ACCA Paper

Advanced Financial
Management

Class Notes
Contents PAGE

INTRODUCTION TO THE PAPER 5

FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER 7

CHAPTER 1: CFO AND FINANCIAL STRATEGY FORMULATION 13

CHAPTER 2: GOVERNANCE & ETHICS 26

CHAPTER 3: ECONOMIC ENVIRONMENT FOR MULTINATIONALS 31

CHAPTER 4: DISCOUNTED CASH FLOW TECHNIQUES 37

CHAPTER 5: APPLICATION OF OPTION PRICING IN INVESTMENT DECISIONS 55

CHAPTER 6: IMPACT OF FINANCING ON INVESTMENT DECISIONS 64

CHAPTER 7: ADJUSTED PRESENT VALUE 85

CHAPTER 8: INTERNATIONAL INVESTMENT APPRAISAL 90

CHAPTER 9: ACQUISITIONS AND MERGERS 97

CHAPTER 10: BUSINESS VALUATIONS 100

CHAPTER 11: FRAMEWORK 111

CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANIZATION 117

CHAPTER 13: HEDGING FOREIGN EXCHANGE RISK 124

CHAPTER 14: HEDGING INTEREST RATE RISK 140

CHAPTER 15: ISSUES FOR MULTINATIONALS 153

Aim of the paper
The aim of the paper is to apply relevant knowledge, skills and exercise professional
judgment as expected of a senior financial executive or advisor, in taking or
recommending decisions relating to the financial management of an organization.

Outline of the syllabus

A. Role of senior financial adviser in the multinational organization
B. Advanced investment appraisal
C. Acquisitions and mergers
D. Corporate reconstruction and reorganization
E. Treasury and advanced risk management techniques

Format of the exam paper

The examination will be a three-hour paper (with the additional 15 minutes reading
and planning time) of 100 marks in total, divided into two sections:

Section A:

Section A will contain a compulsory question,

comprising 50 marks.(10 professional marks)
Section A will normally cover significant issues relevant to the senior financial
manager or advisor and will be set in the form of a case study or scenario. The
requirements of the section A question are such that candidates will be expected to
show a comprehensive understanding of issues from across the syllabus. The
question will contain a mix of computational and discursive elements. Within this
question candidates will be expected to provide answers in a specified form such as
a short report or board memorandum commensurate with the professional level of
the paper in part or whole of the question.

Section B:

In section B candidates will be asked to answer two questions, comprising

25 marks each( 5 professional marks in each question).
Section B questions are designed to provide a more focused test of the syllabus.
Questions will normally contain a mix of computational and discursive elements,
but may also be wholly discursive or evaluative where computations are already
provided.

Candidates will be provided (within the examination paper) with a

formulae sheet as well as present value, annuity and standard normal
distribution tables
Present value table
Present value of 1 ie (1 + r)-n
Where r = discount rate
n = number of periods until payment

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
Annuity table
1 - (1 + r)-n
Present value of an annuity of 1 ie
r

Where r = discount rate

n = number of periods

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
Standard normal distribution table
0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879

0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2703 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389

1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319

1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767

2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936

2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986

3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990

This table can be used to calculate N(di), the cumulative normal distribution
functions needed for the Black-Scholes model of option pricing.
If di > 0, add 0.5 to the relevant number above.
If di < 0, subtract the relevant number above from 0.5
 Chapter 1

CFO and Financial

Strategy
Formulation
Primary financial management objective
Shareholder wealth maximization which is achieved by;
● increasing the value of the entity
● providing a cash flow to investors via a dividend

Core financial management decisions

Financial management is often described in terms of the three basic decisions to be
made:
● the investment decision,
● the financial decision,
● the dividend decision.
Each of these decisions have to be looked at in far greater detail later on in the
course but as an outline these are the basic considerations:

A company may invest its funds in one of three basic areas:

1. Capital assets
2. Working capital
3. Financial assets
The investment decision will be covered in significant detail in chapters 4 - 8

When looking at the financing of a business there are 4 basic questions to consider:
1. total funding required,
2. internally generated vs externally sourced,
3. debt or equity,
4. long-term or short-term debt.
The financing decision will be covered later in this chapter and also is chapter 6

The amount of return to be paid in cash to shareholders. This is a critical measure

of the companies’ ability to pay a cash return to its shareholders.
The dividend decision will be covered later in this chapter
Other financial management responsibilities

All elements of risk need be identified and mitigated including;

1. Operational
2. Reputational
3. Political
4. Economic
5. Regulatory
6. Fiscal
Risk management will be evident across the entire syllabus, with specific coverage
of interest rate and foreign exchange risk covered in chapter 14 and 15.

Communication has far reaching implications to all stakeholders and as such careful
dialogue must be maintained with both internal and external stakeholders

To ensure objectives are adhered to and necessary corrective action is taken to

pursue primary objective.
LONG TERM SOURCES OF FINANCE
Equity relates to the ownership rights in a business.

Ordinary shares
1. Owning a share confers part ownership.
2. High risk investments offering higher returns.
3. Permanent financing.
4. Post-tax appropriation of profit, not tax efficient.
5. Marketable if listed.

1. No fixed charges (e.g. interest payments).

2. No repayment required.
3. Carries a higher return than loan finance.
4. Shares in listed companies can be easily disposed of at a fair value.

1. Issuing equity finance can be expensive in the case of a public issue (see later).
2. Problem of dilution of ownership if new shares issued.
3. Dividends are not tax-deductible.
4. A high proportion of equity can increase the overall cost of capital for the
company.
5. Shares in unlisted companies are difficult to value and sell.

Preference shares
1. Fixed dividend
2. Paid in preference to (before) ordinary shares.
3. Not very popular, it is the worst of both worlds, ie
● not tax efficient
● no opportunity for capital gain (fixed return).
DEBT
The loan of funds to a business without any ownership rights.
1. Paid out as an expense of the business (pre-tax).
2. Risk of default if interest and principal payments are not met.

The debtholder will normally require some form of security against which the funds
are advanced. This means that in the event of default the lender will be able to take
assets in exchange of the amounts owing.

A further means of limiting the risk to the lender is to restrict the actions of the
directors through the means of covenants. These are specific requirements or
limitations laid down as a condition of taking on debt financing. They may include:

1. Dividend restrictions

2. Financial ratios

3. Financial reports

4. Issue of further debt.

Types of debt
Debt may be raised from two general sources, banks or investors.

For companies that are unlisted and for many listed companies the first port of call
for borrowing money would be the banks. These could be the high street banks or
more likely for larger companies the large number of merchant banks concentrating
on ‘securitised lending’.
This is a confidential agreement that is by negotiation between both parties.

Debt instruments sold by the company, through a broker, to investors. Typical

features may include:
1. The debt is denominated in units of $100, this is called the nominal or par
value and is the value at which the debt is subsequently redeemed.
2. Interest is paid at a fixed rate on the nominal or par value.
3. The debt has a lower risk than ordinary shares. It is protected by the charges
and covenants.
OTHER SOURCES

Capital provided by an organization for high risk enterprises which demonstrate

high growth potential. Funds will usually be provided in return for an equity stake in
the business, with a pre-determined exit strategy.

1. Selling good quality fixed assets such as high street buildings and leasing
them back over many (25+) years.
2. Funds are released without any loss of use of assets.
3. Any potential capital gain on assets is forgone.

1. Often related to regional assistance, job creation or for high tech companies.
2. Important to small and medium sized businesses (ie unlisted).
3. They do not need to be paid back.
4. Remember the EU is a major provider of loans.

The single most important source of finance, for most businesses the use of retained
earnings is the core basis of their funding.

1. An option to buy shares at a specified point in the future for a specified

(exercise) price.
2. The warrant offers a potential capital gain where the share price may rise
above the exercise price.
3. The holder has the option to buy the share. On a future date at a pre-
determined date.
4. The warrant has many uses including:
● additional consideration when issuing debt.
● incentives to staff.

A debt instrument that may, at the option of the debtholder, be converted into
shares. The terms are determined when the debt is issued and lay down the rate of
conversion (debt: shares) and the date or range of dates at which conversion can
take place.
The convertible is offered to encourage investors to take up the debt instrument.
The conversion offers a possible capital gain (value of shares › value of debt).
BEHAVIOURAL FINANCE
Financial management theory assumes that decisions will always be made in a
rational manner, however this may not be the case and as such irrational decisions
and systematic errors will occur.
This theory undermines the efficient market hypothesis which suggests that no
excessive gains can be made, as information is effectively absorbed in to the share
price. However examples of such irrationality which creates opportunity for
arbitrage include;

Where investors overestimate the forecasted financial performance, and as a

consequence make inaccurate decisions.

Where investors pay consideration only to information which supports their view and
overlook anything that suggests an error has been made

Where investors are immune to positive information and do not believe that the
outcome is likely to be repeated, as such the information is not absorbed into the
share price.

DIVIDEND POLICY
Dividend decisions relate to the determination of how much and how frequently
cash can be paid out of the profits of an entity as income for its owners. The owners
of profit-making organizations look for reward from their investment in two ways:
the growth of the capital invested (capital gains), and the cash paid out as income
(dividend).
The dividend decision thus has two elements: the amount to be paid out and the
amount to be retained to support the growth of the entity, the latter being a
financing decision; the level and regular growth of dividends represent a significant
factor in determining a profit-making company’s market value, that is the value
placed on its shares by the stock market.
FACTORS INFLUENCING DIVIDEND POLICY
In deciding a company’s dividend policy the following factors should be considered:

1. Profitability
Dividends are paid out of distributable profit and a company cannot pay dividends
which is higher than its distributable profit. For all other things being equal, a
company with stable profits is more likely to be able to pay out a higher percentage
of earnings than a company with fluctuating profits.

2. Liquidity
To pay dividends sufficient liquid funds should be available. Even very profitable
companies might sometimes find it difficult to pay dividends if resources are tied up
in other forms of asset, especially if bank overdraft facilities are not available.

3. Repayment of debt
Dividend pay-out may be made difficult if debt is scheduled for repayment and this
is not financed by a further issue of funds.

4. Restrictive covenants
The articles of association may contain agreed restrictions on dividends. In addition,
some form of debt may have restrictive covenants limiting the amount of dividend
payments or the rate of growth that applies to them.

5. Rate of expansion
Growth companies faced with many investment opportunities may prefer to finance
their expansion by retaining a large proportion of their profit instead of distributing
the profit by way of dividend and asking the existing shareholders to provide extra
money for expansion through rights issue which will incur issue cost.

6. Control
The use of retained earnings to finance new projects preserves the company’s
ownership and control.

7. Policy of competitors
Dividend policies of competitors may influence corporate dividend policy. It may be
difficult, for example, to reduce a dividend for the sake of further investment, when
competitors follow a policy of higher distribution.

8. Signaling effect
This is the information content of the dividend. Dividends are seen as signals from
the company to the financial markets and shareholders. Investors perceive dividend
announcements as signals of future prospects for the company. A company should
therefore consider the likely effect on share prices of the announcement of a
proposed dividend.

9. Companies Act restrictions

The Companies Act imposes restrictions on the distribution of profit by companies.
It should be noted that the purpose of the law is to determine the maximum
allowable distribution.
 10. The level of gearing
If financial risk is high, for example due to a high level of gearing arising from a
substantial level of debt finance, maintaining a low level of dividend payments can
result in a high level of retained earnings, which will reduce gearing by increasing
the level of reserves. The cash flow from a higher level of retained earnings can
also be used to decrease the amount of debt being carried by a company.

11. Taxation
In some countries dividends and capital gains are subject to different marginal
rates of taxation, usually with capital gains being subject to a lower level of taxation
than dividend. This distortion in the personal tax system can have an impact on
investors’ preference. The preference would very much depend on the tax position
of investors. This is the clientele effect.

POSSIBLE APPROACHES TO DIVIDEND POLICY

There are four major possibilities a company could adopt as to the pattern of
dividend pay-out over time. These are:

1. Constant Pay-out Ratio

The company pays a constant proportion of earnings available to equity
shareholders as dividend hence dividend per share will fluctuate from year to year
in line with earnings.

2. Stable Dividend Policy

The company pay out a fixed dividend per share irrespective of the earnings
available to equity shareholders.

3. Residual Dividend Policy

Retained earnings are used to fund all profitable projects. Remaining funds (if any)
are used to pay dividends. This policy leads to a very volatile dividend stream over
time.

4. Zero Payout
The company chooses not to pay a dividend as they wish to retain the funds for
reinvestment. This would usually occur in fast growing companies, or those in
financial distress.
DIVIDEND POLICY AND SHAREHOLDERS’ WEALTH
Does the dividend policy adopted by a company have an influence on its
shareholders’ wealth? There are broadly two schools of thought in relation to this
question. These theories are the dividend relevance theory and dividend irrelevance
theory as discussed below:

Dividend relevance theory – traditional theory

This argument is that dividends pay-out influences the market value of the
company because of the following practical influences:

1. Signalling effect
In a semi-strong form efficient market, information available to directors is more
substantial than that available to shareholders, so that information asymmetry
exists. Investors perceive dividend announcements as signals of future prospects
for the company. The signalling effect also depends on the dividend expectations in
the market. The size and direction of the share price change will depend on the
difference between the dividend announcement and the expectations of
shareholders.

2. Clientele effect
The clientele effect states that shareholders are attracted to particular companies
as a result of being satisfied by their dividend policies. A company with an
established dividend policy is therefore likely to have an established dividend
clientele. The existence of this dividend clientele implies that the share price may
change if there is a change in the dividend policy of the company, as shareholders
sell their shares in order to reinvest in another company with a more satisfactory
dividend policy.

3. Bird in hand theory

One argument often put forward for high dividend pay-out is that income in the
form of dividend is more secure than income in the form of capital gains hence
investors place value on high pay-out shares.

4. Preference for current income

Many investors, both individuals and institutional, require cash dividends to finance
current consumption, hence prefer companies paying regular cash dividends and
therefore value their shares more highly.
Dividend irrelevance theory – Modigliani and Miller (M&M)
M&M began by examining the effects of differences in dividend policy on the
current price of shares in an ideal economy characterized by perfect capital
markets, no tax, rational behavior and perfect certainty.
Under these assumptions, M&M argue that a change in the dividend policy, per say,
will not affect the shareholders’ wealth as the value of a company depends on its
investment decision alone, and not on its dividend or financing decisions.
According to them, investors react to the reasons for change, not the change itself.
For example, if the dividend is reduced in order to finance expansion, the share
price will not automatically fall. It would be the shareholders’ expectations with
respect to the expansion that influences the share price. Provided the reinvestment
is at a rate at least as higher as that obtainable by the shareholders themselves (for
the risk involved), that is invested in all projects with a positive net present value
the market value of the company should rise correspondingly, hence the cash lost
now is compensated by the increase in the value of their shares. If the funds were
actually reinvested at higher than the expected return for the level of risk, this
would increase shareholders wealth.
Given a set investment policy, a dividend cut now to finance new projects will be
compensated by higher dividends at a later stage. Since investors had perfect
information, they will be indifferent between dividends and capital gains.
Shareholders who are unhappy with the level of dividend declared by a company
could gain a ‘home-made dividend’ by selling some of their shares. This was
possible since there are no transaction costs in a perfect capital market. It
theoretically makes no difference whether the new investment is funded by
retention of dividend or new equity raised.
ALTERNATIVES TO A CASH DIVIDEND
A number of companies have established ways of rewarding shareholders other than
by traditional dividend payments. These methods include:

When the directors of a company consider that they must pay a certain level of
dividend, but would really prefer to retain funds within the business, they can
introduce a scrip dividend scheme.
This involves giving ordinary shareholders the choice of receiving dividend in the
form of shares instead of in the form of cash.
Scrip dividend if accepted by shareholders has the advantage of preserving the
liquidity position of the company because it will reduce the cash outflow and
enables the company to use internally generated funds to finance new investments.
Scrip dividend will also lead to a decrease in gearing because of the increase in
issued shares and may help to increase the company’s debt capacity.
A disadvantage of scrip dividend is that it may lead to increase in future dividend
payments as a result of increase in the number of shares (assuming constant
dividend per share).
Another issue is that it is optional and shareholders may not accept the proposal.
In addition, scrip dividend may give wrong signal to the market as to why the
company is making such a proposal and may have adverse effects on the share
price.

Companies with cash surpluses, but having no positive NPV projects, may choose to
introduce a share buy-back scheme, whereby the company’s shares are purchased
at the company’s instructions on the open market.
This will have the effect of using up the surplus cash, increasing future EPS
(because of the reduction in the number of shares in issue), changing the gearing
level of the company and (hopefully) reducing the likelihood of a takeover. However
share repurchases are often seen as an admission that the company cannot make
better use of shareholders’ funds.
Example Cedi Plc and Dollar Plc
Cedi plc and Dollar plc both operate department stores in Europe. They operate in
similar markets and are generally considered to be direct competitors. Both
companies have similar earning records over the past ten years and have similar
capital structures. The earnings and dividend record of the two companies over the
past six years is as follows:
CEDI PLC DOLLAR PLC
EPS DPS Share price EPS DPS Share price
Years cents cents cents cents cents cents
20X1 230 60 2,100 240 96 2,200
20X2 150 60 1,500 160 64 1,700
20X3 100 60 1,000 90 36 1,400
20X4 -125 60 800 -110 0 908
20X5 100 60 1,000 90 36 1,250
20X6 150 60 1,400 145 58 1,700
Both companies have 25 million shares in issue. At the beginning of 20X% Dollar
plc made a rights issue. The EPS and DPS have been adjusted in the above table.
The chairman of Cedi plc is concerned that the share price of Dollar plc is higher
than his company’s, despite the fact that Cedi plc has recently earned more EPS
than Dollar plc and frequently during the past six years has paid a higher dividend.

Required:
Discuss:
(a) The apparent dividend policy followed by each company over the past six
years and comment on the possible relationship of those policies to the
companies’ market values and current share prices; and
(b) Whether there is an optimal dividend policy for Cedi plc that might increase
shareholders’ value.
 Chapter 2

Governance & Ethics

Corporate strategy and financial management

The role of the financial manager is to align the aims of the financial management
team with those of the wider corporate strategy. The strategy of the business may
be separated into corporate, business and operational objectives. Financial
managers should be attempting to fulfill those objectives.
The nature of financial management means that it is fundamental to the translation
of strategic aims into financial transactions.

Financial objectives
Financial objectives of commercial companies may include:
1. Maximizing shareholders’ wealth
2. Maximizing profits
3. Satisficing.

Stakeholders
We tend to focus on the shareholder as the owner and key stakeholder in a
business. A more comprehensive view would be to consider a wider range of
interested parties or stakeholders.
Stakeholders are any party that has both an interest in and relationship with the
company. The basic argument is that the responsibility of an organization is to
balance the requirements of all stakeholder groups in relation to the relative
economic power of each group.
These include:
● Shareholders
● Directors
● Management and employees
● Loan creditors
● Customers
● Suppliers
● The government
● Environmental pressure groups
● The general public
Many of these groups may have conflicting objectives, which need to be reconciled.

The very nature of looking at stakeholders is that the level of ‘return’ is finite within
an organization. There is a need to balance the needs of all groups in relation to
their relative strength.

Agency relationships occur when one or more people employ one or more persons
as agents. The persons who employ others are the principals and those who work
for them are called the agent
In an agency situation, the principal delegates some decision-making powers to the
agent whose decisions affect both parties. This type of relationship is common in
business life. For example shareholders of a company delegate stewardship function
to the directors of that company. The reasons why an agent is employed will vary
but generally an agent may be employed because of the special skills offered, or
information the agent possesses or to release the principal from the time
committed to the business.
 Goal congruence is defined as the state which leads individuals or groups to take
actions which are in their self-interest and also in the best interest of the entity.
For an organization to function properly, it is essential to achieve goal congruence
at all levels. All the components of the organization should have the same overall
objectives, and act cohesively in pursuit of those objectives.
In order to achieve goal congruence, there should be introduction of carefully
designed remuneration packages for managers and the workforce which would
motivate them to make decisions which will be consistent with the objectives of the
shareholders.

The most direct use of money as a motivator is payment by results schemes

whereby an employee’s pay is directly linked to his results. However, research has
shown that money is not a single motivator or even the prime motivator.

Ethics
Consideration of ethical implications which may impede shareholder wealth
maximization as consideration must be given to other stakeholder groups
Modern thinking recognises the link between an ethical approach and enhanced
revenue, by contrast unethical behavior may have consequences such as customer
and supplier boycotts which impact upon financial and business performance.
Ethical framework for decision making
● Integrity
● Objectivity
● Professional competence
● Confidentiality
● Professional behavior
Exam questions may require you to consider environmental issues and their impact
upon corporate objectives.
Ensure that you consider a decision with the potential conflict and damage to the
business reputation

Requires the reporting of performance from three perspectives

1.Economic
2.Social
3.Environmental
Environmental indicators could include carbon emissions, renewable energy
consumed as a percentage of total, quantity of waste recycled etc.

Clearly the executive directors of a listed company are both decision-makers and
major stakeholders. They are therefore open to the accusation of making key
decisions for their own benefit. Following a number of notable financial scandals in
the UK during the late 20th century (e.g. the Maxwell affair and the collapse of the
BCCI) the Cadbury Committee was set up to investigate procedures for appropriate
corporate governance.
The Cadbury Code (1992) defined corporate governance as “the system by which
companies are directed and controlled”. This initial document has been subject to
subsequent amendments by the Greenbury, Hampel and Higgs Reports. The
Financial Conduct Authority requires listed companies to confirm that they have
complied with the Code’s provisions or – in the event of non-compliance – to
provide an explanation of their reasons for departure.

The broad principles of corporate governance are similar in the UK, the USA and
Germany, but there are significant differences in how they are applied. Whereas the
UK and Germany have voluntary corporate governance codes, the US system is
based upon legislation within the Sarbanes-Oxley Act.

Corporate governance structure is more formalized, with legally enforceable

controls. These requirements include the certification of published financial
statements by the CEO and the chief financial officer (CFO), faster public
disclosures by companies, legal protection for whistleblowers, a requirement for an
annual report on internal controls, and requirements relating to the audit
committee, auditor conduct and avoiding ‘improper’ influence of auditors.
Germany
As both the UK and Germany are members of the EU, they must both follow EU
directives on company law. A major difference that exists in the board structure for
companies is that the UK has a unitary board (consisting of both executive and
non- executive directors), whereas German companies have a two-tier board of
directors.
The Supervisory Board typically includes representatives from major banks that
have historically been large providers of long-term finance to German companies
(and are often major shareholders).

Japan
Although there are signs of change in Japanese corporate governance, much of the
system is based upon negotiation or consensual management rather than upon a
legal or even a self-regulatory framework. Banks as well as representatives of other
companies (in their capacity as shareholders) also sit on the Boards of Directors of
Japanese companies.
It is not uncommon for Japanese companies to have cross holdings of shares with
their suppliers, customers and banks etc., all being represented on each other’s
Board of Directors.
 Chapter 3

Economic
Environment for
Multinationals

INTERNATIONAL TRADE
International trade occurs to allow companies to enjoy economies of scale, increase
their turnover and profits, use up spare capacity and to promote division of labor. In
economics, theoretical justifications of the benefits of international trade were put
forward by:
● Adam Smith – the theory of absolute advantage.
● David Ricardo – the theory of comparative advantage.
Sources of advantage may include close proximity to raw materials or markets,
access to capital or an available labour force with the necessary skills.

Free trade and protectionism

Free trade is the unhindered movement of goods and services throughout world
markets.
Protectionism aims to boost the economic wealth of the country concerned through
government measures which prevent free trade. However retaliatory measures may
defeat such government action. Protectionist measures may include:
● Tariffs.
● Import quotas.
 ● Bureaucratic regulations (red tape).
● Exchange controls.
● Government subsidies to domestic industries.
● Imposition of import licenses.
● Devaluation of the currency – making imports more expensive.
● Subsidies to exporters.

Trade blocks
Trade blocs arise where a group of countries conspire to promote trade between
themselves. Trade blocs include:
● Free trade area – free movement of goods and services (no internal tariffs)
between member countries, with external tariffs set individually, e.g. North
American Free Trade Area (NAFTA).
● Customs union – no internal tariffs between member countries and with
common external tariffs against non-member countries, e.g. the former
European Economic Community.
● Common market – no internal tariffs, common external tariffs, as well as the
free movement of labour and capital between member countries, e.g. the
European Union.

Gatt and the World Trade Organisation (WTO)

The General Agreement on Tariffs and Trade was set up in 1947 with the aim of
achieving agreements between trading nations to reduce protectionism and to free
international trade by the progressive removal of artificial barriers. Several rounds
of agreement were achieved - notably the Kennedy Round in the mid 1960s, the
Tokyo Round in the late 1970s and the Uruguay Round which ended in 1994.
The treaty at the conclusion of the Uruguay Round created the WTO as a
replacement body to continue the work of GATT into the future. GATT ceased to
exist in 1994.
The WTO will press for future reductions on trade barriers in areas such as
agriculture, textiles, intellectual property rights and services. The WTO, based in
Geneva, currently has a membership of about 150 countries. Membership obliges
countries to sign up to an extensive range of agreements, rather than be selective,
as was the case with GATT.

Multinational companies (MNCs)

A MNC owns or controls production or service facilities based in a number of
overseas countries. MNCs may engage in “foreign direct investment” (FDI) in order
to seek markets, raw materials, knowledge, production efficiency, or safety from
political interference. Horizontal or vertical integration and product specialization
have fuelled the growth of companies such as General Motors, Royal Dutch Shell,
BP Amoco, Nissan and Hitachi and many MNCs now have annual turnovers
exceeding the GNPs of several large countries.
The balance of payments
The balance of payments is a statistical record of a country’s international trade
transactions (current account) and capital transactions with the rest of the world
over a period of time eg

UK balance of payments 2010

£bn
Current account
Exports 200
Imports (215)
Visible balance (15)
Invisibles balance 5
(10)

UK external assets and liabilities: net transactions 2

Balancing item 8
10

N.B. The statistics that are gathered are not wholly perfect and some transactions
will be omitted. Thus the balancing item is unavoidable.
Temporary deficits can be financed by short term borrowing, but persistent balance
of payments deficits usually require government intervention, such as:
● Devaluation of the currency or government intervention on the foreign
exchange markets.
● Raising interest rates.
● Restricting the money supply.
● Imposing tariffs or import quotas.

The international financial institutions

International Monetary Fund (IMF)

Founded in Bretton Woods, New Hampshire in 1944 with the aim of promoting
world trade and maintaining global monetary stability. Assists countries with
balance of payments problems by making loans in the form of Special Drawing
Rights.
Such loans are normally dependent upon the country concerned making strict
internal financial adjustments to solve their economic problems.

The International Bank for Reconstruction and Development

(IBRD)
Popularly known as the World Bank, it was also created at Bretton Woods in 1944,
with the aim of financing the reconstruction of Europe after the Second World War.
The World Bank is now an important source of long-term low interest funds for
developing countries.

The Bank for International Settlements (BIS)

Established in Basle, Switzerland in 1930, it acts as a supervisory body for central
banks assisting them in the investment of monetary assets. It acts as a trustee for
 the IMF in loans to developing countries and provides bridging finance for members
pending their securing longer term finance for balance of payments deficits.

The Euromarkets refer to transactions between banks and depositors/borrowers of

Eurocurrency.
● Eurocurrency refers to a currency held on deposit outside the country of its
origin eg Eurodollars are $US held in a bank account outside the USA.
● Eurocurrency loans are bank loans made to a company, denominated in a
currency of a country other than that in which they are based. The term of
these loans can vary from overnight to the medium term.
● Eurobonds are bonds issued (for 3 to 20 years) simultaneously in more than
one country. They usually involve a syndicate of international banks and are
denominated in a currency other than the national currency of the issuer.
Interest is paid gross.
● Euronotes are issued by companies on the Eurobond market. Companies issue
short-term unsecured notes promising to pay the holder of the Euro Note a
fixed sum of money on a specified date or range of dates in the future.
● Euroequity market refers to the international equity market where shares in
US or Japanese companies are placed on as overseas stock exchange (e.g.
London or Paris). These have had only limited success, probably due to the
absence of an effective secondary market reducing their liquidity.

The global debt problem

This problem arose following the oil price increases in the 1970s, when the OPEC
countries invested their large surpluses with banks in the western world. The banks
then lent substantial sums to the less developed countries (LDCs) believing the
default risk to be low. The oil price rises fuelled inflation and interest rates
increased, forcing most of the world’s economies into recession.
High interest rates and reduced exports placed LDCs in a situation where they could
no longer pay interest or repay loans. These problems made economic conditions in
many LDCs extremely difficult, affecting the position of multinationals and making
international banks less willing to lend.
Methods of dealing with such excessive debt burdens have been:
● A programme of debt write-offs by banks and other lenders.
● Rescheduling existing debt repayments.
● Re-selling debt at a discount to recoup capital.
● Provision of additional loans where the debt problem is regarded as temporary.
● Drastic changes in the economic policies of the LDC imposed and monitored
by the IMF.
Risks of foreign trade
Importing from and exporting to foreign countries includes the following categories
of risk:
● Currency risk – sometimes referred to as “exchange rate risk”. It involves the
possibility of financial gains or losses arising out of unpredictable changes in
exchange rates. It can be classified into:
o Translation risk – the gains or losses to be reported when overseas
operations are consolidated into group accounts.
o Economic risk – the possibility that the value of the overseas entity
(based upon the PV of all future cash flows) will change due to
unexpected exchange rate movements arising at sometime in the future.
o Transaction risk – the gains or losses that are made when ultimate
settlement occurs at a date when the exchange rate differs from the rate
prevailing at the date of the original transaction.
● Political risk – the possibility of the financial success of a venture being
affected by the actions of an overseas government or population. Government
agencies can advise on potential risks.
● Physical risk – the likelihood of damage or theft arising from the physical
distances involved and the length of time between despatch and receipt of the
goods by the customer. Normal commercial insurance is, of course, available.
● Credit risk – this is the risk of non-payment for the goods/services involved in
an export transaction. Insurance cover for up to 180 days can be provided by
NCM UK; for longer periods the ECGD may provide this service. Private sector
companies such as Trade Indemnity plc provide similar services.
● Trade risk – the overseas customer may refuse to accept the goods and be
uncooperative in returning them, thus taking advantage of the long physical
distances involved.
● Liquidity risk – this is caused by the duration of the delivery period and the
lengthy periods of credit expected by some overseas customers.
● Cultural risk – there may be misunderstandings caused by differences in trade
practice, religious and moral attitudes, legal systems and language barriers.

Sources of finance for foreign trade

● Bank overdrafts – either in sterling or in the overseas currency.
● Bills of exchange
● Promissory notes
● Documentary letters of credit
● Factoring
● Forfaiting
● Leasing and hire purchase
● Acceptance credits
● Produce loans
 ● Requesting payment in advance from the importer

Countertrade
This is an agreement in which the export of goods to a country is matched by a
commitment to import goods from that country. This usually occurs because the
foreign importing country either lacks foreign currency, has exchange controls in
place or where there are barriers to imports which can be circumvented by means
of countertrade.
The volume of countertrade is now reported at about 30% of total international
trade. In the case of some Eastern European and Third World countries it is the
only way of organizing international trade because of their shortage of foreign
currency. Many countertrade deals can be highly complex involving many parties.
 Chapter 4

Discounted
Cash Flow
techniques
DISCOUNTED CASH FLOW TECHNIQUES

Discounting cash flow techniques are investment appraisal techniques which take
into account both the time value of money and also total profitability over the
project life. It is therefore superior to both the ARR and the payback as methods of
investment appraisal.
The discounting methods include:
● Net present value,
● Internal rate of return,
● Modified internal rate of return,
● Discounted payback period,
● Duration,
● Profitability index,
● Adjusted present value.
The assumed objective is to maximize the shareholders’ wealth.

Net present value (NPV)

The NPV of a project is the value obtained by discounting all the cash outflows and
inflows at a chosen target rate of return or cost of capital and taking the net total.
That is the present value of inflows minus present value of outflows.
NPV = PV of future cash flows – initial investment.
There are three variables required in calculating NPV. These variables are:
● The number of years of the project,
● The relevant cash flows,
 ● Appropriate discount factor (cost of capital).

1. If the NPV is positive, then the cash inflows from the investment will yield a
return in excess of the cost of capital and so the project should be
undertaken.
2. If the NPV is negative, the cash inflows from the investment will yield a return
below the cost of capital, and the project should not be undertaken.
3. If the NPV is exactly zero, then the cash inflows from the investment will yield
a return which is exactly the same as the cost of capital, so the company
should be indifferent between undertaking and not undertaking the project.

Internal rate of return is that discount rate which gives a net present value of zero.
Alternatively, the IRR can be described as the maximum cost of capital that can be
applied to finance a project without causing harm to the shareholders.
It is sometimes called the yield, or DCF yield, or internal yield, or discounted rate of
return.
The IRR is found approximately using interpolation. This is given as:

irr = L% + NPVL
X (H-L)
—--------------

NPVL- NPVH
L = lower discount rate (say 10%)
H = higher discount rate (say
15%)
NPVL = net present value of L% = 190
NPVH = net present value of H% = 65
IRR = 10% + (190/ 190-65) x (15% -10%)
= 10% + 7.6% = 17.6%

If the expected (calculated) IRR exceeds the cost of capital, the project should be
undertaken.

Discounted payback period (DPB)

It is the length of time the present values of cash flows from an investment recover
the original cash outlay required by the investment. Through the DPB method, the
normal payback period problem of time value of money is resolved.

A relevant cash flow is a future cash flow arising as a result of a decision. The cash
flows that should be included are those specifically generated or incurred as a result
of the accepting or non-accepting of the project.
Relevant cash flows should be judged on the basis of:
 ● Incremental cash flows,
● Avoidable cash flows, and
● Opportunity cost.
Irrelevant cash flows include:
● Depreciation – not a cash flow item. If profit is given after depreciation, the
depreciation should be added back to get the cash flows.
● Apportioned fixed cost. Fixed costs may appear in a DCF calculation only if it is
known that they will increase as a result of accepting a project.
● Interest payments – this is factored into the discount rate.
● Sunk or past costs.

Working capital
Some capital investment involves an investment in working capital as well as fixed
assets. Working capital should be considered to consist of investments in stocks
and debtors, minus trade creditors.
An increase in working capital reduces cash flows and a reduction in working capital
improves the cash flow in the year that it happens
By convention, in DCF analysis, if a project will require an investment in working
capital, the investment is treated as a cash outflow at the beginning of the year in
which it occurs. The working capital is eventually released or recouped at the end of
the project, when it becomes a cash inflow.

INFLATION AND PROJECT APPRAISAL

Inflation is a general increase in prices leading to a general decline in the real value
of money. In general, the effects are the following:
1. revenue increases
2. cost increases
3. increases discount factor.

‘Money’ cash flows

These are the predictions of the actual sums of money which will be received and
paid taking into account predicted inflation levels. The ‘money’ rate of interest is
the interest rate which is normally quoted and contains an allowance for inflation
(for example, a 20% discount rate may contain an allowance for expected inflation
of 5%).

‘Real’ cash flows

These are cash flows expressed in today’s prices. A ‘real’ discount rate is the real
required rate of return after adjusting the money discount rate for the inflation
allowance.
1. Money or Nominal rate is used to discount the nominal cash flows.
2. Real rate is used to discount the real cash flows.
3. Because inflation affect financing needs, is also likely to affect gearing and so
cost of capital.
The relationship between money rate (m), real rate (r) and inflation (i) is given as:
(1 + m) = (1 + r)(1 + i)

● Tax on cash profit (sales minus expenses).

● Tax savings on capital allowances (tax allowable depreciation).
● Timing of the cash flows.

The capital allowances are used to reduce the taxable profits and the consequence
reduction in a tax payment should be treated as a cash savings arising from the
acceptance of a project.

When the asset is eventually sold, the difference between the sale proceeds and the
written down amount at the time of sale will be treated as:
● A balancing charge (taxable profit) if the sale price exceed the written down
balance.
● A balancing allowance (taxable loss) if the sale price is less than written down
balance.
Example Jato Co
Jato Co is considering a project – whether or not to commercialize an innovative
muscle toning device (MTD) that will be used in the treatment of sporting injuries.
It is expected that the commercial life of MTD will be four years after which
technological advances will bring more sophisticated devices to the market and the
sales of MTD will fall to virtually zero. $8,000,000 has been spent in developing
and testing the device over the past year. Initial market research has been
conducted at a cost of $2,500,000 and is due to be paid shortly.
Information on future returns from the investment has been forecast to be as
follows:
Year 1 2 3 4
Units demand 20,000 70,000 125,000 20,000
Selling Price in current price terms ($/unit) 2,000 2,200 1,600 1,500
Variable cost in current price terms ($/unit) 900 1,000 1,020 1,020
Fixed costs in current price terms
10 10 10 10
($million/year)

Selling price inflation and fixed costs inflation are expected to be 5% per year and
variable cost inflation is expected to be 4% per year. Fixed costs represent
incremental fixed production overheads which are wholly attributable to the project.
The production equipment for the new device would cost $120 million and an
additional initial investment of $20 million would be needed for working capital.
The equipment is expected to be sold at the end of four years for $10 million when
the production and sales cease. The average general level of inflation is expected
to be 3% per year and working capital would experience inflation of this level.
Capital allowances (tax-allowable depreciation) on a 25% reducing balance basis
could be claimed on the cost of equipment. Profit tax of 30% per year will be
payable one year in arrears. A balancing allowance would be claimed in the fourth
year of operation.
Jato Co has a real cost of capital of 7.8%.

Required: calculate the NPV / IRR / Payback & Discounted payback.

NPV and IRR compared

A single project will be accepted if it has a positive NPV at the required rate of
return. If it has a positive NPV then, it will have an IRR that is greater than the
required rate of return.

Two projects are mutually exclusive if only one of the projects can be undertaken.
In this circumstance the NPV and IRR may give conflicting recommendation.
The reasons for the differences in ranking are:
1. NPV is an absolute measure but the IRR is a relative measure of a project’s
viability.
2. Reinvestment assumption. The two methods are sometimes said to be based
on different assumptions about the rate at which funds generated by the
project are reinvested. NPV assumes reinvestment at the company’s cost of
capital and IRR assumes reinvestment at the IRR.

Where there is conflict between IRR and NPV, accept the project with the larger NPV.

Modified internal rate of return (MIRR)

An assumption underlying the NPV method is that any net cash flows generated
during the life of the project will be reinvested elsewhere at the cost of capital (the
discount rate). The IRR method assumes that the net cash flows are reinvested
elsewhere at the IRR.
If the IRR is considerably higher than the cost of capital this is an unlikely
assumption. If the assumption is not valid the IRR method overestimates the
projects return.
To help overcome the problem of IRR, a recent innovation is the development of the
modified IRR, described by F. Lefley (January 1997).
Modified IRR has the following benefits:
● It eliminates multiple IRR rates.
● It addresses the reinvestment rate issue and reduces over optimism.
● It produces a result which, when ranking projects, is consistent with the NPV
rule.
 ● Provides a % rate of return for project evaluation. It is claimed that non-
financial managers prefer a % result to a monetary NPV amount, since a %
helps measure the “headroom” when negotiating with suppliers of funds.
Using this method (MIRR) all cash flows after investment are converted, by
assuming that the cash flows can be reinvested at the cost of capital, to a single
cash inflow at the end of the final year of the project.

Calculating modified internal rate of return (MIRR)

The MIRR assumes a single outflow at time 0 and a single inflow at the end of the
final year of the project. The procedures are as follows:
● Convert all investment phase outlays as a single equivalent payment at time
0. Where necessary, any investment phase outlays arising after time 0 must
be discounted back to time 0 using the company’s cost of capital.
● All net cash flows generated by the project after the initial investment (ie the
return phase cash flows) are converted to a single net equivalent terminal
receipt at the end of the project’s life, assuming a reinvestment rate equal to
the company’s cost of capital.
● The MIRR can then be calculated employing one of a number of methods, as
illustrated in the following example.

Net cash inflows

Year £
1 6,500
2 7,750
3 5,750
4 4,750
5 3,750
Duration
Duration is the average time taken to recover the cash flows on an investment. The
average is taken as the value weighted average of the number of the year (1 to n)
in which the cash flows arise. In capital investment, the duration can be calculated
using either the firm’s original outlay, or the present value of its future cash flows
as the basis for the annual weighting.
If duration is based upon the average time to recover the initial capital investment:
1. Calculate the value of each future net cash flow, discounted at the IRR of the
project;
2. Calculate each year’s discounted cash flow as a proportion of the original
capital outlay;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
If duration is based upon the average time taken to recover the present value of the
project:
1. Calculate the value of each future net cash flow, discounted at the chosen
hurdle rate;
2. Calculate each year’s discounted cash flow as a proportion of the PV of total
cash inflows;
3. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.

Year 0 1 2 3 4
Incremental cash (£34,000) £7,600 £16,500 £13,000 £6,600
flows
CAPITAL RATIONING
Capital rationing occurs whenever there is a budget ceiling or a market constraint
on the amount of funds which can be invested during a specific period of time. It is
a situation where there are insufficient funds to finance all profitable projects.

There are two causes of capital rationing:

Soft capital rationing is often used to refer to situations where, for various reasons,
the firm internally imposes a budget ceiling on the amount of capital expenditure.
It occurs due to internal factors such as:
● Management may be reluctant to issue additional share capital because of the
concern that this may lead to a dilution in control.
● Management may be unwilling to issue share capital if it will lead to a dilution
in earnings per share.
● Management may not want to raise additional debt capital because they do
not want to be committed to large fixed interest payments or due to the
concern of gearing.
● There may be a desire within the company to limit investment to a level that
can be financed solely from retained earnings.

Hard capital rationing occurs whenever there is a market constraint on the amount
of funds which can be invested during a specific period of time.
This occurs due to external factors such as:
● Raising money through the stock market is not possible because share prices
are depressed.
● There may be restrictions on bank lending due to government controls.
● Lending institutions may consider an organization to be too risky to be
granted further loan facility.
● The cost associated with making small issues of capital may be too great.
Types of capital rationing
The two types of capital rationing are single period and multi period capital rationing.

Single period capital rationing is where there are shortages of funds now, but funds
are expected to be freely available in all later periods.
Projects may be:

1. Divisible
An entire project or any fraction of that project may be undertaken. In this event
projects may be ranked by means of a profitability index, which can be calculated
by dividing the present value (or NPV) of each project by the capital outlay required
during the period of restriction.
Projects displaying the highest profitability indices will be preferred. Use of the
profitability index assumes that project returns increase in direct proportion to the
amount invested in each project.

2. Indivisible
An entire project must be undertaken, since it is impossible to accept part of a
project only. In this event the NPV of all available projects must be calculated.
These projects must then be combined on a trial and error basis in order to select
that combination which provides the highest total NPV within the constraints of the
capital available. This approach will sometimes result in some funds being unused.

This is where available finance is limited not only during the current period, but also
during subsequent periods.
Projects may be:

1. Divisible
In this event, linear programming is used to determine the optimal combination of
projects.
Two techniques, which both result in identical project selections can be used,
ie the objective is to either:
● Maximise the total NPV from the investment in available projects, or
● Maximise the present value (PV) of cash flows available for dividends.

2. Indivisible
In this event, integer programming would be required to determine the optimal
combination of investments.
Example 5 Banden Ltd
Banden Ltd is a highly geared company that wishes to expand its operations. Six
possible capital investments have been identified, but the company only has access
to a total of £620,000. The projects are not divisible and may not be postponed
until a future period. After the projects end, it is unlikely that similar investment
opportunities will occur.
Expected net cash inflows (including salvage value)

Initial
Project Year 1 2 3 4 5 outlay
£ £ £ £ £ £
A 70,000 70,000 70,000 70,000 70,000 246,000
B 75,000 87,000 64,000 180,000
C 48,000 48,000 63,000 73,000 175,000
D 62,000 62,000 62,000 62,000 180,000
E 40,000 50,000 60,000 70,000 40,000 180,000
F 35,000 82,000 82,000 150,000

Projects A and E are mutually exclusive. All projects are believed to be of similar
risk to the company’s existing capital investments.
Any surplus funds may be invested in the money market to earn a return of 9%
per year. The money market may be assumed to be an efficient market. Banden’s
cost of capital is 12% per year.

Required:

Give reasoned advice to Banden Ltd recommending which projects should

be selected.
Multi-period capital rationing
Please remember that you are only likely to be asked to set up the equations for
both the linear programming and integer programming formulations and then to
interpret the output. The actual solving of these equations are computer-based
calculations.

Example 6 Barney Ltd

The management team of Barney Ltd has identified the following independent
investment projects, all of which are divisible.
No project can be delayed or performed on more than one occasion. The projected
cash flows during the life of each project are as follows:

Year 0 Year 1 Year 2 Year 3 Year 4

£’000 £’000 £’000 £’000 £’000
Project A (25) (50) 25 50 50
Project B (25) (25) 75 - -
Project C (12.5) 5 5 5 5
Project D - (37.5) (37.5) 50 50
Project E (50) 25 (50) 50 50
Project F (20) (10) 37.5 25 -

The capital available at Year 0 is only £50,000 and only £12,500 is available at
Year 1, together with any cash inflows from the projects undertaken at Year 0.
From Year 2 onwards there is no restriction on the access to capital. The
appropriate cost of capital is 10%.

Required:
Formulate both:
1. The NPV linear programme, and
2. The PV of dividends linear programme.
Dual Values
Dual values (also referred to as “shadow prices”) reflect the change in the objective
function as a result of having one more or one less unit of scarce resource. In the
context of capital rationing the scarce resource is available cash, so that the dual
price states the change in the objective function if one more unit of currency (eg
£1) becomes available or if one less GB pound is invested.
Shadow prices can therefore be used to calculate the impact of raising additional
finance for further investment or the effect of diverting capital away from current
projects into newly discovered investments.
The dual price depends upon which method is used to formulate the linear
programme ie
● Under the NPV formulation, it reflects the change in the NPV if £1 more or
£1 less is available
● Under the PV of dividends formulation, it reflects the change in the PV of
cash available for dividend payments if £1 more or £1 less capital is available.
Dual prices relate only to marginal changes in the availability of capital. Thus,
suppose that a dual value of £1.25 arises under the PV of dividends method, this
means that if an additional £1 of funds became available, the total value of the
objective function would rise by £1.25. It does not necessarily mean that if an
additional £10,000 became available, that the value of the objective function would
increase by (£10,000 x 1.25) £12,500.
Shadow prices can therefore be used to test the validity of new investments which
emerge. The cash flows generated by the new project can be compared with the
cash flows lost by diverting funds from existing investments, thereby calculating the
effect of diversion of that finance.
Example 7 Bruno Ltd
Bruno Ltd is experiencing capital rationing during both Year 0 and Year 1 in relation
to a number of divisible projects. It has used linear programming to develop an
investment strategy over its three year planning horizon for dividend payments,
using a cost of capital of 10%.
Shadow prices have been calculated under the NPV formulation for the two years
of capital constraints and under the PV of dividends formulation for the three year
planning horizon. The dual prices per £1 of capital available are as follows:

NPV method PV of dividends method

£ £
Year 0 0.1 (1 + 0.1) = 1.1
Year 1 0.08 (0.909 + 0.08) = 0.989
Year 2 0 (0.826 + 0) = 0.826

A new investment opportunity has emerged with the following cash flows:

Cash flow
£’000
Year 0 (75)
Year 1 50
Year 2 50

Required:
Appraise the new project using both the NPV dual prices and the PV of
dividend shadow prices.
 Project A Project B Project C Project D
£ £ £ £
Year 0 17,500 22,500 - 12,500
Year 1 25,000 - 15,000 15,000
Year 2 10,000 30,000 20,000 17,500

£
Year 0 40,000
Year 1 35,000
Year 2 42,500

Project A Project B Project C Project D

Project NPV +£20,000 +£27,500 +£15,000 +£10,000
RISK AND UNCERTAINTY
Forecasts must consider risk and uncertainty.

Future events might not be certain, because there are several possible outcomes.
However, it might be possible to predict the likelihood that each possible outcome
will occur. The predictions of risk in the future might be based on statistical
assessment of what has occurred in the past.
With risk analysis, the probabilities might be obtained from analysing what has
happened in the past.

Uncertainty exists where there are several possible outcomes, but there is little
previous statistical evidence to enable the possible outcomes to be predicted.

The methods of treating risk include:

● sensitivity analysis
● probability estimate of cash flows
● certainty equivalent
● adjusting the discount rate
● simulation modeling.

Sensitivity analysis
Sensitivity analysis is one method of analyzing the risk surrounding a capital
expenditure project and enables an assessment to be made of how responsive the
project’s NPV is to changes in the variables that are used to calculate that NPV.
It is applied by varying the expected cash flows of a project to measure what would
happen if the investment were to work out somewhat worse than expected.
The NPV could depend on a number of variables such as
● initial cost or investment
● estimated selling price
● estimated sales volume or quantity
● estimated cost of capital
● estimated operating cost, both fixed and variable
● The number of years of the project.
The basic approach to sensitivity analysis is to calculate the net present value of
the project under alternative assumptions to determine how sensitive it is to
changing conditions.
 To find the percentage change required to achieve an NPV of zero, the calculation is
as follows if the variable under consideration is a cash flow item:

% change = NPV of project ×100

PV of cash flows
affected by the
variable

This is the discount factor to make the NPV zero and is simply calculated as the
internal rate of return.

This is calculated as the discounted payback period.

Example 9 CC plc
An cted NPV has already been calculated for the following project of CC plc:
expe
Cash flow 10% discount factor Present value
Year
£000 £000
0 Initial investment (100) 1 (100.00)
1-3 Revenues 40 2.487 99.48
3 Scrap value 10 0.751 7.51
NPV +6.99
Required:

Monte Carlo simulation

Sensitivity analysis assesses the effect on an overall decision if a single constituent
variable were to change. Monte Carlo simulation is a mathematical model which will
include all combinations of the potential variables associated with the project. It
results in the creation of a distribution curve of all possible cash flows which could
arise from the investment and allows for the probability of the different outcomes to
be calculated.
The steps involved are as follows:
1. Specify all major variables
2. Specify the relationship between those variables
3. Using a probability distribution, simulate each environment.
This is repeated a large number of times until a distribution of net present values
emerges. By the central limit theorem the resulting distribution will approximate
normality and from which project volatility can be estimated.
The advantage of this technique is that it includes all foreseeable outcomes.
The disadvantages are the difficulty in formulating the probability distribution and
the model becoming very complex.
Project value at risk
Value at risk (VaR) is the value which can be attached to the downside of a value or
price distribution of known standard deviation and within a given confidence level.
VaR and related measures give an indication of the potential loss in monetary value
which is likely to occur with a given level of confidence. The setting of the
confidence level is necessary because, in principle, if a price distribution is normally
distributed for example, the downside loss is potentially infinite.
Confidence levels are often set at either 95% (in which case the VaR will provide
the amount that has only a 5% chance of decline) or at 99% (when the VaR
considers a 1% chance of loss of value).
 Chapter 5

Application of
Option Pricing in
Investment
Decisions
Terminology of Options

The holder or buyer of the option is an investor or speculator who pays the option
money as consideration for the right to buy or sell at a fixed price over a limited
period.

The writer or seller of the option is an organization or individual who will grant the
option and take the option money in payment for the services. Unlike the holder,
the writer has an obligation to the deal, if the holder is to exercise the right under
the option.

A call option is the option that gives its holder the right, but not an obligation to
buy the underlying item at the specific price on or before the specific expiry date of
the option. For example, a call option on shares of central college, gives its holder
the right to buy that number of shares in central college at the fixed price on or
before the expiry date of the option.
 A put option is the option that gives its holder the right to sell the underlying item
at the specific price on or before the specific expiry date of the option. For example,
a put option in central college shares, gives its holder the right to sell that number
of shares at the specific price on or before the specific expiry date of the option.

European options only allow the option holder to exercise the right on the expiry
date itself and not before. American options allow the holder to exercise the right at
any time up to and including the expiry date of the option.

This is the predetermined price at which the underlying item would be bought or
sold if the holder of the option decides to exercise the right under the option
contract.

If the exercise price is more than the market price of the underlying item, a call
option will be out of money and a put option will be in the money.
If the exercise price is less than the market price of the underlying item, a call
option will be in the money and a put option will be out of the money.
If the exercise price is equal to the market price of the underlying item both call and
put options will be at the money.

Option premium or money is the fee payable by the holder to the writer. It is the
writers return for the risks they are accepting. The premium will vary in value
according to the market expectations of future values of the underlying assets.

Intrinsic value is the difference between the strike price for the option and the
current market price of the underlying item. However, an in-the-money option has
an intrinsic value; but because intrinsic value cannot be negative, an out of the
money option has an intrinsic value of zero.

Factors determining the value(price) of option

The major factors determining the price of options are as follows:

For a call option, the greater the price for the underlying item the greater the value
of the option to the holder. For a put option the lower the share price the greater
the value of the option to the holder.
 The price of the underlying item is the market prices for buying and selling the
underlying item. However, mid-price is usually used for option pricing, for example,
if price is quoted as 200–202, then a mid-price of 201 should be used.

For a call option the lower the exercise price the greater the value of the option. For
a put option the greater the exercise price, the greater the value of the option.
The exercise price will be stated in terms of the option contract.

The longer the remaining period to expiry, the greater the probability that the
underlying item will rise in value. Call options are worth more the longer the time to
expiry(time value) because there is more time for the price of the underlying item
to rise. Put options are worth more if the price of the underlying item falls over
time.
The term to expiry will also be stated in the terms of the option contract.

The seller of a call option will receive initially a premium and if the option is
exercised the exercise price at the exercised date. If interest rate rises the present
value of the exercise price will diminish and he will therefore ask for a higher
premium to compensate for his risk.
The risk free rate such as treasury bills is usually used as the interest rate.

The greater the volatility of the price of the underlying item the greater the
probability of the option yielding profits.
The volatility represents the standard deviation of day-to-day price changes in the
underlying item, expressed as an annualized percentage.

The Black Scholes option pricing model

Black-Scholes model is a model for determining the price of a call option. The model
considers the factors discussed above and states that the market value of a call
option at a particular time can be calculated as:
Option price = PaN(d1) – Pe(Nd2) e-rt

( )
ln(Pa / Pe) + r + 0.5s2 t

d1 =

d2 = d1 – s√t

ln = natural log
Nd1 and Nd2 are the normal distribution function of d1 and d2 respectively.
Where:
Pa = current market price of the underlying item
Pe = the exercise price
R = the annual risk free rate in decimals
T = time to expiry of option in years, so six months will be 0.5
years.
S = the standard deviation of the underlying instrument returns.
This measures the volatility of the underlying item.
REAL OPTIONS IN INVESTMENT APPRAISAL
Real options are concerned with options related to operational and strategic
decisions, in particular those concerned with investment in projects.
Conventional DCF analysis looks at whether a project is going to add value for
shareholders. In practice, managers of a business are unlikely to consider net
present values of projects alone. Investing in a particular project might lead to
other opportunities that may have been ignored in a DCF analysis. Managers could
take action to help boost a project’s NPV if it falls behind forecast. They can create
and take advantage of options in managing projects.
The flexibility provided by real options in investments appears in many guises.
Busby and Pitts identify the following types:
● Timing options – options to embark on an investment, to defer it or abandon it.
● Scale options – options to expand or contract an investment.
● Staging options – option to undertake an investment in stages.
● Growth options – options to make investments now that may lead to greater
opportunities later, sometimes called ‘toe-in-the-door’ option.
● Switching option – options to switch input or output in a production process.
Based on the P4 syllabus, we have to consider option to delay, expand, redeploy
and withdraw.

Option to delay or defer

An option to delay gives the company the right to undertake the project in a later
period without losing the opportunity of creating a call option on the future
investment. This is more applicable if a company has exclusive rights to a project or
product for a specific period.

Option to expand
The option to expand exists when firms invest in projects which allow them to make
further investments in the future or to enter new markets. The initial project may
be found in terms of its NPV as not worth undertaking. However, when the option to
expand is taken into account, the NPV may become positive and the project
worthwhile.
Expansion will normally require additional investment creating a call option.
The option will be exercised only when the present value from the expansion is
higher than the extra investment.
Option to abandon
An abandonment option is the ability to abandon the project at a certain stage in
the life of the project. Whereas traditional investment appraisal assumes that a
project will operate in each year of its lifetime, the firm may have the option to
cease a project during its life.
Abandon options gives the company the right to sell the cash flows over the
remaining life of the project for a salvage/scrap value therefore like American put
options. Where the salvage value is more than the present value of future cash
flows over the remaining life, the option will be exercised.

Option to redeploy or switch

The option to redeploy or switch exist when the company can use it productive
assets for activities other than the original one. The switching from one activity to
another will be exercised only when the present value of cash flows from the new
activity will exceed the cost of switching. This could result to a put option if there is
a salvage value for the work already performed, together with a call option arising
on the right to commence the new investment at a later stage.

Valuation of real options

The Black-Scholes model can be used to value real options just as financial options
seen earlier, but the following should be noted:
● The exercise price (Pe) will be replaced by the capital investment (initial
investment) for the option to delay and expand. Pe for option to abandon is
the proceeds from the sale of the project.
● The price of the underlying (Pa) item will be replaced by the present value of
future cash flows from the project.
● Time to expiry (t) is the time to exercise the option.
● Interest rate is still the risk free rate.
● Volatility of cash flows can be measured using typical industry sector risk.
Pricing of share options

Writers of options need to establish a way of pricing them. This is important because
there has to be a method of deciding what premium to charge to the buyers.
The pricing model for call options are based on the Black-Scholes model.

Limitations of the Black-Scholes model

The model has a number of limitations including the following:
● It assumes that no dividends are paid in the period of the option.
● It applies to European call options only, and not to American options.
● It assumes that the risk free rate is known and constant throughout the option
life.
● It assumes that there are no transaction costs and tax effects involved in
buying or selling the option or its underlying item.
● The difficulty of estimating the standard deviation of the returns of the
underlying item to which the model is sensitive, and the use of this historical
measure to estimate future movements.
THE GREEKS
In principle, an option writer could sell options without hedging his position. If the
premiums received accurately reflect the expected pay-outs at expiry, there is
theoretically no profit or loss on average. This is analogous to an insurance
company not reinsuring its business. In practice, however, the risk that any one
option may move sharply in-the-money makes this too dangerous. In order to
manage a portfolio of options, the dealer must know how the value of the options
he has sold and bought will vary with changes in the various factors affecting their
price. Such assessments of sensitivity are measured by the “Greeks”, which can be
used by options traders in evaluating their hedge positions.

1. Delta
For each option held, the delta value can be established i.e.

Delta = Change in option price

Change in price of underlying security
Delta is a measure of how much an option premium changes in response to a
change in the security price. For instance, if a change in share price of 5p results in
a change in the option premium of 1p, then the delta has a value of (1p/5p) 0.2.
Therefore, the writer of options needs to hold five times the number of options than
shares to achieve a delta hedge. The delta value is likely to change during the
period of the option, and so the option writer may need to change his holdings to
maintain his delta hedge position.
Accordingly, a writer can hedge a holding of 300,000 shares using options with a
delta value estimated by N(d1) of 0.6, by holding the following number of LIFFE
contracts (each of 1,000 shares).
300,000 = 500 contracts.
Number of =
shares Delta 0.6 ×1,000

value×Contract
size

A delta value ranges between 0 and +1 for call options, and between 0 and -1 for
put options. The actual delta value depends on how far it is in-the-money or out-of-
the-money.
The absolute value of the delta moves towards 1 (or -1) as the option goes further
in-the-money and shifts towards 0 as the option goes out-of-the-money. At-the-
money calls have a delta value of 0.5, and at-the-money puts have a delta value of
-0.5.

2. Gamma
Gamma measures the amount by which the delta value changes as underlying
security prices change. This is calculated as the:

Change in the delta value

Change in the price of the underlying security
3. Vega
Vega measures the sensitivity of the option premium to a change in volatility. As
indicated above, higher volatility increases the price of an option. Therefore any
change in volatility can affect the option premium. Thus:

Vega = Change in the option price

Change in volatility
N.B. Vega is the name of a star, not a letter of the Greek alphabet!!

4. Theta
Theta measures how much the option premium changes with the passage of time.
The passage of time affects the price of any derivative instrument because
derivatives eventually expire. An option will have a lower value as it approaches
maturity. Thus:

Theta = Change in the option price (due to changes in value)

Change in time to expiry

5. Rho
Rho measures how much the option premium responds to changes in interest rates.
Interest rates affect the price of an option because today’s price will be a
discounted value of future cash flows with interest rates determining the rate at
which this discounting takes place. Thus:

Rho = Change in the option price

Change in the rate of interest

Summary of the Greeks

Changes in In response to changes in

DELTA Option premium Value of underlying security

GAMMA Delta value Value of underlying security
VEGA Option premium Volatility
THETA Time value in option premium Time to expiry
RHO Option premium Risk free rate of interest
 Chapter 6

Impact of financing
on investment
decisions

Cost of Capital
The cost of capital is the return that investors expect to be paid for putting funds
into the company. In other words, it is the cost incurred by a company for raising
money to finance its activities.
The elements of cost of capital are:
● The risk-free rate of return – return required from an investment which is
completely free from risk, example return on government securities.
● The risk premium – return to compensate for financial risk (having debts in
capital structure) and business risk (return to compensate for uncertainty
about the future and about a firm’s business prospects).
COST OF EQUITY – USING DIVIDEND VALUATION MODEL

Where a company is expected to pay a constant divided in perpetuity the cost of

equity can be calculated as:
D
Ke = P0
(ex-
div)

Where a company is expected to pay divided at a constant growth rate in perpetuity

the cost of equity can be calculated as:
The Dividend Growth mode
ke = Do(1+g)/po + g

Ke = cost of equity g = constant growth

rate D0 = current dividend P0 = ex-div market price

Ex-div price = cum-div share price - dividend just about to be paid

Cum div price = ex-div price + dividend due
Estimating growth rate
The growth ‘g’ can be estimated using either historical pattern or Gordon’s growth
model depending on the information available.

A growth rate may be estimated from historical dividend pattern, as follows:

g = (D0/Dn)^(1/n) -1

Where:
dn = dividend in the past. That is the base dividend.
d0 = the current dividend. That is the last dividend
paid.
n = number of years of growth.

Year Dividends
£
1 180,000
2 210,000
3 220,000
4 245,000
5 280,000

In Gordon’s growth model, growth is measured as follows:

g = rb
Where:
r = the accounting rate of return/return on reinvested fund

= Earnings
×100%
Book value of equity capital employed
 b = the earnings retention rate/proportion of funds/profit retained

= Earnings-dividend ×100%
Earnings

Cost of Preference Share Capital

The cost of irredeemable preference share capital, paying an annual dividend d in
perpetuity, and having a current ex-div price of Po can be calculated as follows:
D (ne t) P0 (ex- div) x 100%
Kps =

Dividends are constant and there is no growth.

Cost of Non Tradable Debt

The cost of short-term funds such as bank loans and overdrafts is the current
interest being charged on such funds reduced for the tax effect on the interest.
Kd = I (1-t)
Cost of Irredeemable Debt
The cost of irredeemable loan notes paying an annual interest in perpetuity and
having a current market price will be calculated as follows:

Kb = i(1-t)/po

Cost of Redeemable Debt

The cost of redeemable loan notes/debentures is the internal rate of return of the
net cash flows of the capital.

The cost of convertible debt is calculated in a similar manner to the calculation of

the cost of redeemable debt, EXCEPT that in the final year, one must include the:
- redemption value of the debt, or
- conversion value of the
debt whichever is the GREATER
WEIGHTED AVERAGE COST OF CAPITAL (WACC)
The weighted average cost of capital (WACC) is the average cost of the different
elements within the capital structure of a company, using the market value of each
of the different elements as the basis of the weightings.
Although book values are often easier to obtain, they are of doubtful economic
significance, that is, it is more meaningful to use market values.

Example 11 Hunt plc

The management of Hunt plc is trying to decide upon a cost of capital discount rate
to apply to the evaluation of investment projects.
The company has an issued share capital of 500,000 ordinary £1 shares, with a
current market value cum div of £1.17 per share. It has also issued £200,000 of
10% debentures, which are redeemable at par in 2 years and have a current
market value of £105.30 per cent and £100,000 of 6% preference shares,
currently priced at 40p per share. The preference dividend has just been paid, and
the ordinary dividend and debenture interest are due to be paid in the near future.
(The preference dividend is shown net).
The ordinary share dividend will be £60,000 this year, and the directors have
publicised their view that earnings and dividends will increase by 5% per annum
into the indefinite future.
The fixed assets and working capital of the company are financed by:

£
Ordinary shares of £1 500,000
6% £1 Preference shares 100,000
Debentures 200,000
Reserves 380,000
1,180,000

Required: Calculate the WACC. Assume corporation tax at 50% per annum,
payable one year in arrears.

Assumptions in the use of WACC

WACC can be used as a cut-off or discount rate for calculating NPVs of projected
cash flows for new investments, but the following criteria should be met.
● There is no significant change in capital structure of the company as a result
of the investment.
● The operating risk of the company does not change as a result of the
investment.
● The project to appraise is small relative to the size of the company. It
represents a marginal investment.
The Frederick Macaulay duration method
In 1938, Frederick R. Macaulay defined “Duration” as the total weighted average
time for recovery of the payments and principal in relation to the current market
price of a bond.
The maturity of a bond is not a particularly good indication of the timing of the cash
flows associated with that bond, since a significant proportion of those cash flows
will occur prior to maturity – normally in the form of interest payments.
One could calculate an average of the timings of each cash flow, weighted by the
size of those cash flows. Duration is very similar to such an average, but instead of
taking each cash flow as a weighting, duration uses the present value of each cash
flow.

Steps required to calculate bond duration

1. Establish the cash flows arising at each future time period;
2. Calculate the present value of these future cash flows, discounted at the IRR
(ie the gross yield to maturity) of the security. Incidentally, the sum of these
figures must be the current price of the bond;
3. Calculate each year’s discounted cash flow as a proportion of the current value
of the bond;
4. Take the time from investment to each discounted cash flow and multiply by
the respective proportion. Finally, sum the weighted year values.
Significance of the calculation of duration
Duration is an important measure for fixed-income investors and their advisers,
since bonds with higher durations may have greater price volatility than similar
bonds with lower durations. In general:
● Changes in the value of a bond are inversely related to changes in the rate of
return – ie the lower the yield to maturity, the higher the value of the bond;
● Long-term bonds have higher interest rate risk than shorter term bonds, due
to the greater probability (over the longer time period) of market interest rate
increases; and
● High coupon bonds have less interest rate sensitivity than low coupon bonds,
since the greater the amounts of the cash flows received in the short-term,
the earlier the purchase price of the bond will be recouped.
The Macaulay duration method measures the number of years required to recover
the cost of the bond (taking account of the present value of all interest and capital
cash flows within the future time period). The result is expressed in years.
A measure referred to as Modified Duration (or Volatility) expands on the basic
method, but the ACCA P4 Syllabus only requires a knowledge of the “simple”
Macaulay duration method, as a means of assessing exposure to interest rate
changes.
The basic lessons of “duration” are:
● As maturity increases, the measure of duration will also increase and the
market value of the bond will become more sensitive to changes in the level of
interest rates;
● As the coupon rate of a bond increases, duration will decrease and the value
of the bond will be less sensitive to changes in the level of interest rates; and
● As interest rates rise, duration will decrease and the value of the bond will be
less sensitive to subsequent rate changes.
Modified Duration
Modified duration looks at how sensitive the value of a security is in relation to the
changes in interest rates, measuring the percent change in a bond’s price for a 1%
change in its yield to maturity.
The formula is - Macaulay Duration / (1+ Yield to Maturity /N)
This recognises the inverse relationship that occurs between bond price and interest
rates. This is effectively price sensitivity.

Credit Rating Agencies

Assess the credit risk by using financial ratios and other financial information. Most
common considerations include maturity period of the debt, debt to asset ratio,
volatility of asset value, cash flow generation, industry and competitive position,
quality of management, capital structure and profitability.

Rating Risk of Default

AAA High Quality – zero risk

AA High Quality – very little risk

A Upper Medium Grade – minimal risk

BBB Medium Grade

BB Lower Medium grade – speculative risk

B Speculative

CCC Poor Quality – considerable risk exposure

CC Highly speculative

C Lowest grade – very high default risk

Macauley Duration / (1+ Yield to Maturity /N)

Credit Spread & cost of debt
Credit spread is the premium over the equivalent return on risk free bond to
compensate the investor for credit risk. The higher the risk the higher the spread.
Cost – risk free return + spread
This is likely to be adjusted for the tax implications when determining cost of capital

Rating 1 Year 2 Year 3 Year 4 Year

AAA 8 16 24 32

A 32 52 72 92

BB 78 128 188 248

B 102 194 274 346

1 basis point = 0.01%

Note the lower the rating the higher the spread, further the yield to maturity
increases with time.
1 year = 2%
2 year = 4%
3 year = 6%
4 Year = 7%

Thus a four year A rated bond will cost 7 + 0.92 = 7.92% whereas a 3 year B rated
bond will cost 6.0 + 2.74 = 8.74%
CAPITAL STRUCTURE THEORY
There are three theories which detail the implications of the firms capital structure
upon the WACC

The traditional view of capital structure

At relatively low levels of gearing the increase in gearing will have relatively low
impact on Ke. As gearing rises the impact will increase Ke at an increasing rate.

There is no impact on the cost of debt until the level of gearing is prohibitively high.
When this level is reached the cost of debt rises.

Key point
There is an optimal level of gearing at which the WACC is minimized and the value
of the company is maximized
Modigliani and Miller (M&M) – no taxes

Ke rises at a constant rate to reflect the level of increase in risk associated with
gearing.

There is no impact on the cost of debt until the level of gearing is prohibitively high.

M&M in 1958 was based on the premise of a perfect capital market in which:
1. Perfect capital market exist where individuals and companies can borrow
unlimited amounts at the same rate of interest.
2. There are no taxes or transaction costs.
3. Personal borrowing is a perfect substitute for corporate borrowing.
4. Firms exist with the same business or systematic risk but different level of
gearing.
5. All projects and cash flows relating thereto are perpetual and any debt
borrowing is also perpetual.
6. All earnings are paid out as dividend.
7. Debt is risk free.

The increase in Ke directly compensates for the substitution of expensive equity

with cheaper debt. Therefore the WACC is constant regardless of the level of
gearing.

If the weighted average cost of capital is to remain constant at all levels of gearing
it follows that any benefit from the use of cheaper debt finance must be exactly
offset by the increase in the cost of equity.
Modigliani and Miller – with tax
In 1963 M&M modified their model to include the impact of tax. Debt in this
circumstance has the added advantage of being paid out pre-tax. The effective cost
of debt will be lower as a result.

As the level of gearing rises the overall WACC falls.The company benefits from
having the highest level of debt possible.

Problems with high gearing

It is rare to find firms who seek to have very high gearing. This is due to problems
such as:
● bankruptcy
● tax exhaustion
● loss of borrowing capacity
● risk attitude of potential investors.

A reflection that funding of companies does not follow theoretical rules but instead
often follows the ‘path of least resistance’.
 A suggested order is as
follows: 1st retained

earnings 2nd bank debt

3rd issue of equity.

MODIGLIANI AND MILLER FORMULAE

.
THE CAPITAL ASSET PRICING MODEL (CAPM)

The underlying theory of CAPM

The CAPM assesses investments from the viewpoint of well-diversified shareholders
and considers that when companies invest in projects they must accept that the
majority of their shareholders are well-diversified institutions.
Obviously an investor can reduce risk by holding a portfolio of shares in companies
in different industries, which will to some degree offer different risk/return profiles
over time.

Thus a standard deviation (σ or s) is a measure of total risk, and this can be

analysed between:
● UNSYSTEMATIC (aka SPECIFIC or UNIQUE) RISK ie the risk which will
initially disappear as a result of diversification, and
● SYSTEMATIC (aka MARKET) RISK ie the risk which can never be avoided
when investing in company shares.
Specific risk reflects factors which are unique to the company or to the industry in
which it operates, whereas systematic risk reflects market wide factors such as the
state of the economy.
Diversification therefore eliminates the unsystematic risk relating to shares held in
a well-diversified portfolio, but sadly the systematic risk of that portfolio will
remain.
Accordingly, CAPM recognises that investors cannot expect to receive a return on
their exposure to unsystematic risk – therefore returns will only be received as a
result of systematic risk, which investors can never avoid.
Systematic business risk and systematic financial risk
At a gearing level of zero, the equity shareholders of a company would have to bear
systematic business risk only. However as a company increases its debt levels and
becomes more and more highly leveraged, its equity shareholders will not only
have to face the same level of systematic business risk as before, but will also have
to accept increasing amounts of systematic financial risk.
Accordingly:
● Equity shareholders in an ungeared company bear systematic business
risk only, whereas
● Equity shareholders in an otherwise identical geared company bear the
same level of systematic business risk as before, but will also have to
face an ever increasing level of systematic financial risk as borrowing
levels become greater and greater,
with a consequence increase in the Ke of the company concerned. This is illustrated
below.
Following the M & M with corporation tax theory of 1963, as gearing levels increase,
Ke behaves as follows:

Now that the issue of leverage has been introduced, there becomes a need to
distinguish:
● β asset (βa), which reflects systematic business risk only, and
● β equity (βe), which reflects both systematic business risk TOGETHER
WITH ANY systematic financial risk which MAY exist.
 Therefore:
● In the case of an all equity company, βe = βa, since no systematic financial
risk can possibly exist.
● In the case of a geared company, βe > βa, since βe contains both
systematic business risk and systematic financial risk, whereas βa reflects
systematic business risk only.

Project specific cost of capital

Discount rates for capital investment appraisal should be consistent with the risk
that go with the project and as such should take into account both the systematic
risk and the company’s gearing level.
This approach is appropriate where a company is diversifying into another industry
or is undertaking a major new investment which will affect business and financial
risks significantly.
The stages of establishing the specific cost of capital for appraising such
investments are:
● Identify a proxy beta. This is the average equity beta of the industry in which
the project is to be undertaken.
● Ungear the proxy equity beta to remove the financial risk to establish the
asset beta or ungeared equity beta (Beu) using the above formula.
● Regear the asset beta (Beu) to establish the geared equity beta by including
the financial risk that reflects the method of financing the new project. This is
the debt equity ratio of financing the new project or the company’s existing
debt/equity proportion if it will not change as a result of the new project.
● Use the re-geared beta (Beg) from above to calculate the project specific cost
of equity using the CAPM formula.
● The project specific WACC can be calculated based on the weighted average of
cost of equity and cost of debt. This WACC will be used to discount the project
cash flows to determine the net present value.
Example 17 - Hotalot plc
Hotalot plc produces domestic electric heaters. The company is considering
diversifying into the production of freezers. Data on four listed companies in the
freezer industry and for Hotalot are shown below:

Freezeup Glowcold Shiverall Topice Hotalot

£’000 £’000 £’000 £’000 £’000
Fixed assets 14,800 24,600 28,100 12,500 20,600
Working capital _9,600 _7,200 11,100 _9,600 12,700
24,400 31,800 39,200 22,100 33,300

Financed by:
Bank loans 5,300 12,600 18,200 4,000 17,400
Ordinary shares* 4,000 9,000 3,500 5,300 4,000
Reserves 15,100 10,200 17,500 12,800 11,900
24,400 31,800 39,200 22,100 33,300

Turnover 35,200 42,700 46,300 28,400 45,000

Earnings per share 25 53.3 38.1 32.3 106
(in pence)
Dividend per share 11 20 15 14 40
(in pence)
Price/earnings ratio 12 10 9 14 8
Beta equity 1.1 1.25 1.30 1.05 0.95

*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice
and £1 for Glowcold and Hotalot.
Corporate debt may be assumed to be almost risk-free, and is available to Hotalot
at 0.5% above the Treasury Bill rate, which is currently 9% per year. Corporate
taxes are payable at a rate of 35%. The market return is estimated to be 16% per
year. Hotalot does not expect its financial gearing to change significantly if the
company diversifies into the production of freezers.

Required:
(a) Estimate what discount rate Hotalot should use in the appraisal of its
proposed diversification into freezer production.
(b) Discuss whether systematic risk is the only risk that Hotalot’s shareholders
should be concerned with.
WACC of combined activities
This occurs when the company is involved in two or more activities in different
industries.
The stages for calculating the WACC of combined activities are:
1. Identify proxy beta for each activity, ideally from each respective industry.
2. Un-gear each beta to determine the asset beta for each activity.
3. Calculate the market value of each activity.
4. Find the weighted average of the asset betas using the respective market
values of each activity. This represents the combined asset beta of the
company.
5. Re-gear the combined asset beta using the debt-equity proportion of the
company to determine the equity beta.
6. Using CAPM, calculate the combined cost of equity.
7. Finally, calculate the combined WACC.
Example 19 Edwards plc – Combined Asset Beta

Edwards plc is considering the acquisition of a 100% stake in Colman Ltd in order to
achieve backward vertical integration. Considerable savings are anticipated due to
the combination of both the marketing operations and distribution networks of the
two companies. Therefore synergies will arise to create cash flows which are in
excess of the current estimated cash flows of the two separate companies. Upon
the acquisition of Colman Ltd, Edwards plc will immediately sell one of the
warehouses of the target company, providing instant cash inflows of £5 million. The
forecast cash inflows of the merged businesses are as follows:

Year £ millions
2016 5.00
2017 110.00
2018 115.40
2019 121.29
2020 127.70

The cash flows are expected to grow by 1.5% per annum into perpetuity after
2020. The forecast rate of corporation tax is expected to remain at 30%. The risk
free rate of interest is to be taken at 5% and the expected return on a market
portfolio is 9%.
Information currently relating to the two companies is as follows:

Edwards plc Colman Ltd

£m £m
Market values:
Debt 100 20
Equity 900 280
Total 1,000 300

β asset 0.9 2.4

Cost of debt 7% 7%

Edwards plc plans to make a cash offer of £380 million for the purchase of the
entire share capital of Colman Ltd. This cash offer will be funded by additional
borrowings undertaken by Edwards plc.

Advise the directors of Edwards plc whether to proceed with the acquisition.
 Chapter 7
Adjusted present
value
ADJUSTED PRESENT VALUE (APV)
Traditionally financial management has appraised new investments by discounting
their after-tax operating cash flows to present value at the firm’s weighted average
cost of capital and subtracting the initial investment cost to arrive at an NPV. We
have already noted problems with the use of the WACC and seen that adjustments
are commonly needed to tailor the discount rate to the systematic business risk and
the financial risk of the project under consideration.
M & M based adjustments to the cost of capital form one approach to this problem.
Here we examine another, adjusted present value (APV), which offers significant
advantages.
APV is often described as a “divide and conquer approach”. To do this the project
will first be evaluated as if it were being undertaken by an all-equity company.
“Side effects” like the tax shield on debt and the issue costs being ignored. This first
stage will give us the so-called base NPV or base case NPV. The second stage is to
calculate the present value of the side effects and to add these to the base NPV.
The result is the APV which shows the net effect on shareholder wealth of adopting
the project.
Situations where APV is better than NPV
The APV method may be better than NPV because:
1. There is a significant change in capital structure of the company as a result of
the investment.
2. There are subsidized loans or other benefits (grant) associated explicitly with
an individual project and which requires discounting at a different rate than
that applied to the mainstream cash flows.
3. The investment involves complex tax payments and tax allowances, and or
has periods when taxation is not paid.
4. The operating risk of the company changes as a result of the investment.

CALCULATION OF THE APV

The APV method therefore sees the value of the project to shareholders as being:

Project value if all equity financed + present value of tax + Present value of
(the base case NPV) shield on the loan other side effects
The APV method involves two stages:
1. Evaluate the project first of all as if it were all equity financed, and so as if the
company were an all equity company to find the ‘base case NPV’.
2. Make adjustments to the base case NPV to allow for the side effects of the
method of financing that has been used. The financing effects may consist of:
(i) Present value of tax savings on interest paid
(ii) Present value of issue costs incurred
(iii) Present value of subsidies/cheap loans.

Issue Cost
The issue cost is the cost associated with raising funds needed to finance the
project. The issue cost is a cash outflow and that its present value should be
deducted from the base case NPV in the calculation of APV. Risk free rate is usually
used as the discount factor in calculating the present value of issue cost.
Tax savings on interest Paid

Interest payments on debt are tax allowable expenses and the APV will increase by
the present value of the tax savings on the interest otherwise called the tax shields.

The calculation of the tax shield depends on whether the interest is payable on a
fixed amount every year or there is equal repayment.

Interest saved on subsidized loans

Interest payments on debt are tax allowable expenses and the APV will increase by
the present value of the tax savings on the interest otherwise called the tax shields.
PRACTICAL PROBLEMS OF THE APV APPROACH
1. Determining a suitable cost of equity for the initial DCF computation as if the
project was all equity financed, and also establishing the all equity beta are
still based on M&M assumptions.
2. Difficulties in identifying all the costs associated with the method of financing.
3. Difficulties in choosing the correct discount rate used to discount the side
effects such as issue cost and the corporation tax savings on debt capital
interest. Although the risk-free rate of return is assumed.
4. In complex investment decisions the calculations can be extremely long and
hence more difficult.

Example 4 - Strayer
The managers of Strayer Inc are investigating a potential $25 million investment.
The investment would be a diversification away from existing mainstream activities
and into the printing industry. $6 million of the investment would be financed by
internal funds, $10 million by a rights issue and $9 million by long term loans. The
investment is expected to generate pre-tax net cash flows of approximately $5
million per year, for a period of ten years. The residual value at the end of year ten
is forecast to be $5 million after tax. As the investment is in an area that the
government wishes to develop, a subsidised loan of $4 million out of the total $9
million is available. This will cost 2% below the company's normal cost of long-term
debt finance, which is 8%.
Strayer's equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by
market value. The average equity beta in the printing industry is 1.2, and average
gearing 50% equity, 50% debt by market value.
The risk free rate is 5.5% per annum and the market returns 12% per annum.
Issue costs are estimated to be 1% for debt financing (excluding the subsidised
loan), and 4% for equity financing. The corporate tax rate is 30%.

Required:
(a) Estimate the Adjusted Present Value (APV) of the proposed
investment. (15
marks)
(b) Comment upon the circumstances under which APV might be a better
method of evaluating a capital investment than Net Present Value
(NPV). (5 marks)
(20 marks)
 Chapter 8

International
investment appraisal

Introduction

In essence capital budgeting for overseas investments is similar to domestic

investment appraisal. It includes the following steps:
● Identification of relevant cash flows.
● Dealing with inflation to assess real or nominal cash flows.
● Dealing with tax, including the tax savings on capital allowances.
● Dealing with intercompany transactions, such as management charges and
royalties and cash flow remittance restrictions.
● Estimating future exchange rates (spot rates).
● Dealing with double taxation arrangements.
● Estimating the appropriate cost of capital (discount factor).
Taxation and international investment appraisal
The following procedure can be applied:
1. Allow for host country investment incentives (capital allowance) before
applying the local tax rate to local taxable cash flows.
2. Apply the relevant parent company rate of tax to the taxable/remitted cash
flows.
3. Adjust point 2 above for any double taxation
agreement. Consider the following:
Italy tax UK tax
(1) 20% 20%
(2) 20% 30%
(3) 20% 18%
In (1) no further tax will be paid in the UK as profit is taxed in Italy at 20%.
In (2) profit would be taxed at 30%, 20% in Italy and a further 10% in the UK.
In (3) no further tax will be paid in the UK. The 20% is charged in Italy.

If an overseas investment takes place in a country that has a different corporation

tax rate to the domestic country, then an opportunity may exist to reduce the
global tax bill through good transfer price planning.
However, if a double taxation treaty exists between the two countries, then this
opportunity will not be available as the investment will ultimately be taxed at the
highest corporation tax between the two countries.
Forecasting exchange rates
Exchange rates can be estimated using purchased power parity (PPP) or
international Fisher effect (IFF).
The PPP is used when inflation rates are given and the IFE is used when interest
rates are given.
The formula is simply stated as:
Purchasing power parity and interest rate parity
(1 + hc) Fo = (1 + ic)
S1
= (1 + hb) So × (1 + ib)
S0 ×

UK USA Bargonia
Year 1 5% 5% 20%
2 5% 5% 30%
3 5% 7% 30%
4 5% 7% 30%
5 5% 7% 30%

Project discount rates

In the same way as for domestic capital budgeting, project cash flows should be
discounted at a rate that reflects their systematic risk. Many firms assume that
overseas investment must carry more risk than comparable domestic investment
and therefore increase discount rates accordingly.
This assumption, however, is not necessarily valid. Although the total risk of an
overseas investment may be high, in the context of a well-diversified parent
company portfolio much of the risk may be diversified away. Because of the lack of
correlation between the performance of some national economies, the systematic
risk of overseas investment projects may in fact be lower than that of comparable
domestic projects.
It must therefore be realized that the automatic addition of a risk premium simply
because a project is located overseas does not always make sense, and any
increase in the discount rates used for foreign projects should be viewed with
caution.
Overcoming exchange controls – block remittances
Block funds are funds in overseas bank accounts subject to exchange controls, such
that restrictions are placed on remitting the funds out of the country.
 A number of ways have been devised to try and avoid such restrictions. They
mainly aim to circumvent restrictions on dividends payments out of the account by
reclassifying the payment as something else:
1. Management Charges
The parent company can impose a charge on the subsidiary for the general
management services provided each year. The fees would normally be based on the
number of management hours committed by the parent on the subsidiary’s
activities.
2. Royalties
The parent company can charge the subsidiary royalties for patent, trade names or
know-how. Royalties may be paid as a fixed amount per year or varying with the
volume of output.
3. Transfer Pricing
The parent can charge artificially higher prices for goods or services supplied to the
subsidiary as a means of drawing cash out. This method is often prohibited by the
foreign tax authorities.

Exchange rate risk

Changes in exchange rates can cause considerable variation in the amount of funds
received by the parent company. In theory this risk could be taken into account in
calculating the project’s NPV, either by altering the discount rate or by altering the
cash flows in line with forecast exchange rates. Virtually all authorities recommend
the latter course, as no reliable method is available for adjusting discount rates to
allow for exchange risk.

Political risk
This relates to the possibility that the NPV of the project may be affected by host
country government actions. These actions can include:
● Expropriation of assets (with or without compensation!);
● Blockage of the repatriation of profits;
● Suspension of local currency convertibility;
● Requirements to employ minimum levels of local workers or gradually to
pass ownership to local investors.
The effect of these actions is almost impossible to quantify in NPV terms, but their
possible occurrence must be considered when evaluating new investments. High
levels of political risk will usually discourage investment altogether, but in the past
certain multinational enterprises have used various techniques to limit their risk
exposure and proceed to invest. These techniques include the following:
(a) Structuring the investment in such a way that it becomes an unattractive
target for government action. For example, overseas investors might ensure
that manufacturing plants in risk-prone countries are reliant on imports of
components from other parts of the group, or that the majority of the
technical “know-how” is retained by the parent company. These actions would
make expropriation of the plant far less attractive.
(b) Borrowing locally so that in the event of expropriation without compensation,
the enterprise can offset its losses by defaulting on local loans.
 (c) Prior negotiations with host governments over details of profit repatriation,
taxation, etc, to ensure no problems will arise. Changes in government,
however, can invalidate these agreements.
(d) Attempting to be “good citizens” of the host country so as to reduce the
benefits of expropriation for the host government. These actions might include
employing large numbers of local workers, using local suppliers, and
reinvesting profits earned in the host country.

Economic risk
Economic risk is the risk that arises from changes in economic policies or conditions
in the host country that affect the macroeconomic environment in which a
multinational company operates. Examples of economic risk include:
● Government spending policy.
● Economic growth or recession.
● International trading conditions.
● Unemployment levels.
● Currency inconvertibility for a limited time.

Fiscal risk
Fiscal risk is the risk that the host country may increase taxes or change the tax
policies after the investment in the host country is undertaken. Examples of fiscal
risk include:
● An increase in corporate tax rate.
● Cancellation of capital allowances for new investment.
● Changes in tax law relating to allowable and disallowable tax expenses.
● Imposition of excise duties on imported goods or services.
● Imposition of indirect taxes.

Regulatory risk
Regulatory risk is a risk that arises from changes in the legal and regulatory
environment which determines the operation of a company. Examples are:
● Anti-monopoly laws.
● Health and safety laws.
● Copyright laws.
● Employment legislation.

Financing overseas projects

The chief sources of long-term finance are the following:
1. Equity
The subsidiary is likely to be 100% owned by the parent company. However,
in some countries it is necessary for nationals to hold a stake, sometimes
even a majority of the ordinary shares on issue.

2. Eurocurrency Loan
Eurocurrency loan is a loan by a bank to a company denominated in a
currency of a country other than that in which they are based. For example, a
UK company may require a loan in dollars which it can acquire from a UK bank
operating in the Eurocurrency market. This is called a Eurodollar loan.
The usual approach taken is to match the assets of the subsidiary as far as
possible with a loan in the local currency. This has the advantage of reducing
exposure to currency risk.

3. Syndicated Loan Market

Syndicated loan market developed from the short-term eurocurrency market.
A syndicate of banks is brought together by a lead bank to provide medium-to
long-term currency loans to large multinational companies. These loans may
run to the equivalent of hundreds of millions of pounds. By arranging a
syndicate of banks to provide the loan, the lead bank reduces its risk
exposure.

4. Eurobond
Eurobond are bonds sold outside the jurisdiction of the country in whose
currency the bond is denominated.
Eurobond is a bond issued in more than one country simultaneously, usually
through a syndicate of international banks, denominated in a currency other
than the national currency of the issuer. They are long-term loans, usually
between 3 to 20 years and may be fixed or floating interest rate bonds

5 Euroequity
These are equity sold simultaneously in a number of stock markets. They are
designed to appeal to institutional investors in a number of countries. The
shares will be listed and so can be traded in each of these countries.
The reasons why a company might make such an issue rather than an issue in
just its own domestic markets include:
● larger issues will be possible than if the issue is limited to just one market;
● wider distribution of shareholders;
● to become better known internationally;
Example 3 - Brookday plc
Brookday plc is considering whether to establish a subsidiary in the USA. The
subsidiary would cost a total of $20 million, including $4 million for working capital.
A suitable existing factory and machinery have been located and production could
commence quickly. A payment of $19 million would be required immediately, with
the remainder required at the end of year one.
Production and sales are forecast at 50,000 units in the first year and 100,000 units
per year thereafter.
The unit price, unit variable cost and total fixed costs in year one are expected to be
$100, $40 and $1 million respectively. After year one prices and costs are expected
to rise at the same rate as the previous year’s level of inflation in the USA; this is
forecast to be 5% per year for the next 5 years. In addition a fixed royalty of £5 per
unit will be payable to the parent company, payment to be made at the end of each
year.
Brookday has a 4 year planning horizon and estimates that the realisable value of
the fixed assets in 4 years time will be $20 million.
It is the company’s policy to remit the maximum funds possible to the parent
company at the end of each year. Assume that there are no legal complications to
prevent this.
Brookday currently exports to the USA yielding an after tax net cash flow of
£100,000. No production will be exported to the USA if the subsidiary is
established. It is expected that new export markets of a similar worth in Southern
Europe could replace exports to the USA. United Kingdom production is at full
capacity and there are no plans for further expansion in capacity.
Tax on the company’s profits is at a rate of 50% in both countries, payable one year
in arrears. A double taxation treaty exists between the UK and the USA and no
double tax is expected to arise. No withholding tax is levied on royalties payable
from the USA to the UK.
Tax allowable ‘depreciation’ is at a rate of 25% on a straight line basis on all fixed
assets.
Brookday believes that the appropriate beta for this investment is 1.2 The after-
tax market rate of return is 12%, and the risk free rate of interest 7% after tax.
The current spot exchange rate is US $1.300/£1, and the pound is expected to fall
in value by approximately 5% per year relative to the US dollar.

Required:
(a) Evaluate the proposed investment from the viewpoint of Brookday plc. State
clearly any assumptions that you make.
(b) What further information and analysis might be useful in the evaluation of this
project?
 Chapter 9

Acquisition and Mergers

Merger v Acquisition
There are distinct differences which you must be aware of;
● Merger – the joining of two separate entities
● Acquisition – where one entity uses its resources to buy a controlling interest
in another entity.

Acquisition v Organic Growth

As a strategic decision there are reasons for pursuing an acquisition as opposed to
organic growth which include;
● Instant access into new markets
● Overcomes barriers to entry
● Expertise of the acquired entity
● Reduced competition
However the cost which will include a large premium and post-acquisition integration
issues can lead to problems which invariably reduce shareholder wealth.

Synergy
● An expansion policy based on merger or takeover can be justified on the basis
of synergy. (Sometimes stated as 2 + 2 = 5) ie

Value of A plc Value of A plc Value of B plc

 and B plc combined
>
operating + operating

independently independently
Acquisitions and mergers are ultimately justified as leading to an increase in
shareholder wealth.
● The potential for synergy is often classified as follows:
Revenue synergy: Sources of which include:
o Economies of vertical integration;
o Market power and the elimination of competition
o Complementary resources eg a company with marketing strengths could
usefully combine with the company owning excellent research and
development facilities.
Cost synergy: Sources of which include:
o Economies of scale (arising from eg larger production volumes and bulk
buying);
o Economies of scope (which may arise from reduced advertising and
distribution costs where combining companies have duplicated
activities);
o Elimination of inefficiency;
o More effective use of existing managerial talent.
Financial synergy: Sources of which include:
o Elimination of inefficient management practices;
o Use of the accumulated tax losses of one company that may be made
available to the other party in the business combination;
o Use of surplus cash to achieve rapid expansion;
o Diversification reduces the variance of operating cash flows giving less
bankruptcy risk and therefore cheaper borrowing;
o Diversification reduces risk
o High PE ratio companies can impose their multiples on low PE ratio
companies (however this argument, known as “bootstrapping”, is rather
suspect).
● Conclusions on Synergy
o Synergy is not automatic
o When bid premiums are considered, the consistent winners in mergers
and takeovers are victim company shareholders.

High failure rate of acquisitions

In practice, the shareholders of predator companies seldom enjoy synergistic gains,
whereas the shareholders of victim companies benefit from a takeover. The
acquiring company often pays a significant premium over and above the market
value of the target company prior to acquisition; this problem is particularly acute
for the successful predator following a contested takeover bid.
The reasons advanced for the high failure rate of business combinations from the
perspective of the predator shareholders are as follows
 ● Agency theory suggests that takeover bids are primarily motivated by the self-
interest of the managers of bidding companies, who are in pursuit of status
and job security.
● Over-optimistic assessment of the economies of scale or economies of scope
that may be achieved as a result of the business combination;
● Inadequate investigation of the victim company prior to the bid being made,
or insufficient appreciation of the problems that may arise after the acquisition
takes place.
● Insufficient efforts to integrate and yield the anticipated synergy post
acquisition, often the directors become fixated with their next acquisition.
● Directors of the predator company become so obsessed with the success of
their bid that they often over pay thus transferring all the benefit t investors in
the acquired company.

Reverse Takeover
A reverse takeover is where a smaller listed company acquires a larger unlisted
company. However the shares used to acquire the larger company effectively give
control to the company that has been acquired.
The driving force for the acquisition is to enable the larger unlisted company to gain
the benefits of being a larger organization, though avoiding the long complicated
process to gain such a listing.
Benefits
1. Easier access to capital
markets 2.Higher company
valuation
3.Ability to undertake further acquisitions
Problems
1.Lack of expertise
2.Reputation
3.Enhanced Risk

Post Acquisition Integration

Often the main cause of failure with business combinations. To avoid this problem it
has been suggested that the following rules be applied
● The individual entities must share more than financial interest, i.e. technology
and market
● Consideration must be given to what we can do for acquired business
● Do not disregard products, markets and customers post acquisition
● Aim to share human resources and promote across entities
 Chapter 10

Business Valuations
METHODS OF EQUITY VALUATIONS
The main approaches are:
● The dividend valuation model or dividend growth model;
● The discounted cash flow basis (Free cash flow method);
● The PE ratio (or earnings yield) basis;
● Net assets and calculated intangible value

THE DIVIDEND VALUATION MODEL

This method is based upon the fundamental theory of share valuation, whereby a
current share price is taken to reflect the PV of expected future cash flows,
discounted at the required rate of return of the shareholder. In the case of minority
shareholders, this would represent the PV to infinity of the future dividend stream.
In the case of majority shareholders, these amounts will be increased by the PV of
synergies achieved as a result of the acquisition.
Free cash flow or surplus projected cash flow
Free cash flow is cash that is not retained and reinvested in the business.
Unfortunately, there is dispute as to what is included within free cash flow, as can
be seen from the following typical definitions:
1. The free cash flow to the company is the cash flow derived from operations,
after adjustment for working capital changes, for investment and for taxes
and it represents the funds available for distribution to the providers of
capital, i.e. shareholders and lenders.
2. Free cash flow is the cash flow available to a company from operations after
tax, any changes in working capital and capital spending on assets needed to
continue existing operations (i.e. replacement capital expenditure equivalent
to economic depreciation).
As can be seen, the main difference between the two definitions is whether or not
to deduct capital expenditure required to expand operations. Throughout these
notes the treatment will be varied as a reminder of the inconsistency. In addition,
some authorities suggest that no adjustment is made for working capital changes in
respect of short-term measures of free cash flow.
Free cash flows are commonly used in financial management:
● To calculate the value of a company and thus a potential share price.
● As an indicator of company performance.
● As a basis for evaluating potential investment projects using NPV technique.

Calculating free cash flow from accounting records

From prepared accounting information, free cash flow can be calculated
as: Profit before interest and tax (PBIT) xxxxx
Less taxation (PBIT x Tax rate) (xxx)
Add non-cash items such as depreciation xxxx
Less capital expenditure (xxxx)
Less increase or add decrease
in net working capital (xxxx)
Free cash flow xxxxx
Free cash flow to equity (dividend capacity)
The free cash flow to equity represents the funds available for distribution to only
ordinary shareholders of the company. Where a company finances a project by
issuing debts, then the shareholders are entitled to the residual cash flows after
meeting interest and principal payments.
This residual cash flow is called free cash flow to equity and is calculated
as: Profit before interest and tax (PBIT) xxxxx
Less interest (xxx)
Less taxation (Profit before tax x tax rate) (xxx)
Add non-cash items such as depreciation xxxx
Less capital expenditure (xxxx)
Less increase or add decrease
in net working capital (xxxx)
Add cash raised from debt issue xxxx
Less debt repayments (xxxx)
Free cash flow to equity xxxxx

Dividend cover
Free cash flow to equity provides a more meaningful figure than the earnings in the
calculation of dividend cover and dividend cover in cash terms can be calculated as:

Dividend cover = Free cash flows to equity

Dividend paid

£m
Revenue 1,950.00
Cost of sales (1,314.00)
Gross profit 636.00
Operating expenses (322.50)
Earnings before interest and tax 313.50
Interest charges (24.00)
Profit before tax 289.50
Corporation tax (@ 35%) (101.32)
Profit after tax 188.18
Valuing a firm using free cash flow
This method values a business as the present value of future free-cash flows.
The discount rate applicable should be the rate that reflects the level of risk
attached to the cash flows.
Corporate value is calculated as the present value of free cash flows using the
weighted average cost of capital (WACC) as the discount factor.
Corporate value = Value of equity + value of debt
Therefore:
Value of equity = Corporate value – value of debt
Alternatively, value of equity can be calculated as the present value of free cash
flows to equity using cost of equity as the discount factor.

Financial year X1 X2 X3 X4
Net sales 230 261 281 298
Cost of goods sold (50%) 115 131 141 149
Selling and distributive expenses 32 34 36 38
Capital allowance 40 42 42 42
Interest 18 16 14 12
Cash flow needed for asset replacement 50 52 55 58

Example 6 Heincarl plc

The directors of Heincarl plc are considering the acquisition of Newscot Ltd, an
unlisted company. The shareholders of Newscot Ltd are willing to sell the business
on 1st January 2009 for £500 million. From the perspective of the directors of
Heincarl plc, the projections of the performance of Newscot Ltd are as follows:
Current
Projections during planning horizon (years)
year
2008 2009 2010 2011 2012 2013 2014
£m £m £m £m £m £m £m
EBITDA 117.00 138.70 162.57 188.83 217.71 249.48 251.48
Depreciation
&
amortization (40.00) (42.00) (44.00) (46.00) (48.00) (50.00) (52.00)
EBIT 77.00 96.70 118.57 142.83 169.71 199.48 199.48
Interest
charges _ -_ (32.00) (26.88) (20.19) (11.73) (1.28) _-
Profit before
tax 77.00 64.70 91.69 122.64 157.98 198.20 199.48

The assumed rate of corporation tax is 35% p.a. The terminal value of the
investment is treated as a constant perpetuity equal to the free cash flows for the
year 2014. The risk free rate of interest is assumed to be 6% p.a., the return on a
market portfolio is taken to be 13.5%, whilst an asset beta of 1.1 is used for
purposes of the appraisal.
Annual capital expenditure from 2008 onwards is estimated at £20 million each
year indefinitely. Newscot Ltd currently has on issue £400 million of 8% debt and it
is intended that all available cash flows should be applied to repaying this debt at
the earliest opportunity.

Advise the directors of Heincarl plc whether to proceed with the acquisition.
PRICE EARNINGS RATIO BASIS
The P/E ratio produces an earnings-based valuation of shares. This is done by
deciding a suitable P/E ratio and multiplying by the EPS for the shares to be valued.

Value per share = EPS x P/E ratio.

For a given EPS, a higher P/E ratio will result in a higher price. A higher P/E ratio
may indicate;
(a) Expectations that the earnings will grow rapidly in the future, so that a high
price is being paid for future profit prospects.
(b) That the company is a low risk company than a company with a lower P/E
ratio.

VATA Co ABC
(£000) (£000)
Earnings before tax 1,980 397
Share capital (25p/share) 600 300
Valuing intangible assets/intellectual capital
Valuing intangible assets, such as intellectual capital, is not an exact science but
several methods exist to estimate their value.

Compare the market value of the company to the book value of the assets. The
difference between the two should be equivalent to the value of the intangibles.
However, this method values the assets based on accounting policies and therefore
may no longer represent their ‘true worth’. A better alternative would be to value
the assets based on realisable value.

The CIV involves taking the excess return on intangible assets and uses this figure
as a basis to determine the proportion of return attributable to intangible assets.
The CIV can be calculated using the following steps:
1. Calculate average pre-tax earnings for a given period.
2. Calculate the average year-end tangible assets over the same given period
3. Divide average earnings by the average assets to get the return on assets
(ROA).
4. For the same given period, find the industry’s return on assets as average
earnings divided by average tangible asset.
5. Calculate the ‘excess return’. Multiply the industry-average ROA by the
company’s average tangible assets; this shows what the average the company
would earn from that amount of tangible assets. Now subtract that from the
company’s pre-tax earnings.
This figure shows how much more the company earns from its assets than the
industry average.
6. Calculate the given period average income tax rate and multiply this by the
excess return. Subtract the result from the excess return to show the
after-tax premium attributable to intangible assets.
7. Calculate the net present value (NPV) of the premium. This is done by dividing
the premium by an appropriate discount factor such as the company’s cost of
capital. This is the CIV of the company’s intangible assets – the one that does
not appear on the balance sheet.
 2009 2010 2011
£millions £millions £millions
Revenue 125 137.5 149.9
Less cash operating cost 37.5 41.3 45
Depreciation 20 22 48
Pre-tax earnings 67.5 74.2 56.9
Taxation 20.25 22.26 17.07

2009 2010 2011

£millions £millions £millions
Non-current asset 150 175 201
current assets 48 54 62
198 229 263

Share capital (£1) 30 30 30

retained earnings 148 179 203
178 209 233
Current liabilities 20 20 30
198 229 263
APPLYING THE BLACK SCHOLES MODEL TO EQUITY
The Black Scholes Option Pricing (BSOP) model provides a basis for corporate
valuation in cases where traditional methods are either inappropriate, or where
they fail to fully reflect the risks involved. The usual determinants in the valuation
of options need to be redefined, when the valuation of equity is treated as a call
option:

Determinants Possible appropriate measures

Valuation of the underlying The fair value of the assets of the company

Exercise price Settlement values of outstanding liabilities

Volatility of the underlying Standard deviation of underlying assets

Risk-free rate of interest Current yield on company debt

Time to expiry Average period to settlement of company liabilities

Where the assets of the company are actively traded and easily liquidated, their
current market value would be appropriate. In the case of most companies, fair
value will normally be based upon the present value of the future cash flows that
the company’s assets are expected to generate over their useful lives.
The volatility of the underlying assets is likely to be the most difficult measure to
estimate accurately. One approach is to estimate the probabilities of the likely
future cash flows of the company and generate a distribution of their present values
from which a standard deviation could be established.
A possible approach to the determination of an exercise price is to assume that the
company’s liabilities consist entirely of debt in the form of a zero coupon bond. If
the company’s debt includes other types of bond, adjustments are necessary as
shown in the following illustration.
VALUATION OF DEBT AND PREFERENCE SHARES

A ‘plain vanilla’ bond will make regular interest payments to the investors and pay
the capital to buy back the bond on the redemption date when it reaches maturity.
Therefore the value of a redeemable bond is the present value of the future income
stream discounted at the required rate of return.

The value of a convertible cannot fall below its value as debt, but upside potential
exists due to the possibility of an increase in the share price prior to expiry of the
conversion period.
Therefore the theoretical value of a convertible (known as its “formula value”) is
the greater of its value as debt and its value as shares i.e. its conversion value. In
practice the actual price of convertibles will tend to trade at a value in excess of
formula value, reflecting so called “time value” i.e. the possibility that the share
price could rise prior to expiry of the conversion period.
Valuing bonds based on the yield curve
The spot yield curve can be used to estimate the price or value of a bond. Normally
these rates are published by the central banks or in the financial press.

Year 1 2 3 4
Rate 3.5% 4.0% 4.7% 5.5%

Estimating the yield curve

There are different methods used to estimate a spot yield curve, and the iterative
process based on bootstrapping coupon paying bonds is perhaps the simplest to
understand. The following example demonstrates how the process works.
 Chapter 11

Framework

Mode of Offer

The offer is made to purchase the shares of the target company for cash. This
method is very appropriate for relatively small acquisitions, unless the acquirer has
accumulated cash from operations or divestments.
The advantages of cash offer to the target entity’s shareholders are that:
● The price that they will receive is obvious. It is not like a share exchange
where the movements in the market price may change their wealth.
● The cash purchase increases the liquidity of the target shareholders who are
in position to alter their investment portfolio to meet any changing
opportunities.
A disadvantage to target shareholders’ for receiving cash is that if the price that
they receive on sale is more than the price paid when purchasing the shares, they
may be liable to capital gains tax.
The advantages to the predator company are that:
● The value of the bid is known and target company shareholders’ are
encouraged to sell their shares.
● It represents a quick and easily understood approach when resistance is
expected.
● The shareholders of the target company are bought out and have no further
participation in the control and profits of the combined entity.
The main disadvantages to the predator company are that it may deplete the
company’s liquidity position and may increase gearing.
The predator company can raise cash from many sources to finance the acquisition,
some of the sources are:

Borrowing to obtain cash

The predator company may not have enough cash immediately available to finance
the acquisition and may have to raise the necessary cash through bank loans and
issuing of debt instruments.

Mezzanine finance
Mezzanine finance is a form of finance that combines features of both debt and
equity. It is usually used when the company has used all bank borrowing capacity
and cannot also raise equity capital.
It is a form of borrowing which enables a company to move above what is
considered as acceptable levels of gearing. It is therefore of higher risk than normal
forms of borrowing.
Mezzanine finance is often unsecured.

Retained earnings
This method is used when the predator company has accumulated profits over time
and is appropriate when the acquisition involves a small company and the
consideration is reasonably low. This method may be the cheapest option of
finance.

Vendor placing
In a vendor placing the predator company issues its shares by placing the shares
with institutional investors to raise the cash required to pay the target
shareholders.

The predator company issues its own shares in exchange for the shares of the
target company and the shareholders of the target company become shareholders
of the predator company.
The advantages of a share exchange to target shareholders include:
● Capital gains tax is delayed.
● The shareholders of the target company will participate in the control and
profits of the combined entity.
The main disadvantage is that there is uncertainty with a share exchange where
the movements in the market price may change their wealth.
The advantages to the predator company are that:
● It preserves the liquidity position of the company as there are no outflows of
cash.
● Share exchange reduces gearing and financial risk. However, this may depend
on the gearing of the target company.
● The predator company can bootstrap earnings per share if its price earnings
ratio is higher than that of the target company.
The main disadvantages of a share exchange are that:
● It causes dilution in control.
● It may cause dilution in earnings per share.
● As equity shares are issued this is comparatively more expensive than debt
capital.
● The company may not have enough authorized share capital to issue the
additional shares required.

Very few companies use debentures, loan stock and preference shares as a means
of paying a purchase consideration on acquisitions.
The main problems of using debentures and loan stock to the predator company are
that:
● It affects gearing and financial risk.
● Difficulty in determining appropriate interest rate to attract the shareholders
of the target company.
● Availability of collateral security against repayment.
The main advantages of using debentures and loan stock are that:
● Interest payments are a tax allowable expense.
● Cost of debt is cheaper than equity.
● Does not dilute control.
The main problems of using preference shares are that:
● Dividends on preference shares are fixed and not tax allowable.
● May not be attractive to target shareholders as preference shares carry no
voting power.
● Preference shares are less marketable.

An earn-out arrangement is where the purchase consideration is structured such

that an initial payment is made at the date of acquisition and the balance is paid
depending upon the financial performance of the target company over a specified
period of time.
The main advantages of earn-out arrangements are that:
● Initial payment is reduced.
● The risk to the predator company is reduced as it is less likely to pay more
than the target is worth. The price is limited to future performance.
● It encourages the management of the target company to work hard as the
overall consideration depends on future performance.
Strategic defences against hostile bids

A target company can use the following to defend itself against a possible takeover:
● Try to convince the shareholders that the terms of the offer are
unacceptable. This can be done using the following:
o Attempt to show that the current share price of the company is
unrealistically low relative to the future potential. Assets revaluation,
new profit forecasts, dividends and promises of rationalization are
commonly employed here.
o If it is for share for share exchange, the target company can attempt to
convince the shareholders that the offer’s equity is currently overvalued.
The suitability of the bidding company to run the merged business can
also be questioned.
● Lobbying the office of fair trading and or the department of trade and
industry to have the offer referred to the competition commission. This will at
least delay the takeover and may prevent it completely.
● Launching an advertising campaign against the takeover bid. One
technique is to attack the account of the predator company.
● A reverse takeover (Pac Mac), that is to make a counter offer for the
predator company. This can be done if the companies are of reasonably
similar size.
● Finding a ‘white knight’, a company which will make a welcome takeover
bid. This involves finding a more suitable acquirer and promoting it to
compete with the predator company.

● Selling crown jewels – the tactic of selling off certain highly valued assets
of the company subject to a bid is called selling the crown jewels. The
intention is that, without the crown jewels, the company will be less
attractive.
● Golden parachutes – this is a policy of introducing attractive termination
packages for the senior executives of the victim company. This makes it more
expensive for the predator company.
● Shark repellent – super-majority. The articles of association are changed to
require a very high percentage of shares to approve an acquisition or merger,
say 80%.
● Poison pill
The most commonly used and seemingly most effective takeover defense is
the so-called poison pill.
An example is the Flip-in pill. This involves the granting of rights to
shareholders, other than the potential acquirer, to purchase the shares of the
target company at a deep discount. This dilutes the ownership interest of the
potential acquirer.
Regulation of takeovers
The regulation of takeovers varies from country to country and mainly concentrates
on controlling directors in order to ensure that all shareholders are treated fairly.
Typically, the rules will require the target company to:
● notify its shareholders of the identity of the bidder and the terms and
conditions of the bid;
● seek independent advice;
● not issue new shares or purchase or dispose of major assets of the company,
unless agreed prior to the bid, without the agreement of a general meeting;
● not influence or support the market price of its shares by providing finance or
financial guarantees for the purchase of its own shares;
● the company may not provide information to some shareholders which is not
made available to all shareholders;
● shareholders must be given sufficient information and time to reach a
decision. No relevant information should be withheld;
● the directors of the company should not prevent a bid succeeding without
giving shareholders the opportunity to decide on the merits of the bid
themselves.
Directors and managers should disregard their own personal interest when advising
shareholders.

Competition commission in United Kingdom

Under the terms of this commission, the office of fair trading (OFT) is entitled to
scrutinize all major mergers and takeovers. If the OFT thinks that a merger or
takeover might be against the public interest, it can refer it to the competition
commission. If no referral is made to the commission within normally 20 days, the
merger can proceed without fear of a referral.
The function of the competition commission is to advise the government. The
commission can make recommendations to the relevant government department or
to any other body including the companies involved in the bid.
The result of the investigation by the commission might be:
● Withdrawal of the proposal for the merger or takeover, in anticipation of its
rejection by the commission.
● Acceptance or rejection of the proposal by the commission.
● Acceptance of the proposal by the commission subject to the new company
agreeing to certain conditions laid down by the commission, for example on
prices, employment or arrangement for the sale of the group’s products.
 Chapter 12

Corporate
reconstruction and
reorganization

BUSINESS REORGANISATION

Unbundling
Unbundling is the process of selling off incidental non-core businesses to release
funds, reduce gearing, and allow management to concentrate on their chosen core
business.
The main forms of Unbundling are:
● Divestment.
● Demergers.
● Sell-offs.
● Spin-offs.
● Management buy-outs.

Divestment
Divestment is a proportional or complete reduction in ownership stake in an
organisation. It is the withdrawal of investment in a business. This can be achieved
either by selling the whole business to a third party or by selling the assets
piecemeal.
● The principal motive for divestment will be if they either do not conform to
group or business unit strategy.

● A company may decide to abandon a particular product/activity because it

fails to yield an adequate return.
● Allowing management to concentrate on core business.
● To raise more cash possibly to fund new acquisitions or to pay debts in order
to reduce gearing and financial risk.
● The management lack the necessary skills for this business sector
● Protection from takeover possibly by disposing of the reasons for the takeover
or producing sufficient cash to fight it effectively.

A sell-off is a form of divestment involving the sale of part of an entity to a third

party, usually in return for cash. The most common reasons for a sell-off are:
● To divest of less profitable and/or non-core business units.
● To offset cash shortages.
The extreme form of sell-off is liquidation, where the owners of the company
voluntarily dissolve the business, sell-off the assets piecemeal, and distribute the
proceeds amongst themselves.

This is where a new company is created and the shares in the new company are
owned by the shareholders of the original company which is making the distribution
of assets. There is no change in ownership of assets but the assets are transferred
to the new company. The result is to create two or more companies whereas
previously there was only one company. Each company now owns some of the
assets of the original company and the shareholders own the same proportion of
shares in the new company as in the original company.
An extreme form of spin-off is where the original company is split up into a number
of separate companies and the original company broken up and it ceases to exist.
This is commonly called demerger.
Demerger involves splitting a company into two or more separate parts of roughly
comparable size which are large enough to carry on independently after the split.
The main disadvantages of demerger are:
● Economies of scale may be lost, where the de-merged parts of the business
had operations in common to which economies of scale applied.
● The ability to raise extra finance, especially debt finance, to support new
investments and expansion may be reduced.
● Vulnerability to takeovers may be increased.
● There will be lower revenue, profits and status than the group before the de-
merger.
Management buy-out (MBO)
A management buy-out is the purchase of a business from its owners by its
managers. For example, the directors of a company in a subsidiary company in a
group might buy the company from the holding company, with the intention of
running it as proprietors of a separate business entity.

MBOs may exist for several reasons including:

● A parent company wishes to divest itself of a business that no longer fits in
with its corporate objectives and strategy.
● A company/group may need to improve its liquidity. In such circumstances a
buy-out might be particularly attractive as it would normally be for cash.
● A company may decide to abandon a particular product/activity because it
fails to yield an adequate return.
● In administration a buy-out may be the management’s only best alternative to
redundancy.

● To raise cash to improve liquidity.

● If the subsidiary is loss-making, sale to the management will often be better
financially than liquidation and closure costs.
● There is a known buyer.
● Better publicity can be earned by preserving employer’s jobs rather than
closing the business down.
● It is better for the existing management to acquire the company rather than it
possibly falling into enemy hands.

● It preserves their jobs.

● It offers them the prospects of significant equity participation in their company.
● It is quicker than starting a similar business from scratch.
● They can carry out their own strategies, no longer having to seek approval
from the head office.

● Management may have little or no experience in financial management and

financial accounting.
● Difficulty in determining a fair price to be paid.
● Maintaining continuity of relationships with suppliers and customers.
● Accepting the board representation requirement that many sources of funding
may insist on.
● Inadequate cash flow to finance the maintenance and replacement of assets.
 Several institutions specialize in providing funds for MBOs. These include:
● The clearing banks.
● Pension funds and insurance companies.
● Venture capital.
● Government agencies and local authorities, for example Scottish Development
Agency.

● The purchase consideration. Is the purchase price right or high?

● The level of financial commitment of the buy-out team.
● The management experience and expertise of the buy-out team.
● The stability of the business’s cash flows and the prospects for future growth.
● The rate of technological change in the industry and the costs associated with
the changing technologies.
● The level of actual and potential competition.
● The likely time required for the business to achieve a stock market flotation,
(so as to provide an exit route for the venture capitalist).
● Availability of security.

● Board representation for the venture capitalist.

● Equity options.
● A right to take a controlling equity stake and so replace the existing
management if the company fails to achieve specific performance targets.

Management buy-in
Management buy-ins occur when a group of outside managers buys a controlling
stake in a business.

Share repurchase
Any limited company may, if authorised by its articles, purchase its own shares. The
Companies Act permits any company to purchase its own shares. Therefore if a
company has surplus cash and cannot think of any profitable use of that cash, it
can use that cash to purchase its own shares.
Share repurchase is an alternative to dividend policy where the company returns
cash to its shareholders by buying shares from the shareholders in order to reduce
the number of shares in issue.
Shares may be purchased either by:
● Open market purchase – the company buys the shares from the open market
at the current market price.
 ● Individual arrangement with institutional investors.
● Tender offer to all shareholders.

● Shares may be purchased in order to buy out dissident shareholders.

● To adjust the gearing ratio towards an optimal capital structure.
● Reduction in the size of the company.
● Purchase of own shares may be used to take a company out of the public
market and back into private ownership.
● Purchase of own shares provides an efficient means of returning surplus cash
to the shareholders.
● It enables companies to reduce total dividend payments whilst maintaining or
increasing the level of dividend to individual shareholders.
● Purchase of own shares increases earnings per share and return on capital
employed.
● To increase the share price by creating artificial demand.

● Lack of new ideas. Shares repurchase may be interpreted as a sign that the
company has no new ideas for future investment strategy. This may cause the
share price to fall.
● Costs. Compared with a one-off dividend payment, share repurchase will
require more time and transaction costs to arrange.
● Resolution. Shareholders have to pass a resolution and it may be difficult to
obtain their consent.
● Gearing. If the equity base is reduced because of share repurchase, gearing
may increase and financial risk may increase.

Going private
A public company may occasionally give up its stock market quotation and return
itself to the status of a private company.
The reasons for such a move are varied, but are generally linked to the
disadvantages of being in the stock market and the inability of the company to
obtain the supposed benefits of a stock market quotation.
Other reasons are:
● To avoid the possibility of takeover by another company.
● Savings of annual listing costs.
● To avoid detailed regulations associated with being a listed company.
● Where the stock market undervalues the company’s shares.
● Protection from volatility in share price with its financial problems.
CAPITAL RECONSTRUCTION SCHEMES
A capital reconstruction scheme is a scheme whereby a company reorganizes its
capital structure by changing the rights of its shareholders and possibly the
creditors. This can occur in a number of circumstances, the most common being
when a company is in financial difficulties, but also when a company is seeking
floatation or being acquired.

If a company is in financial difficulties it may have no recourse but to accept

liquidation as the final outcome.

Typical financial difficulties

● Large accumulated losses.
● Large arrears of dividends on cumulative preference shares.
● Large arrears of debenture interest.
● No payment of ordinary dividend.
● Market share price below nominal value.
However, it may be in position to survive, and indeed flourish, by taking up some
future contract or opening in the market. The only major problem is the cash
needed to finance such operations because the present structure of the company
will not be attractive to outside investors. To get cash the company will need to
reorganize or reconstruct.

The changing or reconstruction of the company’s capital could solve these

problems. The company can take any or all of the following steps:
● write off the accumulated losses.
● write of the debenture interest and preference share dividend arrears.
● write down the nominal value of the shares.
To do this the company must ask all or some of its existing stakeholders to
surrender existing rights and amount owing in exchange for new rights under a new
or reformed company.
The question is ‘why would the stakeholder be willing to do this? The answer to this
is that it may be preferable to the alternatives which are:
● to accept whatever return they could be given in a liquidation;
● to remain as they are with the prospect of no return from their investment
and no growth in their investment.
Generally, stakeholders may be willing to give up their existing rights and amounts
owing (which are unlikely to be met) for the opportunity to share in the growth in
profits which may arise from the extra cash which can be generated as a
consequence of their actions.

For a reconstruction to be successful the following principles are to be followed:

1. Creditors must be better off under reconstruction than under liquidation. If
this is not the case they will not accept the reconstruction as their agreement
is a requirement for the scheme to take place.
2. The company must have a good chance of being financially viable and
profitable after the reconstruction.
3. The reconstruction scheme must be fair to all the parties involved, for
example preference shareholders should have preferential treatment over
ordinary shareholders.
4. Adequate finance is provided for the company’s needs.

In solving reconstruction questions the following steps can be followed:

1. State the above principles of reconstruction.
2. Check what each party will get if the company were to go on liquidation. This
can be done by adding up the break-up values of the assets.
Note the sequence of creditor priorities as followings:
● taxes and unpaid wages
● secured debts, including unpaid interest – fixed charge
● secured debt – floating charge
● unsecured creditors
● preference shareholders including unpaid dividend
● ordinary shareholders.
3. Check the sufficiency of the amount of finance that will be raised from the
scheme. This includes proceeds from the sale of investment, existing assets
when new assets are to be bought to replace them, and reduction in working
capital.
4. Check if the parties will be better off under the proposed scheme than under
liquidation. Assess the fairness of the scheme.
5. Assess the post-reconstruction financial viability and profitability of the
company by calculating post-reconstruction EPS and P/E ratio.
6. Come to a conclusion.
 Chapter 13

Hedging foreign
exchange risk

EXCHANGE RATES
An exchange rate is the rate at which one country’s currency can be traded in
exchange for another country’s currency.

Variable and base currency

Exchange rate is quoted as the number of one currency for one of another currency.
The base currency is the currency expressed as one and the variable currency is the
currency expressed as the number of a currency for the base currency.
Bid and offer prices
Bid
A bid is the rate at which the dealer is willing to buy the foreign currency (base
currency) from a customer by paying in home currency (variable currency).

Offer or ask price

It is the rate the dealer will sell the foreign currency (base currency) and buy the
home currency (variable currency).

Spread
The spread is the difference between the bid price and the offer price. The offer
price is slightly higher than the bid price and the difference (spread) exists to
compensate the dealer for holding the risky foreign currency and for providing the
services of converting currencies.

Spot and forward rates

Spot rate is the price at which foreign exchange can be bought or sold today with
payment made within two business days. It is simply the rate of buying or selling
for immediate settlement.
Forward rate is the rate quoted today for delivery at a fixed future date of specified
amount of one currency against another currency. It is simply the buying or selling
now, but settlement at an agreed future date. Note that the agreed future date
could be one month, two, three, six months up to one year, although a two years
contract can exist in some currencies like sterling and dollar.

Outright quotation
Outright quotation means that the full price to all of its decimal points is given.
Point quotation
A point quotation is the number of points away from the outright spot rate with the
first number referring to points away from the spot bid and second number to
points away from the spot offer price.
Whether the point quotation is subtracted or added to the spot rate is explained by
premium or discount on the exchange rate movements.
Subtract premium from the spot rate and add a discount to the spot rate.
RISK AND FOREIGN EXCHANGE
Foreign exchange risk, basically Currency risk, is the possibility of making profit or
loss as a result of changes in exchange rate. Examples of situations a company may
be exposed to currency risk are:
● Imports of raw materials.
● Exports of finished goods.
● Importation of foreign-manufactured non-current assets.
● Investments in foreign securities.
● Raising an overseas loan.
● Having a foreign subsidiary or being a foreign subsidiary.
The foreign exchange risk exposures are divided broadly into three categories as
follows:
● transaction exposure;
● economic exposure;
● translation exposure.

Transaction exposure
Transaction exposure relates to the gains and losses to be made when settlement
takes place at some future date of a foreign currency denominated contract that
has already been entered into. These contracts may include import or export of
goods on credit terms, borrowing or investing funds denominated in a foreign
currency, receipt of dividends from overseas, or unfulfilled foreign exchange
contract. Transaction exposure can be protected against by adopting a hedged
position: that is, entering into a counter balancing contract to offset the exposure.

Translation exposure
This arises from the need to consolidate worldwide operations according to
predetermined accounting rules. This is the risk that the organisation will make
exchange losses or gains when the accounting results of its foreign subsidiaries are
translated into the presentation currency of the parent company. Assets, liabilities,
revenue and expenses must be restated into presentation currency of the parent
company in order to be consolidated into the group accounts.
Translation exposure can result from restating the book value of a foreign
subsidiary’s assets at the exchange rate on the balance sheet date. Such exposure
will not affect the firm’s cash flows unless the asset is sold.

Economic exposure
Economic exposure also called operating or competitive exposure or strategic
exposure measures the changes in the present value of the firm resulting from any
changes in the future operating cash flows of the firm caused by unexpected
changes in exchange rates. The change in value depends on future sale volume,
price and costs.
For example, a UK company might use raw materials which are priced in US dollars,
but export its product mainly within the EU. A depreciation of the pound against the
 The dollar or appreciation of the pound against the Euro will both erode the
competitiveness of this UK company.
The magnitude of economic exposure is difficult to measure as it considers
unexpected changes in exchange rates and also because such changes can affect
firms in many ways.

Transaction and economic exposures both have cash flow consequences for the firm
and they are therefore considered to be extremely important. Economic exposure is
really the long-run equivalent of transaction exposure, and ignoring either of them
could lead to reduction in the firm's future cash flows, resulting in a fall in
shareholders wealth.
Both of these exposures should therefore be protected against.
The importance of translation exposure to financial managers is however often
questioned. In financial management terms we ask the question ‘does translation
loss reduce shareholders wealth? The answer is that it is unlikely to be of
consequence to shareholders who should, in an efficient market, value shares on
the basis of the firm’s future cash flows, not on assets value in the published
accounts. Unless management believes that translation losses will greatly affect
shareholders there would seem little point in protecting against them.

PROTECTION AGAINST ECONOMIC EXPOSURE

If a firm borrows in a foreign currency it must pay back in that same currency. If
that currency should appreciate against the home currency, this can make interest
and principal repayments far more expensive. However, if borrowing is spread
across many currencies it is unlikely they will all appreciate at the same time and
therefore risk can be reduced. Borrowing in foreign currency is only truly justified if
returns will then be earned in that currency to finance repayment and interest.

If a firm manufactures all its products in one country and that country’s exchange
rate strengthens, then the firm will find it increasingly difficult to export to the rest
of the world. Its future cash flows and therefore its present value would diminish.
However, if it had established production plants worldwide and bought its
components worldwide it is unlikely that the currencies of all its operations would
appreciate at the same time. It would therefore find that, although it was losing
exports from some of its manufacturing locations, this would not be the case in all
of them.
Also if it had arranged to buy its raw materials worldwide it would find that a
strengthening home currency would result in a fall in its input cost and this would
compensate for lost sales.

Please see later in the chapter for currency swaps

PROTECTION AGAINST TRANSACTION EXPOSURE
Once a company has decided to hedge a particular foreign currency risk, there are
a number of methods to consider. They can be grouped as internal and external
hedging techniques.

One way of avoiding exchange risk is for an exporter to invoice his foreign customer
in his home currency, or for an importer to arrange with his supplier to be invoiced
in his home currency. However, although either the exporter or importer can avoid
any exchange risk in this way, only one of them can deal in his home currency. The
other must accept the exchange risk.
Although invoicing in the home currency has the advantage of eliminating exchange
rate risk, the company is unlikely to compete well with a competitor who invoice in
the buyer's home currency, hence the customer may purchase from the competitor.

Leading and lagging is a mechanism whereby a company accelerates (leads) or

delays (lags) payment or receipt in anticipation of exchange rate movements. This
technique can be used only when exchange rate forecasts can be made with some
degree of confidence. Interest rates would also have to be considered in granting
long term credit.

Netting is setting the debtors and creditors of all the companies in the group
resulting from transactions between them so that only net amount is either paid or
received.
There are two types of netting:

1. Bilateral Netting
In the case of bilateral netting, only two companies are involved. The lower balance
is netted against the higher balance and the difference is the amount remaining to
be paid.

2. Multilateral Netting
Multilateral netting is a more complex procedure in which the debts of more than
two group companies are netted off against each other. There are different ways of
arranging for multilateral netting. The arrangement might be coordinated by the
company’s own central treasury or alternatively by the company’s bankers. The
common currency in which netting is to be affected needs to be decided on.
 Owed by Owed to Amount
UK SA 1,200,000 SA Rand ®
UK FR 480,000 Euro
FR SA 800,000 SA rand
SA UK 74,000 Sterling
SA FR 375,000 Euro

This is the use of receipts in a particular currency to match payment in that same
currency. Wherever possible, a company that expects to make payments and have
receipts in the same foreign currency should plan to set its payments against its
receipts in that currency.
Since the company is offsetting foreign payment and receipt in the same currency,
it does not matter whether that currency strengthens or weakens against the
company’s domestic currency because there will be no purchase or sale of the
currency.
The process of matching is made simply by having a foreign currency account,
whereby receipts and payments in the currency are credited and debited to the
account respectively. Probably, the only exchange risk will be limited to conversion
of the net account balance into the domestic currency. This account can be opened
in the domestic country or as a deposit account in overseas country.

Factors to consider prior to protecting

The factors may include the following:
● Future exchange rate movement, where the currency is very volatile. The
future movements in the exchange rate may depend on a number of factors
including interest rate, inflation, central bank actions and economic growth.
● The availability of a market for the currency in question.
● The cost involved in the hedging, eg commission.
● The ability of the company to absorb foreign exchange losses.
● Expertise within the company.
● the company’s attitude towards foreign currency transactions and the
importance of overseas trading.
External hedging techniques
External hedging techniques means using the financial markets to hedge foreign
currency movements.
The techniques include the following:
● forward contract,
● money market hedge,
● currency futures contract,
● currency options, and
● currency swaps.

The foreign-exchange forward market is an inter-bank market, where one party

agrees to deliver a specified amount of one currency for another at a specified
exchange rate at a designated date in the future. The designated exchange rate and
date are called the forward rate and settlement (delivery) date respectively. Where
an investor takes a position in the market by buying a forward contract, the
investor is said to be in a long- position, and where he takes a position to sell a
forward contract we say the investor is in a short-position.
A forward contract is a binding contract on both parties. This means that having
made the contract, a company must carry out the agreement, and buy or sell the
foreign currency on the agreed date and at the rate of exchange fixed by the
agreement. If the spot rate moves in the company’s favour, that will be bad for the
company and vice versa.

The money market is a market where companies and individuals lend and borrow
money for a short period of time. The period of time could be overnight or up to a
year.
Steps in money market hedge are:
● Borrow an appropriate amount in foreign currency today.
● Convert it immediately to the home currency.
● Place it on deposit account in the home currency.
● Settlement.

Example 3
FRT is a company in the UK that trades frequently with companies in the USA.
Transactions to be completed within the next six months are as follows:
Receipts Payments
Three months $350,000 $250,000
Six months £100,000 $1,000,000
Foreign exchange rates ($/£)
Spot 1.4960 – 1.4990
In order to reduce the volatility of their exchange rates, some countries (e.g. China,
Russia, India, Brazil, Philippines and Korea) have attempted to ban forward foreign
exchange trading. In these markets, non-deliverable forwards (NDF’s) have been
developed. Although they resemble forward contracts, no physical currency delivery
actually takes place. Instead, the difference between the actual spot rate and the
NDF rate is calculated. This will result in a profit or loss on the transaction between
the two counterparties, who merely settle with each other for this net amount.

When this profit or loss is combined with the actual currency exchanged at the
prevailing spot rate, this will effectively fix the ultimate exchange rate in a manner
which resembles a forward exchange contract.
The underlying principles of a SAFE are similar to the procedures employed for a
forward rate agreement (FRA), which is offered by banks for clients who wish to
hedge their interest rate risk.
FUTURES
A futures is a legal binding contract between two parties to buy or to sell a
standardized quantity of an underlying item at a future date, but at a price agreed
today, through the medium of an organized exchange.
Future contracts are forward contracts traded on a future and options exchange.

Underlying item
Underlying item is the quantity of the item which is to be bought or sold under the
futures contract. Each futures contract has a standardised quantity of these
underlying items and the futures contract cannot be undertaken in fractions.
The underlying item may include agricultural products, like meat, cocoa, maize,
energy products, like crude oil gas, financial products, like currency and interest
rate, and stock index futures on shares.

Delivery dates
Financial futures are normally traded on a cycle of three months, March, June,
September and December of each year.

Each futures exchange has a clearing house. When a futures deal has been made
the clearing house assumes the role of counterparty to both the buyer and the
seller. Thus the buyer has effectively bought from the clearing house whilst the
seller is treated as having sold to the clearing house, thus removing the risk of
default on the futures contract. The clearing house imposes upon its members the
requirement to pay “margins”, which effectively acts as a security deposit.

If you entered the futures contract by buying, then that contract will be closed by
selling and if you entered by selling futures contract, you close by buying. That is, a
position is closed by reversing what you did to enter the futures contract.
A person who bought a futures contract will close by selling and is said to hold a
long position.
A person who sold a futures contract will close by buying and is said to hold a short
position.

A tick is the minimum price movement permitted by the exchange on which the
future contract is traded. Ticks are used to determine the profit or loss on the
futures contract. The significance of the tick is that every tick movement in price
has the same money value.
If someone has a long position, a rise in the price of the future represents a profit,
and a fall in price represents a loss.
If someone has a short position, a rise in the price of the future represents a loss,
and a fall represents a profit.
When a deal has been made both buyer and seller are required to pay margin to
the clearing house. This sum of money must be deposited and maintained in order
to provide protection to both parties.

Initial margin
Initial margin is the sum deposited when the contract is first made. This is to
protect against any possible losses on the first day of trading. The value of the
initial margin depends on the future market, risk of default and volatility of interest
rates and exchange rates.

Variation margin
Variation margin is payable or receivable to reflect the day-to-day profits or losses
made on the futures contract. If the future price moves adversely a payment must
be made to the clearing house, whilst if the future price moves favorably variation
margin will be received from the clearing house. This process of realizing profits or
loss on a daily basis is known as “marking to market”.
This implies that the margin account is maintained at the initial margin as any daily
profit or loss will be received or paid the following morning. Default in variation
margins will result in the closure of the futures contract in order to protect the
clearing house from the possibility of the party providing cash to cover

accumulating losses.

Basis is the difference between the futures price and the current cash market price
of the underlying security. In the case of exchange rates, the basis is the difference
between the current market price of a future currency and the current spot rate of
the currency. At the final settlement date itself, the futures price and the market
price of the underlying item ought to be the same otherwise speculators would be
able to make an instant profit by trading between the futures market and spot cash
market.
Most futures positions are closed out before the contract reaches final settlement,
hence a difference between the close out future price and the current market price
of the underlying item.
Basis risk may arise from the fact that the price of the futures contract may not
move as expected in relation to the value of the underlying item which is being
hedged.
Hedging with a future contract means that any profit or loss on the underlying item
will be offset by any loss or profit made on the future contract. A perfect hedge is
unlikely because of:
● Basic risk.
● The “round sum” nature of futures contracts, which can only be bought or sold
in whole numbers.

A currency futures is an exchange traded agreement between two parties to

buy/sell a particular quantity of one currency in exchange of another currency at a
particular rate on a particular future date.
Typical available futures contracts are as follows:
quantity of currency price value of one
Futures tick size
per contract quotation tick
£/ $ £62,500 $ per £1 $0.0001 $6.25
€/ $ €125,000 $ per €1 $0.0001 $12.50
€/£ €100,000 £ per €1 £0.0001 £10
FORWARD v FUTURES CONTRACTS
Futures contracts differ from forward contracts in a number of ways including the
following:
● Size of the contract
Futures contracts are for multiples of standard-size contracts whereas forward
contracts with a bank can be negotiated for any size desired.
● Maturity
Futures contracts are available only for a set of fixed maturities, the longest of
which is typically for less than a year. A bank will write a forward contract for
maturity up to a year and occasionally for longer than a year.
● Location
Futures trading is conducted by brokers on the flow of an organised exchange,
where orders from all buyers and sellers compete in one central place.
Forward contracts are negotiated with banks at any location in person or by
telephone.
● Price
Futures prices are determined through an open outcry process at the ’pit’ in
which the particular contract is traded. Forward contract prices are quoted by
the bank in the form of bid and offer.
● Counter parties
Purchasers and sellers of futures contracts are unknown to each other, since
the opposite party to every trade is the exchange clearing house. Purchasers
and sellers of forward contracts deal with the bank where they are known,
either personally or by reputation.
● Margin
Futures contracts require payment of margin while no payments are made
under forward contract apart from settlement payment.

Advantages of using futures contracts

1. Futures could be used to hedge both interest rates and foreign currency risk
2. Default risk is minimal as contracts are marked to market daily by the clearing
house, with the protection of the margin payment.
3. There is a single specified price, which is transparent. No bid and offer.

Disadvantages of using futures contracts

1. Futures prices might not move by exactly the same amount as the cash
market due to basic risk, and perfect hedges are rare.
2. An initial margin (deposit) is required, and further variation margins may be
necessary.
3. Futures contracts are not very flexible. Contracts are only on standardised size.
4. It is more complex than a forward contract.
5. Futures contract is not available in every currency.
Currency Options
A currency option is the right, but not an obligation, to buy (a call option) or sell
(put option) a particular currency at a specified exchange rate on a particular date
or at any time up to a particular date.

Example 6 - Diano plc

Diano plc is a company based in Ghana that trades frequently with companies in the
UK. The national currency of Ghana is the Cedi (GHC).
Transactions to be completed within the next three months are as follows:
Receipts Payments
3 months time £4.8 million £7.6 million
3 months time GHC 5.8 million
Exchange rates GHC/£1
Spot 5.5640 – 5.5910
3 month forward 5.5880 – 5.6190
Ghana Cedi market traded option prices (125,000 Cedis contract size against
sterling) in the UK.
Exercise price (£ per
June contracts September contracts
GHC)
Calls Puts Calls Puts
0.175 0.331 0.082 0.476 0.143
0.180 0.112 0.241 0.203 0.314
0.185 0.034 0.530 0.096 0.691

Option premia are in UK pence per Ghana Cedi and are payable up front. The
options are American style.
Assume that it is now 1 June and that option contracts mature on the 15th of the
month.
Diano plc can borrow at an interest rate of 7% per year.

Required:
Show the outcome of using both forward contract and currency options to hedge
foreign currency risk and recommend the best action.
CURRENCY SWAPS
Currency swaps are similar to interest rate swaps, but the underlying obligations
are in different currencies.
Currency swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Exchange of regular interest payment during the life of the swap.
● Final exchange of principal currencies at maturity of the swap.
When currencies are exchanged at the commencement and maturity of the swap,
the same exchange rate is used. In other words, the amounts exchanged at the
start of the swap and at the end are exactly the same.

Benefits of currency swaps

1. Hedging against foreign exchange risk. Swaps can be arranged for up to ten
years which provide protection against exchange rate movements for much
longer periods than forward contracts. It is very useful when dealing with
countries with exchange controls and/or volatile exchange rates.
2. The ability to obtain finance at a cheaper cost than would be possible by
borrowing directly in the relevant market.
3. The opportunity to effectively restructure a company’s capital profile without
physically redeeming debt.
4. Access to capital markets in which it is impossible to borrow directly, for
example because the borrower is relatively unknown in the market or has a
relatively low credit rating.
 5. Swaps can be arranged for any sum typically $5m to $50m over varying time
periods, and may be reversed by re-swapping with other counter parties.
Hence it is flexible.
6. There may be low transaction cost, as cost may be limited to the legal fees in
agreeing the documentations and arrangement fees.

Forex Swaps
A forex swap is an agreement between two parties to exchange equivalent amounts
of currency for a period and then re-exchange them at the end of the period at a
predetermined agreed rate.
Forex swaps are characterised by the following mechanism:
● Initial exchange of principal currencies at the commencement of the swap.
● Final exchange of principal currencies at maturity of the swap normally at a
different rate.
The purpose of forex swap is to hedge against foreign exchange risk for a longer
period, say more than one year, and where it is difficult to raise money directly.

Risk associated with Swaps

1. Credit Risk
This is the risk that the counterparty to the swap will default before the end of the
swap and fail to carry out their agreed obligation. Such risk is reduced if a reputable
bank is used as an intermediary to the deal
2. Market Risk
This is the risk that interest rates of exchange rates will move unfavorably against
the company after it has committed itself into the swap.
3. Sovereign Risk
This is the risk associated with the country in whose currency a swap is being
considered. It covers political instability or the possibility of exchange controls being
introduced.
4. Liquidity Risk
Liquidity risk is the risk that the entity will not have access to sufficient cash to
meet its payment obligations when these are due.

Swaptions
Swaption may also be referred to as swap option, options on swap or option swap.
Swaptions are combinations of swap and option.
In return for the payment of premium by the holder, a swaption gives the right, but
not an obligation, to enter into the swap on or before a particular date.
Swaptions are available on an over-the-counter market and are therefore tailored to
the exact specifications of the holder. They may be American or European style.
Swaptions are examples of financial engineering. Financial engineering is the
construction of a financial product from a combination of existing derivative
products.
 Chapter 14

Hedging interest

rate risk

\
INTEREST RATE RISK
Interest rate risk is the risk of incurring losses or higher costs due to an adverse
movement in interest rates or gains as a result of favourable movement in interest
rates. The interest rate exposure can arise due to many reasons including the
following:
● The company has an asset whose market value changes whenever market
interest rates change.
● The company is expected to make some payment in the future, and the
amount of the payment will depend on the interest rate at that time.
● The company is expecting some income in the future, and the amount of
income received will depend on the interest rate at that time.

LIBOR means the London interbank offered rate. It is the rate of interest at which a
top-level bank in London can borrow wholesale short-term funds from another bank
in London money markets.
LIBID means the London inter-bank bid rate. It is the rate of interest that a
top-level bank in London could obtain short-term deposits with another bank in
London money markets. The LIBID is always lower than the LIBOR
TERM STRUCTURE OF INTEREST RATES
The “term structure of interest rates” reflects the manner in which the gross
redemption yield on government bonds varies with the term to maturity, i.e. the
period of time before the stock is to be redeemed. For example, government bonds
may be short-dated (e.g. repayment within 5 years), medium-dated (repayment
between 5 and 20 years) or long-dated (redemption in excess of 20 years). Of
course, some government bonds e.g. 2½% Consols are undated (i.e.
irredeemable).
This data is often presented in the form of a graph to illustrate the “bond yield
curve”, which is created by plotting the gross redemption yield of the bond against
the term to maturity. In normal circumstances the yield curve is upward sloping.
The gross redemption yield reflects the internal rate of return on the cash flows
associated with the bond, ie it incorporates the effect of the current market value of
the bond, the gross interest payments and the redemption value of the bond – in
other words it measures not only the gross interest yield but also the capital gain or
loss to maturity. The calculation of the gross redemption yield is very similar to the
calculation of the cost of redeemable debt for the company – the notable difference
is that interest payments are included gross (as opposed to net of corporation tax
as is used in arriving at Kd).

The normal yield curve

The general shape of the normal upward sloping yield curve appears as follows:

Gross
Redemption
Bond
Yield Yield Curve
%

0 5 10 15 20 25
Term to maturity (years)
A normal yield curve slopes upwards because the yield on longer dated bonds is
normally higher than the yield on shorter dated bonds. If you are confused by this
point, remember that your mortgage is only cheaper than your overdraft because
the mortgage is secured on the property, whereas the overdraft is unsecured. The
reason for the upward sloping shape of the yield curve is thought to be based on
the following theories:
● liquidity preference theory
● expectations theory
 ● market segmentation theory.

Lenders have a natural preference for holding cash rather than securities − even low
risk government securities. They therefore need to be compensated for being
deprived of their cash for a longer period of time – hence the higher yield on long-
dated securities and the lower yield on short-dated securities. There is a greater
risk in lending long-term than in lending short-term. To compensate lenders for this
risk they would require a higher return on longer dated investments.

This theory states that the shape of the yield curve will vary depending upon a
lender’s expectations of future interest rates (and therefore inflation levels). A
curve that rises from left to right indicates that rates of interest are expected to
increase in the future to reflect the investors' fear of rising inflation rates.

The slope of the yield curve is thought to reflect conditions in different segments of
the market. In other words, lenders and borrowers tend to confine themselves to a
particular segment of the market and thus it is probably futile to compare
short-term with long-term lending and borrowing. Thus, companies typically finance
working capital with short-term funds and non-current assets with long-term funds.
This leads to different factors affecting short-term and long-term interest rates
leading to irregularities which cause humps, dips or wiggles in the shape of the
yield curve.

The inverse yield curve

A yield curve may occasionally slope downwards, since short-term yields may be
higher than long-term yields for the following reasons:
● Expectations. i.e. if interest rates are currently high, but the market
anticipates a steep fall in the near future, the resultant yield curve will be
downward sloping.
● Government intervention. ie a policy of keeping interest rates relatively high
might have the effect of forcing short-term yields higher than long-term
yields.
An inverse yield curve is downwards sloping and its general shape is as follows:

Gross
Redemption
Yield
%

0 5 10 15 20 25
Term to maturity (years)

Financial managers should inspect the current shape of the yield curve when
deciding on the term of borrowings or deposits, since the curve shows the market
expectations of future movement in interest rates.
If the yield curve slopes steeply upwards, it suggests an increase in interest rate in
the future. In this case the financial manager should avoid borrowing long-term on
variable rates, since the interest rate charge may increase over the term of the
loan. It would be better to either borrow on long-term fixed rate or short-term
variable rate.
HEDGING/PROTECTING INTEREST RATE RISK
There are several methods of hedging interest rate risk including the following:
● forward rate agreements
● interest rate options
● interest rate swaps
● interest rate futures.

Forward rate agreements (FRA)

A forward rate agreement for interest rate is similar to forward foreign exchange
contract.
A forward rate agreement offers companies the facility (with a bank) to fix future
interest rates today on either borrowing or lending for a specified future period.
If the actual interest rate proves to be higher than the rate agreed, the bank pays
the company the difference. If the actual rate is less than the rate agreed, the
company pays the difference. This is called compensation payment.
If a company knows for instance that it will take out a loan in a few months at a
floating rate of interest it may worry what the interest rate will be and try to
manage it by using FRA. The company arranges FRA with a third party (the bank)
at a mutually agreed interest rate for a specified period in advance.
The company then takes the loan on the due date and pays interest at the
prevailing (actual) rate. At the end of the specified period the interest actually paid
is compared with the rate agreed under the FRA and adjustments are made
accordingly between the two parties.
No premium or commission is paid on FRAs.

FRAs are over-the-counter transactions between a bank and a company. The bank
quotes two-way prices for each FRA period for each notional borrowing (loan) or
lending (deposit).
Examples of bank quotations for FRA are:
● 2v5 5.75 - 6.00
Means forward rate agreement that starts in 2 months and lasts for 3 months
at a borrowing rate of 6% and lending rate of 5.75%.
2v6 5.75 - 6.00
3v5 5.78 - 6.13
4v7 5.95 - 6.45

Compensation period is calculated as the difference between the FRA rate fixed and
the LIBOR rate at the fixing date (actual LIBOR) multiplied by the amount of the
notional loan/deposit and the period of the loan/deposit.
The FRA therefore protects against the LIBOR but not the risk premium attached to
the customer.
The settlement of FRA is made at the start of the loan period and not at the end
and therefore compensation payment occurs at the start of the loan period. As a
result the compensation payment should be discounted to its present value using
the LIBOR rate at the fixing date over the period of the loan.
INTEREST RATE FUTURES
Interest rate futures are futures contracts similar to currency futures. They are
standardised exchange-traded contract agreements now between buyers and
sellers, for settlement at a future date, normally in March, June, September and
December.

Pricing futures contracts

The pricing of an interest rate futures contract is determined by the three months
interest rate (r %) contracted for and is calculated as (100 – r). For example if
three months Eurodollar time deposit interest rate is 8%, a three months Eurodollar
futures contract will be priced at (100-8) = 92; and if interest rate is 11%, the
future price
= 89= (100-11).
The decrease in price or value of the contract reflects the reduced attractiveness of
a fixed rate deposit in times of rising interest rates.

Ticks and tick values

Examples of ticks and tick values are:
1. For 3 months Eurodollar futures, the amount of the underlying instrument is a
deposit of $1,000,000. With a tick of 0.01%, the value of the tick is:
0.01% x $1m x 3/12 = $25
2. For 3 months sterling, the underlying instrument is a 3 months deposit of
£500,000. With a tick of 0.01%, the value of tick is:
500,000 x 0.01% x 3/12 = £12.5
Example
If three months LIBOR is 7% and the September price of three months sterling
future is 92.70 now, at the end of March (let’s say), the basis is:
LIBOR (100 - 7) 93.00
Futures 92.70
0.30%
30 basis points

Maturity mismatch occurs if the actual period of lending or borrowing does not
match the notional period of the futures contract (three months). The number of
futures contracts used has to be adjusted accordingly. Since fixed interest is
involved, the number of contracts is adjusted in proportion to the time period of the
actual loan or deposit compared with three months.
Number of contracts =

⎛ amount of actual loan/deposit ⎞ ⎛ time period required for loan/deposit ⎞

×
⎜ ⎟ ⎜ ⎟
futures contract size 3 months

⎝ ⎠ ⎝ ⎠
INTEREST RATE OPTIONS

1. Options on interest rate futures

Interest rate option is a right, but not obligation, to either borrow or lend a notional
amount of principal for a given interest period, starting on or before a date in the
future (expiry date for the option), at a specified rate of interest (exercise price of
the option).
It is simply an option to buy or sell futures.

2. caps, collars and floors

These are hedging techniques that can be used to cover risk on long term
borrowing. As the name implies, a ‘cap’ is the upper-level interest rate, and a ‘floor’
a lower- level interest rate. With a collar a company enters into an arrangement
such that it will borrow for a period of time with a floating interest rate, but it
knows it will not have to pay more than the ‘cap’ rate, but on the other hand it will
not be able to pay less than the ‘floor rate.
Interest rate

10% CAP

open market rate

5% floor

0 time

The open market rate will be applied to the loan as long as it remains between 5%
and 10%. If the open market interest rate goes outside these parameters (say 12%
or 4%) the bank will activate the ‘cap’ or ‘floor’ as appropriate to keep the loan
interest cost between the agreed limits.
The advantage of the collar compared to a normal cap is that the collar has a lower
overall premium cost, due to the potential benefit of the floor to the bank.
Interest rate option is a right, but not obligation, to either borrow or lend a notional
amount of principal for a given interest period, starting on or before a date in the
future (expiry date for the option), at a specified rate of interest (exercise price of
the option).
 Example
Assume that it is now mid-December.
The finance director of APB plc has recently reviewed the company’s monthly cash
budgets for the next year. As a result of buying new machinery in three months’
time, the company is expected to require short-term finance of £30 million for a
period of two months until the proceeds from a factory disposal become available.
The finance director is concerned that, as a result of increasing wage settlements,
the Central Bank will increase interest rates in the near future.
LIBOR is currently 6% per annum and APB can borrow at LIBOR + 0.9%.
Derivative contracts may be assumed to mature at the end of the month.
The company is considering using interest rate futures, options on interest rate
futures or interest rate collars.

Three months sterling Future (£500,000 contract size, £12.50 tick size)
December 93.870
March 93.790
June 93.680

Options on three months sterling futures (£500,000 contract size, premium

cost in annual %)
Calls Puts
December March June December March June
93750 0.120 0.195 0.270 0.020 0.085 0.180
94250 0.000 0.030 0.085 0.400 0.480 0.555

Required:
Illustrate how the short-term interest risk might be hedged, and the possible results
of the alternative hedges if interest rate increase or decrease by 0.5%.

SWAPS

A swap is an agreement between two parties to exchange cash flows related to

specific underlying obligations for an agreed period of time. It is the exchange of
one stream of future cash flows for another stream of future cash flows with
different characteristics.
INTEREST RATE SWAPS
Interest rate swap allows a company to exchange either:
● Fixed rate interest payments into floating rate payment, or
● Floating rate interest payment into fixed rate payments.
Here a company worried about interest rate volatility on a floating rate loan finds a
swap partner with a fixed interest loan who is unworried by interest rate volatility.
The parties swap their interest rate commitments to obtain the interest style they
want. This is operative over the duration of the loans and so provides long-run
hedging. Normally a financial intermediary is employed to find a suitable swap
partner for the arrangement and is paid a fee.

Example 6 Fred plc

Fred plc has a loan of £20m repayable in one year. Fred plc pays interest at LIBOR
plus 1.5% and could borrow fixed at 13% per annum. Martin plc also has a £20m
loan and pays fixed interest at 12% per annum. It could borrow at a variable rate of
LIBOR plus 2.5%.
The companies agree to swap their interest commitments with Fred plc paying
Martin plc fixed rate plus 0.5% and Martin plc paying Fred plc LIBOR plus 2%. An
arrangement fee of £10,000 is charged on each company.

Required:
Calculate the total interest payments of the two companies over the year if LIBOR
is 10% per annum

Example 7
A company wants to borrow £6 million at a fixed rate of interest for four years, but
can only obtain a bank loan at LIBOR plus 80 basis points. A bank quotes bid and
ask prices for a four year swap of 6.45% - 6.50%.

Required:
(a) Show what the overall interest cost will become for the company, if it arranges
a swap to switch from floating to fixed rate commitments.
(b) What will be the cash flows as a percentage of the loan principal for an
interest period if the rate of LIBOR is set at 7%?
Reasons for interest rate swaps
Interest rate swaps have several uses including:
1. Long-term hedging against interest rate movements as swaps may be
arranged for periods of several years.
2. The ability to obtain finance at a cheaper cost than would be possible by
borrowing directly in the relevant market.
3. The opportunity to effectively restructure a company’s capital profile without
physically redeeming debt.
4. Access to capital markets in which it is impossible to borrow directly, for
example because the borrower is relatively unknown in the market or has a
relatively low credit rating.
 Chapter 15

Issues for
Multinationals

TRANSFER PRICING WITHIN MULTINATIONAL

Essentially a transfer price is an internal recharge which is not an actual cash flow,
however it will in effect redistribute income and cost within an organisation and as a
consequence adjust the profit reported by separate divisions.
Whilst this has an internal consequence in the evaluation of divisional management,
it is of particular significance within multinational organisations due to the tax
implications.

Transfer pricing can be used in international investments as a way to circumvent

any restrictions relating to blocked funds. The parent company will charge the
foreign subsidiary an inflated amount to ensure a cash flow that might have
otherwise not been possible to obtain.

Transfer pricing can also be used to minimize the global tax payable, by adjusting
the transfer price to ensure that a low profit is declared in nations of high tax rates
and a larger profit is declared in nations where the rate is more favourable.
This may need the approval of the respective governments who may not take kindly
to such blatant attempts to avoid paying tax. They may enforce that the transaction
is carried out at “arm’s length” using a price that would be applied to an external
customer to ensure that the transaction is fair and tax is collected as it should be.
ISLAMIC FINANCE
A form of finance that specifically follows the teachings of the Quran.
The teachings of the Quran are the basis of Islamic Law or Sharia. Sharia Law is,
however, not codified and as such the application of both Sharia Law and, by
implication, Islamic Finance is open to more than one interpretation.

In Shariah Law there are some activities that are not allowed and as such must not
be provided by an Islamic financial institution, these include:
1. Gambling (Maisir)
2. Uncertainty in contracts (Gharar)
3. Prohibited activities (Haram)

Riba
Interest in normal financing relates to the monetary unit and is based on the
principle of time value of money. Sharia Law does not allow for the earning of
interest on money. It considers the charging of interest to be usury or the
‘compensation without due consideration’. This is called Riba and underpins all
aspects of Islamic financing.
Instead of interest a return may be charged against the underlying asset or
investment to which the finance is related. This is in the form of a premium
being paid for a deferred payment when compared to the existing value.
There is a specific link between the charging of interest and the risk and earnings of
the underlying assets. Another way of describing it is as the sharing of profits
arising from an asset between lender and user of the asset.
Gharar
The prohibition on Gharar means that forward contracts and derivatives are not
allowed. Short selling is prohibited because the seller needs to own the asset.
Constructive ownership is acceptable where the goods are under the direct control of
the owner even if the owner does not have physical possession.
Due to the above prohibitions, the majority of the conventional financial instruments
are not suitable to Islamic finance.

● Mudaraba – equity finance

A profit sharing contract where one party provides capital and the other the
expertise to invest the capital and manage the activities. There is a pre-agreed ratio
of profit share.
The partner contributing capital is liable to the extent of the capital provided. The
contract can be terminated at any time with reasonable notice.
Mudaraba transactions are appropriate for private equity investments. In the case
of financial institutions and banks, the mudaraba method become applicable as the
bank is a lender to a business it can share in the profits that the business makes
instead of charging an interest on the loan.
The result is that risk is shared equally between lender and borrower. Similarly, if
the bank is a borrower, the lender’s deposit is treated as an equity investment, and
he or she shares in the profit that the bank makes through its investments.
Conventional banks make a profit on the spread between the interest rate charged
to borrowers and paid to depositors – Islamic banks make a profit on the
investments that they make or their borrowers make.

● Musharaka – venture capital

Has more in common with a joint venture than an equity investment. All (or most)
investors will have an active role in managing the business. Where all parties
provide capital as well as skills and expertise and share the profits and losses on
agreed basis. Partners have unlimited liability.
There are different types of musharakah. In permanent musharakah the bank
participates in the equity of a company and receives an annual share of the profits
on a pro rata basis. The period of termination of the contract is not specified. This
financing technique is also referred to as continued musharaka.
Diminishing musharaka is a special form of musharakah, which ultimately results in
the ownership of the asset or the project by the client. The bank participates as a
financial partner, in full or in part, in a project with a given income forecast. An
agreement is signed by the partner and the bank through which the bank receives a
share of the profits as a partner. However, the agreement also provides payment of
a portion of the net income of the project as repayment of the principal financed by
the bank.

● Murabaha – trade credit

If a consumer wishes to purchase an asset, the bank can buys the asset for the
individual on an agreed upon price between the individual and the seller. The
individual then purchases the asset from the bank at the purchase price plus a
mark- up. However, critics have pointed out that the mark-up has the same
connotation as interest, and this similarity with traditional banking is perhaps one of
the reasons why murabaha contracts are widely accepted.
The sale price of goods is agreed to cover all costs and generate a profit margin.
The time value of money is incorporated in the costs. There is a reassurance that
the ‘credit’ is based on trade and not simply a financing transaction.
Murabaha contracts are applied to financing of raw materials, machinery,
equipment and consumer durables as well as short-term trade financing.
● Ijara – lease finance
A bank makes an asset available to a customer for a fixed period in exchange for a
fixed price. At the end of the period, the customer often has the option to pay a
fixed price in return for transfer of ownership of the asset from the bank.
Leasing is emerging as a popular technique of financing among Islamic banks.
Under this scheme of financing, the bank purchases a real asset and leases it to the
client. The period of lease may be from three months to five years or more, and is
determined by mutual agreement according to the nature of the asset. During the
period of lease, the asset remains in the ownership of the bank but the physical
possession of the asset and the right of use is transferred to the lessee. After the
expiry of the leasing period these revert to the lessor. A lease payment schedule is
agreed by the bank and the lessee based on the amount and terms of financing is
agreed upon by the bank and the lessee. The agreement may or may not include a
grace period.
According to the Islamic principles, the maintenance of the asset during the leasing
period is the responsibility of the owner of the asset, as the benefit or rental is
linked to the responsibility of maintenance.
DARK POOL TRADING
The recent financial crisis has seen the alleged (see newspaper article below)
growth of a practice, which is sometimes referred to as “Dark pool trading”. It is
also known as “Dark pool liquidity”, the “Upstairs market”, “Dark liquidity” or simply
“Dark pool”.
The term “Dark pool” relates to trades which are concealed from the public – as if
they had been undertaken in “pools of murky water”. Many traders believe that
such activities should be publicized in order to make trading more fair for all parties
involved, so that all such transactions are performed on “a level playing field”.
Dark pool trading refers to the volume of trade created by institutional investors in
financial trading venues or “crossing networks” that are unavailable to the general
public. The bulk of Dark pool liquidity is represented by block trades undertaken
away from the central exchanges. Such transactions are never displayed and are
useful for institutions who wish to deal in large numbers of shares, whilst not
revealing such trades to the open market.
Dark liquidity pools avoid the risk of revealing the actions of such institutions, since
neither the identity of the trader nor the price at which the transactions took place
are displayed. Dark pools are recorded as over-the-counter transactions, but
detailed information is only reported to clients if they so desire and are under a
contractual obligation to do so.
The Upstairs market allows Fund managers to move large blocks of equity shares
without revealing details as to what has actually occurred. The lack of human
intervention within the electronic platforms employed has reduced the time scale
for such trades. The increased responsiveness of equity price movements has made
it extremely difficult to trade large blocks of shares without affecting the price.
A report in “The Independent” newspaper on 25th May 2010 stated: