for Eurobonds respectively. These markets are collectively called
euromarkets. The word euro means in foreign currency, not European. Large companies can
also borrow on the syndicated loan market where a syndicate of banks provides medium to
long-term currency loans.

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Syndicated loan is a loan offered by a group of lenders (a syndicate) to a single borrower. The
lenders will share the risk together.
Shorter term international borrowing includes:
1. Euro notes debt securities with a maturity of less than a few years traded in the
Eurocurrency market.
2. Short-term syndicated credit facilities.
3. Multiple Options Funding Facility (MOFF) credit lines that are accompanied by option
contracts to provide more variety to borrowers in standard currencies.
The main cost of alternative sources of international finance is the exposure to exchange rate
risk. However there are a number of benefits:
1. Availability domestic financial markets may lack the depth and liquidity to accommodate
either large debt issues or issues with long maturities.
2. Lower cost of borrowing in Eurobond markets, interest rates are normally lower than
borrowing rates in national markets.
3. Lower issue costs cost of debt issuance is normally lower than the cost of debt issue in
domestic markets.
Conclusion
This is the end of syllabus area C. The ideas you learnt include investment appraisal techniques,
valuing real options, financing the projects and its effect on cost of capital, and investing in
overseas.

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Acquisitions and mergers


1. Acquisitions and mergers versus other growth strategies
We normally compare mergers and acquisitions (M&A) with organic growth/internal
development. The principle behind M&A is that two companies together are more valuable
than two separate companies. Therefore, they aim to create synergy where market value of
combined companies is greater than sum of two separate companies (2 + 2 = 5).
Arguments for and against the use of acquisitions and mergers as a method of corporate
expansion
Advantages of M&A include:
1. Growth is achieved more rapidly since we get another company that is already in operation.
2. Cheaper way of acquiring productive capacity.
3. Intangible assets are acquired, such as brand recognition, customer base, reputation etc.
4. In expanding to overseas market, acquiring local firm may be the only option of breaking into
the overseas market.
5. By acquiring a competitor, company eliminates the competition.
Disadvantages of M&A include:
1. Normally need to pay premium over the market value of the target company.
2. Exposure to business risk acquisitions normally represent large investment. If the acquired
company does not perform as well as it was anticipated, then the effect on the acquiring firm
may be catastrophic.
3. Exposure to financial risk acquiring firm may have less than complete information on the
target company, and there may exist aspects that have been kept hidden from outsiders.
4. Management of acquiring firm may not have the experience to deal with new operations in
the acquired company.
5. Integration problems may arise as each company has its own culture, history and ways of
operation.
Corporate and competitive nature of a given acquisition proposal
Corporate issues include:
1. Target identification need to identify acquisitions in overseas markets.
2. Synergy identification mergers present its own unique set of negotiation challenges.
3. Synergy capture successful, established practices leveraged from one deal to the next.
4. Cultural differences new single culture must serve strategic needs better than
predecessors.
5. Getting it right skills which are important should be centralised in acquisition.

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6. Building on lessons learned merger integration should be monitored, measured and


improved.
7. Capital structure of combined entity this can impact gearing level and WACC.
Competitive issues include:
1. Greater bargaining power merged company has greater bargaining power when dealing
with suppliers.
2. Barriers to entry vertical mergers (merge with supplier or customer) may create barriers to
entry for the new entrants as supply chain and distribution channel are controlled by the
merged company.
3. Economies of scale merged company may have larger scale of operation, resulting in
reduction of cost per unit.
4. Economies of scope cost of producing two or more products could be reduced when they
are jointly produced in a single production unit rather than to produce in separate firms.
Criteria for choosing an appropriate target for acquisition
There are many criteria to consider for choosing an appropriate target for acquisition:
1. Benefit for acquiring undervalued company target company should trade at a price below
the estimated value of the company when acquired (bargain acquisition).
2. Diversification target company should be in a business which is different from the acquiring
firms business and the correlation in earnings should be low (negatively correlated
diversification can reduce unsystematic risk).
3. Operating synergy target company should have the characteristics that create operating
synergy, for example economies of scale and increased monopoly power.
4. Tax savings target company should have large claims to be set off against taxes and not
sufficient profits. It may be beneficial in terms of tax by acquiring a loss making business.
5. Increase the debt capacity target company should have capital structure such that its
acquisition will reduce bankruptcy risk and will result in increasing its debt capacity.
6. Disposal of cash slack target company should have great projects but no funds. This is
where acquiring company can utilise its cash rich position to invest in the projects.
7. Better control of the company acquiring company may feel that it has greater expertise to
manage and utilise target companys resources.
8. Access to key technology target company has some enabling technologies which are useful
for acquiring company.
9. Access to cash resources target companys cash resources may be useful for acquiring
company which invests heavily in R&D.

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Causes of high failure rate of acquisitions in enhancing shareholder value


A number of theories have been put forward to explain the high failure rate of acquisitions and
these include:
1. Agency theory takeovers are primarily motivated by the self-interest of the management of
acquiring company. If target company is aware that the merger will benefit the management of
the acquiring firm rather than the shareholders, target company may seek to extract some of
the value that would have gone to acquiring firm management, resulting in high bid price. How
much value the target company can extract depends on the bargaining power they have.
2. Errors in valuing a target company managers of acquiring company may advise to bid too
much as they do not know how to value an essentially recursive problem. The merger may fail
as the subsequent performance cannot compensate for the high price paid.
3. Market irrationality a rational manager may have the incentive to exchange overvalued
stocks in his firm to real assets before the market corrects the overvaluation. A merger
therefore occurs in order to take advantage of market irrationality and it is not related to either
synergies or better management. The lack of the latter may lead to a failing merger.
4. Pre-emptive theory this theory explains why acquiring firms pursue value-decreasing
horizontal mergers (acquiring competitor). If a firm fears that one of its rivals will gain large cost
savings or synergies from taking over some other firm, then it can be rational for the first firm
to pre-empt this merger with a takeover attempt of its own. The acquiring firm did not
recognised that the target was creating negative value to shareholders.
Other causes include:
1. Window dressing financial statements of target company may involve window dressing.
Acquiring company acquires such company because of its better financial picture in the shortterm, but ignored synergies that the target company may create.
2. Poor integration management inflexibility in the application of integration plans and poor
man-management can be detrimental to successful integration. Culture is also an issue in this.
3. Over-optimistic assessment of synergy effect.
4. Dominance of subjective factors such as the status of respective boards of directors.
Potential for synergy
Three main types of synergy to be gained from acquisitions or mergers are:
1. Revenue synergy opportunity for combined corporate entity to generate more revenue
than its two predecessors independent companies would be able to generate. This arises from
increased market power, marketing synergies and strategic synergies.
2. Cost synergy refers to opportunity for combined entity to reduce or eliminate expenses
associated with running business. This arises from economies of scale and scope and
elimination of inefficiency.

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3. Financial synergy refers to financial benefits that a corporation expects when it merges
with or acquires another company. This arises from risk diversification, surplus cash (disposal of
cash slack as discussed above), tax benefits and increased debt capacity.
2. Valuation of acquisitions and mergers
In exam you may have to derive a value by using several valuation methods and discussing the
advantages and disadvantages of each. The methods will not give a precise valuation figure, but
a starting point for negotiation.
Argument and the problem of overvaluation
When a company acquires another company, it always pays above current market value. This is
known as the overvaluation problem. Empirical studies have shown that during an acquisition,
there is normally a fall in the price of the bidder and an increase in the price of the target. This
shows that shareholders of target company will enjoy the benefits of the premium paid by
acquiring company while shareholders of the acquiring company might lose value.
Overvaluation problem may arise as a miscalculation of the potential synergies or the
overestimation of the ability of acquiring firms management to improve performance. Both
errors will result in higher price being paid.
Estimating the potential near-term and continuing growth levels of a companys earnings
The growth rate of a companys earnings is the most important determinant of a companys
value. The growth rate may be based on historical estimates (using geometric average),
analysts forecasts or company fundamentals (using Gordons growth model/earnings retention
model).
Historical estimates
This is to look at the trend of earnings over the years. This does not hold true for new
companies and companies that deal with uncertainty. The idea is that:
Earnings n year ago x (1 + g)^n = Current earnings
g = (current earnings/earnings n year ago)^(1/n) 1
Example: Earnings in 20X1 are $150000 and in year 5 are $262350, calculate the growth rate.
Solution: g = (262350/150000)^(1/4) 1 = 15%.
Company fundamentals
The determinants of rate of growth are the return on equity and the retention rate of earnings.
The formula is given in exam as g = br where r = return on equity and b = retention rate =
(earnings dividend payments)/earnings.

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Example: Leaf Co had a dividend yield (dividend per share/market price per share) of 3.8% and
P/E ratio of 15.3 times. What is the implied retention rate of Leaf Co?
Solution: Dividend yield x P/E ratio = dividend per share/EPS
3.8% x 15.3 = 0.5814.
To get retention rate, we need (EPS DPS)/EPS, we already got DPS/EPS so we can create one
EPS/EPS.
Retention rate = EPS/EPS DPS/EPS = 1 0.5814 = 0.4186 or 41.86%.
Impact of an acquisition or merger upon the risk profile of the acquirer
The risk of the acquirer in the process of acquisition can be classified as either financial risk or
business risk. We can distinguish acquisitions into three types:
1. Type 1 acquisitions these do not disturb the acquirers exposure to financial or business
risk. Capital structure of acquirer will not change and nature of business of both companies is
the same. Therefore, asset and equity beta remain the same.
2. Type 2 acquisitions these will impact upon the acquirers exposure to financial risk. Finance
cost, WACC and market value of acquirer will change.
3. Type 3 acquisitions these will impact upon the acquirers exposure to both financial and
business risk. It will be difficult to calculate WACC.
Type 1, 2 and 3 are listed in the study guide and so examiner knows the meaning of these.
Asset beta of combined entity is the weighted average of the betas of the target company, the
acquirer and the synergy generated from the acquisition. WACC of the combined entity is the
weighted average of the cost of equity and cost of debt of the combined entity.
Valuation of a type 1 acquisition of both quoted and unquoted entities
We will look at three methods to value type 1 acquisition: Book value-plus models, market
relative models, and cash flow models including EVA and MVA.
Book value-plus models
Book value or asset-based methods are based on the statement of financial position (SOFP) as
the starting point in the valuation process. This is the net assets basis of valuation which you
learnt in F9. We derive value of companys share from net asset value of equity. Net assets =
Total value of assets (ignore intangible assets) total value of liabilities or non-current assets
(ignore intangible assets) + net current assets long-term debt. Value per share = net asset
value/number of ordinary shares. This would represent the minimum value of the target
company.
Other values such as realisable values or replacement costs of asset may be used as the basis of
net asset value. Always think about the advantages and disadvantages.

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We can also value intangible assets so that total company value = net asset value + estimate of
intangible asset value. The two main ways of deriving intangible asset value are:
1. Calculated Intangible Value (CIV) involves calculating excess return on tangible assets and
this figure is used in determining the proportion of return attributable to intangible assets.
2. Levs knowledge earnings method involves separating the earnings that are deemed to
come from intangible assets and capitalise these earnings. Calculation is not examinable for
this.
In CIV we will have 5 steps to value intangible assets:
1. Find return on assets (average operating profit/average tangible assets) whether of a suitable
competitor (similar in size, structure etc) or industry average.
2. Calculate value spread companys operating profit less (return on assets x company asset
base). This is the excess return.
3. Find the post-tax value spread value spread x (1 T).
4. Using the likely short-term growth rate, find the expected post-tax value spread at T1.
5. Find CIV by discounting the post-tax value spread at T1 to PV.
Example: Directors of Rock Co intend to value the company for the purposes of negotiating with
a potential purchaser and plan to use CIV method to value the intangible element. In the past
year, Rock Co made an operating profit of $137.4m on an asset base of $307m. Earnings are
predicted to grow at 3.4% over the next few years and the companys WACC is 6.5%. A suitable
competitor is identified with operating profit of $315m on assets employed in the business of
$1583m. Corporation tax is 30%. What value should be placed on Rock Co?
Solution: Return on asset = 315/1583 x 100 = 19.9%.
Value spread = 137.4 19.9% x 307 = $76.31m.
Post-tax value spread = 76.31 x (1 0.3) = $53.42m.
At T1, post-tax value spread = 53.42 x 1.034 = $55.24m.
CIV = 55.24/0.065 = $849.85m.
Rock Cos value = $307m + $849.85m = $1156.85m.
Market relative models
Market relative models may be based on the P/E ratio which produces an earnings based
valuation of shares. Since P/E ratio = market value/EPS, then market value per share = EPS x P/E
ratio. P/E ratio applied should be that of a similar company or industry. In practice, this may be
difficult to find, and the parties involved in the acquisition will then negotiate the applied P/E
ratio up or down depending on the specific company circumstances. The P/E ratio of an
unquoted companys shares might be around 50% to 60% of the P/E ratio of a similar public
company with a full Stock Exchange listing so you need to adjust the industry average P/E ratio
suitable for unquoted company.

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For a listed company, the stock market value of the shares (or market capitalisation) is the
starting point for the valuation process. However, a premium usually has to be paid above the
current market price in order to acquire a controlling interest. Market capitalisation = current
market price of share x number of ordinary shares.
Another method is to use Tobins Q ratio (market to book ratio). Q ratio can be market
capitalisation/book value of assets. Market value of a target company = market to book ratio x
book value of assets of target company. A firm with a Q<1 is vulnerable since the assets of a
company can be acquired at a cheaper price than they were bought on their own as assets. So,
high Q firms usually buy low Q firms.
Earnings yield is also one way where earnings yield = EPS/market price per share so market
price per share = EPS/earnings yield or value of company = total earnings/earnings yield.
Cash flow models
There are a number of methods in this model:
1. Dividend valuation/growth model Share price
2. FCF or FCFE cost of equity can be used to discount FCFE to get value of equity directly, or
WACC can be used to discount FCF to give total business value from which debt value should be
deducted to give equity value. Debt value should not be part of company value.
3. EVA value of equity = PV of EVA less debt value.
4. Market Valued Added (MVA) = market value of debt + market value of equity book value of
equity book value of debt. This shows how much the management of a company has added to
the value of the capital contributed by capital providers. MVA is also the PV of EVA. A
companys equity MVA is sometimes expressed as a market to book ratio (MVA/book value).
Valuation of type 2 acquisitions using the adjusted net present value model
As type 2 acquisitions expose acquiring company to financial risk, APV model may be useful to
value the company. You have learnt APV earlier where APV = base-case NPV + PV of financing
side-effects. If the APV is positive then the acquisition should be undertaken. Note that value of
equity will be APV debt value cost of acquisition.
Valuation of type 3 acquisitions using iterative revaluation procedures
Type 3 acquisitions affect both the financial and business risk exposure of the acquiring
company. Iterative procedures can be used where the beta and the cost of capital are
recalculated to take account of the changes in the capital structure, and then the company is
re-valued. This procedure is repeated until the assumed capital structure is closely aligned to
the capital structure that has been re-calculated. This process is normally done using a
spreadsheet package such as Excel. Iterative revaluation procedures will involve a number of
steps:

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1. Calculate the asset beta of both companies.


2. Calculate the average asset beta

for

the

group

post-acquisition

3. Regear the asset beta to reflect the groups post-acquisition gearing average asset beta
from step 2 is regeared to become equity beta of combined company.
4. Calculate the groups new WACC cost of equity is derived using CAPM formula and use the
equity beta calculated in step 3 while cost of debt must be the cost of debt for the combined
company.
5. Discount the groups post-acquisition FCF using the new WACC.
6. Calculate the groups revised NPV and subtract debt to calculate the value of the equity.
Valuing high growth start-ups
Due to the unique characteristics of high growth start-ups such as no track record, heavy losses
initially, highly uncertain work environment, unknown competition, unknown cost structures,
inexperienced management etc, valuing them presents a number of challenges.
All valuation methods require reasonable projections to be made with regard to the key drivers
of the business. The following steps should be undertaken with respect to the valuation of a
high growth start-up company:
1. Identifying the drivers projections must be analysed in light of the market potential,
resources of the business, management team, financial characteristics of the guideline public
companies, and other factors.
2. Period of projection long-term projections, all the way out to the time when the business
has sustainable positive operating margins and cash flows, need to be prepared. These
projections will depend on the assumption made about growth. Forecast period is rare to be
less than seven years.
3. Forecasting growth growth in earnings may be g = retention rate x return on equity or
return on invested capital (ROIC). For most high growth start-ups retention rate = 1 (ie. no
dividend payment) as the company needs to invest in many areas and cant pay dividend.
Therefore, the sole determinant of growth is ROIC and this is can be determined by profit
margin and revenue growth: ROIC = PBIT/IC = EBIT/sales x sales/IC.
Now we review each valuation method:
1. Asset-based method not appropriate because value of capital in terms of tangible assets
may not be high.
2. Market-based method there is a problem in finding suitable company and take its P/E ratio.
Complicating factors include comparability problems, differences in fair market value from
value paid by strategic acquirers and lack of disclosed information.

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3. Discounted cash flows growth rates of revenues and costs may vary. FCF = revenue costs
so lets take revenue = R and costs = C:
capital,

where r = risk-adjusted cost of

= growth rate of revenue and V = value of the company.

Conclusion
You need to take some time to understand the logic of each method. None of the valuation
methods give a right answer for the value of the firm. In practice, actual price paid will depend
on the bargaining power and negotiating skills of the buyer and seller. Valuation models only
give you an idea, for example negotiation may start with net asset value and increase to an
agreed value.
Also note that additional synergy benefit after the acquisition has been paid for needs to be
ascertained which is the post-acquisition value of the combined company less the values of the
individual companies.
3. Regulatory framework and processes
Development of the regulatory framework for mergers and acquisitions globally
Regulations of takeovers vary from country to country but are mainly concerned with
controlling directors. Takeover regulation is an important corporate governance device that
seeks to protect the interests of minority shareholders and other types of stakeholders and
ensure a well-functioning market for corporate control. Two main agency problems that
emerge in the context of a takeover that regulation seeks to address are:
1. Protection of minority shareholders. In addition to existing minority shareholders, transfers
of control may turn existing majority shareholders of the target company into minority
shareholders.
2. Possibility that management of target company may implement measures to prevent the
takeover even if these are against stakeholder interests.
In the UK and the US the regulation model used is a market-based shareholder model aimed at
protecting the rights of shareholders. This involves exerting external control over management.
This model is considered more economically efficient and is becoming more dominant.
The Europeans stakeholder model (block-holder model) uses a stakeholder perspective to
protect all stakeholders in a company. This involves exerting internal control over management.
This model is considered better at dealing with the agency problem.
Main regulatory issues which are likely to arise in the context of a given offer
Regulatory issues would include level of permitted mergers, relevant legislative/regulatory
provisions, conditions imposed by regulators on merger proposals, level of approval required
from shareholders, level of information to be provided to shareholders prior to any merger,

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performance disclosure requirements, allocation of costs of merger, and the extent to which
regulators should intervene to encourage/discourage mergers.
Management needs to assess whether the offer is likely to be in the shareholders best
interests. In the same way like investment appraisal, NPV needs to be calculated.
Defence against takeovers
Directors of a target company can employ the most appropriate defence if a specific offer is to
be treated as hostile. Takeover defences can be categorised into pre-offer and post-offer
defences.
Pre-offer defences include:
1. Maximise share price this causes the cost of acquisition to increase.
2. Communicate effectively with shareholders this includes having a public relations officer
specialising in financial matters liaising constantly with the entitys stockbrokers, keeping
analysts fully informed, and speaking to journalists.
3. Super majority Articles of Association are altered to require that a higher percentage (eg.
80%) of shareholders have to vote for the takeover.
4. Poison pill take steps to make itself less attractive, eg. give rights to existing shareholders to
buy future bonds or preference shares. If a bid is made before the date of exercise of the rights,
then the rights will automatically be converted into full ordinary shares.
5. Strong dividend policy which discourages shareholders from voting for acquisition.
Post-offer defences include:
1. Counterbid/Pacman defence the acquiring company is itself the subject of a takeover bid
by the target company.
2. White knight strategy directors of the target company offer themselves to a more friendly
outside interest. This tactic should only be adopted in the last resort.
3. Press contact publish negative issue about the offer in the press.
4. Crown jewels selling or sale and leaseback the most valuable assets.
5. Golden parachute large compensation payments made to the top management of the
target company if their positions are eliminated due to hostile takeover.
6. Litigation or regulatory defence inviting an investigation by the regulatory authorities or
through the courts. The target company may be able to sue for a temporary order to stop the
predator from buying any more of its shares.

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4. Financing acquisitions and mergers


Various sources of financing available for a proposed cash-based acquisition
In principle, the issue of shares is no more expensive to the purchaser than cash or debt
consideration, and sometimes investors are given a choice. However, this may be problematic
in that the cash needed, the number of shares to be issued and the capital structure resulting
are not known. The various sources of financing include:
1. Retained earnings acquiring company must have sufficient available cash reserves.
2. Sale of assets useful when acquiring company wishes to dispose of certain assets.
3. Rights issue raising funds from existing shareholders.
4. Issue of debt not normally used because this will alert markets to the intentions of the
company to bid for another company and it may lead investors to buy the shares of potential
targets, raising their prices.
5. Loan facility from bank this can be done as a short-term funding strategy until the bid is
accepted and then the company is free to make a bond issue.
6. Mezzanine finance this is unsecured convertible loan with relatively high rate of interest.
This may be the only route for companies that do not have access to the bond markets.
Payments can be in the form of cash, a share exchange or convertible loan stock. The choice
will depend on available cash, desired levels of gearing, shareholders taxation position,
changes in control and so on.
Advantages and disadvantages of a financial offer for a given acquisition proposal
We will focus on cash and shares because debt issue is not common.
Cash offer
1. For acquiring companys shareholders there will be no dilution of control and the cost
should be lower as cash is more certain. However, cash outflows will hamper liquidity of
acquiring company.
2. For target companys shareholders the income is certain and so risk is lower and they can
invest in other securities immediately. However, the income will be liable to capital gains tax (in
UK) and there will be no more share in combined company.
Issue shares or share exchange
1. For acquiring companys shareholders the chances of post-acquisition liquidity problem are
reduced. Also firm with lower EPS can acquire higher EPS company to increase EPS of combined
company (bootstrapping). However, issuing shares will result in dilution of control.
2. For target companys shareholders capital gains tax need not be paid instantly as it can be
rolled over and they can participate in the future profits of combined company. However,

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increase in wealth will depend on combined companys future performance so the risk is
higher.
Convertible loan stock (mix mode of financing)
This gives the rights for investor to convert the loan stock into ordinary shares. This gives
investors the flexibility to convert if they want. For the acquiring company it is good as well
because it can have a lower coupon rate due to the lower risk faced by the investor.
A mix of cash and shares is also an alternative way and is practically used. However, how much
cash to pay and how much shares to issue will be an issue to consider. Two most important
factors to consider when making an offer are the effect on EPS and share prices. This is because
shareholders of both companies will be sensitive to the changes in them. There are
circumstances where a dilution in earnings is acceptable if any of the following benefits arise as
a result:
1. Earnings growth.
2. Quality of earnings acquired is superior.
3. Dilution in earnings compensated by an increase in net asset backing (target company may
be weak in earnings but strong in assets).
Impact of a given financial offer on the reported financial position and performance of the
acquirer
Different financial offer can have different impact on the reported financial position and
performance of the acquiring company, and so the impact on EPS, share prices, gearing ratio,
P/E ratio and dividend cover. If debt is issued to raise cash for acquiring the target company,
gearing level will rise. The larger the target companys earnings relative to the acquirer, the
greater the increase to EPS for the combined company. Also, the higher the P/E ratio of the
acquirer compared to the target company, the greater the increase in EPS to the acquirer.
Dilution of EPS occurs when P/E ratio paid for the target company exceeds the P/E ratio of the
acquiring company.
Example: Fire Co will acquire all the outstanding stock of Water Co through an exchange of
stock. Fire is offering $65 per share for Water Co. Financial information for the two companies
is as follow:
Fire
Water
Net income
$50000
$10000
Shares outstanding
5000
2000
EPS
$10
$5
Market price of stock
$150

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P/E ratio
15
Required:
(a) Calculate the shares to be issued by Fire Co.
(b) Calculate the combined EPS.
(c) Calculate the P/E ratio paid: price offered/EPS of target.
(d) Compare P/E ratio paid to current P/E ratio.
(e) Calculate maximum price before dilution of EPS.
Solution:
(a) Shares to be issued = $65/$150 x 2000 = 867 shares.
(b) Combined EPS = (50000 + 10000)/(5000 + 867) = $10.23
(c) P/E ratio paid = $65/$5 = $13.
(d) P/E ratio paid to current P/E ratio: since 13 is less than the current P/E ratio of 15, there
should be no dilution of EPS for the combined company.
(e) Maximum price before dilution of EPS: 15 = price/$5 so maximum price = $75.
Conclusion
This is the end of syllabus area D. The ideas you learnt include choosing suitable target
company, value the company, finance the acquisitions and defences against takeovers.

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Corporate reconstruction and re-organisation


1. Financial reconstruction
Before starting with financial reconstruction, we should look at business failure which you will
learn in detailed if you study P5. This is because companies that are failing might use financial
reconstruction (you learnt this in P2) to prevent liquidation.
Financial distress
If a company is in financial distress, corporate failure will follow unless the companys problems
can be identified and corrected. Five principal causes of financial distress in any business are:
1. Revenue failure caused by either internal or external factors. Revenue failure may be through
a loss of orders (market failure) or through the acceptance of business which does not
contribute to the growth of shareholder value.
2. Cost failure caused by weak cost control, changes in technology, inappropriate accounting
policies, inadvertent or exceptional cost burdens, poor financial management or failure of
effective governance.
3. Failure in asset management through failure to invest in appropriate technology, poor
working capital management, inappropriate write off and reinvestment or poor organisation of
the available assets.
4. Failure in liability management through failure to manage the companys relationship with
the money markets, weak control of interest rate risk and currency risk or unsustainable credit
policies.
5. Failure of capital management through either over or under-capitalisation or poor
management of the companys relationship with the capital markets and in particular the
companys debt portfolio and the optimisation of its cost of capital.
Assessing a company situation
We can use ratio analysis to assess the companys performance by looking at the key areas:
1. Profitability ROCE, profit margin.
2. Efficiency asset turnover, receivable days, payable days, inventory days.
3. Liquidity current ratio, quick ratio.
4. Risk gearing ratio, interest cover.
5. Investor EPS, P/E ratio, dividend cover, dividend yield.
The risk of corporate failure can be identified by analysing accounting ratios, and trends in
EVA and MVA. A number of predictors of corporate failure include:
1. Altmans Z score calculating Z using a formula. A score of 3 or more (safe level) is
considered safe and at below 18 (danger level), the company is at risk of failure (insolvent) in
the next two years.

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2. Argentis A score use qualitative scoring on three areas: defects, mistakes made and
symptoms of failure.
3. Beavers ratio operating cash flow to total debt ratio. Organisations failed within 5 years
with a ratio below 0.2 and did not fail in the next 5 years with a ratio above 0.4.
4. Going concern evaluation based on ISA 570.
5. Information regarding an external or environmental issue.
6. Free cash flow analysis.
Remember that the models such as Z score only show a snapshot and are best as short-term
predictors; further analysis is required. Also, some models tend to rate companies low.
Financial reconstruction
Financial reconstruction scheme is a scheme whereby a company reorganizes its capital
structure, including leveraged buyouts, leveraged recapitalisations and debt-equity swaps. It is
part of capital restructuring in which the capital structure of a firm is changed.
1. Leveraged buyouts publicly quoted company is acquired by a specially established private
company. The private company funds the acquisition by substantial borrowing.
2. Leveraged recapitalisations firm replaces the majority of its equity with a package of debt
securities consisting of both senior and subordinated debt. This also causes the firm to be
unattractive for takeover.
3. Debt-equity swaps equity/debt swap is when all specified shareholders are given the right
to exchange their stock for a predetermined amount of debt in the same company while
debt/equity swap works the opposite way. This can be used to affect WACC.
Financial reconstruction may be undertaken by healthy companies and those in financial
distress (more likely).
Solvent company
Objectives of reconstruction may be to improve capital mix and timing of availability of funds.
The options available are: conversion of debt to equity, conversion of equity to debt,
conversion of equity from one form to another, and conversion of debt from one form to
another.
Failing company
Objectives of reconstruction are to attract fresh capital and persuading creditors to accept
some security in the company as settlement of its debts, so as to prevent the company to go
into liquidation. Options available are: Company Voluntary Arrangement (voluntary agreement
with creditors regarding repayment of corporate debts) and administration order.

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Response of the capital market and/or individual suppliers of capital to any reconstruction
scheme and the impact their response is likely to have upon the value of the company
Market response to financial reconstruction has been estimated from empirical studies of the
behaviour of share prices. Market reacts positively to firms raising their level of debt up to a
certain level, since the constraint that debt imposes (covenants) on future cash flows makes
companies choosier when selecting investment opportunities.
The design of reconstruction scheme needs to take into account the interests of, and the
impact upon ordinary shareholders, preference shareholders and creditors (including banks and
debenture holders).
1. Secured lenders respond positively if scheme is made more attractive than liquidation.
2. Unsecured creditors vote in favour of reconstruction in the hope that they recover the
maximum amount that they can.
3. Preference shareholders respond positively if they are given a share in equity or
enhancement in rate of dividend.
4. Ordinary shareholders respond positively if they retain their stake in the company and
achieve a better value for the shares upon reconstruction.
The impact of a financial reconstruction scheme on the value of the firm can be assessed in
terms of the impact of the growth rate of the company, its risk, and its required rate of return.
Through the changes of these three, WACC will be affected and therefore NPV of the firm will
change.
Effect on growth rate
Growth rate following a financial reconstruction can be calculated from the formula
where ROA is the return on net assets,

is the book

value of debt, r is the cost of debt. Original Gordons formula is g = br. Here we expand on the r.
Example: A firm currently has a debt/equity ratio of 0.12 and a ROA of 15%. The optimal debt
ratio is however much lower than the optimal level, since it can raise the debt/equity ratio up
to 0.3 without increasing the risk of bankruptcy. The firm plans to borrow and repurchase stock
to get to this optimal ratio. The interest rate is expected to increase from 7% to 8%. Tax rate is
25% and the retention rate is 50%. Find the impact of the increase in debt on the growth rate.
Solution: Before increase we have g = 0.5 x [0.15 + 0.12 (0.15 0.07 x 0.75)] = 0.08085.
After increase we have g = 0.5 x [0.15 + 0.3 (0.15 0.08 x 0.75)] = 0.0885.
The increase in debt has raised the growth rate by nearly 1%.

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Effect on systematic risk


We can look at the change in equity beta based on the asset beta formula:
or
Example: A firm currently has a debt/equity ratio of 0.12 and an asset beta of 0.9. The optimal
debt ratio is however much lower than the optimal level, since it can raise the debt/equity ratio
up to 0.3 without increasing the risk of bankruptcy. The firm plans to borrow and repurchase
stock to get this optima ratio. The tax rate is 25%. Find the impact of the increase in debt on the
geared beta.
Solution: Before the increase we have = [1 + 0.12 (1 0.25)] x 0.9 = 0.981.
After the increase we have = [1 + 0.3 (1 0.25)] x 0.9 = 1.1025.
Common sense will tell you that the increase in debt (increased financial risk) will increase
equity beta.
Devising reconstruction scheme and its impact upon the reported performance and financial
position of the company
The general procedures in devising a reconstruction scheme are:
1. Write-off fictitious assets and the debit balance on profit and loss account. Revalue assets to
determine their current value to the business.
2. Is further finance required? How much and in what form (shares, loan stock) and from whom
it is obtainable (typically existing shareholders and financial institutions).
3. Determine a reasonable manner in spreading the write-off (the capital loss) between the
various parties that have financed the company (shareholders and creditors) based on the
above.
4. Agree the scheme with the various parties involved.
As discussed earlier, the impact of reconstruction scheme on the market and individual capital
providers must be considered. Reconstruction scheme will significantly alter the reported
performance and position as company may undertake debt-equity swap, selling off assets,
establishing new company, share repurchase and so on. These are likely to impact a number of
capital providers. A reconstruction scheme must be beneficial for each capital provider before
being implemented.
2. Business re-organisation
Companies are restructuring in the pursuit of long-term strategy in order to achieve a higher
level of performance or in order to survive when existing structures and activities are
problematic. Business re-organisations consist of portfolio restructuring and organisational
restructuring. Portfolio restructuring is the acquisition or disposal of assets or business units by

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a company in the form of divestments, demergers, spin-offs or management buy-outs (MBOs).


Organisational restructuring consists of changes in the organisational structure of the firm, such
as divisional changes and hierarchical structures.
Strategies for unbundling parts of a quoted company
Unbundling is a portfolio restructuring strategy which involves the disposal and sale of assets,
facilities, production lines, subsidiaries, divisions or product units from the parent company.
The aim is to improve the performance of the existing company or the newly formed units.
There are many forms of unbundling available:
1. Divestment disposal of a companys assets/operations. When you study BCG matrix, a dog
is normally divested.
2. Demerger opposite of merger. It is the splitting up of a corporate body into two or more
separate and independent bodies. Shareholders of original company are given a share in each
of newly formed companies. A two-division company with one loss making division and one
profit making, fast growing division may be better off by splitting the two divisions.
3. Sell-off a form of divestment involving the sale of part of a company to a third party, usually
another company. Generally, cash will be received in exchange. The extreme form of a sell-off is
where the entire business is sold off in liquidation. Sell-off could be employed where part of the
business is making losses or company may be short of cash.
4. Spin-off a new company is created whose shares are owned by the shareholders of the
original company which is making the distribution of assets. Sometime it is easier to see the
value of the separate parts of the business and there may be improved efficiency.
5. Carve-out a new company is created whose shares are owned by the public with the parent
company retaining a substantial fraction of the shares. Normally, this is undertaken in order to
raise funds in the capital markets.
6. Management buy-out (MBO) purchase of all or part of the business by its managers. The
managers may be more experience to turnaround a loss making business and it is cheaper to
sell to own managers.
7. Management buy-in (MBI) a team of outside managers, as opposed to managers who are
already running the business, mount a takeover bid and then run the business themselves. This
often occurs when major shareholders of a small family company wishes to retire.
Financial and other benefits of unbundling
First we will look at the likely financial benefits of unbundling:
1. Growth rate growth rate and net earnings of a company will generally increase.
2. Business risk companys risk will generally reduce after unbundling due to improved
performance. In other word, asset beta should reduce.

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3. Improvement in EPS could cause the correlation among EPS, P/E ratio and share price
changes.
Other benefits of unbundling include:
1. Loss making units are eliminated.
2. Core business activities are concentrated on.
3. The performance of the company is improved resulting in the maximisation of shareholder
value.
4. Locked up financial resources are released for new investment in profitable ventures.
Financial issues relating to a management buy-out and buy-in
In an MBO or MBI, managers are usually lack of financial resources to fund the acquisition in
full. One important source of financial backing is through venture capital. Venture capitalists
will normally require an equity stake in the company and may wish to have a representative on
the board to look after its interests. A number of clearly defined exit routes (eg. sale of shares
following flotation) in order to ensure the easy realisation of their investment when required.
Other sources of finance for MBO or MBI include clearing banks, pension funds, merchant
banks and so on.
There are a number of factors to consider before MBO or MBI:
1. Do the current owners wish to sell?
2. Potential of the business.
3. Loss of head office support.
4. Quality of the management team.
5. The price.
6. Possible resistance from employees.

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Treasury and advanced risk management techniques


1. The role of treasury function in multinationals
Role of money markets
Money markets are markets in which the securities that are traded have short maturities, less
than a year, and the repayment of funds borrowed is required within a short period of time. We
will look at the role of money markets in a number ways.
Providing short-term liquidity to industry and the public sector
Money markets provide short-term finance and organisations can obtain and invest funds in
short-term.
Providing short-term trade finance
The temporary cash deficits company can meet and obtain finance from company with
temporary cash surplus. Money markets also provide non-inflationary avenue to government
for raising short-term funds.
Allowing a multinational company to manage its exposure to FOREX and interest rate risk
Multinationals will expose to foreign exchange (FOREX) risk and interest rate risk. They can use
money market to hedge the risk and we call it money market hedge which you learnt in F9.
Role of the banks and other financial institutions in the operation of the money markets
Banks and other financial institutions such as pension funds, investment funds, insurance
companies and so on, act as the financial intermediaries in money markets. Financial
intermediaries can run a number of functions:
1. Aggregation small sums from different individuals can be pooled and loaned to a single
borrower. Therefore, the single borrower is able to obtain the finance required.
2. Risk reduction they have the ability to evaluate the credit quality of an individual so the
credit risk to the lender can be reduced.
3. Maturity transformation lenders may want to keep money for liquidity while borrowers
may need long-term borrowing. Financial intermediary can facilitate short-term and long-term
needs of lenders and borrowers.
4. Financial intermediation bringing borrowers and lenders together.
5. Securitisation process of converting illiquid assets into marketable asset-backed securities.
Securitisation started with banks converting their long-term loans such as mortgages into
securities and selling them to institutional investors. Securitisation of loans and sale to investors
with more long-term liabilities reduce the mismatch between the maturities of assets and
liabilities and a banks overall risk profile.

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However, the development of securitisation has led to disintermediation and a reduction in the
role of financial intermediaries as borrowers can reach lenders directly. Disintermediation
describes a decline in the traditional deposit and lending relationship between banks and their
customers and an increase in direct relationships between the ultimate suppliers and users of
financing.
Characteristics and role of the principal money market instruments
There are three group of principal money market instruments that we need to consider.
Coupon bearing instruments
Coupon bearing means involving interest payment. There are two types of coupon bearing
money market instruments:
1. Certificate of Deposit (CD) a certificate of receipt for funds deposited at bank or other
financial institution for a specified term and paying interest at a specified rate.
2. Repurchase agreement (Repo) an agreement between two counterparties under which one
counterparty agrees to sell an instrument to the other on an agreed date for an agreed price,
and simultaneously agrees to buy back the instrument from the counterparty at a later date for
an agreed price. The repurchase price will be the sale price plus interest charged.
Discount instruments
Discount instruments mean those that are issued at a discount to their final redemption value.
There are a number of such instruments in money market:
1. Treasury bill (T-bill) debt instrument issued by government at a discount to the face value
with maturities ranging from one month to one year.
2. Commercial paper short-term unsecured corporate debt (short-term IOU) normally issued
by large organisations with good credit ratings. The debt is issued at a discount that reflects the
prevailing interest rates.
3. Bankers acceptances negotiable bills issued by companies and guaranteed by a bank. Bank
guaranteed the payment by the company for a fee. The interest rates are low because, as they
are guaranteed by a bank, the credit risk is low. Again, this is sold on a discounted basis.
Derivative products
Derivative is a financial instrument whose value changes in response to the change in an
underlying variable such as interest rate, that requires little or no initial investment and that is
settled at a future date (IAS 32). Derivatives are effective tools for hedging currency and
interest risk exposures. There are many derivative products and you will learn about them later
when we discuss about hedging currency risk and interest rate risk.

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Operations of derivatives market


Here we will start by understanding the basic knowledge of dealing with derivatives.
Advantages and disadvantages of exchange traded versus OTC agreements
Exchange traded means that you need to trade through the exchange and so the trade is
standardised. Over-the-counter (OTC) means that the trade can be tailor-made. Example of OTC
agreement is forward contract and the example of exchange traded derivative is futures
contract.
OTC derivative can be tailored to meet the needs of parties and is made with the intention of
delivery (for example the delivery of currency). There is no initial margin payable. However,
there is a limited access to OTC derivative.
Exchange traded derivative is the opposite. It is highly standardised and physical delivery is very
rare. Initial margin would be payable to the exchange in margin account and variation margin
would be required for additional losses. Trader has an unlimited access to exchange traded
derivative since they are traded in the exchange. Refer to below about margin.
Key features, such as standard contracts, tick sizes, margin requirements and margin trading
Here we discuss about the terminologies in derivatives market and further explain about
margin identified above. Here we will focus on exchange traded derivative. We will use
currency futures as example. Currency futures are standardised exchange traded contracts for
currency agreed now between buyers and sellers, for settlement at a future date.
Standard contract is a contract where terms of contract are standardised in nature. The terms
specify amount, type and date of settlement of futures contract. For currency futures, the
trader would trade according the contract size given in the exchange such as Chicago
Mercantile Exchange (CME), for example contract size of British pound is 62500. In this case,
trader needs to buy or sell according to this contract size. We will talk more about this later.
Tick sizes are the smallest movement in price of an exchange traded derivative. Tick size is
always quoted in US dollars. For currency futures, tick size for British Pound is $0.0001 in CME
and tick value = $0.0001 x 62500 = $6.25. Therefore, if the exchange rate moves by $0.004 in
the companys favour, this means 40 ticks and so the profit made will be 40 x $6.25 = $250 per
contract.
Margin will be required by the futures exchange. An initial margin is similar to a deposit. When
a currency future is set up, the trader would be required to deposit some cash with the futures
exchange in a margin account. This acts as security against the trader defaulting on their trading
obligations. The futures exchange monitors the margin account on a daily basis. If the trader is
making significant losses, the futures exchange may require additional margin payments known
as variation margins. This practice creates uncertainty as the trader will not know in advance
the extent (if any) of such margin payments.

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Source of basis risk and how it can be minimised


Basis means futures price spot price. Therefore, basis risk is the risk that the price of a futures
contract will vary from the price of the underlying asset (the spot rate). It is assumed that the
difference between the spot rate and futures price falls over time but there is a risk that basis
will not decrease in this predictable way (which will create an imperfect hedge). In order to
manage basis risk, it is important to choose a futures contract with the closest maturity date to
the actual transaction.
Risks such as delta, gamma, vega, rho and theta, and how these can be managed
These risks relate to option and option is also a derivative product. These are known as
Greeks.
1. Delta change in price of the option/change in the price of the underlying security. In fact,
N(d) in BSOP model is the delta value. Delta factors are often used when deciding which
options to sell or buy, with investors considering the delta value of each option and the trend.
Delta hedge is an option position which, when added to a portfolio, causes the portfolio to be
Delta neutral (the portfolio consisting of a quantity of the underlying instrument and a quantity
of options). If delta value increases, more contracts would be needed to maintain the hedge.
2. Gamma change in delta value/change in price of underlying security. It measures the extent
to which delta changes when the price of underlying security changes. The higher the Gamma
value, the more difficult it is for the option writer to maintain a delta hedge because the delta
value increases more for a given change in share price. Gamma values will be highest for a
share which is close to expiry and is at the money.
3. Vega change in price of option/change in volatility. If a dollar option has a Vega of 0.2, its
price will increase by 20 cents for a one percentage point increase in its volatility. Long-term
options have larger vegas than short-term options. The longer the time period until the option
expires, the more uncertainty there is about the expiry price. Therefore, a given change in
volatility will have more impact on an option with longer until expiration than one with less
time until expiration. Delta and Gamma neutral may need readjusting if the markets view of
future volatility (standard deviation) changes.
4. Rho change in price of option/change in interest rate. This is the amount of change in value
for a 1% change in the risk-free interest rate. Long-term options have larger Rhos than shortterm options. The more time there is until expiration, the greater the effect of a change in
interest rates. Rho for a call option will be positive (as the PV of exercise price payable
decreases as the risk-free rate rises) whereas for a put option the Rho will be negative as the PV
of exercise price receivable decreases.
5. Theta change in price of option/change in time to expiry. Theta measures how much value
is lost over time. At the money options have the greatest time premium and thus the greatest
Theta. Their time decay is not linear; their theta increases as the date of expiration approaches.

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We can summarise these Greeks in a table:


Risks
Delta
Gamma
Vega
Rho
Theta

Change in
Option value
Delta
Option value
Option value
Option value/time premium

With
Underlying asset value
Underlying asset value
Volatility
Interest rates
Time to expiry

Role of the treasury management function


Association of Corporate Treasurers definition of treasury management is the corporate
handling of all financial matters, the generation of external and internal funds for business, the
management of currencies and cash flows, and the complex strategies, policies and procedures
of corporate finance. We can look at the role of treasury management function in three ways:
The short-term management of the companys financial resources
This includes helping to decide portfolio of marketable securities for short-term investment,
short-term cash management (lending/borrowing funds as required) and also short-term
currency management. Working capital management may also be undertaken.
The longer term maximisation of shareholder value
This is linked to the financial management functions where treasurer makes three decisions:
1. Investment decision including investment appraisal, the review of acquisitions and
divestments, and defence from takeover.
2. Financing decision raising long-term finance, including equity strategy, management of
debt capacity and capital structure.
3. Dividend decision developing dividend policy.
The management of risk exposure
Treasurers need to assess the companys risk exposure to, for example, interest rate and
foreign exchange risk, and figure out the best way to manage the risks. They might undertake
hedging to lock-in the risk exposure so that company will not lose out but at the same time,
unable to take advantage of upside risk.
The functions of treasury management that are specific to international groups include:
1. Setting transfer prices to reduce the overall tax bill.
2. Deciding currency exposure policies and procedures.
3. Transferring of cash across international borders.

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4. Decising investment strategies for short-term funds from the range of international money
markets and international marketable securities.
5. Netting and matching currency obligations (more on this later).
2. The use of financial derivatives to hedge against forex risk
You have learnt some of the hedging methods in F9 and its good to remember them. First we
will start with some basics in FOREX and the revisions of some hedging methods.
Basics and revisions
Currency rates can be quoted as direct quotes or indirect quotes. Direct quote is the amount of
domestic currency which is equal to one foreign currency unit and indirect quote is the other
way round. For example, assume that we are UK, 1 = $1.5000 or $1.5000/1 will be indirect
quote for us. Note that in currency, we always use four decimal places.
Bid price is the rate at which the bank is willing to buy the currency and offer (or ask) price is
the rate at which the bank is willing to sell the currency. The difference between the big price
and the offer price is known as the spread. Remember that bank will choose the one that is
more favourable to them. For example, assume that we are UK and we need to buy $5000 from
bank; the spot rate quoted as $/ was $1.5000 - $1.5100, bank will sell to us at $1.5000 so that
they gain more ($5000/$1.5000 = 3333.33 is more than $5000/$1.5100 = 3311.26). Just
remember that you will always get the unfavourable rate no matter spot or forward rate.
In financial management we normally assume that people are risk averse and prefer to reduce
risk if they can do so without too great a cost. Therefore, company would undertake hedging
which avoids the risk of making a foreign currency loss while also avoid the opportunity for
making a currency gain. Hedging is the purchase of contract or tangible good that will rise in
value and offset a drop in value of another contract or tangible good, thus protecting the owner
from loss.
There are two broad types of internal and external hedging methods:
Internal hedging methods
1. Invoicing in home currency we invoice the foreign customers in home currency. This will
avoid FOREX risk but foreign customers may not like it and prevent us from doing so.
2. Leading and lagging leading involves accelerating payments to avoid potential additional
costs due to currency rate movements while lagging involves delaying payments if currency rate
movements are expected to make the later payment cheaper.
3. Matching receipts and payments a company that expects to make payments and have
receipts in the same foreign currency should plan to offset its payments against its receipts in
that currency. The process of matching is made simpler by having foreign currency accounts

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with a bank. Example is where company sells to Japan and buys from USA, company can
demand for the use of Euro as the currency in the invoice so that matching is possible.
4. Netting this includes bilateral and multilateral netting and we will discuss about this later.
External hedging methods
All these will be covered later and include forward contract, money market hedge, currency
futures, currency option and currency swap. These will be more expensive than internal ones.
Impact on a company to exposure in translation, transaction and economic risks and how
these can be managed
The three FOREX risks are covered earlier. In this topic, we are concerned with managing
transaction risk only, through various hedging techniques.
Translation risk can be partially overcome by funding the foreign subsidiary using a foreign loan.
Economic risk is difficult to manage. It can be dealt with by trying to export or import from
more than one currency zone and hope that the zones dont all move together. Another way is
to make your goods in the country you sell them. Although raw materials might still be
imported and affected by exchange rates, other expenses (such as wages) are in the local
currency and not subject to exchange rate movements.
Managing transaction risk
You need to evaluate which of the hedging method is the most appropriate strategy, given the
nature of the underlying position and the risk exposure. Cost is the main factor to consider.
Use of the forward exchange market
Forward exchange market is where one can buy or sell forward exchange contract. Forward
exchange contract is a contract for currency which sets a fixed future date for a predetermined
rate (forward rate). This removes the currency risk by fixing the exchange rate in advance.
Forward contracts are negotiated with banks and can be tailored (OTC) to the exact needs of
the company, in terms of amount and maturity date. For smaller value transactions, however,
rates are not so favourable or may not be available at all. The contract is binding and must be
delivered at the fixed date so the problem here is that if a customer is paying late, we may have
no money to pay the bank for the forward contract. We will still need to close out the forward
exchange contract, by ether selling or buying the missing currency at spot rate.
Forward rate is probably an unbiased predictor of the expected value of the future exchange
rate, based on the information available today. The cost of using forward exchange contract is
easily calculated by converting the receipts or payments using forward rate.

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Synthetic foreign exchange agreements (SAFEs)


Some governments banned foreign currency trading such as in China, Korea, Brazil, Philippine
etc in order to reduce the volatility of their exchange rates. In such markets, SAFEs (nondeliverable forwards) are used. These are forward contracts in which profits or losses
(calculated as difference between agreed SAFE rate and the prevailing spot rate) on a notional
principal amount are settled in cash at the end of the contract. Due to cash settlement, the
notional amount of currencies does not change hands.
Example: A lender enters into a three month SAFE with a counterparty to buy $5m worth of
Philippine pesos at a rate of $1 = PHP44.000. The spot rate is $1 = PHP43.850. When the SAFE is
due to be settled in three months time, the spot rate is $1 = PHP44.050. This means that the
lender will have to pay 5m x (44.050 44.000) = PHP250000 to the counterparty.
As this will be settled in dollars at the prevailing spot rate, the payment to the counterparty will
be PHP250000/44.050 = $5675.
Creation of a money market hedge
Money market hedging is the use of borrowing and lending transactions in foreign currencies to
lock in the home currency value of a foreign currency transaction. This involves borrowing in
one currency, converting the money borrowed into another currency and putting the money on
deposit until the time the transaction is completed, hoping to take advantage of favourable
interest rate movements. Example will be required to understand how it works.
1. Foreign currency receipt (aim to create a foreign currency liability and use the foreign
currency receipt to pay it).
Example: A UK manufacturer exported to a US company and in 3 months time he will receive
US$2m. To face no currency risk, this US$2m can be used to settle a US$2m liability. UK
manufacturer can create a US$2m liability by borrowing US$2m now and repaying that in 3
months time with the US$ receipt. Interest rates information is important, let say US$ 3
months interest rate is 0.54% - 0.66% (this amount is always annualised). Same rule, UK
manufacturer will be charged at higher rate, ie. 0.66% per annum. The amount that UK
manufacturer actually need to borrow now is:
X (1 + 0.66%/4) = 2000000, X = US$1996705. This can be changed now from US$ to at the
current spot rate, say US$/ 1.4701, to give 1358210 (1996705/1.4701). This 1,358,210 is
certain, UK manufacturer can deposit it into the bank or use it elsewhere.
Finally, when US$2m is received from US company, it will be used to repay the loan which
should have increased to US$2m from US$1996705.

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2. Foreign currency payment (aim to create a foreign currency asset and use this to pay the
foreign currency payment, cost involved is the borrowings to create the foreign currency asset).
Example: A UK company owes a Danish creditor Kr3500000 in three months time. Spot
exchange rate is Kr7.5509 Kr7.5548 per 1. The company can borrow in Sterling for 3 months
at 8.6% per annum and can deposit Kroner for 3 months at 10% per annum. What is the cost in
pounds with a money market hedge?
Solution: Interest rates for 3 months are 2.15% (8.6%/4) to borrow in pounds and 2.5% (10%/4)
to deposit in kroner. Amount to borrow = amount to deposit = X (1 + 2.5%) = 3500000, X =
Kr3414634. Convert this to will be 3414634/7.5509 = 452215 (spot rate given will always be
the bad one). Company has to borrow 452215 and with 3 months interest will have to repay:
452215 x 1.0215 = 461938.
In 3 months, deposit (Kr3414634 should have increased to Kr3500000) will be taken out to pay
the Danish creditor and company will pay 461938 to the bank.
The choice between forward exchange contract (forward market) and money markets is
generally made on the basis of which method is cheaper, with other factors being of limited
significance.
Example: ZPS Co, whose home currency is the dollar, took out a fixed-interest peso bank loan
several years ago when peso interest rates were relatively cheap compared to dollar interest
rates. Economic difficulties have now increased peso interest rates while dollar interest rates
have remained relatively stable. ZPS Co must pay interest of 5,000,000 pesos in six months
time. The following information is available.
Per $
Spot rate: pesos
12500 pesos 12582
Six-month forward rate: pesos
12805 pesos 12889
Interest rates that can be used by ZPS Co:
Borrow
Deposit
Peso interest rates:
100% per year
75% per year
Dollar interest rates:
45% per year
35% per year
Calculate whether a forward market hedge or a money market hedge should be used to hedge
the interest payment of 5 million pesos in six months time. Assume that ZPS Co would need to
borrow any cash it uses in hedging exchange rate risk.
Solution: The cost of both methods has to be compared.
Forward market hedge
Cost = 5000000/12.805 = $390472 (always take the rate that is bad).

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Money market hedge


The aim is to create a 5000000 peso asset in 6 months time. The amount of pesos required to
deposit is X (1 + 7.5%/2) = 5000000, X = 4819277 pesos. Therefore, the $ to borrow this amount
will be 4819277/12.500 = $385542. This is the cost now, we have to include the interest cost for
6 months, ie. 385542 x (1 + 4.5%/2) = $394217.
Comparing the cost, forward market hedge is cheaper by $3745 and should be used to hedge.
The money market hedge is based upon interest rate parity. Using the no arbitrage condition of
the interest rate parity formula, we can determine the maximum rate of interest the company
should agree in creating a money market hedge. Arbitrage is the simultaneous purchase and
sale of a security in different markets with the aim of making a risk-free profit through the
exploitation of any price differences between the two markets. IRP also implies that a money
market hedge should give the same result as a forward contract.
Exchange-traded currency futures contracts
Currency futures contract is the same as a forward contract, but is standardised in terms of
amount and maturity date, to allow it to be traded on a futures exchange, such as the Chicago
Mercantile Exchange (CME). Standard maturity dates are once every three months, at the end
of March, June, September and December. The lack of choice of maturity date means that
when futures contracts are used as a hedge, they are nearly always closed out (selling futures if
previously bought them or buying futures if previously sold them).
Contract size, tick size, margin requirements and basis risk are all discussed earlier. You will be
given the contract size and tick size in exam; they are fixed in CME. Margin will be paid for using
currency futures. Basis risk will arise if currency futures is used to hedge.
The following table will be useful to avoid confusion in currency futures question.
Transaction on future date
Now
On future date
Receive currency
Sell currency futures
Buy currency futures
Pay currency
Buy currency futures
Sell currency futures
Receive $
Buy currency futures
Sell currency futures
Pay $
Sell currency futures
Buy currency futures
The steps involved in hedging using currency futures are:
1. Set up the hedge by addressing 3 key questions do we initially buy or sell futures? How
many contracts (depend on contract size)? Which expiry date should be chosen (if transaction is
to be settled in November, choose December)?
2. Contact the exchange. Pay the initial margin. Then wait until the transaction/settlement date.
3. Calculate profit or loss in the futures market by closing out the futures contracts, and
calculate the value of the transaction using the spot rate on the transaction date.

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Example: Leaf Co, a company based in UK, imports and exports to USA. On 1 May it signs three
agreements, all of which are to be settled on 31 October:
(a) A sale to US customer of goods for $205500.
(b) A sale to another US customer for 550000.
(c) A purchase from a US supplier for $875000.
On 1 June the spot rate is 1 = 1.5500 1.5520$ and the October forward rate is at a premium
of 4.00-3.95 cents per pound. Sterling futures contracts are trading at the following prices:
Contract settlement date
Contract price $ per 1
Jun
1.5370
Sep
1.5180
Dec
1.4970
Contract size is 62500 and tick size is $0.0001 (so tick value is 6.25 per contract).
(a) Calculate the net amount receivable or payable in pounds if the transactions are covered on
the forward market.
(b) Demonstrate how a futures hedge could be set up and calculate the result of the futures
hedge if, by 31 October, the spot market price for dollars has moved to 1.5800-1.5820 and the
sterling futures price has moved to 1.5650.
Solution: (a) First we match receipts and payments. Sterling receipt does not need to be hedged
since it is not exposed to FOREX risk. Dollar receipt can be matched against the payment, giving
a net payment of $669500 on 31 October.
Forward rate in October for buying dollars = 1.5500 + 0.0400 (premium) = 1.5100.
Using forward contract, sterling cost of the dollar payment will be 669500/1.5100 = 443377.
The net cash received on October 31 will therefore be 550000 - 443377 = 106623.
(b) We need to pay $669500 so we like to buy dollars futures, but the problem is the contract
size will not have a US based currency of contract (dollars) as it is traded in CME. Therefore, we
sell sterling futures to buy the $ we need. As the settlement is on 31 October, we should choose
December contract.
$669500/1.4970 = 447228 so number of contract we need = 447228/62500 = 7.16 = 7 (we
round off as you cant buy part of the contract and because of this, imperfect hedge may
occur).
The closing futures price is given as 1.5650. Therefore:
$
Opening futures price sell
1.4970
Closing futures price buy
1.5650
Movement loss
0.0680
Futures market loss = 680 ticks x 6.25 x 7 contracts = $29750 or 0.0680 x 62500 x 7 = $29750.
The net outcome would be:

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$
Spot market payment
(669500)
Futures market loss
(29750)
(699250)
Translated at closing spot rate (bank sells low hence we use the rate of 1.5800) =
669250/1.5800 = 442563.
The net cash received on October 31 will therefore be 550000 - 442563 = 107437.
Currency swaps
A swap is an arrangement whereby two organisations contractually agree to exchange
payments on different terms, for example in different currencies, or one at a fixed rate and the
other at a floating rate. Currency swap is the swapping of interest rate commitments on
borrowing in different currencies and includes both the swap and re-swap of principal and an
exchange of interest rates. Currency swaps effectively involve the exchange of debt from one
currency to another. The swap of interest rates could be fixed for fixed or fixed for variable
(these swaps are also known as plain vanilla or generic currency swaps). During the life of the
swap agreement, the counterparties undertake to service each others foreign currency interest
payments. Currency swaps can provide a hedge against exchange rate movements for longer
periods than the forward market and can be a means of obtaining finance from new countries.
In practice, most currency swaps are conducted between banks and their customers.
Example: Jap Co is a Japanese firm looking to expand in USA and is looking to raise $20m at a
variable interest rate. It has been quoted the following rates:
$ LIBOR + 60 points
1.2%
Amer Co is an American company looking to refinance a 2400m loan at a fixed rate. It can
borrow at the following rates:
$ LIBOR + 50 points
1.5%
The current spot rate is $1 = 120. Show how the fixed for variable currency swap would work
in the circumstances described, assuming the swap is only for one year and that interest is paid
at the end of the year concerned.
Solution: As you can see, it is cheaper to borrow at own currency. Therefore, currency swap will
be useful. Jap Co can borrow on behalf of Amer Co 2400m at 1.2% and Amer Co can borrow on
behalf of Jap Co $20m at LIBOR + 50 points. Then, Jap Co pays LIBOR + 50 points interest rate
and Amer Co pays 1.2% interest rate. At the end of one year, Jap Co pays back $20m to Amer
Co and Amer Co pays back 2400m to Jap Co (re-swapping the principal amount).

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We can compare currency swap and forward contract. The attraction of a currency swap is that
it avoids having to enter into a sequence of forward contracts (a forward strip) with a currency
dealer with the associated charges and budget variability entailed. Inevitably, a higher rate will
be quoted on the swap to cover the required commission by currency dealer. A disadvantage of
swap agreements is the relatively complex contract procedure which must be pursued to
ensure that the counter-parties to the swap are in agreement as to the terms. Forward
contracts tend to be less cumbersome to both negotiate and contract with the currency dealer.
FOREX swaps
A FOREX swap involves the swapping and re-swapping of agreed equivalent amounts of
currency at an agreed rate for an agreed period. It is similar to currency swap with the
exception that it only involves the exchange of principal amount.
Example: Fire Co, based in Krownland, wishes to hedge 1 year foreign exchange risk, which will
arise on an investment in Chile. The investment is for 800m escudos and is expected to yield an
amount of 1000m escudos in 1 years time. Fire Co cannot borrow escudos directly and is
therefore considering two possible hedging techniques:
(a) Entering into a forward contract for the full 1000m escudos receivable.
(b) Entering into a FOREX swap for the 800m escudos initial investment, and then a forward
contract for the 200m escudos profit element.
The currency spot rate is 28 escudos to the krown, and the bank has offered a FOREX swap at
22 escudos/krown with Fire Co making a net interest payment to the bank of 1% in krowns
(assume at T1).
Interest
Borrowing
Lending
Krownland
15%
12%
Chile
N/A
25%
A forward contract is available at a rate of 30 escudos per krown. Determine whether Fire Co
should hedge its exposure using a forward contract or a FOREX swap.
Solution:
(a) In the case of forward contract, Fire Co needs to first borrow money to buy 800m escudos at
spot rate, ie. need to borrow 800/28 = 28.57m krown.
Interest on borrowing = 28.57 x 15% = 4.29m krown.
Receipts = 1000/30 = 33.33 krown.
Net receipts = 33.33 (28.57 + 4.29) = 0.47m krown.
(b) In the case of FOREX swap, again Fire Co needs to borrow money first, but this time the
amount to borrow is calculated as 800/22 = 36.36 krown (this amount is repaid at the end of 1
year). Interest = 36.36 x 15% = 5.45m krown. Swap fee = 1% x 36.36 = 0.36m krown.
Receipts hedged using forward contract = 200/30 = 6.67 krown.

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Net receipts = 6.67 (5.45 + 0.36) = 0.86m krown.


Therefore, FOREX swap is financially more favourable and should be chosen.
Currency options
A currency option gives the right (but not obligation) to exchange one currency for another at a
given exchange rate on a given future date. If the exchange rate specified in the option (known
as the exercise price or strike price) is better than that obtainable on the normal currency
markets, the option will be exercised to obtain that favourable rate. The great advantage of an
option is that if the exercise price is less favourable than the market rate, the option can simply
be ignored and allowed to lapse. This is a clear advantage over forward and futures contracts.
However, the right needs to be purchased (option premium) and it is more expensive than
forward and futures contracts. Currency options can be bought OTC (tailor made) or on major
exchanges (eg. London International Financial Futures and Options Exchange, LIFFE).
We would choose currency option in two circumstances:
1. We wish to protect against a FOREX loss but to allow the possibility of a gain.
2. We are uncertain whether we will need to buy or sell the foreign currency because that
depends on the outcome of other uncertain events, such as whether or not we make a sale.
The following table is useful to avoid confusion in exchange traded currency options:
Transaction on future date
Now
Option on future date
Receive currency
Buy currency put
Sell currency
Pay currency
Buy currency call
Buy currency
Receive $
Buy currency call
Buy currency
Pay $
Buy currency put
Sell currency
Steps involved in hedging using currency options are:
1. Set up the hedge by addressing 4 key questions do we need call or put options? How many
contracts? Which expiry date should be chosen? Which exercise price should be used?
2. Contact the exchange. Pay the option premium. Then wait until transaction/settlement date.
3. On the transaction date, compare the exercise price with the prevailing spot rate to
determine whether the option should be exercised or allowed to lapse.
4. Calculate the net cash flows beware that if the number of contracts needed rounding, there
will be some exchange at the prevailing spot rate even if the option is exercised.
Example: A UK company owes a US supplier $2000000 payable in July. The spot rate is 1 =
$1.5350-1.5370 and the UK company is concerned that the $ might strengthen. The details for
$/ 31250 options (cents per 1) are as follows.
Premium cost per contract:
Calls
Puts
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Strike price
June
July
August
June
July
August
1.4750
6.34
6.37
6.54
0.07
0.19
0.50
1.5000
3.86
4.22
4.59
0.08
0.53
1.03
1.5250
1.58
2.50
2.97
0.18
1.25
1.89
Show how traded currency options can be used to hedge the risk at a strike price of 1.525.
Calculate the sterling cost of the transaction if the spot rate in July is (a) 1.46 1.4620 or (b)
1.61-1.6120.
Solution: We need put option as we need to sell pounds in order to generate the dollars
needed. We will base on the strike price of 1.5250. As money is payable in July, we would
choose July as expiry date. Number of contracts we need = (2000000 1.525)/31250 = 41.97 =
42.
Premium payable now = 0.0125 (from July put at 1.5250 strike price) x 31250 x 42 = $16406.
Translated to sterling at spot rate = 16406/1.5350 = 10688.
Closing spot rate = (a) 1.4600 or (b) 1.6100 (since bank will always give us the adverse rate).
Options market outcome:
Strike price
1.5250
1.5250
Closing price
1.46
1.61
Exercise or not
YES
NO
Outcome of options position (31250 x 42)
1312500

Exercise option (31250 x 42 x 1.5250)


Value of transaction
Balance
Translated at spot rate = 1563/1.46 = 1071.

$2001563
$2000000
$1563

Net outcome:

Spot market outcome translated at closing spot rate


(2000000/1.61)
Options position
(1312500)
Difference in hedge at closing rate
1071
(The difference is a receipt as amount owed was over-hedged)
Premium paid
(10688)
Sterling cost of the transaction
(1322117)

(1242236)

(10688)
(1252924)

Use of bilateral and multilateral netting


Netting is a process in which credit balances are netted off against debit balances so that only
the reduced net amounts remain due to be paid by actual currency flows. Bilateral netting is
where only two companies are involved and lower balance is netted off against the higher

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balance. Multilateral netting is where more than two group companies are involved and is more
complex. There are two ways to do netting and both give the same results.
1. Transactions matrix
1. Set up a table with the name of each company down the side and across the top.
2. Input all the amounts owing from one company to another into the table and convert all
currency flows to a common (base) currency using spot rates.
3. By adding across and down the table, identify the total amount payable and the total amount
receivable by each company.
4. Compute the net payable or receivable, and convert back into the original currency.
2. Route minimisation algorithm
1. Convert all currency flows to a common (base) currency using spot rates.
2. Clear the overlap of any bi-lateral indebtedness, eg:
A

10m

4m

6m

3. Clear the smallest leg of any 3 way circuits, eg:


A

A
7m

10m
B

5m

8m

2m

4. Clear the smallest leg of any 4 way circuits (then 5, etc), eg:
A

3m
10m
m

7m
C

B
1m
m

8m
C

5m
D

2m

5. Convert back into original currencies.


6. The simplified figures can be used for settlement or setting up appropriate hedging tools.
A good question to test this is to do June 2010 question 5(a). We will look at one example but I
will only show the transactions matrix method and things are simplified.

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Example: X, Y and Z are three companies within the same UK based international group. W is a
company outside of the group. The following liabilities have been identified for the forthcoming
year:
Owed by
Owed to
Amount (m)
X
Y
39
Y
X
10
Y
W
$20
Z
X
200
Z
Y
15
W
X
$15
W
Z
100
Midmarket spot rates (currency cross rates) are 1 = $2.00, 1 = 1.50, 1 = 250. Establish the
net indebtedness that would require external hedging.
Solution:
Owed to
Owed by
W
X
Y
Z
W
$15
100
X
39
Owed by Y
$20
10
Z
200
15
We need to convert them to a common currency. In this case, sterling is a good choice.
Owed to
Owed by
W
X
Y
Z
W
7.5
0.4
7.9
X
26
26
Owed by Y
10
10
20
Z
0.8
10
10.8
Owed to
10
18.3
36
0.4
Owed by
7.9
26
20
10.8
Net
2.1
-7.7
16
-10.4
We only need to hedge 2.1 x 2 = $4.2m as W is the only outsider.
June 2010 question 5(b) question and answer are worth looking at.
Example: Discuss the advantages and disadvantages of netting arrangements with both group
and non-group companies (8 marks).
Solution: Netting is a mechanism whereby mutual indebtedness between group members or
between group members and other parties can be reduced. The advantages of such an

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arrangement is that the number of currency transactions can be minimised, saving transaction
costs and focusing the transaction risk onto a smaller set of transactions that can be more
effectively hedged. It may also be the case, if exchange controls are in place limiting currency
flows across borders, that balances can be offset, minimising overall exposure. Where group
transactions occur with other companies, the benefit of netting is that the exposure is limited
to the net amount reducing hedging costs and counterparty risk.
The disadvantages: some jurisdictions do not allow netting arrangements, and there may be
taxation and other cross border issues to resolve. It also relies upon all liabilities being accepted
and this is particularly important where external parties are involved. There will be costs in
establishing the netting agreement and where third parties are involved this may lead to reinvoicing or, in some cases, re-contracting.
Now, we shall have a look at June 2008 question 3(b) and (c)s questions and examiners
answers for a good summary and learning.
Example: Discuss the relative advantages and disadvantages of the use of a money market
hedge compared with using exchange traded derivatives for hedging a foreign exchange
exposure (6 marks).
Solution: A money market hedge is a mechanism for the delivery of foreign currency, at a future
date, at a specified rate without recourse to the forward FOREX market. If a company is able to
achieve preferential access to the short term money markets in the base and counter currency
zones then it can be a cost effective substitute for a forward agreement. However, it is difficult
to reverse quickly and is cumbersome to establish as it requires borrowing/lending agreements
to be established denominated in the two currencies.
Exchange traded derivatives such as futures and foreign exchange options offer a rapid way of
creating a hedge and are easily closed out. For example, currency futures are normally closed
out and the profit/loss on the derivative position used to offset the gain or loss in the
underlying. The fixed contract sizes for exchange traded products mean that it is often
impossible to achieve a perfect hedge and some gain or loss on the unhedged element of the
underlying or the derivative will be carried. Also, given that exchange traded derivatives are
priced in a separate market to the underlying there may be discrepancies in the movements of
each and the observed delta may not equal one. This basis risk is minimised by choosing short
maturity derivatives but cannot be completely eliminated unless maturity coincides exactly
with the end of the exposure. Furthermore less than perfectly hedged positions require
disclosure under IAS 39. Although rapid to establish, currency hedging using the derivatives
market may also involve significant cash flows in meeting and maintaining the margin
requirements of the exchange. Unlike futures, currency options will entail the payment of a

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premium which may be an expensive way of eliminating the risk of an adverse currency
movement.
With relatively small amounts, the OTC market represents the most convenient means of
locking in exchange rates. Where cross border flows are common and business is well
diversified across different currency areas then currency hedging is of questionable benefit.
Where, as in this case, relatively infrequent flows occur then the simplest solution is to engage
in the forward market for hedging risk. The use of a money market hedge as described may
generate a more favourable forward rate than direct recourse to the FOREX market. However
the administrative and management costs in setting up the necessary loans and deposits are a
significant consideration.
Example: Discuss the extent to which currency hedging can reduce a firms cost of capital (4
marks).
Solution: The only risk which will impact on a firms cost of capital is that risk which is priced in
either the equity or the debt markets. Considering these two markets in turn:
Currency risk forms part of a firms exposure to market risk and will impact on a firms cost of
capital through its beta value and, as a result, its equity cost of capital. The extent to which this
is significant depends on the exposed volume of currency transactions conducted in a given
period, the average duration of the exposure and the correlation of the currency with the
market. If a given currency has the same correlation with the market as the company, removing
currency risk will have no impact on the firms overall exposure to market risk and as a result no
impact on the firms cost of capital. The greater the difference in the relative correlations, the
higher the potential improvement in shareholder value from hedging.
The impact on the cost of debt is more complex. The most significant impact is through the
firms exposure to default risk. If currency transactions are significant and the foreign currency
is highly correlated with the domestic currency then the impact is unlikely to be significant and
the gains from hedging modest. Where the degree of correlation is low or indeed negative then
eliminating currency risk may significantly alter the firms default risk. However, unlike market
risk, default risk is related to the overall volatility of a firms underlying value and its ability to
finance its debt. The elimination of currency risk is therefore likely to have at least some impact
on the volatility of the firms cash flows and therefore its cost of capital.
3. The use of financial derivatives to hedge against interest rate risk
Interest rate risk is the risk to the profitability or value of a company resulting from changes in
interest rates. The risk with interest rates is not that interest rates might move once the loan
has been taken out (a fixed rate will protect against this). The risk is that rates might fluctuate
between now and the date the loan is needed.
We will start with some basics and revisions.

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Basics and revisions


A bank will quote two interest rates to a customer a lending rate and a depositing rate. The
lending rate is always higher than the depositing rate because the bank wants to make a profit.
The term LIBOR will be used regularly. This is the interest at which a major bank can borrow
wholesale short-term funds from another bank in the London money markets. There are
different LIBOR rates for different lengths of borrowing, typically from overnight to one year.
LIBOR + 100 basis points mean LIBOR + 1%. Note that the quoted interest rates are normally
annualised, so you may need to adjust to months.
Compared to exchange rates, interest rates are less volatile, but changes in them can still be
substantial. The term structure of interest rates provides an implicit forecast (according to
market expectations) that is not guaranteed to be correct but is the most accurate forecast
available. From the yield curve we can see that long-term debt has higher interest rates than
short-term debt because lender faces greater risk.
Just like FOREX risk management, we have internal and external hedging methods.
Internal hedging methods
1. Soothing the company tries to maintain a certain balance between its fixed rate and
floating rate borrowing. The portfolio of fixed and floating rate debts thus provide a natural
hedge against changes in interest rates. There will be less exposure to the adverse effects of
each but there will also be less exposure to favourable movements in the interest rate.
2. Matching the company matches its assets and liabilities to have a common interest rate
(eg. loan and investment both have floating rates).
3. Netting the company aggregates all positions, both assets and liabilities, to determine its
net exposure.
External hedging methods
All these will be covered below.
Managing interest rate risk
Again, you need to learn a number of methods to hedge interest rate risk and be able to
evaluate which is the most appropriate one in the given situation.
Forward Rate Agreements (FRAs)
FRA is an agreement, typically between a company and a bank (OTC). It does not involve the
actual transfer of capital from one party to another. FRA is an agreement to borrow/lend a
notional amount for up to 12 months at an agreed rate of interest (FRA rate). This protects the
borrower from adverse market interest rates movements to the levels above the rate
negotiated for the FRA. However it is likely to be difficult to obtain FRA for periods of over one

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year. When an FRA reaches its settlement date, the buyer and seller of FRA must settle the
contract as it is binding.
Something to note of is the terminology of FRA:
1. 4.00 - 3.80 means that you can fix a borrowing rate at 4.00% (favourable to the bank).
2. A 3 - 6 FRA is one that starts in three months and lasts for three months.
3. 1 basis point is 0.01%.
Benchmark rate of interest (LIBOR) is also called the variable rate, market rate or reference
rate. When FRA rate is higher than reference rate at settlement date, buyer of FRA makes cash
payment to the seller for the amount by which the FRA rate exceeds the reference rate.
Similarly, when FRA rate is lower than market rate, seller of FRA makes cash payment to the
buyer for the amount by which the FRA rate is less than the reference rate.
1. Borrowing (concerned about interest rate rises) company will borrow the required sum on
the target date and will thus contract at the market interest rate on that date. Separately the
company will buy a matching FRA from bank or other market maker and thus receive
compensation if rates rise.
2. Depositing (concerned about fall in interest rate) company will deposit the required sum on
the target date and will thus contract at the market interest rate on that date. Separately, the
company will sell a matching FRA to a bank or other market maker and thus receive
compensation if rates fall.
In each case, the interest rate will be effectively fixed.
Example: It is 30 June. Water Co needs a $10m 6 months fixed rate loan from 1 October. Water
Co wants to hedge using an FRA and the relevant FRA rate is 6% on 30 June. What if the FRA
benchmark rate has moved to 9% later?
Solution: FRA required is 3 - 9. Water Co will buy FRA from bank as it is concerned about
interest rate rises. Since the rate increased later, Water Co will receive 3% (9 6) from bank.
$
Payment on underlying loan at market rate (9% x $10m x 6/12)
(450000)
FRA receipt ($10m x 3% x 6/12)
150000
Net payment on loan
(300000)
Effective interest rate on loan will be 6%, company will avoid the lost when interest rate rises
(but also unable to benefit from fall in interest rate).
Interest rate futures
Interest rate futures are standardised exchange-traded contracts (can be traded in exchange
such as LIFFE in London) agreed now between buyers and sellers, for settlement at a future
date. It is generally closed out before the maturity date, yielding a profit or loss that is offset
against the loss or profit on the money transaction that is being hedged.

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1. A company expecting to borrow can lock in an interest rate by selling futures as company is
receiving money at open position.
2. A company expecting to lend or invest can lock in an interest yield by buying futures as
company is giving out money at open position.
Open price is the price of the future at the beginning of the days trading. Settlement price is
the official price of the future at the end of the days trading. Open price is the benchmark for
the days trading it is compared to the settlement price at the end of the day to determine
whether the future has closed up or down.
There are two broad types of interest rate futures: short-term interest rate futures (STIRs)
which is more commonly used and bond futures. For STIRs, the minimum price movement is
usually one basis point (0.01%). Again, there are some things to learn:
1. Tick value = unit of trading x one basis point x fraction of the year.
2. Interest rate futures prices are stated as 100 minus the expected market reference rate, eg.
96.70 means that market reference rate is 3.30%.
3. Number of contracts needed = amount of loan or deposit/contract size x exposure
period/contract period. Exposure period is the period of exposure to interest rate changes. The
standard contract period is 3 months (March, June, September and December).
4. We will select the shortest available future with maturity following the commencement of
exposure.
5. Futures hedges are imperfect due to basis risk and the need sometimes to round to a whole
number of contracts, for example number of contracts needed is 10.1 and we round up to 10.
The steps involved are quite similar to currency futures.
Example: It is now March. In the UK, Fire Co has recognised from its short-term cash budgets
that it is likely to have a surplus of 10m arising in 2 months time (May) for a period of 3
months, which it plans to invest in short-term money market instruments. It is concerned that
interest rates in the next 2 months may fall and wishes to hedge this risk using futures contract.
June three-month sterling interest rate futures contracts are available with a contract size of
500000 and tick size of 12.50. They are currently priced at 96.00. Interest rates currently
stand at 4%.
Illustrate how Fire Co can hedge its interest rate exposure using the above futures contracts if,
in 2 months time, market interest rates have fallen to 3% and the futures price has moved to
97.00.
Solution: Company wants to hedge the risk of a fall in interest rates on deposits/investments. It
will buy interest rate futures in March (open position). Number of contracts = 10m/500000 x
3/3 = 20 contracts at 96.00. The exposure period is 3 months (March, April, May).
In May, company will close out the futures by selling 20 futures contract at 97.00.

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Open position: Buy futures at


96.00
Close position: Sell futures at
97.00
Gain per contract
1.00 = 100 ticks
Total profit from futures trading = 20 contracts x 12.50 x 100 ticks = 25000.
Actual interest (3%)
75000
Gain on futures
25000
Net interest yield
100000
The fall in actual interest rates are supplemented by the profits from futures trading, which
result in effective interest rate yield of 4% (100000/10000000 x 12/3).
In exam, you may not be told what the closing futures price is. In this case, you should estimate
it by assuming that basis reduces to zero in a linear manner by the contracts official expiry
date. Basis risk occurs when actually the basis does not move in linear manner.
Example: LIBOR is currently 6% and it is estimated to rise by 100 basis points over the next
quarter. A three-month STIRs is undertaken. Current futures price is 93.88. Estimate the futures
closing price.
Solution: LIBOR = 6% = 94.00. Basis = 94.00 93.88 = 12 basis points or ticks. Assuming basis
reduces to zero (at the futures closing date) in a linear manner, the basis is spread evenly so 4
ticks per month (12/3).
LIBOR will also rise to 7% = 93.00.
Closing futures price = 93.00 0.04 = 92.96.
Interest rate swaps
This is normally used to hedge for longer-term. There are two broad types of interest rate swap:
1. Coupon swap (more common, also known as plain vanilla or generic swap) one party makes
payments at a fixed rate of interest in exchange for receiving payments at a floating rate. The
other party pays the floating rate and receives the fixed rate.
2. Basis swap parties exchange payments on one floating rate basis (eg. at three-month LIBOR
or at a six-month CD rate) for payments on another floating rate basis (eg. at six-month LIBOR).
If a company believes that it has an exposure to an increase in interest rates because too much
of its borrowing is at floating rate, it can arrange a swap to change some (or all) of its floating
rate interest obligations into fixed rate obligations, without altering its underlying loans.
Swaps can be used to:
1. Hedge against adverse movements in interest rates.
2. Manage fixed and floating rate debt profiles without having to change underlying borrowing.

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3. To obtain cheaper finance a swap should result in a company being able to borrow what
they want at a better rate under a swap arrangement, than borrowing it directly themselves
(this is known as the theory of comparative advantage).
Example: Happy Co wishes to raise 100m. It wishes to pay floating rate as it wants to take
advantage of any fall in interest rates. It can borrow at a fixed rate of 12% or at a floating rate
of LIBOR + 1%.
Funny Co wishes to raise a similar sum but can only borrow at 14% fixed or LIBOR + 2% floating.
For cash planning purposes it wishes to keep interest payments fixed.
Since Happy can borrow at the more beneficial rates, it requires 75% of any gains from a swap.
Set up the interest rate swap and show the advantages to both companies.
Solution: Happy Co has the absolute advantage in this case.
Fixed rate
Floating rate
Happy Co
12%
LIBOR + 1%
Funny Co
14%
LIBOR + 2%
Difference
2%
1%
The gains from swap = 1% (2 1) and Happy Co wants 0.75% of this. The difference in fixed rate
is higher so it is better for Funny Co to use fixed rate of Happy Co, which the company did.
Happy Co will have to pay Funny Co LIBOR + 2% while Funny Co pays Happy Co 13.75% (14% 0.25%).
Happy Co
Funny Co
Original payment
(12%)
(LIBOR + 2%)
Receipt under swap
13.75%
LIBOR + 2%
Payment under swap
(LIBOR + 2%)
(13.75%)
Net payment
(LIBOR + 0.25%) (13.75%)
Both companies can get the debt type required at advantageous rates, so the swap works. If we
examine the net payment carefully, Happy Co is paying less than 0.75% of its original floating
rate and Funny Co is paying less than 0.25% of its original fixed rate.
Banks (intermediaries) normally arrange swaps and quote the ask rate (the rate at which the
bank is willing to receive a fixed interest cash flow stream in exchange for eg. LIBOR) and a bid
rate (rate at which bank is willing to pay for receiving eg. LIBOR). The difference (the banks
profit margin) is generally at least 2 basis points. The advantage of dealing with a bank is that
there is no problem about finding a swap counterparty and the default risk is borne by bank.
However, the savings from swap will depend on the bank and counterparties will have to
accept the banks ask and bid rate. The following example extracts the December 2009 question
5.

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Example: Thunder Co raised $150 million through the issue of 12-year floating rate notes at 120
basis points over LIBOR, interest payable at six month intervals. The loan now has 10 years to
maturity. 10-year swap rates are quoted at 525540. Estimate the six-monthly interest rate
and the effective annual rate payable if a vanilla interest rate swap is agreed.
Solution: This is the case of floating for fixed swap. As interest is payable every 6 month, within
6 months the rate is LIBOR/2 + 1.2%/2 = LIBOR/2 + 0.6%. Bank always charges us the adverse
rate (ask rate), in this case 5.40 and converted to 6 months = 2.7%.
Payments
(LIBOR/2 + 0.6%)
Receipt under the swap
LIBOR/2
Payment under the swap
(2.7%)
Net payment
(3.3%)
Effective annual rate (EAR) = 1.033^(12/6) 1 = 6.71% (converting from 6 months rate to
annual rate).
Options on FRAs (interest rate guarantees, caps, floors, collars)
Interest rate guarantee (IRG) is a contract with a bank (OTC) fixing a maximum/(minimum)
borrowing/(lending) rate on a notional loan for a stated period from a stated future date in
exchange for an upfront fee (premium). It has a maximum maturity of one year. IRGs are more
expensive than the FRAs as one has to pay for the flexibility to be able to take advantage of a
favourable movement. If actual interest rate turns out to be favourable, the option can be
allowed to lapse.
1. Call option right to buy (receive interest at the specified rate).
2. Put option right to sell (pay interest at the specified rate).
Example: It is 31 October and Big Co is arranging a six-month 5m loan commencing on 1 July,
based on LIBOR. Big wants to hedge against an interest rate rise using an IRG. The current
LIBOR is 8%. The IRG fee is 0.25% per annum of the loan. If LIBOR turned out to be 9% or 5% on
1 July, evaluate the use of IRG.
Solution:
% per annum
% per annum
Actual interest payment
(9.00)
(5.00)
Premium paid on IRG
(0.25)
(0.25)
Claim on IRG
1.00
Net interest
(8.25)
(5.25)
When actual LIBOR is 5%, the IRG is allowed to lapse.
IRGs are sometimes referred to as interest rate options or interest rate caps/floors. IRG is an
interest rate cap (put option) when it sets an interest rate ceiling (maximum interest rate) or
interest rate floor (call option) when it sets a minimum interest rate. For example, company can

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buy a cap from bank to fix the maximum interest rate. However, the cost of a cap may be too
high and it may be necessary to consider interest rate collars.
Interest rate collar is a lower-cost alternative to an interest rate cap or floor. Under a collar
arrangement, the borrower limits its ability to take advantage of a favourable movement. It
buys a cap (put option) as normal but also sells a floor (call option) on the same FRA, but with a
different exercise price. In case of depositor, he can sell the cap to limit maximum receipts
while also buy a floor to limit minimum receipts. Collar is also used on interest rate futures.
Example: A collar might consist of a cap at 8% and a floor at 6.5%. The collar holder will
therefore fix a maximum LIBOR rate for borrowing at 8% but also a minimum rate of 6.5%. The
cost of a collar is the difference between the premium payable on the cap and the premium
receivable from selling the floor. This effectively reduced the premium cost of just using a cap.
Options on interest rate futures
These are exchange traded options so these have standardised amounts and standard periods.
It follows how you hedge using interest rate futures, for example if you buy futures at open
position, you will also buy call option (you are receiving interest) and if you are selling futures at
open position, then you will buy put option (you are paying interest). You need to find out the
exercise price of the option to determine which premium is applicable.
Example: It is 30 June. Ice Co requires a 5m three-month loan due to commence on 1
September. Ice can borrow at LIBOR + 1%, and wishes to protect itself against any future
interest rate increases above current LIBOR of 5.75%. Contract size of the traded options is
500000. The following data (all in %) are available on September LIFFE options:
Strike price
Interest rate cap
Call options premium
Put options premium
93.75
6.25
1.29
0.23
94.25
5.75
0.69
0.77
94.75
5.25
0.16
1.33
st
By 1 September LIBOR has risen to 8%. LIFFE price is 92.10. Illustrate how Ice Co could use
interest rate options to hedge its loan.
Solution: Ice Co is paying interest, so it will sell futures and so purchase put options. When we
are not told which strike price to use, we should use the one closest to the interest rate. In this
case, the current LIBOR is 5.75%, so our strike price is 94.25 (100 5.75) and so the premium
payable is 0.77% (September puts at strike price of 94.25).
Number of contracts = 5000000/500000 x 3/3 = 10.
At 1st September, futures price is 92.10 (7.9%) which is higher than price at open position
(94.25, ie. 5.75%). Option will be exercised so that Ice Co gains on the futures.

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%
Pay loan interest (8 + 1)
(9.00)
Pay premium
(0.77)
Exercise option: Profit on futures (94.25 92.10)
2.15
Net interest payable
(7.62)
Note: The premium can be reduced if Ice Co also sells a floor. If floor is sold at 5.25%, then Ice
Co can receive a premium of 0.16% which reduced the premium payable to 0.61% (0.77 0.16).
Options on interest rate swaps (swaptions)
Swaptions give the holder the right but not obligation to enter into a swap with the seller.
These are hybrids or embedded derivative.
A payer swaption gives the holder the right to enter into a swap as the fixed rate payer (and the
floating rate receiver). A receiver swaption gives the holder the right to enter the swap as the
fixed rate receiver (and the floating rate payer).
Swaptions generate a worst case scenario for buyers and sellers. For example an organisation
that is going to issue floating rate debt can buy a payer swaption that offers the option to
convert to being a fixed rate payer if interest rates increase.
Example: Suppose a party purchases a 1 x 5 payer swaption at a rate of 5%. A year later if the
four year swap is 6% the buyer will exercise the swaption and pay 5% fixed rate for LIBOR on a
four year swap. If instead the four year swap rate is 4% the buyer will not exercise the
swaption.
We will end this area by looking at December 2008 question 5(b) and answer.
Example: Outline the benefits and dangers of using derivative agreements in the management
of interest rate risk (6 marks).
Solution: Derivatives offer an opportunity for a firm to vary its exposure to interest rate risk at a
given rate of interest on the underlying principal (hedging) or to decrease the rate of interest
on its principal at an increased level of risk exposure. For hedging purposes derivatives permit
the management of exposure either for the long term (swaps) or for the short term (Forward
Rate Agreements (FRAs), Interest Rate Futures (IRFs), Interest Rate Options (IROs) and hybrids).
With forward and futures contracts, the mechanism of hedging is the same in that an offsetting
position is struck such that both parties forego the possibility of upside in order to eliminate the
risk of downside in the underlying rate movements. Where the option to benefit from
favourable rate movements is required or in situations where there is uncertainty whether a
hedge will be required, then an IRO may be the more appropriate but higher cost alternative.

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Such hedging can be more or less efficient depending upon the ability to set up perfectly
matched exposures with zero default risk. Matching depends upon the nature of the contract.
With OTC agreements the efficiency of the match may be perfect but the risk of default
remains. With traded derivatives, the efficiency of the match may be less than perfect either
through size effects or because of the lack of a perfect match on the underlying (for example
the use of a LIBOR derivative against an underlying reference rate which is not LIBOR). There
will also be basis risk where the maturity of the derivative does not coincide exactly with the
underlying exposure.
Where a company forms a view that future spot rates will be lower than those specified by the
forward yield curve they may decide to alter their exposure to interest rate risk in order to
capture the benefit of the reduced rate. This can be achieved through the use of IROs.
Alternatively, leveraged swap or leveraged FRA positions can be taken to avoid the upfront cost
of an IRO. For example, taking multiples of the variable leg of a swap (i.e. agreeing to swap fixed
for variable) where a higher than market fixed rate is swapped for n multiples of the variable
rate. However, as a number of cases have demonstrated it may be very difficult with these
types of arrangement to gauge the degree of risk exposure and to ensure that they are
effectively managed by the firm. In the 1990s a number of companies in the US and elsewhere
took leveraged positions, without recognising the degree of their exposure and took losses that
threatened the survival of the firm.
4. Dividend policy in multinationals and transfer pricing
Determining a companys dividend capacity and its policy
It is discussed earlier that dividend capacity can be measured by free cash flow to equity (FCFE).
Dividend capacity of a company depends on its after tax profits, investment plans and foreign
dividends. Here we are considering a number of factors that need to be considered by
multinationals when determining their dividend policy, in addition to just considering dividend
capacity.
The companys short and long-term reinvestment strategy
Company needs to finance its investment strategy which is done continuously. Short-term
investment means investing in working capital and long-term investment means investing in
project which may require significant financing. The finance required for the reinvestment must
be kept and not paid out as dividend.
The impact of any other capital reconstruction programmes on free cash flow to equity such as
share repurchase agreements and new capital issues
1. Share repurchase scheme will result in reduction in FCFE (refer to direct method) available
for payment as dividends and decrease in number of shares/increase in EPS.

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2. New capital issue new capital issue may be debt or equity issue. Both will increase FCFE
with the additional cash finance obtained but the interest payment in debt can reduce FCFE.
The impact of these on FCFE is important to consider as the changes in FCFE will result in the
need to alter the dividend policy.
The availability and timing of central remittances
Remittance blocking by the foreign countries governments can limit funds available to pay
dividends to parent company shareholders. Therefore, as discussed before, methods to prevent
or minimise the effect of blocked remittances include transfer pricing (setting high transfer
price for goods sold to the oversea subsidiary), charging royalty, make loan with high interest
rate to subsidiary, and management charges.
The timing of central remittance can also affect the FCFE. Factors like tax rate and exchange
rate should be considered and repatriation at the right time will be important.
The corporate tax regime within the host jurisdiction
Tax considerations are thought to be the primary reason for the dividend policies inside the
multinational firm. For example, parent company may reduce its overall tax liability by, for
example, receiving larger amounts of dividends from subsidiaries in countries where
undistributed earnings are taxed.
For subsidiaries of UK companies, all foreign profits, whether repatriated or not, are liable to UK
corporation tax, with a credit for the tax that has already been paid to the host country.
Similarly, the US government does not distinguish between income earned abroad and income
earned at home and gives credit to MNCs headquartered in the US for the amount of tax paid
to foreign governments.
Example: Assume that the corporate tax rate in the home country (US) is 40% and in the
overseas country where a subsidiary is located is 30%. Assume that both the parent company
and subsidiary have pre-tax profits of $1000. Show the total tax payable.
Solution: Tax paid to foreign government = 1000 x 30% = $300, therefore foreign tax credit =
$300.
US tax = 1000 x 40% = $400.
Total tax payable = (400 300) + 300 = $400.
Despite the financial sense of a residual approach to dividends, most multinationals adopt a
ratchet pattern of dividends. This means to pay out a stable but rising dividend per share and
dividends can be maintained when earnings fall.

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Multinational transfer pricing


You learnt transfer pricing in F5 where there are a number of bases for transfer pricing such as
cost-based, market-based and negotiated. In P4 we are interested in transfer pricing of goods
and services across international borders so factors like taxation and repatriation of funds are
important to consider.
Taxation
The group will wish to reduce tax by manipulating transfer prices, eg. if selling divisions country
has lower tax rate than the buying divisions country, selling division might sell at high price to
buying division (ie. more income with low tax rate) and buying division buys it at high cost (ie.
high cost attracts more reliefs), with this the groups profitability can increase. Clearly tax
authorities are very interested in preventing the loss of tax revenues by such actions. Double
taxation agreements between countries mean that companies pay tax on specific transactions
in one country only. If a company sets an unrealistically low transfer price, company will then
have to pay tax in both countries if it is spotted by the tax authorities.
Most countries now accept the Organisation for Economic Co-operation and Development
(OECD) 1995 guidelines. These aim to standardise national approaches to transfer pricing and
provide guidance on the application of the arms length price. This can be determined in three
main ways:
1. Comparable uncontrolled price method most widely used and most preferred option of
OECD, using market price as transfer price.
2. Resale price method margin earned on sales by unrelated firms selling similar products is
taken into account to determine transfer price as similar margins should be earned for similar
functions.
3. Cost-plus method used where the comparable uncontrolled price method cannot be used.
The mark-up is estimated from those earned by similar manufacturers.
However, the following should be noted:
i. Market value is usually encouraged by tax authorities.
ii. Full cost transfer price is usually acceptable.
iii. Transfer price at variable cost is unlikely to be acceptable.
Repatriation of funds
This may be illegal in certain countries depending on the relevant legislation. Repatriation of
funds would mean bringing foreign-earned funds back to companys home country.
Repatriation of funds would be suitable when the foreign currency is weak compared to home
countrys currency. Therefore, in other word, the purpose of repatriation of funds is to have
gain on exchange rate, but company is still exposed to foreign exchange risk. If there are

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difficulties due to local laws in repatriating funds, transfer prices for goods sold to subsidiaries
could be increased, with this the subsidiaries profits are reduced and therefore tax paid will be
reduced.
Other issues to consider
1. Import tariffs if there are import tariffs in the country where buying division operates,
group can minimise costs by keeping the transfer price to a minimum value.
2. Anti-dumping legislation governments may take action to protect home industries by
preventing companies from transferring goods cheaply into their countries. They may do this,
for example, by insisting on the use of a fair market value for the transfer price.
3. Competitive pressures transfer pricing can be used to enable profit centres to match or
undercut local competitors.
4. Ethical issues such as social responsibility and acting as a responsible citizen need to be
considered when setting transfer prices as do the potential negative aspects of bad publicity
and loss of reputation.
5. Behavioural impact of the prices being charged must be considered.

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Emerging issues in finance and financial management


1. Developments in world financial markets
Developments in international financial markets have facilitated the growth in trade and the
funding of overseas expansion strategies and have opened up more opportunities for investors.
The main developments are: the global financial crisis, dark pool trading systems, the removal
of barriers to the free movement of capital, and international regulations on money laundering.
Global financial crisis credit crunch
Credit crunch is a crisis caused by banks being too nervous to lend money to customers or to
each other. When they do lend, they will charge higher rates of interest to cover their risk. This
has meant that many businesses have struggled to refinance their debts. Since credit crunch
began, the phrase toxic assets has been used by the international media to describe the range
of financial products traded by banks and other financial institutions in order to earn some
income and lay off risk.
The global crisis originated from the way in which debt was sold onto investors. US banking
sector packaged sub-prime home loans into mortgage-backed securities known as collateralised
debt obligations (CDOs). CDOs are a way of repackaging the risk of a large number of risky
assets such as sub-prime mortgages. Unlike a bond issue, where the risk is spread thinly
between all the bond holders, CDOs concentrate the risk into investment layers or tranches.
Each tranche of CDOs is securitised and priced on issue to give the appropriate yield to the
investors. The investment grade tranche (tranche 3, AAA or senior tranche) of CDOs will be the
most highly priced, giving a low yield but with low risk attached. At the other end, the equity
tranche (tranche 1) carries the bulk of the risk it will be very lowly priced but with a high
potential, but very risky, yield. CDOs are, therefore, a mechanism whereby losses are
transferred to investors with the highest appetite for risk (such as hedge funds), leaving the
bulk of CDOs investors (mainly other banks) with a low risk source of cash flow. When cash
flows are received from borrowers in the form of interest payments and loan repayments,
these payments are paid to tranche 3 first until their obligation is fulfilled, then tranche 2
(intermediate risk or mezzanine tranche), and anything left over is paid to the equity tranche.
Any defaults hit tranche 1 first, then tranche 2 and so on. When borrowers started to default on
their loans, the value of these investments plummeted, leading to huge losses by banks on a
global scale. CDO is an example of toxic asset which banks recorded it as asset.
We can identify other causes of credit crunch as:
1. No proper due diligence carried out before deciding on investing in financial instruments.
2. Enough disclosures in financial statements were not made which misleads the investors.

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3. Remuneration of traders is linked to trading volumes, so traders dealt in risky assets to earn
high incentives at the cost of putting organisation at risk.
4. Poorly drafted and inadequately implemented regulation, ie. many credit rating agencies did
not have any sort of statutory regulation.
The impact of global crisis is significant, leading to losses to investors, increasing
unemployment, decline in business globally etc.
Dark pool trading systems
Dark pools are an alternative trading system that allows participants to trade without
displaying quotes publicly. They allow brokers and fund managers to place and match large
orders anonymously to avoid influencing the share price. The transactions are only made public
after the trades have been completed.
The main problem with dark pool trading is that the regulated exchanges do not know about
the transactions taking place until the trades have been completed (information asymmetry).
Such a lack of information on significant trade makes the regulated exchanges less efficient.
Transparency is definitely reduced and liquidity in the regulated exchanges is reduced as well.
This defeats the purpose of fair and regulated markets with large numbers of participants and
threatens the healthy and transparent development of these markets.
Removal of barriers to the free movement of capital
With free movement of capital, convergence of financial institutions throughout the world
becomes possible. This can lead to the creation of financial conglomerates with operations in
banking, securities and insurance. The effect of this convergence is:
1. The creation of economies of scale as operations that were previously performed by different
companies are now performed by one company.
2. The creation of economies of scope since one factor of production can be employed in the
production of more than one product.
3. The reduction of volatility of earnings since some of the earnings are fee-based and not
influenced by the economic cycle.
4. The saving of consumers significant search costs since they can buy all financial product from
one source.
As finance can be obtained more easily, the raising of capital through global equity and bond
markets has become commonplace and has made easier cross-border mergers as well as
foreign direct investment (FDI).

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International regulations on money laundering


The growth of globalisation and free movement of capital have created more opportunities for
money laundering. Money laundering is the act of changing the appearance of money that
comes from illegitimate sources so that it appears to be legitimate money. In attempt to
combat such activities there has been:
1. The establishment of an international task force on money laundering.
2. The issue of specific recommendations to be adopted by nation states.
3. The enactment of legislation regarding criminal justice systems, law enforcement, financial
systems and regulation as well as international cooperation.
4. The requirement on professional advisors (including accountants) to inform the national
Financial Intelligent Unit (FIU) of knowledge or suspicion of such an offence.
Professional accountants are required to keep abreast and comply with these regulations,
including:
1. Undertaking customer due diligence procedures before acting for a client.
2. Keeping records of transactions undertaken and the verification procedures carried out by
clients.
3. The reporting of suspicions to the FIU.
There may be penalties for non-compliance and disciplinary action from the accountants
professional body.
2. Developments in international trade and finance
The globalisation and integration of financial markets has contributed to expansion of
international trade, but it has also created potentially more uncertainty for multinational
companies. A stable macroeconomic environment with minimal exchange rate and interest rate
fluctuations allows business to plan their activities and to predict the key drivers of their value.
An economic environment in which there is uncertainty about the cost of capital or currency
rates does not support long-term planning. We will consider a number of developments in the
macroeconomic environment.
Trade and world deflation
Foreign trade can usually be justified on the principle of comparative advantage (country
should specialised and produce what it is good at and import what it is not good at). China has
exploited its comparative advantage stemming from low wages to dominate the production of
labour-intensive products which being produced at a fraction of the production cost in
developed countries. This has contributed to the world-wide low inflation regime of the last
few years. The reduction of the cost has kept prices down and has increased consumer
purchasing power word wide.

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Control of monetary policy


Monetary policy has been assigned the task of controlling inflation and is largely outside the
control of the national governments. Bank of England became independent of the government
in 1997 and sets interest rates so as to meet the inflationary target set out by the government.
Similarly, European Central Bank sets the interest rates in the euro zone. The independence of
central banks from government interference has given credibility to their policies and has
stabilised the financial markets. This in turn has affected expectations about inflation of market
participants and has lowered inflation. A low inflation environment is conducive to long-term
planning by business and stimulates investment.
Trade zones and international trade
In the last few years, there has been an increasing realisation that tariffs deny individuals and
nations the benefits of greater productivity and a higher standard of living and tariffs eliminate
or reduce the advantages of specialisation and exchange among nations and prevent the best
use of scarce world resources. The presence of tariffs also hinders the expansion of
multinational companies and international trade and inhibits their growth and the benefits of
consumers.
Therefore, many countries have come together to create free trade areas with the creation of
World Trade Organisation. By eliminating trade barriers (eg. zero rate tariffs), the trade zone
facilitates cross-border movement of goods and services, increases investment opportunities,
promotes fair competition, and enforces intellectual property rights in the three countries.
Trade financing
International trade financing has become easier to be obtained by companies. Financing
sources for international trade transactions include commercial bank loans within the host
country and loans from international lending agencies. Foreign banks can also be used to
discount trade bills to finance short-term financing.
Eurobond market is widely used for long-term funds for multinational US companies. Eurobond
is a long-term security issued by an internationally recognised borrower in several countries
simultaneously. The bonds are denominated in a single currency.
Furthermore, many countries have organised development banks that provide intermediate
and long-term loans to private enterprises. Such loans are made to provide economic
development within a country.

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Developments in non-market macro-environment


Non-market environments consist of social, political and legal arrangements.
1. Regulation many governments have responded to globalisation and the loss of control
through tariffs and other methods of control by introducing regulation. For example, antitrust
scrutiny (intended to promote competition) restrains the emergence of cross-border oligopolies
(imperfect competition, a small group of firms rule).
2. Pressure groups the globally networked pressure groups can influence the public and put
pressure on governments to take measures against multinational companies.
3. Political risks MNCs are vulnerable to political developments in their home and host
countries. Citizen groups in home/host countries can impact MNCs strategies in yet another
country.
Final words
In order to fully understand the syllabus, reading ACCA articles will be one important step. Then,
of course doing sufficient question practices is part of learning.

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