Financial Management Notes

Theoretical Notes & Concepts for Financial Management

1. Agency Theory Vs. Goal Congruence

Answer:

Agency theory
Agency theory is the relationship between the various interested parties in the firm. An
agency relationship exists when one party, the principal, employs another party, the
agent, to perform a task on their behalf. For example, a manager is an agent of the
shareholders. Similarly, an employee is an agent of the managers. Conflicts of interests
exist when the interests of the agent are different from the interests of the principal. For
example, an employee is likely to be interested in higher pay whereas the manager may
want to cut costs. It is therefore important for the principal to find ways of reducing the
conflicts of interest. One example is to introduce a method of remuneration for the
agent that is dependent on the extent to which the interests of the principal are fulfilled
– e.g. a director may be given share options so that he is encouraged to maximise the
value of the shares of the company.

Goal congruence
Goal congruence is where the conflict of interest is removed and the interests of the
agent are the same as the interests of the principal. The main approach to achieving this
is through the remuneration scheme, that of giving share options to the directors.
However, no one scheme is likely to be ‘perfect’. For example, although share options
encourage directors to maximise the value of shares in the company, the directors are
more likely to be concerned about the short-term effect of decision on the share price
rather than worry about the long-term effect. The shareholders are more likely to be
concerned with long-term growth. An alternative approach is to introduce profit-related
pay, for example by awarding a bonus based on the level of profits. However, again this
may not always achieve the desired goal congruence – directors may be tempted to use
creative accounting to boost the profit figure, and additionally are perhaps more likely
to be concerned more with short-term profitability rather than long-term.

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

2. Terms used in director’s behaviour

a. Empire building Chief executives having the aim of building as large a group as
possible by takeovers – not always improving the return to shareholders

b. Creative accounting Using creative techniques to improve the appearance of

published accounts and artificially boosting the share price. Such techniques include
capitalising intangibles on the balance sheet (e.g. development expenditures,
putting a value on brands, recognising revenue on long-term contracts at the
earliest possible time, not depreciating fixed assets). The Accounting Standards
Board attempts to cut out creative accounting practices as much as practically
possible.

c. Of balance sheet finance For example, leasing assets rather than purchasing them
(although this is now dealt with by the Accounting Standards)

d. Takeover bids There have been many instances of directors spending time and
money defending their company against takeover bids, even when the takeover
would have been in the best interests of the shareholders. The reason for this is
suggested as being that the directors are frightened for their own jobs were the
takeover bid to succeed.

e. Unethical activities Such as trading with unethical countries, using ‘slave’ labour,
spying on competitors, testing products on animals.
f. Corporate governance Corporate governance is the combination of rules, processes
or laws by which businesses are operated, regulated or controlled. The term
encompasses the internal and external factors that affect the interests of a
company's stakeholders, including shareholders, customers, suppliers, government
regulators and management.
In the UK there is a mix of legislative (Companies Acts) and institutionally endorsed
voluntary codes. Institutional investor input to boards is generally weak, although
recent years have seen a greater emphasis on strong non-executives and better
corporate reporting.

g. Growth strategies Growth can be via:

i. Expansion: existing products and/or existing markets
ii. Horizontal integration: new products to existing markets / new markets for
existing products
iii. Vertical integration: expansions up (backwards) or down (forwards) the
supply chain
iv. Concentric diversification: new products / markets with technological /
marketing synergy with existing products / markets
v. Conglomerate diversification: apparently unrelated expansion

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

3. Efficient Market Hypothesis

The efficient market hypothesis (EMH) or theory states that share prices reflect all
information. The EMH hypothesizes that stocks trade at their fair market value on
exchanges. Proponents of EMH posit that investors benefit from investing in a low-cost,
passive portfolio. Opponents of EMH believe that it is possible to beat the market and
that stocks can deviate from their fair market values.

EMH: how information is available and used -

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

4. What are the traditional and basic methods of interest rate risk management?
Answer:
(i) matching and smoothing
(ii) asset and liability management
(iii) forward rate agreements

Smoothing
In this simple approach to interest rate risk management the loans or deposits are
simply divided so that some are fixed rate and some are variable rate. Looking at
borrowings, if interest rates rise, only the variable rate loans will cost more and this will
have less impact than if all borrowings had been at variable rate. Deposits can be
similarly smoothed.

Matching
This approach requires a business to have both assets and liabilities with the same kind
of interest rate. The closer the two amounts the better.

Asset and liability management

This relates to the periods or durations for which loans (liabilities) and deposits (assets)
last. The issues raised are not confined to variable rate arrangements because a
company can face difficulties where amounts subject to fixed interest rates or earnings
mature at different times. So, it would have been wiser to match the loan period to the
lease period so that the company could benefit from lower interest rates – if they occur.

Forward rate agreements (FRA)

These arrangements effectively allow a business to borrow or deposit funds as though it
had agreed a rate which will apply for a period of time. The period could, for example
start in three months’ time and last for nine months after that. Such an FRA would be
termed a 3 – 12 agreement because is starts in three months and ends after 12 months.
Note that both parts of the timing definition start from the current time.

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

5. Identify the main types of interest rate derivatives used to hedge interest rate risk and
explain how they are used in hedging
Answer:
(i) Interest rate futures
(ii) Interest rate options
(iii) Interest rate caps, floors and collars
(iv) Interest rate swaps

Interest rate futures

Futures contracts are of fixed sizes and for given durations. They give their owners the
right to earn interest at a given rate, or the obligation to pay interest at a given rate.
If you are borrowing money from bank sell futures
If you are depositing money with the bank, buy futures
Futures price movements do not move perfectly with interest rates so there are some
imperfections in the mechanism. This is known as basis risk.

Interest rate options

Interest rate options allow businesses to protect themselves against adverse interest
rate movements while allowing them to benefit from favourable movements. They are
also known as interest rate guarantees. Options are like insurance policies:
You pay a premium to take out the protection. This is non-returnable whether or not
you make use of the protection.
If you are borrowing money from bank, use Put options i.e use cap
If you are depositing money with the bank, use Call options i.e use floors

Interest rate caps, floors and collars

An interest rate cap involves using interest rate options to set a maximum interest rate
for borrowers. If the actual interest rate is lower, the option is allowed to lapse.
An interest rate floor involves using interest rate options to set a minimum interest
rate for investors. If the actual interest rate is higher the investor will let the option
lapse.
An interest rate collar involves using interest rate options to confine the interest paid
or earned within a pre-determined range. A borrower would buy a cap and sell a floor,
thereby offsetting the cost of buying a cap against the premium received by selling a
floor. A depositor would buy a floor and sell a cap.

Interest rate swaps

Interest rate swaps allow companies to exchange interest payments on an agreed
notional amount for an agreed period of time. Swaps may be used to hedge against
adverse interest rate movements or to achieve a desired balanced between fixed and
variable rate debt. The most common type of swap involves exchanging fixed interest
payments for variable interest payments on the same notional amount. This is known as
a plain vanilla swap.

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

6. Types of Foreign exchange Hedging:

Forward Exchange Contract

A forward exchange contract is a special type of foreign currency transaction. Forward
contracts are agreements between two parties to exchange two designated currencies at
a specific time in the future. These contracts always take place on a date after the date
that the spot contract settles and are used to protect the buyer from fluctuations in
currency prices.
Forward contracts are not traded on exchanges, and standard amounts of currency are
not traded in these agreements. They cannot be cancelled except by the mutual
agreement of both parties involved. The parties involved in the contract are generally
interested in hedging a foreign exchange position or taking a speculative position. The
contract's rate of exchange is fixed and specified for a specific date in the future and
allows the parties involved to better budget for future financial projects and known in
advance precisely what their income or costs from the transaction will be at the specified
future date.

Money Market Hedge:

A money market hedge is a technique used to lock in the value of a foreign currency
transaction in a company’s domestic currency. Therefore, a money market hedge can
help a domestic company reduce its exchange rate or currency risk when conducting
business transactions with a foreign company. It is called a money market hedge because
the process involves depositing funds into a money market, which is the financial market
of highly liquid and short-term instruments like Treasury bills, bankers’ acceptances, and
commercial paper. The money market hedge allows the domestic company to lock in the
value of its partner’s currency (in the domestic company’s currency) in advance of an
anticipated transaction. This creates certainty about the cost of future transactions and
ensures the domestic company will pay the price that it wants to pay.

Currency Future Contract

A futures contract is a legal agreement to buy or sell a particular commodity asset, or
security at a predetermined price at a specified time in the future. Futures contracts are
standardized for quality and quantity to facilitate trading on a futures exchange. The
buyer of a futures contract is taking on the obligation to buy and receive the underlying
asset when the futures contract expires. The seller of the futures contract is taking on the
obligation to provide and deliver the underlying asset at the expiration date.

Futures contracts are financial derivatives that oblige the buyer to purchase some
underlying asset (or the seller to sell that asset) at a predetermined future price and
date.

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

A futures contract allows an investor to speculate on the direction of a security,

commodity, or a financial instrument, either long or short, using leverage.
Futures are also often used to hedge the price movement of the underlying asset to help
prevent losses from unfavorable price change.

Options Contract:
An options contract is an agreement between two parties to facilitate a potential
transaction involving an asset at a preset price and date.
Call options can be purchased as a leveraged bet on the appreciation of an asset, while
put options are purchased to profit from price declines. Buying an option offers the right,
but not the obligation to purchase or sell the underlying asset.

Currency Swaps:
If a company does business around the world, it may experience currency risk - that the
exchange rate will change when converting foreign money back into domestic currency.
Currency swaps are a way to help hedge against that type of currency risk by swapping
cash flows in the foreign currency with domestic at a pre-determined rate.
Considered to be a foreign exchange transaction, currency swaps are not required by law
to be shown on a company's balance sheet the same way a forward or options contract
would.

Leading & Lagging:

Leading and lagging refers to the timing of payments on international agreements.
Entities that have control over payments may find it advantageous to delay (lagging) or
accelerate payments based on anticipated currency changes (leading).

Netting & Matching:

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

7. Terms used in dividend policies

a) Signalling Effect. The announcement of a dividend is the release of a piece of publicly

available information. The semi-strong form of the efficient market hypothesis says
that the share price will react to this information. The problem is: what signal does a
change in dividend give out and therefore how should share prices move? For
example, does a cut in dividend mean that the company is conserving cash because it
expects hard times or does it mean that the company sees a great investment
opportunity? There is inevitably information asymmetry as the directors will almost
certainly be in possession of information that is not in the public domain. Almost
always shareholders will be unsettled by abrupt changes in dividend policy.

b) The clientele effects. This idea suggests that investors buy shares that ‘suit’ their
needs. So, a pension fund will base much of its investment portfolio on its need to
produce income to pay to pensioners. It will therefore invest heavily in shares that
pay regular, relatively predictable dividends. Similarly, tax can affect investment
decisions if gains are taxed less severely than income. If a company abruptly changes
its dividend policy it will disturb investors’ carefully constructed portfolios and
investors will have to adjust their mix of shares incurring transaction costs. It is
sometimes argued that if a cut in dividend reduces an investor’s income, the investor
can sell some shares to manufacture ‘income’. Of course, this will again incur
transaction costs and different tax treatment.

c) Liquidity preference. Some shareholders invest for income and others for capital
growth. If they require income then they will choose to invest in companies that have
a record of high dividend payments whereas if they prefer growth then they will
choose companies that have a record of lower dividends but more retention and
expansion. If, for example, an investor requires income and has therefore chosen a
company paying high dividends, they are going to be unhappy if the company
changes its policy and starts to retain a higher proportion of earnings.

d) Scrip dividends. a very common practice in recent years has been to ofer investors
the choice between taking dividends in cash or in shares. Tis overcomes the ‘liquidity
preference’ problem by allowing each shareholder to choose whichever is best for
them

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

8. What are the three theories of Dividend policies?

Answer:
i. The dividend valuation model
ii. The Gordon growth model
iii. Modigliani and Miller’s dividend irrelevancy theory.

The dividend valuation model

This states that the value of a company’s shares is sustained by the expectation of future
dividends. Shareholders acquire shares by paying the current share price and they would
not pay that amount if they did not think that the present value of future inflows (ie
dividends) matched the current share price. The formula for the dividend valuation model
provided in the formula sheet is:
P0 = D0 (1+ g)/(re – g)

The Gordon growth model

This model examines the cause of dividend growth. Assuming that a company makes neither
a dramatic trading breakthrough (which would unexpectedly boost growth) nor suffers from
a dreadful error or misfortune (which would unexpectedly harm growth), then growth arises
from doing more of the same, such as expanding from four factories to five by investing in
more non-current assets. Apart from raising more outside capital, expansion can only
happen if some earnings are retained. If all earnings were distributed as dividend the
company has no additional capital to invest, can acquire no more assets and cannot make
higher profits.
It can be relatively easily shown that both earnings growth and dividend growth is given by:
g = bR
P0 = D0 (1+ g)/(re – g)

Modigliani and Miller’s dividend irrelevancy theory

Modigliani and Miller argued that the level of dividend is irrelevant and that is simply the
level of profits that matters. Their logic was that it is the level of earnings that determines
the dividends that the company is able to pay, but that the company has the choice as to
how much to distribute as dividend and how much to retain for expansion of the company.
A large dividend will result in little future growth whereas a smaller dividend (and therefore
more retention) will result in more growth in future dividend. It is expected future dividends
that determine the share price and therefore the shareholders should be indifferent
between the alternatives outlined above. As a result, the company should focus on
improving earnings rather than worry about the level of dividends to be paid.

9. Ratios & their Analysis

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

10. Risk Management Terms:

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

Risk management: ‘A process of understanding and managing the risks that the entity is
inevitably subject to in attempting to achieve its corporate objectives. For management
purposes, risks are usually divided into categories such as operational, financial, legal
compliance, information and personnel. One example of an integrated solution to risk
management is enterprise risk management.’

Financial Risks: ‘Relating to the financial operation of an entity and includes:

1. Currency risk: risk that the value of a financial instrument will fluctuate due to
changes in foreign exchange rates (IAS 32).
a) Transaction risk This is the risk that a transaction in a foreign currency at one
exchange rate is settled at another rate (because the rate has changed). It is
this risk that the financial manager may attempt to manage.
b) Translation (or accounting) risk This relates to the exchange profits or losses
that result from converting foreign currency balances for the purposes of
preparing the accounts. These are of less relevance to the financial manager,
because they are book entries as opposed to actual cash flows.
c) Economic risk This refers to the change in the present value of future cash
flows due to unexpected movements in foreign exchange rates. E.g. raw
material imports increasing in cost.

2. Interest rate risk: risk that interest rate changes will affect the financial wellbeing of
an entity. This includes changes in interest rates adversely affecting the value and
liquidity of fixed or floating rate exposures. In addition to bond prices, interest rate
fluctuations also directly affect stock prices, foreign exchange rates and economic
growth.

3. Liquidity: funding or cash flow risk: risk that an entity will encounter difficulty in
realising assets or otherwise raising funds to meet commitments associated with
financial instruments.

4. Credit risk: the possibility that a loss may occur from the failure of another party to
perform according to the terms of a contract. One form of credit risk is debt leverage
risk: the larger a debt becomes as a portion of an entity’s capital structure; the risk of
default of interest payments and repayment of the principal becomes greater.

11. Islamic Finance principles & terms:

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

The main principles of Islamic finance are that:

i. Wealth must be generated from legitimate trade and asset-based investment. (The
use of money for the purposes of making money is expressly forbidden.)
ii. Investment should also have a social and an ethical benefit to wider society beyond
pure return.
iii. Risk should be shared.
iv. All harmful activities (haram) should be avoided.

Prohibitions:
i. As a consequence of the laws regarding the generation of wealth, it is strictly forbidden
to use money for the purpose of making money – i.e. it is forbidden to charge interest
(riba)
ii. Investments in businesses dealing with alcohol, gambling, drugs, pork, pornography or
anything else that the Shariah considers unlawful or undesirable (haram)

Islamic financial instruments

i. Murabaha This is effectively a form of credit sale, where the customer receives the
goods but pays for them later on a fixed date. However, instead of charging interest, a
fixed price is agreed before delivery – the mark-up effectively including the time value of
money.

ii. Ijara This is effectively a lease, where the lessee pays rent to the lessor to use the asset.
Depending on the agreement, at the end ot he rental period the lessor might take back
the asset (effectively an operating lease) or might sell it to the lessee (effectively a
finance lease – Ijara-wa-Iqtina).

iii. Muduraba This is similar to equity finance, or a special kind of partnership. The investor
provides capital and the business partner runs the business. Profits are shared between
both parties, but all losses are attributable to the investor (limited to the capital
provided).

iv. Musharaka This again is similar to a partnership, but here both parties provide both
capital and expertise. Profits are shared between the parties according to whatever ratio
is agreed in the contract, but losses are shared in proportion to the capital contributions.
It is regarded as being similar to venture capital.

v. Sukuk This is the equivalent of debt finance (Islamic bonds). Sukuk must have an
underlying tangible asset, and the holders of the Sukuk certificates have ownership of a
proportional share of the asset, sharing revenues from the asset but also sharing the
ownership risk. There are two types of sukuk
a. Asset based Sukuk – raising finance where the principal is covered by the capital
value of the asset but the returns and repayments to sukuk holders are not directly
financed by these assets.

Prof. Darshan Shah

Senior Faculty, ISDC
 Financial Management Notes

b. Asset backed sukuk – raising finance where the principal is covered by the capital
value of the asset but the returns and repayments to sukuk holders are directly
financed by these assets.

vi. Salam contracts are similar to forward contracts, where a commodity (or service) is sold
today for future delivery. Cash is received immediately from the IFI and the quantity,
quality, and the future date and time of delivery are determined immediately. The sale
will probably be at a discount so that the IFI can make a profit. In turn, the IFI would
probably sell the contract to another buyer for immediate cash and profit, in a parallel
Salam arrangement. Salam contracts are prohibited for commodities such as gold, silver
and other money-type assets.

vii. Istisna contracts are often used for long-term, large construction projects of property
and machinery. Here, the IFI funds the construction project for a client that is delivered
on completion to the IFI’s client. The client pays an initial deposit, followed by
instalments, to the IFI, the amount and frequency of which are determined at the start of
the contract.

viii. Sharia Boards (SBs) ensure that all products and services offered by IFIs are compliant
with the principles of Sharia rules. They review and oversee all new product offerings
made by the IFI and make judgments on an individual case-by-case basis, regarding their
acceptability with Sharia rulings. Additionally, SBs often oversee Sharia compliant
training programmes for an IFI’s employees and participate in the preparation and
approval of the IFI’s annual reports. SBs are in-turn supervised by the International
Association of Islamic Bankers (IAIB).

ix. Islamic finance institutions (IFIs), including banks, could raise finance via Mudaraba and
Musharaka equity-type contracts through multi-partnership contracts (see below). Here,
investors (known as rub-ul-mal) would invest funds with the IFI (known as the mudareb
or investment manager). The funds are then pooled and used in profit-making projects
while also keeping within Sharia rules. Therefore, the IFI would effectively become the
rub-ul-mal and the corporation that uses the funds for investment purposes becomes
the mudareb. In each case, the emphasis is on partnerships, and the profits earned are
shared between the corporation, the bank and the investors.

x. Diminishing Musharaka contracts are a recent innovation where not only are the profits
shared between rub-ul-mal(investor ) and the mudareb (investment manager), but the
mudareb would pay greater amounts to the rub-ul-mal. In this way the mudareb owns
greater and greater proportion of the asset, until eventually the ownership of the asset is
passed to the mudareb entirely.
12. Behavioural Finance terms

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

Behavioural finance attempts to explain how decision makers take financial decisions in
real life, and why their decisions might not appear to be rational every time and,
therefore, have unpredictable consequences.

Market Paradox. This occurs because in order for markets to be efficient, investors have
to believe that they are inefficient. This is because if investors believe markets are
efficient, there would be no point in actively trading shares –which would mean that
markets would not react efficiently to new information.

Herding. This refers to when investors buy or sell shares in a company or sector because
many other investors have already done so. Explanations for investors following a herd
instinct include social conformity, the desire not to act differently from others. Following
a herd instinct may also be due to individual investors lacking the confidence to make
their own judgements, believing that a large group of other investors cannot be wrong.

Market Bubble. If many investors follow a herd instinct to buy shares in a certain sector.
This can result in significant price rises for shares in that sector and lead to a stock
market bubble.

Noise Traders. There is also evidence to suggest that stock market ‘professionals’ often
do not base their decisions on rational analysis. Studies have shown that there are
traders in stock markets who do not base their decisions on fundamental analysis of
company performance and prospects. They are known as noise traders. Characteristics
associated with noise traders include making poorly timed decisions and following
trends.

Loss Aversion. Avoiding investments that have the risk of making losses, even though
expected value analysis suggests that, in the long-term, they will make significant capital
gains. Investors with loss aversion may also prefer to invest in companies that look likely
to make stable, but low, profits, rather than companies that may make higher profits in
some years but possibly losses in others.

Momentum Effect. A period of rising share prices may result in a general feeling of
optimism that prices will continue to rise and an increased willingness to invest in
companies that show prospects for growth. If a momentum effect exists, then it is likely
to lengthen periods of stock market boom or bust.

Prof. Darshan Shah

Senior Faculty, ISDC
 Financial Management Notes

13. What contributes to the risk suffered by equity shareholders, hence contributing to
the beta value?

Answer:
There are two main components of the risk suffered by equity shareholders:

The nature of the business. Businesses that provide capital goods are expected to show
relatively risky behaviour because capital expenditure can be deferred in a recession
and these companies’ returns will therefore be volatile. You would expect ßi > 1 for
such companies. On the other hand, a supermarket business might be expected to show
less risk than average because people have to eat, even during recessions. You would
expect ßi < 1 for such companies as they offer relatively stable returns.

The level of gearing. In an ungeared company (ie one without borrowing), there is a
straight relationship between profits from operations and earnings available to
shareholders. Once gearing, and therefore interest, is introduced, the amounts
available to ordinary shareholders become more volatile.

The rate of return required by shareholders (the cost of equity) will also be affected by
two factors:
i. The nature of the company’s operations.
ii. The amount of gearing in the company.

When we talk about, or calculate, the ‘cost of equity’ we have to be clear what we
mean. Is this a cost which reflects only the business risk, or is it a cost which reflects the
business risk plus the gearing risk?

When using the dividend growth model, you measure what you measure. In other
words, if you use the dividends, dividend growth and share price of a company which
has no gearing, you will inevitably measure the ungeared cost of equity. That’s what
shareholders are happy with in this environment. If, however, these quantities are
derived from a geared company, you will inevitably measure the geared company’s cost
of equity.

Prof. Darshan Shah

Senior Faculty, ISDC
 Financial Management Notes

14. What are the different Capital Structure Theories?

Conventional theory
When there is only equity, the WACC starts at the cost of equity. As the more expensive
equity finance is replaced by cheaper debt finance, the WACC decreases. However, as
gearing increases further, both debt holders and equity shareholders will perceive more
risk, and their required returns both increase. Inevitably, WACC must increase at some
point. This theory predicts that there is an optimum gearing ratio at which WACC is
minimised.

Modigliani and Miller (M&M) without tax

M&M were able to demonstrate that as gearing increases, the increase in the cost of
equity precisely offsets the effect of more cheap debt so that the WACC remains
constant.

Modigliani and Miller (M&M) with tax

Debt, because of tax relief on interest, becomes unassailably cheap as a source of
finance. It becomes so cheap that even though the cost of equity increases, the balance
of the effects is to keep reducing the WACC.

Conclusion:
Whichever theory you believe, whether there is or isn’t tax, provided the gearing ratio
does not change the WACC will not change. Therefore, if a new project consisting of
more business activities of the same type is to be funded so as to maintain the present
gearing ratio, the current WACC is the appropriate discount rate to use. In the special
case of M&M without tax, you can do anything you like with the gearing ratio as the
WACC will remain constant and will be equal to the ungeared cost of equity.

Summary:
i. M + M (No Tax): Cheaper Debt = Increase in Financial Risk / Keg
ii. M + M (With Tax): Cheaper Debt > Increase in Financial Risk / Keg
iii. Traditional Theory: The WACC is U shaped, ie there is an optimum gearing ratio
iv. The Pecking Order: No theorised process; simply the line of least resistance first
internally generated funds, then debt and finally new issue of equity

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

15. Terms used in Small & Medium Enterprises:

The business angel. A business angel is a wealthy individual willing to take the risk of
investing in SMEs. One limitation is that these individuals are not common and are very
often quite particular about what they are prepared to invest in. Once a business angel is
interested, they can become very useful to the SME, as they will often have great business
acumen themselves and are likely to have many useful contacts.
Trade credit. SMEs, like any company, can take credit from their suppliers. However, this is
only short-term and, indeed, if their suppliers are larger companies who have identified
them as a potentially risky SME the ability to stretch the credit period may be limited.
Factoring and invoice discounting. Both of these sources of finance effectively let a
company raise finance against the security of their outstanding receivables. Again, this
finance is only short-term and is often more expensive than an overdraft. However, one of
the features of these sources of finance is that, as an SME grows, their outstanding
receivables will grow and so the amount they can borrow from their factor or from invoice
discounting will also grow. Hence, factoring and invoice discounting are two of the very
limited number of finance sources which grow automatically as the business grows.
Leasing. Leasing assets rather than buying them is often very useful for an SME as it avoids
the need to raise the capital cost. However, leasing is only really possible on tangible assets
such as cars, machines, etc.
The venture capitalist. A venture capitalist company is very often a subsidiary of a company
that has significant cash holdings that they need to invest. The venture capitalist subsidiary
is a high-risk, potentially high-return part of their investment portfolio. Hence, many banks
will have venture capitalist subsidiaries. In order to attract venture capital funding an SME
has to have a business idea that may create the high returns the venture capitalist is
seeking. Hence, for many SMEs, operating in regular business, venture capitalist financing
may not be possible.
Listing. By achieving a listing on a stock exchange an SME would become a quoted company
and, hence, raising finance would become less of an issue. However, before a listing can be
considered the company must grow to such a size that a listing is feasible. Many SMEs can
never hope to achieve this.
Supply chain financing. In supply chain financing (SCF) the finance follows the value as it
moves through the supply chain. SCF is relatively new and is different to traditional working
capital financing methods, such as factoring or offering settlement discounts, because it
promotes collaboration between buyers and sellers in the supply chain. Traditionally there
was competition as the buyer wanted to take extended credit, and the seller wanted quick
payment. SCF works very well where the buyer has a better credit rating than the seller.

Prof. Darshan Shah

Senior Faculty, ISDC
 Financial Management Notes

16. Yield to Maturity (YTM) in Bond Valuation:

Yield to Maturity (YTM) – otherwise referred to as redemption or book yield – is the
speculative rate of return or interest rate of a fixed-rate security, such as a bond. The YTM is
based on the belief or understanding that an investor purchases the security at the current
market price and holds it until the security has matured (reached its full value), and that all
interest and coupon payments are made in a timely fashion.

How YTM is Calculated

YTM is typically expressed as an annual percentage rate (APR). It is determined through the
use of the following formula:

Approximated YTM
It’s important to understand that the formula above is only useful for an approximated YTM.
In order to calculate the true YTM, an analyst or investor must use the trial and error method.
This is done by using a variety of rates that are substituted into the current value slot of the
formula. The true YTM is determined once the price matches that of the security’s actual
current market price.

The formula’s purpose is to determine the yield of a bond (or other fixed-asset security)
according to its most recent market price. The YTM calculation is structured to show – based
on compounding – the effective yield a security should have once it reaches maturity. It is
different from simple yield, which determines the yield a security should have upon maturity,
but is based on dividends and not compounded interest.

Importance of Yield to Maturity

The primary importance of yield to maturity is the fact that it enables investors to draw
comparisons between different securities and the returns they can expect from each. It is
critical for determining which securities to add to their portfolios. It’s also useful in that it also
allows the investors to gain some understanding of how changes in market conditions might
affect their portfolio because when securities drop in price, yields rise, and vice versa.

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

17. Types of Margin in interest rate futures

Initial margin
When a futures hedge is set up the market is concerned that the party opening a
position by buying or selling futures will not be able to cover any losses that may arise.
Hence, the market demands that a deposit is placed into a margin account with the
broker being used – this deposit is called the ‘initial margin’.

These funds still belong to the party setting up the hedge but are controlled by the
broker and can be used if a loss arises. Indeed, the party setting up the hedge will earn
interest on the amount held in their account with their broker. The broker in turn keeps
a margin account with the exchange so that the exchange is holding sufficient deposits
for all the positions held by brokers’ clients.

Maintenance Margin
Maintenance margin is the minimum amount of equity that an investor must maintain in
the margin account after the purchase has been made. Maintenance margin is currently
set at 25% of the total value of the securities in a margin account as per FINRA
requirements. The investor may be hit with a margin call if the account equity falls
below the maintenance margin threshold which may necessitate that the investor
liquidate positions until the requirement is satisfied.

Mark to Market Margin (also known as Variation Margin)

In securities trading, mark to market involves recording the price or value of a security,
portfolio, or account to reflect the current market value rather than book value. This is
done most often in futures accounts to ensure that margin requirements are being met.
If the current market value causes the margin account to fall below its required level,
the trader will be faced with a margin call. Mutual funds are also marked to market on a
daily basis at the market close so that investors have a better idea of the fund's Net
Asset Value (NAV).
It is additional amount of cash you are required to deposit to your futures trading
account after your futures position have taken sufficient losses to bring it below the
"Maintenance Margin". Futures traders are typically required to provide variation
margin through "Margin Calls".

Formula:
Variation Margin = Initial Margin - Margin Balance

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

18. Corporate Governance Code

Corporate governance is concerned with how companies are directed and controlled.
The purpose of this chapter is to briefly compare how this is approached in different
countries, and to consider in more detail the approach in the UK. In the UK there is a mix
of legislative (Companies Acts) and institutionally endorsed voluntary codes. Institutional
investor input to boards is generally weak, although recent years have seen a greater
emphasis on strong non-executives and better corporate reporting.

There are 45 ‘code provisions’ which include the following:

(a) Board members
• the roles of Chair of the Board and Chief Executive should be separated unless
the company publicly justifies reasons for not doing so
• the identification of a senior independent director
• not less than one-third of the board comprises non-executive directors
• the majority of non-executive directors should be independent

(b) Board structure and function

• there should be a nominations committee (unless the board is small)
• the formalisation of the role of Chairman in ensuring that all directors are
properly briefed on issues arising at board meetings
• the audit and remuneration committees must only be of non-executive directors
• directors should, at least annually, conduct a review of the effectiveness of the
group’s system of internal controls and should report to shareholders that they
have done so

(c) Remuneration of directors

• performance related elements should form a significant proportion of the total
remuneration package

(d) Conduct of AGMs

• announcement of proxy votes at AGMs
• unbundling of resolutions
• sending out the notice of the AGM and the related voting papers at least 20
working days before the meeting

(e) There is also a requirement that companies consider:

• a reduction of the notice period of directors to one year or less
• early termination arrangements
• the extent to which the principal shareholders should be contacted about
directors’ remuneration
• whether the remuneration report should be voted on at the AGM

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

19. Real Options

A real option relates to project appraisal. It may be possible to improve the potential
return by having the right to change something about the project during its life. This
would be a ‘real’ option. Real options will be valued using the Black Scholes model.

Option to delay:
Suppose we are considering a project, but the returns are uncertain because of forecast
general economic problems over the next few years. The ability to delay starting the
project could be attractive because if economic conditions turn out to be unfavourable,
we could cancel, whereas if they turn out to be favourable, we could go ahead and
maybe get even better returns. The fact that we would be able to remove the
‘downside’ potential would mean that we had an option and this would be worth paying
for. It would effectively be a call option (the right to invest in a project at a future date)

Option to expand
This would be similar to an option to delay in that we could invest a certain amount in
the project now and decide later whether or not to invest more if project is successful.
Again, this right would be worth money to us and could be valued, as a call option.

Option to abandon
We usually assume that the project lasts for the full life of asset. However, if the cash
flows turned out to be lower than expected, we would clearly want to be able to
consider stopping the project early. This right would effectively be a put option.

Option to redeploy
Projections of a project could turn out to be wrong and it could be beneficial to
effectively stop the project earlier than planned and use the resources towards another
project. This ability would be a put option.

Greeks:
Black and Scholes produced formulae to measure the rate of change in the options price
with changes in each of the factors listed. You do not need to know the formulae, but
you need to be aware of the names given to each of the measures as follows:
i. Delta - The rate at which the option price changes with the share price (=N(d1))
ii. Theta - The rate at which the option price changes with the passing of time.
iii. Vega - The rate at which option price changes with changes in the volatility of the
share
iv. Rho - The rate at which option price changes with changes in the risk-free
interest rate
v. Gamma - The rate at which delta changes

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

20. Securitisation through Collateralised Debt Obligations (CDOs)

One common use of securitisation occurs when banks lend through mortgages, credit
cards, car loans or other forms of credit, they invariably move to ‘lay off’ their risk by a
process of securitisation. Such loans are an asset on the statement of financial position,
representing cash flow to the bank in future years through interest payments and
eventual repayment of the principal sum involved. By securitising the loans, the bank
removes the risk attached to its future cash receipts and converts the loan back into
cash, which it can lend again, and so on, in an expanding cycle of credit formation.

Securitisation is achieved by transferring the lending to specifically created companies

called ‘special purpose vehicles’ (SPVs). In the case of conventional mortgages, the SPV
effectively purchases a bank’s mortgage book for cash, which is raised through the issue
of bonds backed by the income stream flowing from the mortgage holder. In the case of
sub-prime mortgages, the high levels of risk called for a different type of securitisation,
achieved by the creation of derivative-style instruments known as ‘collateralised debt
obligations’ or CDOs.

Securitisation may be also appropriate for an organisation which wants to enhance its
credit rating by using low-risk cash flows, such as rental income from commercial
property, which will be diverted into a "ring-fenced" SPV.

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’, so that
some investors take proportionately more of the risk for a bigger return and others take
little or no risk for a much lower return.

The structure of CDOs

An example of a possible structure for a CDO is as follows. For a pool of mortgages taken
over by the SPV, three tranches of CDOs are created:

1. Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising
about 10% of the value of the mortgages in the pool. Throughout the CDOs’ life, the
equity tranche will absorb any losses brought about by default on the part of
mortgage holders, up to the point that the principal underpinning the tranche is
exhausted. At this point the investment is worthless.
2. Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the
principal and will absorb any losses not absorbed by the equity tranche until the
point at which its principal is also exhausted.
3. Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and will
absorb any residual losses.

Prof. Darshan Shah

Senior Faculty, ISDC
Financial Management Notes

21. Miscellaneous
Pecking order theory
Pecking order theory starts that companies raise finance in the ‘easiest’ way (or the ‘law of
least effort’) and that therefore they prefer to use internal funds (retained earnings) first,
followed by debt finance, only raising new equity as a last resort.

Static trade-off theory

M&M proved that the WACC of a company will reduce as more debt is raised, and therefore
a company should raise as much debt as possible. However, their proof relies on many
assumptions which are not completely realistic in real life (such as investors having perfect
knowledge, and acting rationally with respect to risk).
Static trade-off theory states that the cost of equity certainly is likely to increase with higher
gearing (although not necessarily in a predictable way) and that the cost of debt is certainly
likely to be lower. However, because it is impossible in practice to estimate the changes
precisely, all we can state it that the WACC is likely to change with different levels of
gearing. If the WACC is likely to change, then there must be a level of gearing at which the
WACC is a minimum. The company should aim for this level of gearing and should then
maintain this ‘optimum’ level of gearing. (The theory does not predict the ‘optimum’ level –
this would be found by trial and error).

Adjusted Present Value

M&M stated that the only benefit of using debt (as opposed to equity) to finance a project
was the fact that the company gains as a result of the tax saved on the debt interest (the tax
shield).
We can use this to provide a way of calculating the gain from a project taking into account
the method of financing used.
For adjusted present value calculations, there are two steps:
(1) Calculate the NPV of the project if all equity financed
(2) Calculate the PV of the tax benefit on any debt used
The total of the two is the overall gain (or loss) to the company and is known as the
Adjusted Present Value (APV).

Prof. Darshan Shah

Senior Faculty, ISDC
 Financial Management Notes

22. Full forms of terms used in ACCA

CD = Certificates of Deposit
In exchange for a deposit of funds the issuer writes a receipt (the CD) offering a one-of
interest payment plus repayment of the face value of the deposit at maturity. The CDs are
negotiable and can be traded.

EVA = Economic Value Added

A measure of the ‘super’ profit generated by a firm. It can be defined as net operation profit
after tax (NOPAT) less the value of the firms’ invested capital multiplied by its weighted
average cost of capital.

LIBID = The London Inter-Bank Bid Rate.

The effective lending rate in the interbank market representing the spread against LIBOR.

LIBOR = London Inter-Bank Offered Rate.

The average overnight rate of interest offered by deposit accepting banks as complied on a
daily basis by the British Bankers Association. A LIBOR is quoted for sterling, dollar, yen,
euro and other currency deposits.

LIFFE = London International Financial Futures Exchange.

The London International Financial Futures and Options Exchange was a futures exchange
based in London. In 2014, following a series of takeovers, LIFFE became part of
Intercontinental Exchange, and was renamed ICE Futures Europe.

NYBOT = New York Board of Trade

(the parent body for the New York options and futures exchange).

OTC = Over the counter

the term relating to private agreements between counterparties to by or sell a security
(normally, but not always, referring to derivatives)

(P/E) ratio = Price/earnings Ratio

The ratio of a company’s price per share divided by its earnings per share. Tis ratio is
commonly used as a valuation metric by the multiple method.

STRIPS = separate trading of interest and principal.

This is where (normally) government bonds are decomposed into a coupon element and a
redemption element which are traded separately in the market.

Prof. Darshan Shah

Senior Faculty, ISDC
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