ACCA P4 Class Notes June 2011 Version

ACCA Papero P4 sp
s ok Advanced Financial o eb Management 0 20 0 log .b
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Class Notes June 2011
ebooks2000.blogspot.com
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Typeset by Debbie Crossman
Ken Preece January 2011 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Ken Preece.
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Contents
PAGE
INTRODUCTION TO THE PAPER FORMULAE & TABLES PROVIDED IN THE EXAMINATION PAPER CHAPTER 1: CHAPTER 2: CHAPTER 3: CHAPTER 4: CHAPTER 5: CHAPTER 6: CHAPTER 7: CHAPTER 8: CHAPTER 9: ISSUES IN CORPORATE GOVERNANCE ADVANCED INVESTMENT APPRAISAL SECTION 1 ADVANCED INVESTMENT APPRAISAL SECTION 2 COST OF CAPITAL EFFICIENT MARKET HYPOTHESIS THEORIES OF GEARING 5 7 13 39 63 97 121 129
PORTFOLIO THEORY AND THE CAPITAL ASSET PRICING MODEL 147 ADJUSTED PRESENT VALUE
VALUATIONS, ACQUISITIONS AND MERGERS SECTION 1
CHAPTER 10: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 2 CHAPTER 11: VALUATIONS, ACQUISITIONS AND MERGERS SECTION 3 CHAPTER 12: CORPORATE RECONSTRUCTION AND REORGANISATION CHAPTER 13: CORPORATE DIVIDEND POLICY CHAPTER 14: MANAGEMENT OF INTERNATIONAL TRADE AND FINANCE CHAPTER 15: HEDGING FOREIGN EXCHANGE RISK CHAPTER 16: FUTURES AND OPTIONS CHAPTER 17: HEDGING INTEREST RATE RISK CHAPTER 18: SWAPS CHAPTER 19: INTERNATIONAL INVESTMENT APPRAISAL
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191 205 231 257 281 291 301 317 345 375 407 423
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Introduction to the paper
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IN T R O D U C T I O N T O T H E P A P E R
Aim of the Paper

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

A. B. C. D. E. F. G. Role and responsibility towards stakeholders Economic environment for multinationals Advanced investment appraisal Acquisitions and mergers Corporate reconstruction and re-organisation Treasury and advanced risk management techniques Emerging issues in finance and financial management
Format of the Exam Paper
m co 15 minutes reading t. The examination will be a three-hour paper (with the additional potwo sections: and planning time) of 100 marks in total, divided s g into o Section A .bl 0 Section A will contain two compulsory questions, comprising between 50 00 2 and 70 marks in total. ks o Section A will normally cover significant issues relevant to the senior financial bo be set in the form of a short case study or scenario. e manager or advisor and will
The requirements of the section A questions are such that candidates will be expected to show a comprehensive understanding of issues from across the syllabus. Each question will contain a mix of computational and discursive elements. Each question in section A will comprise of between 25 and 40 marks. 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. Section B In section B candidates will be asked to answer two from three questions, comprising of between 15 and 25 marks each. Section B questions are designed to provide a more focused test of the syllabus with, normally, one question being wholly discursive. Candidates will be provided (within the examination paper) with a formulae sheet as well as present value, annuity and standard normal distribution tables.
Formulae & tables provided in the examination paper
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F O R M U L A E & T A B L E S P R O V ID E D IN T H E E X A M I N A T IO N P A P E R
Formulae
Modigliani and Miller Proposition 2 (with tax) ke = kie + (1 T)(kie kd)
Vd Ve
Two asset portfolio sp =

wa sa
2 2
+ wb
sb
+ 2 w a w b rab s a s b
The Capital Asset Pricing Model

E(rj) = Rf + j (E(rm) Rf)
The asset beta formula
Ve Vd (1 - T) a = e + d (Ve + Vd (1 - T)) (Ve + Vd (1 - T ))
The Growth Model
e Gordons growth approximation

g = bre
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0D
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0
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(1 + g) (re - g)
The weighted average cost of capital
Ve Vd WACC = V + V ke + V + V kd(1T) d d e e
The Fisher formula

(1 + i) = (1 + r) (1 + h)
Purchasing power parity and interest rate parity

S1 = S0
(1 + hc ) (1 + hb )
Fo =
So
(1 + ic ) (1 + ib )
Modified Internal Rate of Return

1
PV MIRR = R PV I
n (1 + re) 1
The Black Scholes Option Pricing Model

c = Pa N(d1) Pe N(d 2 ) e Where: d1 = and d 2 = d1 s t -rt
ln(Pa /Pe ) + (r + 0.5s 2 )t s t
The Put Call Parity relationship

p = c P a + Pe e -rt
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Present value table

Present value of 1 i.e. (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 2 3 4 5 6 7 8 9 10 0.990 0.980 0.971 0.961 0.951 0.942 0.933 0.923 0.914 0.905 0.980 0.961 0.942 0.924 0.906 0.888 0.871 0.853 0.837 0.820 0.971 0.943 0.915 0.888 0.863 0.837 0.813 0.789 0.766 0.744 0.962 0.925 0.889 0.855 0.822 0.790 0.760 0.731 0.703 0.676 0.952 0.907 0.864 0.823 0.784 0.746 0.711 0.677 0.645 0.614 0.943 0.890 0.840 0.792 0.747 0.705 0.665 0.627 0.592 0.558 0.935 0.873 0.816 0.763 0.713 0.666 0.623 0.582 0.544 0.508 0.926 0.857 0.794 0.735 0.681 0.630 0.583 0.540 0.500 0.463 0.917 0.842 0.772 0.708 0.650 0.596 0.547 0.502 0.460 0.422 0.909 0.826 0.751 0.683 0.621 1 2 3 4 5
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 ________________________________________________________________________________
ok o14% 15% 16% 17% 18% 19% 20% (n) 11% 12% 13% b e ________________________________________________________________________________
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0.901 0.812 0.731 0.659 0.593 0.535 0.482 0.434 0.391 0.352 0.317 0.286 0.258 0.232 0.209 0.893 0.797 0.712 0.636 0.567 0.507 0.452 0.404 0.361 0.322 0.287 0.257 0.229 0.205 0.183 0.885 0.783 0.693 0.613 0.543 0.480 0.425 0.376 0.333 0.295 0.261 0.231 0.204 0.181 0.160 0.877 0.769 0.675 0.592 0.519 0.456 0.400 0.351 0.308 0.270 0.237 0.208 0.182 0.160 0.140 0.870 0.756 0.658 0.572 0.497 0.432 0.376 0.327 0.284 0.247 0.215 0.187 0.163 0.141 0.123 0.862 0.743 0.641 0.552 0.476 0.410 0.354 0.305 0.263 0.227 0.195 0.168 0.145 0.125 0.108 0.855 0.731 0.624 0.534 0.456 0.390 0.333 0.285 0.243 0.208 0.178 0.152 0.130 0.111 0.095 0.847 0.718 0.609 0.516 0.437 0.370 0.314 0.266 0.225 0.191 0.162 0.137 0.116 0.099 0.084 0.840 0.706 0.593 0.499 0.419 0.352 0.296 0.249 0.209 0.176 0.148 0.124 0.104 0.088 0.074 0.833 0.694 0.579 0.482 0.402 1 2 3 4 5
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0.564 6 0.513 7 0.467 8 0.424 9 0.386 10
0.335 6 0.279 7 0.233 8 0.194 9 0.162 10 0.135 0.112 0.093 0.078 0.065 11 12 13 14 15
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Annuity table
Present value of an annuity of 1 i.e.
1 - (1 + r) -n r
Where
r n
= =
discount rate number of periods
Discount rate (r) Periods (n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10% ________________________________________________________________________________ 1 2 3 4 5 6 7 8 9 10 0.990 1.970 2.941 3.902 4.853 5.795 6.728 7.652 8.566 9.471 0.980 1.942 2.884 3.808 4.713 5.601 6.472 7.325 8.162 8.983 0.971 1.913 2.829 3.717 4.580 5.417 6.230 7.020 7.786 8.530 0.962 1.886 2.775 3.630 4.452 5.242 6.002 6.733 7.435 8.111 0.952 1.859 2.723 3.546 4.329 5.076 5.786 6.463 7.108 7.722 0.943 1.833 2.673 3.465 4.212 4.917 5.582 6.210 6.802 7.360 0.935 1.808 2.624 3.387 4.100 4.767 5.389 5.971 6.515 7.024 0.926 1.783 2.577 3.312 3.993 4.623 0.917 1.759 2.531 3.240 3.890 4.486 5.033 5.535 5.995 6.418 0.909 1.736 2.487 3.170 3.791 1 2 3 4 5
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 ________________________________________________________________________________
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m co 5.206 ot. 5.747
6.247 6.710
4.355 6 4.868 7 5.335 8 5.759 9 6.145 10
(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20% ________________________________________________________________________________ 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 0.901 1.713 2.444 3.102 3.696 4.231 4.712 5.146 5.537 5.889 6.207 6.492 6.750 6.982 7.191 0.893 1.690 2.402 3.037 3.605 4.111 4.564 4.968 5.328 5.650 5.938 6.194 6.424 6.628 6.811 0.885 1.668 2.361 2.974 3.517 3.998 4.423 4.799 5.132 5.426 5.687 5.918 6.122 6.302 6.462 0.877 1.647 2.322 2.914 3.433 3.889 4.288 4.639 4.946 5.216 5.453 5.660 5.842 6.002 6.142 0.870 1.626 2.283 2.855 3.352 3.784 4.160 4.487 4.772 5.019 5.234 5.421 5.583 5.724 5.847 0.862 1.605 2.246 2.798 3.274 3.685 4.039 4.344 4.607 4.833 5.029 5.197 5.342 5.468 5.575 0.855 1.585 2.210 2.743 3.199 3.589 3.922 4.207 4.451 4.659 4.836 4.988 5.118 5.229 5.324 0.847 1.566 2.174 2.690 3.127 3.498 3.812 4.078 4.303 4.494 4.656 4.793 4.910 5.008 5.092 0.840 1.547 2.140 2.639 3.058 3.410 3.706 3.954 4.163 4.339 4.486 4.611 4.715 4.802 4.876 0.833 1.528 2.106 2.589 2.991 1 2 3 4 5
3.326 6 3.605 7 3.837 8 4.031 9 4.192 10 4.327 4.439 4.533 4.611 4.675 11 12 13 14 15
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Standard normal distribution table

0.0 0.1 0.2 0.3 0.4 0.5 0.6 0.7 0.8 0.9 1.0 1.1 1.2 1.3 1.4 1.5 1.6 1.7 1.8 1.9 2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 0.00 0.0000 0.0398 0.0793 0.1179 0.1554 0.1915 0.2257 0.2580 0.2881 0.3159 0.3413 0.3643 0.3849 0.4032 0.4192 0.4332 0.4452 0.4554 0.4641 0.4713 0.4772 0.4821 0.4861 0.4893 0.4918 0.4938 0.4953 0.4965 0.4974 0.4981 0.01 0.0040 0.0438 0.0832 0.1217 0.1591 0.1950 0.2291 0.2611 0.2910 0.3186 0.3438 0.3665 0.3869 0.4049 0.4207 0.4345 0.4463 0.4564 0.4649 0.4719 0.4778 0.4826 0.4864 0.4896 0.4920 0.4940 0.4955 0.4966 0.4975 0.4982 0.02 0.0080 0.0478 0.0871 0.1255 0.1628 0.1985 0.2324 0.2642 0.2939 0.3212 0.3461 0.3686 0.3888 0.4066 0.4222 0.4357 0.4474 0.4573 0.4656 0.4726 0.4783 0.4830 0.4868 0.4898 0.4922 0.4941 0.4956 0.4967 0.4976 0.4982 0.03 0.0120 0.0517 0.0910 0.1293 0.1664 0.2019 0.2357 0.2673 0.2967 0.3238 0.3485 0.3708 0.3907 0.4082 0.4236 0.4370 0.4484 0.4582 0.4664 0.4732 0.4788 0.4834 0.4871 0.4901 0.4925 0.04 0.0160 0.0557 0.0948 0.1331 0.1700 0.2054 0.2389 0.2703 0.2995 0.3264 0.3508 0.3729 0.3925 0.4099 0.4251 0.4382 0.4495 0.4591 0.4671 0.4738 0.4793 0.4838 0.4875 0.4904 0.4927 0.05 0.0199 0.0596 0.0987 0.1368 0.1736 0.2088 0.2422 0.2734 0.3023 0.3289 0.3531 0.3749 0.3944 0.4115 0.4265 0.4394 0.4505 0.4599 0.4678 0.4744 0.06 0.0239 0.0636 0.1026 0.1406 0.1772 0.2123 0.2454 0.2764 0.3051 0.3315 0.3554 0.3770 0.3962 0.4131 0.4279 0.4406 0.4515 0.4608 0.4686 0.4750 0.07 0.0279 0.0675 0.1064 0.1443 0.1808 0.2157 0.2486 0.2794 0.3078 0.3340 0.3577 0.3790 0.3980 0.4147 0.4292 0.08 0.0319 0.0714 0.1103 0.1480 0.1844 0.2190 0.2517 0.2823 0.3106 0.3365 0.3599 0.3810 0.3997 0.4162 0.4306 0.4429 0.4535 0.4625 0.4699 0.4761 0.4812 0.4854 0.4887 0.4913 0.4934 0.4951 0.4963 0.4973 0.4980 0.4986 0.09 0.0359 0.0753 0.1141 0.1517 0.1879 0.2224 0.2549 0.2852 0.3133 0.3389 0.3621 0.3830 0.4015 0.4177 0.4319 0.4441 0.4545 0.4633 0.4706 0.4767 0.4817 0.4857 0.4890 0.4916 0.4936 0.4952 0.4964 0.4974 0.4981 0.4986
o bo
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o .bl0.4798 0 0.4842
0.4946 0.4960 0.4970 0.4978 0.4984
0.4803 0.4846 0.4878 0.4881 0.4906 0.4909 0.4929 0.4931 0.4948 0.4961 0.4971 0.4979 0.4985
p gs
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0.4418 0.4525 0.4616 0.4693 0.4756 0.4808 0.4850 0.4884 0.4911 0.4932 0.4949 0.4962 0.4972 0.4979 0.4985
0.4943 0.4957 0.4968 0.4977 0.4983
0.4945 0.4959 0.4969 0.4977 0.4984
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
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Chapter 1
Issues in corporate governance
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C H A P T E R 1 I S S U E S IN C O R P O R A T E G O V E R N A N C E
CHAPTER CONTENTS
FINANCIAL OBJECTIVES ------------------------------------------------ 15 THE UK CORPORATE GOVERNANCE CODE ----------------------------- 17
CODE OF BEST PRACTICE 17
INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 36

UNITED STATES OF AMERICA GERMANY JAPAN 36 36 37
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FINANCIAL OBJECTIVES
Advanced Financial Management is concerned with the following key decisions: What to invest in (INVESTMENT DECISIONS) How to finance the investment (FINANCING DECISIONS) The level of dividend distributions (DIVIDEND DECISIONS).
Objectives
Primary objective: to maximise the wealth of shareholders. A positive NPV equates (in theory) to an increase in shareholder wealth. Secondary objectives may be e.g. meeting financial targets (say satisfactory ROCE), meeting productivity targets, establishing brands and quality standards and effective communication with customers, suppliers, employees. As an alternative to maximising the wealth of shareholders a company must in reality consider satisficing objectives for each of the major stakeholders.
Stakeholders (user groups) and their goals

These include:
Shareholders
Ownership is separate from control. Institutional investors may have different requirements from private shareholders. Information is provided to shareholders via published financial statements, forecasts by directors responding to takeover bids, investment analysts and the financial press.
Directors
ok omade by directors, who are the stakeholders with the The key decisions are ebjobs, their investments and their reputation. Does this most to lose their
influence their decisions? Hence the extensive work on corporate governance matters.
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Management and employees

Obviously they require long-term security and appropriate rewards (pay/benefits). Should performance related incentives be offered e.g. share options, long-term incentive plans (LTIPs)?
Loan creditors
Covenants in loan agreements may restrict gearing and dividend levels and the sale of assets. Loan creditors would have remedies if the company defaults.
Customers
No doubt these should be the most important interest group of all.
Suppliers
Must be reliable if not, consider internal production (vertical integration)
The government Environmental pressure groups The general public
Many of these groups may have conflicting objectives, which need to be reconciled.
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Corporate governance
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 Services Authority requires listed companies to confirm that they have complied with the Code provisions or in the event of non-compliance to provide an explanation of their reasons for departure.
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THE UK CORPORATE GOVERNANCE CODE Code of best practice

Section A: Leadership A.1 The Role of the Board
Main Principle: Every company should be headed by an effective board which is collectively responsible for the long-term success of the company. Supporting Principles
The boards role is to provide entrepreneurial leadership of the company within a framework of prudent and effective controls which enables risk to be assessed and managed. The board should set the companys strategic aims, ensure that the necessary financial and human resources are in place for the company to meet its objectives and review management performance. The board should set the companys values and standards and ensure that its obligations to its shareholders and others are understood and met.
m co best interests of the . All directors must act in what they consider to tbe the po(as set out in the Companies company, consistent with their statutory duties s Act 2006). log .b Code Provisions 00 0 s2 1.1 The board should meet sufficiently regularly to discharge its duties effectively. k There should be a formal schedule of matters specifically reserved for its oo decision. The annual report should include a statement of how the board eb
operates, including a high level statement of which types of decisions are to be taken by the board and which are to be delegated to management. 1.2 The annual report should identify the chairman, the deputy chairman (where there is one), the chief executive, the senior independent director and the chairmen and members of the board committees. It should also set out the number of meetings of the board and its committees and individual attendance by directors. The company should arrange appropriate insurance cover in respect of legal action against its directors.
1.3
A.2 Division of Responsibilities

Main Principle: There should be a clear division of responsibilities at the head of the company between the running of the board and the executive responsibility for the running of the companys business. No one individual should have unfettered powers of decision. Code Provision
2.1 The roles of chairman and chief executive should not be exercised by the same individual. The division of responsibilities between the chairman and chief executive should be clearly established, set out in writing and agreed by the board.
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A.3 The Chairman

Main Principle: The chairman is responsible for leadership of the board and ensuring its effectiveness on all aspects of its role. Supporting Principle
The chairman is responsible for setting the boards agenda and ensuring that adequate time is available for discussion of all agenda items, in particular strategic issues. The chairman should also promote a culture of openness and debate by facilitating the effective contribution of non-executive directors in particular and ensuring constructive relations between executive and nonexecutive directors. The chairman is responsible for ensuring that the directors receive accurate, timely and clear information. The chairman should ensure effective communication with shareholders.
Code Provision
3.1 The chairman should on appointment meet the independence criteria set out in B.1.1 below. A chief executive should not go on to be chairman of the same company. If, exceptionally, a board decides that a chief executive should become chairman, the board should consult major shareholders in advance and should set out its reasons to shareholders at the time of the appointment and in the next annual report. (Compliance or otherwise with this provision need only be reported for the year in which the appointment is made).
A.4 Non-executive Directors
Main Principle: As part of their role as members of a unitary board, nonexecutive directors should constructively challenge and help develop proposals on strategy.
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Supporting Principle
Non-executive directors should scrutinise the performance of management in meeting agreed goals and objectives and monitor the reporting of performance. They should satisfy themselves on the integrity of financial information and that financial controls and systems of risk management are robust and defensible. They are responsible for determining appropriate levels of remuneration of executive directors and have a prime role in appointing and, where necessary, removing executive directors, and in succession planning.
Code Provisions
4.1 The board should appoint one of the independent non-executive directors to be the senior independent director to provide a sounding board for the chairman and to serve as an intermediary for the other directors when necessary. The senior independent director should be available to shareholders if they have concerns which contact through the normal channels of chairman, chief executive or other executive directors has failed to resolve or for which such contact is inappropriate. The chairman should hold meetings with the non-executive directors without the executives present. Led by the senior independent director, the non-
4.2
18
executive directors should meet without the chairman present at least annually to appraise the chairmans performance and on such other occasions as are deemed appropriate. 4.3 Where directors have concerns which cannot be resolved about the running of the company or a proposed action, they should ensure that their concerns are recorded in the board minutes. On resignation, a non- executive director should provide a written statement to the chairman, for circulation to the board, if they have any such concerns.
Section B: Effectiveness B.1 The Composition of the Board

Main Principle: The board and its committees should have the appropriate balance of skills, experience, independence and knowledge of the company to enable them to discharge their respective duties and responsibilities effectively. Supporting Principles
The board should be of sufficient size that the requirements of the business can be met and that changes to the boards composition and that of its committees can be managed without undue disruption, and should not be so large as to be unwieldy.
o sp The board should include an appropriate g o combination of executive and nonexecutive directors (and, in particular, independent non-executive directors) .bl 0 such that no individual or small group of individuals can dominate the boards 00 2 decision taking. ks The value of ensuring o bo that committee membership is refreshed and that undue reliance is e not placed on particular individuals should be taken into
account in deciding chairmanship and membership of committees. No one other than the committee chairman and members is entitled to be present at a meeting of the nomination, audit or remuneration committee, but others may attend at the invitation of the committee.
o t.c
Code Provisions
1.1 The board should identify in the annual report each non-executive director it considers to be independent. The board should determine whether the director is independent in character and judgement and whether there are relationships or circumstances which are likely to affect, or could appear to affect, the directors judgement. The board should state its reasons if it determines that a director is independent notwithstanding the existence of relationships or circumstances which may appear relevant to its determination, including if the director: has been an employee of the company or group within the last five years; has, or has had within the last three years, a material business relationship with the company either directly, or as a partner, shareholder, director or senior employee of a body that has such a relationship with the company;
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has received or receives additional remuneration from the company apart from a directors fee, participates in the companys share option or a performance-related pay scheme, or is a member of the companys pension scheme; has close family ties with any of the companys advisers, directors or senior employees; holds cross-directorships or has significant links with other directors through involvement in other companies or bodies; represents a significant shareholder; or has served on the board for more than nine years from the date of their first election.
1.2
Except for smaller companies (i.e. those below the FTSE 350 throughout the year immediately prior to the reporting year), at least half the board, excluding the chairman, should comprise non-executive directors determined by the board to be independent. A smaller company should have at least two independent non-executive directors.
B.2 Appointments to the Board

Main Principle: There should be a formal, rigorous and transparent procedure for the appointment of new directors to the board. Supporting Principles
The search for board candidates should be conducted, and appointments made, on merit, against objective criteria and with due regard for the benefits of diversity on the board, including gender. The board should satisfy itself that plans are in place for orderly succession for appointments to the board and to senior management, so as to maintain an appropriate balance of skills and experience within the company and on the board and to ensure progressive refreshing of the board.
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Code Provisions
2.1 There should be a nomination committee which should lead the process for board appointments and make recommendations to the board. A majority of members of the nomination committee should be independent non-executive directors. The chairman or an independent non-executive director should chair the committee, but the chairman should not chair the nomination committee when it is dealing with the appointment of a successor to the chairmanship. The nomination committee should make available its terms of reference, explaining its role and the authority delegated to it by the board. (This requirement would be met by including the information on the company website). The nomination committee should evaluate the balance of skills, experience, independence and knowledge on the board and, in the light of this evaluation, prepare a description of the role and capabilities required for a particular appointment. Non-executive directors should be appointed for specified terms subject to reelection and to statutory provisions relating to the removal of a director. Any term beyond six years for a non-executive director should be subject to
2.2
2.3
20
particularly rigorous review, and should take into account the need for progressive refreshing of the board. 2.4 A separate section of the annual report should describe the work of the nomination committee, including the process it has used in relation to board appointments. An explanation should be given if neither an external search consultancy nor open advertising has been used in the appointment of a chairman or a non-executive director.
B.3 Commitment
Main Principle: All directors should be able to allocate sufficient time to the company to discharge their responsibilities effectively. Code Provisions
3.1 For the appointment of a chairman, the nomination committee should prepare a job specification, including an assessment of the time commitment expected, recognising the need for availability in the event of crises. A chairmans other significant commitments should be disclosed to the board before appointment and included in the annual report. Changes to such commitments should be reported to the board as they arise, and their impact explained in the next annual report.
3.2
3.3
m co directors should be The terms and conditions of appointment of non-executive t. made available for inspection (at the companys registered office and at the po s AGM). The letter of appointment should set out the expected time log undertake that they will have commitment. Non-executive directors should 0.b sufficient time to meet what is0expected of them. Their other significant 0 commitments should be disclosed to the board before appointment, with a s2involved and the board should be informed of broad indication of the ok time subsequent changes. o eb agree to a full time executive director taking on more The board should not
than one non-executive directorship in a FTSE 100 company nor the chairmanship of such a company.
B.4 Development
Main Principle: All directors should receive induction on joining the board and should regularly update and refresh their skills and knowledge. Supporting Principles
The chairman should ensure that the directors continually update their skills and the knowledge and familiarity with the company required to fulfil their role both on the board and on board committees. The company should provide the necessary resources for developing and updating its directors knowledge and capabilities. To function effectively, all directors need appropriate knowledge of the company and access to its operations and staff.
21
Code Provisions
4.1 The chairman should ensure that new directors receive a full, formal and tailored induction on joining the board. As part of this, directors should avail themselves of opportunities to meet major shareholders. The chairman should regularly review and agree with each director their training and development needs.
4.2
B.5 Information and Support

Main Principle: The board should be supplied in a timely manner with information in a form and of a quality appropriate to enable it to discharge its duties. Supporting Principles
The chairman is responsible for ensuring that the directors receive accurate, timely and clear information. Management has an obligation to provide such information but directors should seek clarification or amplification where necessary. Under the direction of the chairman, the company secretarys responsibilities include ensuring good information flows within the board and its committees and between senior management and non-executive directors, as well as facilitating induction and assisting with professional development as required. The company secretary should be responsible for advising the board through the chairman on all governance matters.
Code Provisions
5.1
The board should ensure that directors, especially non-executive directors, have access to independent professional advice at the companys expense where they judge it necessary to discharge their responsibilities as directors. Committees should be provided with sufficient resources to undertake their duties.
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5.2
All directors should have access to the advice and services of the company secretary, who is responsible to the board for ensuring that board procedures are complied with. Both the appointment and removal of the company secretary should be a matter for the board as a whole.
B.6 Evaluation
Main Principle: The board should undertake a formal and rigorous annual evaluation of its own performance and that of its committees and individual directors. Supporting Principles
The chairman should act on the results of the performance evaluation by recognising the strengths and addressing the weaknesses of the board and, where appropriate, proposing new members be appointed to the board or seeking the resignation of directors. Individual evaluation should aim to show whether each director continues to contribute effectively and to demonstrate commitment to the role (including commitment of time for board and committee meetings and any other duties).
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Code Provisions
6.1 6.2 The board should state in the annual report how performance evaluation of the board, its committees and its individual directors has been conducted. Evaluation of the board of FTSE 350 companies should be externally facilitated at least every three years. A statement should be made available of whether an external facilitator has any other connection with the company. (This requirement would be met by including the information on the company website). The non-executive directors, led by the senior independent director, should be responsible for performance evaluation of the chairman, taking into account the views of executive directors.
6.3
B.7 Re-election
Main Principle: All directors should be submitted for re-election at regular intervals, subject to continued satisfactory performance. Code Provisions
7.1 All directors of FTSE 350 companies should be subject to annual election by shareholders. All other directors should be subject to election by shareholders at the first annual general meeting (AGM) after their appointment, and to reelection thereafter at intervals of no more than three years. Non-executive directors who have served longer than nine years should be subject to annual re-election. The names of directors submitted for election or re-election should be accompanied by sufficient biographical details and any other relevant information to enable shareholders to take an informed decision on their election. The board should set out to shareholders in the papers accompanying a resolution to elect a non-executive director why they believe an individual should be elected. The chairman should confirm to shareholders when proposing re-election that, following formal performance evaluation, the individuals performance continues to be effective and to demonstrate commitment to the role.
7.2
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Section C: Accountability C.1 Financial and Business Reporting

Main Principle: The board should present a balanced and understandable assessment of the companys position and prospects. Supporting Principle
The boards responsibility to present a balanced and understandable assessment extends to interim and other price-sensitive public reports and reports to regulators as well as to information required to be presented by statutory requirements.
Code Provisions
1.1 The directors should explain in the annual report their responsibility for preparing the annual report and accounts, and there should be a statement by the auditor about their reporting responsibilities.
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1.2
The directors should include in the annual report an explanation of the basis on which the company generates or preserves value over the longer term (the business model) and the strategy for delivering the objectives of the company (This explanation would ideally be located within the Business Review required by CA 2006). The directors should report in annual and half-yearly financial statements that the business is a going concern, with supporting assumptions or qualifications as necessary.
1.3
C.2 Risk Management and Internal Control

(The Turnbull Guidance, last updated in October 2005, suggests means of applying this part of the Code)
Main Principle: The board is responsible for determining the nature and extent of the significant risks it is willing to take in achieving its strategic objectives. The board should maintain sound risk management and internal control systems. Code provision
2.1 The board should, at least annually, conduct a review of the effectiveness of the companys risk management and internal control systems and should report to shareholders that they have done so. The review should cover all material controls, including financial, operational and compliance controls.
C.3 Audit Committee and Auditors
(The FRC Guidance on Audit Committees - formerly referred to as the Smith Guidance - suggests means of applying this part of the Code)
Main Principle: The board should establish formal and transparent arrangements for considering how they should apply the corporate reporting and risk management and internal control principles and for maintaining an appropriate relationship with the companys auditor.
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Code provisions
3.1 The board should establish an audit committee of at least three, or in the case of smaller companies (i.e. those below the FTSE 350 throughout the year immediately prior to the reporting year) two, independent non-executive directors. In smaller companies the company chairman may be a member of, but not chair, the committee in addition to the independent non-executive directors, provided he or she was considered independent on appointment as chairman. The board should satisfy itself that at least one member of the audit committee has recent and relevant financial experience. The main role and responsibilities of the audit committee should be set out in written terms of reference and should include: to monitor the integrity of the financial statements of the company and any formal announcements relating to the companys financial performance, reviewing significant financial reporting judgements contained in them; to review the companys internal financial controls and, unless expressly addressed by a separate board risk committee composed of independent
3.2
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directors, or by the board itself, to review the companys internal control and risk management systems; to monitor and review the effectiveness of the companys internal audit function; to make recommendations to the board, for it to put to the shareholders for their approval in general meeting, in relation to the appointment, reappointment and removal of the external auditor and to approve the remuneration and terms of engagement of the external auditor; to review and monitor the external auditors independence and objectivity and the effectiveness of the audit process, taking into consideration relevant UK professional and regulatory requirements; to develop and implement policy on the engagement of the external auditor to supply non-audit services, taking into account relevant ethical guidance regarding the provision of non-audit services by the external audit firm, and to report to the board, identifying any matters in respect of which it considers that action or improvement is needed and making recommendations as to the steps to be taken.
3.3
The terms of reference of the audit committee, including its role and the authority delegated to it by the board, should be made available (e.g. by including the information on the company website). A separate section of the annual report should describe the work of the committee in discharging those responsibilities. The audit committee should review arrangements by which staff of the company may, in confidence, raise concerns about possible improprieties in matters of financial reporting or other matters. The audit committees objective should be to ensure that arrangements are in place for the proportionate and independent investigation of such matters and for appropriate follow-up action.
3.4
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3.5
The audit committee should monitor and review the effectiveness of the internal audit activities. Where there is no internal audit function, the audit committee should consider annually whether there is a need for an internal audit function and make a recommendation to the board, and the reasons for the absence of such a function should be explained in the relevant section of the annual report. The audit committee should have primary responsibility for making a recommendation on the appointment, re-appointment and removal of the external auditor. If the board does not accept the audit committees recommendation, it should include in the annual report, and in any papers recommending appointment or re-appointment, a statement from the audit committee explaining the recommendation and should set out reasons why the board has taken a different position. The annual report should explain to shareholders how, if the auditor provides non-audit services, auditor objectivity and independence is safeguarded.
3.6
3.7
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Section D: Remuneration D.1 The Level and Components of Remuneration

Main Principle: Levels of remuneration should be sufficient to attract, retain and motivate directors of the quality required to run the company successfully, but a company should avoid paying more than is necessary for this purpose. A significant proportion of executive directors remuneration should be structured so as to link rewards to corporate and individual performance. Supporting Principle
The performance-related elements of executive directors remuneration should be stretching and designed to promote the long-term success of the company. The remuneration committee should judge where to position their company relative to other companies. But they should use such comparisons with caution, in view of the risk of an upward ratchet of remuneration levels with no corresponding improvement in performance. They should also be sensitive to pay and employment conditions elsewhere in the group, especially when determining annual salary increases.
Code Provisions
1.1
1.2
0 20 Where a company releasess executive director to serve as a non-executive an director elsewhere, the k o remuneration report (required by UK legislation) o should include a statement as to whether or not the director will retain such eb
earnings and, if so, what the remuneration is. Levels of remuneration for non-executive directors should reflect the time commitment and responsibilities of the role. Remuneration for non-executive directors should not include share options or other performance- related elements. If, exceptionally, options are granted, shareholder approval should be sought in advance and any shares acquired by exercise of the options should be held until at least one year after the non-executive director leaves the board. Holding of share options could be relevant to the determination of a non-executive directors independence (as set out in provision B.1.1). The remuneration committee should carefully consider what compensation commitments (including pension contributions and all other elements) their directors terms of appointment would entail in the event of early termination. The aim should be to avoid rewarding poor performance. They should take a robust line on reducing compensation to reflect departing directors obligations to mitigate loss. Notice or contract periods should be set at one year or less. If it is necessary to offer longer notice or contract periods to new directors recruited from outside, such periods should reduce to one year or less after the initial period.
In designing schemes of performance-related remuneration for executive directors, the remuneration committee should follow the provisions in Schedule A to this Code.
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1.3
1.4
1.5
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D.2 Procedure
Main Principle: There should be a formal and transparent procedure for developing policy on executive remuneration and for fixing the remuneration packages of individual directors. No director should be involved in deciding his or her own remuneration. Supporting Principles
The remuneration committee should consult the chairman and/or chief executive about their proposals relating to the remuneration of other executive directors. The remuneration committee should also be responsible for appointing any consultants in respect of executive director remuneration. Where executive directors or senior management are involved in advising or supporting the remuneration committee, care should be taken to recognise and avoid conflicts of interest. The chairman of the board should ensure that the company maintains contact as required with its principal shareholders about remuneration.
Code Provisions
2.1 The board should establish a remuneration committee of at least three, or in the case of smaller companies two, independent non-executive directors. In addition the company chairman may also be a member of, but not chair, the committee if he or she was considered independent on appointment as chairman. The remuneration committee should make available its terms of reference, explaining its role and the authority delegated to it by the board. Where remuneration consultants are appointed, a statement should be made available of whether they have any other connection with the company (This requirement would be met by including the information on the company website).
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2.2
The remuneration committee should have delegated responsibility for setting remuneration for all executive directors and the chairman, including pension rights and any compensation payments. The committee should also recommend and monitor the level and structure of remuneration for senior management. The definition of senior management for this purpose should be determined by the board but should normally include the first layer of management below board level. The board itself or, where required by the Articles of Association, the shareholders should determine the remuneration of the non-executive directors within the limits set in the Articles of Association. Where permitted by the Articles, the board may however delegate this responsibility to a committee, which might include the chief executive. Shareholders should be invited specifically to approve all new long-term incentive schemes (as defined in the Listing Rules) and significant changes to existing schemes, save in the circumstances permitted by the Listing Rules.
2.3
2.4
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Section E: Relations with shareholders E.1 Dialogue with Shareholders

Main Principle: There should be a dialogue with shareholders based on the mutual understanding of objectives. The board as a whole has responsibility for ensuring that a satisfactory dialogue with shareholders takes place. Supporting Principles
Whilst recognising that most shareholder contact is with the chief executive and finance director, the chairman should ensure that all directors are made aware of their major shareholders issues and concerns. The board should keep in touch with shareholder opinion in whatever ways are most practical and efficient.
Code Provisions
1.1 The chairman should ensure that the views of shareholders are communicated to the board as a whole. The chairman should discuss governance and strategy with major shareholders. Non-executive directors should be offered the opportunity to attend scheduled meetings with major shareholders and should expect to attend meetings if requested by major shareholders. The senior independent director should attend sufficient meetings with a range of major shareholders to listen to their views in order to help develop a balanced understanding of the issues and concerns of major shareholders.
1.2
0 20annual report the steps they have taken to The board should state in s the ensure that the memberskof the board, and, in particular, the non-executive o directors, develop an o ebunderstanding of the views of major shareholders about the company, for example through direct face-to-face contact, analysts or
brokers briefings and surveys of shareholder opinion.
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E.2 Constructive Use of the AGM

Main Principle: The board should use the AGM to communicate with investors and to encourage their participation. Code Provisions
2.1 At any general meeting, the company should propose a separate resolution on each substantially separate issue, and should, in particular, propose a resolution at the AGM relating to the report and accounts. For each resolution, proxy appointment forms should provide shareholders with the option to direct their proxy to vote either for or against the resolution or to withhold their vote. The proxy form and any announcement of the results of a vote should make it clear that a vote withheld is not a vote in law and will not be counted in the calculation of the proportion of the votes for and against the resolution. The company should ensure that all valid proxy appointments received for general meetings are properly recorded and counted. For each resolution, where a vote has been taken on a show of hands, the company should ensure that the following information is given at the meeting and made available as
2.2
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soon as reasonably practicable on a website which is maintained by or on behalf of the company: 2.3 the number of shares in respect of which proxy appointments have been validly made; the number of votes for the resolution; the number of votes against the resolution; and the number of shares in respect of which the vote was directed to be withheld.
The chairman should arrange for the chairmen of the audit, remuneration and nomination committees to be available to answer questions at the AGM and for all directors to attend. The company should arrange for the Notice of the AGM and related papers to be sent to shareholders at least 20 working days before the meeting.
2.4
Schedule A:
The design of performance-related remuneration for executive directors
The remuneration committee should consider whether the directors should be eligible for annual bonuses. If so, performance conditions should be relevant, stretching and designed to promote the long-term success of the company. Upper limits should be set and disclosed. There may be a case for part payment in shares to be held for a significant period. The remuneration committee should consider whether the directors should be eligible for benefits under long-term incentive schemes. Traditional share option schemes should be weighed against other kinds of long-term incentive scheme. Executive share options should not be offered at a discount save as permitted by the relevant provisions of the Listing Rules.
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In normal circumstances, shares granted or other forms of deferred remuneration should not vest, and options should not be exercisable, in less than three years. Directors should be encouraged to hold their shares for a further period after vesting or exercise, subject to the need to finance any costs of acquisition and associated tax liabilities. Any new long-term incentive schemes which are proposed should be approved by shareholders and should preferably replace any existing schemes or, at least, form part of a well considered overall plan incorporating existing schemes. The total potentially available rewards should not be excessive. Payouts or grants under all incentive schemes, including new grants under existing share option schemes, should be subject to challenging performance criteria reflecting the companys objectives, including non-financial performance metrics where appropriate. Remuneration incentives should be compatible with risk policies and systems. Grants under executive share option and other long-term incentive schemes should normally be phased rather than awarded in one large block. Consideration should be given to the use of provisions that permit the company to reclaim variable components in exceptional circumstances of misstatement or misconduct. In general, only basic salary should be pensionable. The remuneration committee should consider the pension consequences and associated costs to the company of
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basic salary increases and any other changes in pensionable remuneration, especially for directors close to retirement.
Schedule B:
Disclosure of corporate governance arrangements
Corporate governance disclosure requirements are set out in three places: FSA Disclosure and Transparency Rules, which set out certain mandatory disclosures; FSA Listing Rules, which include the comply or explain requirement; and The UK Corporate Governance Code (in addition to providing an explanation where they choose not to comply with a provision, companies must disclose specified information in order to comply with certain provisions).
These requirements are summarised below. There is some overlap between the mandatory disclosures required under the Disclosure and Transparency Rules and those expected under the UK Corporate Governance Code. Areas of overlap are summarised in the Appendix to this Schedule. In respect of disclosures relating to the audit committee and the composition and operation of the board and its committees, compliance with the relevant provisions of the Code will result in compliance with the relevant Rules.
o sp audit committees or bodies The Disclosure and Transparency Rules (DTR) g o concern carrying out equivalent functions. .bl 0 00 DTR set out requirements relating to the composition and functions of the 2 committee or equivalent body: ks o An issuer must have a body which is responsible for performing the functions bo e set out below, and at least one member of that body must be independent
Disclosure and Transparency Rules
and at least one member must have competence in accounting and/or auditing. The requirements for independence and competence in accounting and/or auditing may be satisfied by the same member or by different members of the relevant body. An issuer must ensure that, as a minimum, the relevant body must: (1) (2) (3) (4) monitor the financial reporting process; monitor the effectiveness of the issuers internal control, internal audit where applicable, and risk management systems; monitor the statutory audit of the annual and consolidated accounts; review and monitor the independence of the statutory auditor, and in particular the provision of additional services to the issuer.
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The following disclosures are required: The issuer must make a statement available to the public disclosing which body carries out the above functions and how it is composed. This can be included in the corporate governance statement as described below.
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Compliance with the relevant provisions of the UK Corporate Governance Code (as set out in the Appendix to this Schedule) will result in compliance with much of the DTR. Issuers are required to produce a corporate governance statement that must be either included in the directors report; or in a separate report published together with the annual report; or on the issuers website, in which case there must be a cross-reference in the directors report. DTR requires that the corporate governance statements must contain a reference to the corporate governance code to which the company is subject (for companies with a Premium listing this is the UK Corporate Governance Code). DTR requires that, to the extent that it departs from that code, the company must explain which parts of the code it departs from and the reasons for doing so. Compliance with the comply or explain rule will also satisfy these requirements. DTR sets out certain information that must be disclosed in the corporate governance statement i.e. the statement must contain:
A description of the main features of the companys internal control and risk management systems in relation to the financial reporting process. DTR states that an issuer which is required to prepare a group directors report must include in that report a description of the main features of the groups internal control and risk management systems in relation to the process for preparing consolidated accounts. The information required by SI 2008 No. 410 [The Large and Medium-sized Companies and Groups (Accounts and Reports) Regulations 2008], where the issuer is subject to its requirements. A description of the composition and operation of the issuers administrative, management and supervisory bodies and their committees. Compliance with the provisions of the UK Corporate Governance Code (as set out in the Appendix to this Schedule) will satisfy the requirements of DTR.
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Listing Rules
The Listing Rules state that in the case of a company that has a Premium listing of equity shares, the following items must be included in its annual report and accounts: a statement of how the listed company has applied the Main Principles set out in the UK Corporate Governance Code, in a manner that would enable shareholders to evaluate how the principles have been applied; a statement as to whether the listed company has:
complied throughout the accounting period with all relevant provisions set out in the UK Corporate Governance Code; or not complied throughout the accounting period with all relevant provisions set out in the UK Corporate Governance Code, and if so, setting out: (i) those provisions, if any, it has not complied with;
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(ii)
in the case of provisions whose requirements are of a continuing nature, the period within which, if any, it did not comply with some or all of those provisions; and the companys reasons for non-compliance.
(iii)
The UK Corporate Governance Code

In addition to the comply or explain requirement in the Listing Rules, the Code includes specific requirements for disclosure which must be provided in order to comply. The annual report should include: a statement of how the board operates, including a high level statement of which types of decisions are to be taken by the board and which are to be delegated to management; the names of the chairman, the deputy chairman (where there is one), the chief executive, the senior independent director and the chairmen and members of the board committees; the number of meetings of the board and those committees and individual attendance by directors; where a chief executive is appointed chairman, the reasons for their appointment (this only needs to be done in the annual report following the appointment); the names of the non-executive directors whom the board determines to be independent, with reasons where necessary;
0 20 work of the nomination committee, including a separate section describing the s the process it has used okrelation to board appointments and an explanation in o if neither external search consultancy nor open advertising has been used in eb
the appointment of a chairman or a non-executive director; any changes to the other significant commitments of the chairman during the year; a statement of how performance evaluation of the board, its committees and its directors has been conducted; an explanation from the directors of their responsibility for preparing the accounts and a statement by the auditors about their reporting responsibilities; an explanation from the directors of the basis on which the company generates or preserves value over the longer term (the business model) and the strategy for delivering the objectives of the company; a statement from the directors that the business is a going concern, with supporting assumptions or qualifications as necessary; a report that the board has conducted a review of the effectiveness of the companys risk management and internal control systems; a separate section describing the work of the audit committee in discharging its responsibilities; where there is no internal audit function, the reasons for the absence of such a function;
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where the board does not accept the audit committees recommendation on the appointment, re-appointment or removal of an external auditor, a statement from the audit committee explaining the recommendation and the reasons why the board has taken a different position; an explanation of how, if the auditor provides non-audit services, auditor objectively and independence is safeguarded; a description of the work of the remuneration committee as required under the Large and Medium-Sized Companies and Groups (Accounts and Reports) Regulations 2008 including, where an executive director serves as a nonexecutive director elsewhere, whether or not the director will retain such earnings and, if so, what the remuneration is; the steps the board has taken to ensure that members of the board, in particular the non-executive directors, develop an understanding of the views of major shareholders about their company.
The following information should be made available (which may be met by placing the information on a website that is maintained by or on behalf of the company): the terms of reference of the nomination, audit and remuneration committees, explaining their role and the authority delegated to them by the board; the terms and conditions of appointment of non-executive directors;
om cfacilitated, a statement of t. where performance evaluation has been externally powith the company; and whether the facilitator has any other connection s log a statement of whether they where remuneration consultants are b appointed, 0. have any other connection with the company. 0 20 in the papers accompanying a resolution The board should set out to shareholders ks to elect or re-elect directors: o o eb sufficient biographical details to enable shareholders to take an informed
decision on their election or re-election; why they believe an individual should be elected to a non-executive role; and on re-election of a non-executive director, confirmation from the chairman that, following formal performance evaluation, the individuals performance continues to be effective and to demonstrate commitment to the role.
The board should set out to shareholders in the papers recommending appointment or reappointment of an external auditor: if the board does not accept the audit committees recommendation, a statement from the audit committee explaining the recommendation and from the board setting out reasons why they have taken a different position.
Additional guidance
The Turnbull Guidance and FRC Guidance on Audit Committees contain further suggestions as to information that might usefully be disclosed in the internal control statement and the report of the audit committee respectively.
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Appendix: Overlap between the disclosure and transparency rules and the UK Corporate Governance Code
DISCLOSURE AND TRANSPARENCY RULES UK CORPORATE GOVERNANCE CODE
Provision C.3.1
Sets out minimum requirements on composition of the audit committee or equivalent body. Sets out recommended composition of the audit committee.
Provision C.3.2
Sets out minimum functions of the audit committee or equivalent body. Sets out the recommended minimum terms of reference for the audit committee.
Provision A.1.2
The composition and function of the audit committee or equivalent body must be disclosed in the annual report. The annual report should identify members of the board committees.
eb
s ok
00
o sp C.3.3 Provision log The 0.b annual report
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should describe the work of the audit committee. Further recommendations on the content of the audit committee report are set out in the FRC Guidance on Audit Committees.
Provision C.2.1
The corporate governance statement must include a description of the main features of the companys internal control and risk management systems in relation to the financial reporting process. The Board must report that a review of the effectiveness of the risk management and internal control systems has been carried out. Further recommendations on the content of the internal control statement are set out in the Turnbull Guidance.
The corporate governance statement must include a description of the composition and operation of the administrative, management and supervisory bodies and their committees.
This requirement overlaps with a number of different provisions of the Code:
A.1.1: the annual report should include a statement of how the board operates. A.1.2: the annual report should identify members of the board and board committees.
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B.2.4: the annual report should describe the work of the nomination committee. C.3.3: the annual describe the work committee.
report should of the audit
D.2.1: a description of the work of the remuneration committee should be made available. [Note: in order to comply with DTR this information will need to be included in the corporate governance statement].
Schedule C:
Engagement principles for institutional shareholders
This schedule has been superseded by the Stewardship Code for institutional investors.
Principle 1: Dialogue with companies
Main Principle: Institutional shareholders should enter into a dialogue with companies based on the mutual understanding of objectives.
0 20 companies governance arrangements, s Main Principle: When evaluating okboard structure and composition, institutional particularly those relating to o eb shareholders should give due weight to all relevant factors drawn to their
Principle 2: Evaluation of Governance Disclosures attention. Principle 3: Shareholder Voting Main Principle: Institutional shareholders have a responsibility to make considered use of their votes.
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INTERNATIONAL GOVERNANCE
COMPARISONS
OF
CORPORATE
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.
United States of America

Whereas the UK has historically relied upon a system of self-regulation and voluntary codes of best practice, the USA corporate governance structure is more formalised, with legally enforceable controls. In the US, statutory requirements for publicly-traded companies are set out in the Sarbanes-Oxley Act. 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. The Act also requires the Securities and Exchange Commission (SEC) and the main stock exchanges to introduce further rules, relating to matters such as the disclosure of critical accounting policies, the composition of the Board and the number of independent directors. The Act has also established an independent body to oversee the accounting profession, which is known as the Public Company Accounting Oversight Board. Managers must be careful to comply with regulations to avoid possible legal action against the company or themselves individually.
Germany
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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 of non-executives (Aufsichtsrat) has responsibility for corporate policy and strategy and the Management Board of executive directors (Vorstand) has responsibility primarily for the day-to-day operations of the company. 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). The Supervisory Board does not have full access to financial information, is meant to take an unbiased overview of the company, and is the main body responsible for safeguarding the external stakeholders interests. The presence on the Supervisory Board of representatives from banks and employees (trade unions) may introduce perspectives that are not present in some UK boards. In particular, many members of the Supervisory Board would not meet the criteria under UK Corporate Governance Code for their independence.
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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 others Board of Directors. There are often three boards of directors: Policy Boards, responsible for strategy and comprised of directors with no functional responsibility; Functional Boards, responsible for day to day operations; and largely symbolic Monocratic Boards. The interests of the company as a whole should dictate the actions of these boards. This is in contrast to the UK or USA systems where, at least in theory, the board should act primarily in the best interests of the shareholders, being the owners of the company.
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Chapter 2
Advanced investment appraisal section 1

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C H A P T E R 2 A D V A N C E D I N V E S T M E N T A P P R A IS A L : S E C T I O N 1
CHAPTER CONTENTS
INVESTMENT APPRAISAL TECHNIQUES ------------------------------- 41
1. 2. 3. ACCOUNTING RATE OF RETURN PAYBACK PERIOD DISCOUNTED CASH FLOW 41 42 42
CONGO LTD --------------------------------------------------------------- 44 INFLATION AND DISCOUNTED CASH FLOW -------------------------- 48

MONEY CASH FLOWS REAL CASH FLOWS RELATIONSHIP BETWEEN MONEY INTEREST RATES AND REAL INTEREST RATES 48 48 48
TAXATION AND INVESTMENT APPRAISAL ---------------------------- 50 CAPITAL RATIONING ---------------------------------------------------- 52

WHAT ARE THE 2 TYPES OF CAPITAL RATIONING? CAPITAL RATIONING AND TIME SINGLE PERIOD CAPITAL RATIONING MULTI-PERIOD CAPITAL RATIONING
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52 52 53 56
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INVESTMENT APPRAISAL TECHNIQUES

Assumed objective is
Selection of those projects which will maximise the wealth of the owners (or shareholders) of the enterprise. Involves a consideration of FUTURE events, not PAST performance.
Accepted techniques are

1. 2. 3. Accounting Rate of Return (alternatively called Return on Investment) Payback Period Discounted Cash Flow, of which there are two major variants: (a) (b) Net Present Value Internal Rate of Return (alternatively called Yield)
1. Accounting rate of return

The ARR (or ROI) is a measure of relative project profitability, which expresses: 1. The expected average annual profit (after allowing for depreciation, but before taxation) emerging from a project,
AS A PERCENTAGE OF 2.
The investment involved. Normally the average investment over the life of the project is used, but initial investment is sometimes employed.
Advantages

k oo It is relatively easy to understand eb

The required figures are readily available from accounting data. The ROI technique is frequently used as an assessment of managements actual (hindsight) performance. It gives an indication as to whether available projects are meeting target returns on capital employed.
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Disadvantages
Based on accounting profits not cash flows - the success of an enterprise depends on its ability to generate cash. The ability to invest depends on availability of cash. Ignores the time value of money It is relative rate of return, thus ignores the size of the project No set rules (theoretical or practical) for determining the cut-off rate of return.
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2. Payback period
The Payback Period demonstrates how long an enterprise must expect to wait before the after-tax cash flows generated by the project allow it to recoup the initial amount invested. Thus it gives an investor an idea of how long their money will be at risk; a short payback period is taken to reveal low risk, and a long payback high risk.
Advantages
The most tried and tested of all methods Easy to calculate and understand An enterprise with limited cash resources is obviously concerned with speed of return. Some companies combine DCF techniques with the payback method.
Disadvantages
Does not measure profitability nor increases in shareholders wealth, since it ignores cash flows expected to arise beyond the payback period. Ignores the time value of money (but discounted payback sometimes used). No set rules (theoretical or practical) for determining the minimum acceptable payback period. May be difficult to measure the initial amount invested when e.g. net outlays arise in both the initial and final years of a project.
3. Discounted cash boo flow
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DCF is a method of capital investment appraisal which takes account of: 1. 2. The overall cash flows arising from projects, and The timing of those cash flows.
Only relevant cash flows are considered (i.e. those future cash flows which arise as a result of those projects) and the timing effect is incorporated by means of the discounting technique. Both the Accounting Rate of Return and the Payback approaches are surpassed by the DCF methods. The basic arguments are: it is better to consider cash rather than profits because cash is how investors will eventually see their rewards (i.e. dividends, interest, or the proceeds from the sale of the shares or debentures). the timing of the cash flows is important because early cash receipts can be reinvested to earn interest. it is important to consider the cash flows arising over the project. entire life of a
The technique of discounting reduces all future cash flows to current equivalent values (present values) by allowing for the interest which could have been earned if the cash had been received immediately. There are two common techniques, net present value and internal rate of return, but net terminal value can be used.
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DCF Net present value

The NPV of a project is the net value of a projects cash flows after discounting (i.e. allowing for reinvestment) at the companys cost of capital. Projects with a negative NPV should be rejected. N.B. Cost of capital is the average required return which is set by the market for the company in view of the risk associated with its operations. Provided that: 1. 2. The project under consideration is of average risk for the company, and There is no restriction on access to capital,
a positive NPV provides the best theoretical estimate of the total absolute increase in wealth which accrues to an enterprise as a result of accepting that project. However in the short run the use of the NPV rule may not lead to good profits being reported in the published accounts of the enterprise although in the long term cash flows and reported profits should move in tandem. The NPV rule has a sound theoretical basis and is likely to produce investment decision advice of consistently good quality.
m co DCF Internal rate of return (economic return/yield) t. po rate which when applied The IRR (or Economic return) of a project is thats discount log to a projects cash flows provides an NPV of zero. The IRR is therefore the expected b earning rate of an investment. If the 0. of a project exceeds the cost of capital 0 IRR of that enterprise, that project is acceptable. 0 s2in isolation IRR will give the same decision as k When considering a single project oo is positive, its IRR will exceed the cost of capital). NPV (i.e. if the NPV of a project eb However, when choosing between mutually exclusive projects, the two techniques
may conflict and (subject to the provisos set out above) NPV always provides the correct solution.
Disadvantages of IRR
1. IRR provides a relative (as opposed to an absolute) result, and may give incorrect decision advice if mutually exclusive projects:
o o
2. 3. 4.
Are of different size, or Have unequal lives.
May be multiple IRRs or no IRR Cannot adapt to expected changes in cost of capital during the life of a project. Makes an inconsistent assumption about the rate at which cash surpluses can be reinvested; it assumes they are reinvested at whatever the IRR happens to be. The companys cost of capital is a more appropriate reinvestment rate i.e. the assumption underlying NPV. More difficult to calculate than the theoretically more sound NPV approach.
5.
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Congo Ltd
Congo Ltd is considering the selection of one of a pair of mutually exclusive investment projects. Both would involve purchase of machinery with a life of five years Project 1 would generate annual cash flows (receipts less payments) of 200,000; the machinery would cost 556,000 and have a scrap value of 56,000. Project 2 would generate annual cash flows of 500,000; the machinery would cost 1,616,000 and have a scrap value of 301,000. Congo uses the straight-line method for providing depreciation. Its cost of capital is 15 per on the anniversaries of the the project lives and that required amount of working cent per annum. Assume that annual cash flows arise initial outlay, that there will be no price changes over acceptance of one of the projects will not alter the capital.
Requirements
(i) Calculate for each project (a) the accounting rate of return (i.e. the percentage of the average accounting profit to the average book value of investment) to the nearest 1%. the net present value
(b) (c) (d)
the internal rate of return (Yield or Economic return) to the nearest 1%, and the payback period to one decimal place.
Ignore taxation. (ii)
WITHOUT ANY REFERENCE TO THE INCREMENTAL YIELD METHOD, briefly explain which one of the discounted cash flow techniques used in part (i) of this question should be used by the management of Congo Ltd, in deciding whether Project 1 or Project 2 should be undertaken.
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Suggested solution to Congo Ltd

(i) Summary of results
Project a) b) c) d) Accounting rate of return Net present value (000) Internal rate of return (Economic return) Payback period (years) 1 33% 142 25% 2.8 or 3 2 25% 210 20% 3.2 or 4
Summary of rankings Better project a) b) c) d) Accounting rate of return Net present value Internal rate of return Payback period 1
WORKINGS
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(a)
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2 1 1
Project 1 000 556 (56) 500 100 200 (100) 100 Project 1 000
Project 2 000 1,616 (301) 1,315 263 500 (263) 237 Project 2 000
Accounting rate of return Initial investment Scrap value Total depreciation Annual depreciation Cash flows Depreciation (see above) Average accounting profit
Average book value of investment (000) (556 + 56) (1,616 + 301) Accounting rate of return
306 33% 958 25%
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(b) Year 0 15
Net present value 000 Initial outlay Cash flows 200 x 3.352 500 x 3.352 Residual value 56 x 0.497 301 x 0.497 Net present value (000) Internal rate of return (Economic return) 000 000 (556) 670 1,676 28 ___ 142 000 (1,616)
150 210
(c)
By trial and error Try 20% Initial outlays Cash flows Residual values NPV (000) Try 25% Initial outlays Cash flows Residual values NPV (000) IRR (d) Payback period
(556) 598 _22 64
(1,616) 1,495 _121 NIL
Annual cash flows Initial investment
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538 __18 NIL 25%
(1,616) 1,345 __99 (172) 20%
000 200 556
000 500 1,616
Payback period in years If cash flows arose during each year If cash flows arose at year end (as in this question) 2.8 3 3.2 4
(ii)
Investment Decision
This example illustrates the conflict which will often be found between the two discounted cash flow appraisal techniques in a ranking decision. Under the net present value criterion, project 2 is preferred because it has a higher net present value when the project cash flows are discounted at the cost of capital. On the other hand project 1 has the higher internal rate of return. To decide which method of ranking is correct it is necessary to consider the assumed objective of the firm, which is to maximise the wealth of the providers of finance. Both projects earn more than the required rate of return but project 2 generates larger cash surpluses in excess of the required amounts than project 1, as can be seen from the net present value
46
calculations. It is these cash surpluses which improve the wealth of the owners of the firm. IRR provides a relative (as opposed to an absolute) result, and may give incorrect decision advice if mutually exclusive projects are of different size (as in this instance) or have unequal lives. IRR makes an inconsistent assumption about the rate at which cash surpluses can be reinvested; it assumes they are reinvested at whatever the IRR happens to be. The companys cost of capital is a more appropriate reinvestment rate i.e. the assumption underlying NPV. Accordingly PROJECT 2 IS PREFERRED TO PROJECT 1 and this can be justified by the following argument: Project 1 is relatively more profitable than project 2, but it is smaller. The two projects are mutually exclusive, which means that only one of them can be accepted. It is better for the owners of the company to receive the large cash surpluses from a large adequately profitable project than to receive the smaller cash surpluses from a small very profitable project. Taken to extremes, a return of ten per cent on 1,000 is better than a return of one thousand per cent on a penny.
m co . This question examines the conflicting rankings t posometimes given by the NPV and IRR technique. You may wish to add a graph to amplify your solution to s part (c). log .b 00 0 s2 k oo eb
Tutorial Note
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INFLATION AND DISCOUNTED CASH FLOW

The mechanics of allowing for inflation are basically easy to handle in DCF calculations. The real difficulty is one of predicting what the rate will be. At this point we will discuss the mechanics. There are two possible techniques: 1. 2. discount money (nominal) cash flows at the money (nominal) discount rate. discount real cash flows at the real discount rate.
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 todays prices. A real discount rate is the real required rate of return after adjusting the money discount rate for the inflation allowance.
Relationship between interest rates
Suppose we can invest money in a bank to earn 7% per annum interest. However, we expect inflation to be 4% per annum next year. If I invest 1 this must grow to 1.04 to keep pace with inflation. So, if I have 1.07 cash in the bank after one year, the real interest I have received is 1.07 - 1.04 = 3p. When compared with the capital required to keep pace with inflation (1.04), this shows a return of 0.03/1.04 = 2.9%. The formula which relates real and money interest rates is as follows: 1 + r = 1 + m or, according to the ACCA Formula Sheet, (1 + i) = (1 + r)(1 + h) 1+i Where r is the real interest rate, m is the money interest rate and i is the rate of inflation. Thus 1 + r = 1.07/1.04 in the above example, giving r = 0.029 or 2.9%.
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Example
A project requires an outlay of 1.5m in year 0 and will repay cash flows in real terms (todays prices) as follows: Year 1 2 3 000 670 500 1,200
The companys money cost of capital is 15%. Appraise the project if inflation is estimated to remain at 5% per annum.
Method 1: Compute the real discount rate and discount the real cash flows
1+r Thus r = 0.1 or 10% Real cash flow Year 0 1 2 3 (1,500) 670 500 1,200 1 1/1.1 1/1.12 1/1.13 NPV 10% factor Present value = 1+ m 1+i = 1.155 1.05 = 1.1
Method 2: Compute the money cash flows, using the rate of inflation and discount at the money discount rate.
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(1,500) 609.1 413.2 901.6 423.9
Money cash flow Year 0 1 2 3 (1,500) 670 x 1.05 = 703.5 500 x 1.052 = 551.25 1,200 x 1.053 =1,389.15
15.5% factor
Present value
1 1/1.155 1/1.1552 1/1.1553 NPV
(1,500) 609.1 413.2 901.6 423.9
Please note that discount rates have been computed as opposed to looked up in tables, to ensure that accuracy is obtained for the reconciliation.
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TAXATION AND INVESTMENT APPRAISAL

Example 1
A company buys a fixed asset for 10,000 at the beginning of an accounting period (1 January 2001) to undertake a two year project. Net trading revenues at t1 and t2 are 5,000 per annum. The company sells the fixed asset on the last day of the second year for 6,000. Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required Calculate the net cashflows for the project.
Solution to example 1
t0 Net trading revenue Tax at 33% Fixed asset Scrap proceeds Tax savings on WDAs Net cashflow WORKING t1 5,000 t2 5,000 (1,650) t3 (1,650)
(10,000) _____ (10,000) ____ 5,000
2 ks Tax savings on writing down allowances o bo e

t0 t1 t2 Investment in fixed asset WDA @ 25% Proceeds Balancing allowance
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825 10,175
495 (1,155)
10,000 (2,500) 7,500 (6,000) (1,500)
Tax relief at 33%
Timing
825
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495
t3
Example 2
A company buys a fixed asset for 10,000 at the end of the previous accounting period (31 December 2000) to undertake a two year project. Net trading revenues at t1 and t2 are 5,000 per annum. The fixed asset has zero scrap value when it is disposed of at the end of year 2. Corporation tax = 33%. Writing down allowance = 25% reducing balance.
Required
Calculate the net cashflows for the project.
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Solution to example 2
t0 Net trading revenue Tax at 33% Fixed asset Tax savings on WDAs Net cashflow WORKING Tax savings on writing down allowances Tax relief at 3% Timing t1 5,000 t2 5,000 (1,650) 619 3,969 t3 (1,650) 1,856 206
(10,000) _____ (10,000)
825 5,825
t0 t0 t1 t2
Investment in fixed asset WDA @ 25% WDA @25% Proceeds Balancing allowance
10,000 (2,500) 7,500 (1,875) 5,625 ____ (5,625)
825
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1,856
t3
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CAPITAL RATIONING
Where the finance available for capital expenditure is limited to an amount which prevents acceptance of all new projects with a positive NPV, the company is said to experience capital rationing.
What are the 2 types of capital rationing?

They are:
1.
Hard capital rationing
This applies when a company is restricted from undertaking all worthwhile investment opportunities due to external factors over which it has no control. These factors may include government monetary restrictions and the general economic and financial climate (eg, a depressed stock market, which precludes a rights issue of ordinary shares).
2.
Soft capital rationing
This applies when a company decides to limit the amount of capital expenditure which it is prepared to authorise. Segments of divisionalised companies often have their capital budgets imposed by the main board of directors. A company may purposely curtail its capital expenditure for a number of reasons eg, it may consider that it has insufficient depth of management expertise to exploit all available opportunities without jeopardising the success of both new and ongoing operations.
Capital rationing and time ok

Capital rationing may exist in a:
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Single period
i.e. available finance is only in short supply during the current period, but will become freely available in subsequent periods.
Projects may be:
(i)
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.
(ii)
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.
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2.
Multi-period
i.e. available finance is limited not only during the current period, but also during subsequent periods. Projects may be:
(i)
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 i.e. 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.
(ii)
Indivisible - In this event, integer programming would be required to determine the optimal combination of investments.
Single period capital rationing

Example of single period capital rationing
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)
Project A B C D E F
Year 1 70,000 75,000 48,000 62,000 40,000 35,000
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2 70,000 87,000 48,000 62,000 50,000 82,000
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3 70,000 64,000 63,000 62,000 60,000 82,000
4 70,000 73,000 62,000 70,000
5 70,000
40,000
Initial outlay 246,000 180,000 175,000 180,000 180,000 150,000
Projects A and E are mutually exclusive. All projects are believed to be of similar risk to the companys 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. Bandens cost of capital is 12% per year.
Required
(a) Calculate: (i) (ii) The expected net present value; The expected profitability index associated with each of the six projects.
Rank the projects according to both of these investment appraisal methods and explain briefly why these rankings differ. (b) Give reasoned advice to Banden Ltd recommending which projects should be selected.
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Solution to single period capital rationing example

(a) (i)
Calculation of expected Net Present value

NPV 70,000 x 3.605 - 246,000 75,000 x 0.893 + 87,000 x 0.797 + 64,000 x 0.712 - 180,000 48,000 x 0.893 + 48,000 x 0.797 + 63,000 x 0.712 + 73,000 x 0.636 - 175,000 62,000 x 3.037 - 180,000 40,000 x 0.893 + 50,000 x 0.797 + 60,000 x 0.712 + 70,000 x 0.636 + 40,000 x 0.567 - 180,000 35,000 x 0.893 + 82,000 x 0.797 + 82,000 x 0.712 - 150,000 = 6,350
Project A. B.
1,882
C.
= (2,596) = 8,294
D. E.
5,490
F.
(ii)
Calculation of Profitability Index
Present value of cash inflows initial outlay: Project A. B. C. D. E. F.
252,350/246,000
181,882/180,000 172,404/175,000 188,294/180,000 185,490/180,000 154,993/150,000
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4,993
PI = = = = = = 1.026 1.010 0.985 1.046 1.031 1.033
Ranking
1 2 3 4 5 6
NPV
D A E F B C
P.I
D F E A B C
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The rankings differ because NPV is an absolute measure of the benefit from a project, whilst profitability index is a relative measure, and shows the benefit per of outlay. Where the initial outlays vary in size the two methods may give different rankings. (b) In a capital rationing situation, the projects should be selected which give the greatest total NPV from the limited outlay available. A and E are mutually exclusive. C is not considered as it has a negative NPV. Total outlay is limited to 620,000. Possible selections are: Projects Expected NPV A, B, D A, B, F A, D, F (6,350 + 1,882 + 8,294) (6,350 + 1,882 + 4,993) (6,350 + 8,294 + 4,993) Total NPV 16,526 13,225 19,637 (246 + 180 + 180) (246 + 180 + 150) 606 576 576 540 510 510 510 Outlay in 000
(246 om + 180 + 150) .c B, D, E (1,882 + 8,294 + 5,490) 15,666ot (180 + 180 + 180) p gs B, D, F (1,882 + 8,294 + 4,993) lo 15,169 (180 + 180 + 150) .b 0 B, E, F (1,882 + 5,490 + 4,993) 00 12,365 (180 + 180 + 150) 2 ks+ 4,993) 18,777 (180 + 180 + 150) D, E, F (8,294 + 5,490 o bo e The recommended selection is projects A, D and F
Tutorial note: Neither the NPV nor PI rankings will necessarily be appropriate because of the sheer size of these indivisible investments. In this particular instance, because of the similarity in size of the projects, only three can be undertaken, and the NPV ranking clearly leads to A, D and E. Profitability index will not work if projects are indivisible or where multiple limiting factors exist. The PI might lead to the incorrect solution of D, E and F.
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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 of multi-period capital rationing using linear programming

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 0 000 Project Project Project Project Project Project A B C D E F (25) (25) (12.5) (50) (20) Year 1 000 (50) (25) 5 (37.5) 25 (10) Year 2 000 25 75 5 (37.5) (50) 37.5 Year 3 000 50 5 50 50 25 Year 4 000 50 5 50 50 -
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%.
Formulate both:
1. 2.
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The NPV linear programme, and The PV of dividends linear programme.
Multi-period capital rationing solutions for divisible projects NPV formulation

Since the objective is to maximise the total NPV from these projects, it is initially necessary to calculate the NPV of each project at a discount rate of 10%: Year 0 Discount factor (10%) Project Project Project Project Project Project A B C D E F 1.000 000 (25) (25) (12.5) (50) (20) Year 1 0.909 000 (45.45) (22.73) 4.55 (34.09) 22.73 (9.09) Year 2 0.826 000 20.65 61.95 4.13 (30.97) (41.30) 30.98 Year 3 0.751 000 37.55 3.75 37.55 37.55 18.77 Year 4 0.683 000 34.15 3.42 34.15 34.15 000 +21.90 +14.22 +3.35 +6.64 +3.13 +20.66 Total NPV
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The combination of projects, which will maximise the total NPV can now be specified, where: a b c d e f = = = = = = the proportion of Project A to be undertaken the proportion of Project B to be undertaken the proportion of Project C to be undertaken the proportion of Project D to be undertaken the proportion of Project E to be undertaken the proportion of Project F to be undertaken
The objective function, which represents the maximum NPV that can be earned, is: z = 21.90a + 14.22b + 3.35c + 6.64d + 3.13e + 20.66f
This is subject to the following constraints: Year 0 : 25a + 25b + 12.5c + 50e + 20f 50 12.5 + 5c + 25e Year 1 : 50a + 25b + 37.5d + 10f Furthermore : 0 a, b, c, d, e, f 1 When solved, the linear programme will provide the proportions of each project which should be undertaken in order to establish the value of z, which represents the maximum NPV achievable in view of the limitation of available capital. Notice that the first constraint relates to the limited capital available at Year 0. The second constraint concerns the capital limitation at Year 1, which is of course eased by the Project C and E cash inflows, which can also be used to fund investment needs at that time. The third constraint shows that each project can only be undertaken once and that it is impossible to undertake a negative quantity of any project. This non-negative rule is essential, since if it were excluded a computer model may well establish that negative quantities of a project could make cash inflows available that would be included within the solution!!
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PV of dividends formulation
The combination of projects, which will maximise the PV of cash flows available for dividends must be specified, where: a b c d e f = = = = = = the the the the the the proportion proportion proportion proportion proportion proportion of of of of of of Project Project Project Project Project Project A to be undertaken B to be undertaken C to be undertaken D to be undertaken E to be undertaken F to be undertaken
The objective function will be based upon the premise that: z = the PV of dividends.
The dividend flows need to be defined for each year up to the point where the investment with the longest life ceases in this case up to the end of Year 4 i.e. d0 d1 d2 d3 d4 = = = = = the the the the the dividend dividend dividend dividend dividend flow flow flow flow flow generated generated generated generated generated at at at at at Year Year Year Year Year 0 1 2 3 4 by by by by by the the the the the projects projects projects projects projects selected selected selected selected selected
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Therefore the objective function, which represents the present value of the maximum dividends, discounted at the cost of capital of 10% is: z = d0 +
d1 1.1
d2 1.1
2
d3 1.1
3
d4 1.14
alternatively z = d0 + 0.909 d1 + 0.826 d2 + 0.751 d3 + 0.683 d4
This is subject to the following constraints: Year 0 : 25a Year 1 : 50a Year 2 : 37.5d Year 3 : Year 4 : Furthermore : 0 Additionally : + 25b + 12.5c + 50e + 20f + d0 + 25b + 37.5d + 10f + d1 + 50e + d2 d3 d4 a, b, c, d, e, f 1 d0, d1, d2, d3, d4 0 50 12.5 + 5c + 25e 25a + 75b + 5c + 37.5f 50a + 5c + 50d + 50e + 25f 50a + 5c + 50d + 50e
When solved, the linear programme will provide the proportions of each project which should be undertaken in order to establish the value of z, which represents the maximum PV of dividends earned in view of the capital constraints. With an NPV formulation, we only have constraints for the periods during which capital rationing exists (in this instance, Years 0 and 1), whereas under the dividend formulation we have a constraint for every year of potential project cash flows (in this case, Years 0 to 4). The available funds are the same as in the NPV formulation (i.e. available capital together with cash inflows from the projects); however the dividend flow for each period must also be included. Furthermore an additional non-negative constraint is used, since the dividends must be greater than or equal to zero. If this constraint were excluded, a computer model may specify negative dividend payments, which make cash inflows available that could be used to finance more projects!!
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One advantage of the PV of dividends formulation is that it removes the need to even calculate the NPV of each investment opportunity, since the discounting process is carried out by the linear programme as part of the calculation of the solution. Notice the only difference in the value of z in these formulations is as follows: Under the NPV formulation, z provides the NPV of the project returns, whereas Under the PV of dividends formulation, z provides the PV of the project returns.
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 (e.g. 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.
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The dual price depends upon which method is used to formulate the linear programme i.e. 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 of the use of dual values in linear programming

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:
k oo NPV method eb
0.1 0.08 0
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PV of dividends method (1 + 0.1) (0.909 + 0.08) (0.826 + 0) = = = 1.1 0.989 0.826
Year 0 Year 1 Year 2
A new investment opportunity has emerged with the following cash flows: Cash flow Year 0 Year 1 Year 2 000 (75) 50 50
Appraise the new project using both the NPV dual prices and the PV of dividend shadow prices.
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Solution to example of the use of dual values in linear programming

Appraisal using NPV dual values
The NPV of the new investment project is: Year 0 1 2 NPV Cash flow 000 (75) 50 50 Discount factor @ 10% 1 0.909 0.826 Present value 000 (75) 45.45 41.3 11.75
The net dual value of the new investment project (i.e. the impact of diverting funds from the current investment strategy) is: Year 0 1 2 Net dual value Cash flow 000 (75) 50 50 Shadow price 0.1 0.08 0 Opportunity cost 000 (7.5) 4 -_ (3.5)
o sp would fall by 3,500 if the Accordingly, the NPV of the current investmentg lo strategy new project were accepted. However, Bruno Ltd would benefit from the positive .b NPV of that new investment opportunity. Therefore: 00 0 000 s2 ok NPV of new project o 11.75 b Net dual value e (3.5)
Net benefit of undertaking new project 8.25 This indicates that this project is worth further consideration, since if it were accepted in full (and in doing so does not violate the marginality assumption of dual values) it would result in the value of the objective function increasing by 8,250.
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Appraisal using PV of dividends dual values

The net dual value of the new investment project (i.e. the impact of diverting funds from the current investment strategy) is: Year Cash flow Shadow price Opportunity cost 000 (82.5) 49.45 41.3 8.25
000 0 (75) 1.1 1 50 0.989 2 50 0.826 Net dual value (i.e. net benefit of undertaking new project)
The two techniques will always provide the same result, but as can be seen the PV of dividends dual prices technique is far quicker and simpler to solve. Again, the project is worth considering; the linear programme should therefore be reformulated (by including the new project) and then re-solved.
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Example of multi-period capital rationing using integer programming

The management team of Toby Ltd has identified four indivisible projects, which require funds to be invested over the next few years, as set out below: Project A Year 0 Year 1 Year 2 17,500 25,000 10,000 Project B 22,500 30,000 Project C 15,000 20,000 Project D 12,500 15,000 17,500
The board of directors of that company has approved the following capital expenditure programme for those same accounting periods: Year 0 Year 1 Year 2 40,000 35,000 42,500
The four projects are expected to produce the following positive net present values: Project A Project NPV +20,000 Project B +27,500
You are required to discuss the approach for calculating the optimum mix of projects.
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m Project co C t.
Project D +10,000
+15,000
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Multi-period capital rationing solution for indivisible projects

The problem is to identify that combination of investment projects which will produce the highest possible total NPV (within the annual funding limitations). For instance, if Projects C and D were undertaken, they would satisfy the annual capital constraints, because the combined investment for Year 0 is 12,500, for Year 1 is 30,000 and for Year 2 is 37,500, whilst achieving a total positive NPV of 25,000. On the other hand, if Projects A and B were selected, they would also remain within the annual capital limitations. The combined investment for Year 0 is 40,000, for Year 1 is 25,000 and for Year 2 is 40,000, whilst achieving a total positive NPV of 47,500. This amount exceeds the NPV earned by the combination of Projects C and D. This problem can be solved by an integer programming formulation. The procedures would be to establish the value of variables YA, YB, YC and YD for each of the four projects, which maximise the total net present value i.e. Maximise: 20,000 YA + 27,500 YB + 15,000 YC + 10,000 YD
Subject to three annual capital investment constraints: Year 0 Year 1 : : 17,500 YA + 22,500 YB + 25,000 YA +
A
0 YC + 12,500 YD
o sp Y 42,500 Year 2 : 10,000 Y + 30,000 Y + 20,000 og 17,500 Y + bl .result in Y = 1, Y = 1, Y = 0, Y = 0. The solution to the above problem would 0 In other words, both Project A and Project B would be selected, whilst the other two 00 2 projects would be rejected and the positive NPV of the entire investment strategy ks o would be 47,500. bo e Notice that the above solution is superior to the combination of Y = 0, Y = 0, Y
0 YB + 15,000 YC + 15,000 YD 35,000
B C D A B C D A B C
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m 40,000
= 1, YD = 1, since the combined positive NPV of Project C and Project D is only 25,000, as already stated.
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Chapter 3
Advanced investment appraisal section 2

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CHAPTER CONTENTS
MODIFIED INTERNAL RATE OF RETURN ------------------------------ 65
CALCULATING THE MIRR 65
FREE CASH FLOW -------------------------------------------------------- 68

DEFINITION OF FREE CASH FLOW FREE CASH FLOW TO EQUITY 68 69
RISK AND UNCERTAINTY ----------------------------------------------- 74

SENSITIVITY ANALYSIS PROBABILITY AND EXPECTED VALUES MONTE CARLO SIMULATION PROJECT VALUE AT RISK 74 75 75 76
DURATION ---------------------------------------------------------------- 78 GENTO LTD --------------------------------------------------------------- 80 HULME LTD --------------------------------------------------------------- 85 BAILEY PLC --------------------------------------------------------------- 91
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MODIFIED INTERNAL RATE OF RETURN

To assist in remedying some of the deficiencies of IRR, a technique called Modified Internal Rate of Return (MIRR) has been developed. MIRR has certain advantages in that it: Eliminates the possibility of multiple internal rates of return. Addresses the reinvestment rate issue i.e. it does not make the assumption that the companys reinvestment rate is equal to whatever the project IRR happens to be. Provides rankings which are consistent with the NPV rule (which is not always the case with IRR). Provides a % rate of return for project evaluation. It is claimed that nonfinancial managers prefer a % result to a monetary NPV amount, since a % helps measure the headroom when negotiating with suppliers of funds.
Calculating the 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:
m co Convert all investment phase outlays as a single . t equivalent payment at time po arising after time 0 must 0. Where necessary, any investment phases outlays g be discounted back to time 0 using the companys cost of capital. o .bl after the initial investment (i.e. the All net cash flows generated by the project 00 return phase cash flows) are 0 converted to a single net equivalent terminal 2 receipt at the end of the projects life, assuming a reinvestment rate equal to ks the companys cost of oo b capital. e The MIRR can then be calculated employing one of a number of methods, as
illustrated in the following example.
Example
Carter plc is considering an investment in a project, which requires an immediate payment of 15,000, followed by a further investment of 5,400 at the end of the first year. The subsequent return phase net cash inflows are expected to arise at the end of the following years: Net cash inflows Year 1 2 3 4 5 6,500 7,750 5,750 4,750 3,750
You are required to calculate the modified internal rate of return of this project assuming a reinvestment rate equal to the companys cost of capital of 8%.
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Solution
Single equivalent payment discounted to year 0 at an 8% discount rate: Year 0 1 (5,400 x 0.926) Present Value (PV) of investment phase cash flows 15,000 _5,000 20,000
Single net equivalent receipt at the end of year 5, using an 8% compound rate: Year 8% compound factors 1 6,500 1.3605 2 7,750 1.2597 3 5,750 1.1664 4 4,750 1.08 5 3,750 1 Terminal Value (TV) of return phase cash flows The above compound factors are produced with a calculator. A five year PV factor can now be established i.e.(20,000 34,193) = 0.585 Using present value tables, this 5 year factor falls between the factors for 11% and 12% i.e. 0.593 and 0.567. Using linear interpolation: MIRR = 11% + 8,843 9,763 6,707 5,130 3,750 34,193
(0.593 - 0.585) x (12% - 11%) = 11.3% (0.593 - 0.567)
Alternatively, the MIRR may be calculated as follows;
34,193 MIRR = 5 20,000
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11.3%
Furthermore, in examples where the PV of return phase net cash flows has already been calculated, there is yet another formula for computing MIRR (which is given on the ACCA formulae sheet). This formula avoids having to establish the Terminal Value of those return phase net cash flows i.e. PV of return phase net cash flows (6,500 x 0.926) + (7,750 x 0.857) + (5,750 x 0.794) + (4,750 x 0.735) + (3,750 x 0.681) = 23,271
23,271 1.08 - 1 MIRR = 5 20,000
= 11.3%
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The reservations which are often cited concerning the MIRR technique include: In what are claimed to be the very exceptional circumstances where the reinvestment rate exceeds the companys cost of capital, the MIRR will underestimate the projects true rate of return. The determination of the life of a project can have a significant effect on the actual MIRR, if the difference between the projects IRR and the companys cost of capital is large. Like IRR, the MIRR is biased towards projects with short payback periods and large initial cash inflows. The extent to which this method is being used in industry is unclear and only time will tell whether it eventually becomes popular.
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FREE CASH FLOW Definition of free 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. 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).
2.
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.
Example
Hawthorns plc has earnings before interest and tax of 225,000 for the current year. Depreciation charges for the year have been 15,000 and working capital has increased by 2,500. The company needs to invest 22,500 to acquire noncurrent assets. Profits are subject to taxation @ 30% p.a.
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Calculate free cash flow.
Solution
EBIT Less: Corporation tax @ 30% 225,000 (67,500) 157,500 15,000 (22,500) (2,500) 147,500
Add back: Depreciation (non-cash amount) Deduct: Capital expenditure Working capital increases
Free cash flow
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Free cash flow to equity

The dividend capacity of a company is measured by its free cash flow to equity. Free cash flow to equity can be calculated by establishing the free cash flow described above, and then:
Deducting any interest payments and any loan repayments; and Adding any cash inflows arising from the issue of debt.
Free cash flow to equity is thought by some authorities to provide a superior measure of dividend cover i.e. Free cash flow to equity Dividend cover (in terms of free cash flow) = Dividends paid
Example
The following data relates to Molineux Ltd:
Forecast Income statement for 2010
Revenue Cost of sales Gross profit Operating expenses Earnings before interest and tax Interest charges Profit before tax Corporation tax(@ 35%) Profit after tax
eb
s ok
0 00
.b
s log
m co ot.
m 1,950.00 (1,314.00) 636.00 (322.50) 313.50 (24.00) 289.50 (101.32) 188.18
During the year loan repayments are expected to amount to 69 million, depreciation charges to 30 million and capital expenditure to 60 million.
You are required to calculate:

(a) (b) Free cash flow; Free cash flow to equity.
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Solution
(a) Free cash flow
m 313.50 (109.72) 203.78 30.00 (60.00) 173.78
EBIT Less: Corporation tax (@ 35% thereon)
Add back: Depreciation (non-cash amount) Deduct: Capital expenditure

Free cash flow
(b)
Free cash flow to equity Method One

m 173.78 (69.00) (15.60) 89.18
Free cash flow (as above) Deduct: Loan repayments Interest charges, net of tax [24m x (1 0.35)] Free cash flow to equity
Method Two
Profit after tax Add back: Depreciation (non-cash amount) Deduct: Capital expenditure Loan repayments
s Free cash flow to equity ok o eb
0 00
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s log
t. po
om
m 188.18 30.00 (60.00) (69.00) 89.18
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Example
The following information relates to the forecasts of Bescot plc for the forthcoming year: 000 100 240 300 120 220 40 60 1,880 552 1,840
Capital expenditure for expansion Capital expenditure to replace existing non-current assets Depreciation charges Amounts raised from fresh bond issue Increase in working capital Interest paid Repayment of loans Profit from operations Corporation tax paid (@ 30%) Ordinary share capital (@ 25p par value) Dividend paid for the year is expected to be 5p per share
You are required to calculate:

(a) (b) (c) Free cash flow; Free cash flow to equity;
Dividend cover based upon free cash flow to equity.
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Solution
(a) Free cash flow
000 1,880 (564) 1,316 300 (240) (100) (220) 1,056
Profit from operations (EBIT) Deduct: Corporation tax (@ 30% thereon)
Add back: Depreciation (non-cash amount) Deduct: Capital expenditure to replace existing non-current assets Capital expenditure for expansion (ARGUABLY, THIS SHOULD NOT BE DEDUCTED IN ARRIVING AT FREE CASH FLOW) Increase in working capital
Free cash flow
(b)
Free cash flow to equity Method One

000 1,056 (60) (28) 120 1,088
Free cash flow (as above) Deduct: Loan repayments Interest charges, net of tax [40,000 x (1 0.3)] Add: Proceeds of bond issue Free cash flow to equity
Method Two
EBIT Interest charges Corporation tax Profit after tax (i.e. Earnings after interest and tax) Add back: Depreciation (non-cash amount) Deduct: Increase in working capital Capital expenditure [240,000 + 100,000] Loan repayments Add: Amounts raised from bond issue
eb
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000 1,880 (40) (552) 1,288 300 (220) (340) (60) 120 1,088
Free cash flow to equity
(c)
Dividend cover
Earnings after interest and tax The normal dividend cover calculation is: Dividends for the year
ie,
1,288,000 368,000
3.5 times
WORKING: Dividends for the year: Number of shares in issue =

Dividends for the year = 1,840,000 0.25 7,360,000 x 0.05 = = 7,360,000 368,000
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The above result is thought by some authorities to be misleading, since it is cash (and not earnings) that is used to pay dividends. Therefore, dividend cover based upon free cash flow to equity may be used, as follows: Free cash flow to equity Dividend cover (in terms of free cash flow) ie = = Dividends paid
1,088,000 368,000
2.96 times
This would be considered a satisfactory level of assurance for ordinary shareholders.
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RISK AND UNCERTAINTY

Risk occurs where there are several possible outcomes for each component of a decision and probabilities can be assigned for each possible outcome. This allows for the calculation of an expected value based upon the probability of each outcome. Uncertainty occurs where there are several possible outcomes, but the probability attaching to each cannot be established.
Sensitivity analysis
A technique which assesses the effect on an overall decision if a single constituent variable were to change i.e. how sensitive is the investment decision to a change in a single aspect (e.g. sales revenue, material price, project life, etc). This allows for the consideration of a range of possible outcomes. Sadly the technique does not take into account the interdependence of the variables i.e. the technique ignores the interaction of the constituent variables.
Procedure
Firstly, calculate the expected NPV, using the best estimates available. Then, calculate for each input factor (e.g. initial investment, sales price, wage rate, discount rate, residual value, etc) the necessary percentage change which would cause the NPV to become zero.
blo .achieve an NPV of zero, the calculation is To find the percentage change required 0 0to as follows: 20 s ok NPV of project o 100 % change = PV b cash flows affected by the variable e of
Illustration
An expected NPV has already been calculated for the following project:
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Year
0 1-3 3 NPV Initial investment Revenues Scrap value
Cash flow 000 (100) 40 10
10% discount factor

1 2.487 0.751
Present value 000 (100.00) 99.48 7.51 +6.99
From these results, the sensitivity to each variable, which would create an NPV of 0 is: Initial investment: 6.99 100 6.99 99.48 6.99 7.51 x 100 = an increase of 7%
Annual revenues:
100
a decrease of
7%
Scrap value:
100
a decrease of
93%
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Discount factor: (this requires the calculation of the IRR, since this would cause the NPV to be 0. The IRR is, of course, established by trial and error), ie:
Year
0 1-3 3 NPV IRR =
Cash flow 000 (100) 40 10
Try 13% DF 000 1 (100) 2.361 94.44 0.693 6.93 +1.37

=
Try 14% DF 000 1 (100) 2.322 92.88 0.675 6.75 -0.37

13.79%
13% +
1.37 (14% 13%) 1.37 + 0.37
Cost of capital will have to increase by 37.9% (i.e. from 10% to 13.79%) for an NPV of 0 to arise. Project life: Clearly if the project life were for a shorter period than 3 years an NPV of 0 would at some point arise. Accurate calculations are in this case not possible, since at a life of less than 3 years, the scrap value would be greater, but the precise amount is unknown.
Probability and expected values

A probability calculate the deviation of dealing with (CAPM).
distribution of expected cash flows could be estimated and used to expected value of the NPV and measure risk (normally the standard that NPV). This aspect will be demonstrated during the lectures Project Value at Risk (VAR) and the Capital Asset Pricing Model
0 20 the same amount as one of the specific This expected value is unlikely s be k to outcomes, since it is basedoupon a weighted average calculation. Whilst the o expected value is simple b calculate and easy to understand, it does suffer from e to
the following limitations: Probabilities usually have to be estimated and therefore may be inaccurate or unreliable; Expected values are long-term averages, which assume repetition of the task and may clearly be inappropriate for one-off projects; Does not take into account the decision makers attitude to risk think of a banker!; May not take into account the time value of money.
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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. 2. 3. Specify all major variables Specify the relationship between those variables Using a probability distribution, simulate each environment.
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The advantage of this technique is 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).
Example
Andrews plc estimates the expected NPV of a project to be 100 million, with a standard deviation of 9.7 million.
Establish the value at risk using both a 95% and also a 99% confidence level.
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Solution
Using Z = X- and establishing Z from the normal distribution tables i.e. at a 95% confidence level, 1.65 is the value for a one tailed 5% probability of decline (i.e. 0.4505) and at a 99% confidence level, 2.33 is the value for a one tailed 1% probability of loss of NPV (i.e.0.4901). At 95% confidence level, therefore At 99% confidence level, therefore Z X Z X = = = = X - 100 = 1.65; 9.7 (9.7 x 1.65) + 100 = X - 100 = 2.33; 9.7 (9.7 x 2.33) + 100 =
84.
77.4.
There is a 5% chance of the expected NPV falling to 84 million or less and a 1% probability of it falling to 77.4 million or below.
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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 firms 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. 2. 3. Calculate the value of each future net cash flow, discounted at the IRR of the project; Calculate each years discounted cash flow as a proportion of the original capital outlay; 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.
m co 2. Calculate each years discounted cash flow as a t. proportion of the PV of total cash inflows; po gs 3. Take the time from investment to eacho l discounted cash flow and multiply by b the respective proportion. Finally, 0. the weighted year values. 0 sum 0 s2 Example k oo to a proposed project are: The forecast cash flows relating eb
Year Incremental cash flows 0 (34,000) 1 7,600 2 16,500 3 13,000 4 6,600 Establish both the duration to recover the original investment (using the IRR of this project of 11.13%) and the duration to recover the present value of the project (at an 8% hurdle rate).
Calculate the value of each future net cash flow, discounted at the chosen hurdle rate;
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Solution
Duration taken to recover the original investment
Year 1. Discount cash inflows @ 11.13% 2. Proportion of initial outlay (34,000) 3. Proportion multiplied by year number 1 6,839 0.201 0.201 2 13,361 0.393 0.786 3 9,473 0.279 0.837 4 4,327 0.127 0.508
Finally, sum these to provide the duration i.e. on average the company will take 2.332 years to recover the initial investment i.e. an indication of project uncertainty (see below).
Duration taken to recover the present value of the project

Year 1. Discount cash inflows @ 8% 2. Proportion of project PV (36,354) 3. Proportion multiplied by year number 1 7,037 0.194 0.194 2 14,146 0.389 0.778 3 10,320 0.284 0.852 4 4,851 0.133 0.532
Finally, sum these to provide the duration i.e. on average the company will take 2.356 years to recover half the present value of the project i.e. a different indication of project uncertainty. The longer the duration, the greater the uncertainty attaching to future returns!!
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Gento Ltd
Gento Ltd has been invited to make a tender for a contract to manufacture six special processing machines. Manufacture would take a total of three years, commencing immediately (1st August 2005), and the contract price would be payable in two equal instalments, the first on 1st August 2005 and the second on 31st July 2008. The company would manufacture two machines each year. The following estimates are available about the resources required to produce the special processing machines: (1) Materials Type of material Quantity per machine tons 20 10 Amount in stock now Original cost of stock per ton 700 500 Current purchase price per ton 1,000 750 Current realisable value per per ton 800 see below
Gamma Zeta
tons 60 20
Gamma is used regularly by the company on many contracts. Zeta is used rarely and if the existing stock is not applied to this contract it will have to be disposed of immediately at a net cost of 100 per ton. Materials required for the contract must be purchased and paid for annually in advance. Replacement costs of Gamma and Zeta and the realisable value of Gamma are expected to increase at an annual compound rate of 20%. (2)
0 20 3,000 hours of skilled labour and 5,000 hours s Each of six machines will require ok of unskilled labour. Current wage rates are 4 per hour for skilled labour and o 3 per hour for unskilled labour. eb
Labour Gento Ltd expects to suffer a shortage of skilled labour during the year to 31st July 2006 so that acceptance of the contract would make it necessary to give up other work on which a contribution of 7 per hour, net of skilled labour costs, would be earned. (The other work would require no unskilled labour). For the year to 31st July 2006 only, the company expects to have 20,000 surplus unskilled labour hours. Gento Ltd has an agreement with its labour force whereby it lays off employees for whom there is no work and pays them two-thirds of their normal wages during the layoff period. All wage rates are expected to increase at an annual compound rate of 15%.
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(3)
Overheads Overhead costs are currently allocated to contracts at a rate of 14 per skilled labour hour, calculated as follows: 11.00 3.00 14.00
Fixed overheads (including equipment depreciation of 5) Variable overheads
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Special equipment will be required for this contract, and will be purchased on 1st August 2005 at a cost of 200,000 payable immediately. It will be sold on 31st July 2008 for 50,000. Both fixed and variable overheads are expected to increase in line with the Retail Price Index. Gento Ltd has a cost of capital of 20% per annum in money terms. The Retail Price Index is expected to increase in the future at an annual compound rate of 15%. Assume that all payments will arise on the last day of the year to which they relate except where otherwise stated. Assume also that input prices will change annually at midnight on 31st July.
You are required to: (a)

Calculate the minimum price at which Gento Ltd should be willing to undertake the contract to manufacture the six special processing machines based on the information given above. Provide brief explanations of the figures you have used, and Comment on other factors, not reflected in your calculations, which may affect the minimum acceptable price.
(b) (c)
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Gento Ltd solution

(a) Calculation of minimum price
Present value of costs Date Year Reference to workings Equipment Materials Gamma Zeta Labour Skilled Unskilled Variable overheads Net cash outflows Money Discount Factor 20% 000 (200) 1 2 3 4 5 (40) 2 (238) 000 (48) (18) (66) (10) (18) (160) 000 (57.6) (21.6) (27.6) (34.5) (20.7) (162.0) 000 50 (31.74) (39.67) (23.81) (45.22) 1.8.05 0 31.7.06 1 31.7.07 2 31.7.08 3
Total PV of costs
The minimum contract price will be such that the PV of the cash received just covers the total PV of the costs, i.e. 509,890. If X =
X X will be received on 1.8.05 (Year 0) and on 31.7.08 (year 3) 2 2

The PV of these cash inflows will be For the minimum price therefore 0.7895X X = 509,890 = 645,839
ok Total price bo paid e
0 20
log .b (509.89)
1.0 (238)
o sp (133.28)
m co . t0.833
0.694 (112.43)
0.579 (26.18)
X 2
0.579X = 0.7895X 2
The minimum total contract price is 645,839 WORKINGS (1) Material Gamma 2 machines p.a. each requiring 20 tons at current price. Cost for 2006 = 2 x 20 x 1,000 = 40,000 (paid in advance Year 0) 2007 2008 = = 40,000 x 1.20 40,000 x (1.20)2 = = 48,000 (Year 1) 57,600 (Year 2)
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(2)
Material Zeta 2 machines p.a. requiring 10 tons each. Costs for 2006 20 tons used from stock produce a cost saving of 20 x 100 = 2,000 (Year 0) Costs for 2007 2008 = = 20 x 750 x 1.20 20 x 750 x (1.20)2 = = 18,000 (Year 1) 21,600 (Year 2)
(3)
Skilled Labour Annual requirement = 2 x 3,000 hours = 6,000 hours. Year 1 6,000 hours at opportunity cost (4 + 7) Year 2 6,000 hours at normal wage rate 6,000 x 4 x 1.15 Year 3 6,000 x 4 x (1.15)2 = = = 66,000 27,600 31,740
(4)
Unskilled Labour Annual requirement 2 x 5,000 hours = 10,000 hours. Year 1 only: 20,000 surplus hours
Extra wages payable for 10,000 hours worked = 10,000 x 3 x 1/3 = 10,000 Year 2 10,000 x 3 x 1.15 = 34,500
(5)
20 Year 3 10,000 x 3 ks x 1.15 o bo Variable Overheads e
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= 39,675.
6,000 x 3 p.a. = 18,000 p.a. rising by 15%.
(b)
Brief explanation of the figures used

(1) General approach The general approach is to estimate the relevant money cash flows associated with each cost, that is the cash flows after allowing for expected rates of inflation. These cash flows are then discounted at the money cost of capital which contains an element of inflation. (2) Material Gamma This material is used on many contracts. The extra requirement on this contract will therefore be met by purchasing extra material at current replacement cost. (3) Material Zeta If existing stock is not applied to this contract, it will have to be disposed of immediately at a net cost of 100 per ton. The 20 tons now in stock will therefore be valued as a cash inflow of 100 per ton, because the use of this material will actually produce cost savings to the organisation as a whole.
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(4)
Skilled Labour In year one the use of skilled labour does not in fact produce any extra cash outlay on labour, because the men would be employed on other work if this contract was not accepted. However the use of skilled labour on this contract means that revenues from the other work are lost. The measure of this loss is 7 contribution per skilled labour hour, but since this contribution is after deducting 4 per hour for labour, the total relevant opportunity cost per hour is 7 + 4 = 11.
(5)
Unskilled Labour In year one the incremental cost to the organisation is the payment of the remaining one-third of normal wage rates for 10,000 hours to the men who are at present laid off.
(6)
Overheads It is assumed that fixed overheads will be unchanged as a result of the decision. Accordingly, only variable overheads are relevant costs.
(c)
Discussion of other factors affecting the minimum acceptable price

(1) It has been assumed that all estimates of cash flows, inflation rates etc can be made with certainty. This is unrealistic. Allowance for uncertainty can be incorporated into the appraisal in various ways. An assessment can be made of the sensitivity of the project to a number of variables (e.g. price level changes). Alternatively several estimates can be made for each variable and subjective probabilities attached to each with a view to quantifying the uncertainty. The relationship between the risk characteristics of the project and the present portfolio of projects being undertaken by Gento Ltd must be taken into account with a view to a possible reduction in the overall risk of the firm.
(2)
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(3) (4)
Taxation should be included in the analysis to obtain a realistic minimum price.

The availability of working capital to finance the project has been assumed. The first instalment received at 1st August 2005 will cover the cost of the equipment and materials required at this date but extra cash will be required in Years 1 and 2. This project must be appraised in relation to any other alternatives which might be available in competition for the scarce resources of the firm. The effect of accepting the project on future trading should be considered, particularly in two respects: (i) (ii) the possibility of losing future trade from present customers perhaps affected by the transfer of the skilled labour. the desirability of influencing the proposed customer on the present contract, by offering a lower tender, in the hope of obtaining more lucrative contracts later.
(5)
(6)
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Hulme Ltd
Hulme Ltd is considering the manufacture of a new product, the Champ, to add to its existing range. Manufacture would commence on 1 January 2007 and 100,000 Champs would be produced and sold each year for three years. The directors of Hulme Ltd expect to be able to charge a price of 6 per Champ during 2007 and to increase the price during 2008 and 2009 in line with increases in the Retail Price Index. The Index is expected to increase in the future at an annual compound rate of 10%. The following costs are involved in producing Champs.
Labour. Each Champ requires hour of skilled labour and hour of unskilled labour (1 January 2007) wage rates are 3 per hour for skilled labour and 2 per hour for unskilled labour. For 2007 only Hulme Ltd expects to have 100,000 surplus hours of unskilled labour. Whether or not Champs are manufactured, the employees concerned will be retained and paid by the company. All labour costs are expected to increase at an annual compound rate of 20%. Materials. Each Champ requires 2kgs of Alpha and 1 kg of Beta. Hulme Ltd currently holds in stock 200,000 kgs of Alpha and 100,000 kgs of Beta. The stock of Alpha originally cost 0.40 per kg and has a current realisable value of 0.30 per kg. The current buying price is 0.50 per kg. The stock of Beta originally cost 0.80 per kg and has a current realisable value of 0.90 per kg. The current buying price is 1.10 per kg. Alpha is used regularly by the company on many products. Beta is used rarely and the only use for the existing stock, if it is not applied to the manufacture of Champs, is to sell it immediately.
o .bl must be purchased and paid for Materials required to manufacture Champs 00 annually in advance. Replacement 0 costs and realisable values of Alpha and Beta 2 are expected to increase at an annual compound rate of 10%. ks o bo Overheads. It is the policy of the company to allocate all overhead costs to its e various products. The calculated overhead cost per unit for Champs, at current
price, is as follows: 0.70 0.30 0.50 1.50 Allocated head office fixed costs (rent, rates, administration, etc) Depreciation 30,000 100,000 Variable overheads
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Head office costs and variable overheads are expected to increase in line with the Retail Price Index. The machine required to manufacture Champs was bought some years ago. Its current book value is 90,000, and the above depreciation charge is based on a remaining life of three years at the end of which the machine will have no scrap or re-sale value. If it is not used to produce Champs the machine will be sold immediately for 150,000. Hulme Ltd has a cost of capital of 20% per annum in money terms. Assume that all receipts and payments (except costs of materials and machine sale proceeds) will arise on the last day of the year to which they relate. Assume also that input prices will change annually on 31 December.
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Requirements (a) (b) (c)

Prepare calculations showing whether Hulme Ltd should undertake production of the Champ. Provide brief explanations of the figures you have used. Comment on factors which are not included in your calculations but which may affect the decision.
Ignore taxation.
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Hulme Ltd solution

(a) Cash flows resulting from manufacture and sale of champs
Ref. to Workings Machine Labour Materials Alpha Beta Overheads Total outflows Sales Net inflow/(outflow) 20% discount factor Present value Net present value = +200,000 Time 0 000 (150) (100) (90) (340) (340) 1.000 (340) Time 1 000 (75) (110) (121) (50) (356) 600 244 0.833 203 Time 2 000 (210) (121) (133) (55) (519) 660 141 0.694 98 Time 3 000 (252) (61) (313) 726 413 0.579 239
(1) (2) (3) (4) (5)
m co is worthwhile. t On the basis of the estimates given, production of .Champs po which manufacture would Note Time 0 is taken to be the gs on date commence, i.e. 1 January blo time 1 is 31 December 2007, etc 2007; . 00 0 WORKINGS s2 k For explanations of the figures used, see part (b) oo eb (1) Labour cost
Year 1 Skilled Unskilled Skilled Unskilled Year 2 cost x 1.2 25,000 hours @ 3 No cost incurred 25,000 x (3 x 1.2) 50,000 x (2 x 1.2) 75,000 75,000 90,000 120,000 210,000 252,000
Year 2
Year 3 (2)
Material Alpha Current buying price is 50p per kg, rising at 10% per annum. Time 0 cost Time 1 cost Time 2 cost 50p x 200,000 100,000 x 1.1 110,000 x 1.1 = = = 100,000 110,000 121,000
(3)
Material Beta Quantity held is enough for one year Time 0 realisable value Time 1 buying price Time 2 buying price 100,000 x 90p 100,000 x 1.10 x 1.1 121,000 x 1.1 = = = 90,000 121,000 133,100
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(4)
Overheads The only relevant cost are variable overheads, which rise at 10% per annum. Year 1 cost Year 2 cost Year 3 cost 100,000 x 50p 50,000 x 1.1 55,000 x 1.1 = = = 50,000 55,000 60,500
(5)
Sales The selling price rises at 10% per annum Year 1 Year 2 Year 3 100,000 x 6 600,000 x 1.1 660,000 x 1.1 = = = 600,000 660,000 726,000
(b)
Brief explanations of figures used

(1) Machine Although the machine is owned already, it has an opportunity cost if used on this project, which is the revenue foregone if it is not sold now for 150,000. (2) Labour
In the first year of the project the company will have to pay for extra skilled labour only, as there is enough surplus unskilled labour to cover the necessary 50,000 hours on the project. As this unskilled labour is paid whether or not the Champs are produced, there is no relevant unskilled labour cost in year 1 of the project. In years 2 and 3 of the project the company will have to pay for extra skilled and unskilled labour. (3) Material Alpha Alpha is used regularly by the company on many projects. If existing stocks are used to manufacture Champs, the company will have to buy in more stocks of Alpha for its other projects. The relevant cost of Alpha is thus always its buying price, which is expected to rise by 10% per annum. (4) Material Beta Present stocks of Beta are sufficient for the first years production of Champs. Since there is no alternative use for Beta within the company, the opportunity cost of existing stocks is the realisable value of 90p per kg. After one year present stocks will be exhausted, and the relevant cost of further supplies of Beta will be the buying price.
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(5)
Overheads Fixed costs allocated from head office will be irrelevant to this decision as they will be incurred whether or not Champs are produced. Depreciation is irrelevant to a project appraisal based on cash flows. The only relevant cost is, therefore, the variable overhead.
(c)
Factors not included in the calculations which may affect the decision
(i) Availability of more profitable projects The project has been appraised in its own right, but it should be compared with alternative uses for the funds employed, particularly if there are constraints on capital or other resources. (ii) Scarcity of resources The calculations assume that there is no scarcity in supply of the resources used on the project, e.g. that sufficient supplies of Alpha or skilled labour are available at the prices stated and that the use of them will not affect the quantities available for the companys normal operations. If there is a scarcity in supply, the opportunity cost of these resources will include the lost contribution through not using the resources on alternative projects. (iii) Risk and uncertainty of estimates
lo .bthe project appraisal are subject to Most of the figures used 0 in 00 uncertainty. The decisions might be affected by revised estimates of the 2 following: ks o (1) The sales price/sales volume relationship. Marketing of the Champ bo e may encourage others to compete with the new product, leading to
reduced sales, or to reduced selling price, or to a combination of the two. The rate of inflation, which could lead to revised forecasts for costs and the cost of capital. The length of the project Whether head office fixed costs would be unaltered by the new project. In practice, the addition of a new line is likely to increase fixed costs. Additional staff may be employed in accounts, despatch or stores (for example) not directly connected with the new product line, but ultimately resulting from the increased turnover. The need for additional storage area may require the utilisation of space which could otherwise have been sub-let. If so, the rental income foregone would be treated as a relevant cash outflow.
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(2) (3) (4)
Other more general possibilities, such as a change of government or a change in fiscal policy, may affect the profitability of the project.
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(iv)
Management and labour skills The calculation assumes that the necessary skills exist for this new project or that they can be quickly acquired without any initial problems. In practice this would be a major factor in the decision.
(v)
Technological change Changing technology may render the Champ obsolete before the end of three years.
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Bailey plc
Bailey plc is developing a new product, the Oakman, to replace an established product, the Shepard, which the company has marketed successfully for a number of years. Production of the Shepard will cease in one year whether or not the Oakman is manufactured. Bailey plc has recently spent 75,000 on research and development relating to the Oakman. Production of the Oakman can start in one years time. Demand for the Oakman is expected to be 5,000 units per annum for the first three years of production and 2,500 units per annum for the subsequent two years. The products total life is expected to be five years. Estimated unit revenues and costs for the Oakman, at current prices, are as follows. Selling price per unit Costs per unit Materials and other consumables Labour (see (1) below) Machine depreciation and overhaul (see (2) below) Other overheads (see (3) below) Loss per unit (1) 35.00
Each Oakman requires two hours of labour, paid 3 per hour at current prices. The labour force required to produce Oakmans comprises six employees, who are at present employed to produce Shepards. If the Oakman is not produced, these employees will be made redundant when production of the Shepard ceases. If the Oakman is produced, three of the employees will be made redundant at the end of the third year of its life, when demand halves, but the company expects to be able to find work for the remaining three employees at the end of the Oakmans five year life. Any employee who is made redundant will receive a redundancy payment equivalent to 1,000 hours wages, based on the most recent wage rate at the time of the redundancy.
eb
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8.00 6.00 12.50 _9.00
35.50 0.50
(2)
A special machine will be required to produce the Oakman. It will be purchased in one years time (just before production begins). The current price of the machine is 190,000. It is expected to last for five years and to have no scrap or resale value at the end of that time. A major overhaul of the machine will be necessary at the end of the second year of its life. At current prices the overhaul will cost 60,000. As the machine will not produce the same quantity of Oakmans each year, the directors of Bailey plc have decided to spread its original cost and the cost of the overhaul equally between all Oakmans expected to be produced (i.e. 20,000 units). Hence the combined charge per unit for depreciation and overhaul is 12.50 [(190,000 + 60,000) 20,000 units]. Other overheads at current prices comprise variable overheads of 4.00 per unit and head office fixed costs of 5.00 per unit, recovered on the basis of labour time.
(3)
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All wage rates are expected to increase at an annual compound rate of 15%. The selling price per unit and all costs other than labour are expected to increase in line with the Retail Price Index. The Index is expected to increase in the future at an annual compound rate of 10%. Corporation tax at 35% on net cash income is payable in full one year after the income arises. 25% writing down tax allowances are available on the machine. Bailey plc has a money cost of capital, net of corporation tax, of 20% per annum. Assume that all receipts and payments will arise on the last day of the year to which they relate. Assume also that all current prices given above have been operative for one year and are due to change shortly. Subsequently all prices will change annually.
Requirements: (a) (b)

Prepare calculations, with explanations, showing whether Bailey plc should undertake production of the Oakman. Discuss the particular investment appraisal problems created by the existence of high rates of inflation.
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Bailey plc solution

(a)
Year Contribution before labour costs Labour cost Redundancy payments Redundancy payments avoided Machine overhaul
Investment appraisal of production of Oakmans

1 2 139,150 (39,675) 3 153,065 (45,626) 4 168,371 (52,470) (15,741) 20,700 _____ 20,700 ______ 99,475 (7,245) (79,860) ______ 27,579 (34,816) ______ 100,160 (9,653) _____ 62,434 (35,056) ______ 67,169 (21,852) ______ (23,509) 5 92,604 (30,170) 6 101,865 (34,696) 7
Tax at 35% Cost of machine Tax saved on WDAs Net cash flows 20% factors Present value
(209,000) ______ (188,300) 0.833 (156,854) 18,288 110,518 0.694 76,699 13,716 6,479 0.579 3,751 10,287 100,794 7,715 35,093 5,786 51,103 0.335 17,120 17,359 (6,150) 0.279 (1,716)
Net present value = +1,690
s okbasis of the positive net present value, undertake Bailey plc should, on o the eb production of the Oakman. However, the decision is fairly marginal, and the
Conclusion
estimate of all variables should be carefully reviewed to ensure that the decision to produce is the correct one.
0 20
o .bl
o sp 48,583 g
0.482
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m 0.402
14,107
Explanatory notes
If the current date (per question) is taken as year 0, production will commence and the machine will be purchased one year later at the end of year 1. Revenue and costs will arise initially during year 2. Current (year 0) prices are due to change shortly and therefore two price increases will occur before the start of production (year 0 and year 1 increases). (1) Contribution from sales before labour costs These cash flows have been grouped as they all inflate at 10% per annum. At current values the cash flow per unit is as follows: 35 (8)
Sales price Material and other consumables
(It is assumed that there is no change in head office fixed costs if Oakman is produced)
Variable overheads Net contribution before labour costs
(4) 23
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Year 2 3 4 5 6 (2) Labour cost
Production units 5,000 5,000 5,000 2,500 2,500
Contribution before labour costs Unit/ 23 x (1.1)2 23 x (1.1)3 23 x (1.1)4 23 x (1.1)5 23 x (1.1)6 Total/ 139,150 153,065 168,371 92,604 101,865
At current prices the labour cost per unit of 2 hours x 3 is included as the six employees would not be paid if the Oakman were not produced. Year 2 3 4 5 6 (3) Production units 5,000 5,000 5,000 2,500 2,500 6 6 6 6 6 Labour costs Unit/ x (1.15)2 x (1.15)3 x (1.15)4 x (1.15)5 x (1.15)6 Total/ 39,675 45,626 52,470 30,170 34,696
Redundancy payment
(4)
o .bl x (1.15) = 15,741 outflow. 0 Year 4: 3 men x 1,000 hours x 3 00 2 Redundancy payments avoided ks o If the Oakmanbo not produced, there would be a payment to the six were e
4
This is the payment to the three redundant employees in four years time.
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employees who would be made redundant. This is avoided and hence is an incremental cash inflow. Year1: (5) 6 men x 1,000 hours x 3 x 1.15 = 20,700 inflow.
Purchase and maintenance of machine These are the cash flows that will be incurred at year 1 and two years later at year 3 Purchase cost at year 1: 190,000 x 1.1 Overhaul cost at year 3: = 209,000.
60,000 x (1.1)3 = 79,860.
(6)
Overhead costs It is assumed that the overhead costs will be allowed for tax in the year in which they are incurred.
(7)
Taxation All tax paid on accounting profit is based on the previous years cash flow at 35%.
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(8)
Writing down allowances and tax savings WDA Cost paid at end of first year (t1) WDA year 1 WDA year 2 WDA year 3 WDA year 4 WDA year 5 Proceeds end of year 6 Balancing allowance 209,000 (52,250) 156,750 (39,188) 117,563 (29,391) 88,172 (22,043) 66,129 (16,532) 49,597 -__ 49,597 Tax saved Timing
52,250 39,188 29,391 22,043 16,532
18,288 13,716 10,287 7,715 5,786
t2 t3 t4 t5 t6
49,597
17,359
t7
(9)
The production of Oakman has been evaluated by considering the incremental change in the companys cash flows caused by a decision to produce. These have been valued at the actual cash flow in each year after allowing for the differing effects of inflation on each item. These money cash flows have then been discounted at the money cost of capital (net of corporation tax). The 75,000 already spent on research and development is a sunk cost and is therefore irrelevant to our calculations.
(b)
Discussion of investment appraisal problems caused by high inflation rates.
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The existence of high rates of inflation creates problems in investment appraisal by contributing to the uncertainty attached both to the cash flows themselves and the appropriate discount rate. It is unlikely that in any investment appraisal situation each cash flow stream will be affected in the same way by specific price changes. The budget must predict as accurately as possible the anticipated level of inflation. Higher rates of inflation will tend to be more volatile than lower rates, especially as government action will be directed to reducing them. With different inflation rates applying to each item (e.g. materials and labour) the value of an investment could be highly sensitive to changes in those rates. The extent to which the effect of inflation can be passed on by income increases (e.g. raising product selling price) must also become less certain as government controls, competitors reactions and the elasticity of demand become more important. The conventional treatment of inflation is to discount the anticipated money cash flows at a money discount rate. This money rate would normally be derived from the so-called dividend valuation model, to give the shareholders required rate of return and the required rate of return for other suppliers of capital such as debenture holders. Such a required rate of return will consist of both a real rate reflecting the time value of money to the providers of funds, plus an additional return to compensate for the decrease in purchasing power caused by inflation.
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Clearly, with higher anticipated inflation rates, such a money rate will be higher than with lower rates. However, the company must anticipate such a required rate of return when evaluating capital projects. With high inflation rates this anticipation becomes more difficult, as again the expectations of the shareholders as to the effect of inflation on them will become more diverse. Also with the increased probability of changes in inflation in the future, the required rate of return is unlikely to be constant over the life of the project. The company will be faced with increasing uncertainty as to whether it is acting in the best interests of shareholders by accepting or rejecting a particular project. Finally, it should be noted that the above comments refer to the problems presented to investment appraisal by expected or anticipated inflation. The correct treatment in capital budgeting of unanticipated inflation has so far defied a workable solution, and this represents a serious gap in the theory of financial decision making.
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Chapter 4
Cost of capital
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ebooks2000.blogspot.com www.studyinteractive.org
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CHAPTER 4 COST OF CAPITAL
CHAPTER CONTENTS
PURPOSE OF COST OF CAPITAL ---------------------------------------- 99 CALCULATING THE COMPONENT COSTS OF CAPITAL --------------- 100
1. 2. 3. COST OF EQUITY SHARE CAPITAL COST OF PREFERENCE SHARE CAPITAL COST OF DEBT 100 102 102
CALCULATING THE WEIGHTED AVERAGE COST OF CAPITAL------- 104 MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE DISCOUNT RATE --------------------------------------------------------------------- 107 JUSTIFICATION FOR THE USE OF WACC ----------------------------- 108 SOURCES OF FINANCE ------------------------------------------------- 109
SOURCES OF SHORT-TERM FINANCE SOURCES OF LONG-TERM FINANCE SMALL AND MEDIUM-SIZED ENTITIES (SMES)
QUESTION (NEVADA PLC) --------------------------------------------- 112 QUESTION (CRYSTAL PLC) -------------------------------------------- 114 QUESTION (NILE PLC) ------------------------------------------------- 117
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109 110 110
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PURPOSE OF COST OF CAPITAL

As a discount rate for NPV or cut-off rate for IRR. (N.B. Cost of Capital is sometimes denoted by the letter r, whilst in other texts it is denoted by the letter k. The note which follows uses the latter notation).
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CALCULATING THE COMPONENT COSTS OF CAPITAL 1. Cost of equity share capital

(a) Retained earnings (an opportunity cost)
Ke =
D P0 (ex - div)
Example 1 (Naylor plc)

Naylor plc is expected to pay a constant annual net dividend of 30p per ordinary share. The current market price per share is 2.30 (cum-div). The dividend is about to be paid.
What is Ke?
Solution 1 (Naylor plc)

Ke =
30p = 15% 230p 30p
(b) Fresh issue of equity

Two views: (i) Ke =
D P0 f
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Example 2 (Goodman plc)

Goodman plc wishes to finance a new project by the issue 40,000 ordinary shares of 2.50 each, out of which share issue (flotation) costs of 8% of issue price have to be paid. New shareholders expect constant annual dividends of 32.2p per share.
What is Ke?
Solution 2 (Goodman plc)

Ke = (ii) 32.2p = 14% 92% x 2.50 Carsberg recommends that share issue costs are treated as a year 0 cash outflow of the project for which the share capital is raised. Thus share issue costs do not affect Ke. In Example 2, Ke would be calculated as follows: Ke = 32.2p = 12.9% 2.50
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(c)
Growth
D 0 (1 + g) +g P0 D1 +g P0
The Dividend Growth model is: Ke =
Example 3
Current cum-div price Impending dividend Expected growth p.a. 2.20 20p 10%
Calculate Ke
Solution 3
Ke =
22p + 10% = 21% 2
Two methods of estimating future growth (i) Historical growth in dividends
Example 4 (Talbot plc)
The dividends of Talbot plc over the last five years have been: Year 2004 2005 2006 2007 2008
k oo Annual Net Dividends b 150,000 e

172,000 195,380 230,100 262,350
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Estimate the historical growth rate as a prediction of future growth.
Solution 4 (Talbot plc)

Dividend in 2004 (1 + g)4 (1 + g)4 = = Dividend in 2008 Dividend in 2008 Dividend in 2004
262,350 150,000
4
1.749
(1 + g) g
= =
1.749
1.15
15%
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(ii)
Use of Gordon growth approximation g = br where: b = proportion of earnings retained p.a. r = average return on reinvested funds.
Strictly only applicable to all-equity companies, but is often used for geared companies as an approximation of growth rates.
Example 5
Establish an estimate of future growth and of Ke if:
Proportion of earnings distributed p.a. Average return on reinvested funds Current cum-div price Impending dividend 60% 10% 1.08 12p
Solution 5
g Ke = = 40% x 10% = 4% 17%
12.48p + 4% = 96p
2. Cost of preference share capital 0.b

Kps =
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D (net) P0 (ex - div)
3. Cost of debt
(a)
Kb
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Irredeemable
=
Interest (l t) Market Value of debt (ex - int)
(b)
Redeemable
IRR exercise
Example 6
A 5% debenture is currently quoted at 95.84 (ex-int). It is redeemable at the end of 3 years at 100.
Taking corporation tax at 50%, and ignoring the timing lag for tax savings, calculate Kd.
102
Solution 6
Year 0 1 2 3 NPV Cost Interest Interest Interest & Redemption (95.84) 5(0.5) 2.50 102.50 Try DF @ 4% 1.00 0.962 0.925 0.889 (95.84) 2.41 2.31 91.12 NIL
Therefore, Kb NB Kb
IRR
4%
Try 3% (NPV + 2.74) and 5% (NPV - 2.63), then by linear interpolation = 3% + 2.74 x 2% 5.37 = 4.02%
i.e. linear interpolation tends to overstate the IRR of normal cash flows
(c)
Convertible
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.
00 2most bank loans and overdrafts) is the current The cost of floating rate debt (e.g. ks interest rate being charged oosuch funds. on eb Accordingly, if a company is paying interest at LIBOR + 8%, when LIBOR is set at
(d) Floating rate debt
5% p.a. and corporation tax rates are at 30%, Kd will be calculated as follows: Kd = (5% + 8%) x (1 0.3) = 9.1%
.bl 0
p gs
o t.c
103
CALCULATING THE CAPITAL (WACC)
WEIGHTED
AVERAGE
COST
OF
Difficult to associate a project with a specific source of finance, as a pool of resources are available in order to invest in projects. Thus a WACC is an appropriate discount rate/cut off rate.
Example 7 (Whyte plc)

Whyte plc has on issue: (a) 500,000 ordinary shares of 1 each, whose ex-div share price is 2. A constant dividend of 36p per share will be paid on these for several years hence. 500,000 6% preference shares of 1 each, whose ex-div share price is 50p. 1,000,000 10% irredeemable debentures, quoted at 75 (ex-interest).
(b) (c)
Calculate K0 (i.e. the WACC) assuming Corporation Tax at 40%.
Solution 7 (Whyte plc)

Market Value 1,000,000 250,000 750,000 2,000,000
Equity (m @ 2) Prefs (m @ 50p) Debt (1m @ 75)
K0 *Kb
ok o270,000 b
0 s2
.bl 0
m co Cost Component t. po gs 18%

12% 8%*
180,000 30,000 60,000 270,000
2,000,000
10 (1 0.4) 75
13.5%
8%
104
Comprehensive example (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: 500,000 100,000 200,000 380,000 1,180,000
Ordinary shares of 1 6% 1 Preference shares Debentures Reserves
Calculate the WACC. Assume corporation tax at 50% per annum, payable one year in arrears
o bo
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105
Solution to comprehensive example (Hunt plc)

Ke =
12p (1.05) + 5% 1.17 12p 6p 40p
17%
Kps = Kb Year 0 1 2 3
15%
Capital (95.30) 100
Interest 10 10
Tax
(5) (5)
Net (95.30) 10 105 (5)
Try DF @ 8% 1.00 0.926 0.857 0.794
Net (95.30) 9.26 89.99 (3.97) -0.02
Therefore, Kb WACC
IRR
8%
Equity Prefs Debt
(m @ 1.05) (100K @ 40p) (200K @ 95.30)
Market Value 525,000 40,000 190,600 755,600
Component Cost
Ko
110,498 = 755,600
eb
k oo
14.6%
0 20
log .b
o sp 17%
o t.c
15% 8%
89,250 6,000 15,248 110,498
106
MAIN ASSUMPTIONS UNDERLYING USE OF WACC AS THE DISCOUNT RATE

1. 2. Only under conditions of perfect capital markets will the costs of capital calculated represent the true opportunity cost of funds used. The project must be small relative to the size of the company (i.e. it represents a marginal investment). This is because the costs of capital calculated refer to the minimum required return of marginal investors and therefore are only appropriate for the evaluation of marginal changes in the companys total investment. Using the existing market value mix of funds as weights in the calculation assumes that in the long run funds will be raised in this proportion (i.e. in the long run the capital structure of the company will remain unchanged). This implies that the current gearing ratio is thought to be optimal. No attempt is made to match a project with a particular source of funds. All funds are regarded as forming a pool out of which all projects are financed (the pool concept). The project is of average risk for the firm and will cause no change in the risk of the company as perceived by investors. This is because the cost of capital estimates are only valid for the existing level of risk in the enterprise.
3.
4.
5.
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107
JUSTIFICATION FOR THE USE OF WACC

NOTE. For simplicity of explanation, the following example uses the IRR technique of investment appraisal. It is emphasised that most authorities would advocate use of the NPV approach.
Illustration
Whyte plc has the following capital costs: Ko Ke Kb = = = 13.5% 18% 8%
Suppose that in March 2008 the company proposes to raise debt at 8% to finance Project A whose IRR is 12%. Whyte plc accepts Project A since IRR > Kb. Subsequently in June 2008 Whyte plc considers the issue of equity at 18% to finance Project B whose IRR is 17%. However the company rejects Project B since IRR < Ke. Is it logical to reject a project yielding 17%, whilst accepting one yielding 12%? The use of WACC (at 13.5%) would have provided the logical answer i.e. Reject Project A (with an IRR of 12%), and Accept Project B (with an IRR of 17%)
Therefore generally do not test the viability of a project by reference to its specific financing source, but by reference to WACC. The only exception to this rule is when the finance is provided (by e.g. a local authority or government department) to assist in the financing of a specific project undertaken for that agency.
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108
SOURCES OF FINANCE Sources of short-term finance

Bank overdrafts
If cash outflows from a bank current account exceed inflows for a temporary period, a clearing bank may provide an overdraft. Overdrafts may be arranged speedily, but are subject to review by the bank, may be renewable and offer a level of flexibility, whilst interest is only paid on the overdrawn amount. Overdrafts are technically repayable on demand and may require some form of security or guarantee. Interest is often payable at a variable rate (ie benchmark rate plus a premium) and an arrangement fee is normally payable upon the initial grant of the facility.
Short-term loans
Bank loans are an agreement for the provision of a specific fixed sum for a predetermined period at an agreed interest rate. A term loan is provided in full at the start of the loan period and is repaid at a specified time or in instalments over a period of agreed dates.
o sp but are more expensive and Bank loans are only repayable on the agreed g lo dates, less flexible than overdrafts. The terms .of the loan must be adhered to and the b bank may impose loan covenants with 00 which the borrower must comply. 0 s2 k Trade credit oo eb Raw materials are normally purchased on credit and this effectively represents an
interest free short-term loan. It is important to remember that payment delays would worsen the credit rating of the company and that additional credit may then be difficult to obtain. The loss of settlement discounts that suppliers may offer for early payment must be considered.
o t.c
Lease finance
Instead of the outright purchase of a non-current asset, a company may choose to obtain the temporary use of that asset by means of an operating lease, whereby the risks and rewards of ownership are retained by the lessor (ie the legal owner). An operating lease contract between a lessor and lessee is for the hire of a specific asset, whereby the lessee has possession and use of equipment for a period which is shorter than the economic useful life of the asset, but the lessee is committed to pay specified rentals during the period of the lease. The lessor is normally responsible for repairs and maintenance and the lease can sometimes be cancelled at short notice.
109
Sources of long-term finance

The main sources are: Fixed interest capital (i.e. debt finance) and preference share capital; Equity finance, which is commonly raised by rights issues, placings, offers for sale or public issues following a stock exchange introduction. Details may be found in your Study Manual.
Two other long-term sources of finance available to businesses are:
Lease finance
A long-term leasing arrangement is likely to be finance lease, ie a lease that transfers substantially all the risks and rewards incidental to the ownership of an asset to the lessee. Legal title may or may not eventually be transferred. The lessor is likely to be a bank or other financial institution, which does not normally trade in the type of asset concerned. The lessee normally becomes responsible for the cost of repairs and maintenance. The substance of a finance lease arrangement is that the lessee is effectively borrowing in order to have use of a non-current asset for substantially the whole of its useful economic life and thereby becomes liable for all lease payments. In contrast, an operating lease is equivalent to the short-term rental of an asset from an organisation which normally trades in that type of asset.
Venture capital
Venture capital is the provision of risk bearing capital, normally provided in return for an equity stake in companies with high growth potential. The 3i Group (a FTSE 100 Index) is one of the worlds oldest venture capital organisations and is involved in schemes in Europe, the USA and the Far East. The 3i Group is prepared to invest in companies with a highly motivated management team, having a well defined strategy and target market, which are committed to innovation and a proven ability to outperform competitors. Venture capitalists may provide finance for business start-ups, the development of existing businesses, management buyouts and the realisation of the investments of existing owners who wish to exit their companies. Where company directors seek assistance from a venture capitalist they must expect that the institution will require an equity stake in the company, need convincing that the business will be successful, seek representation on the companys board of directors, demand exceptional returns on their investment and expect an obvious ultimate exit route.
k oothe member of eb
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Small and medium-sized entities (SMEs)

The funding gap
SMEs normally have difficulty obtaining equity finance from third parties. They normally rely on finance from retentions, bank borrowings and rights issues. Such companies are often considered risky, since they may not have an established track record, lack the necessary assets to offer as security, have inexperienced management and inadequate financial control systems.
110
The funding (or equity) gap becomes crucial when they wish to expand beyond their limited sources of finance, but are not yet mature enough for a stock market quotation. A major problem for SMEs in obtaining equity finance is their inability to offer an easy exit route for any investors wishing to dispose of their shares. The company could, of course, purchase its own shares back from shareholders, but this uses cash that could be more profitably employed elsewhere in the business of the company.
The maturity gap

This presents a further problem for SMEs, who may ideally wish to obtain mediumterm loans. This arises due to the mismatching of the maturity of assets and liabilities. Since the SME can secure long-term loans with mortgages against their property assets, they find that longer term borrowing is much easier to obtain than the medium term loans that they require.
Investors
Due to lack of security and a risk-averse attitude, banks have been reluctant to make large investments in SMEs. However, investment has become more readily available from:
o sp Business Angels These are wealthy private individuals prepared to invest in log Angels provide more modest start-up or expanding companies. .b Business sums than venture capitalists. They normally wish to obtain an equity holding 00 0 and this will permit the company to gain access to the Angels network of s2 experience. contacts and accumulatedk business oo eb
Venture capitalists (as above)
o t.c
111
Question (Nevada plc)

(i) Nevada plc has issued 10 million ordinary shares of a nominal value of 1 each. Details of the companys earnings and dividends per share during the past four years are as follows: Year ended31 December 2003 2004 2005 2006 Earnings per share 35p 33p 43p 42p Dividend per share 26p 27p 29p 30p
The current (December 2006) market value of each ordinary share of Nevada plc is 2.35 cum div. The 2006 dividend of 30p per share is due to be paid in January 2007.
Required
Estimate the cost of capital for Nevada plcs ordinary share capital. (ii) Ten years ago California plc issued 2.5 million 6% redeemable debentures at a price of 98 per cent. The debentures are redeemable six years from now at a price of 102 per cent. They are currently quoted at 59 per cent, ex interest.
(iii)
o .bl plcs redeemable debentures. Estimate the cost of capital for California 0 00 2 The following figures are from the current balance sheet of Delaware plc ks o bo 000 e Ordinary share capital
Required
Authorised: 10,000,000 shares of 1 Issued: 8,000,000 shares of 1 Share premium account Revenue reserves Shareholders funds 12% Irredeemable debentures 10,000 8,000 2,000 _6,000 16,000 4,000
p gs
o t.c
An annual ordinary dividend of 20p per share has just been paid. In the past, ordinary dividends have grown at a rate of 10% per annum and this rate of growth is expected to continue. Annual interest has recently been paid on the debentures. The ordinary shares are currently quoted at 2.75 and the debentures at 80 per cent.
Required
Estimate the weighted average cost of capital for Delaware plc.
112
Solution (Nevada plc)

(i) Cost of ordinary shares Growth rate in dividend =
3
30 1 = 26
0.049
(i.e. 4.9%)
Cost of equity
D1 +g P0
30 x 1.049 + 0.049 235 - 30 0.2025 (i.e. 20.25%)
= = (ii) Cost of redeemable debentures Time 0 1-6 6 Flow (59) 6 102
20% factor 1 3.326 0.335
PV (59.000) 19.956 34.170 (4.874)
15% factor 1 3.784 0.432
By interpolation: IRR = 15 + 7.768 x (20 15) 7.768 + 4.874 = 18.07%
Cost of debentures (iii)
Weighted average cost of capital Cost of equity =
o bo
=
0 s2
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p gs
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PV (59.000) 22.704 44.064 7.768
= 18.07
20 1.1 + 0.1 275 12 80
= 0.18 (i.e. 18%) = 15%
Cost of debenture
Weighted average cost of capital =
8m 2.75 18%) + (4m 0.80 15%) (8m 2.75) + (4m 0.80) 444 = 17.6% 2,520
113
Question (Crystal plc)

The following figures have been extracted from the most recent accounts of Crystal plc. Balance sheet as on 30 June 2007 000 Fixed assets Investments Current assets Less current liabilities 000 10,115 821
3,658 1,735 _1,923 12,859
Ordinary share capital Authorised: 4,000,000 ordinary shares of 1 Issued: 3,000,000 ordinary shares of 1 Reserves Shareholders funds 7% Debentures Corporation tax
Summary of profits and dividends Year ended 30 June: Profit after interest and before tax Less tax Profit after interest and tax Less dividends Added to reserves 2003 000 1,737 573 1,164 620 544
eb
k oo
0 20
o .bl
p gs
o t.c
m
2006 000 1,866 616 1,250 740 510
3,000 6,542 9,542 1,300 _2,017 12,859
2004 000 2,090 690 1,400 680 720
2005 000 1,940 640 1,300 740 560
2007 000 2,179 719 1,460 810 650
The current (1 July 2007) market value of Crystal plcs ordinary shares is 3.27 per share cum div. An annual dividend of 810,000 is due for payment shortly. The debentures are redeemable at par in ten years time. Their current market value is 77.10 per cent. Annual interest has just been paid on the debentures. There have been no issues or redemptions of ordinary shares or debentures during the past five years. The current rate of corporation tax is 33%, and the current basic rate of income tax is 25%. Assume that there have been no changes in the system or rates of taxation during the last five years.
Required (a) (b)

Estimate the cost of capital which Crystal plc should use as a discount rate when appraising new investment opportunities. Discuss any difficulties and uncertainties in your estimates.
114
Solution (Crystal plc)

(a) The post-tax weighted average cost of capital
(i) Ordinary shares Market value of shares cum div Less dividend per share (810 3,000) 3.27 0.27 3.00
The formula for calculating the cost of equity when there is dividend growth is Ke =
D 0 (1 + g) +g P0
In this case we can estimate the future rate of growth (g) from the average growth in dividends over the past four years. 810 = (1 + g)4 (1 + g) g Ke (ii) = = 620(1 + g)4 = = 810 = 620 1.069 = 6.9% 1.3065
0.069
0.27 1.069 = 0.069 = 3
7% Debentures
In order to find the post-tax cost of the debentures, which are redeemable in ten years time, it is necessary to find the discount rate (IRR) which will give the future post-tax cash flows a present value of 77.10.
o bo
0 s2
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p gs
o t.c
16.5%
The relevant cash flows are: 1. 2. annual interest payments, net of tax, which are 100 x 7% x 67% = 4.69 (for ten years); a capital repayment of 100 (in ten years time)
It is assumed that tax relief on the debenture interest arises at the same time as the interest payment. In practice the cash flow effect is unlikely to be felt for about a year, but this will have no significant effect on the calculations. Try 8% PV Current market value of debentures Annual interest payments net of tax 4.69 x 6.710 Capital repayment 100 x 0.463 NPV Try 9% PV Current market value of debentures Annual interest payments net of tax 4.69 x 6.418 Capital repayment 100 x 0.422 NPV (77.10) 31.47 46.30 0.67 (77.10) 30.10 42.20 (4.80)
115
IRR
0.67 8% + x (9 8) % 0.67 + 4.80
8.12%
(iii)
The weighted average cost of capital Market value 000 9,000 1,002 10,002 Cost % 16.50 8.12
Equity 7% Debentures
000 1,485 81 1,566
WACC (Ko) =
1,566 x 100 10,002
15.7%
The above calculations suggest that a discount rate in the region of 16% might be appropriate.
(b)
Difficulties and uncertainties arise in a number of areas.

(i) The cost of equity. The above calculation assumes that all shareholders have the same marginal cost of capital and the same dividend expectations, which is unrealistic. In addition, it is assumed that dividend growth has been and will be at a constant rate of 6.9%. In fact, actual growth in the years 2003/04 and 2006/07 was in excess of 9%, while in the year 2005/2006 there was no dividend growth. 6.9% is merely the average rate of growth for the past four years. The rate of future growth will depend more on the return from future projects undertaken than on the past dividend record.
(ii)
0 20 The use of the weighted average cost of capital. Use of the weighted ks average cost of oo capital as a discount rate is only justified where the company in eb question has achieved what it believes to be the optimal
.bl 0
p gs
o t.c
capital structure (the mix of debt and equity) and where it intends to maintain this structure in the long term.
(iii)
The projects themselves. The weighted average cost of capital makes no allowance for the business risk of individual projects. In practice some companies, having calculated the WACC, then add a premium for risk. This risk premium should vary from project to project, since not all projects are equally risky. In general, the riskier the project the higher the discount rate which should be used. Ideally, the use of the capital asset pricing model should provide a suitable risk adjusted discount rate, which is obviously preferable to the result of the dividend growth model, which has been used in the solution to part a) of this question
116
Question (Nile plc)

Nile plc is considering an investment in projects, which will be financed from the issue of new ordinary shares and debentures in a mix, which will hold its gearing ratio approximately constant. It wishes to estimate the cost of capital for purposes of appraising the projects, which would be small in relation to the companys present scale of operations. The company has an issued share capital of 1 million ordinary shares of 1 each; it has also issued 800,000 of 8% debentures. The market price of ordinary shares is 4.76 per share and debentures are priced at 79.40 per cent. Dividends and interest are payable annually. An ordinary dividend has just been paid; and the next instalment of interest is payable in the near future. Debentures are redeemable at par in eight years time. Dividends relating to the last five years have been as follows: Year Total dividends 2002 000 200 2003 000 230 2004 000 230 2005 000 260 2006 000 300
Assume that there have been no changes in the system or rates of taxation during the last five years and that the current rate of corporation tax is 40 per cent. Ignore personal taxation.
Required: (a) (b)
Estimate the cost of capital which Nile plc should use as a discount rate for purposes of investment appraisal, and Discuss any difficulties and uncertainties in your estimation.
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Solution (Nile plc)

(a) Estimate of cost of capital
(i) Cost of equity, based on assumed constant growth rate Ke =
D 0 (1 + g) +g P0
The future expected growth in dividends may be estimated from the historical growth rate which can be seen to be approximately 10.7%, i.e. Average growth rate, g, may be calculated as follows: 2002 Dividend (1 + g)4 (1 + g)4 = 2006 Dividend = 2006 Dividend 2002 Dividend =
300,000 200,000
= 1.5 Now, g can be found by use of compound interest tables, or by the use of a calculator: 1+g =
4
1.5
p g = 10.7% s g o .bl Now the growth model can be employed: 00 30p (1.107 20 K = s+ 0.107 476p k o o 33.21p eb = 0.107 =
e
= 1.107
o t.c
476p
= (ii)
17.68%
Cost of debt (after corporation tax) The effective cost of the debentures to the company allowing for corporation tax of 40% on interest paid (an allowable charge against profits) can be calculated by the following IRR method. Try 10% Year 0 1-8 (8 x 60%) 8 Cash flow (71.40)* 4.80 100 DF 1.0 5.335 0.467 (71.40) 25.61 46.70 +0.91 Try 11% DF 1.0 5.146 0.434 (71.40) 24.70 43.40 -3.30
Kb
= = =
0.91 10% + x 1% 0.91 + 3.30 10% + 0.22% 10.22%
* Ex-interest price = 79.40 - 8 = 71.40

118
(iii)
Calculation of WACC Using market value weightings: Market value Ordinary shares: 1m @ 4.76 Debentures: 71.4 800,000 x 100 = 4,760,000 x K% 17.68 = 841,568
571,200
10.22
58,377
5,331,200 WACC (Ko) =
899,945 16.88% (say 17%)
899,945 5,331,200
(b)
Difficulties and uncertainties in estimating WACC

The concept of the cost of capital is perhaps the most difficult of all the DCF concepts and one about which there is still considerable controversy. The approach taken above employs the weighted average cost of capital concept. It is based on the following basic principles: (i) The cost of capital required for investment appraisal is the cost of raising more capital in the market. The historical cost of existing capital is irrelevant. It is for this reason that current yields (returns related to current market prices) are used.
(ii)
0 20 It is assumed that the company will maintain approximately the same s mix of capital as ok hitherto and that the consequent weighted average cost of capitalbo an appropriate measure of the future cost. This is e is managements declared intention in this case, although it is probably
unrealistic in practice.
.bl 0
p gs
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The difficulties and uncertainties in the estimation of the cost of capital are as follows: (i) (ii) Growth rate the expected future growth rate of dividends has been obtained from the historical average growth rate of the last five years. Current share price it is assumed that the current share price is a reflection on logical investor behaviour in the market and reflects the markets anticipation of future dividends unaffected by extraneous events or influences. This will frequently not be the case. Corporation tax it is assumed that the future rate of corporation tax will remain at 40%. Any change in the rate, or for that matter in the system of taxation, would affect the earnings available for distribution and therefore the future dividend growth rate. Risk class it is assumed that the project to be appraised is of the same risk class as existing project.
(iii)
(iv)
119
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120
Chapter 5
Efficient market hypothesis
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121
C H A P T E R 5 E F F I C IE N T M A R K E T H Y P O T H E S IS
CHAPTER CONTENTS
EFFICIENT MARKET HYPOTHESIS------------------------------------- 123
1. 2. DEFINITION AND FORMS OF EFFICIENCY THE IMPLICATIONS OF THE EMH FOR FINANCIAL MANAGERS 123 124
EFFICIENT MARKET HYPOTHESIS ILLUSTRATION ------------------ 125 EFFICIENT MARKET HYPOTHESIS SOLUTION ----------------------- 126
FUNCTIONS PERFORMED BY THE CAPITAL MARKET EFFICIENT MARKET HYPOTHESIS 126 126
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122
EFFICIENT MARKET HYPOTHESIS 1. Definition and forms of efficiency

Definition
An efficient market is one in which the market price of all securities traded on it instantly and perfectly reflect all new information as it becomes available.
If this is correct, a companys real financial position, with respect to both current and future profitability, will be reflected in its share price. The implication for an investor is that he can rarely outperform the market, because it will already have anticipated developments in the future and have reflected these in the share price. Therefore the best course of action for an investor is to hold a well-diversified portfolio of shares to reduce overall risk. Other areas of financial management, such as the dividend valuation model, Modigliani and Millers arbitrage proof, the dividend irrelevancy hypothesis and aspects of mergers and takeovers rely on the existence of an efficient market.
Forms of Market Efficiency (i) Weak form
Share prices reflect all the information contained in the record of past prices and past trading volumes. As a result it is not possible to predict future share price movements by reference to past trends. Share prices follow a random walk. Accordingly a chartist (technical analyst) must regard the stock market as being totally inefficient.
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(ii) Semi-strong form

Share prices also reflect all current publicly available information. Therefore prices will change only when new information is published. As a result it would only be possible to predict share price movements if unpublished information were known (insider dealing). Accordingly fundamental analysis is a waste of effort if the stock market is semi-strong efficient.
(iii) Strong form

Share prices reflect all information which is relevant to the company. If this is the case then share price movements can never be predicted. Gains through insider dealing are not possible because shares are priced absolutely fairly. The government must not consider the stock market to be strong form efficient, because of its attempts to outlaw insider dealing.
123
2. The implications of the EMH for financial managers

In their book Principles of Corporate Finance, Richard Brealey, Stewart Myers and Franklin Allen describe six lessons of market efficiency as follows:
Lesson 1 - Markets Have No Memory.

The weak form of the EMH states that a study of past price changes will not be helpful in predicting future price changes, i.e. markets have no memory. This means that there is no right time to issue shares and the common reluctance of managers to make a new issue after a price fall has no basis in theory.
Lesson 2 - Trust Market Prices.

In an efficient market the price of a security is reliable and allows for all available information about that security. This means that it is not possible for most investors to achieve consistently above average returns, i.e. you cannot beat the market.
Lesson 3 - Read the Entrails.

If the market is efficient, the current price incorporates all available information about the future. Therefore, a careful study of security prices will provide a lot of information about investors expectations of the future, since investors are heavily influenced by economic prospects.
Lesson 4 - There Are No Financial Illusions.

Attempts to improve the image of the company through such cosmetic operations as bonus issues and changes in accounting policies or methods (e.g. depreciation methods) are unlikely to have any material effects on market values in the longrun. In fact they may be regarded as a sign of weakness and not of strength.
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Lesson 5 - The Do-It-Yourself Alternative.

Rational investors operating in an efficient market will not pay others to do what they can do equally well themselves. Diversification for its own sake will not enhance market values, because shareholders could achieve the same results for themselves, much more cheaply, by holding shares in a variety of companies.
Lesson 6 - Seen One Stock, Seen Them All.

In buying shares investors are simply buying an expected return for a given level of risk. Where two shares have the same risk and return characteristics they will be seen by the market as perfect substitutes one for the other (just like similar brands of coffee). The homogeneous nature of many securities results in the demand for the companys shares being very elastic. N.B. Most studies of this subject have been based on Wall Street or the London Stock Exchange, which are surely more efficient than most other stock markets.
124
EFFICIENT MARKET HYPOTHESIS ILLUSTRATION

Company A has 2 million shares in issue and company B, 6 million. On day 1 the market value per share is 2 for A and 3 for B. On day 2 the management of B decides, at a private meeting, to make a cash takeover bid for A at a price of 3.00 per share. The takeover will produce large operating savings with a present value of 3.2 million. On day 4 B publicly announces an unconditional offer to purchase all shares of A at a price of 3.00 per share with settlement on day 15. Details of the large savings are not announced and are not public knowledge. On day 10 B announces details of the savings which will be derived from the takeover.
Requirements
(a) Briefly outline the major functions performed by the capital market and explain the importance of each function for corporate financial management. How does the existence of a well functioning capital market assist financial management? Describe the efficient market hypothesis and explain the difference between the three forms of the hypothesis which have been distinguished.
(b) (c)
o sp between day 1 and 15, and Ignoring tax and the time-value of money log assuming the details given are the only factors having an impact on the share .b price of A and B, determine the day 2, day 4 and day 10 share price of A and 00 0 B if the market is: s2 k 1. semi-strong form efficient, and oo eb 2. strong form efficient,
in each of the following separate circumstances: (i) the purchase consideration is cash as specified above, and (ii) the purchase consideration, decided upon on day 2 and publicly announced on day 4, is one newly issued share of B for each share of A.
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EFFICIENT MARKET HYPOTHESIS SOLUTION Functions performed by the capital market

Important points are as follows:
1.

Functions
a source of new finance (the primary market) provides a market for those who already hold securities (a secondary market).
2.
(1)
Importance of each function

The primary market Provides a focal point for would-be borrowers and lenders and enables the typically small sums provided by lenders to be combined into the large amounts required by borrowers. An efficient primary market enables companies to raise finance quickly and with relatively low transaction costs.
(2)
The secondary market Provides liquidity for investors.
An efficient (perfect) market is a precondition for the application of many of the financial management decision rules.
Efficient market hypothesis oo
eb Important points to make are:

(i)
0 s2
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The EMH - states that the current share price reflects all available information about a security and that the market will react correctly and immediately to new information which emerges. The weak form - the current price reflects all information about past prices and past trading volumes. The semi-strong form - the current share price reflects all publicly available information (e.g. published accounts). The strong form - the current price reflects all available information - both public and private.
(ii) (iii) (iv)
126
Illustration continuation of solution

The important thing in answering this type of question is to be methodical. The first step is to get a clear idea of what is required. Here the question is asking for the prices of two different shares on three different days with two forms of the efficient market hypothesis and two alternative forms of purchase consideration, a total of 2 x 3 x 2 x 2 = 24 prices! Set up a series of grids that will show the eventual answers. (i) Cash consideration (1) Semi-strong form Day 2 4 10 Notes 1 Only publicly available information affects share prices under the semi-strong form. No information is publicly available until day 4 so prices remain unaltered from day 1 levels. Offer made known so A rises to offer price. B is apparently paying 6m for assets worth 4m. The apparent loss of 2m spread over 6 million shares causes the price to fall by 33p. News of savings publicly available so price of B increases by 3.2m spread over 6 million shares, i.e. increase of 53p. Share A 2.00 3.00 3.00 Share B 3.00 2.67 3.20 Note 1 2 3
(2)
Strong form Day 2 4 10 4
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Share A 3.00 3.00 3.00
Share B 3.20 3.20 3.20
Note 4 4 4
Strong form so all information, public and private, is immediately reflected in share price. Final price, as per note 3, operates from day 2.
127
(ii)
Share issue 1. Semi-strong form Day 2 4 10 5 Share A 2.00 2.75 3.15 Share B 3.00 2.75 3.15 Note 1 5 6
The best way to see this is to think of a new merged company A and B with 8 million shares. The share price will be the markets view of the total value of the company divided by the number of shares. On day 4 savings are not public so total value is (2m x 2) + (6m x 3) = 22m. The share price is therefore 22m 8m = 2.75. Savings known so total value increases to 22m + 3.2m = 25.2m and the share price = 25.2m 8m = 3.15.
2.
Strong form Day 2 4 10 7 Share A 3.15 3.15 3.15 Share B 3.15 3.15 3.15
As with note 4, all information reflected immediately so final price calculated in note 6 is in effect from day 2.
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Note 7 7 7
128
Chapter 6
Theories of gearing
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C H A P T E R 6 T H E O R I E S O F G E A R IN G
CHAPTER CONTENTS
THE TRADITIONAL VIEW ---------------------------------------------- 131 MODIGLIANI & MILLER TAX IGNORED (1958) ------------------- 132
GRAPH FORMULAE ASSUMPTIONS ARBITRAGE IN A WORLD WITH NO TAXES 132 132 133 133
MODIGLIANI & MILLER INCLUDING CORPORATION TAX (1963)135

GRAPH CORPORATION TAX POSITION (U AND G IN WORLD WITH TAXES) EQUILIBRIUM POSITION M & M FORMULAE WHY DO COMPANIES NOT ATTEMPT A 99.9% DEBT STRUCTURE? 135 135 136 136
PECKING ORDER THEORY ---------------------------------------------- 139 STATIC TRADE-OFF THEORY------------------------------------------- 140 SOLVENCY RATIOS ----------------------------------------------------- 141
1. 2.
k oo INTEREST COVER eb
GEARING RATIO
0 20
log .b
t. po
om
137
141 141
BERLAN AND CANALOT ------------------------------------------------ 142
130
THE TRADITIONAL VIEW
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131
MODIGLIANI AND MILLER TAX IGNORED (1958)

All companies with the same earnings in the same risk class have the same future income stream and should therefore have the same value, independent of capital structure.
Graph
Modigliani & Miller (no tax)
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Formulae
Vg = Vu
Keg = Kog =
Keu + (Keu Kb)

Keu
D E
N.B. These formulae may be derived from the expressions which include the effect of corporation tax treating t = 0
132
Assumptions
Investors are rational Investors have the same view of the future Personal and corporate gearing are perfect substitutes Information is freely available No transaction costs No tax Firms can be grouped into similar risk classes.
The arbitrage proof, which incorporates these assumptions, can be used to support this M & M proposition.
Arbitrage in a world with no taxes

Assume two companies, identical in every respect, except G is financed by 1,000 of 10% irredeemable debt trading at par. The above assumptions hold. The traditional view of the two companies would be: U (ungeared) 500 -_ 500 G (geared) 500 (100) 400
EBIT Interest Dividends Cost of Equity (assumed) E (equity) D (debt) V (total) WACC
eb
ok
0 20 20% s
.bl 0
p gs
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2,500 -_ 2,500 20%
25% 1,600 1,000 2,600 19.2%
If an investor owned 1% of Gs equity (income 4) he should arbitrage i.e. 1. 2. 3. 4. Dividends from U (1.04% x 500) Interest on borrowings (10% x 10) Net income Sell his stake in G for 16 Adopt same financial risk as in G by borrowing personally a proportional amount at 10% i.e. 1,000 x 1% = 10. Invest 26 in U to obtain 1.04% of Us equity (26 2,500) 5.20 (1.00) 4.20
i.e. the investor is better off as a result of arbitrage
133
If one person makes the switch, many other investors will sell their shares in G and purchase equity shares in U. Gs share price will fall, whilst Us share price will rise. Assuming Gs share price is the only one which changes, then the equilibrium will arise where the net income from the two equity investments is identical. 5.00 (1.00) 4.00
i.e.
Dividends from U (balance) Interest Net 5 dividend from U = 1% of shares
1% represents a 25 investment, of which 10 is borrowed. proceeds from Gs shares in equilibrium must be 15 Accordingly all Gs shares are worth 1,500 in equilibrium Thus: Vg = = = Vu 2,500 26.7%
Therefore sales
(1,500 + 1,000) Ke in G is now
400 1,500 500 2,500
and WACC is Therefore:
= Kog =
20% Keu = 20%
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134
MODIGLIANI AND MILLER INCLUDING CORPORATION TAX (1963)

The values of companies with the same earnings in the same risk class are no longer independent. Companies with a higher gearing ratio have a greater net future income stream (purely due to corporation tax relief on interest payments) and therefore a higher value.
Graph
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D E
Corporation tax position (U and G in world with taxes)

Assume corporation tax rate is 35%. The net of tax distributions to investors are shown in the following table: 500 500 (175) 325 500 (100) 400 (140) 260
EBIT Interest Profit before tax Tax (35%) Dividends
135
Equilibrium position M & M

M & M argue that as G pays less tax it can distribute more to its investors. The difference in equilibrium values is explained by the present value of the tax shield on debt interest available to G. As Gs debt is irredeemable this difference can be measured by D x Kb x t Kb therefore where Vg Vu = = = Dt
Vu + Dt value of an equivalent ungeared company
Assuming U is correctly valued and its cost of equity is 20%, then we calculate the equilibrium value of G with reference to U 1,625
Value of U
325 0.20 1,000 x 0.35
Dt Value of G
350 1,975
CONCLUSION: a 99.9% debt structure is optimal!!!
Formulae
Vg = Vu + Dt
Keg =
*Kb or kd is the PRE-TAX COST OF DEBT for this formula. N.B. The formula on the right-hand side is provided on the ACCA P4 Formulae sheet Kog = Dt Keu 1 E + D
0 20 s or D(1 t) Keu + (Keu Kb*) ok E o eb
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p gs
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k i e + (1 - T)(k i e - k d )
Vd Ve
Capital structure illustration (Grant plc)

Grant plc (an all equity company) has on issue 6,000,000 1 ordinary shares at market value of 2.50 each. Bell plc (a geared company) has on issue: 17,000,000 25p ordinary shares; and 8,000,000 15% debentures (quoted at 125) Taking corporation tax at 35%, and assuming that: 1. 2. The companies are in all other respects identical; and The market value of Grants equity and the market value of Bells debt are in equilibrium;
Calculate the equilibrium price per share of Bells equity.
136
Solution
Vg = Vu + Dt = 8,000,000 x 125 100 = 10m m 15 3.5 18.5m m 8.5 10_ 18.5m
N.B. D
Vu Dt Vg
= = =
6,000,000 10,000,000
@ x
2.50 35%
= =
E D Vg Price per share
(balancing figure) (as above) (as above)
8.5m 17m
50p
Why do companies not attempt a 99.9% debt structure?

1. Bankruptcy costs
The higher the level of gearing the greater the risk of bankruptcy with the associated COSTS OF FINANCIAL DISTRESS. Vg = Vu + Dt
2.
Agency costs
Costs of restrictive covenants to protect the interests of debt holders at high levels of gearing.
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Present value of costs of financial distress
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3.
Tax exhaustion
The value of the company will be reduced if advantage cannot be taken of the tax relief associated with debt interest.
4.
Debt capacity
Generally loans must be secured against a companys assets and clearly some assets (e.g. property) provide better security for loans than other assets (e.g. hightech equipment which may become obsolescent overnight). The depth of the assets second hand market and its rate of depreciation are important characteristics.
137
5.
Personal taxes (MILLERS CRITIQUE 1977)

If a firms income is paid out as debt interest, corporation tax savings are made (see M & M 1963) but investors will have to pay income tax on debt interest. If a firms income is paid out as an equity return, corporation tax has to be paid but personal tax can be saved (e.g. by avoidance of capital gains tax using exemptions). In deciding its gearing level, a firm should consider its corporation tax position and the personal tax position of its investors if it wishes to maximise their wealth. In his 1977 article, Miller argues that firms will gear up until marginal investors face a personal tax cost of holding debt equal to the corporation tax saving. At this point there is no further advantage of gearing.
Investors will be concerned with returns net of all taxes
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PECKING ORDER THEORY

The Pecking Order Theory is that a companys capital structure decision is not determined by the costs and benefits of using a combination of debt and equity finance to minimise the cost of capital. The theory suggests that a company has a well defined order of preference in relation to available sources of finance i.e. (a) The first preference is the use of retained earnings, since internal finance is readily accessible, has no issue costs and does not involve negotiating with third parties, such as banks. If external finance has to be used (because the company has identified more positive NPV projects than can be financed by retentions alone), bank borrowings, loan stock and debentures are the initial preferred source of external finance. The cost of issuing new debt is normally much smaller than the cost of equity issues. Furthermore it is possible to raise smaller amounts of debt than of equity. When raising debt, initially it is advisable to issue low risk secured debt, and when there are no more assets available as security, then to issue unsecured debt with a consequent higher risk and higher cost.
(b)
m co there remain further (c) If, after the companys level of debt capacity is reached, t. po positive NPV projects that remain to be financed, the final and least preferred s source of finance is the issue of new equity capital. log .b Accordingly there appears to exist a financing pecking order i.e. first use retained 00 debt and finally equity. profits, then secured debt, then unsecured 0 s2 the Pecking Order Theory was developed in k A more sophisticated explanation of oo 1984, when it was suggested that the order of preference stemmed from the eb existence of asymmetry of information between the company and the capital
markets. This term refers to the fact that company management are likely to have a much better idea of the true worth of the companys shares than do outside investors. Accordingly if a company wishes to raise new project finance and the capital market has underestimated the benefits of the project, company management (with their inside information) will be aware that the market has undervalued the company. They would therefore choose to finance the project through retentions, so that when the market discovers the true value of the project, existing shareholders will benefit. If retained earnings are inadequate, the company would choose to raise debt finance in preference to a new equity issue (since they would not wish to issue new equity shares which are undervalued by the market). However if the companys management believe that investors are overvaluing the benefits of the new project and therefore placing too high value on the companys shares, they would prefer to issue new equity at that overvalued price.
139
STATIC TRADE-OFF THEORY

This variation on the 1963 with corporate tax theory of Modigliani and Miller arrives at a conclusion, which is similar to that of the traditional theory of gearing i.e. there exists an optimum level of leverage that companies should attempt to attain. Provided a company is in a static position i.e. not in a period of extreme growth, it is likely to have a gearing policy that is stable over time. This is achieved by striking a balance between the benefits and the costs of raising debt. The benefits of debt relate to the tax relief that is enjoyed when interest payments are made the cheaper debt finance will reduce the weighted average cost of capital and increase corporate value. The costs of debt relate to the increases in the costs of financial distress (e.g. bankruptcy costs) and increases in agency costs that arise when the company exceeds its optimum gearing levels. The resultant increase in required returns demanded by investors cause the weighted average cost of capital of the company to increase and hence corporate value to fall. There is accordingly, in theory, a trade-off between these two effects and hence the cost of capital and the value of the company will be optimised. However, subsequent research suggests that there is little evidence of the static trade-off theory operating in the real world.
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140
SOLVENCY RATIOS 1. Gearing Ratio

This indicates the relationship between: Equity : Fixed return securities (or Debt) on issue It may be based upon balance sheet values (in which case Equity will comprise ordinary share capital and reserves) or upon stock exchange values (in which event the shares and debentures on issue are valued at mid market price).
Illustration
Called-up Share Capital: 250,000 of ordinary shares of 25p, quoted price 53p 55p 500,000 of 7% preference shares of 1, quoted price 71p 73p Reserves 100,000
Loans: 200,000 of 12% irredeemable debentures market yield currently 10%
You are required to calculate the Capital Gearing Ratio, based upon
(a) (b) Book values Market values
Solution to illustration
(a) (b)
Book values = (250,000 + 100,000) : (500,000 + 200,000) = 0.5 : 1 Market values = 540,000 : (360,000 + 240,000) = 0.9 : 1
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N.B. Gearing ratios are expressed in a number of ways e.g.
Debt Equity
Debt Equity + Debt
Debt may include long-term borrowings only or both short and long-term debt. A further problem is the classification of hybrid securities e.g preference shares. In the above illustration they have been classified as debt, but this is open to debate when the ratio is calculated for the benefit of lenders.
2. Interest cover
ie Earnings before Interest and Tax Gross Interest
141
Berlan and Canalot Berlan plc

Berlan plc has annual earnings before interest and tax of 15m. These earnings are expected to remain constant. The market price of the companys ordinary shares is 86 pence per share cum.div. and of debentures 105.50 per debenture ex-interest. An interim dividend of six pence per share has been declared. Corporate tax is at the rate of 35% and all available earnings are distributed as dividends. Berlans long-term capital structure is shown below: 000 12,500 24,300 36,800 23,697 60,497
Ordinary shares (25 pence par value) Reserves 16% debentures 31.12.2007 (100 par value)
Required:
Calculate the cost of capital of Berlan plc according to the traditional theory of capital structure. Assume that it is now 31 December 2004.
o .blan equilibrium market value of 32.5 Canalot plc is an all-equity company00 with 0 million and a cost of capital of 18% per year. 2 ks 5 million of equity and to replace it with The company proposes to repurchase o bo 13% irredeemable loan stock. e
Canalot plc
Canalots earnings before interest and tax are expected to be constant for the foreseeable future. Corporate tax is at the rate of 35%. All profits are paid out as dividends.
p gs
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Required: (a)
Using the assumptions of Modigliani and Miller, explain and demonstrate how this change in capital structure will affect: (i) (ii) (iii) the market value the cost of equity the cost of capital
of Canalot plc.
(b)
Explain any weakness of both the traditional and Modigliani and Miller theories and discuss how useful they might be in the determination of the capital structure for a company.
142
Berlan and Canalot solution

Berlans weighted average cost of capital
Cost of equity 000 15,000 3,792 11,208 _3,923 7,285 7,285 NIL = 12.5 million x 4 = 50 million
Earnings before interest and tax Interest (16% x 23,697) Tax (35% x 11,208) Earnings Dividend (full distribution)
Number of shares
Market price per share: cum div Less interim dividend declared Ex div Value of shares =
50 million x 80p
Cost of equity capital, using the dividend valuation model and assuming constant dividends =
7285 40,000
18.21%
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m
=
Pence 86 _6 80p 40 million
Cost of debt A market value higher than redemption value implies that the cost (pre-tax) is less than the nominal rate of 16%. Using 8% and 9% as discount rates. Year 0 1-3 3 Market value Interest (net of tax) Redemption (105.50) 10.40 100.00 8% factors 1 2.577 0.794 PV (105.50) 26.80 79.40 +0.70 = 9% factors 1 2.531 0.772 PV (105.50) 26.32 77.20 1.98
Cost of debt
0.7 8% + X 1% 0.7 + 1.98 23.697million x 105 .50 100
8.26%
Market value of debt Value of debt plus equity
= =
= =
25 million 65 million
(25 + 40) million
Weighted average cost of capital WACC = 18.21% x 40 25 = + 8.26% x 65 65

14.38%
143
Changes to capital structure: Canalot plc (a)

(i) Market value Using a Modigliani-Miller formula for the value of a geared company (with irredeemable debt): Vg = Vu + Dt When Canalot replaces equity with loan stock, the company will increase in value by the tax shield, Dt. = = 5 million debt issued x 35% tax rate 1.75 million
The market value of the company increases to 32.5 million + 1.75 million = 34.25 million
The market value of equity becomes 34.25 million 5 million = (ii) The cost of equity This can be computed from first principles, or 29.25 million
by using the MM formula for Ke
From first principles
Consider the distribution of profits before and after the change in capital structure.
k ooequity earnings b Before the change, e= 5.85 million. 32.5 million

Pre-tax profits = After the debt issue:
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= 100 65
18%
market value of
5.85 million x
9 million.
Earnings before interest and tax Less interest: 5m x 13% Tax (35% x 8,350) Equity earnings (= dividend) Cost of equity =
000 9,000 _650 8,350 2,922 5,428 = 18.56%
5,428 29,250
The cost of equity has increased by 0.56% because of the increased financial risk experienced by shareholders.
144
Using the MM formula for Ke:

Keg = = (iii)
Keu + (Keu Kb)
D(1 t) E
5(1 0.35) 29.25 = 18.56%
18% + (18% 13%)
Weighted average cost of capital Again, this can be computed either from first principles or by using the MM formula for WACC.
From first principles

WACC = 29.25 5 x 18.56% + x 13% x 0.65 = 34.25 34.25 17.08%
Using the MM formula for WACC

WACCg = Dt Keu 1 E + D 5 x 0.35 18% 1 34.25 =
The WACC has declined from 18%, reflecting the benefits of tax relief on interest.
(b)
Weaknesses of the traditional and Modigliani-Miller theories
0 20 structure is an intuitive theory, which is not The traditional theory of ks o capital supported by a rigorous model building approach, as is the case with o Modigliani and Millers work. It describes how the weighted average cost of eb
capital declines as gearing increases until a point is reached where WACC is at its lowest and starts to increase with further increases in gearing. It therefore suggests that there is an optimal capital structure at which the firm has its lowest cost of capital and highest value. Unfortunately, because the theory is purely descriptive, it does not suggest a method of finding that optimal capital structure, except by trial and error. The traditional view predicts an optimal WACC position, because it effectively suggests that the relationship between the cost of equity and gearing is nonlinear. In this respect it is in conflict with the capital asset pricing model and much of modern financial management theory. Modigliani and Millers theory, used in our discussion of Canalot plc, suggests that the only advantage of borrowing is the tax relief on debt interest. The theory results directly from the assumptions that they make. Some of these are unrealistic, for example: (i) (ii) (iii) that individuals and companies can borrow at the same interest rate that interest rates do not increase with gearing that personal borrowing (which is not covered by limited liability) is no different from corporate borrowing
.bl 0
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17.08%
145
(iv) (v)
that the capital market is perfect that (although corporate taxes are considered) personal taxes are ignored.
Although these assumptions are unrealistic, there is still some logic in MMs suggestion that companies should borrow as much as they can in order to take advantage of tax relief. However, their theory also ignores possible costs arising at high levels of gearing, such as: (i) Bankruptcy costs: both direct (sale of assets below going concern value) and indirect (increased time spent controlling a company which is near bankruptcy). (ii) Agency costs: for example, restrictive covenants in loan agreements which hinder the companys freedom of operation. (iii) Tax exhaustion: inability to take advantage of the all tax relief on the high debt interest because of a lack of taxable profits. (iv) Debt capacity: inability to offer sufficient security to be able to borrow to a high level of gearing. At some level of gearing these costs will start to outweigh the benefits of tax relief, implying that optimal gearing is achieved at a level just below this point. Unfortunately, while the MM theory allows predictions of the effect of borrowing on the cost of capital, it does not enable this optimal borrowing level to be established, because it ignores the costs at high gearing. Miller, in a later paper, argues that when personal taxes are introduced, the capital structure does not affect the firms cost of capital. However, this too ignores bankruptcy costs and other costs of high gearing. In summary neither the traditional nor the MM view of capital structure presents a practical method for identifying a companys optimal capital structure. This can only be achieved by intelligent trial and error. However, Modigliani and Miller do at least identify the various factors which affect the cost of capital and, at reasonable levels of borrowing, enable the company to predict the effect of increasing or decreasing gearing on the value of the firm.
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Chapter 7
Portfolio theory and the capital asset pricing model

m
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147
C H A P T E R 7 P O R T F O L IO T H E O R Y A N D T H E C A P IT A L A S S E T P R IC I N G M O D E L
CHAPTER CONTENTS
PRINCIPLES OF PORTFOLIO THEORY -------------------------------- 149 THE UNDERLYING THEORY OF CAPM --------------------------------- 158 SYSTEMATIC AND UNSYSTEMATIC RISK ----------------------------- 159 THE SECURITY MARKET LINE------------------------------------------ 161 SYSTEMATIC BUSINESS RISK AND SYSTEMATIC FINANCIAL RISK166 ASSUMPTIONS, ADVANTAGES AND LIMITATIONS OF CAPM ------- 172 ARBITRAGE PRICING THEORY AND FAMA & FRENCH THREE FACTOR MODEL ------------------------------------------------------------------- 174 CYGNET PLC ------------------------------------------------------------- 175 FIVE WEALTHY INDIVIDUALS ----------------------------------------- 179 DELL PLC----------------------------------------------------------------- 184 NELSON PLC ------------------------------------------------------------- 186
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148
PRINCIPLES OF PORTFOLIO THEORY

In 1952, Harry Markowitz developed portfolio theory, which is based upon a very simple principle. Any investment (whether an investment in shares or an investment in projects), should never be viewed in isolation, but should instead be considered as part of an overall portfolio of shares or projects. As everyones grandmother might say Dont put all of your eggs in one basket!! Portfolio theory uses statistical techniques to prove that grandmother is correct!! The features of portfolio theory are dealt with in detail in the following illustration.
Illustration 1 (Pastel plc)

Pastel plc is considering whether to accept one of two major new investment opportunities Project 1 and Project 2. Each project would require an immediate outlay of 10,000 and Pastel plc expects to have available enough resources to undertake only one of them. The directors of Pastel plc believe that returns from existing activities and from the new projects will depend upon which of three economic environments prevails during the coming year. They estimate returns for the coming year (that is cash flows to be received at the end of the year plus project value at that time), and the probabilities of the three possible environments, as follows:
Probability of environment Returns from Project 1 Returns from Project 2 Aggregate returns from existing portfolio of projects
eb
po sEnvironment B Environment A g 0.3 blo 0.4 . 0 12,500 12,500 00 210,000 11,750 ks 90,000 o 120,000
o t.c
Environment C 0.3 9,500 13,000 130,000
The company has a current market value of 100,000. The directors of Pastel plc believe that the risk and returns per of market value of their existing activities are similar to those for the stock market as a whole, including their dependence on whichever economic environment prevails. The current rate of interest on shortdated government securities and on bank deposit account is 10% per annum.
You are required to prepare calculations for the directors of Pastel plc showing which, if either, of the two proposed projects should be accepted.
Ignore inflation and taxation
149
Solution 1 (Pastel plc)

(a)
(i)
Choice between proposed projects

Conversion of data into period rates of return Period rate of return = End of year value Start of year value Start of year value
Environment A
PROJECT 1 12.5 10 10 12.5 10 10 = 25%
PROJECT 2 10 10 10 = 0%
EXISTING PORTFOLIO 90 100 100 120 100 100
= -10%
= 25%
11.75 10 = 17.5% 10
= 20%
m co (ii) Calculation of expected returns (Er) and standardt. deviations for each po s w Rates of Expected return og PROJECT l Deviations w(r Er) Return (Er) .b (r Er) % % 00 % 0 1 0.3 25 7.5 +9 24.3 2 s10.0 0.4 25 +9 32.4 k 0.3 -5 -21 132.3 oo (1.5) 189.0 = 16.0 eb
2
9.5 10 10
= -5%
13 10 10
30%
130 100 100
= 30%
s()
13.75%
0.3 0.4 0.3
0 17.5 30
7.0 9.0 16.0 (3.0) 8.0 9.0 14.0
-16 + 1.5 +14
76.8 0.9 58.8 136.5 172.8 14.4 76.8 264.0
= 11.68%
Existing Portfolio and Market
0.3 0.4 0.3
-10 20 30
-24 +6 +16
= 16.25%
(iii)
Naive analysis Provided that investors are generally risk averse, if two mutually exclusive projects have identical expected returns, the preferred project is that with the smaller amount of risk (i.e. standard deviation or variance). In this instance: Er 16% 16% s() 13.75% 11.68%
Project 1 Project 2
Since, they have the same expected returns; it would appear that Project 2 is preferred as it has the lower standard deviation. Furthermore, given that the existing projects of Pastel plc provide a lower level of expected return (14%)
150
for a higher level of risk (a standard deviation of 16.25%) than Project 2, it appears that Project 2 would be an acceptable investment for Pastel plc to undertake. (iv) Portfolio approach The above approach is considered naive because THE MARGINAL PROJECT SHOULD NOT BE VIEWED IN ISOLATION, BUT AS PART OF THE OVERALL PORTFOLIO OF PROJECTS i.e. (a) Period rates of return Environment A EXISTING PORTFOLIO plus PROJECT 1 102.5 110 = - 6.82% 110 132.5 110 110 139.5 110 110 = 20.45% EXISTING PORTFOLIO plus PROJECT 2 100 110 = - 9.09% 110 131.75 110 110 143 110 110 = 19.77%
26.82%
= 30.00%
m co deviation for each t. (b) Calculation of expected returns (Er) and standard po s Rates of Expected Deviations log Er) w(r Er) s() PROJECT w Return return (Er) .b (r 0 % % 0 % 20 Existing + s 0.3 -6.82 -21.0 132.30 Proj. 1 ok -2.046 8.18 +6.27 15.73 0.4 20.45 bo e 0.3 26.82 8.046 +12.64 47.93
2
14.18 Existing + Proj. 2 0.3 0.4 0.3 -9.09 19.77 30.00 -2.727 7.908 9.000 14.18 -23.27 +5.59 +15.82
195.96 162.45 12.50 75.08 250.03
14.00%
15.81%
CORRELATION CO-EFFICIENTS
Where the two assets behave in an absolutely identical way, there is perfect positive correlation (+ 1), where they behave in directly opposing ways there is perfect negative correlation ( 1) and where there is no observable relationship between the two, there is zero correlation (0). The formula to calculate a correlation coefficient (which is not provided on the ACCA formula sheet) is: (r)
PROJECT, EXISTING
COV(PROJ, EXISTING) s PROJECT sEXISTING
151
(1)
Calculations of covariances
PROJECT 1 and EXISTING PORTFOLIO w 0.3 0.4 0.3 Project 1 Deviations (r-Er) +9 +9 - 21 Existing Portfolio Deviations (r-Er) - 24 +6 + 16 Covariance Project, Existing - 64.8 21.6 - 100.8 - 144
PROJECT 2 and EXISTING PORTFOLIO w 0.3 0.4 0.3 Project 2 Deviations (r-Er) - 16 + 1.5 + 14 Existing Portfolio Deviations (r-Er) - 24 +6 + 16 Covariance Project, Existing 115.2 3.6 67.2 + 186
(2)
Standard deviations (already calculated)

s
PROJ.1
= 13.75%
PROJ.2
= 11.68%
EXISTING
(3)
Correlation coefficients
PROJ. 1, EXISTING
144 13.75 x 16.25
(Fairly high degree of negative correlation!)

PROJ. 2, EXISTING
k+ oo.68186 .25 b 11 x 16
0 s2
lo .b= 0
=
p gs
o t.c
= 16.25%
-0.64
+0.98
(Extremely high level of positive correlation!) The above analysis shows that the expanded portfolio (including Project 1) would be less risky than the expanded portfolio (including Project 2). Whilst Project 1 on its own is more risky than Project 2. Once more both portfolios show identical expected returns. The reason for this decision change is the correlation between each of the proposed projects and the existing portfolio i.e. (a) (b) The returns of Project 1 and the existing portfolio are negatively correlated, whilst The returns of Project 2 and the existing portfolio show a high degree of positive correlation.
FORMULAE
Fortunately formulae exist to avoid the necessity for the laborious calculations shown on page 151 of this solution. These formulae are:
Expected return from portfolio
Erp
waEra + wbErb
where wa is the proportion invested in the shares of Company a and, wb is the proportion invested in the shares of Company b Erp is simply a weighted average of the expected returns from each investment.
152
Risk of portfolio
wa sa
2 2
(sp)
2
+ wb
sb
+ 2 w a w b s a s b ab
N.B. sa sb ab =
Cov [Era Erb]
NOTE: Provided ab (correlation coefficient) is less than +1, the risk of the portfolio (the or s of the combined returns) will be less than the weighted average risk of the portfolios two components. Relating these formulae to the Pastel problem and treating each new project as a and the existing portfolio as b, the expected return and total risk of the existing portfolio and Project 1 are as follows: Erp = 1 10 x 16% + x 14% 11 11
2 2
14.18%
sp
1 10 1 10 x 13.75 + x 16.25 + 2 x x x 13.75 x 16.25 x 0.64 11 11 11 11
1.5625 + 218.2335 23.6364
14.00%
And the expected return and total risk of the existing portfolio and Project 2 are as follows: Erp = 1 10 x 16% + x 14% 11 11
2
sp
= =
1 10 1 10 x 11.68 + x 16.25 + 2 x x x 11.68 x 16.25 x 0.98 11 11 11 11
e Notice how these formulae provide the same results as the calculations performed
on page 151, which thankfully will never have to be repeated thanks to these formulae.
1.1275 + 218.2335 + 30.7445
o bo
0 s2
o .bl 0
2
o 14.18% sp g
o t.c
15.81%
153
APPENDIX (To be read after studying the Capital Asset Pricing Model)
The analysis using portfolio theory can be improved upon further by taking into consideration the Capital Asset Pricing Model. This shows that an investment projects risk can be split into two components: Systematic and Unsystematic Risk. The unsystematic risk of an investment project can be eliminated when it is held as part of an efficient well diversified investment portfolio. Therefore, in evaluating the expected return from a project, it should be viewed, not in relation to the projects total risk, but just to the systematic portion of that risk, which cannot be eliminated. The CAPM gives an expression for the return required from a single investment, project j: Erj = Rf + Erj Rf Erm j
sm2
(Erm Rf) j = = = =
=
where
required return from investment j risk-free return expected overall return on the market portfolio
COV
( jm )
2
sm
o sp the returns from the market COV (jm) = covariance of returns of projectg with lo j .b The data given by this question provides0 0 0 r = 10% s2 k oo Er = 14% eb s = 264
variance of the returns from a market portfolio
f m 2 m
o t.c
COV COV
(PROJECT 1 & MARKET) (PROJECT 2 & MARKET)
= =
144
+186
N.B. The question states that the risk and returns on the existing portfolio are similar to those of the stock market as a whole. Thus the in each case is:
PROJECT 1
= =
144 264
186 264
= =
0.545
+0.705
PROJECT 2
Therefore the required return on each project is: PROJECT 1: PROJECT 2: 10% + (14% 10%) 10% + (14% 10%) -144 264 186 264 = = = 7.8% 12.8% 16%
whilst the expected return on both projects
154
In conclusion, this analysis shows that, whilst the return expected from both projects (16%) is above that required (Project 1: 7.8%, Project 2: 12.8%), given their individual levels of systematic risk, Project 1 is preferred since it provides the greatest excess return over required return and hence will add most to shareholders wealth. Notice that this conclusion is the complete opposite to that reached via the naive analysis. An alternative expression for the calculation of is:
s j jm sm
= = = standard deviation of the returns of investment j the correlation coefficient between the returns of j and the returns from the market portfolio standard deviation of the returns from a market portfolio
where sj
jm
sm
Hence the correlation coefficient between the returns of these projects and the market are:
PROJECT 1, MARKET
COV(P1 & MARKET ) s PROJ 1 s m

144 223 .4375
144 13.75 x 16.25
= thus =
PROJECT 1
13.75 x 0.644 = 16.25
PROJECT 2, MARKET
eb
COV(P2 & MARKET ) sPROJ 2 s m
s ok
00
.bl 0
o 0.644 sp g
0.545
o t.c
+186 11.68 x 16.25

+0.98 +0.704*
= thus =
+186 189.8
11.68 x 0.98 16.25
= =
PROJECT 2
*slight difference from main solution due to rounding
155
Illustration 2
The following data are available: Erm sm = 20% = 6% Rf sf = 8% = 0%
Mr R Atkinson has 100 of his own money and he wishes to invest in Portfolio L which lies along the Capital Market Line (CML), above the market portfolio (Portfolio M) where the ratio Rf , M : M , L = 2: 1
As a result he must borrow 50 of additional funds (so that the ratio of PERSONAL FUNDS : BORROWING = 2 : 1) at the risk-free rate. He places the total of 150 in the shares of companies which represent Portfolio M.
Calculate
(a) (b) ErL (i.e. expected return from the total investment), and sL (i.e. the risk of that portfolio)
Solution 2
(a) Expected return from the total investment
Using basic common sense, this can be calculated as follows:
Own funds Borrowed funds Interest paid
eb
(2) (1)
s ok
00
Amounts invested 100 50 150 (50) 100
.bl 0
p gs
o t.c
m
Annual income
x x
20% 8%
= =
30 (4) 26
Therefore ErL will obviously be (26 100)
= 26% p.a.
Alternatively, ErL can be calculated using the normal formula i.e. ErL = = waEra +wbErb (1.5 x 20%) + ([1 1.5] x 8%) = 26% p.a.
(b)
The total risk of the portfolio
If only the personal funds of Mr Atkinson had been invested (i.e. 100), sL would only be 6%. However, since he borrowed a further 50, sL will clearly increase to (1.5 x 6%) = 9% Alternatively, sL can be calculated using the normal formula i.e. sp = = wa sa
2 2
+ wb
sb
(1.5 x 6%)2 + ([1 - 1.5] x 0%) + (2 x 1.5 x [1 - 1.5] x 6% x 0%) = 9%
156
Capital Market Line
r L = 26%
r M = 20%
r F = 8%
6%
For Portfolio L
r L = (1.5 20%) + ([1 1.5] 8%) =26% L = 1.5 6%

= 9%
eb
k oo
0 20
o .bl
p gs
9%
o t.c
m
p
157
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 (i.e. pension funds, insurance companies, unit trusts and investment trust companies). In fact only about 13% of the shares in UK quoted companies are held by individuals and many of these are so wealthy that they can invest their savings in a number of different companies in various market sectors. 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. For instance an investor holding shares in both BP and British Airways should find that if oil prices increase the share price of BP should rise, whereas the share price of BA would probably fall. Obviously an oil price decrease would cause an opposite effect on the share prices of the two companies. Provided that the returns on shares do not demonstrate perfect positive correlation, any additional investment brought into a shareholders portfolio should (subject to the point made in the next paragraph) cause the overall risk of the portfolio to reduce. Suppose an investor who has built up a small portfolio in the shares of (say) three companies now decides to add to that portfolio the shares of a few more companies in different market sectors. He should find a substantial risk reduction as the additional investments are added to the portfolio. However as the shares of more and more companies (in different sectors) are added to the portfolio, the risk reduction will eventually slow down and once the portfolio increases up to about 16 to 20 companies (again in different market sectors) the risk reduction will eventually cease. Thus a standard deviation ( or s) is a measure of total risk, and this can be analysed between: UNSYSTEMATIC (aka SPECIFIC or UNIQUE) RISK i.e. the risk which will initially disappear as a result of diversification, and SYSTEMATIC (aka MARKET) RISK i.e. the risk which can never be avoided when investing in company shares.
o bo
0 s2
.bl 0
p gs
o t.c
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. CAPM uses a factor, which compares the systematic risk of the shares of a company with the systematic risk of the market. The higher the , the greater the return the investor demands as compensation for the systematic risk borne. Obviously unsystematic risk (which is diversified away by holding the shares of a sufficient number of companies) can be ignored.
158
SYSTEMATIC AND UNSYSTEMATIC RISK
Total portfolio risk(s)
UNSYSTEMATIC RISK
SYSTEMATIC RISK Number of different companies in which shares are held Number of different companies o which shares are held pin gs o .bl 0 CAPM formulae 00 2 ks be required by a well-diversified, risk-averse CAPM provides the return that would o bo investor. The formula can be expressed in a variety of ways, e.g.: e E(ri) = Ke = Rf + i (E(rm) Rf) Rf + [Rm Rf] rf + (Erm rf) j 1 1 5 9 13
om c17 t.
21
25
Required return = where: Rf Rm [Rm Rf] (beta)
= the risk free rate of interest (e.g. the return on 90 day Treasury bills) = the average return on a market portfolio (e.g. the return on FTSE 100 constituents) = the market risk premium or excess market return
= an index which compares the systematic risk of the investment with the systematic risk of the market portfolio
The above CAPM formula appears in one form or another on formulae sheets provided by the accountancy bodies. However the following formulae for calculating are not provided in the examination and must therefore be committed to memory:
159
Formulae for calculating

Formula one
j
Where =
jm s j sm
= correlation coefficient between the investment and the market = total risk of the investment = total risk of the market, which is entirely systematic risk since the market is totally diversified.
jm
sj sm
Formula two
j
Where = COV( jm ) sm COV(jm) = sm2 =
2
covariance between the investment and the market variance of the market (i.e. the standard deviation squared).
o bo
0 s2
.bl 0
p gs
o t.c
160
THE SECURITY MARKET LINE

The security market line is a graph of the capital asset pricing model i.e.
Return % Rm
Security market line
Rf
-0.5
0.5 Systematic risk ( )
There are accordingly two benchmarks for and for the Security market line, i.e. The return on a risk free security, which obviously carries no systematic risk and therefore has a of 0; The return on the market portfolio, which due to its ultimate diversification carries only systematic risk and will always have a of 1.
eb
k oo
0 20
log .b
o sp
o t1.c
m
1.5
An investment with a:
of 0 is referred to as a risk free investment; of 1 is called a neutral investment (since its risk is equivalent to that of the market); of > 1 is termed an aggressive investment (since it is riskier than average); of < 1 is called a defensive investment (since it is less risky than the market average)
Accordingly if an investor wishes to hold equity shares despite the existence of a bear market, he would be advised to invest in defensive investments, since their prices would fall more slowly than the market average. During a bull market an investor should hold aggressive investments, since their increases in value would outpace the market average.
161
Illustration 3
In the case that follows, four states-of-the-world are considered with respect to future prospects for real growth in Gross National Product. State 1 represents a relatively serious recession, State 2 is a mild recession, State 3 is a mild recovery and State 4 is a strong recovery. The probabilities of these alternative future states-of-the-world are set forth in column 2 of the table below. Estimates of market returns and project rates of return are set forth in the remaining columns.
Summary of information Morton Company

(1) State of world (2) Subjective probability w 1 2 3 4 0.1 0.3 0.4 0.2 (3) Market return Project 1 rm (4) (5) (6) (7)
Project rates of return Project 2 Project 3 Project 4
0.15 0.05 0.15 0.20
0.30 0.10 0.30 0.40
0.30 0.10 0.30 0.40
The Morton Company is considering four projects in a capital expansion programme. The economics staff projected the future course of the market portfolio over the estimated life span of the projects under each of the four statesof-the-world (first three columns in the table); it is recommended the use of a riskfree rate of return of 5 per cent. The finance department provided the estimates of project return conditions on the state-of-the-world (columns 4 to 7 above). Each project involves an outlay of approximately 50,000. Assuming that the projects are independent and that the firm can raise sufficient funds to finance all four projects, which projects would be accepted using the capital asset pricing model?
o bo
0 s2
.bl 0
p gs
o t.c
0.09 0.01 0.05 0.08
0.05 0.05 0.10 0.15
162
Solution 3
In Table 1 the data provided by market relationships are utilised to calculate the expected return on the market along with its variance. The probabilities of the future states-of-the-world are multiplied by the associated market returns and their products are summed to obtain the expected market return (Erm) of 10 per cent.
Table 1: Calculation of Market Parameters

Col. no. (1) State of world 1 2 3 4 (2) w (3) Rm (4) wRm (5) (Rm Erm) (6) (Rm Erm)
2
(7) w(Rm Erm)2
0.1 0.3 0.4 0.2
0.15 0.05 0.15 0.20 Erm
0.015 0.015 0.060 0.040 = 0.10
0.25 0.05 0.05 0.10
0.0625 0.0025 0.0025 0.0100 Var(Rm)
0.00625 0.00075 0.00100 0.00200 0.01
The expected market return (Erm) is used in calculating the variance of the market returns. This is shown in columns 5 to 7. The expected return is deducted from the return under each state, and deviations from Erm in column 5 are squared in column 6. In column 7 the squared deviations are multiplied by the probabilities of each expected future state (which appear in column 2). The products are summed to give the variance of the market return. (N.B. The square root of the variance which does not have to be calculated in this instance is its standard deviation). A similar procedure is followed in Table 2 for calculating the expected return and the covariance for each of the four individual projects. The expected return is obtained by multiplying the probability of each state by the associated forecast return. The deviations of the return under the state from the expected return are next calculated in column 5. The deviations of the market returns from their mean are repeated for convenience in column 6. In column 7, the deviations of project returns are multiplied by the deviations of the market returns. In column 8 the figures established in column 7 are multiplied by the probability factors to determine the covariance for each of the four projects.
o bo
0 s2
.bl 0
p gs
o t.c
In Table 3, the beta for each project is calculated as the ratio of its covariance to the variance of the market return, and they are employed in Table 4 to estimate the required return on each project in terms of the security market line relationship. The risk-free rate of return is 5 per cent, with a market risk premium of (10% 5%) i.e. 5 per cent. Required returns as shown in column 2 of Table 4 are deducted from the estimated returns for each individual project (calculated in column 4 of Table 2) to derive the excess returns. These relations may be depicted graphically. The CAPM criterion accepts the projects with positive excess returns, which appear above the security market line. It rejects those with negative excess returns (plotted below the security market line).
163
Table 2: Calculation of Expected Returns and Covariances for Projects

Col no (1) State of world P1 1 2 3 4 (2) w (3) rj (4) wrj (5) (6) (7) (8) w(rj-Erj)(rm-Erm)
(rj-Erj)(rm-Erm)
0.1 0.3 0.4 0.2
0.30 0.10 0.30 0.40 Er1 0.30 0.10 0.30 0.40 Er2 0.09 0.01 0.05 0.08 Er3 0.05 0.05 0.10 0.15 Er4
0.03 0.03 0.12 0.08 = 0.20 0.03 0.03 0.12 0.08 = 0.14 0.009 0.003 0.020 0.016 = 0.030 0.005 0.015 0.04 0.03 = 0.08
(0.50)(0.25) (0.10)(0.05) (+0.10)(+0.05) (+0.20)(+0.10)
= = = =
0.125 0.005 0.005 0.020 Cov(r1,rm) 0.110 0.012 0.008 0.026 Cov(r2,rm) 0.030 0.001 0.001 0.005 Cov(r3,rm)
0.0125 0.0015 0.0020 0.0040 0.0200 0.0110 0.0036 0.0032 0.0052 0.0230 0.0030 0.0003 0.0004 0.0010 0.0047 0.00325 0.00045 0.00040 0.00140 0.00550
P2
1 2 3 4
0.1 0.3 0.4 0.2
(0.44)(0.25) (0.24)(0.05) (+0.16)(+0.05) (+0.26)(+0.10)
= = = =
P3
1 2 3 4
0.1 0.3 0.4 0.2
(0.12)(0.25) (0.02)(0.05) (+0.02)(+0.05) (+0.05)(+0.10)
P4
1 2 3 4
0.1 0.3 0.4 0.2
o bo
0 s2
(0.13)(0.25) (0.03)(0.05) (+0.02)(+0.05) (+0.07)(+0.10)
.bl 0
p gs
o t.c
= = = =
= = = =
0.0325 0.0015 0.0010 0.0070 Cov(r4,rm)
Table 3: Calculation of the Betas

1 2 3 4 = = = = 0.0200 0.0230 0.0047 0.0055 0.01 0.01 0.01 0.01 = = = = 2.00 2.30 0.47 0.55
Table 4: Calculation of Excess Returns

(1) Project P1 P2 P3 P4 r1 r2 r3 r4 = = = = (2) Measurement of required return 0.05 0.05 0.05 0.05 + + + + 0.05(2.0) 0.05(2.3) 0.05(0.47) 0.05(0.55) = = = = 0.150 0.165 0.0735 0.0775 (3) Expected return 0.200 0.140 0.030 0.080 (4) Excess return % (alpha value) + 5.00 2.50 4.35 + 0.25
164
An all-equity company
25 Security Market Line 20
Expected & Required Return on Project %
P1
15
P2
ke
10
P4
P3
0 0.5 1.0
Note conflict between dividend valuation model (DVM) & CAPM with projects P2 and P4. ke (using DVM) is assumed to be 12% To construct the SECURITY MARKET LINE
eb
k oo
0 20
o .bl1.5 0
p gs
o t.c
2.0
2.5
of project
When At
0 1
Return 5% 10%
165
SYSTEMATIC BUSINESS FINANCIAL RISK
RISK
AND
SYSTEMATIC
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 business risk only, whereas
ungeared
company
bear
systematic
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, This is
with a consequence increase in the Ke of the company concerned. illustrated below.
Following the M & M with corporation tax theory of 1963, as gearing levels increase, Ke behaves as follows:
Ke %
o bo
0 s2
.bl 0
p gs
o t.c
Ke
SYSTEMATIC FINANCIAL RISK
SYSTEMATIC BUSINESS RISK
Gearing %
D E
Now that the issue of leverage has been introduced, there becomes a need to distinguish:
asset (a), which reflects systematic business risk only, and equity (e), which reflects both systematic business risk TOGETHER WITH ANY systematic financial risk which MAY exist.
166
Therefore: In the case of an all equity company, e = a, since no systematic financial risk can possibly exist. In the case of a geared company, e > a, since e contains both systematic business risk and systematic financial risk, whereas a reflects systematic business risk only.
The theoretical relationship between a and e is commonly expressed by the following formulae: a =
Ve Vd (1 T ) (V + V (1 T )) e + (V + V (1 T )) d d d e e
E D(1 t ) + d E + D(1 t ) E + D(1 t )
The latter version will now be used throughout this course.
Illustration 4
Giles plc is an all-equity company whose coefficient is 0.95. Stiles plc is a levered company in all other respects has the same risk and operating characteristics as Giles. The capital structure of Stiles plc is as follows: Nominal value m 6 4 10 Market value m 15 6 21
Equity Debt
o bo
0 s2
.bl 0
p gs
o t.c
The debentures of Stiles plc are virtually risk-free and the corporation tax rate is 40%.
What would be the predicted of the equity of Stiles plc?
Solution 4
Since the debt of Stiles plc may be assumed to be risk free: a =
E E + D(1 t )
Therefore since Giles plc is an all equity company within the same industry as Stiles plc, the e of Stiles plc can be calculated as follows: e = = =
E + D(1 t ) E
15 + 6(1 0.4) 15
0.95 x 1.178
167
Illustration 5
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 000 14,800 _9,600 24,400 Glowcold 000 24,600 _7,200 31,800 Shiverall 000 28,100 11,100 39,200 Topice 000 12,500 _9,600 22,100 Hotalot 000 20,600 12,700 33,300
Fixed assets Working capital
Financed by: Bank loans Ordinary shares* Reserves
5,300 4,000 15,100 24,400 35,200 25 11 12 1.1
12,600 9,000 10,200 31,800 42,700 53.3 20 10 1.25
18,200 3,500 17,500 39,200 46,300 38.1 15
4,000 5,300 12,800 22,100 28,400 32.3
17,400 4,000 11,900 33,300 45,000 106 40 8 0.95
Turnover Earnings per share (in pence) Dividend per share (in pence) Price/earnings ratio Beta equity
*The par value per ordinary share is 25p for Freezeup and Shiverall, 50p for Topice and 1 for Glowcold and Hotalot.
0 00almost risk-free, and is available to Hotalot Corporate debt may be assumed to be s2 at 0.5% above the Treasury ok rate, which is currently 9% per year. Corporate Bill taxes are payable at a rate o 35%. The market return is estimated to be 16% per eb of year. Hotalot does not expect its financial gearing to change significantly if the
company diversifies into the production of freezers.
log .b
t9.c o1.30 p
om
14 14 1.05
Required: (a) (b) (c)

The equity beta of Hotalot is 0.95 and the alpha value 1.5%. meaning and significance of these values to the company. Explain the
Estimate what discount rate Hotalot should use in the appraisal of its proposed diversification into freezer production. Corporate debt is often assumed to be risk-free. Explain whether this is a realistic assumption and calculate how important this assumption is likely to be to Hotalots estimate of a discount rate in (b) above. For this purpose assume that Hotalot and the four freezer companies all have a debt beta of 0.3. Discuss whether systematic risk is the only risk that Hotalots shareholders should be concerned with.
(d)
168
Solution 5
(a) Alpha and beta values
The equity beta is a measure of the systematic risk of the companys shares that is, the relative volatility of the shares compared with the market as a whole. Systematic risk, which is caused by general economic and market factors, cannot be eliminated by diversification. The equity beta can be estimated as
jm sj sm
where jm is the correlation between the returns of the share and the returns of the market, and sj and sm are the standard deviations of the returns of the share and the market respectively. An equity beta of 0.95 for Hotalot plc suggests that if the stock market return moves up or down by 10%, the return on Hotalot will be expected to move by 0.95 x 10% = 9.5%. In other words, Hotalots returns are slightly less volatile than the market as a whole, because its beta is just less than 1. The capital asset pricing model shows how the expected returns of a share will depend on its beta value. If the actual returns of the share are higher or lower than the CAPM prediction, the share is said to have an abnormal return. The alpha value is the measure of this abnormal return, that is, the difference between the actual return and that predicted by the CAPM. In the case of Hotalot the alpha value is positive, at 1.5%, which should cause investors to buy the shares. This in turn will increase the price, forcing down the excess return until alpha falls to zero. Thus alpha values should only be temporary. In a well diversified portfolio the alpha value is expected to be zero.
(b)
Discount rate freezers
k oo appraisal for b e the
0 s2
.bl 0
p gs
o t.c
of the proposed diversification into
First, estimate the average equity beta in the freezer industry, then degear this figure. Regear it up to Hotalots debt/equity ratio and apply the CAPM to find Hotalots cost of equity. A WACC can then be calculated for Hotalot. Average equity beta in the freezer industry Company F G S T Value of shares* 16 million x 0.25 x 12 9 million x 0.533 x 10 14 million x 0.381 x 9 10.6 million x 0.323 x 14 Equity Beta factor 1.1 1.25 1.30 1.05
= = = =
48 million 48 million 48 million 48 million 192 million
*Value of shares = Number of shares x eps x PE ratio Since all the companies have the same market value of shares, the average equity beta is simply:
1.1 + 1.25 + 1.30 + 1.05 4
1.175
169
Total value of debt in the companies is: million 5.3 12.6 18.2 4.0 40.1 million
F: G: S: T:
The average debt/equity ratio in the freezer industry is therefore 40.1 192 Degearing the equity beta: a =
E E + D(1 t ) 192 192 + 40.1(1 0.35)

= 1.035
1.175
The market value of Hotalots shares is (4 million x 1.06 x 8) = 33.92 million, the market value of its debt is 17.4 million. Then regearing the beta to Hotalots debt/equity ratio: e = =
E + D(1 t) E
1.035x
33.92 + (17.4 x 0.65) 33.92
The required return on Hotalots equity, from the CAPM = = Rf + (Rm Rf) 9% + (16% 9%) 1.38 = 18.66%
eb
ok
0 s2
.bl 0
p gs
=
o t.c
1.38
The weighted average cost of capital for Hotalots new diversification is =
18.66% x
(33.92 + 17.4)
33.92
+ 9.5%(1 0.35) x
(33.92 + 17.4)
17.4
14.42%
(c)
The assumption that corporate debt is risk-free
Corporate debt is not risk-free. There is a risk of default which implies that the debt has a positive beta. Studies show that corporate debt is likely to have a beta of between 0.2 and 0.3. From the information given in this question Hotalot must have a debt beta of 0.0714 since its Kd = 9% + (16% 9%) 0.0714 = 9.5%. However the instruction in the question is to assume a debt beta of 0.3, and this must, of course, be observed. Assuming that all corporate debt has a beta of 0.3, both the degearing and regearing calculations in part (b) above will need to be adjusted.
170
The asset beta of an organisation is the weighted average of the beta of equity and the beta of debt. The asset beta is the same as the degeared beta, so: a =
1.175 x
192 40.1 x 0.65 + 0.3 x 192 + (40.1 x 0.65) 192 + (40.1 x 0.65)
=1.07
This is the revised degeared for the freezer industry. Regearing to Hotalots level of gearing 1.07 = 1.07 = e =
e x
33.92 (17.4x0.65) + 0.3 x 33.92 + (17.4 x 0.65) 33.92 + (17.4 x 0.65)
e x 0.750 + 0.075
1.327
Applying the CAPM gives Hotalots cost of equity as 9% + (16% 9%) 1.327 Hotalots WACC then becomes = 18.29%
om cmargin of error on these . compared with the original estimate of 14.42%. ot p Thethat the assumption that estimates is, however, quite high which means s corporate debt is risk-free is unlikely to have o significant effect on the accuracy of l ag .b Hotalots estimates. 00 0 (d) Does systematic risk give 2 complete picture? sthe ok The capital asset pricing o model assumes that Hotalots shareholders are well eb diversified and are only concerned with systematic risk. Undiversified or partly
diversified shareholders should also be concerned with unsystematic risk and should seek a total return appropriate to the total risk that they face. Even well diversified shareholders might be concerned with unsystematic risk. The total risk of a company comprises systematic and unsystematic risk. It is total risk (the total variability of cash flows) which determines the probability of a company failing, and the investor experiencing additional bankruptcy costs. The greater the expected bankruptcy costs and the greater the probability of corporate failure, the more concerned investors are likely to be with the total risk and not just systematic risk.
18.29% x
33.92 17.4 + 9.5% x 0.65 x 51.32 51.32
14.18%
171
ASSUMPTIONS, CAPM
Assumptions
ADVANTAGES
AND
LIMITATIONS
OF
All shareholders hold the market portfolio. Although this is questionable in practice, even a limited spread of shareholdings produces some diversification, therefore this assumption is appropriate; A perfect capital market (e.g. no transaction costs, information about risk and return is freely available); The ability of investors to both borrow and lend at the risk free rate of interest; All forecasts are made for a single time period only; All investors share the same uniform expectations concerning future earnings streams and are only concerned with risk and return.
Advantages
It demonstrates that unsystematic risk can be diversified away, therefore the only risk premium required is for systematic risk only; Probably the best practical method for establishing the Ke of a publicly traded company; It highlights the relationship between risk and return, based upon stock market performance and provides a measure of the risk of shares held within a well-diversified portfolio and measures the required rate of return in view of that level of risk; Helps to provide a risk adjusted discount rate for use in investment appraisal.
o bo
0 s2
.bl 0
p gs
o t.c
Limitations
It concentrates purely upon systematic risk and is therefore of limited use for investors who do not hold a well-diversified portfolio; Since CAPM only considers the level of return to investors, it ignores the manner in which that return is received. Therefore, it treats dividends and capital gains as equally desirable to investors, thus totally ignoring the tax position of individual investors; It is purely a single period model, therefore not ideal for use in projects which extend for multiple periods; The model requires the use of data which can be difficult to obtain i.e. (i) (ii)
The risk free rate of interest: It is necessary to take the best proxy measure of a short-term default free rate e.g. UK 90 day Treasury bills; The return on the market portfolio: Should the FT all-share index be used, or the FTSE 100, or the FTSE 350, or a world composite share price index?; Beta: Clearly this should strictly be based on subjective probabilities of future events, but since this is impracticable in practice, regression analysis is often used to compare the historical behaviour of individual
(iii)
172
securities with the behaviour of a suitable market index within the same time period. CAPM tends to overstate the required return of high beta securities and to understate the required return of low beta securities. The returns of small companies, returns on certain days of the week or months of the year have in practice been observed to differ from those expected from CAPM.
o bo
0 s2
.bl 0
p gs
o t.c
173
ARBITRAGE PRICING THEORY AND FAMA & FRENCH THREE FACTOR MODEL
Arbitrage Pricing Theory (APT), which was first introduced by S A Ross in 1976, is an alternative theory of risk and return. It states that the risk premium on a share depends on that shares exposure to a number of factors, and not simply Erm. The problem is that APT does not state what these factors are, but researchers have identified several possibilities, including unanticipated changes in the level of industrial production; the rate of inflation; the effect of the yield curve; real rates of interest; levels of personal consumption; money supply in the economy and risk premiums on bonds.
APT states that the required return from Security A is expressed as follows: Required return = rf + [ErF1 rf] F1 + [ErF2 rf] F2 + [ErF3 rf] F3 Where: ErF1 = F1 = expected return arising from factor 1
s A A ,F1 s F1
APT has less constraining assumptions than CAPM. For instance, it is not a single factor model and does not require some of the perfect market assumptions of CAPM. The major weakness of APT is that it is extremely difficult to identify the relevant factors and the sensitivity of such factors for individual companies. Hence APT is difficult to use as a practical decision-making technique.
The Fama and French three factor model was derived in 1993, when two American academics considered that CAPM could be significantly improved by introducing two further factors in addition to market risk i.e. Size effect: Investors find small (less actively traded) companies more risky than larger entities, and Distress factor: The ratio of book value of equity to market value of equity is compared. The more market value falls towards book value, the greater the companys exposure to financial distress.
o bo
0 s2
.bl 0
p gs
o t.c
Fama and Frenchs three factor model is as follows: Required return = rf + [Erm rf] jm + [SMB] js + [HML] jd Where:
jm is the normal equity beta of the company applied to the excess market return, js is the companys factor loading for the size effect where [SMB] is the difference in return between a portfolio of the smallest stocks in the economy and a portfolio of the largest stocks, and jd is the factor loading for the distress effect where [HML] is the difference in return between a portfolio of the highest book to market value stocks and a portfolio of the lowest book to market value stocks.
To calculate the SMB and HML premia, Fama and French used stocks quoted on the New York Stock Exchange, the American Stock Exchange and the NASDAQ.
174
Cygnet plc
Cygnet plc is a large listed company, which owns a variety of businesses in the retailing sector. It now wishes to diversify into brewing and has consequently highlighted two possible target companies in the brewing sector, Parched Ltd and Fullup Ltd. The following data has been collected regarding each target company, the existing activities of Cygnet plc and the market generally. Parched Ltd 15% 10% Fullup Ltd 16% 12% Cygnet plc 18% 15% Market 25% 20%
Expected return Risk
Risk is measured as the standard deviation of possible returns around the average (or expected) return. Correlation coefficients of targets with: - existing activities of Cygnet plc; and - the market generally; are estimated as follows: Parched Ltd 0.85 0.25
Cygnet plc Market
The risk-free rate is to be taken as 5% and either target will represent 10% of the now enlarged Cygnet plc (that is the existing operations of Cygnet plc will represent 90% of the expanded company and the new acquisition will form the remaining 10% of Cygnets extended business operation).
eb
k oo
0 20
log .b
o sp
o t.c
m
Fullup Ltd 0.40 0.95
Required
Appraise each of the target companies using: (i) (ii) portfolio theory; and capital asset pricing model
explaining briefly the basis of each method and state which you recommend in this case. NOTE: It is thought that for purposes of portfolio theory, the shareholders of Cygnet plc would accept an increase of 1% in risk to achieve a 0.5% increase in return or alternatively to accept a 0.5% decrease in return in order to achieve a 1% decrease in risk.
175
Cygnet plc solution

(i) Portfolio theory approach
We calculate the expected return and risk of the following combinations: - Cygnet plc with Parched Ltd - Cygnet plc with Fullup Ltd Cygnet plc and Parched Ltd Expected return is given by waEra + wbErb Where wa = wb Era Erb Return = proportion represented by Cygnet plc proportion represented by Parched Ltd
= expected return from Cygnet plc = expected return from Parched Ltd = (0.9 x 18%) + (0.1 x 15%) = 17.7%
Risk of the combination is given by sp = wa sa sa sb = = =

2 2
+ wb
where
ab
sp = = =
(0.9 x 15)2 + (0.1 x 10)2 + (2 x 0.9 x 0.1 x 15 x 10 x 0.85) (182.25 + 1 + 22.95)

14.36%
. risk of Cygnet plc 0 0 0 risk of Parched Ltd s2 k oo correlation coefficient of one with the other. eb
sb
+ 2 w a wb
p gs s s blo
a b ab
o t.c
Cygnet plc and Fullup Ltd Return = = sp = = = (0.9 x 18%) + (0.1 x 16%) 17.8%
(0.9 x 15)2 + (0.1 x 12)2 + (2 x 0.9 x 0.1 x 15 x 12 x 0.4) (182.25 + 1.44 + 12.96)
14.02%
176
Summary
Return 18% 17.7% 17.8% Risk 15% 14.36% 14.02%
Cygnet plc Cygnet plc and Parched Ltd Cygnet plc and Fullup Ltd
Both takeovers decrease both risk and return. The combination of Cygnet plc and Fullup Ltd decreases risk by a greater extent and decreases return by a lesser extent and hence is preferred to the alternative. In deciding whether the combination is better than Cygnet plcs existing operations alone we use the information about shareholders attitudes to risk. The decrease in risk is just under 1%. The acceptable decrease in return corresponding to this is 0.5%. The actual decrease is 0.2%, and hence the takeover of Fullup Ltd is worthwhile.
(ii)
CAPM approach
We calculate, for each target company, its beta factor and hence the minimum required return from each company. Comparison of this with the expected return from each company then determines whether the takeover is worthwhile. Parched Ltd
j
Where
jm s j sm
jm
sj sm
= correlation coefficient between the investment (Parched Ltd) with the market =
k oo risk ofb investment e the

0.25 10 = 20
0 s2
.bl 0
p gs
o t.c
= risk of the market. = 0.125
Hence
The CAPM formula now gives Minimum required return = = = Fullup Ltd Rf + (Erm - Rf) j 5 + (25 - 5)0.125 7.5%
0.95 x 12 = 20
0.57 = 5 + (25 - 5)0.57 = 16.4%
Minimum required return
177
Summary
Required return Parched Ltd Fullup Ltd 7.5% 16.4% Expected return 15% 16%
Thus, the takeover of Fullup is not worthwhile, since the expected return is less than that required to compensate shareholders for the systematic risk in the company. The takeover of Parched should go ahead.
Explanation of the methods and conclusion

Portfolio theory appraises a proposed investment from the point of view of the fit that it has with the existing operations of the company. The aim is always to increase return and decrease risk. Sometimes both these effects are not possible at the same time, in which case one takes into account the shareholders attitudes to risk (indifference curves). This is, however, difficult in practice. Unlike portfolio theory, which considers an investment in combination with the existing portfolio of investments and seeks to obtain satisfactory changes in return for changes in total risk, CAPM considers an investment in isolation. This is because the existing portfolio is assumed to be fully diversified and can thus be ignored. At the point of full diversification only systematic risk remains in a portfolio. Provided that the new investment being considered makes a sufficient return to compensate for its level of systematic risk, it is satisfactory. Again this is in stark contrast to portfolio theory which is concerned with total risk rather than just systematic risk. A benefit of CAPM is that the conclusion on the acceptability of an investment would be universally held by all fully diversified investors. In this case, since Cygnet plc is large and quoted, it is reasonable to suppose that its shareholders are well diversified and therefore the CAPM approach would seem to be the more appropriate. Parched Ltd is thus the preferred takeover target.
o bo
0 s2
.bl 0
p gs
o t.c
178
Five Wealthy Individuals

Five wealthy individuals have each put 200,000 at your disposal to invest for the next two years. The funds can be invested in one or more of four specified projects and in the money market. The projects are not divisible and cannot be postponed. The investors require a minimum return of 24% over the two years. Details of these possible investments are: Initial cost 00 600 400 600 600 100 Return over two years (%) 22 26 28 34 18 Expected standard deviation of returns over two years (%) 7 9 15 13 5
Project 1 Project 2 Project 3 Project 4 Money market (minimum)
Correlation coefficients of returns (over two years) Between projects 1 1 1 2 2 3 and and and and and and 2: 3: 4: 3: 4: 4: 0.70 0.62 0.56 0.65 0.57 0.76 Between projects and the market portfolio 1 2 3 4 and and and and market: market: market: market: 0.68 0.65 0.75 0.88 Between projects and the money market 1 2 3 4 0.40 and money market: 0.45 and money market: 0.55 and money market: 0.60
Between the money market and the market portfolio: 0.40
The risk-free rate is estimated to be 16%, the market return 27% and the variance of returns on the market 100% (all for the two-year period).
eb
k oo
0 20
log .b
po
om cand money market: t.
Required: (a)
Evaluate how the 1m should be invested using (i) (ii) portfolio theory, the capital asset pricing model (CAPM) Portfolio risk may be assessed using the formula sp = wa sa
2 2
+ wb
sb
(b) (c)
Explain why portfolio theory and CAPM might give different solutions as to how the 1m should be invested. Discuss the main problems of using CAPM in investment appraisal.
179
Suggested solution to Five Wealthy Individuals

(a)
(i)
How the 1 million should be invested

Using portfolio theory Consider the possible combinations for investing 1 million and the return that will be made from each combination: Projects 1 and 2 2 and 3 2 and 4 1 and money market: 2 and money market: 3 and money market: 4 and money market: Money market only: Portfolio return + 0.4 x 26% = + 0.6 x 28% = + 0.6 x 34% = + 0.4 x 18% = + 0.6 x 18% = + 0.4 x 18% = + 0.4 x 18% =
A: *B: *C D: E: *F: *G: H:
0.6 0.4 0.4 0.6 0.4 0.6 0.6
x x x x x x x
22% 26% 26% 22% 26% 28% 34%
23.6% 27.2% 30.8% 20.4% 21.2% 24.0% 27.6% 18%
The minimum required return is 24%. * Therefore, only alternatives B, C, F and G are acceptable. To choose between these we must examine portfolio risk, using the formula given in the question. Alternative B: Portfolio risk: Projects 2 and 3 = = Alternative C: Portfolio risk:
o bo136.08 e
(0.4
2
(0.4 200+ (0.6 x9 )
ks
.bl 0
o
2
p gs
o t.c
x 152 + (2 x 0.4 x 0.6 x 0.65 x 9 x 15)
11.67%
Projects 2 and 4 = =
x 9 2 + 0.6 2 x 132 + (2 x 0.4 x 0.6 x 0.57 x 9 x 13)

= 10.29%
) (
105.81
Alternative F: Portfolio risk:
Project 3 and the money market = =
(0.6
x 152 + 0.4 2 x 52 + (2 x 0.6 x 0.4 x 0.55 x 15 x 5)

= 10.24%
) (
104.8
Alternative G: Portfolio risk
Project 4 and the money market = =
(0.6
x 132 + 0.4 2 x 52 + (2 x 0.6 x 0.4 x 0.6 x 13 x 5)

= 9.14%
) (
83.56
180
In order to rank the investment combinations, we need to summarise return and risk. Combination 2 and 3 2 and 4 3 and money market 4 and money market Portfolio expected Return 27.2% 30.8% 24.0% 27.6% Portfolio risk 11.67% 10.29% 10.24% 9.14%
In ranking the portfolios, we are looking for high return and low risk (assuming risk-averse investors). It may therefore be said that: (1) (2) Combination 2 and 4 is better than 2 and 3 because it has a higher return and lower risk. Combination 4 and the money market is better than both 2 and 3 and 3 and the money market because it has a higher return and lower risk.
The choice between combinations 2 and 4 and 4 and the money market is impossible to make without further data on the investors risk/return preferences.
m co S tan dard Deviation t. Coefficient of Variation = po Expected Re turn s log In the case of 2 and 4 this is (10.29% 30.8%) = 0.334, and in the case of .b 4 and the money market this is0 0 (9.14% 27.6%) = 0.331. Clearly the combination of 4 and the money market is marginally preferable, since it 20 offers the lower level of ks per 1% of return. However, this technique is risk open to criticism as the o o decision is too close for comfort!!. eb
(ii) Using the CAPM First calculate the beta factors of the projects using the formula:
However, an attempt to make the decision may be possible by calculating the coefficient of variation, which employs the following formula:
jm s j sm
Project 1 0.68 x 7 10 0.65 x 9 10 0.75 x 15 10 0.88 x 13 10 0 .4 x 5 10 Beta = 0.476
= 0.585
= 1.125
= 1.144
Money market
= 0.20
181
Now calculate the betas of the combinations with returns above 24%. The beta of a portfolio is the weighted average of the betas of the component investments. Combination 2 and 3 2 and 4 3 and money market 4 and money market Portfolio (0.6 x (0.6 x (0.4 x (0.4 x beta 1.125) 1.144) 0.20) 0.20)
(0.4 (0.4 (0.6 (0.6
x x x x
0.585) 0.585) 1.125) 1.144)
+ + + +
= = = =
0.909 0.920 0.755 0.766
Now find the required return of the portfolio, using the CAPM, and compare it with its expected return: Combination 2 and 3 2 and 4 3 and money market 4 and money market CAPM required return 16% + (27% 16%) 0.909 = 26% 16% + (27% 16%) 0.920 = 26.12% 16% + (27% 16%) 0.755 = 24.3% 16% + (27% 16%) 0.766 = 24.43% Expected return 27.2% 30.8% 24.0% 27.6%
Using the CAPM, all combinations except 3 and the money market are expected to earn above their minimum required return. If the investors require the greatest excess return, the choice would be projects 2 and 4, since its excess return i.e. alpha value, is (30.8% 26.12%) = 4.68%.
(b)
Why portfolio theory and the CAPM might give different solutions
The portfolio theory calculations assume that each portfolio can be viewed in isolation from any other investments which the wealthy individuals may hold. As shown in the answer above, the aim is to find the combination of investments with the most satisfactory trade-off of expected return and risk. Some potential combinations can be eliminated, but ultimately the final choice is a subjective one which depends on the investors attitude to risk. The portfolio theory approach recognises that investments must be viewed as part of a portfolio, but it effectively makes the assumption that the chosen portfolio will account for all the investors funds.
o bo
0 s2
.bl 0
p gs
o t.c
The capital asset pricing model assumes that the investor already holds a widely diversified portfolio (the market portfolio). New investments are appraised by considering their effect on the market portfolio in terms of return and risk. In doing this it becomes apparent that only the systematic risk of the investment is relevant, that is the proportion of the risk which is dependent on general economic and market factors. Unsystematic risk is eliminated when the investment is added to the market portfolio. The result is a simple formula for appraising a new investment (or combination of new investments) in terms of systematic risk, measured by the beta factor.
182
In summary
Portfolio theory assumes the new investments are an addition to the investors total portfolio; considers the total risk of the portfolio of investments.
CAPM assumes the new investments are a small addition to the market portfolio; considers only systematic risk of the new investments
Investments which have high total risk but low systematic risk will be appraised more favourably by the CAPM than by portfolio theory.
(c)
The main problems of using CAPM in investment appraisal
The problems of using CAPM include (i) (ii) (iii) the assumptions behind the model the difficulty in obtaining data the accuracy of the model in explaining investment and security returns
Many of the assumptions behind the model are unrealistic. include: (i) (ii) (iii) (iv) (v)
p gs exist o No transaction costs or market imperfections .bl investments is freely available 0 Information about the risk and return of 00 2 Investors measure risk by the standard deviation of expected returns ks o All investors have the same expectations about future profits and dividends bo e and are single-period terminal wealth maximisers. This is based only on risk
Investors can borrow and lend easily at the risk-free rate of return and return.
m co ot.
The assumptions
Obtaining data for the model is difficult. It is an ex-ante model which requires data for expected returns and risk of the investment and the market. The practical difficulty of forecasting such risk and returns means that the model is usually applied using historical ex-post data, requiring the beta to be stable over time. The model requires the risk-free rate, and the market return. What is the appropriate measure of the risk-free rate and the market return? Over what period should data be used? At what interval should observations be made? What is the market the UK all-share index, or a world composite share price index, or some other measure e.g. the FTSE 100 index? These are only some of the possible data problems. The accuracy of the model has been questioned by many pieces of empirical research. CAPM requires alpha, the intercept term, not to be significantly different from zero; many studies suggest that it is significantly different from zero. Low beta securities earn higher returns than CAPM would predict, and higher beta securities earn lower returns. Company size, seasonality, day of the week, dividend yield, and price-earnings ratios are among the factors that are said to explain observed returns in addition to the systematic risk. Such problems raise serious questions about the accuracy of using CAPM in investment appraisal.
183
Dell plc
You have purchased the following data from a merchant bank. Company Dell plc Baseball plc Burnden plc Roker plc Forecast total equity return 17% 12% 14% 21% Standard deviation of total equity return 6.3% 4.8% 4.7% 6.9% Covariance with market return 32% 19% 24% 43%
The market return, market standard deviation and market variance are 14.5%, 5% and 25% respectively, and the risk free rate is 6%. Returns and all other data relate to a one-year period.
Required: (a)
Estimate the differences between the required returns and the forecast total equity returns (that is the alpha values) for each of these companies shares and explain what use alpha values might be to financial managers. Briefly discuss reasons for the existence of alpha values, and whether or not the same alpha values would be expected to exist in one years time.
(b)
Suggested solution to Dell plc

(a)
The alpha value is any abnormal return that exists relative to the required return from an investment, as estimated by using the capital asset pricing model (CAPM). The beta of the companies shares may be estimated from:
Co var iance Jm Variancem
o bo
0 s2
.bl 0
p gs
o t.c
The beta estimates are: Dell 32 25 = = = = 1.28 0.76 0.96 1.72
Baseball 19 25 Burnden 24 25 Roker 43 25
Required returns Dell Baseball Burnden Roker 6% 6% 6% 6% + + + + (14.5% (14.5% (14.5% (14.5% 6%) 6%) 6%) 6%) 1.28 0.76 0.96 1.72 = = = = 16.88% 12.46% 14.16% 20.62%
Forecast returns 17% 12% 14% 21%
Alpha +0.12% -0.46% -0.16% +0.38%
A positive alpha value implies that it is possible to make a higher than normal return, for the systematic risk taken. A negative alpha implies a lower than normal return.
184
A financial manager wishing to invest in shares might favour those with a positive alpha, subject to the shares satisfying other selection criteria such as the desired level of risk. If a positive or negative alpha exists for the shares of the company of the financial manager, and the market is at least semi-strong form efficient, the alpha would be expected to move to zero as the companys share price changes due to arbitrage profit taking. For example in theory a company with a positive alpha would expect relatively high demand for its shares, increasing share price and thereby decreasing return until the alpha is zero.
(b)
Positive or negative alpha values exist for shares most of the time. If CAPM is a realistic model alpha values should only be temporary and the same alpha values would not be expected to exist in a years time. Alpha may exist due to inaccuracies and/or limitations of the CAPM model including: (i) CAPM tends to overstate the required return of high beta securities and to understate the required return of low beta securities. The returns of small companies, returns on certain days of the week or months of the year are observed to differ from those expected from CAPM. Data input into the model may be inaccurate. For example it is impossible to accurately calculate the market risk and return. Other factors in addition to systematic risk might influence required return. The arbitrage pricing theory (APT) suggests that a multi-factor model is necessary. CAPM is based upon a number of unrealistic assumptions.
(ii) (iii)
(iv)
o bo
0 s2
.bl 0
p gs
o t.c
185
Nelson plc
The management of Nelson plc wish to estimate their firms equity beta. Nelson has had a stock market listing for only two months and the financial manager feels that it would be inappropriate to attempt to estimate beta from the actual share price behaviour over such a short period. Instead, it is proposed to ascertain, and where necessary adjust, the observed equity betas of other companies operating in the same industry and with the same operating characteristics as Nelson, as these should be based on similar levels of systematic risk and be capable of providing an accurate estimate of Nelsons beta. Three companies have been identified as firms having operations in the same industry as Nelson which utilise identical operating characteristics. However, only one company, Oak plc, operates exclusively in the same industry as Nelson. The other two companies have some dissimilar activities or opportunities, in addition to operating characteristics which are identical to those of Nelson. Details of the three companies are: (i) (ii) Oak plc. Observed equity beta 1.12. 60% equity, 40% debt. Capital structure at market values is
(iii)
lo .bPine has two divisions East and West. 0 Pine plc. Observed equity beta 1.14. 00 Easts operating characteristics are considered to be identical to those of 2 Nelson. The operating characteristics of West are considered to be 50% more ks o risky than those of East. In terms of financial valuation East is estimated as bo as West. Capital structure of Pine at market values is e being twice as valuable
75% equity, 25% debt.
Beech plc. Observed equity beta 1.11. It is estimated that 30% of the current market value of Beech is caused by risky growth opportunities which have an estimated beta of 1.9. The growth opportunities are reflected in the observed beta. The current operating activities of Beech are identical to those of Nelson. Beech is financed entirely by equity.
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Nelson is financed entirely by equity. The tax rate is 40%.
Required: (a)
Assuming all debt is virtually risk-free, determine three estimates of the likely equity beta of Nelson plc. The three estimates should be based, separately, on the information provided for Oak, Beech and Pine plc. Explain why the estimated beta of Nelson, when eventually determined from observed share price movements, may differ from those derived from the approach employed in a) above. Specify the reasons why a company which has a high level of share price volatility and is generally considered to be extremely risky, can have a lower beta value, and therefore lower systematic risk, than an equally geared firm whose share price is much less volatile.
(b)
(c)
186
Suggested solution to Nelson plc

(a) Estimates of likely beta
a =
E D(1 t ) + d E + D(1 t ) E + D(1 t )

0
But assumed d = a =
E E + D(1 t )
=
Therefore e (i)
E + D(1 t ) E
The beta of Oaks equity must be degeared to reflect Nelsons all equity status Hence, a =
E E + D(1 t ) 6 6 + 4(1 0.4)

=
= (ii)
1.12 x
To obtain a beta for Nelson, we must isolate the beta of Beechs current operating activities. Hence 1.11 = 1.11 = 0.54 =
k oo operations eb Current
(iii)
0 s2
( Current operations x 0.7) + (1.9 x 0.3) ( Current operations x 0.7) + 0.57 Current operations x 0.7
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0.8
0.54 = 0.7
0.77
In this case we must degear Pines equity beta to remove the financial risk carried by Pine and then isolate the beta of Pines Eastern Division. a =
E E + D(1 t ) 75 75 + 25(1 0.4)

= 0.95
= overall 0.95
1.14 x
= = = = =
2/3 E + 1/3 W 2/3 E + 1/3 W 2/3 E + 1/3 x 1.5 E 2/3 E + 1/2 E 7/6 E = 0.814
Therefore a
0.95 x 6/7
Note that this calculation could have been performed by firstly isolating the beta of the Eastern division and then by degearing to remove the financial risk carried by Pine.
187
(b)
Reasons for estimated beta differences
The reasons include: (i) Statistical estimation Estimates of beta derived from observed share prices are usually the results of a linear regression. They are, therefore, an estimate of the share beta rather than a precise determination of that beta. Even if the true underlying betas are identical, the regression estimates may differ. Normally betas of portfolios are considered to be more reliable than betas of individual securities. (ii) Changes in operations While the firms may currently have identical operating activities, by the time a valid estimate of Nelsons beta can be made from actual share price data (probably at least three years hence) the operating practices may have changed. (iii) Abnormal share price behaviour The period immediately following a firms quotation on a stock exchange may produce non-typical share price behaviour. The inclusion of such a period in the observations used to determine beta may distort the calculations. (iv) Size difference
Difference in size between Nelson and the other companies may cause a difference in perceived risk which is reflected in the beta estimation. Generally, smaller companies are perceived as being of greater risk than larger firms. (v) Differences in current cost structures Although firms may appear to have identical operating characteristics, differences in cost structures (e.g. caused by differences in the ages of production equipment) can affect beta. Usually, the higher the proportion of fixed costs the higher will be beta. (vi) Growth opportunities of Nelson Investors may perceive Nelson as having opportunities for growth and its actual share price, share price behaviour and beta may reflect growth opportunities as well as current activities. (vii) Degearing process The approach used to degear betas is derived from the Modigliani and Miller 1963 hypothesis. If any of the assumptions of their theory are violated (e.g. risk free and permanent debt) then the procedure is invalid. In general terms any of the criticisms levelled against the Modigliani and Miller 1963 theory (e.g. bankruptcy costs, tax exhaustion, personal taxes, etc) could be used to criticise our calculations above.
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(c)
Share price volatility and systematic risk
The reasons for the lower beta value of a company with high share price volatility stem from the differences between total risk and systematic risk. Total risk, represented by measures of total share price (or return) volatility, comprise: systematic risk + unsystematic risk The unsystematic element of total risk is not connected with economy-wide factors but is unique to a particular firm. This unsystematic risk can largely be diversified away in a widely spread portfolio. The systematic risk results from the connection between the share and the economy, or stock market, generally and cannot be diversified away in a portfolio. It is this systematic risk, measured by beta, which is of relevance. For example, the success of a mineral prospecting company is unlikely to be a function of the economy generally and is more likely to be determined by factors unique to the firm. While the firms share price may be very volatile and the share is extremely risky if held in isolation, the small level of dependence on the economy means the share is largely risk-free in a portfolio context. Hence, large total risk but small systematic risk is to be expected from this type of firm. However, a manufacturing company may have a far greater dependence on the economy and so its systematic risk is higher, even though its total risk is lower than that of the prospecting firm.
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189
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Chapter 8
Adjusted present value
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CHAPTER 8 ADJUSTED PRESENT VALUE
CHAPTER CONTENTS
ADJUSTED PRESENT VALUE ------------------------------------------- 193 POLYCALC PLC ---------------------------------------------------------- 194 TOVELL PLC ------------------------------------------------------------- 196 ALASTAIR BROWN PLC ------------------------------------------------- 201
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ADJUSTED PRESENT VALUE

Traditionally financial management has appraised new investments by discounting their after-tax operating cash flows to present value at the firms 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. The APV method therefore sees the value of the project to shareholders as being:
m co + Present value of tax Project value if all equity financed + present value oft. (the base case NPV) shield on the loan other side effects po gs o .bl Weaknesses of the APV technique 00 (a) The process of degearing an20 equity beta of a levered company in the new industry to obtain a suitable asset beta for an all-equity firm relies upon the M ks omarket imperfections such as bankruptcy costs are o & M 1963 case. When eb introduced, it is unlikely that the M & M 1963 position is valid.
(b) The discount rates used to evaluate the various side effects can be difficult to determine. Normally the risk-free rate is used to evaluate the corporation tax savings on loan interest and issue costs. This is valid if the firm is certain that it will be earning sufficient profits to take immediate advantage of the tax relief. If the firm were not certain, then the situation is more risky and a higher discount rate should be used. The problem is how much higher? This would largely be a matter of educated guesswork. In complex investment decisions the calculations can be extremely long.
(c)
193
Polycalc plc
Polycalc plc is an internationally diversified company. It is presently considering undertaking a capital investment in Australia to manufacture agricultural fertilizers. The project would require immediate capital expenditure of A$15m, plus A$5m of working capital which would be recovered at the end of the projects four year life. It is estimated that an annual revenue of A$18m would be generated by the project, with annual operating costs of A$5m. Straight-line depreciation over the life of the project is an allowable expense against company tax in Australia, which is charged at a rate of 50%, payable at each year-end without delay. The project can be assumed to have a zero scrap value. Polycalc plans to finance the project with a 5m 4-year loan at 10% from the Eurosterling market, plus 5m of retained earnings. The proposed financing scheme reflects the belief that the project would have a debt capacity of two-thirds of capital cost. Issue costs on the Euro debt will be 2 % and are tax deductible. In the UK the fertilizer industry has an equity beta of 1.40 and an average debt:equity gearing ratio of 1:4. Debt capital can be assumed to be virtually riskfree. The current return on UK government stock is 9% and the excess market return is 9.17%. Corporate tax in the UK is at 35% and can be assumed to be payable at each yearend without delay. Because of a double-taxation agreement, Polycalc will not have to pay any UK tax on the project. The company is expected to have a substantial UK tax liability from other operations for the foreseeable future. The current A$/ spot rate is 2.0000 and the A$ is expected to depreciate against the at an annual rate of 10%.
Required
Using the Adjusted Present Value technique, advise the management of Polycalc on the projects desirability.
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Polycalc solution
Base-case discount rate
asset = 1.40 x
4 4 + 1(1 0.35)
1.20 = 20%
Base-case discount rate = 9% + (9.17% x 1.20)
Project tax charge and cash flows in A$m (Years 1 to 4)

Revenue Operating costs Depreciation (15 4) Taxable profit Tax charge @ 50% Tax 18 (5) (3.75) 9.25 4.625 Cash flow 18 (5)
(4.625) 8.375
Base-case net present value calculation in m

Exch. Rate increasing at 10% pa 2 2.2 2.42 2.662 2.9282
Year 0 (15 + 5) 1 2 3 4 (8.375 + 5)
A$m = (20) 8.375 8.375 8.375 = 13.375
PV of tax shield
eb
s ok
0 00
.b
= = = = =
s log
m rate (10) x 1 3.807 x 0.833 3.461 x 0.694 3.146 x 0.579 4.568 x 0.482 Base-case NPV
c ot.
m20% oDiscount
= = = = = =
m PV of cash flows (10) 3.171 2.402 1.821 2.202 (0.404m)
Based upon debt capacity created i.e. A$15m 2 x 2 3 = 5m (which happens to be equal to the loan raised) = 5m x 0.10 x 0.35 = = 175,000
Annual tax relief on interest PV of tax relief for 4 years:
175,000 x 3.170
554,750
PV of issue costs
5m x 0.025 x (1 0.35) = 81,250

m (0.404) 0.555 (0.081) 0.07m
Base case NPV PV of tax shield PV of issue costs Adjusted present value
or +70,000 approx
Therefore accept project and finance it in the manner indicated.
195
Tovell plc
The selection of appropriate discount rates for capital investments has frequently been a problem for the finance director of Tovell plc. The company has adopted a strategy of diversification into many different industries, in order to reduce risk for the companys shareholders. This has resulted in frequent changes in the companys gearing level and widely fluctuating risks of individual investments. The current project under appraisal, an investment in the fast food industry where Tovell has no other investments, is expected to generate pre-tax operating cash flows of 420,000 in the first year, rising by 5% per year for the five year expected life of the project. After five years the land and buildings are expected to have a realisable value of 1,250,000 (after any tax effects), the same as their original cost, but in order to continue operations major new investment in equipment would be required at that time. Other fixed assets would have negligible value after five years. The total initial outlay of the project (net of issue costs) is 2.3 million, and all but the land and buildings, attracts a 25% per year capital allowance on a reducing balance basis. The project would be financed by a 800,000 fixed rate loan from a regional development agency at a subsidised interest rate of 6% per year, 3% less than Tovell could borrow at in the capital market. The remainder of the finance would be provided by an underwritten rights issue at a 10% discount on current market price with total underwriting and issue costs of 5% of gross proceeds. The investment is believed to add 1 million to the companys debt capacity. Current financial data for Tovell and the fast food industry includes:
P/E ratio Dividend yield Equity beta Debt beta Gearing (debt/equity): Book values Market values Share price Number of ordinary shares
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Tovell plc 12 5% 1.1 0.2
Fast food industry (average) 20 3% 1.4 0.25 1.6 to 1 1 to 1 n.a. n.a.
1.1 to 1 0.4 to 1 470 pence 3.5 million
The corporate tax rate is currently 30% per year, and tax is payable one year in arrears Treasury bills are currently yielding 5% per year after tax, and the return required by well diversified investors is 12.5% per year.
Required: (a) (b)

Provide a reasoned explanation as to whether you would support the companys strategy of diversifying into many different industries. Prepare a report for the finance director of Tovell plc advising on the financial viability of the proposed fast food investment. Include in the report an assessment of the limitations of the method of appraisal that you have used. Supporting calculations should form an appendix to your report.
196
Tovell plc solution

(a)
Candidates are expected to show understanding of the theoretical and practical arguments relating to corporate diversification into several industries. Tovell has a strategy of diversifying into many industries in order to reduce risk of the companys shareholders. Rational shareholders should already be well diversified, in order to eliminate unsystematic risk. If shareholders are not well diversified this may be achieved quickly and cheaply through the purchase of such investments as general unit trusts. The expense of the company undertaking diversification is likely to be much greater than that of individual investors in the company diversifying themselves, and therefore sub-optimal strategy from the investors viewpoint. As the primary objective of companies is usually assumed to be the maximisation of shareholder wealth the strategy would not normally be recommended. However, diversification might have beneficial effects for shareholders including: (i) Less volatile internal cash flows, making servicing existing debt less risky, and therefore increasing the debt capacity of the company. Greater use of debt with no extra risk could reduce the overall cost of capital, and increase shareholder wealth. If diversification is into foreign markets where exchange controls or other barriers prevent or restrict shareholders directly investing (i.e. segmented markets), it might be possible for shareholders to reduce their systematic risk through Tovell investing in such markets which have risk-return combinations which would not otherwise be available to shareholders.
(ii)
(iii)
k oo are many bankruptcy costs including receivers b If a company fails there epossibility of assets being sold cheaply in a forced-sale. fees and the
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Such costs may significantly reduce wealth of shareholders. A diversified company may have a lower risk of corporate failure because of reduced total risk of the company (measured by variance of returns). Shareholders may be willing to accept the costs of diversification if the probability of corporate failure is reduced.
(b)
Candidates are required to select an appropriate investment evaluation technique (hopefully APV) in a diversification situation where gearing levels have changed, to show understanding of its limitations, and to prepare a report supported by the financial valuation of given data.
Report on the financial viability of the fast food investment

The proposed investment is in an industry where the company has no existing activities, and differs in risk to the companys existing activities, as is evidenced by the equity betas of the company and the industry. The investment is to be financed 800,000 by debt and 1,578,947 equity, a gearing level of approximately 0.5 to 1, which is significantly different from the companys current market weighted gearing of 0.4 to 1. As the investment results in a change in capital structure, is not marginal relative to the size of the company, and does not have the same level of systematic risk as the company, the current weighted average cost of capital should not be used as the discount rate.
197
There is no easy way to adjust the weighted average cost to take into account these changes. It is recommended that the fast food investment is evaluated using the adjusted present value (APV) technique. This approach examines directly the effects of the financing methods that are being used, which, for this investment relate to tax relief on interest payments, the benefit of a subsidised loan, and issue costs associated with the rights issue. The estimated APV of the investment is MINUS 113,620, which suggests that the investment is not financially viable. However, this ignores the potentially valuable option to continue operations after the initial five year period by further investment in equipment. Any final decision should include consideration of the financial effects of this option, and any other opportunities that might arise as a result of diversifying into the fast food industry.
Limitations of APV
APV offers an opportunity to evaluate investments where gearing and risk differ from the companys existing operation. However, it has its limitations including: (i)
m co side effects and their (ii) APV requires the identification of all financing t. discount at a rate reflecting their risk. po In a complex investment s situation, especially an overseas investment, it might be difficult to log and their appropriate discount identify relevant financing sideb effects, 0. rates. 0 20 s Appendix ok o APV = Base NPV plus the present value of financing side effects. eb
Base case NPV
This may be estimated by discounting net cash flows by the discount rate applicable to the risk associated with an ungeared investment. As the investment is in the fast food industry the base case NPV should be estimated using data from this industry. asset =
The equation for asset betas in a taxed world assumes that cash flows are perpetuities. The cash flows for this investment are not perpetuities.
E D(1 t ) + d E + D(1 t ) E + D(1 t ) 1 1(1 0.3) + 0.25 x 1 + 1(1 0.3) 1 + 1(1 0.3)
0.926
asset
= =
1.4 x
0.823 + 0.103 =
Using CAPM Ke ungeared = = rF + (ErM rF) asset 5% + (12.5% 5%) 0.926 = 11.945%
198
Base case NPV (000)

Year Operating flows Taxation Tax saved by Capital allowances* Initial outlay Realisable value Net flows Discount factors Present values 0 1 420 2 441 (126) 79 (2,300) ______ (2,300) 1.00 (2,300) ___ 420 .893 375 ___ 394 .798 314 3 463 (132) 59 ___ 390 .713 278 4 486 (139) 44 ____ 391 .637 249 5 511 (146) 33 1,250 1,648 .569 938 6 (153) 100 ____ (53) .508 (27)
Base case NPV = (173,000) *Capital allowances Year 1 2 3 4 5 (Balancing) Written-down value 1,050 788 591 443 332 Allowance 262 197 148 111 332 Tax saving 79 59 44 33 100 Available year 2 3 4 5 6
(It might be argued that the tax saving is a relatively safe cash flow and should be discounted at a rate lower than the ungeared cost of equity. If so the resultant base case NPV would be slightly larger).
Financing side effects

(i)
Tax relief on interest payments (assumed available years 2 6) The benefit from the investment in terms of increased debt capacity is 1 million. Although only 800,000 is being borrowed, the APV should be based upon theoretical benefits of the debt capacity as these are available to the company and may be used through debt issues for other investments (these too must be evaluated on their own impact on debt capacity). The tax shield benefit is therefore based upon 1 million of debt, 800,000 at 6% and the remaining 200,000 at the normal market rate of 9%. Tax relief on annual interest 800,000 x 6% 200,000 x 9% 14,400 5,400 19,800
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= =
48,000 x 0.3 18,000 x 0.3
= =
The discount rate used will be a rate reflecting the risk of the debt, in this case the pre-tax cost of debt, 9% PV annuity 9% for five years 3.890 x 19,800 x 1 = 1.09 70,662
The PV of tax relief, commencing year 2, is 70,662
199
(ii)
Subsidised loan Tovell is receiving 800,000 at 3% less than normal market rates because of its financing choice. This produces an after-tax saving (with a one year lag in tax) of: Years 1 to 5 800,000 x (0.09 0.06) per year Years 2 to 6 tax of 24,000 x 0.3 = = 24,000 (7,200)
The PV of this saving, discounted at 9% representing the market risk of debt is: 3.890 x 24,000 3.890 x (7,200) 1.09 = = 93,360 (25,695) _____ 67,665
(iii)
Issue costs The cost of the investment after issue costs (it is assumed that none exist on the loan) is 2.3 million. Net proceeds of the rights issue are 2.3m 0.8m = 1.5m. 1.5m 0.95
Tax relief on interest Benefit from subsidised loan Issue costs APV
m corights issue are . With issue costs of 5%, the gross proceeds of tthe po s = 1,578,947. log .b Issue costs are (1,578,947 1,500,000) = 78,947 00 The expected APV of the investment 0 s2 is: k oo (173,000) Base case NPV eb
70,662 67,665 (78,947) (113,620)
200
Alastair Brown plc

Alastair Brown plc is considering diversifying into a new industry. The company is investigating an investment project which would cost 18.8 million. Internally generated funds would provide 5.8 million of the necessary finance, a further 5.5 million (net of costs) would be raised by means of a rights issue, 2 million would be provided by a subsidised development loan and the remainder from a clearing bank term loan at a fixed interest rate of 10%. The subsidised loan offers a 3% subsidy on normal market rates. Issue costs associated with the loans are 1%. The rights issue will incur 3% administration costs. This financing package is thought to fully utilise the projects debt capacity. Both loans would be for a five year term. The project is expected to generate after tax (but, before WDA tax relief) net cash flows of approximately 4 million per year during the companys five year planning period. A residual value of 9 million is expected at the end of the five years. Corporation tax is at a rate of 40% and is paid 12 months in arrears. Capital expenditure attracts a 25% Writing Down Allowance (WDA) on the reducing balance. Alastair Brown plc has identified a correlation coefficient of +0.7 between the equity returns from a random sample of companies in the new industry and returns from the market. The standard deviation of market returns is 5%, and the standard deviation of equity returns of companies in the new industry is 8%. The companies sampled in the new industry have an average gearing of 50% equity, 50% debt by book values, and 70% equity, 30% debt by market values. The yield on Treasury Bills is 10%, and the return on the market is 15.6%. Corporate debt may be assumed to be approximately risk free.
Required: (a) (b)
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Estimate the adjusted present value (APV) of the proposed investment, and recommend whether it should be undertaken. Discuss the advantages and disadvantages of the APV relative to alternative techniques of capital investment appraisal.
201
Alastair Brown solution

(a)
(i) equity =
industry x industry, m m
8% 0.70 5% =1.12
= (ii) asset =
E E + D(1 t ) 7 7 + 3(1 0.40)

= = = = 0.89
= (iii)
1.12 x
Base-case discount rate
rF + [ErM rF] asset 10% + [15.6% 10%] x 0.89 15% (approx)
Writing-down allowances tax relief (assumes project is bought at start of companys accounting year)
m 18.8 4.7 14.1 3.52 10.58 2.65 7.93 1.98 5.95 (18.8 WDA 0.25 0.25 0.25 0.25 9.0 9.0)
x x x x
= = = = s ok =
4.7 3.52
2 1.98
(3.05)
0 00
2.65
.b
m co = x 0.40 t. po = x s 0.40 log

x x x x 0.40 0.40 0.40 0.40 = = = =
Tax relief 1.88 1.41 1.06 0.79 (1.22) 3.92
Timing Year 2 Year 3 Year 4 Year 5 Year 6
eb
Base-case net present value (m)

0 (18.8) 1 2 3 4 5 6
Outlay WDA tax relief After-tax cash flow Scrap value Net cash flow 15% discount factor PV cash flow
1.88 4.0 ____ (18.8) _1__ (18.8) ___ 4.0 0.870 3.48 4.0 ___ 5.88 0.756 4.44
1.41 4.0 ___ 5.41 0.658 3.56
1.06 4.0 ___ 5.06 0.572 2.89
0.79 4.0 9.0 ____ 13.79 0.497 6.85
(1.22)
____ (1.22) 0.432 (0.53)
Base-case net present value = +1.89m
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PV of financing side-effects Financing of project

m Internal funds Rights issue (net receipts) Loans (net receipts): Development Bank (balancing figure) m 5.8 5.5
2.0 5.5 _7.5 18.8
Funds raised from loans m Total (as above) 7.5m is a net receipt, therefore The gross amount is (7.5m 0.99) Development loan Bank term loan = 7.576 (2.00) 5.576
PV of the tax shield

(i)
Bank term loan

5.576m
(ii)
o sp tax relief 0.5576m x 0.40 = 0.223m per annum log .b = 0.223m x 3.791 x 0.909 0.223m x a x (1.10) 00 0.77m 0 s2 Development loank o bo = 0.14m per annum interest 2m xe 0.07
x 0.10 = 0.5576m per annum interest
5 0.10 -1
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m
=
0.14m 0.056m 0.19m
x 0.40 x a
5 0.10
= 0.056m per annum tax relief x (1.10)-1 = 0.056m x 3.791 x 0.909 =
PV of cheap loan
(i)
PV of interest saved on cheap loan

Interest saved 2m x (0.10 0.07) = 60,000 per annum
PV : 60,000 x 3.791 = 0.227m (ii)
Tax relief lost

2m x 0.03 60,000 x 0.40 = = 60,000 per annum interest saving 24,000 per annum tax relief lost = (0.083m)
PV : 24,000 x 3.791 x (1.10)-1
PV of the rights issue costs

The rights issue must raise 5.5m 0.97 = 5.67m = (0.17m)
Therefore the rights issue costs are 5.67m 5.5m
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PV of the after-tax loan issue cost

Pre-tax loan issue cost
(5.5m + 2m)
0.99
x 0.01 (1.10)-1
(0.076m) 0.028m
Tax relief thereon 0.076m x 0.4 x

m 1.89 0.77 0.19 0.227 (0.083) (0.17) (0.076) 0.028 +2.776
Base-case net present value PV of term loan tax shield PV of development loan tax shield PV of subsidised development loan: Interest saved Tax relief lost PV of rights issue costs PV of loan issue costs: Gross cost Tax relief thereon APV
(b)
Include the following points:

(1) APV is similar to NPV in that both are DCF models. However NPV is only a project appraisal technique and needs to assume that a company is maintaining its capital structure. In contrast, APV is a more general model which can evaluate both a project and its proposed financing package.
(2)
(3)
lo .bNPV and would only be used for major APV is a lengthier analysis than 0 00 projects especially where there was a complex financing package 2 involved. The muchks simpler approach of NPV would be an advantage for o smaller, more routine projects. bo e APV has similar advantages and disadvantages with respect to the other
main capital investment appraisal techniques (i.e. IRR, payback and return on investment) it is more complex and so more difficult to use. On the other hand its divide and conquer approach makes it able to handle much more complex decisions correctly.
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Chapter 9
Valuations, acquisitions and mergers section 1

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C H A P T E R 9 V A L U A T I O N S , A C Q U IS I T IO N S A N D M E R G E R S : SE C T I O N 1
CHAPTER CONTENTS
REASONS FOR VALUATIONS ------------------------------------------- 207 METHODS OF SHARE VALUATION ------------------------------------- 208 THE DIVIDEND VALUATION MODEL ---------------------------------- 209 DISCOUNTED CASH FLOW BASIS ------------------------------------- 214 PRICE EARNINGS RATIO BASIS --------------------------------------- 216 NET ASSETS BASIS ----------------------------------------------------- 218 DIVIDEND YIELD BASIS ----------------------------------------------- 220 VALUATION OF DEBT AND PREFERENCE SHARES ------------------- 221
IRREDEEMABLE DEBT REDEEMABLE LOAN STOCK PREFERENCE SHARES CONVERTIBLE DEBT 221
THE THREE ACQUISITION TYPES ------------------------------------- 224

TYPE I ACQUISITIONS
o eb TYPE III ACQUISITIONS

TYPE II ACQUISITIONS
s ok
0 20
log .b
sp
m co ot.
221 222 222
224 224 226
HIGH GROWTH START-UPS -------------------------------------------- 229
206
REASONS FOR VALUATIONS

Valuations of businesses and financial assets may be needed for several reasons e.g. To establish the terms of takeover bids or mergers; To fix a share price for an initial public offering; For investors to make buy, hold or sell decisions; For capital gains tax or inheritance tax purposes; Where a major shareholder or director wishes to dispose of a large block of shares; When the company needs to raise additional finance.
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METHODS OF SHARE VALUATION

The main approaches are: The dividend valuation model or dividend growth model; The discounted cash flow basis; The PE ratio (or earnings yield) basis; The net assets basis; The dividend yield method.
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208
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.
Illustration 1
The market expects a rate of return of 20% per annum on ordinary shares in Winterburn plc, a company which is expected to pay constant annual dividends of 20p per share.
At what price will the market value the shares?
Solution 1
P0 = D Ke = 0.20 0.2 = 1.00
po sper share next year. The market Seaman plc is expected to pay a dividend of og l 30p annum and has a required return expects dividends to grow at the rate of 5% per .b of 20%. 00 0 s2 Estimate the share price. ok o eb Solution 2
Illustration 2
P0 =
o t.c
D1 Ke g
0.30 0.2 0.05
2.00
Illustration 3
Merson plc is just about to pay a dividend of 40p per share. Future dividends are expected to grow at the rate of 6% per annum. The markets required return on shares of this risk level is 25%.
What is the cum-div share valuation?
Solution 3
This years dividend, D0 = 40p. Next years dividend will be a factor of g higher: D1 = D0 (1 + g) = = P0 = = 40p (1 + 0.06) 42.4p 42.4p + 40p 0.25 0.06
D1 + D0 Ke g
2.63
209
Illustration 4
Wright plc has just paid a dividend of 15p per share. The market is in general agreement with directors forecasts of 30% growth in earnings and dividends for the next 2 years. Thereafter, a reasonable estimate is 15% growth in year 3 followed by 6% growth to perpetuity. The markets required return on investments of this risk level is 25% per annum.
Estimate the share value.
Solution 4
For years1 to 3, compute the expected dividends and discount them. Dividend computation, Years 1 3 Year 1 2 3 Dividend 15p x 1.3 = 19.5 19.5p x 1.3 = 25.35 25.35p x 1.15 = 29.15 25% factor 0.800 0.640 0.512 Present value, p 15.60 16.22 14.93 46.75p
Then compute the dividend for year 4 and plug this into the growth formula with g = 0.06 Year 4 dividend = 29.15p x 1.06 = 00 0
Using the growth formula P3
o .bl 30.90p
p gs
o t.c
m
= =
30.90p 162.63p
The growth formula for P is based on dividends from year 1 to perpetuity. Since the dividends in the above calculation go from year 4 to perpetuity, the value for P above must be at year 3. But we want its present value at year 0. Therefore we must discount back three further years, using the 3 year factor at 25%, which is 0.512.
eb
s ok
0.25 0.06
Present value at year 0 of dividends from year 4 to perpetuity = 162.63p x 0.512 = 83.27p Adding the present value of dividends from years 1 to 3 gives: Share value = 46.75p + 83.27p = 1.30
210
Illustration 5
Zed plc is considering the immediate purchase of some, or all, of the share capital of one of two companies Red Ltd and Yellow Ltd. Both Red and Yellow have 1 million ordinary shares issued and neither company has any debt capital outstanding. Both firms are expected to pay a dividend in one years time Reds expected dividend amounting to 30p per share and Yellows being 27p per share. Dividends will be paid annually and are expected to increase over time. Reds dividends are expected to display perpetual growth at a compound rate of 6% per annum. Yellows dividend will grow at the high annual compound rate of one third until a dividend of 64p per share is reached in year 4. Thereafter Yellows dividend will remain constant. If Zed is able to purchase all the equity capital of either company then the reduced competition would enable Zed to save some advertising and administrative costs which would amount to 225,000 per annum indefinitely and, in year 2, to sell some office space for 800,000. These benefits and savings will only occur if a complete take-over were to be carried out. Zed would change some operations of any company completely taken over the details are: (i) (ii) Red No dividend would be paid until year 3. Year 3 dividend would be 25p per share and dividends would then grow at 10% per annum indefinitely. Yellow No change in total dividends in years 1 to 4, but after year 4, dividend growth would be 25% per annum compound until year 7. Thereafter annual dividends would remain constant at the year 7 amount per share.
An appropriate discount rate for the risk inherent in all the cash flows mentioned is 15%.
Required (a)
o bo
0 s2
.bl 0
p gs
o t.c
Ignoring taxation, calculate:
(i)
the valuation per share for a minority investment in each of the firms Red and Yellow which would provide the investor with a 15% rate of return. the maximum amount per share which Zed should consider paying for each company in the event of a complete take-over.
(ii) (b)
Comment on any limitations of the approach used in part (a) and specify the other major factors which should be important to consider if the proposed valuations were being undertaken as a practical exercise.
211
Solution 5
(a) (i) Valuation per share for minority interest
Red Ltd Employing the dividend growth model: Ex-div value per share Yellow Ltd PV of future dividend stream: Year 1 2 3 4 5 to infinity Dividend 0.27 0.36 0.48 0.64 0.64 15% x DF(15%) 0.870 0.756 0.658 0.572 0.572 = = = = PV 0.235 0.272 0.316 0.366 1.189 2.441 3.630 3.63 =
D1 30p = Ke g 15% 6%
3.33
Ex-div value per share
(ii)
Maximum amount per share for take-over

Red Ltd
Total dividends for year 3 = 1m @ 25p
eb
k oo
0 20
log = .b
sp
m co ot.
=
PV = 250,000
PV of future dividend stream at Year 2 250,000 = = 5,000,000 15% 10% PV at Year 0 = 5,000,000 x 0.756 Annual savings: 225,000 15% = 1,500,000 = 604,800 2,104,800 5,884,800 5.8848 = 3,780,000
Sale of office space 800,000 x 0.756 PV of savings and benefits Total value Maximum amount per share
212
Yellow Ltd PV 1,189,000
PV of total dividends in Years 1 to 4 (see i) above 1m x 1.189 Year 5 (1m x 0.64 x 1.25) 6 7 8 to infinity Dividends 000 800 1,000 1,250 1,250 15% x DF(15%) 0.497 0.432 0.376 0.376
= = = =
397,600 432,000 470,000 2,488,600 3,133,333 5,621,933 2,104,800 7,726,733 7.726733
PV at Year 0 PV of savings and benefits (see Red Ltd above) Total value Maximum value per share
(b)
Limitations and practical factors
The approach used in part (a) was to base the equity valuation only on future dividends alone and no consideration was given to underlying asset values which may be of importance in a take-over situation. The dividend valuation model is a valid approach capable of producing accurate results provided the data used are themselves accurate. The major limitations of the use of the model stem not from the formula itself, but from the assumptions concerning the input data. The major limitations include the assumptions of: (i) (ii) Smooth dividend growth. from year to year.
Perpetual growth and infinite life. It may be unrealistic to expect an infinite life for the firm, but due to discounting this assumption may produce a good working approximation for purposes of the valuation. A constant discount rate or expected rate of return.
o bo
0 s2
.bl 0
p gs
o t.c
In reality dividends may display some volatility
(iii)
Other factors which should be considered include: (i) Are all alternatives equally risky and is risk constant over the whole life? There may be greater risk during periods of expected high growth (years 1-4 of Yellow) than during periods of low or zero growth. An adjustment to the required return may be necessary during periods of abnormal risk. Asset values may be an important aspect in a take-over and should be considered. Generally the higher the asset values of the firm taken over, the greater their marketability, then the lower is the potential risk inherent in that take-over. Management and competition. Will the existing management team continue and/or will competition increase? The cash flow estimates should consider the actions of existing management, competition etc. Financing of the take-over. The method of financing the take-over (i.e. loans, own equity etc.) must be considered carefully. Full consideration of all tax consequences should be taken into account.
(ii)
(iii)
(iv) (v)
213
DISCOUNTED CASH FLOW BASIS

This method is based upon the present value of the free cash flow to equity of an enterprise, either for a limited time horizon (fifteen years may be regarded as typical) or to infinity. There are a number of variations in the definition of free cash flow to equity, but it is often described as follows: Free cash flow to equity is the cash flow available to a company from operations after interest expenses, tax, repayment of debt and lease obligations, any changes in working capital and capital spending on assets needed to continue existing operations (i.e. replacement capital expenditure equivalent to economic depreciation) In theory, this is probably the best method by which to value a company. However it relies on estimates of cash flows, discount rates, tax rates, inflation rates and the choice of a suitable time horizon. The notion of using a valuation to infinity is probably unrealistic.
Illustration 6
The predicted free cash flows of Miller Ltd, an all equity company, for its planning horizon, (which for simplicity is taken to be the next five years) are: Year 1 2 3 4 5 Free cash flows 000 150 200 250 375 500
o bo
0 s2
.bl 0
p gs
o t.c
A cost of capital of 12% is assumed to represent the systematic risk of the cash flows of Miller Ltd.
What is the estimated market capitalisation of this company?
Solution 6
Year 1 2 3 4 5 Free cash flows 000 150 200 250 375 500 Discount factor 12% 0.893 0.797 0.712 0.636 0.567 Present values 133,950 159,400 178,000 238,500 283,500 993,350
Estimated market capitalisation for 5 year planning horizon
214
Illustration 7
The following data relating to Morrison Ltd is expected to continue annually for the foreseeable future: Turnover Cost of goods sold, excluding depreciation Distribution costs and administrative expenses, excluding depreciation Capital allowances claimed Non-current assets purchased in the year Irredeemable bonds (market value 130) Working capital changes are assumed to be insignificant because of the absence of growth. Corporation tax rate Weighted average cost of capital in nominal (i.e. money) terms Predicted inflation rate m 525 315 36 46.5 72 21
30% 13.3% 3%
Calculate the estimated equity market capitalisation of this company.
Solution 7
Net cash flows
Turnover Cost of goods sold Distribution costs and administrative expenses
k oox 174,000) Tax on operating profits (30% eb Tax saved on writing down allowances (30% x 46,500)
Real discount rate (using Fisher effect) r =
0 s2
.bl 0
p gs
o t.c
m
000 525,000 (315,000) (36,000) 174,000 (52,200) 13,950 (72,000) 63,750
Non-current assets purchased Annual net cash flows
(1 + m) 1 = (1 + i)
1.133 1 = 1.03
10%
Since the annual net cash flows are perpetuities expressed in terms of real cash flows, it has been necessary to establish a real discount rate. 000 63,750 Corporate value 10% Less market value of irredeemable bonds (21,000 x 1.3) Equity market capitalisation 637,500 (27,300) 610,200
215
PRICE EARNINGS RATIO BASIS

This income based method is popular for the valuation of majority holdings in a going concern. It requires the prediction of a maintainable EPS for the company being valued and the use of the PE ratio of a listed company, whose activities are very similar to those of the business being valued i.e. Share value = EPS of company being valued x PE of similar listed company If a similar listed company (pureplay company) is not readily available, it may be appropriate to use the average PE for the market sector in which the company operates. It may be necessary to adjust the PE used or the final calculated price, if the company being valued is an unlisted company, or where the company in question has different risk or different growth potential from the similar company or constituents of the industry average. Since an earnings yield is simply a reciprocal of the PE ratio, a valuation on an earnings yield basis would be as follows: Share value = EPS of company being valued earnings yield of similar listed company
Illustration 8
Flycatcher Ltd wishes to make a takeover bid for the shares of an unlisted company, Mayfly Ltd. The earnings of Mayfly Ltd over the past five years have been as follows. 2002 2003 2004 50,000 72,000 68,000
o bo
0 s2
.bl 0
p gs
o t.c
2005 2006
71,000 75,000
The average P/E ratio of listed companies in the industry in which Mayfly Ltd operates is 10. Listed companies which are similar in many respects to Mayfly Ltd are: Bumblebee plc, which has a P/E ratio of 15, but is a company with very good growth prospects; Wasp plc, which has had a poor profit record for several years, and has a P/E ratio of 7.
What would be a suitable range of valuations for the shares of Mayfly Ltd?
216
Solution 8
Earnings. Average earnings over the last five years have been 67,200, and over the last four years 71,500. There might appear to be some growth prospects, but estimates of future earnings are uncertain. A low estimate of earnings in 2007 would be, perhaps, 71,500. A high estimate of earnings might be 75,000 or more. This solution will use the most recent earnings figure of 75,000 as the high estimate. P/E ratio. A P/E ratio of 15 (Bumblebees) would be much too high for Mayfly Ltd, because the growth of Mayfly Ltd earnings is not as certain, and Mayfly Ltd is an unlisted company. On the other hand, Mayfly Ltds expectations of earnings are probably better than those of Wasp plc. A suitable P/E ratio might be based on the industrys average, 10; but since Mayfly is an unlisted company and therefore more risky, a lower P/E ratio might be more appropriate: perhaps (60% to 70% of 10) = 6 or 7, or conceivably even as low as (50% of 10) = 5. Valuation. The valuation of Mayflys shares might therefore range between: High P/E ratio and high earnings: Low P/E ratio and low earnings:
eb
k oo
o sp 5 x 71,500 log .b 00 20
7 x 75,000
o t.c
= =
525,000; and 357,500
217
NET ASSETS BASIS

Asset-based valuation models include: net book value (balance sheet basis) largely a meaningless figure, since it is affected by accounting conventions; net realisable value basis again, not particularly relevant. However, where the break-up value exceeds income-based valuations, it would be advisable for the proprietor to cease trading and sell the assets as quickly as possible; net replacement cost basis this represents the current cost of setting up the existing business. Sadly it totally ignores goodwill, which can only be established by using income-based valuations.
Illustration 9
The current balance sheet of Cactus Ltd is as follows: Fixed assets Land and buildings Plant and machinery Motor vehicles Goodwill Current assets Stocks Debtors Short-term investments Cash
eb
s ok
00
.bl 0
p gs
o t.c
160,000 80,000 20,000 20,000 280,000
80,000 60,000 15,000 5,000 160,000 440,000
Capital and reserves Ordinary shares of 50p Reserves 4.9% preference shares of 1 12% debentures Deferred taxation Creditors: amounts falling due within one year Creditors Taxation Proposed ordinary dividend 60,000 10,000
80,000 140,000 220,000 50,000 270,000
70,000 60,000 20,000 20,000 100,000 440,000
What is the value of an ordinary share using the net assets basis?
218
Solution 9
THERE IS INSUFFICIENT INFORMATION TO ANSWER THIS QUESTION, BUT AN ATTEMPT MUST BE MADE, OTHERWISE NO MARKS WILL BE GAINED, i.e. Total value of net assets Less Goodwill Preference shares Net asset value of equity Number of ordinary shares (of 50p each) Share price 270,000 (20,000) (50,000) 200,000 160,000 1.25
NOW STATE THAT FAIR VALUE (UNDER IFRS 3 OR FRS 7) DETAILS ARE NEEDED FOR A DECENT ANSWER! FURTHERMORE, HOW DOES ONE ESTABLISH GOODWILL?
o bo
0 s2
.bl 0
p gs
o t.c
219
DIVIDEND YIELD BASIS

This income based method is popular for the valuation of minority holdings in a going concern. It requires the prediction of a maintainable dividend for the company being valued and the use of the dividend yield of a listed company, whose activities are very similar to those of the business being valued i.e. Share value =
Dividend of the company being valued Dividend yield of similar listed company
If a similar listed company (pureplay company) is not readily available, it may be appropriate to use the average dividend yield for the market sector in which the company operates. It may be necessary to adjust the calculated price if the company being valued is an unlisted company, or where the company in question has different risk or different growth potential from the similar company or constituents of the industry average. Care must be taken to ensure consistency in the treatment of tax credits i.e. look at the information given in a question very carefully to establish whether the yields given are net or gross dividend yields and whether the dividends provided include or exclude related tax credits.
Illustration 10
Taylor Ltd, which has on issue 500,000 ordinary shares of 25p each, intends to pay a constant dividend of 360,000 (net) for the foreseeable future. Listed companies within the same industry sector as Taylor Ltd currently provide a gross dividend yield of 5% p.a. The current rate of tax credit on gross dividends is 10% (i.e. 1/9th of net dividend).
Estimate a current share price for Taylor Ltd.
o bo
0 s2
.bl 0
p gs
o t.c
Solution 10
Number of ordinary shares on issue Expected net dividend per share Expected gross dividend per share Net dividend yield for market sector Share price = = = = = 2,000,000
360,000 2,000,000
18p + (1/9 x 18p) 5% x 0.9 20p 5% 18p 4.5%
= = = =
18p 20p 4.5% 4.00
Gross dividend = Gross yield Net dividend Net yield

=
or
4.00
Since Taylor Ltd is a private company the calculated share price of 4.00 could be reduced by between 30% to 50%, i.e. around 2.80 to 2.00, due to lack of marketability.
220
VALUATION OF DEBT AND PREFERENCE SHARES Irredeemable debt

Illustration 11
Koren plc has on issue 7% irredeemable loan stock. The gross return required by investors is 5% p.a. The corporation tax rate is 30%.
Establish the current market value for this stock.
Solution 11
Market value =
Gross interest payment Gross yield
7% 100 = 5%
140
Redeemable loan stock

Illustration 12
Beattie plc has issued 1,000,000 of 6% redeemable bonds. Interest payments will be made at the end of March, June, September and December of each year until redemption occurs on 30 June 2010 at 120 per cent. Bondholders require a gross redemption yield of 1% per quarter.
0 20 of these bonds at 1 January 2007. s Calculate the current market value ok o Solution 12 eb
Interest payment for 14 quarters = Redemption value Market value Period Cash flow 15,000 1,200,000 Discount factor 1% per quarter 13.00 0.870 =
.bl 0
p gs
o t.c
6% 1,000,000 4
15,000
120% x 1,000,000 =
1,200,000
Present value 195,000 1,044,000 1,239,000
1-14 14
Market value of redeemable bonds
Since there are 10,000 bonds on issue each with a 100 par value, an individual bond has a market value of:
1,239,000 10,000
123.90
221
Preference shares
Illustration 13
Steele Ltd has on issue some 9% preference shares of 1 nominal value. Investors require a return of 12.5% p.a. on these shares.
Estimate the current market price per share.
Solution 13
P0 =
D = Kps
9% 1 0.125
72p
Convertible debt
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.
0 20 notes on issue. Each 100 unit may be Kiely plc has 11% convertible s k loan converted at any time up to the date of expiry (in seven years time) into 15 fullyoo b paid ordinary shares in e Kiely plc. Any loan notes which remain outstanding at the
Illustration 14
end of the seven year period are to be redeemed at 120 per cent. Loan note holders normally require a yield of 9% p.a. on seven year debt.
.bl 0
p gs
o t.c
Recommend whether investors should convert, if the current share price is:
(a) (b) (c) 7.00, or 8.00, or 9.00.
222
Solution 14
Value as debt (i.e. if conversion does not take place): End of year 1-7 7 Value as debt Value as equity (a) (b) (c) (15 shares @ 7) = 105 (15 shares @ 8) = 120 (15 shares @ 9) = 135 Value as debt 121 121 121 Gross annual interest Redemption value 11 120 Discount factor 9% 5.033 0.547 Present value 55.36 65.64 121.00 Formula value 121 121 135 Convert ? NO NO YES
Notice that there is no need to calculate the present value of the share price, since under the fundamental theory of share valuation a current share price reflects the PV of the future cash flow streams associated with holding the share. The conversion price where the investor would be indifferent between redemption and conversion is (121 15 shares) i.e. 8.07. The value of the convertible will never fall below its value as debt (121). However if the share price rises above 8.07, the convertible loan notes will then reflect the value of the equity receivable on conversion.
o bo
0 s2
.bl 0
p gs
o t.c
223
THE THREE ACQUISITION TYPES Type I acquisitions

These are acquisitions that do not disturb the acquirers exposure to either business risk or financial risk. In theory, the value of the acquired company, and hence the maximum amount that should be paid for it, is the Present Value of the future cash flows of the target business discounted at the WACC of the acquirer. The valuation techniques already considered would deal adequately with this type of business combination.
Type II acquisitions
These are acquisitions which do not disturb the exposure to business risk, but do impact upon the acquirers exposure to financial risk e.g. through changing the gearing levels of the acquirer. Such acquisitions may be valued using the Adjusted Present Value (APV) technique by discounting the Free Cash Flows of the acquiree using an ungeared cost of equity and then adjusting for the tax shield.
Illustration 15
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 year 2008 m 117.00
o bo
kProjections during planning horizon (years)

2010 m 162.57 2011 m 188.83 2012 m 217.71 2013 m 249.48 2014 m 251.48
0 s2
.bl 0
p gs
o t.c
EBITDA Depreciation & amortisation EBIT Interest charges Profit before tax
2009 m 138.70
(40.00) 77.00 _ -_
(42.00) 96.70 (32.00) 64.70
(44.00) 118.57 (26.88) 91.69
(46.00) 142.83 (20.19) 122.64
(48.00) 169.71 (11.73) 157.98
(50.00) 199.48 (1.28) 198.20
(52.00) 199.48 _ -__ 199.48
77.00
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 acquisition.
whether to
proceed
with the
224
Solution 15
Calculation of Keu
Keu = Rf + (Rm Rf) a = 6% + (13.5% 6%) 1.1 = 14.25%
Calculation of Free Cash Flow of Newscot Ltd

2008 m 77.00 (26.95) 50.05 40.00 (20.00) 2009 m 96.70 (33.84) 62.86 42.00 (20.00) 2010 m 118.57 (41.50) 77.07 44.00 (20.00) 2011 m 142.83 (49.99) 92.84 46.00 (20.00) 2012 m 169.71 (59.40) 110.31 48.00 (20.00) 2013 m 199.48 (69.82) 129.66 50.00 (20.00) 2014 m 199.48 (69.82) 129.66 52.00 (20.00)
EBIT Less CT @ 35%
Add back Depreciation Less Capital expenditure Company Free Cash Flow
70.05
84.86
101.07
118.84
138.31
159.66
161.66 Total m
Discount factor (14.25%) PV (m)
0.875 74.25
From 2014 to infinity:
PV to infinity of Company Free Cash Flow
o eb
2 ks
p gs 0.766 lo0.671 0.587 77.42 b 79.74 81.19 . 0 161.66 00 0.514

0.1425
m co ot.
0.514 82.07 =
394.67 583.11 977.78
Tax Shield (discounted at Kd of 8%)

(32.00 x 35% x 0.926) + (26.88 x 35% x 0.857) + (20.19 x 35% x 0.794) + (11.73 x 35% x 0.735) + (1.28 x 35% x 0.681) = 10.37 + 8.06 + 5.61 + 3.02 + 0.31 = 27.37
APV Corporate value (977.78 + 27.37) Less Value of debt Value of equity Less Purchase consideration APV
m 1005.15 (400.00) 605.15 (500.00) 105.15
Therefore, the directors of Heincarl plc should proceed with the acquisition of Newscot Ltd.
225
Type III acquisitions

These are acquisitions that impact upon the acquirers exposure to both business risk and financial risk. In order to estimate WACC there is a need to establish the cost of capital of the combined businesses. However, the Ke of the combination is dependent upon the price paid for the equity capital of the target, but it is impossible to establish the price to be paid until the value of the target is determined.
Illustration 16
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 2008 (proceeds from warehouse sale) 2009 2010 2011 2012 2013
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%.
eb
s ok
0 00
millions 5.00 60.00 65.40 71.29 77.70 84.69
.b
s log
m 2014 co2015 ot.

Year
2016 2017 2018 Terminal value
millions 92.32 100.63 109.68 119.55 130.29 2,396.84
Information currently relating to the two companies is as follows: Edwards plc m Market values: Debt Equity Total asset Cost of debt 100 900 1,000 0.9 7% Colman Ltd m 20 280 300 2.4 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.
226
Solution 16
asset of combined company
1,000 300 0.9 + 2.4 1,000 + 300 1,000 + 300
1.25
equity of combined company

Revised gearing levels are: E D m 1,180 500 1,680 = 1.62
= =
900 + 280 100 + 20 + 380
= =
E + D (1 t ) 1,180 + 500 (1 0.3) = 1.25 E 1,180
Cost of equity
Ke = 5% + (9% 5%) 1.62
Weighted average cost of capital
s log 0.3) 1,180 500 11.48% + .b (1 7% WACC = 1,680 1,6800 0 0 s2flows k Present value of combined cash oo eb Cash flows of Discount factor
combined entity m 5.00 60.00 65.40 71.29 77.70 84.69 92.32 100.63 109.68 119.55 130.29 2,396.84 (9.52%) 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 Terminal value 1 11.0952 11.09522 11.09523 11.09524 11.09525 11.09526 11.09527 11.09528 11.09529 11.095210 11.095211
t. po
om
=
11.48%
9.52%
Present value @ 9.52% m 5.00 54.78 54.52 54.27 54.01 53.75 53.50 53.24 52.99 52.74 52.48 881.48 1,422.76
Value of equity
m 1,422.76 (500.00) 922.76
PV of combined entity Less combined value of debt Value of equity
227
Therefore the combination is beneficial to the shareholders of Edwards plc, since the value of their equity shareholding will increase from 900 million to 922.76 million. However, one further major problem remains! There is an inconsistency! In the weightings used for the WACC calculation, (1,180 1,680) about 70% has been applied to equity, whilst (500 1,680) about 30% has been used for debt. On the other hand, ultimately the value of equity has been shown to represent (922.76 1,422.76) about 65% of corporate value and the value of debt (500 1,422.76) about 35% of corporate value. Where these two sets of weights differ significantly an inconsistent valuation will occur. There is then a need to adopt an iterative revaluation procedure to achieve consistency between the WACC and the corporate value. This would involve a recalculation of e, using weightings that are closer to those derived from the valuation. This procedure would be continuously repeated until the assumed weights and the weightings ultimately derived from the corporate valuation are reasonably consistent. Thankfully this iterative process is not performed manually, since it can be calculated in Excel (shown in Tools > Options > Calculation). The consistent results of the iterative revaluation procedure apparently work out as follows:
PV of combined entity Less combined value of debt Value of equity e will now become: 1.25
e The weighted average cost of capital is revised to:

WACC =
Ke is now revised to become: 5% + (9% 5%) 1.74
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895 .45 + 500 (1 0.3) 895.45
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m 1,395.45 (500.00) 895.45 = = 1.74 11.96%
895.45 500 11.96% + 7% (1 0.3) 1,395.45 1,395.45
9.43%
The increased proportion of debt (500 1,395.45) i.e. about 36% of corporate value has caused both e and Ke to increase, whilst there has been a slight reduction in WACC due to the larger weighting applied to debt. Since the value of equity has now fallen to 895.45 million, which is below the current value of the equity shares in Edwards plc (i.e. 900 million), the acquisition would cause a reduction in shareholder wealth of 4.55 million. The business combination should thus be abandoned.
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HIGH GROWTH START-UPS

The valuation of Start-ups create additional problems to that of well established businesses. This may be due to: their lack of a proven track record, initial on-going losses, untested products with little market acceptance, little market presence, unknown competition, high development costs, and inexperienced managers with over-ambitious expectations of the future.
om cas shown in the following The decision as to growth expectations is rather critical t. illustration: po s log Illustration 17 .b 00 million in the coming year, thereafter 0 Bednar plc anticipates costs of 1,200 s2 growing at a rate of 4% per annum. The anticipated revenues for that year are k expected to be 320 million. The company expects to achieve a return on oo reinvested funds of between 16% and 18% per annum. Furthermore the directors eb
Using a cost of equity of 20% p.a., produce a valuation for Bednar plc based upon both the maximum and the minimum growth rate predictions, using the Growth Model combined with Gordons growth approximation.
The valuation procedures depend upon the reasonableness of financial projections, the length of the period chosen for long-term projections and the selection of future growth rates. The growth in earnings may be forecast using Gordons growth approximation i.e. g = br, where normally b = 1, since all profits made are likely to be reinvested into the business. Therefore the sole determinant of growth is the measure of r.
of Bednar plc do not anticipate the payment of any dividends for the foreseeable future.
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Solution 17
Since no dividends are expected to be paid, b = 1
Maximum valuation
Growth prediction: (g = br) g = 1 x 0.18 = 18%
Valuation using the Growth Model: 320 1,200 20% 18% 20% 4% = 16,000 7,500 = 8,500 million
Minimum valuation
Growth prediction: (g = br) g = 1 x 0.16 = 16%
Valuation using the Growth Model: 320 1,200 20% 16% 20% 4% = 8,000 7,500 = 500 million
Growth rates are affected by changes in technology, management competence, demand and inflation levels, and are therefore extremely difficult to predict. Notice the dramatic change in the business valuation that has been caused by a slight change in the predicted rate of growth.
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Chapter 10

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C H A P T E R 1 0 V A L U A T I O N S , A C Q U I S IT IO N S A N D M E R G E R S : S E C T I O N 2
CHAPTER CONTENTS
MERGERS AND ACQUISITIONS ---------------------------------------- 233
1. 2. 3. 4. 5. 6. SYNERGY 233 HIGH FAILURE RATE OF ACQUISITIONS IN ENHANCING SHAREHOLDER VALUE 234 MODE OF OFFER DEFENCES SIGNIFICANT PERCENTAGE HOLDINGS CONDUCT OF TAKEOVER BIDS 235 235 236 236
DARK POOL TRADING -------------------------------------------------- 238 OXCLOSE PLC AND SATAC LTD ---------------------------------------- 239 DEMAST LTD------------------------------------------------------------- 245 KELLY PLC --------------------------------------------------------------- 250
m co EICHNER PLC ------------------------------------------------------------ 253 t. po s log .b 00 0 s2 k oo eb
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MERGERS AND ACQUISITIONS 1. Synergy

An expansion policy based on merger or takeover can be justified on the basis of synergy. (Sometimes stated as 2 + 2 = 5) i.e. Value of A plc and B plc combined Value of A plc Value of B plc
>
operating independently
operating 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 o

Economies of vertical integration; Market power and the elimination of competition i.e. the desire to earn monopoly profits (which is good for shareholders but not in the public interest); Complementary resources e.g. 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 e.g. larger production volumes and bulk buying); Economies of scope (which may arise from reduced advertising and distribution costs where combining companies have duplicated activities); Elimination of inefficiency; More effective use of existing managerial talent.
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o o
Financial synergy: Sources of which include: o o

Elimination of inefficient management practices; Use of the accumulated tax losses of one company that may be made available to the other party in the business combination; Use of surplus cash to achieve rapid expansion; Diversification reduces the variance of operating cash flows giving less bankruptcy risk and therefore cheaper borrowing; Diversification reduces risk (however this is a suspect argument, since it only reduces total risk not systematic risk for well diversified shareholders); High PE ratio companies can impose their multiples on low PE ratio companies (however this argument, known as bootstrapping, is rather suspect).
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Conclusions on Synergy
o o
Synergy is not automatic When bid premiums are considered, the consistent winners in mergers and takeovers are victim company shareholders.
2. High failure rate shareholder value
of
acquisitions
in
enhancing
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. Often free cash flow may be used to increase the size of their company in order to enhance the status of directors who wish to be seen as heading a large listed plc. Diversification of the activities of the predator may provide job security for the directors of such companies;
o spof scale or economies of scope Over-optimistic assessment of the economies og that may be achieved as a result of the lbusiness combination; .b 00 company prior to the bid being made, Inadequate investigation of the victim 0 or insufficient appreciation of2 problems that may arise after the acquisition s the k takes place (e.g. the difficulties experienced by Wm. Morrison Supermarkets ooSafeway); following the takeover of eb
Following a successful bid, the directors and managers of the predator become too keen to identify their next victim, instead of devoting time to ensuring that the company that they have already taken over provides the expected synergies; Directors of the predator company become so obsessed with the success of their bid that they fail to seek alternative target companies. Furthermore, their valuations of the victim and their justifications for the acquisition become exaggerated.
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3. Mode of offer
Advantages Cash
Simple Price certain Saves cash Maintains ownership state Avoids capital gains tax Vendor placings for sellers who need cash Saves cash Avoids capital gains tax - Gearing problems - Changes character of investment
Disadvantages
- Liquidity problems - Capital gains tax - Value uncertain - Dilution of EPS
Shares
Loan stock
Sometimes hybrid instruments (e.g convertible loan stock) may be issued.
4. Defences
Pre-bid o o o o o o
Strategic shareholdings Poison pills Fat man strategy Golden parachutes
Crown jewels (or scorched earth) policy Pacman strategy (likely target making a reverse takeover bid for a potential bidder). Revaluation of fixed assets
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Post-bid (Note: all defences must be in line with the City Code) o
Appeal to your own shareholders. Argue that victim shares are undervalued, bidders shares are overvalued (contrary to EMH but directors have inside information). White knight defence encourage a more friendly bid. Appeal to the Competition Commission. Greenmail questionable in the UK. Crown jewels (or scorched earth) policy, with the approval shareholders in general meeting (City Code Rule 21.1 (b)(iv)). of
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5. Significant percentage holdings

Under CA 2006, the City Code or Listing Rules, the following percentage acquisitions have a significant impact.
3% or more. concerned.
Disclose your identity to the directors of the company
15%, but less than 30%. The Substantial Acquisitions Rules once applied to purchases of shares within this range of shareholding. However, these Rules were abolished with effect from 20th May 2006. 30% or more. A general offer must be made to all remaining shareholders of the target company More than 50%. In normal circumstances control is gained and a parent/subsidiary undertaking relationship is established. 75% or more. A special resolution can be passed once this level of control has been achieved. 90% or more. An offer to minority shareholders can generally be enforced.
6. Conduct of takeover bids
The following information was circulated by the Board of Forte plc as part of its first Defence document following the takeover offer by Granada plc in November 1995:
blo .bids Guidance note on the conduct of takeover 0 00 some guidance to Forte shareholders 2 The purpose of this appendix issto provide kdetailed provisions contained in the Takeover Code who may be unfamiliar with the o which govern takeover bids. It is not intended to be a definitive guide and you bo e should consult your own professional adviser.
Timing
The offer document was posted to you by the bidder; Granada, on 24th November, 1995. The first closing date for the offer is 15th December, 1995. Typically, in a contested bid, this date will pass without any action by the vast majority of shareholders and acceptances at the first closing date will usually be very low. The bidder has reserved the right to lapse or close its full cash alternative on the first, or any subsequent closing date. The bidder normally extends the offer in 14 day steps. Alternatively, the bidder may allow the bid to lapse on the first, or any subsequent closing date, but only if it is not unconditional as to acceptances. Forte cannot normally disclose trading results, profit or dividend forecasts, asset valuations or proposals for dividend payments after the 39th day after the offer document is posted, currently 2nd January, 1996. The bidder cannot normally revise the terms of its bid after the 46th day after the posting of the offer document, currently 9th January, 1996. The bidder must normally declare its bid unconditional as to acceptances (see below) by 23rd January, 1996, the 60th day after posting, or it will lapse automatically.
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Acceptance condition
The bidder may declare the bid unconditional as to acceptances at any level above 50 per cent of the ordinary shares outstanding (assuming that the bidder is permitted to exclude the Forte trust shares for this purpose). Shareholders who have not yet accepted when a bid is declared unconditional as to acceptances are still able to accept the offer (although not necessarily any cash alternative) as the bid must be kept open for acceptance for at least another 14 days after it has been declared unconditional as to acceptances.
Communication with shareholders

The offer document you have received contains the bidders arguments. Forte has set out in this defence circular a response to the bidders arguments and why the bid should be rejected. Further circulars to shareholders are likely to follow from both Forte and the bidder.
If another bidder announces an offer, the timetable normally restarts from the date that its offer document is posted.
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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 publicised 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: Six big investment banks published trading volumes for their dark pools for the first time yesterday, showing them as a tiny fraction of the market and not the major hidden rivals to stock exchanges that some argue. Citi, Credit Suisse, Deutsche Bank, J P Morgan Cazenove, Morgan Stanley and UBS together executed 596 million (513 million) of equity trades from 15 countries on their automated crossing systems on Friday, according to Markit data. That accounted for about 0.4 per cent of all types of cash equity trades in Europe and 1.6 per cent of all over-the-counter (OTC) trades reported on the Markit BOAT service that day, according to Thomson Reuters data. Dark pools are electronic platforms that allow would-be buyers and sellers of large orders of shares to avoid revealing pre-trade information and signalling their intentions to the rest of the market. Bankers argue that for the bulk of OTC trades they act purely as dealers, using their own money or share inventories to take one or another side, or they act in a non-automated way to match buyers and sellers for big blocks of stock.
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Oxclose plc and Satac Ltd

The board of directors of Oxclose plc is considering making an offer to purchase Satac Ltd, a private limited company in the same industry. If Satac is purchased it is proposed to continue operating the company as a going concern in the same line of business. Summarised details from the most recent financial statements of Oxclose and Satac are shown below:
Balance sheet at 31 March

Oxclose plc m m Freehold property Plant and equipment (net) Stock Debtors Cash Less: Current liabilities 33 58 29 24 3 (31) 330 290 20 (518) Satac Ltd 000 000 460 1,310
Financed by: Ordinary shares* Reserves Shareholders equity Medium-term bank loans
k oo Satac Ltd 25p ordinary shares. *Oxclose plc 50p ordinaryb e shares;
Year # t 5 t 4 t 3 t 2 t 1 Oxclose plc Profit after tax Dividend m m 14.30 9.01 15.56 9.80 16.93 10.67 18.42 11.60 20.04 12.62
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35 43 78 38 116
25 116
122 1,892
160 964 1,124 768 1,892
Satac Ltd Profit after tax Dividend 000 000 143 85.0 162 93.5 151 93.5 175 102.8 183 113.1
# t5 is five years ago, t1 the most recent year, etc. Satacs shares are owned by a small number of private individuals. The company is dominated by its managing director who receives an annual salary of 80,000, double the average salary received by managing directors of similar companies. The managing director would be replaced if the company were purchased by Oxclose. The freehold property of Satac has not been revalued for several years and is believed to have a market value of 800,000. The balance sheet value of plant and equipment is thought to fairly reflect its replacement cost, but its value if sold is not likely to exceed 800,000. Approximately 55,000 of stock is obsolete and could only be sold as scrap for 5,000.
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The ordinary shares of Oxclose are currently trading at 430p ex div. It is estimated that, because of difference in size, risk and other factors, the required return on equity by shareholders of Satac is approximately 15% higher than the required return on equity of Oxcloses shareholders (i.e., 115% of Oxcloses required return). Both companies are subject to corporate taxation at a rate of 40%.
You are required: (a)

to prepare estimates of the value of Satac using three different methods of valuation, and advise the board of Oxclose plc as to the price, or possible range of prices, that it should be prepared to offer to purchase Satacs shares; to briefly discuss the theoretical and practical problems of the valuation methods that you have chosen; to discuss the advantages and disadvantages of the various terms that might be offered to the shareholders of a potential victim company in a takeover situation.
(b) (c)
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Oxclose plc and Satac Ltd solution

(a)
There are various methods by which the value of an unlisted company may be estimated. These include: (i) (ii) (iii) Dividend valuation model Price/earnings ratio Net assets basis in this case a going concern
These three are illustrated below. Other methods exist (including the present value of expected future cash flows for a fixed number of years) but some of these are of little practical or theoretical relevance.
(i)
Dividend valuation model
P0 =
D1 Ke g
D1 +g P0
Ke for Oxclose may be estimated from Ke =
Growth of dividends is approximately 8.8% i.e. g =

=
4
(12.62 9.01) 1
8.8%
Current dividend per share is 18.03 pence i.e. D0 =
k oo 70m shares on issue of 50p each) (N.B. Oxclose has eb

The cost of equity of Oxclose plc is Ke = = 18.03(1.088 ) + 0.088 430 13.36%
12.62 70
0 20 18.03 s
=
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The cost of equity of Satac Ltd is approximately 15% higher than Oxcloses Ke 13.36% x 1.15 = 15.36%
The dividend growth model can now be used to establish the value of the shares of Satac. Growth in dividends in all years except t3 (which is assumed to be an extraordinary year) is approximately 10%. The dividend of Satac in the most recent year is 113,100, thus P0 = 113,100 1.1 0.1536 0.10 = approximately 2,321,000
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(ii)
Price/earnings ratio
The valuation method here is to multiply the current earnings of Satac by the P/E ratio of a similar company. The only data given relates to Oxclose plc, a much larger company in the same industry. EPS of Oxclose = 20.04 70 = = 28.63p = 15.02
P/E ratio of Oxclose
430 28.63
Satacs earnings, adjusted for the extra earnings generated if the managing director is replaced, are: 183,000 + 40,000 (1 0.4) = 207,000 207,000 x 15.02 = 3,109,140
Some adjustment to the P/E, and therefore to this valuation, is desirable as: (1) (2) (3) Satac is not a listed company; it is much smaller than Oxclose; the systematic risk of the companies is likely to be different;
m co that of Oxclose and (4) earnings growth of Satac has been lower than t. may be so in the future. po s These factors would suggest thatoa substantially lower P/E ratio and l g .b valuation are appropriate. 00 0 (iii) Net assets basis s2 k oo Replacement cost rather than net realisable value is used, as the b company wille continue as a going concern.
000 Freehold property Plant and equipment (net) Stock Debtors Cash Less: Current liabilities 000 800 1,310
280 290 20 (518) 72 2,182 (768) 1,414
Less: Medium term bank loan
The replacement cost value of net assets is 1,414,000. However, this does not include any allowance for the goodwill of the business. On the basis of these estimates a valuation of Satac of well in excess of 1,414,000, but well below 3,109,140 (say between 2,300,000 and 2,700,000) would appear to be reasonable. The valuation of unquoted companies is far from an exact science, and other price ranges are acceptable. The actual price paid will be a matter for negotiation and will depend in part upon the current ownership pattern of Satacs shares. The highest price suggested might not prove high enough to
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purchase Satac if Satacs managing director or others have majority control of the shares and do not wish to sell the company. Other factors of relevance to the buyer might be the impact on future profits if the managing director is replaced. If he is a key man and is important to the success of the business, profits might fall when he is replaced. There is also the possibility of a golden handshake for the managing director, which would add to the cost of buying the company. The question assumes that the taxation rates and regimes for both Oxclose and Satac are similar. In practice this might not be the case, and Oxclose might wish to assess the value of Satac based upon pre-tax rather than post-tax earnings. On economic grounds the maximum price that Oxclose should be prepared to offer should depend upon the difference between the present value of its own expected cash inflows before the acquisition, and the present value of the combined expected cash flows after the acquisition which, if synergy occurs, might justify a higher price than any other valuation methods that have been illustrated.
(b)
In theory the present value of the incremental cash flows associated with the acquisition should form the basis of the valuation. None of the valuation methods illustrated offers a valuation of this nature (indeed such a valuation, while theoretically desirable, is in practice very difficult to undertake). The three valuation methods should only be considered as rough estimates.
(i)
The model relies on restrictive assumptions, including a constant expected growth rate (or a series of different expected growth rates). How should the growth rates(s) be estimated? If historical data is used as a guide, over what period of time? Should more recent growth be more heavily weighted in the estimate?
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Any growth rate estimate is likely to involve subjectivity. The valuation in this question is dependent upon the estimate that Ke for Satac is 15% higher than for Oxclose. There is no accurate way of estimating such a relationship. Dividends can be set at any level that a majority shareholder (or perhaps dominating managing director) chooses, within the constraints set by earnings (past and present) and liquidity. It might not, therefore, be appropriate to value the company by the discounted value of the future dividend stream.
(ii)
P/E ratio
Some of the possible problems of the P/E ratio have been outlined above. It is difficult to find a comparable company from which the P/E may be taken in order to estimate another companys value
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(iii) Net assets basis

Asset based valuations, even after adjustments, may bear little relationship to the market value of a company. The market value of going concern is based upon an expected stream of future earnings, which will depend upon the quality of management and many other factors, in addition to the nature of the assets that a company possesses.
(c)
Terms that might be offered in a takeover situation include cash, shares, fixed interest stock or a combination of these. Occasionally the shareholders of the victim company will be offered a choice of terms e.g. all cash or less cash plus shares or fixed interest stock. Fixed interest stocks might include a convertible element, or have warrants associated with them. Advantages and disadvantages may be considered from both the viewpoint of the bidding company and the shareholders of the potential victim. The bidding company will wish to offer the terms that result in success at the minimum expected cost. The use of shares conserves corporate liquidity but leads to possible dilution in ownership. However, a bid mainly in the form of shares might be the only possibility when the victim company is relatively large. The use of debt will also conserve corporate liquidity; but it will increase gearing. A cash bid allows the bidder to know exactly the cost of the bid. The victims shareholders will similarly only know the exact value of the bid if it is in the form of cash, as fluctuations in the prices of shares and fixed interest stocks make their values uncertain. Cash gives shareholders the freedom to spend the cash or to invest elsewhere (in the bidding company if they wish!) without incurring the transaction costs of selling the shares. However, a cash payment might be subject to an immediate tax liability e.g., in countries where capital gains tax exists. The use of shares allows the shareholders to maintain a continued interest in the company, as part of a larger group. Fixed interest stock also allows a continued interest, but not an ownership interest, unless the offer is convertible into shares at some future date (and if market prices are favourable). Fixed interest stock is likely to alter the nature and risk of the shareholders investment portfolios which might not be well received by the shareholders. Although the stock could be sold, this would incur additional transaction costs.
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Demast Ltd
Demast Ltd has grown during the last five years into one of the UKs most successful specialist games manufacturers. The companys success has been largely based on its Megaoid series of games and models, for which it holds patents in many developed countries. The company has attracted the interest of two plcs, Nadion, a traditional manufacturer of games and toys, and BZO International, a conglomerate group that has grown rapidly in recent years through the strategy of acquiring what it perceives to be undervalued companies. Summarised financial details of the three companies are shown below:
Demast Ltd Summarised balance sheet as at 31 December 2003

000 Fixed assets (net) Current assets Stock Debtors Cash Less: Current liabilities Trade creditors Tax payable Overdraft 000 8,400 5,500 3,500 100 9,100 4,700 1,300 1,200 7,200 10,300 3,800 6,500
0 s2 Medium and long-term loans k Net assets oo eb
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Financed by: Ordinary shares (25 pence nominal) Reserves
1,000 5,500 6,500
Summarised profit and loss account for the year ended 31 December 2003
000 27,000 4,600 _1,380 3,220 1,500 1,720
Turnover Profit before tax Taxation Dividend Retained earnings
Additional information
(1) (2) (3) The realisable value of stock is believed to be 90% of its book value Land and buildings, with a book value of 4 million were last revalued in 1989 The directors of the company and their families own 25% of the companys shares
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Turnover (m) Profit before tax (m) Fixed assets (m net) Current assets (m) Current liabilities(m) Overdraft (m) Medium and long-term liabilities (m) Interest payable (m) Share price (pence) EPS (pence) Estimated required return on equity Growth trends per year Earnings Dividends Turnover
Demast 27 4.6 8.4 9.1 7.2 1.2 3.8 0.5 80.5 16%
12% 9% 15%
Nadion 112 11 26 41 33 6 18 3 320 58 14%

6% 5% 10%
BZO Int 256 24 123 72 91 30 35 10 780 51 12%

13% 8% 23%
Assume that the following events occurred shortly after the above financial information was produced.
m co per share plus one 2 October Nadion makes a counter bid of 170 pence cash t. 100 10% convertible debenture 2018, issued at o p par, for every 6.25 nominal s value of Demasts shares. Each convertible debenture may be exchanged for 26 log 2007 and 31 December 2009. ordinary shares at any time between 1 .b 0 January is rejected by the directors of Nadions share price moves to 335 pence. This offer 0 Demast. 20 s ok 19 October BZ0 offers cash of 600 pence per share. The cash will be raised by a o term loan from the companys bank. The board of Demast are all offered seats on eb
subsidiary boards within the BZO group. BZOs shares move to 680 pence.
7 September BZO makes a bid for Demast of two ordinary shares for every three shares of Demast. The price of BZOs ordinary shares after the announcement of the bid is 710 pence. The directors of Demast reject the offer.
20 October The directors of Demast recommend acceptance of the revised offer from BZO. 24 October BZO announces that 53% of shareholders have accepted its offer and makes the offer unconditional. Required (a) (b)
Discuss the advantages and disadvantages of growth by acquisition. Discuss whether or not the bids by BZO and Nadion are financially prudent from the point of view of the companies shareholders. Relevant supporting calculations must be shown. Discuss problems of corporate governance shareholders of Demast Ltd and BZO plc. that might arise for the
(c)
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Demast Ltd solution

(a)
Growth by acquisition is said to allow companies to expand much more rapidly than by organic growth. Rapid increases in size may offer: (i) (ii) (iii) Economies of scale in production, marketing, R & D and finance A reduction in the companys risk, and cost of capital Greater market share and market power. In some markets to operate effectively requires the achievement of a critical mass size.
Additionally acquisitions may allow: (i) (ii) (iii) (iv) (v) Improvements in gearing Purchase of patents, brands or skilled management Synergistic effects Entry into a new market quickly Acquisition of undervalued assets or companies, as is the stated strategy of BZO International. This may encompass the removal of relatively inefficient management.
However, there is evidence that many acquisitions are financially unsuccessful. There is often some abnormal return for the shareholders of the target company (in the form of high prices received for their shares), but very little for the bidding companys shareholders. Acquisitions often experience difficulties in integrating the operations of the companies concerned (unless asset-stripping is the motive for the acquisition).
(b)
Demast is an unlisted company, with no market price. Ideally the valuation of the company should be based upon the expected net present value of future cash flows, but accurate estimates of this value will rarely be available in an acquisition situation. Valuation could in practice be based upon either assets or earnings. For Nadion, which is likely to be purchasing Demast as a going concern, an earnings valuation is appropriate. BZO International has a strategy of acquiring what are perceived to be undervalued companies. If the intention is to quickly dispose of all or part of the company, the realisable value of Demasts assets would provide a useful guide, but if asset stripping is not to occur an earnings valuation would once again be recommended.
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Asset valuations
No precise estimate of the realisable value of assets is possible. Net asset value, adjusted for a 10% decrease in the value of stock, is 5,950,000 or 149 pence per share. This, however, ignores important factors including: (i) Land and buildings have not been revalued since 1989. In the light of the subsequent recession and fall in commercial property prices, the realisable value could be less than the book value of 4 million. No information is provided regarding the difference between book and realisable values of other fixed assets. The patents are not valued in the balance sheet. These could have substantial value if they have a number of years to run.
(ii) (iii)
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Earnings valuations
Two common methods of earnings based valuations are the P/E ratio and the dividend valuation model.
P/E ratio model

As Demast is not listed a P/E valuation must be based upon the P/E of a similar (pure play) company. The only available information for a company in the same industry is for Nadion, a much larger company. The EPS of Demast is 80.5 pence (given in question). EPS of Nadion is 58 pence. P/E of Nadion is 320p 58p = 5.52
If this is used for Demast the estimated value per share is: 5.52 x 80.5p = 444 pence
Although Nadion is listed and much larger than Demast, the much higher growth rates of Demast might justify the use of the P/E of Nadion, without any adjustment for lack of marketability.

P0 =
D1 Ke g
Current dividend of Demast is
At 9% growth the expected net dividend is 37.5 x 1.09 = P0 = 40 .875 0.16 0.09
eb
s ok
1,500,000 4,000,000
00
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p gs
=
o t.c
37.5p per share 40.875p
584 pence per share
All of these estimates are subject to considerable margins of error.
Value of the bids

7 September BZO bids 710 x 2/3 = 473 pence per share 2 October Nadion bids 170 pence plus effectively 4 per share (100 debentures at par for 6.25 nominal value or 25 ordinary shares), amounting to 570p per share plus the conversion opportunity. The conversion is currently at an implied price of 100 26 = 385 pence per share. This is only 14.9% above the current share price of Nadion (335p), and the opportunity for substantial capital gains on conversions exists as there are up to five years before the final conversion date. A rise in market price could mean that Nadion issues new shares on conversion at well under market price to Demasts old shareholders. 19 October BZO cash offer of 600 pence per share.
248
Commentary
Although all offers are significantly above the estimated asset valuation, the final successful bid is only 16 pence above the dividend valuation model figure. If this is accurate, the bid would seem to be financially prudent. However, BZOs strategy is to acquire undervalued companies. Unless BZO has knowledge of how to significantly increase the value of Demast e.g. by disposing of part of the operations, or the land, the acquisition of Demast does not appear to be in line with this strategy. Additionally financing the 600 pence cash offer with a 24 million term loan increases the book value of BZOs gearing (measured by loans and overdraft to shareholders funds) from its already high level of 30 + 35 123 + 72 91 35 = 65 69 = 94%
If the stock market is efficient the significant falls in BZOs share price on the occasions of both the companys bids illustrate that the acquisition is not regarded as financially beneficial by the companys shareholders.
(c)
Corporate governance is the system by which companies are directed and controlled. The board of directors should act on behalf of the shareholders, taking note of other interest groups such as the government, creditors, customers and employees. In an acquisition situation the actions of directors are constrained by the City Code on Takeovers and Mergers, a set of self-regulatory rules administered and enforced by the Panel on Takeovers and Mergers. The directors of both the bidding and target companies should disregard their own personal interests when advising shareholders. It is questionable whether BZOs directors actions are in the best interests of the companys shareholders, given the market reaction to the bid and the likely adverse effects on the companys gearing and interest cover. The company appears short of liquidity (current ratio 0.79:1), and may be trying to maintain its high growth in turnover through acquisitions.
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The directors of Demast advised shareholders to reject the bid of Nadion worth 570 pence plus a likely capital gain on conversion, and accept the bid from BZO of 600 pence, which also offered them seats on subsidiary boards within BZO. It could be argued that the directors were acting in their own interests to retain well-paid employment, and not in the interests of the owners of the 75% of the shares not controlled by the directors and their families, although the value of the conversion option is difficult to quantify. Acceptance of the bid by BZO might also affect the operations and employment levels of Demast, if part of the operation or the patents were sold. Continuity of current operations would be more likely under the ownership of Nadion, a company in the same industry, though some costsaving might occur, with loss of employment.
249
Kelly plc
On 1st July 2005, Kelly plc had the following three classes of debenture all of which had been in issue for some years: Coupon Rate 14% 14% 6% Year(s) of redemption 2009 2008-2010 2010 Date of redemption 31 December 1 July 1 April Dates of interest payments 1 July, 31 December 1 July, 31 December 1 April, 1 October Market price at 1 July 2005 110.43 ex int. 110.15 ex int. unlisted
All the companys debentures will be redeemed at par. Market evidence suggests that the 6% 2010 debentures should have a six-monthly gross redemption yield (i.e internal rate of return to maturity) of 6%. The prevailing level of market interest rates can be assumed to remain unchanged over the next six years.
Requirements (a) (b)

Calculate the six-monthly gross redemption yield of the 14% 2009 debenture Determine when investors are likely to assume that Kelly plc will redeem the 14% 2008-2010 debentures, and hence calculate their effective annual gross redemption yield. Estimate the price on 1st July 2005 that an investor should be prepared to pay for the 6% 2010 debentures.
(c)
NOTE: Ignore taxation
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Kelly plc solution

(a) Six-Monthly Gross Redemption Yield
This is found as the IRR of the following cash flows: Initial capital cost: market value 110.43 Interest: Redemption: Time nine payments of 7 due yearly one payment of 100 in nine years time. 10% factor 1 5.759 0.424 PV at 10% (110.43) 40.31 42.40 (27.72) 5% factor 1 7.108 0.645 PV at 5% (110.43) 49.76 64.50 3.83
Cash flows 0 (110.43) 1-9 7.00 9 100.00 Net present values IRR, i.e. 6 monthly yield
3.83 5+ 5 = 31 .55
5.6%
(b)
Redemption Date and Effective Annual Gross Redemption Yield
m co Kelly plc will presumably choose the option which . t minimises the effective cost (based on similar IRR calculations) of the loan stock to themselves. po s (i) Redeem 2008 log .b PV at 10% PV at 5% 00 0 s2 Market value (110.15) (110.15) k Six interest payments of 7 30.49 35.53 oo One paymentb 100 of 56.40 74.60 e
Net present values = 5% (23.26) (0.02) IRR
(ii)
Redeem 2010 Market value Ten interest payments of 7 One payment of 100 (110.15) 43.02 38.60 (28.53) 5.8% (110.15) 54.05 61.40 5.30
IRR
5.30 5+ 5 = 33 .83
Therefore Kelly will redeem the loan stock in July 2008. The effective annual gross redemption yield is (1.05)2 1 = 10.25%.
251
(c)
Price of Debentures on 1 July 2005

The value at 1 October 2005 is the present value, at 6%, of two cash flows: (1) (2) Interest: 9 interest payments of 3 plus 3 due on 1 October Redemption payment: = = = PV of capital = 100 in nine years time
9 0.06]
PV of interest
[3.00 x a
+ 3.00
[3.00 6.802] + 3.00

20.41 + 3.00
100 0.592
= =
23.41 59.20
DF @ six monthly yield of 6% for 3 month period =
1.06
1.0296
Value at 1 July
(23.41 + 59.20) 1.0296
80.24
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252
Eichner plc
At 31 July 2003, Eichner plc and Beck plc both have in issue 5 million ordinary shares each with a nominal value of 50p. In addition, the companies have in issue the following actively traded securities. Eichner plc: 50,000 units of convertible debentures, carrying an annual coupon rate of 11%. Each unit has a nominal value of 100 and may be converted into 40 ordinary shares at any time up to and including 31 July 2008. At that date any unconverted debenture will be redeemed at 105 per 100 nominal value. Beck plc: 800,000 warrants, each of which provides the holder with the option to subscribe for one ordinary share at a price of 2.50 per share. The warrants can be exercised at any time up to and including 31 July 2008.
Required: (a)
Calculate the value of each 100 unit of convertible debenture and of each warrant on 30 July 2008, if the share price for each company on 30 July 2008 is either 2 or 3, and advise holders of the securities whether or not to exercise their conversion or option rights. Estimate the market price at 31 July 2003 of each 100 unit of convertible debenture, if the current share price on the same date is either 2 or 3. The current pre-tax rate of interest on 11% debentures of companies with similar risk to Eichner plc is 8% per annum. Discuss, briefly the factors which would influence the current price of a warrant.
(b)
(c)
NOTE: Ignore personal taxation.
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Eichner plc solution

(a) Value of convertibles and warrants
(i) Value of convertibles Share price 2 3 (ii) Value as debentures 105 105 Value as shares 40 x 2 40 x 3 = = 80 120 Market value 105 120 Convert? NO YES
Value of warrants Share price 2 3 Exercise price 2.50 2.50 Value of warrant NIL 0.50 Exercise option? NO YES
(b)
Market price of convertible debentures

(i) Value as debt t15 t5 11 105 x x 3.993 0.681 = = 43.92 71.51 115.43
5 year annuity factor at 8%
5 year single discount factor at 8% (ii)
Value as equity will be 40 x market price per share Share price 2 3
k oo as debt b Value
(ex int) 115.43 115.43
0 s2
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= =
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3.993 0.681
Value as equity (ex div) 80 120
Formula value 115.43 120.00
The actual price of the convertibles is likely to display a premium on the formula value prices, reflecting the time to go before expiry (i.e. time value). There is no downside risk on the lower share price and only a limited amount on the higher. The value of a convertible cannot fall below its value as debt, but upside potential is available due to the possibility of an increase in share price. Thus a convertible will trade at a value in excess of formula value, and that premium will be at its greatest where the value as debt and the value as equity are fairly close to each other.
254
(c)
Factors influencing the current price of a warrant

Warrants are effectively call options on equity and their value may be estimated within an option pricing framework. The major factors determining the market price of a warrant are as follows: 1. 2.
The price of the underlying security. Clearly the higher the security price the more valuable the warrant. The exercise price, i.e. the price at which the underlying security may be purchased. The lower the exercise price the more valuable the warrant. The time to expiry. The longer the period to expiry the greater the probability that the value of the underlying security will rise in value. The volatility of the underlying security. Warrants like options can give protection from downside risk, but give participation in upside potential. Accordingly the greater the variability of the underlying security the greater the probability of the warrant showing high returns. Interest rates. As the exercise of the warrant is at some future date we must consider the present value of the exercise price in determining the value of a warrant. As interest rates rise, the present value of the exercise price will be lower and hence the value of the warrant will increase.
3. 4.
5.
6.
o sp may only be exercised on Exercise conditions. Warrants sometimes og expiry (equivalent to European l Call Options) whilst others may be .b exercised at any time up 00 to expiry (American Call Options). In most circumstances it is not 0 2 sensible to exercise warrants until expiry as whilst there is still s k time left to run, the underlying security could o increase in value. In this case both variants should have the same bo e value. Large dividend payouts effectively transferring equity value to
cash can be detrimental to European type warrants. American type warrants could exercise early and avoid this problem and therefore may be more valuable.
o t.c
255
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256
Chapter 11

m
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257
CHAPTER CONTENTS
A QUESTION OF VALUES ----------------------------------------------- 259
MARKET VALUE ADDED ECONOMIC VALUE ADDED (EVA) SHAREHOLDER VALUE ADDED (SVA) 259 261 268
INTELLECTUAL CAPITAL ----------------------------------------------- 271

VALUING INTELLECTUAL CAPITAL MARKET-TO-BOOK VALUES TOBINS Q CALCULATED INTANGIBLE VALUE 271 271 272 272
ILLUSTRATION DESTROYING VALUE ------------------------------- 274
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258
A QUESTION OF VALUES
By Steve Jay, BA, M Phil This is an article, which appeared in the October 2001 edition of Student Accountant.
Introduction
It is generally accepted that the objective of corporate financial management is to maximise shareholder wealth in the form of rising share prices and dividends. Whilst this is obviously in the interest of shareholders it should also benefit society as a whole. This is because it should lead to the most efficient companies finding it easiest to raise new share capital and thus ensure that societys scarce resources are allocated and managed most efficiently. Unfortunately history shows us that accounting profit measures often appear to have little correlation with share price performance. This is particularly true in new-economy companies, many of whom have poor profit records but who have demonstrated large increases in wealth for their investors during the 1990s.
Market value added
Before proceeding with a look at economic value added it is important that we clarify our measure of shareholder wealth. Imagine two quoted companies A plc and B plc. Both firms are entirely equity financed. Both have a start of year stock market equity capitalisation of 400 million. A plc raises 20 million via a rights issue and invests it in a project that adds 100m to the present value of its future earnings. B plc raises 150 million via a rights issue and invests in a project that adds 120m to the present value of its future earnings. Table 1 demonstrates the changes to equity market capitalisation and shareholder wealth. ---------------------------------------------------------------------------------------------
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Table 1 Changes in stock market value

Opening total value (equity market capitalisation) Addition to present value of earnings stream Closing total value (equity market capitalisation)
Company A 400m 100m 500m
Company B 400m 120m 520m
Changes in shareholder wealth

Increase in total value (equity market capitalisation) Funds subscribed by shareholders Market value added for the period 100m (20m) 80m 120m (150m) (30m)
--------------------------------------------------------------------------------------------It is clear that although Company B has the greatest increase in market capitalisation it has decreased the wealth of its shareholders as the present value of the future income generated by its new project is less than the funds invested. Company A on the other hand adds 80m to the wealth of its investors. This is a simple but important point. Shareholder wealth is not simply the increases in stock market value over the period; rather it is the increase in stock market value less funds subscribed by shareholders.
259
This concept can be enlarged to cover the whole life of the business. Over a longer time period the market value added is the difference between the cash that investors have put into the business (either by purchase of shares or the reinvestment of potentially distributable profits) and the present value of the cash they could now get out of it by selling their shares.
The link with NPV

None of the above is particularly new. NPV is a well-established rule that measures the impact that new projects will have on shareholder wealth. Table 2 adds some more detail to the two projects being considered by Companies A and B. ---------------------------------------------------------------------------------------------
Table 2 Cash flows Company A Company B Project Project m m (20) (150) 35.03 46.35
t0 tl-t4 CAPM based required rate of return
Initial investment Net cash flow pa
Net present value of Project A = (20) + Annuity factor for 4 years @ 15% x 35.03
o .bl = 80m 0 0 20 + Annuity factor for 4 years @ 20% x 46.35 Net present value of Project B = s k (150) o= (150) + 2.589 x 46.35 o eb = (30m)
= (20) + 2.855 x 35.03 Both of these figures correspond with the market value added in the period, thus the NPV rule should guide managers to select projects that maximise shareholder wealth. ---------------------------------------------------------------------------------------------
p gs
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m 15%
20%
260
Economic value added (EVA)

So far we have established that the prime objective of financial management is to maximise investor wealth and that this can be achieved by using NPV in decision making. What is lacking is an operating performance measure for management that will guide managers to maximise NPV and thus shareholder wealth. Traditionally operating managers are judged on accounting profit based measures (controllable profit, return on investment, etc) which we have noted, often lack correlation with shareholder wealth and largely ignore NPV. It seems very strange that we expect managers to evaluate new projects on the basis of NPV, but that we subsequently ignore NPV in appraising managerial performance. Economic value added attempts to cure this problem. Economic value can be defined as
Cash earnings before interest but after tax* MINUS An imputed charge for the capital consumed.
*often referred to as NOPAT (net operating profit after tax)
In this way a managers operating performance is judged after charging a amount for capital funds used.
m coa performance measure It will be noted that this is very similar to residual income, t. you will have considered in earlier studies. po gs Crucially the present value of the economic lo value added figure equals the NPV of .b the project. 00 0 Economic value added is sometimes referred to as EVA. EVA is the registered s2Co who have done much to popularise and k trademark of Stern Stewart and oo implement this measure of residual income. eb
Table 3 shows the calculation of economic value added for our two projects and demonstrates its equivalence with NPV. ---------------------------------------------------------------------------------------------
Table 3 million t2 t3
15 35.03 (5) (2.25) 27.78 10 35.03 (5) (1.5) 28.53
t1
t4 5 35.03 (5) (0.75) 29.28
Company A Project Year beginning capital employed (net)

Net of tax operating cash flow Economic depreciation* Imputed capital charge (15% of capital employed) Economic value added
20 35.03 (5) (3)__ 27.03
Company B Project Year beginning capital employed (net)

Net of tax operating cash flow Economic depreciation* Imputed capital charge (20% of capital employed) Economic value added
150 46.35 (37.5) (30) (21.15)
112.5 46.35 (37.5) (22.5) (13.65)
75 46.35 (37.5) (15)_ (6.15)
37.5 46.35 (37.5) (7.5)_ 1.35
261
Equivalence with NPV Company A economic value added PV factors @ 15% Present value
Total present value = 27.03 0.870 23.50 = 27.78 0.756 21.00 28.53 0.658 18.76 29.28 0.572 16.74
80 million
Project NPV (21.15) 0.833 (17.62) (13.65) 0.694 (9.47) (6.15) 0.579 (3.56) 1.35 0.482 0.65
Company B economic value added PV factors @ 20% Present value

Total present value =
(30 million)
Project NPV
*Economic depreciation measures the true fall in the value of assets each year through wear and tear and obsolescence. Although depreciation would not normally be charged in calculating discounted cash flow, in this case it must be recovered from a companys cash flow to provide investors with a return of their capital before they can enjoy a return on their capital G Bennett Stewart. Alternatively it could be viewed as the capital expenditure the firm would have to make each year to maintain its capital base. In this example, for simplicity, economic depreciation is assumed to occur on a straight-line basis though clearly other patterns are possible.
---------------------------------------------------------------------------------------------
The Linkages
To recap, the increase in shareholder wealth = Market value added
Therefore if we tell managers that their performance will be judged upon economic value added, this should result in the maximisation of NPV and thus shareholder wealth. We now have a performance measure that corresponds exactly with the NPV based decision-making technique. Proponents therefore recommend that managers and divisions performance should be measured on an economic value added basis operating
eb
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= Project NPV = Present value of economic value added
Some complications
1. Geared companies
Not all companies are financed entirely by equity; many fund substantial parts of their plant and equipment by using debt finance. The principles of economic value added still apply. Cash earnings before interest but after tax are charged for capital at a rate that blends the after-tax cost of debt and the cost of equity in the target proportions the firm would plan to employ (rather than the actual mix used in a particular year).
262
Imagine that Company A financed its project by 50% equity finance and 50% risk free debt finance and that this was considered to reflect the target capital structure. To reflect this higher gearing As cost of equity finance increases to 18.5%. Its post-tax cost of debt is 7%. This gives a weighted average cost of capital for the project of: 18.5% x 50% + 7% x 50% = 12.75%
The capital charge to the project will now be at 12.75% of capital employed at the start of the year. Note that interest on the loan should not be deducted from the net of tax operating cash flow as it is allowed for in the imputed capital charge. The tax relief on interest should not be allowed for in the tax bill, as once again this is included in the capital charge. Students will note that this is similar to the approach taken in estimating net cash flow in NPV calculations. This approach is illustrated in table 4 together with other adjustments.
2.
Economic value added and reported accounting results

Published accounting profit figures are more complicated than operating cash flow less economic depreciation as featured in Table 3. For reasons of prudence, losses are often recognised at an early date and accruals accounting makes many timing adjustments to cash flow in converting it to accounting profit. As we are really interested in economic profit rather than accounting profit these adjustments have to be eliminated or added back in. The consulting firm Stern-Stewart, have identified 164 performance measurement issues in its calculation of EVA from published accounts. The adjustments mainly involve: (i) Converting accounting profit to cash flow (ii) Distinguishing between operating cash flows and investment cash flows They include such issues as treatment of stock valuation, revenue recognition, bad debts, the treatment of R & D, advertising and promotion, pension expenses, contingent liabilities etc. Whilst it is unlikely that you would have to make 164 adjustments in the exam some simple changes may be required! Some of these are demonstrated in Table 4, which includes a calculation of EVA from a set of published results. ---------------------------------------------------------------------------------------
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Table 4 XYZ plc Profit and Loss Account year ended 31/12/2000 (unadjusted)
Sales revenue Cost of sales Depreciation Net operating profit Interest paid R&D Advertising Amortisation of goodwill Profit before tax Tax paid (30%) Available to equity
m 50 (28.3) (0.8) 20.9 (1.6) (2.1) (2.3) (1.3) 13.6 (4.08) 9.52
XYZ plc Balance Sheet as at 31/12/1999 (unadjusted)

Fixed assets (net) Current assets Less Current liabilities Borrowings Net assets Ordinary shareholders funds
m 40 125 (98) (27) 40

40
XYZ plc Profit adjustments
and
Loss
Account
Profit before tax Add Interest paid R&D Advertising Goodwill Net operating profit Less adjusted tax bill Adjusted profit
eb
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oyear
p gs
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m
31/12/2000 after
ended
m 13.6
1.6 2.1 2.3 1.3 20.9 (4.56) 16.34 note note note note 1 2 3 4
note 5 note 7
XYZ plc Balance Sheet as at 31/12/1999 after adjustments

Ordinary shareholders funds Add Borrowings R&D Advertising Goodwill Adjusted capital employed Adjusted return Required return (15% x 104.3m) = EVA
m 40
27 13.4 15 8.9 104.3 16.34 (15.645) 0.695m note note note note 1 2 3 4
note 6
Conclusion: this company has added value for its shareholders
264
Notes
1 Interest paid is added back as this will be charged in the imputed capital charge. Borrowings are added to the capital base as profits must cover the cost of borrowings (see geared companies above). R & D is considered an investment in the future in the same way as expenditure on capital equipment. 2.1m is therefore removed from the P & L account. At the same time the last (say) 5 years R & D expense (assumed 13.4m) is added back to the balance sheet. This will increase the capital base and thus the imputed capital charge. A small charge for R & D may remain in the P & L a/c to reflect the economic depreciation of the capitalised value. Advertising is a market building investment and is removed from the P & L a/c. The last (say) 5 years advertising expense is added to the capital base (assumed 15m). A small charge for advertising may remain in the P & L a/c to reflect the economic depreciation of the capitalised value. 4 Goodwill represents the premium paid for a business on acquisition. Again this is an investment in the future and similar adjustments as for R & D and advertising apply. The cumulative goodwill write off of (assumed 8.9m) is added to the capital base. The tax figure will include tax relief on debt interest. As this will be allowed for in the weighted average cost of capital it should be adjusted out. The tax bill will rise to 4.08 + (30% x 1.6m) = 4.56m. This is an assumed 15% WACC applied to the adjusted capital employed. Note that WACC would be calculated following the approach outlined in geared companies above. No adjustment is made for depreciation as this is assumed to approximate economic depreciation on physical assets as discussed above.
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265
Arguments for and against Economic Value Added
FOR
1. It makes the cost of capital visible to managers. Under conventional management accounting performance measures the only profit and loss charge for capital is depreciation on the asset. Under the economic value added approach managers will also be charged the financing cost of capital employed. This should cause managers to be more careful in investing new funds and to control working capital investment. It can also lead to underutilised assets being disposed of. To improve their performance managers will have to: 2. Invest in positive NPV projects, OR Eliminate negative NPV operations, OR Reduce the firms weighted average cost of capital, OR Hopefully all three
It supports the NPV approach to decision making. If managers pursue negative NPV projects they will eventually find that the imputed capital charge outweighs earnings and will lead to a deterioration in their reported performance.
AGAINST
1.
Economic value added does not measure NPV in the short term. Some projects have poor cash flows at the beginning, but much better ones at the end (and vice versa). Projects with good NPVs may show poor economic value added in earlier years and thus be rejected by managers with an eye on their performance measure. Managers who have a short term time horizon (possibly due to impending promotion or retirement) could still make decisions that conflict with NPV and thus the maximisation of shareholder wealth.
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If we return to projects being considered by Companies A and B, but this time alter the pattern of cash flows (but not the NPVs) the point will be clearer. Table 5 illustrates this point.
----------------------------------------------------------------------------------------------------Table 5 Cash flows m Company A Project DF PV m 15% m (20) 1 (20) 5 0.870 4.35 5 0.756 3.78 5 0.658 3.29 154.87 0.572 88.58 80m Company B Project DF PV m 20% m (150) 1 (150) 133.52 0.833 111.22 5 0.694 3.47 5 0.579 2.90 5 0.482 2.41 (30m)
t0 t1 t2 t3 t4
Investment Net cash flow Net cash flow Net cash flow Net cash flow NPV
NPVs are unchanged and should therefore have the same effect on market value added as before.
266
Economic value added computations Company A Project

Year beginning capital employed (net) Net of tax operating cash flow Economic depreciation Imputed capital charge (15% of capital employed) Economic value added DF(15%) PV NPV = 80m 20 15 10 5
5 (5) (3) (3) 0.870 (2.61)
5 (5) (2.25) (2.25) 0.756 (1.70)
5 (5) (1.5) (1.5) 0.658 (0.99)
154.87 (5) (0.75) 149.12 0.572 85.30
Company B Project
Year beginning capital employed (net) Net of tax operating cash flow Economic depreciation Imputed capital charge (20% of capital employed) Economic value added DF(20%) PV NPV = 30m 150 112.5 75 37.5
133.52 (37.5) (30) 66.02 0.833 54.99
5 (37.5)
5 (37.5) (15) (47.5) 0.579 (27.50)
5 (37.5) (7.5) (40.0) 0.482 (19.29)
Conclusion
The present value of the economic value added figures is still equal to the projects NPV, but the year-by-year distribution of economic value added has changed. Managers with a short term time horizon may well accept Company Bs project but reject Company As project.
o bo
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(22.5) (55.0) 0.694 (38.20)
---------------------------------------------------------------------------------------2. Validity of EVA adjustments Part of the problem with economic value added in the short term lies in the accounting measurement of profit. In table 5, Company As project might show poor cash flows earlier on due to large investments in R & D. To a certain extent this problem can be removed by using the adjustments proposed by Stern Stewart covered above. However Brealey and Myers question if these adjustments to accounting profit are sufficient. They cite the case of Microsoft and question whether its capital base has been understated in published Stern Stewart figures. The value of its intellectual property - the fruits of its investment in software and operating systems is not shown in the balance sheet. This would undervalue its capital base and result in its imputed capital charge being too small and thus overstate its EVA.
267
Shareholder value added (SVA)

Shareholder value is a much-discussed concept and many companies now express a commitment to it. It should be noted however that economic value added is simply one way of measuring the increase in shareholder wealth achieved by the company. Kevin Mayes gave a useful overview of the various shareholder value metrics in a Student Newsletter article in the November/December 2000 edition. Of these competitors to EVA, shareholder value added is also included in the Paper P4 syllabus. Shareholder value added involves calculating the present value of the projected future free cash flow to equity of the business. Any increase in this present value should result in an equivalent increase in market value added and thus increase shareholder wealth. Free cash flow to equity is the cash flow available to a company from operations after interest expenses, tax, repayment of debt and lease obligations, any changes in working capital and capital spending on assets needed to continue existing operations (i.e. replacement capital expenditure equivalent to economic depreciation). Although different definitions of free cash flow exist they all relate to cash flow after replacement capital expenditure. Free cash flow in our definition represents the cash available to shareholders, which in principle could be used to invest in new positive NPV projects, paid out as dividend or used for share repurchase. The present value of this free cash flow should equal the current equity market capitalisation of the business, and any changes in this present value (less shareholder funds subscribed) represent the market value added.
0 20 of calculation involved. s Table 6 gives an example of the types ok o --------------------------------------------------------------------------------------------eb

Table 6
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A company prepares a forecast of future free cash flow at the end of each year. A period of 15 years is used as this is thought to represent the typical time horizon of investors in this industry. The companys CAPM derived cost of equity is 10%. During 2000, a rights issue of 5m is made which is invested in a project that will increase future earnings. Note that present values are calculated at a cost of equity, as free cash flow is measured after debt servicing costs (i.e. it represents a return to equity holders). If debt interest and principal payments had been excluded from the free cash flow calculation then the present value would have been calculated at the WACC as this version of free cash flow represents a return to both equity and debt holders. The resultant present values would then represent the value of debt plus equity in the company. The value of equity could be calculated by subtracting the stock market value of debt.
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Free cash flow forecast as at 31/12/1999 t1 10,000 (4,000) (1,000) (500) (1,000) 3,500 0.909 3,182 36,337 m t2 12,000 (5,000) (1,000) (4,000) (500) (3,000) (1,000) (2,500) 0.826 (2,065) t3-t15 14,000 (6,000) (500) (500) (1,000) 6,000 5.870* 35,220
Sales Operating costs Interest Debt repayments Working capital Replacement capital expenditure Tax Free cash flow to equity PV factors @ 10% (the companys cost of equity) Present value of free cash flow to equity Total present value
Free cash flow forecast as at 31/12/2000 t1 12,000 (5,000) (1,000) (4,000) (500) (3,000) (1,000) (2,500) 0.909 (2,273) m t2 14,000 (6,000) (500) (500) (1,000) 6,000 0.826 4,956 t3-t15 15,000 (6,000) (500) (500) (1,000) 7,000 5.870* 41,090
Sales Operating costs Interest Debt repayments Working capital Replacement capital expenditure Tax Free cash flow to equity PV factors @ 10% (the companys cost of equity) Present value of free cash flow to equity Total present value
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43,773
PV of free cash flow to equity as at 31/12/2000 PV of free cash flow to equity as at 31/12/1999 Increase in present value Funds subscribed by shareholders in the year Market value added
m 43,773 36,337 7,436 (5,000) 2,436
Conclusion This company has increased the wealth of its shareholders

* The annuity factor for t3-t15 is calculated as follows: t 1 to 15 1&2 Annuity factor 7.606 (1.736) 5.870
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Arguments for and against the shareholder value added approach
For
It takes a multi-period view and should therefore overcome some of the short termism of EVA
Against
1. The estimates of future free cash flow are very subjective and are very difficult to verify. This technique would be almost impossible for outsiders to the business to use. The time horizon over which free cash flow is forecast is difficult to determine. If you use a short period you lose the present value earned in later years, but if a long period is used the forecasting of cash flows becomes very subjective.
2.
Conclusions
Shareholder value is high on the agenda of many companies as shareholders increasingly look for competitive rates of return on their investments. The two metrics discussed here draw heavily on traditional financial management and management accounting theory. EVA, SVA and free cash flow are all included in the Paper P4 syllabus and are fair game for future exam questions.
o sp of Applied Corporate Finance G Bennett Stewart: The EVA Fact or Fantasy-Journal log 1994. .b 00 Finance-McGraw Hill 6 Edition 2000 R Brealey & S Myers: Principles of Corporate 0 s2 K Mayes: Shareholder Value-ACCA Student Newsletter November/December 2000 ok ohis valuable comment on the drafts of this article. Thanks to Scott Goddard for eb
References and Acknowledgements
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INTELLECTUAL CAPITAL
Patents, trademarks and copyrights are the only form of intellectual capital that are regularly recognised in financial reporting. However, accounting conventions based upon historical cost often understate their value, since market values and value in use would be more appropriate. The the Value Platform is an intellectual capital management model which recognises its three main components: Human capital this refers to the know-how, capabilities, skills and expertise of the human members of the organisation; Organisational (structural) capital this refers to the organisational capabilities developed to meet market requirements e.g. patents, design rights, trade secrets, corporate culture, information systems and financial relations; Customer (relational) capital this refers to the connections outside the organisation e.g. customer loyalty, brands, distribution channels, supplier relations and franchising agreements.
Valuing intellectual capital
Intellectual capital is influenced by the unique culture of the organisation and the distinct processes and relationships evolving therein. In view of its complexity the measurement of intellectual capital would require a number of evaluation measures.
0 20 Three broad indicators have been developed to facilitate comparisons of intellectual s capital stocks between organisations: ok o market-to-book values; eb
Tobins q; Calculated intangible value
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Market-to-book values
This is the most widely known indicator of intellectual capital. The contention is that the value of an entitys intellectual capital will be represented by the difference between the book value of the enterprise and its market value. If a companys market value is 10m and its book value 5m, then the residual 5m represents the value of the firms intangible (or intellectual) assets. The principal benefit of this method is its simplicity. However, as with most other measures, the more simple the calculation, the less likely it is to capture the complexities of the real world. In this case, simply subtracting book value from market value tends to ignore external factors that can influence market value, such as deregulation, supply conditions and general market nervousness, as well as the various other types of information that determine investors perception of the income-generating potential of the business, such as industrial policies in foreign markets, media, political influences, rumour, etc. In addition, the current accounting model does not attempt to value a company in its entirety. Instead it records each of its separate net assets at an amount appropriate to the relevant financial reporting standard, under which the accounts
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have been prepared (e.g. historical cost, modified historical cost, replacement cost, etc.). The market, however, values a business in its entirety as a going concern with strategic intent. It may be argued that the differences between these two forms of valuation can be defined as the value of intellectual capital. This value will then be subject to variations arising from the book value of the separable net assets, their current market price, and various imperfections that may exist in the market valuations. Calculations of intellectual capital that use the difference between market and book values can also suffer from inaccuracy because book values can be affected if businesses choose, or are required, to adopt tax depreciation rates for accounting purposes, and the tax rates reflect factors other than an approximation of the diminution in value of an asset.
Tobins q
Another way of getting around the depreciation rate problem when comparing the intellectual capital between entities is to use Tobins q. This was developed initially by James Tobin as a method of predicting investment behaviour. It uses the value of the replacement costs of a companys assets to predict the investment decisions of a business, independent of interest rates. The q is the ratio of the market value of the enterprise (i.e. number of shares on issue multiplied by mid-market price) to the replacement cost of its assets. If the replacement cost of a companys assets is lower than its market value, then a company is obtaining monopolistic benefits, or higher-than-normal returns on its investments. A high value of q indicates that the company will likely purchase more of those assets. Technology and human capital assets are typically associated with high q-values. As a measure of intellectual capital, Tobins q identifies a companys ability to get unusually high profits because it has something that no other business has.
k ooto the same external variables that influence market However, Tobins q is subject eb price as the market-to-book value approach. Both methods are best suited to
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making comparisons of the value of intangible assets of businesses within the same industry, serving the same markets, and having similar types of tangible assets. In addition, these ratios are useful for comparing the changes in the value of intellectual capital over a number of years. When both the Tobins q and the market-to-book value ratio of a company are falling over time, it is a good indicator that the intangible assets of the firm are depreciating. This may provide a signal to investors that a particular company is not managing its intangible assets effectively and may cause them to adjust their investment portfolios towards companies with increasing or stable values of q. By making intra-industry comparisons between a companys primary competitors, these indicators can act as performance benchmarks and can be used to improve the internal management or corporate strategy of the entity.
Calculated intangible value

A third measure, calculated intangible value (CIV) has been developed by NCI Research to calculate the fair market value of the intangible assets of the entity. The CIV involves taking the excess return on tangible assets, using this figure as a basis for determining the proportion of return attributable to intangible assets. Merck & Co, a pharmaceutical company, can be used as an example in illustrating how the CIV works:
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1. 2. 3. 4.
Calculate average pre-tax earnings for three years. For Merck: $3.694bn. Go to the balance sheet and calculate the average year-end tangible assets over three years: US$12.952bn. Divide earnings by assets to get the return on assets (ROA): 29 per cent. For the same 3 years, find the industrys return on assets. For pharmaceuticals, the number in this example was 10 per cent. If a companys ROA is below average, then stop. NCIs method will not work. Calculate the excess return. Multiply the industry-average ROA by the companys average tangible assets; this shows what the average drug company would earn from that amount of tangible assets. Now subtract that from the companys pre-tax earnings. For Merck, excess earnings are: 3.694bn (0.10 x 12.952bn) = $2.39bn
5.
This figure shows how much more Merck earns from its assets than the average drug-maker would! 6. Calculate the 3-year 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. For Merck (average tax rate 31 per cent) the figure was $1.65bn. Calculate the net present value (NPV) of the premium. This is done by dividing the premium by an appropriate discount factor such as the companys cost of capital. Using an arbitrarily chosen 15 per cent yields, for Merck, $11bn. This is the CIV of Mercks intangible assets the one that does not appear on the balance sheet.
7.
0 20 inter- and intra-industry comparisons on While the CIV offers the potential to make s the basis of audited financial results, two problems remain. First, the CIV uses ok o average industry ROA eb a basis for determining excess returns. By nature, as
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average values suffer from certain problems and could result in excessively high or low ROA. Second, the companys cost of capital will dictate the NPV of intangible assets. However, in order for the CIV to be comparable within and between industries, the industry average cost of capital should be used as a proxy for the discount rate in the NPV calculation. Again, the problem of averages emerges, and one must be careful in choosing an average that has been adjusted for excessively high or low values.
Conclusion
It is recognised that the intellectual capital of a business plays a significant role in creating competitive advantage, and thus managers and other stakeholders in organisations are asking, with increasing frequency, that its value be measured and reported for planning, control, reporting and evaluation purposes. However, at this point, there is still a great deal of room for experimentation in quantifying and reporting on the intellectual capital of the entity. Given the potential for both complexity and diversity, developing intellectual capital measures and reporting practices that are comparable between enterprises remains one of the key challenges to the accountancy profession.
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Illustration Destroying value

The most recent published results for V plc are shown below. 20XX profit before tax m 13.6
Summary consolidated balance sheet at 31 December 20XX

Fixed assets Current assets Less: current liabilities Net current assets Total assets less current liabilities Borrowings Deferred tax provisions Net assets Capital and reserves m 35.9 137.2 (95.7) 41.5 77.4 (15.0) (7.6) 54.8 54.8
An analyst working for a stockbroker has taken these published results, made the adjustments shown below, and has reported his conclusion that the management of V plc is destroying value.
Analysts adjustments to profit before tax
Profit before tax Adjustments Add: Interest paid (net) R & D (research and development) Advertising Amortisation of goodwill Less: Taxation paid Adjusted profit
eb
k oo
0 20
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m 13.6 1.6 2.1 2.3 1.3 (4.8) 16.1
Analysts adjustments to summary consolidated balance 20XX m Capital and reserves 54.8 Adjustments Add: Borrowings 15.0 Deferred tax provisions 7.6 R&D 17.4 Advertising 10.5 Goodwill 40.7
sheet at 31 December
Last 7 years expenditure Last 5 years expenditure Written off against reserves on acquisitions in previous years
Adjusted capital employed
_____ 146.0 m 17.5 (weighted average cost of capital = 12%) 16.1 1.4
Required return Adjusted profit Value destroyed
(12% x 146.0m)
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The chairman of V plc has obtained a copy of the analysts report.
Required (a)
Explain, as management accountant of V plc, in a report to your chairman, the principles of the approach taken by the analyst. Comment on the treatment of the specific adjustments to R & D, advertising, interest and borrowings and goodwill. Having read your report, the chairman wishes to know which division or divisions are destroying value, when the current internal statements show satisfactory returns on investment (ROIs). The following summary statement is available.
(b)
Turnover Profit before interest and tax Total assets less current liabilities ROI
Divisional performance, 20XX Division A Division B Division C (Retail) (Manufacturing) (Services) m m m 81.7 63.2 231.8
5.7 27.1 21.0% 5.6 23.9 23.4% 5.8 23.2
Head Office m (1.9) 3.2
Total
m 376.7 15.2 77.4
Some of the adjustments made by the analyst can be related to specific divisions: Advertising relates entirely to Division A (retail) R & D relates entirely to Division B (manufacturing)
k oo Division B (Manufacturing) eb
Division C (Services) Division B (Manufacturing) Division C (Services)
Goodwill write-offs relate to 10.3m 30.4m
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m25.0%
The deferred tax relates to 1.4m 6.2m
Borrowings and interest, per divisional accounts, are as follows:
Borrowings Interest paid/(received)
Division A (Retail) m (0.4)
Division B (Manufacturing) m 6.6

0.7
Division C (Services) m 6.9

0.9
Head Office m 1.5

0.4
Total
m 15.0 1.6
Required
Explain, with appropriate comment, in a report to the chairman, where value is being destroyed. Your report should include: A statement of divisional performance An explanation of any adjustments you make A statement and explanation of the assumptions made comment on the limitations of the answers reached
275
Solution to Destroying value

(a) REPORT
To: From: Subject: Chairman Management accountant Destroying value in V plc Date: XX.XX.XX
This report considers the recent observations by the analyst of X Stockbrokers on our 20XX results. It will explain the principles of the approach taken by the analyst and will provide a commentary on the treatment of the specific adjustments made to our reported profit figure and balance sheet.
Principles of the approach taken: economic value added

1. A management team is required by an organisations shareholders to maximise the value of their investment in the organisation and several performance indicators are used to assess whether or not the management team is fulfilling this function. The majority of these performance measures are based on the information contained in the organisations published accounts. These indicators can be easily manipulated and often provide misleading information. Earnings per share, for example, are increased by deferring expenditure in research and development and in marketing. The financial statements themselves do not provide a clear picture of whether or not shareholder value is being created or destroyed: (a) (b)
2.
3.
k oo and loss account, for Thebprofit e quantity but not quality of earnings
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example, indicates the
It ignores the cost of equity financing and only takes into account the costs of debt financing, thereby penalising organisations such as ourselves which choose a mix of debt and equity finance. Neither does the Cash flow statement provide particularly appropriate information. Cash-flows can be large and positive if an organisation reduces expenditure on maintenance and undertakes little capital investment in an attempt to increase short-term profits at the expense of longterm success.
(c)
4.
The analyst has therefore adopted an approach known as economic value added to evaluate our performance. This approach hinges on the calculation of economic profit, which requires several adjustments to be made to traditionally reported accounting profits. These adjustments are made to avoid the immediate writeoff of value-enhancing expenditure such as research and development or the purchase of goodwill. They are intended to produce a figure for capital employed, which is a more accurate reflection of the base upon which shareholders
276
expect their returns to accrue. They also provide a profitafter-tax figure, which is a more realistic measure of the actual cash yield generated for shareholders from recurring business activities. It is not very surprising that if management are assessed using performance measures calculated using traditional accounting policies, they are unwilling to invest in activities which immediately reduce current years profit.
II
The Treatment of specific items 1. Research and development

The analyst has added back expenditure of 2.1 million to the 20XX profit figure on the grounds that the expenditure is providing a base for future activities. Similarly the research and development expenditure over the last seven years of 17.4million has been added back to the capital employed figure on the basis that we are continuing to benefit from the expenditure. A depreciation charge should probably be made against this capitalised value, however, to reflect any fall in its value.
2.
Advertising
The analyst has added back advertising expenditure of 2.3 million to the 20XX profit figure on the assumption that the expenditure has supported sales, raised customer awareness and/or increased brand image/loyalty, all of which could produce significant cashflows in the future and hence are for the long-term benefit of the organisation. The advertising expenditure over the last five years of 10.5 million has been added back to the capital employed figure (in much the same way as the research and development expenditure) to reflect the fact that the costs will provide for future growth. Again, an amortisation charge should be made if brand values are being eroded, possibly by competition.
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3.
Interest and borrowings

Because our profits are being earned using both debt and equity finance, the published profit figure is overstated since it takes no account of the cost of the equity finance. The analyst has therefore added back the cost of the debt finance to the 20XX profit figure and the borrowings figure to the capital employed. This produces a profit figure before the cost of borrowing, which can be compared with a figure representing the total long-term finance in our organisation.
4.
Goodwill
The analyst has added back goodwill amortisation of 1.3 million to the 20XX profit figure. Goodwill is the difference between the price paid for a business acquisition and the current cost valuation of that acquisitions net assets. On the assumption that a realistic price was paid, the goodwill purchased should provide benefits in the future, not just in the year of purchase. And the goodwill of
277
40.7 million, which has been written off against reserves on acquisitions in previous years has been added back to the capital employed figure so as to provide a more realistic base upon which we must earn a return. Again, the goodwill capitalised should be regularly reviewed and amortised to reflect any reductions in its value. I hope this information has been of use. If I can be of any further assistance please do not hesitate to contact me. Signed: Management Accountant
(b) REPORT
To: From: Subject: Chairman Management accountant Where is value being destroyed? Date: XX.XX.XX
An analyst working for X Stockbrokers has recently commented that the management of V plc is destroying value. In an attempt to establish where value is being destroyed in our organisation, a revised statement of divisional performance has been prepared, adopting an approach similar to that used by the analyst. The statement, plus supporting explanations, is set out in Appendix 1. The analysis shows that value of 0.1 million was destroyed in Division B, while value of 2.3 million was destroyed in Division C. Division A, on the other hand, created value of 1 million. This is in marked contrast to the performance indicated in the conventional divisional performance report prepared for 20XX. This shows all three divisions earning a return on investment in excess of 20%, with Divisions B and C, the destroyers of value, making higher returns on investment than Division A, the creator of value.
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The analysts approach is similar to performance evaluation using residual income in that a charge is made for the capital employed within the division. Further adjustments are also made to both profit and capital employed to provide more realistic measures for performance analysis (as explained in my earlier report and in Appendix 1). The results of the analysis are dependent upon the following factors: 1. Head office expenses are assumed to have been incurred in relation to divisional turnover. Any one of a number of other bases might be equally valid. Tax paid is assumed to be related to divisional profit after interest and head office expenses. Deferred tax liabilities have not been incorporated into the analysis. Each divisions share of head office assets has been assumed to be in proportion to the divisions share of total turnover. Other bases could be equally valid. It has been assumed that each division has the same cost of capital. This takes no account of the individual characteristics of each division, its risk profile and its mix of financing.
2.
3.
4.
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Despite the limitations set out above, the analysts approach provides an alternative insight into how our divisions are performing and could well prove useful in enabling us to create value for our shareholders in the future. Signed: Management Accountant
APPENDIX 1
Statement of profitability
A m 5.7 2.3 (0.4) (2.0) 5.6 B m 5.6 2.1 0.3 (0.3) (1.6) 6.1 Divisions C Head office m m 5.8 (1.9) 1.0 (1.2) (1.2) 4.4 1.9 Total m 15.2 2.3 2.1 1.3 (4.8) 16.1
20XX PBIT Add back Advertising R&D Goodwill (1) Head office expenses (2) Less: tax paid Revised profit
Statement of capital employed

A m 27.1 B m 23.9
Total assets less current liabilities Adjustments Advertising R&D Goodwill Head office assets (4) Revised capital
eb
2 ks 10.5 o
0 00
.b
log
m co Divisions t. po Head office C s

m 23.2 m 3.2 30.4 2.0 55.6 (3.2) -
Total m 77.4
0.7 38.3
17.4 10.3 0.5 52.1
10.5 17.4 40.7 146.0
Economic value added

A m 5.6 4.6 1.0 B m 6.1 6.2 (0.1) Divisions C Head office m m 4.4 6.7 (2.3) Total m 16.1 17.5 (1.4)
Revised profit Required return (5) Value added/(destroyed)
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Explanation of adjustments made 1. Goodwill

Goodwill amortised has been apportioned to Divisions B and C in proportion to the value of goodwill written off to capital and reserves. Division B C Goodwill write-off m 10.3 30.4 40.7 Goodwill amortised % 25.3 x 74.7 x 100.0 1.3m 1.3m m 0.3289 0.9711 1.3000
2.
Head office expenses

No direction is provided as to the way in which head office expenses should be apportioned to the three divisions. An activity-based approach could be the most suitable but, in the absence of appropriate data, allocation based on turnover has been adopted.
3.
Tax paid
The tax liability of 4.8 million for V plc has to be apportioned over the three trading divisions. Given that the divisions taxable profits will be affected by the allocation of head office expenses and the interest paid, the overall tax liability has been apportioned on the basis of divisional profit after interest paid and allocated head office costs. Division A B C PBIT m 5.7 5.6 5.8
0 20 Head office Interest s paid expenses ok bom e (0.4) 0.4

0.7 0.9 0.3 1.2
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Apportionme nt figures m = 5.7 = 4.6 = 3.7 14.0
Charge % 41 33 26 100 m 2.0 1.6 1.2 4.8
4.
Head office assets

Head office assets have been apportioned to the three trading divisions on the basis of divisional turnover so as to be consistent with the basis used to apportion head office expenses
5.
Required return
The required return is based on a weighted average cost of capital of 12%.
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Chapter 12
Corporate reconstruction and reorganisation

m
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281
CHAPTER 12 CORPORATE RECONSTRUCTION AND REORGANISATION
CHAPTER CONTENTS
FINANCIAL RECONSTRUCTION---------------------------------------- 283 ILLUSTRATION JENKINS PLC --------------------------------------- 285 MANAGEMENT BUYOUTS (MBO)--------------------------------------- 290
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FINANCIAL RECONSTRUCTION
The Companies Act (CA) 2006 provides for the reduction of the share capital of a company, subject to:
o o o
The passing of a special resolution; Confirmation by the High Court*; and The articles of the company not specifically restricting or prohibiting a reduction of capital (N.B. Under CA 1985, the articles of the company had to actually give authority for the reduction).
*Under CA 2006, where a private company limited by shares undertakes a capital reduction scheme, confirmation of the court is not necessary if the directors make a Solvency statement. This is a statement, made before the date of the proposed resolution, that each of the directors has the view that there are no grounds on which the company could then be found unable to pay its debts and are of the opinion that any winding up made within the next year would be a solvent liquidation. The Court will usually sanction such a scheme, provided that the rights of all creditors are protected and that losses are fairly divided among all interested parties. Under a scheme of capital reduction, a company may: 1. 2. 3.
The Court must settle a list of creditors entitled to object and hear objections. However the Court may choose to dispense with the consent of any creditor provided the company secures payment of that claim. The Court may order the company to publish the reasons for the reduction in capital. It may also order the company to add the words and reduced to the end of its name. Under Situation 2. above, the objective of a capital reduction scheme is normally to:
o sp its shares, which are not paid Extinguish or reduce the liability on g of loany up; or .b 00 Cancel any paid-up share capital that is lost or unrepresented by 20 available assets; or s k oo Repay any paid-up share capital in excess of the companys wants. eb
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o o
Write-off any debit balances on the profit and loss reserve; Write-off or write-down any asset values, which are considered to be excessive; Revalue all assets on a going concern basis; and Reorganise the capital structure of the company in line with the assets employed.
o o
Guidelines for implementation of the scheme are as follows:
Ordinary shareholders (i.e. the risk-takers) must bear the majority of the losses; Preference shareholders may be asked to bear a small part of such losses. However, they may be issued with new equity shares in the
283
company as compensation for their waiver of any arrears of unpaid preference dividends;
In exceptional circumstances, bondholders and other creditors may be persuaded to participate in part of the losses; Amounts made available under the terms of the scheme would then be used to write-off any overstated values and to adjust the values of all assets on a going concern basis; It would also be necessary to ensure the provision of adequate working capital to meet foreseeable future needs. A rights issue is likely to be necessary, with the directors expected to take up any such shares which are rejected by other shareholders.
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284
Illustration Jenkins plc

Jenkins plc has been suffering from adverse trading conditions largely due to the effect of obsolescence on its products. This has resulted in losses in each of the last five years. The companys bankers have refused to extend the present overdraft facility and creditors are pressing for payment. The directors feel that a new product recently developed by the company will make the company profitable in the future, but they are worried that a winding-up order may be made before this can be achieved. They have therefore asked you to suggest a scheme of capital reduction that would be acceptable to both the court and creditors and to advise them as to what action should be taken to enable the company to continue trading. The following is the present balance sheet of the company: Book values Non-current assets Intangible Goodwill Patents, trade marks etc Tangible Freehold land and buildings Plant and vehicles Current assets Stocks and debtors Listed shares at cost Present going concern values
eb
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log .b
30,000 11,000
po
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m
2,000 41,000 150,000 36,000
120,000 _50,000 170,000 64,000 15,000 79,000
58,000 14,000
Creditors falling due within one year Trade Overdraft
118,000 _31,000 (149,000) (70,000) 141,000 (60,000) 81,000
Net current liabilities Total assets less current liabilities Creditors falling due after one year 12% mortgage loan secured on freehold
Capital and reserves Called up share capital 7% cumulative preference shares (1) fully paid (dividends are three years in arrears) Ordinary shares of 50p each fully paid Share premium account Profit and loss account reserve
50,000
200,000 250,000 60,000 (229,000) 81,000
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You ascertain the following: 1. 2. 3. Scheme costs are estimated at 4,800. Preference shares rank in priority to ordinary shares in the event of windingup. The bank has indicated that it would advance a loan of up to 50,000 provided that the overdraft is cleared and a second mortgage on the freehold is given. To ensure speedy manufacture of the new product it would be necessary to expend 20,000 on new plant and 15,000 on increasing stocks. The creditors figure of 118,000 includes 19,000 that would be preferential in a liquidation.
4. 5.
Requirements: (a) (b) (c)

Suggest a scheme of capital reduction and write up the capital reduction account. Outline your suggestions as to the action that should be taken by the directors. Show the balance sheet after implementing your suggestions.
Ignore taxation.
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Solution to Jenkins plc

Explanation
The first step is to estimate the losses to be suffered by preference shareholders on a liquidation. For example, on liquidation the following position may arise Proceeds 150,000 24,000 29,000 _14,000 217,000
Freehold Plant (say 2/3 of 36,000) Stocks and debtors (say of 58,000) Listed shares
These proceeds will be used to repay the liabilities: Secured mortgage Overdraft Trade creditors 60,000 31,000 118,000 209,000
m co go to the preference . This leaves 8,000 for the shareholders. This twill po Therefore, the loss suffered shareholders in priority to the ordinary shareholders. s by the preference shareholders is (50,000 8,000), i.e. 42,000. The loss log allocated to them under the scheme must .b less than this. be 00 0 Memorandum to the board s2 k oo (a) Scheme of capital b e reduction
The objective of such a scheme is to write down the capital of the company so that it realistically reflects the present values of the assets (on a going concern basis). The major part of the loss should be borne by the ordinary shareholders although the preference shareholders should bear a part of the loss where it is unlikely that they would receive all their capital in a winding-up. A corresponding increase in the rate of preference dividend is sometimes given as compensation. The reduced capital of the company will ensure that it is possible to pay dividends when the company achieves profitability. Where arrears of cumulative preference dividends have accrued, it is usual to compensate preference shareholders by issuing reduced ordinary shares in part satisfaction of such arrears.
Explanation
Draw up a pro forma balance sheet after the scheme, and capital reduction account; post through the opening position (writing off all goodwill and accumulated losses); then adjust the assets to going concern values posting the double entry as you work through. Remember to post through the scheme costs and compensation in new shares to the preference shareholders; then write down the ordinary and preference shares to a round sum amount to cover the overall loss. The loss written off to the preference shareholders may not exceed 42,000 and ideally should be less than that.
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Write offs Profit & loss reserve Plant & vehicles Goodwill, patents etc Investments Current assets
Capital reduction account Surplus on freehold 229,000 14,000 39,000 1,000 Losses c/d 6,000 289,000 259,000 4,800 Share premium account Amounts written off Ordinary shares (49p) Preference shares (30p)
30,000
259,000 289,000 60,000 196,000 15,000 ______ 271,000
Losses b/d Costs of scheme Ordinary share capital Issue re arrears of preference dividend (50%) Balance c/d
5,250 __1,950 271,000
Explanation
Use notes c) to e) in the question; list total costs, compare to money coming in (always sell any non-trade investments). Issue enough new shares to leave a positive cash balance. Complete double entries as you work. Finally complete the balance sheet.
(b)
(i) (ii) (iii) (iv)
Suggested action (outline)
o .bl in full immediately to prevent them 0 The preferential creditors to be paid off 00 blocking the scheme. 2 ks produce part of the funds necessary to continue The investments to be sold to o trading. bo e
The balance of the funds necessary to be provided by an issue of shares (on a 10 for 1 basis) at par for cash to the directors and shareholders. The following cash is required: Preferential creditors Purchase of new plant Additional stock Pay costs of scheme Clear existing overdraft 19,000 20,000 15,000 4,800 31,000 89,800
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Accept the banks offer of a maximum loan of 50,000 (subject to a second mortgage charge being created)
Produced by Sale of investments (ignoring costs) Bank loan Issue of shares to directors and existing shareholders (10 x 400,000 x 1p) Leaving a balance at bank of 14,000 50,000 _40,000 104,000 14,200
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(c)
Balance sheet if scheme adopted

Non-current assets Intangible Patents (11,000 9,000) Tangible Freehold (120,000 + 30,000) Plant and vehicles (50,000 14,000 + 20,000)
2,000 150,000 56,000 206,000 208,000
Current assets Stock/debtors (64,000 6,000 + 15,000) Bank balance (per b) iv) above) Creditors Amounts falling due within one year Trade (118,000 19,000) Net current liabilities Total assets less current liabilities Creditors falling due after one year Loan (secured on the freehold) Bank loan
73,000 14,200 87,200 (99,000) (11,800) 196,200 (60,000) (50,000)
Capital and reserves Called up share capital 1p ordinary shares fully paid (200,000 196,000 + 5,250 + 40,000) 70p 10% preference shares fully paid (50,000 15,000)
Reserve arising on scheme (capital reduction account)
o eb
2 ks
00
log .b
t. po
om
(110,000) 86,200
49,250 35,000 84,250 1,950 86,200
Explanation
It could be argued that Jenkins plc is still not in a sufficiently strong liquidity position.
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MANAGEMENT BUYOUTS (MBO)

Distinguishing features
Group of managers acquire effective control and substantial ownership of an operation and form an independent business. Also employee buyouts, buy-ins, spinouts.
Motivations
For sale For purchase Parent company disposals due to losses, lack of fit, or size Private business owners wishing to sell out Potential high returns Relatively low risk as compared to green field starts Elimination of managerial slack
Financing

m co . Commonly highly geared to leave managers with t po controlling interest in equity. s Support from institutions normally required log .b o Examples include clearing banks, 3i group 00 business plans, details of exit routes, 0 o Institutions normally require s2 sometimes board representation k oo include debt, preference shares, equity (limited), o Commonly instruments eb (e.g. convertible loan stock, junk bonds) mezzanine finance
Loss of head office support services Quality and resources of management team Third party bids at buyout stage Problems of high gearing
Potential problems

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Chapter 13
Corporate dividend policy
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C H A P T E R 1 3 C O R P O R A T E D I V ID E N D P O L I C Y
CHAPTER CONTENTS
DIVIDEND IRRELEVANCE HYPOTHESIS ------------------------------ 293 DIVIDENDS IN AN IMPERFECT MARKET ----------------------------- 294 POSSIBLE APPROACHES TO DIVIDEND POLICY --------------------- 295 ALTERNATIVES TO A CASH DIVIDEND ------------------------------- 296 PARABAT PLC ----------------------------------------------------------- 297
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DIVIDEND IRRELEVANCE HYPOTHESIS

Theory
The proponents of the dividend irrelevance hypothesis (Miller & Modigliani) claim that the value of a firm is determined by its future earnings stream. The way this stream is split between dividends and retentions has no impact upon shareholder wealth. Given a set investment policy, a dividend cut now to finance new projects will be compensated by higher dividends at a later stage. The shareholder will be indifferent to the dividend policy provided the PRESENT VALUE of dividend payments remains unchanged.
Assumptions
A set investment policy so that shareholders know the reason for withholding dividends No transactions costs No distorting taxes
o sp maintain his level of income In the case of a withheld dividend, the shareholder can log with no consequent decrease by selling shares to generate home madeb . dividends, 00 in wealth. 0 s2 k oo eb
Share prices move in the manner predicted by the model
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DIVIDENDS IN AN IMPERFECT MARKET

Information content (dividend signalling)
Dividends are an important current source of information Share price will increase if the dividend is greater than expected and vice versa. Tendency to over-react
Transactions costs
Shareholder can no longer replace a withheld dividend by selling shares without incurring dealing commissions Company will benefit by financing investments from retained earnings to avoid the high costs associated with raising new finance
Preference for current income

It is sometimes argued that shareholders prefer high dividend payouts as they see these as more secure than capital gains (the bird in the hand theory) This argument is sometimes thought to be weak. Current dividends are safe, but so are current capital gains. Future dividends are just as uncertain as future capital gains.
Distorting taxes

0 20dividends to capital gains whether a basic-rate Individuals will generally prefer s or higher-rate tax payer, subject to certain complications: ok o eb exemption limit for capital gains tax
non-tax-paying individuals tax-exempt institutions.
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POSSIBLE APPROACHES TO DIVIDEND POLICY

Stable policy with moderate payout
Stable level of dividends with occasional increases (where justified). would avoid sharp movements in share price. This
Moderate payout policy in order to sustain the level of dividends in the face of fluctuating earnings. Very common approach for listed companies.
Constant payout ratio

Constant proportion of earnings paid out as a dividend. Not particularly suitable as dividends will fluctuate, causing erratic share price movements.
Residual dividend policy

Remaining earnings, after funding all profitable projects, are paid out as dividend. Tends to lead to fluctuating dividends and therefore not particularly suitable.
Clientele theory
Consistent dividend policy is maintained which will attract a group of shareholders to whom the policy is suited in terms of tax, need for current income, etc.
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Other considerations
Legality, re distributable profits. Existence of inflation and consideration of real profitability. Growth and requirements for retained earnings. Liquidity position. Limited sources of funds (particularly for small companies). Stability of earnings.
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ALTERNATIVES TO A CASH DIVIDEND

During the last twenty years or so, a number of companies have established ways of rewarding shareholders other than by traditional dividend payments. These methods include:
Shareholder perks
Several UK companies (notably hotel operators) offer discounts to shareholders on room bookings and restaurant meals. A number of transport companies offer reductions in fares. Some retailers provide discount vouchers, which are sent to shareholders at the same time as the annual report and accounts.
Scrip dividends
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 a cash dividend or newly created shares in the company of a similar monetary value. Scrip dividend plans were very popular in the 1990s since they enabled companies to use share premium accounts to create the new shares (instead of reducing retained profits) and there were certain tax advantages for the company.
o sp However a change in the accounting regulations subsequently forced companies to logdividend, and a later change in UK charge the profit and loss account with theb . scrip 00 legislation removed the tax advantages, which companies had enjoyed. Therefore 0 UK companies abandoned scrips2 dividend schemes at the turn of the century, although there is now evidencek a few companies re-introducing this method (e.g. o of Millennium and Copthorne Hotels plc and Whitbread plc). bo e
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Dividend reinvestment plans (DRIPs)

Since many companies had spent the 1990s persuading shareholders to take more shares in the company (rather than receive a cash dividend) shareholders were keen for an alternative to be offered when scrip dividend schemes were abandoned. In the early years of the 21st century DRIPs were created. Shareholders opting for these schemes choose to have their dividends used to purchase existing shares in the company on the open market, through a special arrangement involving very low dealing charges and the payment of stamp duty.
Share repurchases
Companies with cash surpluses, but having no positive NPV projects, may choose to introduce a share buy-back scheme, whereby the companys shares are purchased at the companys 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.
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Parabat plc
Parabat plc has an issued capital of 2 million ordinary shares of 50p each and no fixed interest securities. It has paid a dividend of 70p per share for several years, and the stock market generally expects that level to continue. The market price is 4.20 per share, cum div. The firm is now considering the acceptance of a major new investment which would require an outlay of 500,000 and generate net cash receipts of 120,000 per annum for an indefinite period. The additional receipts would be used to increase dividends. Parabat is appraising three alternative sources of finance for the new project: (i) Retained earnings. The usual annual dividend could be reduced. Parabat currently holds 1.4 million for payment of the dividend which is due in the near future. A rights issue of ordinary shares. One new share would be offered for every ten shares held at present at a price of 2.50 per share; the new shares would rank for dividend one year after issue, when cash receipts from the new project would first be available. An issue of ordinary shares to the general public. The new shares would rank for dividend one year after issue.
(ii)
(iii)
Assume that, if the project were accepted, the firms expectations of future results would be discovered and believed by the stock market, and that the market would perceive the risk of the firm to be unaltered.
You are required to: (a)
Estimate the price ex div of Parabats ordinary shares, following acceptance of the new project, if finance is obtained from (i) retained earnings or (ii) a rights issue.
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(b) (c)
Calculate the price at which the new shares should be issued under option (iii) assuming the objective of maximising the gain of existing shareholders. Calculate the gain made by present shareholders under each of the three finance options.
Ignore taxation and issue costs of new shares
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Parabat plc solution

(a) This is a company financed entirely by equity, hence the dividend valuation model can be used to find the cost of capital i.e. Ke =
D P0 (ex div)
Ke
70p (420p 70p)
70p 350p
20%
(i)
Financed by retained earnings Here the valuation model incorporating a new project can be used i.e. New Price =
existing dividend + future increase cos t of equity capital

=
Future increase per share
120,000 = 2,000,000
=
6p
Hence new price = (ii)
70p + 6p 0.20
Financed by rights issue
First the new dividend per share must be calculated, and then the new ex div price Future expected earnings Future number of shares
k ooshare = Future dividend per eb

69p 0.20
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3.80
1,400,000 + 120,000 2,000,000 + 200,000 1,520,000 2,200,000 = 3.45
= 1,520,000 = 2,200,000 = 69p approx
New price = (b)
Issue of ordinary shares to the public The issue price can be calculated by reference to the change in wealth of the shareholders i.e. New market value Old market value NPV of new project = = = old market value + NPV of new project 2m shares x 3.50 = 7m 100,000
120,000 500,000 = 0.20 = 7,100,000
Therefore new market value
Issue price per new share should be
7,100,000 = 2,0,00,000
3.55p
As 500,000 is required, this would result in the issue of (500,000 3.55) = 140,845 new 50p shares.
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This can be checked as follows: Total number of shares x Market Price = 2,140,845 shares x 3.55 per share = Market Value of company 7,600,000
Expected dividend now equals 1,520,000. Hence the return of maintained. (c) Gain made by present shareholders under each option: Retained Earnings 3.80 3.50 0.30 Rights Issue 3.80* 3.50 0.30 New Issue 3.55 3.50 0.05
1,520,000 = 7,600,00
20%
to
the
shareholders
has
been
Expected future value Current value per share Gain Less: Dividend foregone Paid for rights issue Net gain per share *
500,000 2,000,000 2.50 10
0.25
This represents 1.1 shares @ 3.45 each (i.e. allowing for the 1 for 10 rights issue).
Hence the gain to the original shareholders is 5p per share in each case, whatever the method of financing. The NPV of the project (i.e. 100,000) has been allocated over the 2,000,000 shares already on issue, irrespective of whether the project has been financed by retentions, a rights issue or a correctly priced issue of shares to the general public.
eb
k oo
0 20
log .b
m ___ o c t. 0.05 po
0.25 ___ 0.05 ___ 0.05
Hence the dividend decision was irrelevant.
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300
Chapter 14
Management of international trade and finance

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C H A P T E R 1 4 M A N A G E M E N T O F I N T E R N A T I O N A L T R A D E A N D F IN A N C E
CHAPTER CONTENTS
INTERNATIONAL TRADE ----------------------------------------------- 303
FREE TRADE AND PROTECTIONISM TRADE BLOCKS GATT AND THE WORLD TRADE ORGANISATION (WTO) MULTINATIONAL COMPANIES (MNCS) THE BALANCE OF PAYMENTS THE INTERNATIONAL FINANCIAL INSTITUTIONS THE EUROMARKETS THE GLOBAL DEBT PROBLEM RISKS OF FOREIGN TRADE SOURCES OF FINANCE FOR FOREIGN TRADE COUNTERTRADE 303 303 304 304 304 305 305 306 306 307 308
ARTICLE FROM STUDENTS NEWSLETTER ---------------------------- 309
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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 labour. 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
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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. European Union
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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 specialisation 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 ok
The balance of payments is a statistical record of a countrys international trade transactions (current account) and capital transactions with the rest of the world over a period of time e.g.
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UK balance of payments 2010

bn Current account Exports Imports Visible balance Invisibles balance 200 (215) (15) 5 (10) 2 8 10
UK external assets and liabilities: net transactions Balancing item
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
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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.
o .blacts as a supervisory body for central 0 Established in Basle, Switzerland in 1930, it 00 banks assisting them in the investment of monetary assets. It acts as a trustee for 2 the IMF in loans to developing countries and provides bridging finance for members ks o pending their securing longer term finance for balance of payments deficits. bo e
The Bank for International Settlements (BIS)
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The Euromarkets
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 e.g. 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 Euronote 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 a effective secondary market reducing their liquidity.
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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 the developed countries 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
Translation risk the gains or losses to be reported when overseas operations are consolidated into group accounts in accordance with SSAP 20/UITF 9, or IAS 21 and 29,or FRS 23 and 24 . 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. 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. This is seen as the short-term manifestation of economic risk. It is this category of foreign currency risk, which is particularly relevant to this syllabus.
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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.
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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 a negotiable instrument drafted by the exporter (the drawer), accepted by the importer (the drawee) who thereby agrees to pay for the goods/services either immediately or more commonly after a specified period of credit. If the importer accepts the bill it is known as a trade bill, whereas if the importer arranges for its bank to accept the bill, it becomes a less risky bank bill. Where payment will be made after the specified period of credit, the exporter can sell the bill at a discount to its face value and receive the cash immediately. If the bill is dishonoured the exporter can seek legal remedies in the country of the importer. Promissory notes similar, but less common than bills of exchange, since they cannot usually be discounted prior to maturity.
o .bl obtains a Letter of Credit from its 0 Documentary letters of credit the importer 00to the exporter via a trade bill. Though slow bank, which guarantees payment 2 ks to arrange, this method is virtually risk free provided the exporter presents o specified error free bo documents (e.g shipping documents, certificates of origin e and a fully detailed invoice) within a specified time period. The high bank fees
for this procedure are normally borne by the importer, and the DLC is normally reserved for expensive goods only. Factoring the factoring company (often the subsidiary of a bank) assumes the responsibility for collecting the trade debts of another in this case an exporter. The factor may provide a range of services e.g. providing advances, administering the sales ledger, credit insurance etc for an additional fee. Widely regarded as a useful means of obtaining trade finance and collecting of debts for small or medium sized exporters. However the exporter must always bear in mind the eventual consequences of dispensing with the services of the factor and undertaking the running of the sales ledger and cash collection activities itself. Forfaiting a medium term source of finance whereby a domestic bank will discount a series of medium term bills of exchange, which have normally been guaranteed by the importers bank. The forfaiting bank normally forgoes the right of recourse to the exporter if the bill is dishonoured. The exporter obtains the benefit of immediate funds, but the bank charges are expensive. Forfaiting is normally used for the export of capital goods, where the importer pays in a series of instalments over a period of years.
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Leasing and hire purchase the exporter sells capital goods to a lessor, which in turn enters into a leasing agreement with the exporters overseas customer. Alternatively the equipment can be sold to a hire purchase company which resells to the importer under a HP agreement. Acceptance credits a large reputable exporter can arrange for its bank to accept bills of exchange (which are related to its export activities) on a continuing basis. These bills can then be discounted at an effective cost, which is lower than the bank overdraft interest rate. Produce loans where an importer acquires commodities for the purpose of immediate resale, it can raise a loan from its bank, which takes custody of the goods until the importer is able to sell them. Thereafter the principal sum, interest and storage costs are repaid to the bank out of the proceeds of the sale. Requesting payment in advance from the importer if this were possible it would avoid all of the above complications.
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 organising international trade because of their shortage of foreign currency. Many countertrade deals can be highly complex involving many parties.
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ARTICLE FROM STUDENTS NEWSLETTER

This is a slightly updated version of an article, which appeared in the November 1999 edition of Students Newsletter. The article was not originally intended for Paper 3.7 or Paper P4 students, but it provides a useful insight into the introduction of the Euro. You are therefore asked not to learn the contents of this article in detail, but to gain an overall insight into the features of the single European currency and the arguments in favour and against the entry of the UK into the European Monetary Union. The author, John OToole, is a lecturer at Griffith College, Dublin. EUROPEAN MONETARY UNION AND THE SINGLE EUROPEAN CURRENCY In 1998, the Heads of State or Government of the European Union (EU) Member States confirmed that 12 Member States qualified to form Economic and Monetary Union (EMU) and adopt the single currency, the euro, from 1 January 1999. The twelve original member states of the Eurozone were Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Netherlands, Portugal and Spain. On 31 December 1998 the Council of Economic and Finance Ministers irrevocably fixed the conversion rates to apply between the currencies of these Member States and the euro, and on 1 January 1999 the euro came into being. The United Kingdom and Denmark exercised their Treaty opt-outs from EMU and Sweden deliberately failed to fulfil all the criteria for entry and was therefore rejected by the Commission. Slovenia also joined the Eurozone on 1 January 2007, followed by Malta and Cyprus on 1 January 2008. In addition, three European microstates (Vatican City, Monaco, and San Marino), although not EU members, have adopted the euro via currency unions with member states. Andorra, Montenegro, Kosovo, and Akrotiri and Dhekelia have adopted the euro unilaterally despite not being EU members. Nine relatively new EU member states are required by their Accession Treaties to join the Eurozone, on 1 January of the following years: Slovakia in 2009, Lithuania in 2010, Estonia in 2011, Bulgaria, Czech Republic, Hungary, Latvia and Poland in 2012 and finally Romania in 2014. The formation of EMU and the creation of the euro were the culmination of a process of preparation which had been going on since the signing in 1992 of the Treaty on European Union (the Maastricht Treaty). EMU is one of the most farreaching steps in the history of the European enterprise. Internally, the single currency was intended contribute to a greater sense of common purpose and common endeavour among the peoples of the European Union; externally it is intended to strengthen the Unions ability to play a role in the world commensurate with its economic and political importance.
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The European Monetary System (EMS)

To understand why this single currency was set up it is necessary to look at the previous arrangements. The idea of a single currency in Europe is not new. It goes back at least to 1970. While its fortunes have varied since, the then European Community never lost sight of it as a goal. The European Monetary System (EMS) and its Exchange Rate Mechanism (ERM), which were set up in 1979, were intended to move towards monetary union. The Single Market programme of the late 1980s gave fresh impetus to it.
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In April 1978 at a meeting of the European Heads of State the German Chancellor Schmidt and the French President, Giscard dEstaing, proposed the creation of a European Monetary System (EMS) with the purpose of creating a zone of monetary stability in Europe. In March 1979 the EMS commenced operations in the hope that closer monetary co-operation between member states would lead to monetary stability and economic growth. The EMS utilised a system of quasi-fixed exchange rates, known as the Exchange Rate Mechanism (ERM), and had as its unit of account the European Currency Unit (ECU). The value of the ECU was the weighted average of a basket of national currencies with the weight allocated to each currency being determined by that countrys GNP and intra-EC trade. Those countries which were members of the ERM declared a central exchange value for their currency and the majority of currencies agreed to fluctuate within a band 2.25% of this central value. This meant that the Central Bank of each participating currency was committed to intervening, when necessary, in order to maintain their exchange rate within the specified band. This was done by buying their own currency when it was weak and selling their currency when it was strong. The UK, although a member of the EMS since its inception, did not join the ERM until October 1990. The rules of the EMS allowed governments to realign the central value of their exchange rate if changing circumstances showed it to be no longer appropriate. In the early part of the EMS from 1979 to 1983 there were a number of realignments. However, from 1987 the system became very rigid and there was only one realignment from 1987 the lira was realigned in January 1990 until the currency crisis in 1992.
The currency crisis
Speculators interpreted a number of developments in the world economy during 1992 as being attributable to fundamental weaknesses within currency markets. This perception stimulated a period of intense speculative pressure which caused a currency crisis.
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German unification was a principal cause of the currency crisis. It is difficult to imagine a bigger shock to the fixed parities of the ERM than the absorption of the then East Germany into the European economy. Demand for consumer goods soared, pushing up inflation. The governments budget expanded adding to the Bundesbanks (German Central Bank) alarm. Very low, short-term American interest rates caused huge surges of money from the US into Germany, further fuelling German inflation rates. The Bundesbank reacted by pushing up German interest rates. These high German interest rates occurred just when the rest of Europe needed the rates to be low. The German mark was the anchor currency of the ERM, so no European country could hold its interest rates below those in Germany. When interest rates in Germany were increased all other EMS countries followed suit. Other causes of the currency crisis were the lack of realignments with the EMS, so that its exchange rates had become increasingly rigid and out of touch with international developments. Furthermore, the necessary behind the scenes macroeconomic co-ordination was not taking place as EU Member States publicly bickered over interest rate policy. The existence of widespread unemployment as economic recession threw millions out of work intensified these tensions. The straw that broke the camels back was 2 June 1992 when the Danish people rejected the Maastricht Treaty in a referendum. The Danish rejection by 50.7% to 49.3% cast immediate doubt over the whole process of economic and monetary
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union. Under EU law, the Danish failure to ratify the Maastricht Treaty made the treaty null and void. As there had been no realignments within the ERM since January 1987, the money markets had assumed that the European Unions political commitment to EMU meant that the parties were virtually fixed. Doubts over Maastricht destroyed this assumption. Almost immediately the weaker currencies came under selling pressure. The pressure resulted in the devaluation of the Finnish mark, the Spanish peseta, the Irish punt, the Portuguese escudo and the Swedish krona, in addition to forcing the UK and Italy to leave the ERM in September 1992. In August 1993, further speculative pressure against the French franc and the Danish krone led to a decision to widen fluctuation bands within the ERM to 15%. This action effectively ended the currency crisis. These events strengthened the political resolve in Europe to introduce Economic and Monetary Union and the single currency.
The Maastricht Treaty

The Treaty on European Union was signed at the Dutch town of Maastricht in February 1992. This Treaty became known as the Maastricht Treaty. The centrepiece of the Maastricht Treaty was the decision to set up a single European currency. A single European currency meant that all the participating countries would use the same currency. The new currency was called the euro. It is divided into one hundred cents. An essential aspect of a single European currency is the close co-ordination of economic policies between Member States of the European Union. Economic and Monetary Union means that the currencies of the member states are locked irrevocably to one another at the same exchange rate. (Irrevocably means that these exchange rates cannot be changed afterwards). The EMU depends on a similar level of development of the economies of the countries which are members. In order to ensure that the economies of the countries concerned are at similar levels of development five convergence criteria were developed. These convergence criteria are economic indicators of the strength of each economy.
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Economic and Monetary Union involves: an internal market with free movement of persons, goods, services and capital; the irreversible locking of exchange rates; a single currency among participating Member States; EU management of macro-economic policy with intensified co-ordination of the economic and budgetary policies of participating countries; EU management of market-regulating policies, for example, competition policy, to ensure every country plays by the same rules; a European Central Bank in Frankfurt deciding European monetary policy.
The Stability and Growth Pact is part of the arrangements agreed by those countries which are part of the EMU. The pact requires Member States in the EMU to commit themselves to aim for a medium-term budgetary position of close to balance or in surplus. As part of the process of ensuring that the euro is as stable as possible, the Stability and Growth Pact is aimed at minimising internal fiscal imbalances in the short term. The rationale underlying the pact is that in
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favourable economic times, Member States should so manage their budgets as to ensure that they can, over the course of a normal economic cycle, reliably keep under the 3% ceiling on budget deficits set out in the Treaty. The pact allows for exceptional circumstances when deficits can exceed 3% of GDP. It provides for penalties and fines of up to 0.5% of GDP if deficits persist.
The five Maastricht criteria

These criteria are measures of the economy of each country across a number of headings:
Inflation
The level of inflation must be within 1.5% of the average of the three lowest inflation countries in the system.
Government borrowing
The amount of Government borrowing is an important measure of the strength of the economy. The amount of this borrowing as a percentage of the Gross Domestic Product must be below 60% or making progress towards 60%.
Interest rates
States are permitted a maximum of 2% points above the average of the three lowest inflation countries.
o sp This is the toughest and politically most sensitive criterion involving tax policy and log overall debt. Member states must keep their government budget deficit within 3% .b of Gross Domestic Product. 00 0 Exchange rates s2 k The fifth and final criterionoo joining the EMU covers exchange rates. Countries for must carefully manage their exchange rate and must not have unilaterally devalued eb
Budget deficit
their currency within two years.
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The timetable to EMU

The timetable to Economic and Monetary Union was decided by European leaders. On 1 January 1999 the new European currency, the euro, came into being. From this date there was be no change in the exchange rates of the member countries. Euro notes and coins were introduced into circulation on 1 January 2002. Dual circulation of the euro and the legacy currencies of each country continued for a short period of time. Thereafter participating countries have only used euro notes and coins.
The arguments in favour of EMU Transparency

The strongest argument in favour of a single European currency is transparency prices of goods in the shops will be in the same currency and this will allow people to compare prices between euro countries.
Foreign exchange costs

Another advantage is that bank commission charges will no longer be levied on transactions between the currencies of member states. Economists call these transaction costs. The EU Commission has estimated that there will be savings of 0.25% of GDP on transaction costs which will improve conditions for trade within
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the EU and make EU industry more competitive on world markets. The elimination of these transaction costs will help also tourism and investment among participating Member States.
Stability in global trade

The introduction of a single currency will help eliminate exchange rate uncertainty and currency fluctuations within Europe and with other countries. This will increase trade among members of the Union and globally. This is because currency movements can inhibit business people from expanding their sales in other countries.
Political union
Economic and monetary union is an important step towards closer European integration.
Interest rates
Interest rates will be lower and fairly uniform in participating countries within the EMU, and this will reduce costs for government and business.
Price stability
With prices, margins and profits coming under competitive pressure as a result of the introduction of the single currency, inflation rates will tend to move towards lower levels under the EMU.
Economic growth and stability
Economic growth will be increased by entering the EMU and there will be increased attractiveness of participating Member States to foreign investment.
0 20 The EMU makes it necessary that Governments act very responsibly as regards tax s and spending. ok o Fragmentation of Europe eb
If a country refuses to join, it may be isolated and risk becoming excluded from important decisions that will apply to it in any event.
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Global currency
The euro is emerging as a significant international reserve currency.
The level playing field

The discipline of a single currency prevents individual countries depreciating their currency to steal competitive advantages over each other. Without a single currency, there would always be a temptation for some countries to devalue, which undermines a single market.
The arguments against EMU Loss of control over economic policy

The most important argument against the EMU is the loss of economic sovereignty. Countries are no longer able to pursue their own independent economic policies. This is particularly important in the area of exchange rates. With independent monetary policies the countries with weaker economies were able to devalue their currencies. With the EMU, devaluation will not be possible for any reason. European monetary policy will now be decided by the European Central Bank in Frankfurt, Germany.
Less flexibility
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A disadvantage of joining the EMU would be that countries would have less flexibility in their economic policies. Under the Stability and Growth Pact countries will have less economic flexibility.
Loss of national pride

Many countries, like Britain are proud of their currencies as a symbol of economic success and national cohesion.
Price increases
Some firms might use the transition to the euro to disguise price increases.
The weak currencies

Those in favour of the EMU make much of the benefits of being tied to Europes stronger currencies. There would be powerful pressures on members to bail out economies that borrow too much. This could be very costly.
Regional disparities
Another disadvantage of the EMU is that it may contribute to greater regional disparities, especially for more peripheral regions. There may be a tendency for economic activity to move towards the core of Europe, the golden triangle between Paris, Hamburg and Rome.
Loss of foreign exchange earnings
A disadvantage of the EMU is the loss of money to the banks for the purchase and sale of foreign exchange.
One way Street
The EMU sets EU member states on an inevitable track to a federal Europe. Effectively, once a country signs up it loses control of economic policy. As a result, national parliaments would be no more than regional town halls within Europe, with effectively little more power than local government.
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Changeover costs
The changeover to the euro involves transition costs for business, public administrations and financial institutions.
The position of the UK

In a speech in July 1997, the UK Chancellor of the Exchequer specified five economic tests of the UKs suitability for EMU membership. The five economic tests are: 1 2 3 4 5 Are business cycles and economic structures compatible, so that the UK and others could live comfortably with euro interest rates on a permanent basis? If problems emerge, is there sufficient flexibility to deal with them? Would joining the EMU create better conditions for firms making long-term decisions to invest in Britain? What impact would entry into the EMU have on the competitive position of the UKs financial services industry, particularly the Citys wholesale markets? Will joining the EMU promote higher growth, stability and a lasting increase in jobs?
In his statement on the EMU to the House of Commons on 27 October 1997, the Chancellor assessed these five economic tests. His analysis was based on a UK
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Treasury paper published on that date. This concluded that a successful EMU would bring benefits for the UK economy by securing macro-economic stability and underpinning a well-functioning single market. This in turn would be good for investment, growth and employment in the UK economy. However, reflecting the cyclical divergences between the UK and continental European economies at this time, the Chancellor concluded it would not be right for the UK to join the EMU from the outset. On 23 February 1999 the UK Prime Minister, in a statement to the House of Commons, launched an Outline National Changeover Plan. In his statement he indicated that Britains intention is that it should join a successful single currency provided that the five conditions are met. The plan indicated that making a decision to join the single currency at that time was not realistic but that, should the economic tests be met, this could be decided at some future time.
Conclusion
The global economic environment is changing fast. This process will continue, and would continue if the EMU had never been thought of. It involves greater globalisation of activity, increasing intensification of competition among all the countries of the world and increasing technological change. The formation of the EMU marked a substantial change in the economic environment of the European Union as a whole. This is true for all Member States, and it is true whether or not they have joined the EMU. Continuation of the status quo is not an option for any Member State, whether it has joined the EMU or not.
Appendix One: International Financial Institutions

The European Central Bank
A European Central Bank (ECB) to operate the single monetary policy of the euro was set up on 1 June, 1998. The European System of Central Banks (ESCB) is comprised of the ECB and the central banks of the Member States. The primary objective of the ESCB is to maintain price stability. Without prejudice to this objective, the ESCB supports the general economic policies of the EU with a view to contributing to the achievement of EU objectives. Briefly, these are to promote sustainable and non-inflationary growth, a high level of employment and social protection, economic and social cohesion and solidarity among the Member States.
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The basic tasks of the ESCB are to: decide and implement the monetary policy of the EU; conduct foreign exchange operations; hold and manage the official external reserves of the Member States; and promote the smooth operation of payment systems
The Maastricht Treaty provides for the strict independence and accountability of the ECB.
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The International Monetary Fund the IMF

The IMF is a specialised agency within the UN system. It had its origins in the desire of members of the international community to avoid unemployment and economic recession. It is the central institution in the international monetary system and its aims are: to promote international monetary co-operation and to allow the expansion of international trade to provide financial support to countries with temporary balance of payments deficits to provide for the orderly growth of international liquidity.
The World Bank

The World Bank (the International Bank for Reconstruction and Development i.e. the IBRD) assists the economic development of countries by making loans available. These loans are used to build up the educational system, through new schools, and the health system, through new hospitals. This helps to reduce poverty in the developing countries. In recent years the World Bank has increasingly emphasised environmental protection in its work.
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Chapter 15
Hedging foreign exchange risk
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C H A P T E R 1 5 H E D G I N G F O R E IG N E X C H A N G E R I S K
CHAPTER CONTENTS
HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK ----------- 319
TRADE IN THE DOMESTIC CURRENCY ONLY MATCHING NETTING LEADING AND LAGGING FORWARD EXCHANGE CONTRACTS SYNTHETIC FOREIGN EXCHANGE AGREEMENTS (SAFES) MONEY MARKET HEDGING FOREIGN CURRENCY OPTIONS FINANCIAL FUTURES MARKET CURRENCY SWAPS 319 319 319 320 320 320 321 321 321 321
FINANCIAL TIMES CURRENCY TABLES ------------------------------- 322 THE FOREX MODIFIED BLACK-SCHOLES OPTION PRICING MODEL334 MULTILATERAL NETTING ---------------------------------------------- 343
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HEDGING TECHNIQUES FOR FOREIGN CURRENCY RISK

When an enterprise decides to trade internationally, it will become exposed to exchange rate risk. Indeed, where a company has a long-term overseas investment (e.g. in a foreign subsidiary), it may wish to hedge its foreign currency assets by raising a long-term loan in the same foreign currency whereby exchange losses or gains on the assets are offset by matching currency gains or losses on the liability. Sometimes management may consider it appropriate not to hedge exchange rate risk in order to avoid transaction costs this must be carefully considered and not be an outright gamble, which could of course, be dangerous!! The main methods of currency risk management are:
Trade in the domestic currency only

If an exporter always invoices in his domestic currency or an importer insists on paying in his own domestic currency, there is no foreign exchange risk for that company. However, the risk shifts to the other party in the transaction, which may not be welcomed by an exporters overseas customers.
Matching
When an enterprise has both receipts and payments expected on the same date for the same amount in the same foreign currency, no formal hedge is really necessary, since they can be matched against each other.
Netting
k oo When an enterprise haseb receipts and payments expected on the same date in both
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the same foreign currency, but the amounts are different, netting may be employed. For instance, if a UK company expects to receive 5,000,000 from an Italian customer and expects to pay 3,700,000 to a Spanish supplier on the same future date, it would only be necessary to use a formal hedging technique (with the associated transaction costs) for the net receipt of 1,300,000. In instances where two group members wish to settle their inter-company indebtedness using the same currency, the transaction costs associated with foreign exchange receipts and payments that are payable to banks can be reduced considerably by employing bilateral netting. In cases where several group members wish to settle their inter-company indebtedness, large savings in transaction costs can also be achieved by the use of multilateral netting. These procedures are illustrated starting on page 343.
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Leading and lagging

If an importer believes that the currency that it is shortly expecting to pay will appreciate against its home currency, it may decide to settle the liability as soon as possible. This is referred to as leading (and, of course, it may also be possible to take advantage of an early settlement discount). However, if an importer believes that the currency it is shortly expecting to pay will depreciate against its home currency, it may choose to delay payment beyond the due date. This course of action is known as lagging. These approaches are not really hedging techniques, they are simply based upon belief and this will only succeed if the direction of rate movement is correctly estimated.
Forward exchange contracts

A forward market hedge offers protection against foreign exchange risk through a company entering into a binding contract with a bank to purchase or sell a specified quantity of foreign currency at a rate of exchange that is fixed when the contract is made. The purchase or sale is fixed for a specified date when a company expects foreign currency payments or receipts, or between two specified dates (an option forward contract). Most forward contracts are for periods of up to one year, but longer contracts may be arranged in major currencies.
Synthetic foreign exchange agreements (SAFEs) blo
0. 0exchange rates, some countries (e.g. China, In order to reduce the volatility of their 0 Russia, India, Brazil, Philippines s2 Korea) have attempted to ban forward foreign and k exchange trading. In these o omarkets, non-deliverable forwards (NDFs) have been developed. Although eb they resemble forward contracts, no physical currency
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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. These procedures are dealt with in detail in Chapter 17 Hedging Interest Rate Risk starting on page 375
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Money market hedging

This involves the company borrowing funds in one currency and exchanging the proceeds for another currency, often with reinvestment in the second currency. For example a UK company due to pay a dollar debt in three months time might borrow pounds now, convert these pounds to dollars at the present spot rate (this fixes the exchange rate) and invest the dollars in the USA for three months at the end of which the total proceeds of the investment may be used to pay the dollar debt. The cost of the money market hedge is directly determined by the interest rate differential between the two countries concerned. This is in contrast to the cost of a forward market hedge, which depends upon the forward rates quoted by the bank (NB these are, of course, indirectly influenced by that interest rate differential, as explained below under the interest rate parity theory).
Foreign currency options

These offer the right to buy or sell a given amount of foreign exchange at a fixed price (the exercise price) usually at any time during a specified period. There is normally a choice of exercise price and maturity date, the price of the option varying according to the combination of exercise price and maturity date selected. The price of the option is determined by the difference between the exercise price and spot rate, maturity, relative interest rates in the countries concerned, currency volatility and the supply and demand for specific options. The option need only be exercised if exchange rates move in favour of the option holder; this limits the downside risk of the holder. Options may be purchased in standard sizes and maturities on certain Futures Exchanges or over-the-counter in major banks to the clients particular size and maturity requirements.
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Financial futures market

Several financial futures markets offer foreign currency futures. These offer purchase or sale of a standard amount of a limited number of foreign currencies at a specified time and price. They may be considered as an alternative to the forward foreign exchange market, but are less flexible and require initial margin and thereafter variation margin may have to be paid dependent upon subsequent movements in exchange rates.
Currency swaps
These are dealt with in Chapter 18 Swaps starting on page 407.
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FINANCIAL TIMES CURRENCY TABLES
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Illustration 1
(a) Structure of Exchange Rates The following information on exchange rates was extracted from the Financial Times several years ago Pound spot - forward against the pound: Days spread 1.7545 1.7710 2.2669 2.2770 Close 1.7680 1.7690 2.2693 2.2714 Three months 1.56 1.51 cpm 3.39 3.73 cdis
United States Switzerland
Required:
(i) (ii) (b) Identify the banks buying and selling rates. Calculate the three months rates for the US dollar and the Swiss franc.
Determinants of Forward Rates The spot rate for the $/ exchange is $1.77. 14% p.a. and in New York 12% p.a. Interest rates in London are
Required:
Ignoring transaction costs calculate the best rate (for the customer) at which a bank will sell the US $ twelve months forward. (c) Hedging Forex Risk
The following information is available with respect to the $/ exchange rate and interest rates in London and New York. Spot Three months Interest rates: London New York Borrow 15% p.a 10.5% p.a. Lend 13% p.a. 8.5% p.a.
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1.7680 1.56
$/ 1.7690 1.51 cpm
Required:
(i) An American customer will pay $3m in three months time. Show how foreign exchange risk can be eliminated using: (1) (2) (ii) forward market cover, and money market cover.
You must pay an American supplier $3m in three months time. Show how foreign exchange risk can be eliminated using: (1) (2) forward market cover, and money market cover.
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Solution 1
(a) The spot and the three month forward rates are: US Dollars 1.7680 1.7690 (0.0156) (0.0151) cpm 1.7524 1.7539 Sell $ Buy $ Buy $ Sell $ Swiss Francs 2.2693 2.2714 0.0339 0.0373 cdis 2.3032 2.3087 Sell SF Buy SF Buy SF Sell SF
(i) (ii)
Spot (Prem)/dis 3 month rates BANK WE
(b)
This exchange rate can be calculated from first principles as follows: Bank borrows at 14% (say) Buys $ spot at $1.77 Invests $ at 12% for twelve months In one year, the bank has: $ asset $1,770 x 1.12 liability 1,000 x 1.14 1,000 $1,770
= =
$1,982.4 1,140.0
o sp However the interest rate parity theory can alternatively be used i.e. log .b 00 Interest rate parity theory 0 2 (IRPT) s Proponents of this theory claim that the difference between current spot rates and ok o forward rates is based upon interest rate differentials between the two countries eb principle of interest rate parity links the international concerned. Therefore the
money markets with the foreign exchange markets. x Forward rate (Fo) = Current Spot rate
Therefore the bank cannot sell $ forward for more than $1.7389 (i.e. $1,982.4 1,140).
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1 + foreign int erest rate 1 + home int erest rate
1 + ic = S0 1 + i b
= $1.7389
Forward rate
= $1.77
1.12 1.14
In this instance the current spot rate is $1.77 = 1, whereas the one year forward rate is $1.7389 = 1. Thus there is a premium of $0.0311!! Accordingly, provided this theory holds, where: Foreign interest rates < UK interest rates, the forward rate is quoted at a premium, and where: Foreign interest rates > UK interest rates, the forward rate is quoted at a discount.
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(c) (i) (1) Forward market hedge The selling rate in the 3 month forward market (i.e. the banks buying rate) is $1.7539 (see part a)) By selling forward you will receive 1,710,474 in three months time. (2) Money market hedge : exporter case Has a $ asset therefore must create $ liability (1) (2) (3) (4) Borrow in USA Sell $ spot Invest in UK $3,000,000 $2,923,264 1,652,495 1.02625* 1.7690 x 1.0325# = $2,923,264 = 1,652,495 = 1,706,201 proceeds = $3,000,000 $3,000,000 1.7539 =
Repay $ loan with receipts from customer * 10.5% = = 2.625% 3.25%
4
# 13%
It is more effective to hedge in the forward market. (ii) (1) Forward market hedge
Buy $ forward : $3,000,000 1.7524 (2) Money market hedge : importer case Has $ liability therefore must create $ asset (3) (2) (1) (4) Borrow in UK Convert to $ 1,661,525 x 1.7680 Invest in USA $2,937,577 x 1.02125* Repay loan 1,661,525 x 1.0375# * 8.5%
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1,711,938
= = = =
1,661,525 $2,937,577 $3,000,000
1,723,832 cost
4
# 15%
= =
2.125% 3.75%
The forward market cover is cheaper.
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Illustration 2 (Oxlake plc)

Oxlake plc has export orders from a company in Singapore for 250,000 china cups, and from a company in Indonesia for 100,000 china cups. The unit variable cost to Oxlake of producing china cups is 55 pence, and unit sales price to Singapore $2.862 and to Indonesia, 2,246 Rupiahs. Both orders are subject to credit terms of 60 days, and are payable in the currency of the importers. Past experience suggests that there is 50% chance of the customer in Singapore paying 30 days late. The Indonesian customer has offered to Oxlake the alternative of being paid US $125,000 in 3 months time instead of payment in the Indonesian currency. The Rupiah is forecast by Oxlakes bank to depreciate in value during the next year by 30% (from an Indonesian viewpoint) relative to the $US. Whenever appropriate, Oxlake uses option forward foreign exchange contracts. Foreign Exchange Rates (mid rates) $Singapore/$US $US/ Rupiahs/ Spot 1 month forward 2 months forward 3 months forward 2.1378 2.1132 2.0964 2.0915 1.4875 1.4963 1.5047 1.5105 2,481 No forward market exists
m co Assume that in the United Kingdom any foreign t. currency po immediately converted into pounds sterling. s log per year) Money Market Rates (% 0.b Borrowing Deposit 0 0 UK clearing bank 11 s62 k4 Singapore bank 7 oo 7 Euro-dollars 12 eb 15 Indonesian bank Not available
Euro-sterling US domestic bank 6 8 10 12
holding must be
These interest rates are fixed rates for either immediate deposits or borrowing over a period of two or three months, but the rates are subject to future movement according to economic pressures.
Required (a)
Using what you consider to be the most suitable way of protecting against foreign exchange risk, evaluate the sterling receipts that Oxlake can expect from its sales to Singapore and to Indonesia, without taking any risks. All contracts, including foreign exchange and money market contracts, may be assumed to be free from the risk of default. Transactions costs may be ignored
(b)
If the Indonesian customer offered another form of payment to Oxlake, immediate payment in $US of the full amount owed in return for a 5% discount on the Rupiah unit sales price, calculate whether Oxlake is likely to benefit from this form of payment. Discuss the advantages and disadvantages to a company of invoicing an export sale in a foreign currency.
(c)
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Solution 2 (Oxlake plc)

(a)
Sales to Singapore Cross rates S$ to Spot 1 month forward 2 months forward 3 months forward 2.1378 2.1132 2.0964 2.0915 x x x x 1.4875 1.4963 1.5047 1.5105 = = = = 3.1800 3.1620 3.1545 3.1592
The management of Oxlake plc may cover the foreign exchange risk in one of two ways: 1. In the forward currency market Since the payment date is uncertain the appropriate device is an option forward contract (sometimes called an option date contract). (Note: an ordinary forward contract specifies the date of the exchange and the exchange rates). Option forward contracts specify a period over which the contract may be completed, at Oxlakes option. The forward rate for an option forward contract is the worst rate prevailing during the period of the option. Oxlake could take out an option forward contract to sell S$ to be fulfilled between two and three months hence. The rate will be the worse of the 2 month and 3 month rates (for the seller) i.e. 3.1592. Sterling received (3 months hence) 250,000 2.862 = 3.1592
k oo two month rate: This is worse than the eb

2. In the money market
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S$715,500 S$3.1592
S$715,500 S$3.1545
= 226,481
226,819
Oxlake expects to receive 250,000 x 2.862 = S$715,500 in 3 months time. Therefore: 1) 2) 3) 4) Borrow in Singapore Sell S$ spot S$715,500 1.0175* S$703,194 3.18 = = = = S$703,194 221,130
Invest in Eurosterling 221,130 x 1.01625# (better than UK rate of 6% p.a.) Repay S$ loan in 3 months time with receipts * 7% 4 = 1.75% # 6 12 % 4 =
224,723 proceeds
S$715,500
1.625%
Oxlake is best advised to deal in the forward exchange market
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Sales to Indonesia Oxlake will receive 100,000 x 2,246 = 224,600,000 Rupiahs in two months time. No forward rate exists so Oxlake cannot cover its position in the forward market. Furthermore a money market hedge cannot be achieved since a Rupiah liability cannot be created. However, the management still has two options using the US$ alternative. 1. Forward currency market Oxlake may accept the alternative payment of $125,000. It can sell the $ forward, thus guaranteeing a sterling receipt in 3 months time of 125,000 1.5105 = 82,754. 2. Money market 1) 2) 3) 4) Borrow in Eurodollar market $125,000 1.03* (better than US rate of 12% p.a.) Sell $ spot = $121,359
$121,359 1.4875 = 81,586
Invest in Eurosterling 81,586 x 1.01625#= 82,912 (better than UK rate of 6% p.a.) proceeds Repay Eurodollar loan in 3 months with receipts * 12% 4 = 3% # 6 12 %
Oxlake should cover its position in the money market.
(b)
Alternative form of payment

Sales value in Rupiahs Less 5% discount Discounted sales value
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4
o=
o t.c
$125,000
1.625%
100,000 cups x 2,246
224,600,000 (11,230,000) 213,370,000 1,667.90 $127,927
Using cross rates: Proceeds of sale =
2,481 1.4875
= =
213,370,000 1,667.90
The best US$ deposit rate of interest is 8% p.a. in a US domestic bank. The yield after three months is $127,927 x 1.02* = $130,486. Converted into $130,486 sterling, using the three month forward market, this is 1.5105 =
86,386.
* 8% 4 = 2%
328
Alternatively, the US dollar proceeds could be converted immediately into sterling and then invested for three months in the Eurosterling market. The calculation is as follows: (i) Conversion of US$127,927 into sterling yields 127,927 1.4875 (ii) = 86,001 i.e.
213,370,000 2,481
86,001
Yield of Eurosterling 3 month deposit = 86,001 x 1.01625 # = 1.625% =
87,399
# 6 12 % 4
Conclusion: The best yield without the offer of immediate payment was 82,912. With the alternative form of payment, both the forward market and the money market yield better returns, with the money markets 87,399 as the better form of hedging.
(c)
When a company invoices sales in a currency other than its own, the amount of home currency it will eventually receive is uncertain. This may be an advantage or a disadvantage, depending on changes in the exchange rate over the period between invoicing and receiving payment. With this in mind, invoicing in a foreign currency has the following advantages.
o spmore attractive than a similar The foreign customer will find the g lo deal one in the exporters currency, b . since the customer will bear no foreign 0 exchange risk. Making a sale will therefore be that much easier. 00 2 The exporter can take advantage of favourable foreign exchange rate ks the exchange receipts forward (for more of the o movements by selling bo would be obtained by conversion at the spot rate). home currency than e
In some countries, the importer may find it difficult or even impossible to obtain the foreign exchange necessary to pay in the exporters currency. The willingness of the exporter to sell in the importers currency may therefore prevent the sale falling through.
o t.c
The disadvantages of making export sales in foreign currency are the reverse of the advantages. The exporter (rather than the foreign customer) bears the foreign exchange risk If the exchange rate movement is unfavourable, the exporters profit will be reduced.
329
Illustration 3 (Fidden Ltd)

Fidden Ltd is a medium-sized UK company with export and import trade with the USA. The following transactions are due within the next six months. Transactions are in the currency specified. Purchases of components, cash payment due in three months: Sale of finished goods, cash receipt due in three months: Purchase of finished goods for resale, cash payment due in six months: Sale of finished goods, cash receipt due in six months: 116,000 $197,000 $447,000 $154,000
Exchange rates (London market) $/ Spot 1.7106 1.7140 Three months forward 0.82 0.77 cents premium Six months forward 1.39 1.34 cents premium
Three months or six months Sterling Dollars
Interest rates Borrowing Lending 12.5% 9.5% 9% 6%
o sp York market) Foreign currency option prices g lo (New Prices are cents per ,.contract size 12,500 b 00 Calls Puts 20 Exercise price ($) March June Sept March June s 1.60 ok15.20 1.70 5.65 3.45 bo 7.75 e 1.80 1.70 3.60 9.90 9.32
o t.c
Sept 2.75 6.40 15.35
Assume that it is now December with three months to expiry of the March contract and that the option price is not payable until the end of the option period, or when the option is exercised.
Requirements: (a)
Calculate the net sterling receipts/payments that Fidden Ltd might expect for both its three and six month transactions if the company hedges foreign exchange risk on: (i) (ii) the forward foreign exchange market; the money market.
(b)
If the actual spot rate in six months time was with hindsight exactly the present six months forward rate, calculate whether Fidden Ltd would have been better to hedge through foreign currency options rather than the forward market or money market. Explain briefly what you consider to be the main advantage of foreign currency options.
(c)
330
Solution 3 (Fidden Ltd)

(a)
Fidden Ltd Spot 3 months 6 months Buys $ 1.7106 1.7024 1.6967 Sells $ 1.7140 1.7063 1.7006
THREE MONTH TRANSACTIONS

1. Forward Cover Sell $ 2. $197,000 1.7063 =
115,454
Money Market Cover (Exporter) 1. Borrow in USA at 9% p.a. for 3 months $197,000 1.0225 2. 3. Convert to (sell $ spot) $192,665 1.7140 = $192,665 112,407
Invest in UK at 9% for 3 months
0 00 proceeds 4. Repay loan with $197,000 2 ks o FORWARD MARKET ISo b MORE LUCRATIVE! e THEREFORE, NET STERLING PAYMENT IS:
SIX MONTH TRANSACTIONS
1. Forward Cover Buy $ 2.
112,407 x 1.02375
log .b
po
o t.c
m
= =
115,076
(116,000 115,454)
546
($447,000 $154,000 )
1.6967
$293,000 = 1.6967
172,688
Money Market Cover (Importer) 3. 2. Borrow in UK at 12% for 6 months Convert to $ (buy $ spot) 166,296 x 1.7106 1. Invest in USA at6% for 6 months $284,466 x 1.03 4. Repay loan 166,296 x 1.0625 = = $293,000 = $284,466 = 166,296
176,690
FORWARD MARKET IS CHEAPER!
331
(b)
We want a right to sell in New York, therefore buy put options!
A)
$1.70 put costs 3.45 c per

$1.70 puts require
$293,000 $1.70
= 14 contracts (approx)
172,353
172,353 12,500
Premium is: In six months:
14 x 12,500 x 3.45 c per
$6,037.50
$ 14 contracts x 12,500 x $1.70 Payment to supplier Payment of premium Short by Total cost 293,000 6,037.50
$ 297,500
14 contracts @ 12,500 Extra $
o eb Total cost of exercising option

$293,000 + $6,037.50 $1.6967
B) $1.80 put costs 9.32 c per
$1.80 puts require
ok
0 s2
.bl 0
p gs
o t.c
299,037.50 $1,537.50
175,000 906 _______ 175,906
$1,537.50 $1.6967
N.B. If the currency option were not exercised, the sterling cost would be: = 176,247
$293,000 $1.80
= 14 contracts (approx)
162,778
162,778 12,500
Premium is:
14 x 12,500 x 9.32 c per
$16,310
332
In six months: $ 14 contracts x 12,500 x $1.80 Payment to supplier Payment of premium Over by Total cost 175,000 293,000 16,310 309,310 $5,690 $ 315,000
14 contracts @ 12,500 less $ sold Total cost of exercising option
$5,690 $1.7006
(3,346) _______ 171,654
N.B. If the currency option were abandoned, the sterling cost would be:
$293,000 + $16,310 $1.6967
(c)
0 00 options 2 Advantages of foreign currency ks o The main advantage o foreign currency options is that they offer a right, b of e which need not be exercised, to buy or sell foreign currency. If exchange
rates move such that exercising the option is favourable, then the option will be sold or exercised. If exchange rates move in an unfavourable manner for the option holder, the option will be allowed to lapse unexercised and the only cost will be the option premium. Options therefore offer a way of limiting downside risk while offering potentially unlimited returns.
Therefore the purchase of $1.80 put options is the cheapest strategy of all.
log .b
o sp
m co = t.
182,301
333
The FOREX modified Black-Scholes option pricing model

Currency options can be priced using an adapted version of the Black-Scholes model, known as the Grabbe variant. The risk free rate of interest is one of the five components used in the Black-Scholes formula, however the problem that arises with currency options is that there are two risk free rates to consider one for each of the countries whose currencies are involved. These two interest rates are incorporated into the formula by predicting the forward rate using the interest rate parity theory. For the more familiar indirect currency quotes, this is expressed as follows:
Forward rate (Fo)
= Current Spot rate
1 + foreign int erest rate 1 + home int erest rate
1 + ic = S0 1 + i b
However, since the Grabbe variant employs direct quotes, the basic formula must be rearranged as follows:
1 + home int erest rate 1 + foreign int erest rate
Forward rate (Fo)
= Current Spot rate
m co Formulae sheet for Formulae, which were provided in the 2007 version of t. ACCA the the FOREX modified Black-Scholes option pricing po model are shown below in bold s print: log .b Value of a currency call option (c) c 00 = e -rt [ F N(d ) XN(d )] 0 s2 p = e -rt [ XN(d ) F N(d )] Value of a currency put option (p) k oo b The values for d and d e the specification are: in
0 1 2 2 0 1 1 2
1 + ib = S0 1 + i c
d1 d2
= =
ln(F0 /X ) + s 2 T/2 s T d1 s T
Where:
F0 X r = = = the forward rate, calculated using the interest rate parity formula (as above) the current spot rate employing direct quotes the continuous compound domestic (home) risk-free interest rate
The remaining symbols have already been introduced in the basic Black-Scholes option pricing model. Notice that the ACCA have used both T and t to represent the remaining life of the option, expressed in years and percentages thereof. The 2011 version of the ACCA Formulae sheet has omitted this FOREX modified formulae. However this topic has not yet been officially removed from the revised P4 syllabus. Accordingly, this subject is retained within these Class Notes pending formal clarification.
334
Illustration 4
Sophie plc (a British company) is planning to undertake a construction project in Belgium and in three months time expects to learn whether its tender has succeeded. In that event, an immediate euro () payment will have to be made. The corporate treasurer intends to hedge this payment using currency options. Relevant information is as follows: / direct spot rate / indirect spot rate Three month LIBOR Three month EURIBOR Volatility () of the against Required Calculate the premium on a three month at the money call option with an exercise price of 0.80 = 1. 0.80 = 1 1.25 = 1 4.5% p.a. 3% p.a. 20% p.a.
Solution 4
Forward rate (F0) = = X F0 r T/t s d1 d2 = = = = = Current Spot rate 0.8 0.8 0.803
(1 + 3 / 12 4.5%) po s = (1 + 3 / 12 3og l %)
1+h 1+f
o t.c
m
1.01125 = 0.803 1.0075
0.8
0.045 bo e0.25 = = 0.2
s ok
0 00
.b
ln(0.803 0.8) + 0.22 0.25 2 0.2 0.25

0.0874 0.2 0.25
0.00374 + 0.005 0 .1
= 0.0874 =0.0126
Using the standard normal distribution tables: d1 d2 = = 0.0874 (i.e. 0.09) gives 0.0359
0.0126 (i.e. 0.01) gives 0.004 0.5 + 0.0359 0.5 0.004 = = 0.5359 0.496
N(d1) = N(d2) = c = = =
e-(0.045 x 0.25) [0.803 x 0.5359 0.8 x 0.496] 0.9888 x [0.43033 0.3968] 0.03315 i.e. 3.315p per
335
Illustration 5 Marion Inc

Marion Inc., a company based in the USA, is taking legal action for breach of copyright against an Italian competitor. The matter will be resolved in nine months time and, if successful, Marion Inc. will benefit from an immediate euro () receipt. The corporate treasurer intends to hedge this receipt using currency options. Relevant information is as follows: $/ direct spot rate /$ indirect spot rate Three month $ Federal Reserve rate Three month EURIBOR Volatility () of the against $ Required: Calculate the premium on a nine month at the money put option with an exercise price of $1.3249 = 1. $1.3249 = 1 0.7548 = $1 5% p.a. 3% p.a. 25% p.a.
Solution 5
Forward rate (F0) = = Current Spot rate x $1.3249 x
= X F0 r T/t s = = = = = 1.3249 1.3443 0.05 0.75 0.25
eb
.b 1.0375 00 $1.3249 0 2 x 1.0225 s ok o
(1 + 9 12 5%)o sp g3%) (1 + 9 12 lo
=
1+h 1+f
o t.c
$1.3443
d1
ln(1.3443 1.3249) + 0.252 0.75 2 0.25 0.75

= = 0.1754 -0.0411
= d2
0.01454 + 0.02344 0.2165 =
0.1754 0.25 0.75
Using the standard normal distribution tables: d1 d2 N(d1) N(d2) p = = = = = = = 0.1754 (i.e. 0.18) gives +0.0714 0.0160 = = 0.4286 0.5160
0.0411 (i.e. 0.04) gives 0.5 0.0714 0.5 + 0.0160
e-(0.05 x 0.75) [1.3249 x 0.5160 1.3443 x 0.4286] 0.9632 x [0.68365 0.57617] $0.10353 i.e. 10.353 cents per
336
Illustration 6 (currency futures)

A UK company imports from the USA and is invoiced for $297,500 payable in October. $/ spot rate October forward Required (a) (b) Show how a forward market hedge would be carried out. Show how a futures market hedge would be carried out (one futures contract represents 12,500 and December futures are priced at $1.70). What would be the result in October of the futures market hedge in each of the following independent circumstances? (i) (ii) The $/ spot turned out to be $1.5000 $1.5020 and December futures were then priced at $1.50?, and The $/ spot turned out to be $1.7800 $1.7820 and December futures were then priced at $1.78? 1.7500 1.7520 1.7000 1.7015
o bo
0 s2
.bl 0
p gs
o t.c
337
Solution 6
IMPORTER SITUATION (a) Forward market hedge
$297,500 $1.7000
(b)
175,000
Futures market hedge
$297,500 $1.70 175,000 12,500

Situation (i)
175,000
14 contracts
The UK importer requires protection against a weakening . As the $ strengthened to $1.5000 = 1 by October, he would have to pay ($297,500 1.5000) 198,333 to clear his obligation. Obviously he could protect his exposure to foreign exchange risk by SELLING 14 December futures contracts NOW at $1.70, and then closing his position by BUYING a similar number of December futures when the price has moved to $1.50. Clearly the ($0.20 x 12,500) $2,500 gain on each of the 14 futures contracts i.e. $35,000 would be converted at the then spot rate $1.5000 to provide 23,333 which would compensate for the adverse movement on the foreign exchange market i.e. CASH MARKET Payment to supplier
o bo
0 s2
.bl 0
p gs
o t.c
($297,500 1.5000)
198,333
FUTURES MARKET $ Now: SELL 14 contracts 1.70 In October: BUY 14 contracts 1.50 Gain per $0.20 $0.20 Total Gain 14 contracts 12,500 = $35,000 1 ($35,000 1.5000) In : TOTAL COST
(23,333) 175,000
338
Situation (ii) CASH MARKET Payment to supplier 167,135
($297,500 1.7800)
FUTURES MARKET $ Now: SELL 14 contracts 1.70 In October: BUY 14 contracts 1.78 Loss per $(0.08) $0.08 Total loss 14 contracts 12,500 = $14,000 1 In : ($14,000 1.7800) TOTAL COST
7,865 175,000
As can be seen from the above calculations, hedging with a futures contract means that any profit or loss on the underlying will be offset by any loss or profit made on the futures contract. In practice, a perfect hedge is unlikely because of: The round sum nature of futures contracts, which can only be bought or sold in whole numbers, and Basis risk i.e. the possibility of variability in the prices of the two related securities in the hedging arrangement. For example, if changes in the price of the currency future do no perfectly match the change in the price of the underlying security then a profit or loss may occur on the hedge position. This potential variability in the outcome of a hedge is referred to as basis risk.
Since this example had a precise round number of contracts and there was no basis risk, the total cost is the same whatever the actual exchange rate.
o bo
0 s2
.bl 0
p gs
o t.c
339
Illustration 7 currency options

(a) Explain briefly what is meant by foreign currency options and give examples of the advantages and disadvantages of exchange traded foreign currency options to the financial manager. Exchange traded foreign currency option dollar/sterling contracts are shown below: prices in Philadelphia for
(b)
Exercise price ($) 1.90 1.95 2.00 2.05
Sterling (12,500) contracts Calls Puts September December September December 5.55 2.75 0.25 7.95 3.85 1.00 0.20 0.42 4.15 9.40 1.95 3.80 -
Option prices are in cents per . The current spot exchange rate is $1.9405 $1.9425/. Required:
Assume that you work for a US company that has exported goods to the UK and is due to receive a payment of 1,625,000 in three months time. It is now the end of June. Calculate and explain whether your company should hedge its sterling exposure on the foreign currency option market if the companys treasurer believes the spot rate in three months time will be: 1. 2. $1.8950 $1.8970/. $2.0240 $2.0260/.
o bo
0 s2
.bl 0
p gs
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340
Solution 7
(a) A foreign currency option is a financial instrument, which gives the buyer of the option the right, but not the obligation, to buy or sell a currency at a specified rate of exchange (normally) at any time up to a specified date. Advantages include: They limit downside risk whilst allowing companies to take advantage of favourable foreign exchange rate movements. They are a useful hedge against exchange risk when a company is unsure whether a future foreign exchange risk will occur, for example, when tendering for a contract which it might not obtain, or issuing a price list in foreign currencies. They provide an effective currency hedge, especially when foreign exchange markets are volatile.
Disadvantages include: Cost. A premium is payable when the option is arranged, whether or not the option is exercised. Exchange traded options are only available in a small number of currencies with specific expiry dates (OTC options are much more flexible).
(b)
Any belief about future spot exchange rates by the companys treasurer is a personal viewpoint and, if acted upon, could leave the company exposed to foreign exchange risk. If the company is worried about foreign exposure it should hedge the risk using options, forward contracts or other techniques no matter what the treasurer personally believes the future spot rate will be. If the company acts upon the treasurers forecasts it will need to sell sterling for dollars, i.e. buy put options on sterling. 1,625,000 will require (1,625,000 12,500) 130 contracts. 1. $1.8950 - $1.8970/. The relevant future spot rate for selling for $ is $1.8950/, since a bank would obviously hand over the lower number of $ for each sold. If the future spot rate is $1.8950, the company would receive (1.625m x $1.8950) i.e. $3,079,375 using the spot market. The is expected to weaken relative to the dollar. September options are available at exercise prices of $1.90, $1.95 and $2.00. At all of these prices the option will be exercised. At $1.90 Receipts are 1.625m x $1.90 Option cost of 1.625m x $0.0042 Net At $1.95 Receipts are 1.625m x $1.95 Option cost of 1.625m x $0.0415 Net $ 3,087,500 (6,825) $3,080,675 $ 3,168,750 (67,438) $3,101,312
o bo
0 s2
.bl 0
p gs
o t.c
341
At $2.00 Receipts are 1.625m x $2.00 Option cost of 1.625m x $0.0940 Net
$ 3,250,000 (152,750) $3,097,250
All three options result in higher expected dollar receipts than using the spot market in three months (excluding any further transactions costs). Selection of the $1.95 exercise price would give the highest expected receipts. 2. $2.0240 - $2.0260/. If the spot rate for buying dollars in three months time is $2.0240/ then, if purchased, the options would not be exercised as using the spot rate in three months would give higher dollar receipts (i.e. 1.625m x $2.0240 = $3,289,000) than any of the available option exercise prices. Therefore, the company would not purchase currency options. It must be stressed that this would leave the company exposed to foreign exchange risk, as the spot rate in three months time could be very different to the rate forecast by the treasurer.
o bo
0 s2
.bl 0
p gs
o t.c
342
Multilateral netting
This is a procedure whereby the debts of the different group companies denominated in a given currency are netted off against each other. The principal benefit is that foreign exchange purchase costs, including commission, the buy/sell spread and money transmission costs are reduced. Additionally, it will reduce the loss of interest earned. This is because funds spend less time in transit.
Illustration 8
Forun plc, a UK registered company, operates with four subsidiaries in different foreign countries. It has a number of intra-group transactions with its four foreign subsidiaries in six months time. These are summarised below denominated in US dollars: Paying company Sub 2 Sub 3 $US000 450 210 420 410 230 110 510
Receiving company UK Subsidiary Subsidiary Subsidiary Subsidiary Required
UK 700 140 300 560
Sub 1 300 340 140 300
Sub 4 270 180 700 350 -
1 2 3 4
blo .netting might be of benefit to Forun plc. 0 Explain and demonstrate how multilateral 00 2 ks o bo e
p gs
o t.c
343
Solution 8
Multilateral netting is an effective means of reducing the transaction costs associated with foreign exchange receipts and payments that are payable to banks. The netting of Foruns intra-company US dollar exposures gives the following net payments and receipts: Paying company Receiving company UK Subsidiary 1 Subsidiary 2 Subsidiary 3 Subsidiary 4 Total payments UK Sub 1 Sub 2 Sub 3 Sub 4 Total receipts Net receipts (payments) (470) 220 380 (110) (20) NIL
700 140 300 560 1,700
300 340 140 300 1,080
$US000 450 210 420 410 230 110 510 1,210 1,130
270 180 700 350 1,500
1,230 1,300 1,590 1,020 1,480 6,620
US dollar payments will still need to be made by the UK parent, Subsidiary 3 and Subsidiary 4 to Subsidiary 1 and Subsidiary 2. However these payments/receipts only amount to a total of $600,000. These amounts are insignificant when compared to the total value of transactions amounting to $6,620,000, which would have been involved if multilateral netting had not taken place.
o sp and other costs that would Therefore, this technique will reduce transaction log of $6,020,000. otherwise have been payable on the net difference .b 00 Where only two group members are involved in attempting to settle their intra0 s2 company indebtedness, the much simpler technique called bilateral netting may be k employed. oo eb
o t.c
344
Chapter 16
Futures and options
o bo
0 s2
.bl 0
p gs
o t.c
345
CHAPTER 16 FUTURES AND OPTIONS
CHAPTER CONTENTS
FUTURES ----------------------------------------------------------------- 347 OPTIONS----------------------------------------------------------------- 348 THE BLACK-SCHOLES OPTION PRICING MODEL--------------------- 350 PUT-CALL PARITY ------------------------------------------------------ 360 THE GREEKS ------------------------------------------------------------- 361
1. 2. 3. 4. 5. DELTA GAMMA VEGA THETA RHO 361 361 362 362 362
SUMMARY OF THE GREEKS
REAL OPTIONS ---------------------------------------------------------- 363 APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE THE VALUE OF EQUITY ------------------------------------------------------------------ 368
0 00 2 LIFFE EQUITY OPTIONS TABLE --------------------------------------- 374 ks o bo e
log .b
t. po
om
362
346
FUTURES
Financial futures contracts
A financial futures contract is a legally binding agreement between two parties to buy or to sell a standardised quantity of a specific financial instrument at a future date, but at a price agreed today, through the medium of an organised exchange.
The Clearing House

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 margin, which effectively acts as a security deposit.
Margin
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 is the sum deposited when the contract is first made. Variation margin is payable or receivable to reflect the day-to-day profits or losses made on the futures contract. If the futures price moves adversely a payment must be made to the Clearing House, whilst if the futures price moves favourably variation margin will be received from the Clearing House. This process of realising profits or losses on a daily basis is known as marking to market.
o bo
0 s2
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p gs
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Ticks
A tick is the minimum price movement permitted by the exchange on which the futures contract is traded. Price movements are then stated in numbers of ticks. Thus if a three month interest rate futures contract has a contract size of 500,000 and a tick size of 0.01%, the tick value is (0.0001 x 3/12 x 500,000) 12.50. If you bought 15 Contracts at 93.20 and the contract price rose to 94.50, each contract will have risen in price by (1.30 x 100) 130 ticks. Thus your total profit is (15 contracts x 130 ticks x 12.50 per tick) 24,375, which will wholly or partly cancel any losses made on the cash market due to adverse movements in market interest rates.
Hedging
Hedging with a futures contract means that any profit or loss on the underlying instrument will be offset by any loss or profit made on the futures contract. A perfect hedge is unlikely because of: (a) (b) Basis risk i.e. the possibility that the futures price will move slightly differently to the cash (or spot) market price, and The round sum nature of futures contracts, which can only be bought or sold in whole numbers.
347
OPTIONS
A number of types of option may be created, for example: Companies can create call options on their own shares for purposes of share option schemes for directors and employees, and Over-the-counter (OTC) or negotiated options are often created by e.g. banks to suit the needs of the buyer.
However a large volume of trading occurs in options created by dealers on specialised exchanges. In the UK, the London International Financial Futures and Options Exchange (LIFFE) oversees the creation of options on various financial assets. In 2002, LIFFE was taken over by Euronext and is now known as Euronext.liffe. The paragraphs which follow are mainly concerned with these exchange traded options.
Option
An option confers on the buyer the right, but not the obligation to buy from or sell to the writer, a fixed amount of a financial asset (or instrument) on or before a future maturity date, at a specific exercise price which is fixed today.
Call option
The buyer of a call option has the right to buy the asset, whilst the writer (or seller) of a call option will be obliged to sell the asset should the buyer so elect.
Put option
The buyer of a put option has the right to sell the asset, whilst the writer (or seller) of a put option will be obliged to buy the asset should the buyer so elect.
o bo
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Exercise price
This is the price, which is fixed in the contract at which the underlying instrument can be bought or sold. Sometimes referred to as the strike price. These strike prices are fixed by the Exchange in accordance with a predetermined scale.
Expiry date
Also known as maturity date. Options are traded for delivery either on (or at any time up to) the maturity date.
American style options

The majority of options are American style, in that they can be exercised, should the buyer so decide, at any time between entering into the contract and expiry date.
European style options

The comparatively rare European style options can only be exercised on the maturity date.
348
Bermudan style options

These are options where early exercise is restricted to certain specified dates over the life of the option.
Premium
The premium is the price that the buyer of the option pays for his right to trade the instrument and is the maximum he can lose on the deal. The writer receives the premium for having taken on the obligation to go through with the deal should the buyer so elect. The writer of an option risks potentially unlimited losses.
In-the-money options
A call option is in-the-money if the current market price exceeds the exercise price. A put option is in-the-money if the current market price is below the exercise price.
Out-of-the money options

A call option is out-of-the money if the current market price is below the strike price. A put option is out-of-the money if the current market price exceeds the strike price.
o sp market price happens to be Put and call options are at-the-money if the current log equal to the exercise price. .b 00 0 Intrinsic value of an option s2 k The profit that the buyer of oo in-the-money option could make if the option were an to be exercised immediately. eb
At-the-money options Time value of an option
If there is still a period of time to go before an option expires the option premium will exceed the intrinsic value. Thus the value of the option premium will be equal to intrinsic value plus time value. The greater the time to expiry, the greater the time value.
o t.c
The determinants of the value of a call option premium

1. 2. 3. 4. 5. The higher the price of the underlying instrument, the higher the value of the call option premium. The longer the time to expiry of the option, the higher the value of the call option premium. The greater the price volatility of the underlying instrument, the higher the value of the call option premium. The higher the risk free rate of interest, the higher the value of the call option premium. The higher the exercise price of the option, the lower the value of the call option premium.
349
THE BLACK-SCHOLES OPTION PRICING MODEL

In 1973, Fischer Black and Myron Scholes developed a model to value particular types of options. This model, commonly called the Black-Scholes option pricing model, and its many derivations have been used extensively in establishing the value of a call option. Such sophisticated models are used to determine the appropriate relationship between the price of an option trading on an organised exchange and the cash market price of the underlying financial claim. The Black-Scholes model includes the following five factors in its specification: 1. 2. 3. 4. 5. The price of the underlying security The length of time to expiry of the option period A measure of price volatility The risk-free rate of interest The exercise price
In its basic form, the model cannot be used to incorporate income (i.e. dividends or interest) received on the financial claim. The model originally developed by Black-Scholes was designed for European call options. The model assumes no return on the underlying financial claim and that the options are marketable, that is, they can be bought and sold. This is a very important assumption, since many forms of option that are created cannot be transferred (i.e. are not traded options). This means that the value of options, without transferability, will be less than would be calculated using the Black-Scholes formula. The original model also ignored transaction costs and taxes, but a later improved version introduced the assumption that transaction costs are minimal and that all parties to the transaction have the same marginal tax rate. Given these limitations the model has been successfully used to value many types of options. The objective of the model is to estimate the market value of a call option, c. The model specification is: -rt c = Pa N(d1) Pe N(d 2 ) e where: c Pa Pe e r t N(d1) = = = = = = = Call price for a European option Current market price of the related security The exercise price at the options maturity The exponential constant i.e. 2.7183 Continuous compound risk-free interest rate Remaining life of the option, expressed in years and percentages thereof The cumulative probability distribution from a normal distribution for the value of d1. N(d1) provides an estimate of delta (refer to page 361). The cumulative probability distribution from a normal distribution for the value d2
o bo
0 s2
.bl 0
p gs
o t.c
N(d2)
350
The values for d1 and d2 in the specification are d1 =
ln(Pa /Pe ) + (r + 0.5s 2 )t s t
or
ln(Pa /Pe ) + rt s t
+ 0 .5 s t
N.B. The left hand version is given on the ACCA Formulae sheet, whilst the right hand version was used (with different symbols) in the old syllabus Paper 3.7
d2
d1 s t
where: ln(Pa/Pe) s = = the natural logarithm of (Pa Pe ) the standard deviation () of the continuously compounded rate of return on the underlying financial claim
The assumptions for the Black-Scholes model appear to be numerous i.e. Returns on the underlying stock are normally distributed; The standard deviation of returns must be estimated and be constant over the life of the option; Transaction costs and taxes are zero; The share pays no dividends;
o sp The option has European exercise terms; g blo The market is efficient and operates . continuously; 0 00 rate is known and constant. The short-term (risk-free) interest 2 ks necessary for the Black-Scholes model to be Although these assumptionsoare o correct - if they do not eb a variation is often available. Many financial scholars hold, have expanded upon the original work. For example, in 1973, Robert Merton
relaxed the assumption of no dividends by simply reducing the current share price by the present value of all dividends expected to be paid before expiry of the option. These dividends must be discounted at the risk free rate. Therefore, if a current share price is 520p and a dividend of 21p is expected to be paid shortly before expiry of a call option in one years time and the risk-free rate of interest is 5%, Pa will become: 520p (21p 1.05) = 500p. In 1976, Jonathan Ingerson relaxed the assumption of no taxes or transaction costs, whilst Merton responded by removing the restriction of constant interest rates. The values of the options given by the Black-Scholes model vary considerably. The impact of changes in s (i.e. the ) and time to expiry have a particularly large impact on value. A number of computer programs have been developed to permit analysts to calculate quickly the option values using this model and variations of it. This clearly simplifies the complex and laborious calculations.
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351
Illustrations of the Black-Scholes model

1. The following details relate to an option to buy one share in Hoult plc: Strike price = 45p Time remaining to expiration = 183 days Current share price = 47p Expected price volatility = standard deviation = 25% Short-term risk-free rate = 10% Calculate the price of a European call option premium using the Black Scholes option pricing model. 2. The following details concern the shares and related call options of Lyttle plc: Current share price = 165p Exercise price = 150p Risk-free interest rate = 6% Time to the options expiry = 2 years
3.
m co using the Black Scholes Calculate the price of a European call option premium t. option pricing model. po s log share in Clement plc at 65p when Consider an option to purchase an ordinary .b the price of the share is 62.5p. 00 option will expire in four months or 120 The days. The risk-free interest 20 is 5 per cent. The volatility of Clement plc rate ks shares as measured by the standard deviation of the return on the shares for o the 120-day period to o b expiry is estimated to be 40%. e Calculate the price of a European call option premium using the Black Scholes
Volatility (standard deviation) of share price = 15% option pricing model. A call option on an ordinary share in Gilchrist plc has a strike price of 1.20. The current share price is 1.50 and the risk free rate of interest is 7.5%. The standard deviation of the share is measured at 25% for the 6 month period to maturity. Calculate the price of a European call option using the Black Scholes option pricing model.
4.
5.
The current share price of McInnes plc is 2.90. Estimate the value of a European call option on the shares of the company (with an exercise price of 2.60) which has 6 months to run before it expires. The risk free rate of interest is 6% and the variance of the rate of return on the share has been 15%. The price per ordinary share of Balis plc is 36p, whilst the exercise price is 40p. The risk-free interest rate is 10%, whilst the standard deviation of the rate of return is 40% and the time to expiry is 90 days. Calculate the price of a European call option premium using the Black Scholes option pricing model.
6.
352
7.
From the following data, calculate the call premium on an ordinary share of Butler plc. The share price is 1, whilst the related strike price is 90p. The risk free interest rate is 10%. The volatility (measured by standard deviation) is 30%, whilst the remaining time to expiry is 90 days.
Suggested solutions to illustrations

1. Pe t Pa s r d1 = = = = = = 45 0.5 47 0.25 0.1 (183/365, rounded)
ln(47 45) + 0.1 + 0.5 0.252 0.5 0.25 0.5

0.0435 + 0.05 + 0.015625 0.1768 0.109125 0.1768 0.6172 0.6172 0.25 x
= = = d2 =
0.5
Using the standard normal distribution tables: d1 d2 = =
k oo 0.1700 0.4404 eb gives

0.6172 gives 0.2324 0.5 + 0.2324 0.5 + 0.17 = = 0.7324 0.67 (47 x 0.7324) (45 x 0.67 x e-0.1 x 0.5) 34.423 (45 x 0.67 x 2.7183-0.05) 34.423 (45 x 0.67 x 0.9512) 34.423 28.68 5.74p
0 s2
lo .b= 0
p gs
o t.c
0.4404
N(d1) = N(d2) = c = = = = =
353
2.
Pa Pe r t s d1 =
= = = = =
165 150 0.06 2 0.15
ln(165 150) + 0.06 + 0.5 0.152 2 0.15 2

0.0953 + 0.12 + 0.0225 0.2121 0.2378 0.2121 1.121 1.121 0.15 2 = 0.91
= = = d2 =
Using the standard normal distribution tables: d1 d2 = = 1.121 0.91 gives 0.3686 gives 0.3186 = = 0.8686 0.8186
N(d1) = N(d2) = c = = = = =
0.5 + 0.3686 0.5 + 0.3186
0 20 x 2.7183 s 143.319 (150 x 0.8186 ok o 143.319 b(150 x 0.8186 x 0.8869) e

143.319 108.905 34.41p
(165 x 0.8686) (150 x 0.8186 x e-0.06 x 2)

-0.12
.bl 0
p gs
o t.c
354
3.
Pe Pa t r s d1 =
= = = = =
65 62.5 0.33 (about four months) 0.05 0.4
ln(62.5 65) + 0.05 + 0.5 042 0.33 0.4 0.33

0.0392 + 0.0165 + 0.0264 0.2298 0.0037 0.2298 0.016 0.016 0.4 0.33 = 0.2138
= = = d2 =
Using the standard normal distribution tables: d1 d2 = = 0.016 gives 0.0080 0.2138 gives 0.0832 0.5 + 0.008 0.5 0.0832 = = 0.508
N(d1) = N(d2) = c = = = = =
(62.5 x 0.508) (65 x 0.4168 x 2.7183-0.05 x 0.33) 31.75 (65 x 0.4168 x 2.7183-0.0165) 31.75 (65 x 0.4168 x 0.9836) 31.75 26.65 5.1p
o bo
0 s2
0.4168
.bl 0
p gs
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355
4.
Pe Pa t r s d1 =
= = = = =
120 150 0.5 0.075 0.25
ln(150 120) + 0.075 + 0.5 0.252 0.5 0.25 0.5

0.2231 + 0.0375 + 0.015625 0.1768 0.27622 0.1768 1.5624 1.5624 0.25 0.5 = 1.386
= = = d2 =
Using the standard normal distribution tables: d1 d2 = = 1.5624 1.386 gives 0.4406 gives 0.4177 = = 0.9406
N(d1) = N(d2) = c = = = = =
0.5 + 0.4406 0.5 + 0.4177
(150 x 0.9406) (120 x 0.9177 x e-0.075 x 0.5) 141.09 (120 x 0.9177 x 2.7183-0.0375) 141.09 (120 x 0.9177 x 0.9632) 141.09 106.07 35.02p
o bo
0 s2
0.9177
.bl 0
p gs
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356
5.
Pa Pe t r s2 d1 =
= = = = =
290 260 0.5 0.06 0.15
ln(290 260) + (0.06 + 0.5 0.15)0.5 0.15 0.5 0.1092 + 0.03 + 0.0375 0.075
= = d2 =
0.1767 0.2739 0.6451 0.6451 0.15 0.5 = 0.3712
N(d1) = N(d2) = c = = = = =
0.5 + 0.2422 0.5 + 0.1443
(290 x 0.7422) (260 x 0.6443 x e-0.06 x 0.5) 215.24 (260 x 0.6443 x 2.7183-0.03) 215.24 (260 x 0.6443 x 0.9704) 215.24 162.57 52.67p
o bo
0 s2
0.6443
.bl 0
p gs
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357
6.
Pa Pe r s t d1 =
= = = = =
36 40 0.1 0.4 0.25 (90/365, rounded)
ln(36 40) + 0.1 + 0.5 0.42 0.25 0.4 0.25

0.1054 + 0.025 + 0.02 0 .4 0 .5 0.604 0 .2 0.302 0.302 0.4 0.25 = 0.502
= = = d2 =
N(d1) = N(d2) = c = = = = =
0.5 0.1179 0.5 0.1915
(36 x 0.3821) (40 x 0.3085 x e-0.1 x 0.25) 13.76 (40 x 0.3085 x 2.7183-0.025) 13.76 (40 x 0.3085 x 0.9753) 13.76 12.04 1.72p
o bo
0 s2
0.3085
.bl 0
p gs
o t.c
358
7.
Pa Pe r s t d1 =
= = = = =
100 90 0.1 0.3 0.25 (90/365, rounded)
ln(100 90) + 0.1 + 0.5 0.32 0.25 0.3 0.25

0.1054 + 0.025 + 0.01125 0.15 0.14165 0.15 0.9443 0.9443 0.3 0.25 = 0.7943
= = = d2 =
N(d1) = N(d2) = c = = = = =
0.5 + 0.3264 0.5 + 0.2852
(100 x 0.8264) (90 x 0.7852 x e-0.1 x 0.25) 82.64 (90 x 0.7852 x 2.7183-0.025) 82.64 (90 x 0.7852 x 0.9753) 82.64 68.92 13.72p
o bo
0 s2
0.7852
.bl 0
p gs
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359
PUT-CALL PARITY
Once a value has been established for call options, the following equation can be used to establish the value of a put option with the same exercise price and expiry date as the related call: Price of a put Current value of underlying security Present value of the exercise price
Price of a call
c Pa + Pe e
-rt
Referring to the earlier illustrations, the related put premium in each case is:
Example
1. = = 2. = = 3. = = 4. = = 5. = = 6. = = 7. = = 5.74 47 + (45 x e-0.1 x 0.5) 5.74 47 + (45 x 2.7183-0.05) 5.74 47 + 42.81 34.41 165 + (150 x e-0.06 x 2) 34.41 165 + (150 x 2.7183 34.41 165 + 133.04
-0.12
1.55p
0 s2 5.1 62.5 + (65 x 2.7183 k oo 5.1 62.5 + 63.94 eb

35.02 150 + 115.58
5.1 62.5 + (65 x e-0.05 x 0.33)
.bl 0
)
p gs =
o t.c
2.45p
-0.0165
6.54p
35.02 150 + (120 x e-0.075 x 0.5) 35.02 150 + (120 x 2.7183-0.0375) = 0.6p
52.67 290 + (260 x e-0.06 x 0.5) 52.67 290 + (260 x 2.7183-0.03) 52.67 290 + 252.32p 1.72 36 + (40 x e-0.1 x 0.25) 1.72 36 + (40 x 2.7183-0.025) 1.72 36 + 39.01 13.72 100 + (90 x e-0.1 x 0.25) 13.72 100 + (90 x 2.7183-0.025) 13.72 100 + 87.78 = 1.5p = 4.73p = 14.99p
360
THE GREEKS
In principle, an option writer could sell options without hedging his position. If the premiums received accurately reflect the expected payouts 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
m co number of options than t. Therefore, the writer of options needs to hold five times the po likely to change during the s shares to achieve a delta hedge. The delta value is period of the option, and so the option writer may need to change his holdings to log .b maintain his delta hedge position. 00 Accordingly a writer can hedge a 20 holding of 300,000 shares using options with a ks delta value estimated by N(d ) of 0.6, by holding the following number of LIFFE o contracts (each on 1,000 bo shares). e 300,000 Number of shares
1
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.
Delta value Contract size
0.6 1,000
500 contracts.
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 outof-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-themoney 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
361
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
m co t. Rho measures how much the option premium responds to changes in interest rates. po todays price will be a Interest rates affect the price of an option s g because discounted value of future cash flows with lo interest rates determining the rate at which this discounting takes place. Thus: .b 0 00 Change in the option price 2 Rho = ks Change in the rate of interest o bo e Summary of the Greeks
5. Rho
Changes in DELTA GAMMA VEGA THETA RHO Option premium Delta value Option premium Time value in option premium Option premium In response to changes in Value of underlying security Value of underlying security Volatility Time to expiry Risk free rate of interest
362
REAL OPTIONS
Flexibility increases the value of an investment and financial options theory provides a guide as to how this flexibility can be incorporated into project appraisal. Conventional project appraisal techniques do not adequately recognise the value of flexibility. However, real options theory attempts to apply the principles used in the evaluation of financial options and develop them for use in capital investment appraisal. In some project evaluation situations, a company may have one or more options to make strategic changes to the project during its life e.g. the: Option to delay (i.e. defer investment without loss of the opportunity for further investment, effectively creating a call option); Option to expand (i.e. to increase the scale of investment if market conditions change). Thus the right to expand is effectively a call option; Option to abandon (i.e. where a project consists of clearly identifiable stages, an abandonment option can be considered at the end of each stage, if this is preferable to continuation). The right to generate some salvage value if abandonment occurs is effectively a put option; Option to redeploy (i.e. switch to another use). This could result in the creation of a put option if there is salvage value from the work already performed, together with a call option arising on the right to commence the new investment at a later stage.
o .bloptions to change inputs or outputs, 0 There may even be options to downsize, 00 options to shut down and then subsequently restart or, perhaps, options to invest s2 in stages (as opposed to one ok single major investment). o The building of the East Stand at West Bromwich Albion FC is cited as an example eb
of real options in investment appraisal. This stand, which contains extensive corporate facilities, was built between 1999 and 2001 as a single tier stand. However, due to the stronger foundations which were laid and the design of exits and walkways etc., it would be relatively straightforward to add a second tier at some future stage without having to demolish the existing first tier. Obviously, this single tier stand was more expensive to build than a conventional one tier stand, but the additional expenditure was the premium that was paid as a call option to expand, if or when attendances grow to justify the additional ground capacity. The Black-Scholes option pricing model can be applied to real options (sometimes referred to as embedded options), where there is a single source of uncertainty and a single expiry date (i.e. a European style option). Obviously this model employs the usual five features i.e.
p gs
o t.c
Pa Pe s
: : :
The value of the underlying asset is no longer a share price, but the PV of the future cash flows arising from the project; The exercise price is the capital expenditure (or receipts) arising from the option; This will represent the volatility (in the form of the ) of the operating cash flows related to projects of the type under consideration;
363
This is the risk free rate of interest, however some writers believe that additional project risk should be reflected with the use of a higher interest rate; This is, as usual, the time to expiry for exercising a European style option.
Illustration of an option to expand

Winter plc has investigated the opening of a new restaurant in the Isle of Man. The initial capital expenditure is estimated at 12 million, whilst the present value of the net cash inflows is expected to be 12.005 million. Since the resulting NPV of 0.005 million is a very small positive amount, this appraisal suggests that the project is extremely marginal. However, if this first restaurant is opened, Winter plc would gain the right, but not the obligation to open a second restaurant in five years time at a capital cost of 20 million. The present value of the associated future net cash inflows is estimated at 15 million, with a standard deviation of 28.3%. If the risk free rate of interest is 6%, determine whether to proceed with the restaurant projects.
o bo
0 s2
.bl 0
p gs
o t.c
364
t d1 = 5; = Pe = 20; Pa = 15; s = 0.283; r = 0.06
ln(15 20) + 0.06 + 0.5 0.2832 5 0.283 5

0.2877 + 0.3 + 0.2002 0.6328 = 0.2125 0.6328 = = 0.3358 0.297
= d2 =
0.3358 0.283 5
Using the standard normal distribution tables: d1 d2 c = 0.3358 = 0.297 = = = = gives gives 0.1331; 0.1179; thus thus N(d1) N(d2) = 0.5 + 0.1331 = 0.5 0.1179 = 0.6331 = 0.3821
(15 x 0.6331) (20 x 0.3821 x e-0.06 x 5) 9.4965 (20 x 0.3821 x 0.7408) 9.4965 5.6613 3.8352m
Conclusion:
NPV of first restaurant Value of call option (to expand) on second restaurant Value of combined projects
o bo
0 s2
.bl 0
p gs
o t.c
m 0.005 3.8352 +3.8402
Therefore the project should be accepted, since the additional value (which incorporates the option to expand), allows Winter plc to avoid the downside element of risk.
Illustration of an option to abandon

Summer plc is undertaking a brewing joint venture with Autumn Inc. This project requires an initial outlay by Summer plc of 250 million. The present value of the net cash inflows is expected to be 254 million, with a variance of 9%. The arrangement thus provides an extremely small positive NPV of 4 million. Summer plc, however, has the right but not the obligation to sell its share of the joint venture to Autumn Inc for 150 million at the end of the first five years of the venture. If the risk free rate of interest is 7%, calculate the value of this abandonment option.
365
Pa = 254; Pe = 150; s2 = 0.09; t = 5; r = 0.07
Firstly, calculate the value of the call option: d1 =
ln(254 150) + (0.07 + 0.5 0.09)5 0.09 5

0.5267 + 0.35 + 0.225 0.6708 1.6423 0.6708 = = 1.6423 0.9715
= d2 =
Using the standard normal distribution tables: d1 d2 c = 1.6423 = 0.9715 = = = gives gives 0.4495; 0.3340; thus thus N(d1) N(d2) = 0.5 + 0.4495 = 0.5 + 0.3340 = 0.9495 = 0.8340
(254 x 0.9495) (150 x 0.8340 x e-0.07 x 5) 241.173 (150 x 0.8340 x 0.7047) 241.173 88.156 = 153.017
Secondly, using the put call parity relationship, calculate the value of the put option p = = = =
00 22.7183 153.017 254 + (150 x s ok o 153.017 254 + 105.703 eb 4.72m

c - Pa + P e e
-rt
.bl 0
p gs
)
o t.c
-0.07 x 5
Alternatively, it is possible to directly calculate the value of the put option using the following modified Black-Scholes formula, but this is not provided on the ACCA formula sheet:
p
where: N(d1) N(d2) p
Pe N(d2)e-rt Pa N(d1)
= = = = = =
0.5 0.4495 0.5 0.3340
= =
0.0505 0.166
(150 x 0.166 x 2.7183-0.35) (254 x 0.0505) (150 x 0.166 x 0.7047) 12.827 17.547 12.827 4.72m
366
Conclusion: m 4 4.72 +8.72
NPV of joint venture project Value of put option (to abandon joint venture) Total NPV with the abandonment option
Therefore Summer plc should go ahead with the joint venture, since the additional value, which incorporates the option to abandon allows Summer plc to avoid the downside element of risk.
o bo
0 s2
.bl 0
p gs
o t.c
367
APPLYING THE BLACK SCHOLES MODEL TO ESTIMATE THE VALUE OF EQUITY

A major aspect of the P4 syllabus is the emphasis on corporate valuation. There may, of course, be some companies that cannot realistically be valued by conventional techniques. 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. Some authors refer to the Black Scholes Merton model to reflect the work performed by Robert Merton (a key member of the research team which developed the model). The usual determinants in the valuation of options need to be redefined, when the valuation of equity is treated as a call option:
Determinants
Valuation of the underlying Exercise price Volatility of the underlying
Possible appropriate measures

The fair value of the assets of the company Settlement values of outstanding liabilities Standard deviation of underlying assets
o sp debt Risk-free rate of interest Current yield on company log .b Time to expiry Average period to settlement of company liabilities 00 0 s2 Where the assets of the company are actively traded and easily liquidated, their k current market value would be appropriate. In the case of most companies, fair oo eb value will normally be based upon the present value of the future cash flows that
the companys 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 companys liabilities consist entirely of debt in the form of a zero coupon bond. If the companys debt includes other types of bond, adjustments are necessary as shown in the following illustration.
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Illustration 1
A company has on issue a 5% bond with five years to redemption with a gross yield to maturity of 8%.
Required:
Estimate the market value of that bond and that of an equivalent zero coupon bond.
368
Solution 1
The market value of the debt is estimated as follows:
Year Annual interest and redemption payments () Discount factors @ 8% Present values ()
Present value of debt = 88.06
1 5 0.926 4.63
2 5 0.857 4.29
3 5 0.794 3.97
4 5 0.735 3.67
5 105 0.681 71.50
The redemption value of a zero coupon bond of the same market value is calculated by establishing the unknown future value which (when discounted at 8% p.a. for a five year period) provides a present value of 88.06 i.e. Future value = 88.06 x 1.085 = 129.39 Therefore 129.39 is treated as the exercise price (i.e. the redemption value of a zero coupon bond with the same features as the debt currently in issue, which has a yield to maturity of 8%). Assuming that acceptable estimates of the input variables have been established, the next step is to incorporate them into the BSOP model. The model does have a number of restricting assumptions, but it can be used to produce an acceptable valuation of a company.
Illustration 2
In March 2007, Northern Rock (a UK bank) reported assets and liabilities at fair values of 113.2 billion and 110.7 billion respectively. The average term to maturity on the liabilities of the bank (which consisted of short-term money market borrowing and deposits) was 100 trading days, whilst the annual number of trading days was 250 approximately. At that time the risk-free rate of interest was 3.5% and the company had 495.6 million equity shares in issue.
o bo
0 s2
.bl 0
p gs
o t.c
Required: (a)
Using the BSOP (sometimes referred to as the Black Scholes Merton) model, estimate the share price of Northern Rock in each of the following situations: (i) (ii) Assuming that the standard deviation of the banks assets was 5%; and Assuming that the volatility of the banks assets was 10%.
(b)
Using the Black Scholes Merton model, recalculate an estimate of the share price of Northern Rock if the fair value of the companys assets fell to 110.7 billion and their volatility was 5%. Comment upon the results and consequences of the calculations performed in parts (a) and (b) above.
(c)
369
Solution 2
This entire procedure is based on the notion that if equity shareholders pay off the liabilities at expiry date, they are effectively paying the exercise price of a call option and thus exercising their right to buy the underlying assets of the company at their fair value. Taking the data provided and converting to the ACCA symbols:
(a) Pa = 113.20; Pe = 110.70; r = 0.035; t = (100 250) = 0.4 (since the annual number of trading days is 250); s is initially taken as 0.05 and, subsequently as 0.1 (i) If volatility (s or ) = 0.05:
d1 =
ln(113.20 110.70) + 0.035 + 0.5 0.052 0.4 0.05 0.4

0.0223323 + 0.014 + 0.0005 0.0316227 0.0368323 0.0316227 1.16474 - 0.0316227
= = d2 =
From Normal Distribution tables:

d1 = gives eb
1.16474, by interpolation: 1.16 1.17 1.16 0.3770 0.3790 0.3770 0.0020 gives gives (474 1000)
k oo
0 20
log .b
po
m co = t.
=
1.16474 1.13312
0.00095 0.37795
d2
1.13312, by interpolation: 1.13 1.14 1.13 gives gives gives (312 1000) 0.3708 0.3729 0.3708 0.0021
0.00065 0.37145
Of course, in an exam it is quicker to round up or down to the two decimal places provided by the ACCA tables. In this case, 1.16 (giving 0.3770) and 1.13 (giving 0.3708) would be used!
N(d1) N(d2) c = = = = = 0.5 0.5 + + 0.37795 0.37145 = =
0.87795 0.87145
(110.70 x 0.87145 x e
-0.035 x 0.4
(113.20 x 0.87795) 99.384 99.384
(110.70 x 0.87145 x 0.98610) 95.128 = =
4.258 bn 8.59 per share
Price
(4.258 bn 495.6 m shares)
370
(ii)
If volatility (s or ) = 0.1:
d1 =
ln(113.20 110.70) + 0.035 + 0.5 0.12 0.4 0.1 0.4

0.0223323 + 0.014 + 0.002 0.0632455 0.0383323 0.0632455 0.60609 0.0632455 =
= =
0.60609 0.54284
d2

d1 = 0.60609, by interpolation: 0.60 0.61 0.60 gives gives gives (609 1000) 0.2257 0.2291 0.2257 0.0034
0.00207 0.22777
d2
0.54284, by interpolation: 0.54 0.55 0.54 gives gives gives (284 1000) 0.2088 0.2054 0.0034
0 20 round up or down to the two decimal places Again, in an exam it is quicker to ks provided by the ACCA o tables. In this case, 0.61 (giving 0.2291) and 0.54 o (giving 0.2054) would be used! eb
N(d1) N(d2) c = = = = = 0.5 0.5 + + 0.22777 0.20637 = =
.bl 0
x
p gs
m co0.2054 t.
= 0.00097 0.20637
0.72777 0.70637
(110.70 x 0.70637 x e
-0.035 x 0.4
(113.20 x 0.72777) 82.3836 82.3836
(110.70 x 0.70637 x 0.98610) 77.1082 = =
Price
(5.2754 bn 495.6 m shares)
(b)
In this instance, the asset value (Pa) falls and is now equal to the liability value (at a volatility of 0.05), so that both Pa and Pe become 110.70. All other facts are unchanged. The calculations are: d1 =
ln(110.70 110.70) + 0.035 + 0.5 0.052 0.4 0.05 0.4

0 + 0.014 + 0.0005 0.0316227
371
= d2 =
0.0145 0.0316227 0.45853 0.0316227
= =
0.45853 0.42691

d1 = 0.45853, by interpolation: 0.45 0.46 0.45 gives gives gives (853 1000) 0.1736 0.1772 0.1736 0.0036
0.0031 0.1767
d2
0.42691, by interpolation: 0.42 0.43 0.42 gives gives gives (691 1000) 0.1628 0.1664 0.1628 0.0036
0.0025 0.1653
Once more, in an exam it is quicker to round up or down to the two decimal places provided by the ACCA tables. In this case, 0.46 (giving 0.1772) and 0.43 (giving 0.1664) would be used!
N(d1) N(d2) c = = = = = 0.5 0.5 + + 0.1767 0.1653 = =
(110.70 x 0.6767) 74.9107 74.9107
o bo
0 20 s

lo .b0.6653 0
0.6767
p gs
o t.c
(110.70 x 0.6653 x e
-0.035 x 0.4
(110.70 x 0.6653 x 0.98610) 72.6250 = =
Price (c)
(2.29 bn 495.6 m shares)
Comments
As can be seen from the calculations in part (a), the value of an option increases as the level of risk rises. At a standard deviation of 5%, the share price is 8.59, whilst at a volatility of 10%, the share price rises to 10.64. The actual share price of Northern Rock in March 2007 fluctuated around 9.50 per share. In part (b) of this illustration, the fair value of the banks assets fell to 110.7 billion to be equal to the fair value of its liabilities. Accordingly, the Statement of financial position would show an equity value of zero. However, the BSOP model shows a quite different result, at a volatility of 5% the total value of the equity is still worth 2.29 billion, that is 4.62 per share almost precisely its value in September 2007! At this date, the information being released from the company suggested that its assets had fallen in value as the banks mortgage receivables were written down in line with falling house prices and potential defaults. It was only when the threat of nationalisation became a real possibility (during the final months of 2007) that the equity value began to collapse - and this can be explained within the framework of the BSOP model. Nationalisation eliminates the possibility of asset recovery for the shareholders. This deprives them of the time value on their call option on the underlying assets of the business.
372
The rationale for this rather strange result is that the equity of a business can still have a substantial positive value (despite the Statement of financial position showing a zero equity value) because of the presence of limited liability! Limited liability protects shareholders from a loss - and in fact they have everything to gain if the fair value of the assets should recover! When the equity of a company is at or near the money, ie when its gearing levels approach 100%, the equity investors will become increasingly risk aggressive (i.e. risk-seeking). Agency theory suggests they will provide management with incentives to increase risk, rather than reduce it. Hence, the very high levels of reward offered to bank employees, particularly those employed in the risk-taking departments of the business. The work of Black, Scholes and Merton provides a framework to value those companies that are financed, in part, by borrowing. Where shareholders are protected by limited liability, they have a call option on the underlying business assets. Employing the BSOP model, an estimate can be made of the value of a companys equity on the basis of the value of its assets and their volatility. For companies that are deep in-the-money, time value is small and the intrinsic value of the business (i.e. the present value of the net assets) will dominate the value of the equity. In this case, normal risk aversion can be expected to apply as that intrinsic value will be exposed to equal positive and negative movements in the value of the companys assets. This situation dramatically changes when companies are near-the-money. This occurs with high growth start-ups financed by debt, leveraged buyouts and companies that are in risk of default. One class of company (banks) always operate near-the-money, and in valuing such businesses, time value would be more significant than intrinsic value in equity valuation. When time value dominates, shareholders become risk-seekers and they will grant management incentives to take greater risk, which will cause the company to be pushed closer and closer to-the-money, by expanding assets and liabilities without increasing the equity capital.
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373
LIFFE EQUITY OPTIONS TABLE
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374
Chapter 17
Hedging interest rate risk
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375
C H A P T E R 1 7 H E D G I N G IN T E R E S T R A T E R I S K
CHAPTER CONTENTS
METHODS OF HEDGING INTEREST RATE RISK ---------------------- 377
FORWARD RATE AGREEMENTS (FRA) INTEREST RATE GUARANTEES (IRG) INTEREST RATE FUTURES OPTIONS ON INTEREST RATE FUTURES 377 377 378 379
THE MACAULAY DURATION METHOD --------------------------------- 401 TERM STRUCTURE OF INTEREST RATES ------------------------------ 404
THE NORMAL YIELD CURVE THE INVERSE YIELD CURVE 404 405
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376
METHODS OF HEDGING INTEREST RATE RISK

There are a number of methods that may be used by a company to reduce its exposure to possible adverse fluctuations in interest rates, in either a borrowing or lending arrangement. The main methods are as follows:
Forward rate agreements (FRA)

A forward rate agreement allows a company to effectively agree with a banker a fixed interest rate for a specified level of borrowing or lending for a given future period. An FRA is commonly quoted so as to specify the number of months hence when the borrowing or lending starts and the number of months hence when it finishes. For instance, where a company wishes to borrow for a five month period starting in two months time, this would require a 2 v.7 FRA, i.e. the borrowing will start in two months time and end in seven months time. Accordingly, a company which has borrowed at a floating rate of interest may enter into an FRA, which effectively locks the company into a fixed rate of interest. Whatever happens, the company will continue to pay its original lender the appropriate amount of interest based upon the agreed floating rate.
po sthe percentage agreed under the However, if actual interest rates rise higher than log FRA, the bank will pay the amount of .b difference as compensation to the the company. If rates fall lower than agreed, the company must pay the difference as 00 0 compensation to the bank. s2 k Conversely a lender (i.e. investor) may enter into a similar agreement. If actual oo floating interest rates fall below the agreed fixed percentage, the bank will pay the eb
difference to the company. If rates rise above that specified in the FRA, the company must pay the difference to the bank. FRAs involve no borrowing or lending of the principal sum. They are usually for at least 500,000 (or the equivalent in major currencies) and for periods of less than one year.
o t.c
Interest rate guarantees (IRG)

An interest rate guarantee is an interest rate option specifically arranged with a bank, i.e. it is an over-the-counter (OTC) product. An IRG provides the right, but not the obligation, to pay or receive a fixed specified rate of interest for a defined period of time. Accordingly, it would provide a borrower with the assurance of never paying more than a maximum interest rate (a cap) or give an investor the peace of mind of never earning less than a minimum interest rate (a floor). However, an IRG, like all options will allow the buying company to take advantage of favourable movements in interest rates. An interest rate guarantee therefore gives the best of both worlds, in that if a borrower purchases such an option, it will be exercised if rates rise above the guaranteed percentage, but will be abandoned if rates fall below that percentage, so that the borrower will be able to take advantage of the lower market interest rates.
377
Equally, if an investor buys an interest rate guarantee, it will be exercised if rates fall below the guaranteed percentage, but will be allowed to lapse if rates rise above that percentage, so that the investor can take advantage of the higher market interest rates. The opportunity to abandon the arrangement is not available with FRAs or the futures market. However this advantage must be weighted against the price of the option (the premium) which must be paid up-front to the bank. Many companies consider that they are too expensive since a significant premium is payable.
Interest rate futures

An interest rate future is a binding contract between a buyer and a seller for delivery of an agreed interest rate commitment on an agreed date and at an agreed price. It can be used to protect against unwanted interest rate movements. For example, if a borrower is worried about interest rates rising, it may sell interest rate futures, knowing that if interest rates do rise, the price of the futures will fall, allowing the borrower to buy them back at a lower price. The gain on the futures market can be offset against the additional interest suffered. The reverse happens if interest rates fall. This will have the effect of more or less fixing the effective interest rate paid by the borrower. Equally, if an investor is concerned about interest rates falling, it may buy interest rate futures, knowing that if interest rates do fall, the price of the futures will rise, allowing the investor to sell them at a higher price. The gain on the futures market can be added to the smaller amount of interest actually earned. The reverse happens if interest rates rise. This again has the effect of more or less fixing the effective interest rate received by the investor. 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.
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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 (of between 5% and 10% of contract value) is the sum deposited when the contract is first made. Variation margin is payable or receivable to reflect the day-to-day profits or losses made on the futures contract. If the futures price moves adversely a cash payment must be made to the Clearing House, whilst if the futures price moves favourably the party concerned can elect to receive a cash refund from the Clearing House. This process of realising profits or losses on a daily basis is known as marking to market.
Contract sizes are for fixed sums, e.g. 500,000 for short sterling contracts, which means that a perfect hedge is difficult to achieve. A further reason why a perfect hedge is unlikely is basis risk i.e. the possibility of variability in the prices of the two related securities in the hedging arrangement. For example, if changes in the price of the interest rate future do not perfectly match the changes in the rate of interest, a profit or loss may occur on the hedge position.
378
Futures contracts are available from LIFFE (London International Financial Futures and Options Exchange). In 2002, LIFFE was taken over by Euronext and is now known as Euronext.liffe.
Options on interest rate futures

These exchange traded instruments provide the buyer with the right, but not the obligation to buy or sell the related interest rate futures contract. Once more, the objective is to protect the buyer of the instrument against unwanted interest rate movements. LIFFE deals in option contracts in standard amounts (e.g. 500,000 for short sterling contracts), at standard exercise prices and expiry dates. These traded options are of two kinds:
put options carry the right to sell the related interest rate futures contract, and call options carry the right to buy the related interest rate futures contact.
LIFFE offers these option contracts at a limited number of different exercise (strike) prices. The buyer of the option is required to pay a non-refundable option premium for the flexibility of being allowed to exercise or abandon the option. This premium is the maximum that the buyer can lose on the deal. A writer receives the premium for having taken on the obligation to go through with the deal should the buyer so elect. The writer of an option risks potentially unlimited losses.
0 20 rates rising, but is not totally convinced that s If a borrower is worried about interest ok they will in fact do so, he may decide to buy put options. o eb If interest rates do subsequently increase, the borrower can exercise the put option
Borrowers
and thus sell the related interest rate futures contract, then immediately buy it back at a profit. This gain will obviously offset the additional interest payment suffered on the amount of the borrowing. Should interest rates subsequently remain steady or indeed fall, the borrower would then allow the put option contracts to lapse.
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Investors
If an investor is fearful that interest rates will fall, but is not totally convinced that they will in fact do so, he may decide to buy call options. If interest rates do subsequently decline, the investor will exercise the call option and thus buy the interest rate futures contract, then immediately sell it at a profit. This gain will of course compensate for the smaller amount of interest received on the investment. Should interest rates subsequently remain steady or actually increase, the investor would then abandon the call option contracts.
379
Illustration 1
It is now 31 December 2006. The corporate treasurer of Tripod plc is concerned about the level of cash flows of the company during the next six months, and how the company might be protected from the adverse effects of changing interest rates. Interest rates are widely expected to change in late April when a General Election is due, but the size and direction of the change is dependent upon the result of the election which is forecast by opinion polls to be very close. Current interest rates for Tripod are 11% per year for short-term borrowing, and 8% per year for short-term investment. Apart from an overdraft facility to finance short-term cash shortages, the company has no other form of floating rate debt. Cash forecasts reveal that the company expects to have a fairly consistent overdraft level of approximately 2,420,000 between the end of April and the end of June 2007. June sterling three months deposit futures are currently priced at 90.25. The standard contract size is 500,000 and the minimum price movement is one tick (the value of one tick is 0.01% per year of the contract size). Interest rate guarantees at 11.5% per year for a two month period from May are available to Tripod for a premium of 0.2% of the size of the loan to be guaranteed. Forward rate agreements are available for period of up to four months from May at 11.88-11.83%.
Required:
If at the end of April, interest rates have moved as follows:
Scenario (1)
Borrowing rate for Tripod 13% per year Investment rate for Tripod 10% per year June sterling three month time deposit futures 88.05
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Scenario (2)
Borrowing rate for Tripod 9.5% per year Investment rate for Tripod 6.8% per year June sterling three month time deposit futures 91.75, evaluate with hindsight, separately for each of scenarios (1) and (2) above, the results of four alternative strategies that the company might have adopted towards its interest rate risk. Taxation, margin requirements and the time value of money may be ignored.
380
Solution 1
Four strategies that the company could adopt are as follows: 1. 2. 3. 4. Adopt no protective strategy on the basis that the companys exposure to adverse rate movements may be negligible; Enter into forward rate agreements (FRAs) with bank; Use interest rate guarantees; or Use sterling three month interest rate futures.
Each of these strategies is considered in turn. Tutorial note: since the question only gives data for the prices of FRAs, interest rate guarantees and futures we have no choice but to select these strategies. There is no further information on the fourth strategy, so it must be to do nothing. The risk exposure from interest rates is sometimes very small. Given that rates can move favourably as well as unfavourably, it may be appropriate for no complex hedging strategy to be adopted. The cost of a hedging strategy might be avoided if the risk of adverse movements were minimal.
1.
No hedge
=
Scenario I May and June interest Scenario II May and June interest =
2.42m x 13% x 2/12
2.
Use an FRA
(A 4 v. 6 FRA is needed i.e. one starting 4 months hence and ending in 6 months time) Scenario I = 52,433 = (4,517) = 47,916
o bo
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2.42m x 9.5% x 2/12
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m
= 52,433
38,317
Cost in cash market Less compensation paid by the bank to Tripod May and June interest Scenario II
= 2.42m x 13% x 2/12 2.42m x (11.88% 13%) x 2/12 = 2.42m x 11.88% x 2/12
Cost in cash market Plus compensation paid by Tripod to the bank May and June interest
= 2.42m x 9.5% x 2/12 2.42m x (11.88% 9.5%) x 2/12 = 2.42m x 11.88% x 2/12
= 38,317 = 9,599
= 47,916
(Tutorial note: once the FRA has been entered into, the interest paid by the company for the two months will be 47,916, whatever the prevailing level of interest rates).
381
3.
Interest rate guarantee

= = = 0.2% x 2.42m = 4,840 46,383 51,223
Scenario I Premium payable Interest payable Total cost of strategy Scenario II Premium payable = 4,840 (as above)
2.42m x 11.5% x 2/12 = 4,840 + 46,383 =
This time the option will be abandoned, so the company can enjoy the lower prevailing interest rate. Interest payable = 2.42m x 9.5% x 2/12 4,840 + 38,317 = = 38,317 43,157
Total cost of strategy =
4.
Use futures
= 52,433
Scenario I
m In December, the company wants to hedge for two months an amount of 2.42m co . using three month futures contracts each of 500,000.t po s 2 2.42m Therefore need to sell = 3.22 contracts log 3 0.5m .b 0 We may choose to round down to 300 contracts see result in the Summary shown 2 below. However, rounding up,sthe company must sell 4 contracts to be fully k o hedged. bo e Profit on the futures contracts = 4 x (90.25 88.05)
= = = 4 x 220 ticks 4 x 220 x 12.50* 11,000 = = 41,433 12.50
Cash market: May and June interest, as i) above
The net interest payable is 52,433 11,000 *Note: one tick is valued at 0.0001 x 500,000 x 3/12 Scenario II Cash market: May and June interest, as i) above Loss on the futures contracts = = = = 4 x (91.75 90.25) 4 x 150 ticks 4 x 150 x 12.50 7,500
38,317
The net interest payable is 38,317 + 7,500
45,817
382
SUMMARY
Scenario I 52,433 47,916 51,223 44,183 41,433 Scenario II 38,317 47,916 43,157 43,942 45,817
No hedge FRA Interest rate guarantee Futures Using 3 contracts Using 4 contracts
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383
Illustration 2
The corporate treasury team of Murwald plc are debating what strategy to adopt towards interest rate risk management. The companys financial projections show an expected cash deficit in three months time of 12 million, which will last for a period of approximately six months. Base rate is currently 6% per year, and Murwald can borrow at 1.5% over base, or invest at 1% below base. The treasury team believe that economic pressures will soon force the European Central Bank to raise interest rates by 2% per year, which could lead to a similar rise in UK interest rates. The European Central Bank move is not certain, as there has recently been significant pressure from certain European Union countries not to raise interest rates. In the UK, the economy is still recovering from a recession and representatives of industry are calling for interest rates to be cut by 1%. Opposing representations are being made by pensioners, who do not wish their investment income to fall further due to an interest rate cut. The corporate treasury team believes that interest rates are more likely to rise than to fall, and does not want interest payments during the six month period to increase by more than 10,000 from the amounts that would be paid at current interest rates. It is now 1 December.
Futures:
Options:
m co Liffe prices (1 December)t. o sp LIFFE 500,000 three month sterling interest rate (points of 100%) log .b December 93.75 00 March 93.45 0 2 June 93.10 ks o bo sterling options (points of 100%) LIFFE 500,000 short e
Exercise price 9200 9250 9300 9350 9400 9450 9500 Calls June 3.33 2.93 2.55 2.20 1.74 1.32 0.87 Puts June 0.92 1.25 1.84 2.90 3.46
Required: (a)
Illustrate the results of futures and options hedges if, by 1 March: (i) (ii) Interest rates rise by 2%. Futures prices move by 1.8% Interest rates fall by 1%. Futures prices move by 0.9%
Recommend with reasons, how Murwald plc should hedge its interest rate exposure. All relevant calculations must be shown. Taxation, transactions costs and margin requirements may be ignored. State clearly any assumptions that you make.
(b)
Discuss the advantages and disadvantages of other derivative products that Murwald might have used to hedge the risk.
384
Solution 2
(a)
The treasury team believe that interest rates are more likely to increase than to decrease, and any hedging strategy will be based upon this assumption. There is also a requirement that interest payments do no increase by more than 10,000 from current interest payments.
Current expectations
12m deficit: interest payments 12m x (6% + 1.5%) x 6/12 = 450,000
Using futures hedges (Either March or June contracts may be used or both).
The suggested solution uses June contracts.
(i)
If interest rates rise

With an expected 12m deficit using June contracts As a six month hedge is required the number of contracts sold will be:
12m 6months 500,000 3months

3 The tick value is 0.0001 500,000 12
Cash market =
48 contracts
Current cost
With 2% increase 12m x 9.5% x 6/12
o bo
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p gs
m co 12.50 . t=
Futures market Dec 1: Sell 48 three month sterling futures at 93.10 After interest rate increase: Buy 48 three month sterling futures at (93.10 1.80) = 91.30 Futures gain: 48 x 180# x 12.50 = 108,000 #(100 x 1.80) = 180 ticks
570,000
Extra cash market cost
120,000
Net additional cost after hedging = 12,000 If Murwald expects basis risk to exist (i.e., the futures price moves by a different amount to the cash market interest rates), the number of contracts could be modified to reflect such risk: i.e. then 48 2% 1 .8 % = = 53.3 contracts 120,000.
53.3 x 180 x 12.50
However, basis risk is difficult to predict.
385
(ii)
If interest rates fall

With an expected 12m deficit Cash market = Futures market Dec 1: Sell 48 contracts at 93.10 After interest rate decrease: Buy 48 three month sterling futures at (93.10 + 0.90) = 94.00 Futures loss 48 x 90* x 12. 50= 54,000 *(100 x 0.90) = 90 ticks
Current cost
450,000
With 1% decrease 12m x 6.5% x 6/12
390,000
Cash market saving
60,000
Overall net extra saving = 6,000 Based upon these futures prices, hedging in the futures market does not allow the company to guarantee that interest costs (in the case of a deficit) do not increase by more than 10,000.
Using option hedges
The expectation is for interest rates to rise, therefore put options on futures will be purchased.
po ssell futures, put options must be N.B. Since Murwald may want the right to log put options will also increase) bought. (If interest rates rise the value of the .b 00 price: 0 For example, using the 9400 exercise s2 k (i) If interest rates o orise eb
With an expected 12m deficit Cash market Current cost = 450,000 With 2% increase Cost (see above) = 570,000 Options market Dec 1: Buy 48 9400 puts at 1.84 After interest rate increase: The option may be exercised to sell June futures at 94.00 June futures may be purchased on LIFFE at (93.10 1.80) = 91.30 Profit from options is: 94.00 (91.30 + 1.84) = 0.86 (0.86 x 100) = 86 ticks 48 x 86 x 12.50 = 51,600
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Extra cash market cost
= 120,000
Overall net extra cost = 68,400 In reality the options are likely to be sold rather than exercised, as being June contracts they will still have time value which will be reflected in the option price. The gain from the options sale is therefore likely to be higher than the gain from exercising the options. However, no data is provided on option prices on 1 March.
386
(ii)
If interest rates fall

With an expected 12m deficit Cash market = Options market Dec 1: Sell 48 contracts at 93.10 After interest rate decrease: The futures price moves to (93.10+ 0.90) = 94.00 and the option would not be exercised The loss on options is the premium paid 48 x 184# x 12.50 = 110,400 #(100 x 1.84) = 184 ticks
Current cost
450,000
With 1% decrease Cost (see above)
390,000
Cash market saving
60,000
Overall net extra cost = 50,400
Summary
2% interest rate increase on 12m deficit 1% interest rate decrease on 12m deficit
Different option outcomes will exist if different put option exercise prices are selected. The best exercise price to select if the put options are used will be the 9350 option:
eb
k oo
0 20
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po s(12,000) g
6,000
Futures
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Options (68,400) (50,400)
This will give a gain if exercised of: 93.50 (91.30 + 1.25) = 0.95 or 95 ticks i.e. 48 contracts x 95 ticks x 12.50 = 57,000
If the futures price moves to 94.00, the option will not be exercised, and the loss will be the premium paid of: (1.25 x 100) i.e. 125 ticks x 48 contracts x 12.50 = 75,000
Outcomes using 9350 options:

Cash market (120,000) 60,000 Options market 57,000 (75,000)
2% increase 1% decrease
+ +
= =
(63,000) (15,000)
Neither futures nor options hedges can satisfy, with certainty, the requirement that the interest payment should not increase by more than 10,000. However, one way to achieve this would be to use a collar option, whereby downside risk is protected, but potential gains are also restricted. A collar effectively fixes both a maximum and a minimum interest rate.
387
If a company expects to be borrowing and is worried about interest rate increases, a suitable collar can be achieved by buying put options and selling (or writing) call options, to reduce the cost of protection. For example, a collar could be achieved by buying 48 9400 put options at 1.84 and selling 48 9400 call options at 1.74, a net premium cost of 0.10 (N.B. other alternatives are possible). Murwald does not want interest to move adversely by more than 10,000 for a six month period on a 12 million loan. In annual terms this is 10,000 12 months 12m 6 months = 0.167% p.a.
A put option at the current interest rate (6%) and a total premium cost of less than 0.167% will satisfy the companys requirement. In the above example, the total premium cost is 0.10%, and no matter what happens to interest rates Murwald can fix its borrowing cost at 7.6% p.a. that is: Interest rate implied by 9400 exercise price (100 94.00) Risk premium Net option premium paid (1.84 1.74) Borrowing cost p.a. % 6.0 1.5 0.1 7.6%
This satisfies the requirement. Interest payments would be 12m x 7.6% x 6/12 = 456,000, which is only 6,000 higher than the current interest payment. The use of a collar is thus the recommended hedging strategy.
(b)
0 20include: s Alternative interest rate hedges ok (FRAs) o Forward rate agreements eb

1. Interest rate swaps.
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Over-the-counter (OTC) interest rate options including interest rate guarantees
A forward rate agreement is a contract to agree to pay a fixed interest rate that is effective at a future date. As such Murwald could fix now a rate of interest of 6.1% (for example) to be effective in three months time for a period of six months.
If interest rates were to rise above 6.1%, the counter-party (usually a bank) would compensate Murwald for the difference between the actual rates and 6.1%. If interest rates were to fall below 6.1%, Murwald would compensate the counter-party for the difference between 6.1% and the actual rate.
2.
OTC options. Instead of market traded interest rate options such as those that are available on LIFFE, Murwald might use OTC options through a major bank. This would allow options to be tailored to the companys exact size and maturity requirements. An OTC collar would be possible, and the cost of this should be compared with the cost of using LIFFE options. Interest rate options for periods of less than one year are sometimes known as interest rate guarantees.
388
3.
Interest rate swaps. Murwald expects to borrow at a floating rate of interest. It might be possible for Murwald to swap its floating rate interest stream for a fixed rate stream, pegging interest rates to approximately current levels (the terms of the swap would have to be negotiated). Interest rate swaps are normally for longer periods than six months.
Solutions could also have made reference to Swaptions. A Swaption is a option to enter into an interest rate swap. Murwald could purchase such an instrument, which gives the right but not the obligation to enter into a swap within a predetermined period. The premium would be relatively high in cases where there was a general expectation of interest rate rises and furthermore the arrangement may not satisfy the financial objectives set by Murwald.
o bo
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389
Illustration 3
It is now 31 October. Barney plc wishes to borrow 20 million on 1 March next year for a period of six months, but wishes to protect itself against market interest rates rising above the current LIBOR (London Inter Bank Offered Rate) of 6%. Barney plc can borrow at LIBOR +2%.
LIFFE three month Sterling futures: 500,000 contract size, 12.50 tick size
December March June 93.95 93.90 93.85
LIFFE option price on the appropriate three months Sterling futures: contract size, 12.50 tick size
Calls Mar 0.35 0.22 0.13 Puts Mar 0.25 0.37 0.53
500,000
Strike price 9375 9400 9425 Required:
Dec 0.18 0.07 0.02
June 0.46 0.33 0.23
Dec 0.14 0.28 0.48
po sof the hedge if interest rates and Using interest rate options, calculate the outcome og futures prices were to move on 1 March nextlunder each of the following scenarios: 0.b 0and the relevant futures price rises to 95.90 SCENARIO ONE: LIBOR falls by 2% 0 s29% and the relevant futures price falls to 91.20 SCENARIO TWO: LIBOR rises to k oo by 100 basis points and the change in the futures SCENARIO THREE: LIBOR rises eb price reflects no basis risk.
Note: Assume that interest rates charged by the bank remain constant following the interest rate change. Ignore margin requirements Do NOT employ collars or similar option combinations.
o t.c
June 0.42 0.54 0.69
390
Solution 3
To protect against interest rates rising above current LIBOR, Barney plc (a borrower) will need to buy put option contracts at a (100 6) 9400 exercise price. December contracts will expire before the borrowing starts, therefore March or June contracts are suitable. March contracts are preferred due to their cheaper premium. No. of contracts needed
20m 6 months 500,000 3 months
80 contracts
The premium payable on exercise or expiry for March 9400 puts is (0.37 x 100) = 37 ticks. Thus, the total premium is 80 contracts x 37 ticks x 12.50 = 37,000.
Scenario one
Cash market saving (2% x 6/12 x 20m) Options market NOW: Buy 80 March put option contracts at 9400 exercise price 200,000
AFTER THE INTEREST RATE CHANGE: Abandon the option (since Barney would not wish to sell at 94.00, then buy at 95.90) Loss is the premium paid - as above NET GAIN
Scenario two
Cash market loss (3% x 6/12 x 20m) Options market NOW: Buy 80 March put option contracts at 9400 exercise price AFTER THE INTEREST RATE CHANGE: 1. Exercise and sell at 94.00 2. Then buy at (91.20) 2.80 less premium (0.37) 2.43 x 100 = 243 ticks Profit (80 contracts x 243 ticks x 12.50) NET LOSS
o bo
0 s2
.bl 0
p gs
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m
(37,000) 163,000
(300,000)
243,000 (57,000)
391
Scenario three (100 BASIS POINTS

Cash market loss (1% x 6/12 x 20m)
1%) (100,000)
Options market NOW: Buy 80 March put option contracts at 9400 exercise price AFTER THE INTEREST RATE CHANGE: 1. Exercise and sell at 94.00 2. Then buy at (93.90 1.00) (92.20) 1.10 less premium (0.37) 0.73 x 100 = 73 ticks Profit (80 contracts x 73 ticks x 12.50) NET LOSS 73,000 (27,000)
o bo
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392
Illustration 4
It is now 31 December 2006 and the corporate treasurer of Omniown plc is concerned about the volatility of interest rates. His company needs to immediately borrow 5,000,000 for a six month period. Current interest rates are 14% per year for the type of loan Omniown would use, and the treasurer does no wish to pay more than this. He is considering using either: (i) (ii) (iii) A forward rate agreement (FRA), or Interest rate futures, or An interest rate guarantee Explain briefly how each of these three alternatives might be useful to Omniown plc. The corporate treasurer of Omniown plc expects interest rates to increase by 2% almost immediately and has decided to hedge the interest rate risk using interest rate futures. June sterling three months time deposit futures are currently priced at 86.25. The standard contract size is 500,000 and the minimum price movement is one tick (the value of one tick is 0.01% per year of the contract size).
(a) (b)
Required:
Illustrate the results of using a futures hedge under each of the following three scenarios, if for the entire six month period: (i) (ii) (iii)
k oo by 2% and the futures market price moves by Interest rates b e increase 1.5%.
Interest rates fall by 1% and the futures market price moves by 0.75%
Interest rates increase by 2% and the futures market price also moves by 2%.
0 s2
.bl 0
p gs
o t.c
Ignore taxation, margin requirements, and the time value of money.
(c)
As an alternative to interest rate futures, the corporate treasurer has been able to purchase interest rate guarantees at a rate of 14% per annum for a premium of 0.2% of the size of the loan to be guaranteed.
Required:
Calculate whether the total cost of the loan after hedging in each of the three scenarios in (b) above would have been cheaper or more expensive with the futures hedge than with the interest rate guarantee. The guarantee would be effective for the entire six month period of the loan. Ignore taxation, margin requirements, and the time value of money.
393
Solution 4
(a) Explanation of the three alternative hedging strategies
(i) Forward rate agreements A forward rate agreement is a contract between a company and a bank which sets the interest rate on future borrowings (or deposits). A company can make a FRA with a bank that fixes the rate of interest to be paid at a certain time in the future. If the actual interest rate at the time is higher than that agreed, the bank pays the difference; if it is lower than the rate agreed then the company pays the difference. A FRA does not affect the principal sum. The actual borrowing itself must be arranged separately either with the same bank as the FRA is organised or with a different bank. A FRA could be useful to Omniown since the treasurer will know in advance what the loan is going to cost. The minimum amount is usually 500,000 so would not be a problem in this case. However, if it is expected that interest rates are going to rise, the treasurer might have difficulty in negotiating a FRA at the current rate of 14%. (ii) Interest rate futures
om camounts and for standard t. Interest rate futures are contracts of standard ponumber of dates. They are periods of time running from a limited s therefore less flexible than a FRA. gThey take the form of a contract o linterest rate at an agreed price on an between buyer and seller on an .b 00 agreed date. The contract will require a small initial margin payment 0 and thereafter variation margin will apply. Interest rate futures are s2 rate agreements, except that the terms, similar in effect to k oo forward amounts and b periods are standardised. They are traded on the e
Euronext.liffe. For Omniown protection against interest rate increases could be achieved by selling futures contracts now. As interest rates rise the value of futures contracts will fall. Hence Omniown can buy back the contracts at a lower price and make a profit. This profit should compensate the company for the increase in market interest rates, though (due to basis risk) this profit is unlikely to match perfectly the additional interest costs incurred.
(iii)
Interest rate guarantees An interest rate guarantee is an option which enables the treasurer to fix a maximum interest rate for a period in the future. If the market rate falls the treasurer would choose not to exercise the option and take advantage of the lower rate. Because of the additional benefit of taking advantage of lower interest rates, options tend to be rather expensive. They involve payment of a non-refundable premium in advance at the time the contract is entered into. In this case, since the option would be to guarantee rates at their existing level and because it is a short-term option, the premium is likely to be fairly high unless the market expects rates to fall. N.B. The premium would be lower if the guaranteed rate were higher than existing rates e.g. 16%.
394
(b)
Interest rate futures

=
Number of contracts sold
5,000,000 6 months 500,000 3 months

3/12
= =
20 contracts 12.50
The value of one tick is 0.0001 x 500,000 x
(i)
Interest rates increase by 2% and the futures market price falls by 2%

CASH MARKET Extra interest paid (2% x6/12 x 5,000,000) FUTURES MARKET On 31 December 2006: Sell 20 500,000 June sterling time deposit contracts at (effectively 13.75% per year interest) After interest rate increase: Buy 20 500,00 June sterling time deposit contracts at (effectively 15.75% per year interest) 86.25 (50,000)
84.25 2.00 x 100 m co 200 ticks = t. = 50,000 NIL
Gain on futures contracts = 20 contracts x 200 ticks x 12.50 OVERALL NET PROFIT/(LOSS) ON STRATEGY
This is a perfect hedge with 100% hedge efficiency.
(ii)
Interest rates increase by 2% and the futures market price falls by 1.5%
eb
k oo
0 20
o .bl
p gs
CASH MARKET Extra interest paid (as above) FUTURES MARKET On 31 December 2006: Sell 20 500,000 June sterling time deposit contracts at (effectively 13.75% per year interest) After interest rate increase: Buy 20 500,00 June sterling time deposit contracts at effectively 15.75% per year interest) 86.25 (50,000)
84.25
1.50 x 100 = 150 ticks Gain on futures contracts = 20 contracts x 150 ticks x 12.50 OVERALL NET (LOSS) ON STRATEGY This is a hedge efficiency of = 37,500 (12,500)
37,500 50,000
75%
395
(iii) Interest rates fall by 1% and the futures market price increases by 0.75%
CASH MARKET Saving of interest (1% x 6/12 x 5,000,000) FUTURES MARKET On 31 December 2006: Sell 20 500,000 June sterling time deposit contracts at (effectively 13.75% per year interest) After interest rate reduction: Buy 20 500,00 June sterling time deposit contracts at effectively 13% per year interest) 86.25 25,000
87.00 (0.75) x 100 = 75 ticks
Loss on futures contracts = 20 contracts x 75 ticks x 12.50 OVERALL NET GAIN ON STRATEGY This is a hedge efficiency of
(18,750) 6,250
25,000 18,750
133 %
SUMMARY:
Scenario Cash market interest paid: (16% x 6/12 x 5,000,000) (13% x 6/12 x 5,000,000)
(Gain)/Loss on futures contracts OVERALL COST
eb
k oo
0 s2
lo .b(i) 0
p gs
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m
(iii)
(ii) 400,000
400,000
325,000 (50,000) 350,000 (37,500) 362,500 18,750 343,750
(c)
Interest rate guarantees
The cost (premium) of the guarantee is 5,000,000 x 0.2% = 10,000, payable whether or not the guarantee is exercised.
(i) & (ii) Interest rates increase by 2%

As interest rates have risen to 16%, the guarantee at 14% will be used i.e. 350,000 10,000 360,000
Cash market cost (14% x 6/12 x 5,000,000) Premium
This is more expensive than the futures hedge for (i) and cheaper than for (ii)
396
(iii) Interest rates fall by 1%

As interest rates have fallen to 13%, the guarantee at 14% will not be used i.e. 325,000 10,000 335,000
Cash market cost (13% x 6/12 x 5,000,000) Premium
This is cheaper than the futures hedge as the guarantee has allowed the company to take advantage of lower cash market interest rates.
o bo
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397
Illustration 5
The directors of Tayquer plc are considering the use of options to protect the current interest yield from their companys 9.75 million short-term money market investments. Having made initial enquiries they have been discouraged by the cost of the option premium. A member of the treasury staff has suggested the use of a collar as this would be cheaper. Protection is required for the next eight months. Assume that it is now 1st June. LIFFE interest rate options on three month money market futures Contract size is 500,000; premium cost is in annual % Dec 0.90 0.56 0.27 0.09 0.01 Calls March 1.90 1.45 1.04 0.68 0.20 0.05 Puts Dec 0.05 0.17 0.45 0.83 1.13 March 0.02 0.06 0.13 0.24 0.32 0.54
9100 9150 9200 9250 9300 9350
m co The current interest rate received on Tayquers t. short-term money market po investments is 7.5% per annum. s log Assume that Tayquer can buy or sell options at the above prices. Commission, b taxation and margins may be ignored. 0. 0 0 s2 Required: ok Discuss how, and estimate o what cost, collars may be used to protect against the at eb interest yield risk. Recommend at which exercise price(s) the collar should be
Tick size is 0.01%, and tick value 12.50. arranged.
398
Solution 5
A collar will involve Tayquer arranging both a floor and a ceiling (lower and upper limits) on its interest yield. This may be achieved by buying a call option on futures and selling (or writing) a put option on the same futures contract, but with a different exercise price. As protection is required for the next eight months, to cover the full period, March contracts will be used. If Tayquer wishes to protect its current interest yield, the company is likely to fix the floor at the current yield, i.e. it will buy call options at 9250, which implies an interest rate of 7.5%. The option would be exercised if interest rates fall below 7.5% and the futures price rises above 9250. In order to reduce the net premium cost, the potential gain on the interest from short-term investments (if interest rates were to rise) may be reduced by selling March put contracts at a lower exercise price than 9250. For example, if the interest rate rose to 9% and the put option had been sold at the 9150 exercise price, the buyer of the put option would exercise the option at any futures price lower than 9150. A 9% interest rate implies a futures price of 9100. The 1.5% gain in interest rate rises would be split 1% to Tayquer and 0.5% to the buyer of the put option. Any further interest rate rises will result in the extra interest earned by Tayquer being equal to the increased loss on the puts.
po sof interest rate increases, but will Hence Tayquer will only benefit from the firstog 1% be protected from any reduction in interest rates. Tayquer, in this example, has .bl 0 fixed the minimum interest received at 7.5%, and the maximum at 8.5%. 00 2 To protect 9.75 million for eight months, the following number of contracts are ks o required: bo e 8 months 9.75 million
500,000
x 3 months = 52 contracts The net percentage premium payable at various combinations of collar are: Buy call 1) 2) 3) 9250 9250 9250 Premium paid 0.68 0.68 0.68 Write put 9200 9150 9100 Premium received 0.13 0.06 0.02 Net premium cost (%) 0.55 0.62 0.66 Net premium cost () 35,750 40,300 42,900
o t.c
The net premium cost is calculated as follows: 1) 0.55 x 100 = 55 ticks 52 contracts x 55 ticks x 12.50 = 0.62 x 100 = 62 ticks 52 contracts x 62 ticks x 12.50 = 0.66 x 100 = 66 ticks 52 contracts x 66 ticks x 12.50 = 35,750
2)
40,300
3)
42,900
399
The choice of exercise price at which to sell the put option will depend upon Tayquers views on how far interest rates could rise, and the potential gains if rates do rise. Interest rate 8% 8% 9% Put exercise price 9200 9150 9100 Net premium cost % (0.55) (0.62) (0.66) Interest gain % 0.50 1.00 1.50 Net gain or loss % (0.05) 0.38 0.84 Net gain or loss (3,250) 24,700 54,600
The net sterling gains and losses are calculated as follows: 52 contracts x (0.05) x 100 x 12.50 52 contracts x 0.38 x 100 x 12.50 52 contracts x 0.84 x 100 x 12.50 = = = (3,250) 24,700 54,600
The best potential gains are from a put option exercise price of 9100, but Tayquer may not be willing to lose the 7,150 premium income relative to 9200 put option exercise price. The 7,150 premium income that would be lost is calculated as follows: 9200 premium income = 52 x 0.13 x 100 x 12.50 9100 premium income = 52 x 0.02 x 100 x 12.50
Alternatively, compare the net premium cost in 3) above of 42,900 with the net premium cost in 1) above of 35,750. The difference between these two amounts is 7,150. In reality trading costs may make any option strategies more expensive than they appear to be from the figures presented.
o bo
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m =
=
8,450 1,300 7,150
400
THE 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. 2. Establish the cash flows arising at each future time period; Calculate the present value of these future cash flows, discounted at the IRR (i.e. the gross yield to maturity) of the security. Incidentally, the sum of these figures must be the current price of the bond; Calculate each years discounted cash flow as a proportion of the current value of the bond; Take the time from investment to each discounted cash flow and multiply by the respective proportion. Finally, sum the weighted year values.
3. 4.
Illustration 6
Seven years prior to the maturity of a bond with a 10% coupon, it is trading at a price of 95.01 per cent and has a gross yield to maturity of 11.063%. Using the Macaulay duration method, you are required to calculate the bond duration.
o bo
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Solution 6
Yr 1
2
1
Annual cash flows () Discounted @11.063% () Proportion of price (95.01) Proportion multiplied by year number. 10.00 9.00 0.095 0.095
2
10.00 8.11 0.085 0.170
3
10.00 7.30 0.077 0.231
4
10.00 6.57 0.069 0.276
5
10.00 5.92 0.062 0.310
6
10.00 5.33 0.056 0.336
7
110.00 52.78 0.556 3.892
3 4
Finally, find the totals of row 4, since these provide the bond duration of 5.31 years, ie the weighted average time to full recovery of an investment in this bond. Remember that if the monetary amounts in row 2 (above) are cross-cast, the result must obviously be the current price of the bond, since the gross yield to maturity is the internal rate of return of all cash flows associated with the bond. Furthermore, the above calculation is almost identical to the approach used for calculating the duration taken to recover an original investment in project appraisal (as described earlier on page 78 and page 79).
401
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 i.e. 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:
o sp will also increase and the As maturity increases, the measure of duration og market value of the bond will become lmore sensitive to changes in the level .b of interest rates; 00 0 As the coupon rate of a bond increases, duration will decrease and the value s2 k of the bond will be less sensitive to changes in the level of interest rates; and oo eb As interest rates rise, duration will decrease and the value of the bond will be
less sensitive to subsequent rate changes.
o t.c
Illustration 7
In each of the following cases, you are required to use the Macaulay duration method to calculate the duration for each of the following securities: (a) (b) A bond with a five year maturity has a current value of 92.41 per cent, a coupon rate of 8% and a market yield of 10%. On the 1 February 2011, a 5.5% Treasury Bond (which is redeemable on 1 February 2015), has a market value of 110.28 per cent and a yield to maturity of 2.75%. A 6% bond has three years to redemption. It has a current market price of 89.85 per cent. Interest is paid half-yearly and its market yield is 10% per annum (i.e. 5% every six months).
(c)
402
Solution 7
(a) Year 1 2 3
4 Annual cash flows () Discounted @ 10% () Proportion of bond value (92.41) Proportion multiplied by year number
1 8.00 7.27
0.079 0.079
2 8.00 6.61
0.072 0.144
3 8.00 6.01
0.065 0.195
4 8.00 5.46
0.059 0.236
5 108.00 67.06
0.726 3.630
Finally, establish the totals of row 4, since these provide the bond duration of 4.284 years i.e. the weighted average time to full recovery of an investment in this bond.
(b) Year 1 2
3 4 Annual cash flows () Discounted @ 2.75% () Proportion of bond value (110.28) Proportion multiplied by year number
1 5.50 5.35
0.049 0.049
2 5.50 5.21
0.047
3 5.50 5.07
0.046 0.138
4 105.50 94.65
0.858 3.432
Finally, establish the totals of row 4., since these provide the bond duration of 3.713 years i.e. the weighted average time to full recovery of an investment in this bond.
(c) Period 1 2
3 4
k oo () Half-yearly cash flows eb Discounted @ 5% per

half year () Proportion of bond value (89.85) Proportion multiplied by period number
0 s2
.bl 0
3
p gs
1 3
2.72
o t.c
0.094
1 3
2.59 0.029 0.044
2 3
2.47 0.028 0.056
2 3
2.35 0.026 0.065
3 103
76.86 0.855 2.565
2.86 0.032 0.016
0.030 0.030
Finally, establish the totals of row 4., since these provide the bond duration of 2.776 years i.e. the weighted average time to full recovery of an investment in this bond.
General observations
Note that Macaulay duration will always be lower than the term to maturity (assuming that the coupon rate exceeds zero - you may think that this is a stupid comment, but the world of finance is going through some amazing times!!). Nowadays, the value of Macaulay duration is less evident, due to wide availability of computer programs with Monte Carlo simulation. Obviously, bonds are subject to risk, but duration is not intended to reflect risk; it measures interest rate sensitivity.
403
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. 2% 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 i.e. 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:
e
Gross Redemption Yield %
o bo
0 s2
.bl 0
p gs
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Bond Yield Curve
10
15 20 Term to maturity (years)
25
30
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
404
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
Liquidity preference 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 longdated 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.
Expectations theory
This theory states that the shape of the yield curve will vary dependent upon a lenders 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.
Market segmentation theory
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 shortterm 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.
o bo
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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 i.e. 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:
405
Gross Redemption Yield % Bond Yield Curve
10
15 20 Term to maturity (years)
25
30
o bo
0 s2
.bl 0
p gs
o t.c
406
Chapter 18
Swaps
o bo
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407
CHAPTER 18 SWAPS
CHAPTER CONTENTS
INTEREST RATE SWAPS, CURRENCY SWAPS AND SWAPTIONS --- 409
INTEREST RATE SWAPS CURRENCY SWAPS SWAPTIONS 409 409 410
ILLUSTRATION 1 INTEREST RATE SWAPS ------------------------- 410 ILLUSTRATION 2 CURRENCY SWAPS ------------------------------- 414 ILLUSTRATION 3 SWAPTIONS -------------------------------------- 420
o bo
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408
CHAPTER 18 SWAPS
INTEREST RATE SWAPTIONS Interest rate swaps
SWAPS,
CURRENCY
SWAPS
AND
These are transactions which allow a company to exploit different interest rates in different markets for borrowing, and thereby reduce or alter the timing of interest payments. The parties to a swap may either be two companies, or a company and a bank. In the former case the companies may arrange the agreement themselves or a bank may act as intermediary. The parties to a swap exchange their interest rate commitments with each other. That is, the company with a fixed rate commitment (which believes that interest rates are about to fall) effectively swaps with a counterparty with a floating rate commitment (which believes that interest rates are about to increase). In doing this they simulate each others borrowings, but retain their obligations to the original lenders. Thus they must accept a degree of counterparty risk since if the other party defaults on the interest payments, the original borrower remains liable to the lender. The benefits are that the company can obtain interest rates which are lower than it could get directly from a bank or from other investors, and may be able to structure the timing of payments so as to improve the matching of cash outflows with revenues. Swaps are easy to organise and are flexible since they can be arranged in any size. They may also be reversible by negotiation, but this may involve the payment of a substantial termination premium by the party seeking release from the swap commitment.
Currency swaps
o bo
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p gs
o t.c
Two parties agree to swap equivalent amounts of currency for a given period. This effectively involves the exchange of debt from one currency to another. Again, liability on the principal is retained and the parties are liable to counterparty risk. One benefit to a company is that it can gain access to debt finance in another country and currency where it is little known (and consequently has a poorer credit rating) than in its home country. It can therefore take advantage of lower interest rates than it could obtain if it arranged the loan itself. A further purpose of currency swaps is to restructure the currency base of the companys liabilities. This may be important where the company is trading overseas and receiving revenues in foreign currencies, but its borrowings are denominated in its home currency. Currency swaps therefore provide a means of reducing exchange rate risk exposure. A third benefit of currency swaps is that at the same time as exchanging currency, the company may also be able to convert fixed rate debt to floating rate or vice versa. Thus it may obtain some of the benefits of an interest rate swap in addition to achieving the other advantages of a currency swap.
409
CHAPTER 18 SWAPS
Swaptions
These are an option to enter into an interest rate swap or currency swap. A company could purchase such an instrument, which gives the right, but not the obligation to enter into a swap arrangement within a predetermined period. The premium paid to the bank would be relatively high in cases where there was a general expectation of volatile interest rate or exchange rate movements.
Illustration 1 Interest rate swaps

Manling plc has 14 million of fixed rate loans at an interest rate of 12% per year which are due to mature in one year. The companys treasurer believes that interest rates are going to fall, but does not wish to redeem the loans because large penalties exist for early redemption. Manlings bank has offered to arrange an interest rate swap for one year with a company that has obtained floating rate finance at London Interbank Offered Rate (LIBOR) plus 1.125%. The bank will charge each of the companies an arrangement fee of 20,000 and the proposed terms of the swap are that Manling will pay LIBOR plus 1.5% to the other company and receive from the company 11.625%. Corporation tax is at 35% per year and the arrangement fee is a tax allowable expense. Manling could issue floating rate debt at LIBOR plus 2% and the other company could issue fixed rate debt at 11.75%. Assume that any tax relief is immediately available.
Required: (a)
Evaluate whether Manling plc would benefit from the interest rate swap 1. 2.
0 20 the whole year If LIBOR remains at ks for 10% oo after 6 months If LIBOR falls to 9% eb
.bl 0
p gs
o t.c
(b)
If LIBOR remains at 10% evaluate whether both companies could benefit from the interest rate swap if the terms of the swap were altered. Any benefit would be equally shared.
410
CHAPTER 18 SWAPS
Solution 1
(a) Evaluation of interest rate swap
1.
If LIBOR remains at 10% for whole year

Manling % (12) (11.5) 11.625 (11.875) Other company % (11.125) 11.5 (11.625) (11.25)
Existing commitment Manling pays (10% + 1.5%) Manling receives Revised commitment
(10% + 1.125%)
The current cost of fixed rate debt is: 14m x 12% less tax relief at 35% The cost under the swap is: 14m x 11.875% less tax relief at 35% Plus the arrangement fee 20,000 less tax relief at 35% Total cost
1,092,000
1,080,625 13,000 1,093,625
The swap would not be beneficial, as the final cost, after tax, is increased by (1,093,625 less 1,092,000) = 1,625 2.
If LIBOR falls to 9% after six months
Existing commitment Manling pays (9% + 1.5%) Manling receives Revised commitment
eb
s ok
00
Manling % (12) (10.5) 11.625 (10.875)
.bl 0
p gs
o t.c
(9% + 1.125%)
Other company % (10.125) 10.5 (11.625) (11.25)
If LIBOR falls to 9% after six months the cost is 14m x 11.875% x 6/12 x 0.65 14m x 10.875% x 6/12 x 0.65 Plus arrangement fee (net of tax) Total cost The swap would then be (1,092,000 less 1,048,125)
= = =
540,312 494,813 1,035,125 13,000 1,048,125 Manling benefits by
beneficial since = 43,875
411
CHAPTER 18 SWAPS
(b)
Whether both parties would benefit from the swap if LIBOR remains at 10%
Ignoring the arrangement fee, both companies are benefiting from the swap i.e. For a floating rate arrangement: %
Manling would normally pay LIBOR plus but is actually paying LIBOR plus Thus saving
For a fixed interest rate arrangement:
2% 1.875% 0.125
The other company would normally pay but is actually paying fixed interest of Thus saving Total saving
11.75% 11.25% 0.5 0.625%
If this saving were divided equally, each company would save 0.3125% i.e. Manling % Normal floating rate LIBOR of 10% + 2% Saving 0.625% 2 Revised commitment = = (12) 0.3125 (11.6875)
Accordingly if the terms of the swap were varied so that Manling paid the other company LIBOR plus 1.3125%, which is calculated as follows: Present arrangement of LIBOR plus add back original saving less revised saving Revised arrangement of LIBOR plus
eb
s ok
0 00
.b
sp gNormal fixed rate lo
m co ot.
Other company % (11.75) 0.3125 (11.4375)
% 1.5 0.125 (0.3125) 1.3125
and the remaining terms of the swap were unchanged, the effect would be: Manling % (12) (11.3125) 11.625_ (11.6875) Other company % (11.125) 11.3125 (11.625)_ (11.4375)
Existing commitment Manling pays LIBOR + 1.3125% Manling receives Revised commitment
(10% + 1.125%)
Thus Manling is paying interest at 0.3125% below its normal floating rate of LIBOR + 2% and the other company is paying at 0.3125% below its normal fixed rate of 11.75%.
412
CHAPTER 18 SWAPS
The total cost to Manling of using these new terms is: 1,063,562 13,000 1,076,562 = 15,438 relative to not
14m x 11.6875% x 0.65 Plus arrangement fee (net of tax) Total cost This is a saving of (1,092,000 1,076,562) undertaking the swap.
o bo
0 s2
.bl 0
p gs
o t.c
413
CHAPTER 18 SWAPS
Illustration 2 Currency swaps

(a) (b)
Discuss how interest rate swaps and currency swaps might be of value to the corporate financial manager. Calvold plc has a one year contract to construct factories in a South American country. At the end of the year the factories will be paid for by the local government. The price has been fixed at 2,000 million pesos, payable in the South American currency. In order to fulfil the contract Calvold will need to invest 1,000 million pesos in the project immediately, and a fixed additional sum of 500 million pesos in six months time. The government of the South American country has offered Calvold a fixed rate-fixed rate currency swap for one year for the full 1,500 million pesos at a swap rate of 20 pesos/. Net interest of 10% per year would be payable in pesos by Calvold to the government. There is no forward foreign exchange market for the peso against the pound. Forecasts of inflation rates for the next year are: Probability 0.25 0.50 0.25 UK 4% 5% 7% South American country 40% 60% 100%
and and and
The peso is a freely floating currency which has not recently been subject to major government intervention.
0 20 The current spot rate is ks pesos/. Calvolds opportunity cost of funds is 25 oo 12% per year in the UK. The company has no access to funds in the South b American country. e
Taxation, the risk of default, and discounting to allow for the timing of payments may be ignored.
.bl 0
p gs
o t.c
Required:
Evaluate whether it is likely to be beneficial for Calvold plc to agree to the currency swap.
414
CHAPTER 18 SWAPS
Solution 2
(a) Interest rate swaps
An interest rate swap is a transaction which allows a company to exploit different interest rates in different markets for borrowing, and thereby reduce or alter the timing of interest payments. The parties to a swap may be either two companies, or a company and a bank. In the former case the companies may arrange the agreement themselves or a bank may act as intermediary. The parties to a swap, exchange their interest rate commitments with each other. In doing this they simulate each others borrowings but retain their obligations to the original lenders. Thus they must accept a degree of counterparty risk since if the other party defaults on the interest payments, the original borrower remains liable to the lender. The benefits are that the company can obtain interest rates which are lower than it could get directly from a bank or from other investors, and may be able to structure the timing of payments so as to improve the matching of cash outflows with revenues. Swaps are easy to arrange and are flexible since they can be arranged in any size. They may also be reversible by negotiation, but this may involve the payment of a substantial termination premium by the party seeking release from the swap commitment. Interest rate swaps also provide a means of financial speculation, but your course is more concerned with the hedging of risk as opposed to the seeking of risk.
Currency swaps
In a currency swap, two parties agree to swap equivalent amounts of currency for a given period. This effectively involves the exchange of debt from one currency to another. As with interest rate swaps, liability on the principal is not transferred and the parties are liable to counterparty risk.
o bo
0 s2
.bl 0
p gs
o t.c
One benefit to the company is that it can gain access to debt finance in another country and currency where it is little known, and consequently has a poorer credit rating, than in its home country. It can therefore take advantage of lower interest rates than it could obtain if it arranged the loan itself. A further purpose of currency swaps is to restructure the currency base of the companys liabilities. This may be important where the company is trading overseas and receiving revenues in foreign currencies, but its borrowings are denominated in the currency of its home country. Currency swaps therefore provide a means of reducing exchange rate exposure. A third benefit of currency swaps is that at the same time as exchanging currency, the company may also be able to convert fixed rate debt to floating rate or vice versa. Thus it may obtain some of the benefits of an interest rate swap in addition to achieving the other purposes of a currency swap.
415
CHAPTER 18 SWAPS
b)
Currency swap by Calvold plc

The expected level of inflation in the UK is 5.25%, and in the South American country 65%. The purchasing power parity theory may be used to estimate an expected exchange rate at the end of the year, but it is likely to be more useful to Calvold to see the range of exchange rates that might occur under each of the different inflation scenarios, and evaluate their effects on sterling cash flows. Rate after one year = current spot rate x
1+f 1+h 1+ f 1+h
Rate after six months =
current spot rate
where f = the foreign inflation rate; and h = the home inflation rate Illustration With 40% SA inflation and 4% UK inflation: Rate after one year = 25 x 1 .4 1.04 1 .4 1.04 = 33.65
o sp pesos/ would be acceptable, However a six month exchange rate of og 29.325 being the simple average of the current spot rate (25 pesos) and the predicted .bl 0 one year spot rate (33.65 pesos). 00 s2 Forecast exchange ratesok are: o eb Inflation Forecast exchange rate
Month 0 6 12 0 6 12 0 6 12 SA % 40 40 UK % 4 4 25.00 29.00 33.65 25.00 30.86 38.10 25.00 34.18 46.73
Rate after six months =
25
m co 29.00 . t=
60 60
5 5
100 100
7 7
416
CHAPTER 18 SWAPS
The effect of the swap will be compared with the use of currency markets for each of the three scenarios. It is assumed that Calvold will have to borrow funds in the UK to finance the deal and interest is therefore calculated at the opportunity cost of funds i.e. For one year For six months: 12% 6% 5.8% In the
use 12% x 6/12 or 1.12 1
= =
this will depend upon the method of calculating interest charges. following solution a six-monthly rate of 6% is used. (i)
Using the currency markets

1. Inflation rates 4% and 40% Exchange rate Pesos (m) Investment month 0 Investment month 6 Interest Total cost Received month 12 Net (loss) 2. (1,000.00) (500.00) 25.00 m (40.00) Interest @12% p.a. m (4.80) (1.03) (5.83)
Inflation rates 5% and 60% Investment month 0 Investment month 6 Interest Total cost Received month 12 Net (loss) (1,000.00) (500.00) 25.00 30.86 (40.00) (16.20) (56.20) (5.77) (61.97) 2,000.00 38.10 52.49 (9.48) (4.80) (0.97) (5.77)
eb
k oo
0 s2
02,000.00
.bl 0
p gs
29.00
o t.c
(17.24) (57.24) (5.83) (63.07) 59.44 (3.63)
33.65
3.
Inflation rates 7% and 100% Investment month 0 Investment month 6 Interest Total cost Received month 12 Net (loss) (1,000.00) (500.00) 25.00 34.18 (40.00) (14.63) (54.63) (5.68) (60.31) 2,000.00 46.73 42.80 (17.51) (4.80) (0.88) (5.68)
417
CHAPTER 18 SWAPS
(ii)
Using the currency swap

The currency swap will provide some protection against the likely depreciation in the value of the peso. 1,500 million pesos will be swapped, with the swap reversed at the year end at the same swap rate of 20 pesos/. Calvold will have to borrow sterling in the UK to finance the swap, which will cost (1,500 million pesos 20) i.e. 75 million. Since the cost of funds in the UK is 12% p.a., the interest charge for the year will be (12% x 75 million) = 9million. However swaps involve the transfer of interest rate liabilities as well as of principal, therefore the interest cost to Calvold will be the rate given in the swap agreement of 10% p.a. i.e. (10% x 1,500 million pesos) 150 million pesos. It is assumed that no interest will be earned on the 500 million pesos which will be lying idle until month 6. Accordingly, Calvold will only remain exposed to exchange risk on the balance of the purchase price (500 million pesos) which will be converted at whatever the prevailing end of year rate happens to be. If it is assumed that no interest will be paid to the South American government until the end of the year, the sterling value of interest payments (based on 150 million pesos) will also be dependent on the then prevailing exchange rate. 1. Inflation rates 4% and 40%
Receipts Interest paid Net receipt Net profit with swap
o bo
0 s2
.bl 0
p gs
o t.c
(500 million pesos 33.65) (150 million pesos 33.65) 350
m 14.86 (4.46) ____ 10.40 (3.63)
Net loss without swap (m) 2. Inflation rates 5% and 60%
Receipts Interest paid Net receipt Net profit with swap Net loss without swap (m) 3. Inflation rates 7% and 100%
m 13.12 (3.94) ____ 9.18 (9.48)
Receipts Interest paid Net receipt Net profit with swap Net loss without swap (m)
m 10.70 (3.21) ____ 7.49 (17.51)
418
CHAPTER 18 SWAPS
The above calculations show that since Calvolds receipts, denominated in pesos, will not be received until year end, the profitability of the deal is eroded by inflation if the currency is traded on the markets. However a swap arrangement should be entered into, whereby Calvold borrows 75 million in the UK and immediately exchanges this for 1,500 million pesos from the South American government (whilst similarly swapping interest payment obligations). The effect will be that only the balance of the receipts (500 million pesos) will be subject to exchange fluctuations and therefore the effects of inflation diminished. Thus it appears that it would be beneficial for Calvold to use the currency swap.
o bo
0 s2
.bl 0
p gs
o t.c
419
CHAPTER 18 SWAPS
Illustration 3 Swaptions
Noswis plc borrowed two million Euros () in four year floating rate notes funds nine months ago at an interest rate EURIBOR plus 1%, in an attempt to reduce the level of interest paid on its loans. At that time EURIBOR was 6%. Unfortunately EURIBOR interest rates have increased since that time to 7.2%. The company wishes to protect itself from further interest rate volatility, but does not wish to lose the benefit of possible interest rate reductions that might occur in a few months time. An adviser has suggested the use of a six month American style Euro swaption at 8.5% with a premium of 50,000, commencing in three months time and with a maturity date the same as the floating rate Euro loan.
Required:
Briefly explain what is meant by a swaption, and illustrate under what circumstances this proposed swaption would benefit Noswis. The time value of money may be ignored.
o bo
0 s2
.bl 0
p gs
o t.c
420
CHAPTER 18 SWAPS
Solution 3
Swaptions are hybrid derivative products that integrate the benefits of swaps and options. The buyer of a swaption has the right, but not the obligation, to enter into an interest rate or currency swap during a limited period of time and at a specified rate. Swaptions are available on the over-the-counter market and involve the payment of a premium, normally in advance. They may be European style, exercisable only on the maturity date, or American style, exercisable on any business day during the exercise period. Noswis is interested in protection against interest rate volatility, but wishes to maintain the flexibility to benefit from falls in interest rates. A swaption would offer the opportunity to do this. Noswis is currently paying 8.2% on its Euro loan. The swaption offers a swap from floating rate to fixed rate finance for the remaining three year period of the Euro loan. (N.B. the four year loan was raised nine months ago and the swaption will not commence until another three months have elapsed). The fixed rate is 0.3% per annum above the current floating rate payable by Noswis. The premium payable of 50,000 is 2.5% of the total value of the loan, or, ignoring the time value of money, 0.833% per year over the remaining three year period of the loan. If Euro interest rates rise during the next nine months by more than 0.3% the swaption is likely to be exercised. For the swaption to be beneficial to Noswis, the average floating rate payable by Noswis without the swap over the three year period would have to exceed: 8.2% + 0.3% + 0.833% =
o bo
0 s2
.bl 0
p gs
o t.c
9.333%
This is a 13.8% increase on the current EURIBOR payable rate (i.e. over 8.2%) If interest rates fall then the swaption would not be exercised and Noswis would benefit from borrowing at the lower floating rates. If the swaption is not exercised the premium is still payable, and Noswis would be worse off by the amount of the premium than if no swaption had been agreed. However, this premium is the price that must be paid for the flexibility of being able to take advantage of any lower interest rates in the future. Furthermore it should be noted that once the swaption is exercised this action cannot be reversed. Therefore if interest rates subsequently fall, Noswis will continue to pay the fixed rate of interest set out in the agreement.
421
CHAPTER 18 SWAPS
o bo
0 s2
.bl 0
p gs
o t.c
422
Chapter 19
International investment appraisal

m
o bo
0 s2
.bl 0
p gs
o t.c
423
C H A P T E R 1 9 I N T E R N A T IO N A L I N V E S T M E N T A P P R A I S A L
CHAPTER CONTENTS
INTERNATIONAL INVESTMENT AND FINANCING DECISIONS ----- 425
INTRODUCTION PARENT OR PROJECT VIEWPOINT? PURCHASING POWER PARITY THEORY (PPPT) FOUR-WAY EQUIVALENCE REMISSION OF FUNDS EXCHANGE RATE RISK POLITICAL RISK PROJECT DISCOUNT RATES FINANCING OVERSEAS PROJECTS REPATRIATION OF CASH FROM OVERSEAS INVESTMENTS 425 425 426 427 428 428 428 429 429 430
TRANSFER PRICING ---------------------------------------------------- 435

435 om c ot. BROOKDAY PLC --------------------------------------------------------- 439 p gs o ZEDLAND POSTAL SERVICE -------------------------------------------- 443 .bl 0 00 AXMINE PLC ------------------------------------------------------------- 448 2 ks o bo e ARTICLE FROM A USA PUBLICATION
424
INTERNATIONAL DECISIONS Introduction
INVESTMENT
AND
FINANCING
In essence capital budgeting for overseas investments is similar to domestic investment appraisal. The normal procedure of determining the relevant cash flows and discounting at the rate of return commensurate with the projects risk should be followed to determine project NPVs. In practice, however, several complexities may be encountered. These are examined below.
Parent or project viewpoint?

Any overseas capital project can be assessed from the point of view of the parent company or the local subsidiary. Relevant cash flows may vary between the two viewpoints due to the following factors: Timing of the receipt of funds; Impact of exchange rate changes on the value of the funds; Impact of local and home country tax on the value of funds received; Effect on other parts of the organisation (e.g. sales by the subsidiary reducing the parents export market sales).
o .bl to maximise shareholder wealth, and 0 As the objective of financial management is 00 the vast majority of the shareholders are likely to be located in the parent country, 2 it is essential that projects areks evaluated from a parent currency viewpoint. After o all, in the UK only sterling receipts can be used to pay sterling dividends. bo e Accordingly, the following three-step procedure is recommended for calculating
project cash flows: 1. 2. 3. Compute local currency cash flows from a subsidiary viewpoint as if it were an independent entity; Calculate the amount and timing of transfers to the parent company in sterling terms; Allow for the indirect costs and benefits of the project in sterling terms (e.g. the contribution lost due to the turnover of other members of the group being affected by this overseas project).
p gs
o t.c
425
Purchasing power parity theory (PPPT)

This theory is based upon the law of one price i.e. in equilibrium identical products must have the same relative cost irrespective of the currency used. PPPT claims that the rate of exchange between two currencies depends upon the inflation levels in the countries concerned. The formula is designed to estimate a predicted spot rate between two currencies at some future time. Formula (assuming use of indirect currency quotes)
Predicted Spot rate (S1) =
Current Spot rate
1 + foreign inf lation rate 1 + home inf lation rate
1 + hc S0 1 + h b
Illustration 1
Startall plc wishes to estimate future exchange rates based upon the following projections of inflation. UK 5% 5% 5% 5% 5% USA 5% 5% 7% 7% 7% Bargonia 20% 30% 30% 30% 30%
Year
1 2 3 4 5
If current spot rates are US$1.60 = 1 and Bargonian Dowl 250 = 1, using the PPPT, what are the predicted spot rates for the currencies concerned at the end of each of the next five years?
o bo
0 s2
.bl 0
p gs
o t.c
Solution 1
Exchange rates Year Dowl/ 0 250.0 1 285.7 US$/ 1.60 1. 2 1.05 2 353.7 1 .3 1.05 3 438.0 1 .3 1.05 4 542.2 1 .3 1.05 5 671.3 1 .3 1.05
1.60 1.05 1.05
1.60 1.05 1.05
1.630 1.07 1.05
1.662 1.07 1.05
1.693 1.07 1.05
426
Four-way equivalence
INTEREST RATE PARITY THEORY
Forward rate (F0)
1 + ic 1 + foreign interest rate Current Spot rate = S0 1 + i 1 + home interest rate b
INTERNATIONAL FISHER EFFECT EXPECTATIONS THEORY
(1 + i) = (1 + r )(1 + h)
or
(1 + m) = (1 + r )(1 + i)
PURCHASING POWER PARITY THEORY
Predicted Spot rate (S1) =
1 + hc Current Spot rate = S0 1 + h 1 + home inflation rate b
Where
Fo So S1 ic ib hc hb i (or m) r h (or i)
= =
eb predicted spot rate =

= = = = = = = interest rate in country c (the foreign country) interest rate in country b (the home country) expected country) inflation rate in country c (the foreign
s ok spot rate o current

forward rate
0 20
o .bl
o sp foreign inflation rate g 1 +
o t.c
expected inflation rate in country b (the home country) money (or nominal) interest rate (i.e. including the effect of inflation) real interest rate (i.e. excluding the effect of inflation) expected inflation rate
427
Remission of funds
Certain costs to the subsidiary may in reality be revenues to the parent company. For example, royalties, supervisory fees and purchases of components from the parent company are costs to the project, but result in revenues to the parent. Care should be exercised in identifying exactly how and when funds are repatriated. The normal methods of returning funds to the parent company are: Dividends Royalties Transfer prices; and Loan interest and principal
It is important to note that some of these items may be locally tax-deductible for the subsidiary but taxable in the hands of the parent.
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 projects 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
0 20 NPV of the project may be affected by host s This relates to the possibility that the ok actions can include: country government actions. These bo eof assets (with or without compensation!); Expropriation
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.
.bl 0
p gs
o t.c
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. Borrowing locally so that in the event of expropriation without compensation, the enterprise can offset its losses by defaulting on local loans.
(b)
428
(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. 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.
(d)
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 realised 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.
Financing overseas projects 0 0

(a) Equity
The chief sources of long-term finance are the following:
eb
s ok
.bl 0
p gs
o t.c
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. (b) Loans These could be in sterling, or in the currency of the country of operation, or in another currency (e.g. US dollars) particularly if funds are raised through the Euromarkets. 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. However, this reduced risk must be weighed against the interest rate paid on the loan. A loan in the local currency may carry a higher interest rate, and it may be preferable, for example, to arrange a Eurocurrency loan in a major currency which is highly correlated with the currency of the overseas operations. (c) Government grants Finance may be available from the UK, the overseas government, or an international body, such as the World Bank. (d) Intercompany accounts Financing by intercompany account is useful in a situation where it is difficult to get funds out of the foreign country by way of dividends. This is further discussed below.
429
Repatriation of cash from overseas investments

If it is difficult to repatriate the cash as dividends, various other alternatives are possible, for example Reasonably high management charges Moderately excessive royalties Slightly inflated transfer prices; and Fairly high interest rates on inter-company loans.
Comprehensive example
The directors of Eibl plc are considering whether to set up a subsidiary in Heina, a country whose currency is the Croll. The Heina subsidiary would assemble and market a sophisticated tractor. Survey data indicates that the Heina subsidiary could expect to sell 500 tractors in the first year of operations, increasing by 10 tractors in each of the next four years. In the first year, the unit selling price of a tractor would be three million Crolls, increasing at an annual rate of 10% (rounded to the nearest 100,000 Crolls) and each tractor would require components costing 5,000. The cost of the components would increase by 6% per annum in subsequent years. Eibl plc would provide the components to be assembled and would invoice its Heina subsidiary for these with no profit mark-up. The unit cost would be calculated to the nearest 100.
o .bl costs in Heina are expected to be Annual production, administration and 0 selling 00 45% of the sales value of tractors sold in that year. 2 ksHeina subsidiary would require working capital of At the start of its operations,o the bo 160 million Crolls. At the end of each year of production, the required level of e
p gs
o t.c
working capital would be approximately equal to 10% of that years sales. Assembly equipment costing 1,200 million Crolls would be installed and paid for immediately. Annual profits of companies in Heina are subject to a business tax of 40%. Working capital movements are excluded from the computation of taxable profit, but companies are entitled to include a deduction, representing 20% of the cost of equipment for each of the first five years of the equipments life. Business tax is paid at the end of the year to which the assessment relates. Eibl plc would usually evaluate this type of investment over a five-year period. At the end of the fifth year, a notional market value of the subsidiary would be calculated by applying a price-earnings ratio of six to the profit after tax arising in the fifth year (as pre-tax accounting profit equals taxable profit, no deferred tax liabilities can arise). If Eibl plc were to sell its subsidiary after five years, the sale proceeds would be taxed in Heina at a rate of 30% The initial finance of 1,360 million Crolls would be provided in the form of equity capital from the existing cash resources of Eibl plc. The cost of capital used by Eibl plc for this type of venture is 25%, but investors based in Heina would require a return of only 20%, when investing in an equivalent venture. At present, the Croll/ exchange rate is 150 Croll/ although predictions of the relative interest and inflation rates of the UK and Heina suggest that the Croll will depreciate against the by 4% per annum. In the project appraisals of Eibl plc, the exchange rate is rounded to the nearest whole number.
430
Apart from the initial investment, revenues costs and working capital changes can be assumed to arise at the end of the year in which they occur.
Required (a)
Prepare a statement showing to the nearest 100,000 Crolls the net cash flow that would arise in each year of the venture and hence determine whether the investment would be acceptable to investors based in Heina (assuming details of the venture remain as outlined). Calculate whether Eibl plc should set up the Heina subsidiary, assuming cash surpluses are remitted to the UK at the end of each year. Discuss what improvement could be made by Eibl plc to the proposed financial arrangements with the Heina subsidiary.
(b) (c)
Note: Ignore UK taxation Use the following discount factors: End of year 20% 25% 1 0.83 0.80 2 0.69 0.64 3 0.58 0.51 4 0.48 0.41 5 0.40 0.33
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431
Solution
(a) Net cashflow for each year of the venture and appraisal from viewpoint of investors in Heina
Crolls (millions) 2 3 1,683.0 1,872.0 (437.9) (492.1) (757.3) 487.8 (842.4) 537.5
Year Sales revenue (W1) Components (W2) Overhead cost (45% x sales)
1 1,500.0 (390.0) (675.0) 435.0
4 2,120.0 (556.5) (954.0) 609.5
5 2,376.0 (619.1) (1,069.2) 687.7
Business tax @ 40% (excluding capital allowances) Assembly equipment Tax relief @ 40% (over 5 years) Profit after tax Working capital (W3) Net cash flow in first 5 years* 20% factor PV NPV = (1,200)
(174.0)
(195.1)
(215.0)
(243.8)
(275.1)
96.0 (160) 10.0
96.0 (18.3)
(1,360) 1 (1,360)
164 million Crolls
eb
k oo
o .bl370.4 0 367.0 00 s2 0.83 0.69

305 256
p gs
om c96.0 t.
(18.9) 399.6 0.58 232
96.0 (24.8)
96.0 508.6 (25.6)
436.9 0.48 210
483.0 0.40 193
(*ignoring any final value of investment or return of working capital) This NPV figure ignores the value of the investment at the end of the five-year period because the question asks for the net cashflow in each year. However, the computations are not complete without including this factor. There are various possibilities: 1. The business winds up after five years, returning only working capital. This has a value of 238m Crolls, if recovered in its entirety, which has a present value of 238m x 0.40 = 95m Crolls. The NPV of the project is then 69m Crolls (not worthwhile). 2. The business continues as a going concern with a value of 6 x profit after tax in fifth year: i.e. 6 x 509 (approx) = 3,054m Crolls. PV of this NPV of project = = 3,054 x 0.40 = 1,222m Crolls
1,058m Crolls which is obviously worthwhile.
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Workings 1. Sales revenue Year Sales price per tractor (Cr millions) Sales volume (units) Sales revenue (Cr millions) 2. 0 1 2 3 4 5
3 500 1,500
3.3 510 1,683
3.6 520 1,872
4.0 530 2,120
4.4 540 2,376
Component cost per tractor Total component Cost (m) Exchange rate 150 Component cost (Cr millions) Working capital WC at end of each year (10% x sales) Increase/ (decrease) in year
5,000
5,300
5,600
6,000
6,300
2.500 156
2.703 162
2.912 169
3.180 175
3.402 182
390
437.9
492.1
556.5
619.1
3.
160
150
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0
2 ks o (10)
1
00
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168.3
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m
212.0 237.6
187.2
18.3
18.9
24.8
25.6
(b)
Appraisal from viewpoint of Eibl plc

Year Net cashflow remitted (Cr millions) Exchange rate Net cashflow (m) 25% factor PV 2 3 4 5
(1,360) 150
367 156
370.4 162
399.6 169
436.9 175
483 182
(9.07) 1 (9.07)
2.35 0.80 1.88
2.29 0.64 1.47
2.36 0.51 1.20
2.50 0.41 1.03
2.65 0.33 0.87
NPV =
2.62m.
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However this excludes the cashflow from sale of the subsidiary at its notional market value of 3,054m Crolls. Net of tax this produces: 3,054 x (1 0.3) 2,138m 182 = = 2,138m Crolls 11.75m = 3.88m = 1.26m.
which has a present value of 11.75m x 0.33
The project is therefore worthwhile, with an NPV of 3.88 2.62
(c)
Improvement to the proposed financial arrangements with the Heina subsidiary
Investments in foreign countries involve significant additional risks. Chief amongst these are the problems caused by currency movements. There are several ways in which currency fluctuations can be handled, but the most important point to concern Eibl is that the currency risk attached to a foreign subsidiary can be reduced by matching the subsidiarys assets with liabilities in the same currency. This implies that the subsidiary should be financed to a large extent by borrowing in Crolls. This particularly applies if it is estimated that the Croll will be depreciating against the , because the annual interest suffered becomes lower each year when converted to . However, it is said that there are no free gifts in foreign exchange and it is likely that the interest rate suffered on a Heina loan is higher than on a sterling loan. A further risk of investments in some countries is the problem of remitting the subsidiarys cash surpluses back to the UK. Usually, dividends are the most difficult to get past exchange control regulations. It may be that Eibl would do better to invoice for the components which it supplies at a mark-up on cost rather than at straight cost. Tax considerations are also of prime importance in transfer pricing policy.
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The following amendments to the financial arrangements could also be considered: Eibl could charge the subsidiary with a royalty per tractor produced or sold; Eibl could invoice the subsidiary for management charges for advice given; Eibl could lend money to the subsidiary and charge interest on those loans.
However these revenues would cause a UK corporation tax liability to be incurred.
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TRANSFER PRICING Article from a USA publication

A particularly sensitive problem for multinational firms is establishing a rational method for pricing of goods, services, and technology between related affiliates in different countries. Even purely domestic firms find it difficult to reach agreement on the best method for setting prices on transactions between affiliates. In the multinational case, managers must balance conflicting considerations. These include fund positioning, income taxes, managerial incentives and evaluation, tariffs and quotas, and joint-venture partners.
Fund positioning effect

Transfer price setting is a technique by which funds may be positioned within a multinational enterprise. A parent wishing to remove funds from a particular foreign country can charge higher prices on goods sold to its affiliate in that country. A foreign affiliate can be financed by the reverse technique, a lowering of transfer prices. Payment by the affiliate for imports from its parent transfers funds out of the affiliate. A higher transfer (sales) price permits funds to be accumulated within the selling country. Transfer pricing may also be used to transfer funds between sister affiliates. Multiple sourcing of component parts on a worldwide basis allows changes in suppliers from within the corporate family to function as a device to transfer funds.
Income tax effect
A major consideration in setting transfer price is the income tax effect. Worldwide corporate profits may be influenced by setting transfer prices to minimise taxable income in a country with a high income tax rate and maximise income in a country with a low income tax rate.
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Needless to say, government tax authorities are aware of the potential income distortion from transfer price manipulation. A variety of regulations and court cases exist on the reasonableness of transfer prices, including fees and royalties as well as prices set for merchandise. If a government taxing authority does not accept a transfer price, taxable income will be deemed larger than was calculated by the firm and taxes will be increased. An even greater danger, from the corporate point of view, is that two or more governments will try to protect their respective tax bases by contradictory policies that subject the business to double taxation on the same income. Typical of laws circumscribing freedom to set transfer prices is Section 482 of the US Internal Revenue Code. Under this authority the Internal Revenue Service (IRS) can reallocate gross income, deductions, credits, or allowances between related corporations in order to prevent tax evasion or to reflect more clearly a proper allocation of income. Under the IRS guidelines and subsequent judicial interpretation, the burden of proof is on the taxpayer to show that the IRS has been arbitrary or unreasonable in reallocating income. The correct price according to the guidelines is the one that reflects an arms length price, that is, a sale of the same goods or service to an unrelated customer.
435
IRS regulations provide three methods to establish arms length prices: comparable uncontrolled prices, resale prices, and cost-plus. A comparable uncontrolled price is regarded as the best evidence of arms length pricing. Such prices arise when transactions in the same goods or services occur between the multinational firm and unrelated customers, or between two unrelated firms. The second-best approach to arms length pricing starts with the final selling price to customers and subtracts an appropriate profit for the distribution affiliate to determine the allowable selling price for the manufacturing affiliate. The third method is to add an appropriate markup for profit to total costs of the manufacturing affiliate. The same three methods are recommended for use in member countries by the Organisation for Economic Cooperation and Development (OECD) Committee on Fiscal Affairs. Although all governments have an interest in monitoring transfer pricing by multinational firms, not all governments use these powers to regulate transfer prices to the detriment of multinational firms. In particular, transfer pricing has some political advantages over other techniques of transferring funds. Although the recorded transfer price is known to the governments of both the exporting and importing countries, the underlying cost data are not available to the importing country. Thus the importing country finds it difficult to judge how reasonable the transfer price is, especially for non-standard items such as manufactured components. Additionally, even if cost data could be obtained, some of the more sophisticated governments might continue to ignore the transfer pricing leak. They recognise that foreign investors must be able to repatriate a reasonable profit by their own standards, even if this profit seems unreasonable locally. An unknown or unproven transfer price leak makes it more difficult for local critics to blame their government for allowing the country to be exploited by foreign investors. On the other hand, if the host government has soured on foreign investment, transfer price leaks are less likely to be overlooked. Thus within the potential and actual constraints established by governments, opportunities may exist for multinational firms to alter transfer prices away from an arms length market price.
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Managerial incentives and evaluation

When a firm is organised with decentralised profit centres, transfer pricing between centres can disrupt evaluations of managerial performance. This problem is not unique to multinational firms, but has been a controversial issue in the centralisation versus decentralisation debate in domestic circles. In the domestic case, however, a modicum of coordination at the corporate level can alleviate some of the distortion that occurs when any profit centre sub-optimises its profit for the corporate good. This statement might also be true in the multinational case, but coordination is often hindered by longer and less efficient channels of communication and the need to consider the unique variables that influence international pricing. Even with the best intent, a manager in one country finds it difficult to know what is best for the firm as a whole when buying at a negotiated price from an affiliate in another country. If corporate headquarters establishes transfer prices and sourcing alternatives, managerial disincentives arise if the prices seem arbitrary or unreasonable. Furthermore, if corporate headquarters makes more decisions, one of the main advantages of a decentralised profit centre system disappears. Local management loses the incentive to act for its own benefit.
436
Tariff and quota effect

Transfer pricing may have an influence on the amount of import duties paid. If the importing affiliate pays ad valorem import duties, and if those duties are levied on the invoice (transfer) price, duties will arise under the high-markup policy. The incidence of import duties is usually opposite to the incidence of income taxes in transfer pricing, but income taxes are usually a heavier burden than import duties. Therefore transfer prices are more often viewed from an income tax perspective. In some instances, however, import duties are actually levied against internationally posted prices, if such exist, rather than against the stated invoice price. If so, duties will not be influenced by the transfer price policy. Income taxes will still be affected by both the residual location of operating profit and the deductibility of the assessed import duties. Related to the tariff effect is the ability to lower transfer prices to offset the volume effect of foreign exchange quotas. Should a host government allocate a limited amount of foreign exchange for importing a particular type of good, a lower transfer price on the import allows the firm to bring in a greater quantity? If, for example, the imported item is a component for a locally manufactured product, a lower transfer price may allow production volume to be sustained or expanded, albeit at the expense of profits in the supply affiliate.
Effect on joint-venture partners
Joint ventures pose a special problem in transfer pricing, because serving the interest of local stockholders by maximising local profit may be suboptimal from the overall viewpoint of the multinational firm. Often the conflicting interests are irreconcilable. When Ford Motor Company decided to rationalise production on a worldwide basis so that each division could specialise in certain products or components, it was forced to abandon its policy of working with joint ventures partly because of the transfer pricing problem. It had to purchase the large British minority interest in Ford some years ago, despite the well publicised and ill-timed drain on the US balance of payments. For identical reasons, General Motors has seldom worked with joint ventures despite its arrangement with Toyota.
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Transfer pricing in practice

Given the potential for conflicting objectives, what transfer pricing policies do multinational firms utilise in practice? An empirical study of 164 US multinational firms sheds considerable light on this question. Although Section 482 of the US Internal Revenue Code requires use of arms length pricing, only 35% of the responding firms indicated that they used market based methods to set the arms length transfer price. Almost all of the other firms used either some version of a cost plus price or a negotiated price. This split presumably reflects the relative proportion of products which had a recognised external market price compared to products or components that had no external market price. The authors of the study used the response data to test various hypotheses about the determinants motivating a firms choice of a particular transfer pricing policy. They found that legal and size variables were statistically significant determinants of market-based transfer pricing. Legal considerations include compliance with tax rules (Section 482), customs regulations, antidumping laws, antitrust laws, and the accounting norms of host countries. Large-size firms with
437
multiple products and locations were also likely to use market-based transfer pricing whenever possible. This was probably because they are highly visible and it would be difficult to customise transfer pricing given the complexities of their sales networks. Another interesting finding of the study was that economic restrictions (such as exchange controls, price controls, and restrictions on imports), political-social conditions, and the extent of economic development in host countries are either unimportant or are secondary determinants of market-based transfer pricing strategy. Furthermore, they found no statistical support for assuming that these variables influenced non market-based transfer pricing policies. These findings suggest that transfer pricing policies are not very sensitive to the positioning of funds considerations which were described earlier in this article. The study also found that internal considerations, such as performance evaluation of subsidiaries and their management, were not statistically significant determinants of transfer pricing policies. Presumably multinational firms prefer to maintain separate sets of books for that purpose. A much earlier study of 60 non-US multinational firms and their US affiliates found distinct national differences with respect to the weight accorded host country environmental variable and internal company parameters. Canadian, French, Italian, and US parent firms judged that the tax effect of transfer pricing was the most important consideration. British parent firms emphasised the strong financial appearance of their US affiliates. Inflation was an important consideration by all parent firms, except those in Scandinavia; these firms considered acceptability to the host government to be the most important determinant of their transfer pricing policies. German firms appeared to be least concerned about transfer pricing policies. Non-US firms, in contrast to US firms, did not consider the evaluation of managerial performance to be important because, contrary to the practice of many US firms, they did not usually operate their foreign affiliates on a profit centre basis.
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438
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 years 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 companys 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 companys 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.
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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 aftertax 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) (b)

Evaluate the proposed investment from the viewpoint of Brookday plc. State clearly any assumptions that you make. What further information and analysis might be useful in the evaluation of this project?
439
Brookday plc solution

(a)
Brookdays stated policy is to remit the maximum funds possible to the parent company. The net present value of relevant cash flows to the parent company will be the appropriate decision criterion, and should lead to maximisation of parent shareholder wealth. The dollar profit and relevant cash flow from the subsidiary must be determined first: Projected earnings data of the US subsidiary Year 1 Year 2 Year 3 Year 4 Year 5 $000 $000 $000 $000 $000 10,500 11,025 11,580 5,000 2,000 1,000 309 4,000 7,309 (2,309) 0 (2,309) 4,200 1,050 586 4,000 9,836 664 0 p 664 gs 4,410 1,102 557 4,000 10,069 4,630 1,158 529 4,000 10,317 1,263 0 1,263 (287) (287)
Sales (note 1) Variable cost Fixed costs Royalty (note 2) Depreciation
Taxable profit US tax payable (note 3) Profit after tax
m 956 co t.
0 956
Profit after tax Depreciation Initial investment Additional capital Realisable value of fixed assets (note 4) Tax on realisable value Working capital available Cash flow available to parent
o .bl flow data of the US subsidiary Projected0 cash 00 Year 2 Year 3 Year 4 Year 5 Year 0 Year 1 2 $000 ks $000 $000 $000 $000 $000 o (2,309) 664 956 1,263 (287) o 4,000 4,000 4,000 4,000 eb
(19,000) (1,000)
20,000 (10,000) ______ _____ _____ _____ 4,000 ______
(19,000)
691
4,664
4,956
29,263
(10,287)
440
Projected cash flow data for the parent company Year 0 Year 1 Year 2 Year 3 Year 4 Year 5 000 000 000 000 000 000 Available from US subsidiary Royalty payment UK tax on royalty (note 5) Net cash flow Discount factors @ 13% (note 6) Present values (14,615) 559 250 3,976 500 4,445 500 27,633 500 (10,226)
_____ (14,615)
___ 809
(125) 4,351
(250) 4,695
(250) 27,883
(250) (10,476)
1 (14,615) =
0.885 716
0.783 3,407
0.693 3,254
0.613 17,092
0.543 (5,688)
Net present value
+4,166,000
The loss of exports to the USA if the project is undertaken is not a relevant cash flow.
Notes:
1. Sales price increases by 5% per year
Price ($) Units (000) Sales revenue ($000)
Similar calculations are necessary adjustments for fixed costs.
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o sp 1 gYear
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m
Year 3 110.25 100 11,025 costs and Year 4 115.80 100 11,580 price
100.00 50 5,000 for
Year 2 105.00 100 10,500 variable
2.
The royalty is payable in s and will depend upon the $/ exchange rate. The is expected to fall in value by 5% per year relative to the $. Year 1 1.235 250 309 Year 2 1.173 500 586 Year 3 1.115 500 557 Year 4 1.059 500 529 Year 5 1.006
Expected exchange rates $/ Royalty (000) Royalty ($000) 3. 4.
Losses are assumed to be carried forward and allowed against future profits for taxation purposes. Although the subsidiary will exist for more than four years, the companys planning horizon is only four years. A value must be placed upon the subsidiary at this time. The only information available is an estimate of realisable value of fixed assets. Tax on this realisable value will be payable as the assets are fully depreciated. Potential working capital available must also be considered. There will be no double taxation on cash flows from the USA. However, the royalty has not been subject to US tax, and will be liable to UK taxation.
5.
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6.
Using the capital asset pricing model to determine the discount rate: ke ke = = rf + (Erm rf) project 7% + (12% 7%) 1.2 = 13%
(b)
Further information and analysis might include: (i) (ii) How accurate are the cash flow forecasts? established? How have they been
Why has a four year planning horizon been chosen? The valuation of the fixed assets at year 4 is highly significant to the NPV solution. How has this valuation been established? Is this valuation based upon future earnings as a going concern? It would be more desirable to evaluate the project over the whole of its projected life. Risk is taken into account by using a CAPM derived discount rate. How has this rate been derived for a situation involving two countries? Does this fully reflect the risk of the project? Is the use of CAPM appropriate as it is a single period model? Other, theoretically weaker, measures of risk might be useful as an aid to decision-making e.g., sensitivity analysis of the key variables or simulation. Cash flow is usually assumed to occur at the end of each year. Greater accuracy would result if consideration were given to when during the year cash flow arises and these cash flows discounted at the appropriate rate. Political and economic factors should be considered. How stable is the US government policy? Will a change in government lead to changes in taxation policy, exchange controls, restrictions on the remittance of funds or attitudes towards foreign investment?
(iii)
(iv)
(v)
(vi)
k oo benefits of establishing a manufacturing plant in Are there any intangible eb the USA e.g. making the American public more aware of Brookdays
product?
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Zedland Postal Service

The general manager of the nationalised postal service of a small country, Zedland, wishes to introduce a new service. This service would offer the same-day delivery of letters and parcels posted before 10am, within a distance of 150 km. The service would require 100 new vans costing $8,000 each and 20 trucks costing $18,000 each. 180 new workers would be employed at an average annual wage of $13,000 and five managers at average annual salaries of $20,000 would be moved from their existing duties, where they would not be replaced. Two postal rates are proposed. In the first year of operation, letters will cost $0.525 and parcels $5.25. Market research undertaken at a cost of $50,000 forecasts that demand will average 15,000 letters each working day and 500 parcels each working day during the first year, and 20,000 letters a day and 750 parcels a day thereafter. There is a five-day working week. Annual running and maintenance costs on similar new vans and trucks are estimated in the first year of operation to be $2,000 a van and $1,000 a truck. These costs will increase by 20% a year compound (excluding the effects of inflation). Vehicles are depreciated over a five-year period on a straight line basis. Depreciation is tax-allowable and the vehicles will have negligible scrap value at the end of the five years. Advertising in year one will cost $1,300,000 and in year two $250,000. There will be no advertising after year two. Existing premises will be used for the new service, but additional costs of $150,000 a year will be incurred. All the above data are based on price levels in the first year and exclude any inflation effects. Wage and salary costs and all other costs are expected to rise (because of inflation) by approximately 5% a year during the five-year planning horizon of the postal service. The government of Zedland will not permit annual price increases within nationalised industries to exceed the level of inflation. Nationalised industries are normally required by the government to earn at least an annual after-tax return of 5% on average investment and to achieve, on average, at least zero net present value on their investments.
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The new service would be financed half with internally generated funds and half by borrowing on the capital market at an interest rate of 12% a year. The opportunity cost of capital for the postal service is estimated to be 14% a year. Corporate taxes in Zedland, to which the postal service is subject, are at the rate of 30% for annual profits of up to $500,000 and 40% for the balance in excess of $500,000. Tax is payable one year in arrears. The postal services taxable profits from existing activities exceed $10,000,000 a year. All transactions may be assumed to be on a cash basis and to occur at the end of the year, with the exception of the initial investment which would be required almost immediately.
Required:
Acting as an independent consultant, prepare a report advising whether the new postal service should be introduced. Include in your report a discussion of other factors that might need to be taken into account before a final decision is made on the introduction of the new postal service. State any assumptions that you make.
443
Zedland Postal Service solution

Report on proposed same-day delivery service To: From: 1. The Governing Board, National Postal Service, Zedland. International Management Consultants Ltd
Terms of reference This report considers whether the proposed new same-day delivery service will earn sufficient to meet the twin targets of a 5% after-tax return on average investment and a net present value of at least zero. Other factors affecting the decision are also considered.
2.
Conclusion and recommendation Our calculations on target returns are shown in the appendix. The return on investment, as calculated by us, is 12%, which is acceptable, but the net present value is negative. We therefore recommend that the service is not run under the existing proposals, but this recommendation is subject to the factors considered in the next section.
3.
Other factors affecting the decision (a)
The project could possibly be made more profitable by increasing prices or reducing costs. These possibilities should be investigated. It is good practice to carry out a sensitivity analysis on the estimates made to discover which are the key factors in determining the success or failure of the project. Furthermore analysis can be undertaken on these factors with the objective of making more accurate estimates. For example, our initial reaction is that the price/demand relationship and the staffing levels required should both be subject to further analysis. The proposed service might be of great benefit to the public and to the economy as a whole. The government may consider that it is worth subsidising this service from the profits of the Postal Services other operations. The effect of the new service on existing services does not appear to have been specifically investigated. There will possibly be a reduction in revenue from existing services which should be included in the calculations.
(b)
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(c)
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Appendix
1. Incremental profit figures for the five-year planning horizon Year Revenue: Letters (W1) Parcels (W2) 1 $000 2,048 _682 2,730 $000 Expenses: Additional staff (W3) Vehicle depreciation (W4) Vehicle running costs (W5) Advertising Premises costs 2,340 232 220 1,300 150 4,242 (1,512) 605 (907) 2 $000 2,867 1,075 3,942 $000 2,457 232 277 263 158 3,387 555 (222) 333 3 $000 3,010 1,129 4,139 $000 2,580 232 349 165 3,326 813 (325) 488 4 $000 3,160 1,185 4,345 $000 2,709 232 440 174 3,555 790 (316) 474 5 $000 3,318 1,244 4,562 $000 2,844 232 554 182 3,812 750 (300) 450
Profit before tax Taxation @ 40% Profit after tax 2.
Average annual after-tax return on average investment $ 800,000 360,000 1,563,000 2,723,000
Total investment Vans Advertising
Average investment Average profit
o bo
= = =
0 s2
.bl 0
p gs
o t.c
$2,723,000 2 =
$1,361,500
(-907 + 333 + 488 + 474 + 450) 5 $167,600
Average annual after-tax return on average investment = 3.
167.6 1,361.5
12.3%
Net present value (in $000) Year Profit before tax Add depreciation Taxation (one year delay) Cost of vehicles 0 1 (1,512) 232 2 555 232 605 ____ 1,392 0.769 1,070 3 813 232 (222) ___ 823 0.675 556 4 790 232 (325) ___ 697 0.592 413 5 750 232 (316) ___ 666 0.519 346 6
(300) ___ (300) 0.456 (137)
(1,160) (1,160) 1 (1,160)
____ (1,280) 0.877 (1,123)
14% factor Present value
Net present value = $35,000 negative
445
4.
Assumptions (i) (ii) (iii) The rate of inflation for revenue and costs (excluding depreciation) is assumed to be 5% p.a. over the five-year planning horizon. The cost of market research already undertaken is ignored (sunk cost). The cost of the five managers used for the project is already contracted for and therefore ignored in these calculations, which assume that they would not be made redundant if the project did not go ahead. Return on investment has been computed including advertising costs as part of the investment but, ignoring financing costs. The cost of borrowings is assumed to be already included in the opportunity cost of capital of 14%.
(iv) (v)
Workings
1. Revenue from letters: Year 1: 15,000 letters x 5 x 52 x $0.525 Year 2: 20,000 letters x 5 x 52 x $0.525 x 1.05 = = $2,047,500 $2,866,500, increasing at 5% p.a. thereafter.
2.
Revenue from parcels: Year 2: 500 parcels x 5 x 52 x $5.25 Year 2: 750 parcels x 5 x 52 x $5.25 x 1.05
3.
Additional staff cost:
180 x $13,000 in year 1
The cost of managers is not relevant, as they would have been paid anyway, and it is assumed that they will not be made redundant if the new project is not undertaken. 4. Depreciation: $ 800,000 360,000 $1,160,000 = $232,000
o bo
k=
0 s2
.bl 0
p gs
o t.c
= =
$682,500 $1,074,937, increasing at 5% p.a. thereafter.
$2,340,000, rising at 5% p.a. thereafter.
Cost of vans: Cost of trucks:
100 x $8,000 20 x $18,000
= =
Annual depreciation = $1,160,000 5 (Note: No inflation increase!) 5. Vehicle running costs:
Year 1: Vans Year 1: Trucks
100 x $2,000 20 x $1,000
= =
$ 200,000 20,000 $220,000
These running costs in subsequent years are found by multiplying by 1.26 each year.
446
6.
Taxation Because the other operations of the postal service make high profits, not only will all marginal tax calculations be at 40%, but it is assumed that the losses made in year 1 will result in a reduction in the total tax charge of 40% of the loss made. This is therefore shown as a notional receipt.
o bo
0 s2
.bl 0
p gs
o t.c
447
Axmine plc
(a)
The managers of Axmine plc, a major international copper processor are considering a joint venture with Traces, a company owning significant copper reserves in a South American country. If the joint venture were not to proceed Axmine would still need to import copper from the South American country. Axmines managing director is concerned that the government of the South American country might impose some form of barriers to free trade which puts Axmine at a competitive disadvantage in importing copper. A further director considers that this is unlikely due to the existence of the World Trade Organisation (WTO).
You are required to briefly discuss possible forms of non-tariff barrier that might affect Axmines ability to import copper, and how the existence of the WTO might influence such barriers. (8 marks) (b)
The proposed joint venture with Traces would be for an initial period of four years. Copper would be mined using a new technique developed by Axmine. Axmine would supply machinery at an immediate cost of 800 million pesos and 10 supervisors at an annual salary of 40,000 each at current prices. Additionally Axmine would pay half of the 1,000 million pesos per year (at current prices) local labour costs and other expenses in the South American country. The supervisors salaries and local labour and other expenses will be increased in line with inflation in the United Kingdom and the South American country respectively. Inflation in the South American country is currently 100% per year, and in the UK it is expected to remain stable at around 8% per year. The government of the South American country is attempting to control inflation, and hopes to reduce it each year by 20% of the previous years rate. The joint venture would give Axmine a 50% share of Traces copper production, with current market prices at 1,500 per 1,000 kilogrammes. Traces production is expected to be 10 million kilogrammes per year, and copper prices are expected to rise by 10% per year (in pounds sterling) for the foreseeable future. At the end of four years Axmine would be given the choice to pull out of the venture or to negotiate another four year joint venture, on different terms. The current exchange rate is 140 pesos/. Future exchange rates may be estimated using the purchasing power parity theory. Axmine has no foreign operations. The cost of capital of the companys UK mining operations is 16% per year. As this joint venture involves diversifying into foreign operations the company considers that a 2% reduction in the cost of capital would be appropriate for this projct. Corporate tax is at the rate of 20% per year in the South American country and 35% per year in the UK. A tax treaty exists between the two countries and all foreign tax paid is allowable against any UK tax liability. Taxation is payable one year in arrears and a 25% straight-line writing-down allowance is available on the machinery in both countries. Cash flows may be assumed to occur at the year end, except for the immediate cost of machinery. The machinery is expected to have negligible terminal value at the end of four years.
o bo
0 s2
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p gs
o t.c
448
You are required to prepare a report discussing whether Axmine plc should agree to the proposed joint venture. Relevant calculations must form part of your report or an appendix to it.
State clearly any assumptions that you make.
(18 marks)
(c)
If the South American government were to fail to control inflation, and inflation were to increase rapidly during the period of the joint venture, discuss the likely effect of very high inflation on the joint venture. (4 marks)
Total: 30 marks
o bo
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449
Axmine plc solution

(a) Forms of non-tariff barrier and the WTO
Axmines ability to import copper from the South American country might be affected by the following forms of non-tariff barrier: (i) Deliberately obstructive customs procedures. The authorities might require time-consuming documentation to be completed before exports of copper are permitted, or might carry out detailed quality assurance inspections. Such inspections would be justified in the name of safety or quality control, but in reality the purpose is to reduce the volume of exports. Export quotas. The country might set maximum limits of copper that it is prepared to export. The purpose would be to reduce supply and therefore hope to increase the price of copper provided. Artificial exchange rates. The country might insist that an artificially high exchange rate is used to pay for goods exported. Perhaps a range of different rates could be set by the country for different forms of exports (copper, electrical goods, timber etc) so that control can be exercised over each category. Selective embargo. The country might totally refuse to permit exports to a certain country, either on human rights grounds or to retaliate against alleged unfair trading practices from that other country. Essentially this is a special case of export quotas, with the quota to particular countries set at zero.
(ii)
(iii)
(iv)
(v)
0 20 assistance. Governments commonly offer Withdrawal of government s their exporters a range of export credit guarantees to encourage foreign ok o trade, perhapsb e taking on the risk of other countries not honouring their
debts. Where these guarantees are reduced or withdrawn altogether, exports will be discouraged. Similar points apply to other forms of government assistance e.g., grants or subsidised loans.
.bl 0
p gs
o t.c
The General Agreement on Tariffs and Trade (GATT) was signed in 1947 by 23 countries in an attempt to encourage world-wide trade after the Second World War. The aims of GATT were to reduce existing barriers to free trade, to reduce discrimination in world-wide trade and to prevent protectionism by encouraging member countries to consult with others before taking protectionist measures. GATT eventually had more than one hundred signatory member countries, including many less developed countries, and the last round of negotiations undertaken (the Uruguay Round) was concluded in 1994. A new body, the World Trade Organisation (WTO) was set up in 1995 as a successor body to GATT, which itself officially ceased to exist at the end of 1995. The WTO, with a membership of about 150 countries, has to try to map out the road ahead for global trade policy. The Uruguay Round bequeathed the WTO a substantial agenda. It included further negotiations or reviews in areas including agriculture, textiles, intellectual property rights and services.
450
The implications of the WTO on Axmine plc depend on a number of factors: (i) (ii) If the South American country is not a member of the WTO, then the WTO is irrelevant. GATT was generally successful in driving tariff barriers out of the world trade scene, but has been much less successful in non-tariff barriers. Many countries continue to impose non-tariff barriers, especially against imports rather than exports, since they see doing this as in their best domestic interests. GATT allowed a number of facilities to favour less developed countries at the expense of developed countries, so the South American country might not contravene GATT/WTO terms by its actions of imposing barriers. GATT also allowed preferential rates to exist within trade blocs (e.g. the European Union) and these continue to exist under the WTO.
(iii)
(b)
Report on the proposed joint venture with Traces To: From:

The Board of Directors of Axmine plc L Hughes, Financial Analyst
Terms of reference
The board of directors has requested an evaluation of the financial implications of the proposed joint venture with Traces and of the risks and other factors, which are relevant to making a decision.
Recommendation
An examination of the expected cash flows from this project shows that it is financially sound, having an expected net present value of 4.7 million from an initial outlay of (800m pesos 140) 5.7 million. There would need to be large adverse movements in some of the estimates before the project became unattractive.
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On this basis, it is recommended that the joint venture negotiations proceed whilst gathering as much additional information as possible. The calculations are included in the appendix to this report, but before making a decision, members of the board should weigh up the risks and other considerations, which are listed in the next section.
Risks and other considerations

Some of the cash flow estimates used in the calculations are subject to wide margins of error. For example, both copper prices and exchange rates are extremely volatile. Calculations of exchange rates are based on purchasing power parity a theory, which does not fully explain exchange rate movements. A sensitivity analysis will be undertaken on the key estimates in the calculations. This analysis will be available before the next board meeting.
451
Other risk factors to consider include the following: (i) (ii) The joint venture is based on our confidence that Traces is a sound company and that the management is both competent and trustworthy. Political risk has not been considered in sufficient detail. In addition to trade barriers, the risk of expropriation of assets or severe exchange control regulations must be assessed in a country, which is known to be politically unstable. An estimate must be made of the speed at which skills will be transferred to the local workforce, as this will be a factor in determining the length of the involvement.
(iii)
On the positive side the calculations have ignored the option to withdraw from the venture or negotiate a new agreement at the end of the initial period of four years. This option will itself have a value, which will increase the net present value of the project. On a technical note, further consideration must be given to the discount rate, which was agreed for use in the calculations. Further thought must be given to obtain a more accurate estimate of the systematic risk of South American mining operations, which will help set up a more suitable discount rate. Reducing the discount rate by 2% simply because of diversification overseas is somewhat questionable. However the change in the net present value is not expected to be significant.
o .bl 0 Forecast of future exchange rates 00 Using purchasing power parity: Current exchange rate is 1402 s pesos/. ok o South American Exchange rate eb inflation* (Peso/)
Appendix
Year 0 1 100% 80% : : 140 x 1.80 1.08 1.64 1.08 1.512 1.08 1.41 1.08 1.328 1.08 = = 140 233.3
p gs
o t.c
2 3
64% 51.2%
: :
233.3 354.3
x x
= =
354.3 496.0
41.0%
496.0
647.6
32.8%
647.6
796.3
*At 80% of previous years rate
452
Forecast copper prices

Axmines share of output is (50% x 10m kg x 1.5) = 7.5m. Prices increase at 10% p.a., then convert to local currency. Year 1 2 3 4 Sales (000) 8,250 9,075 9,983 10,981 Exchange rate 233.3 354.3 496.0 647.6 Sales peso(m) 1,925 3,215 4,952 7,111
x x x x
= = = =
Supervisory labour costs

Currently (10 x 40,000) = 400,000, increasing at the 8% p.a. inflation rate and convert to pesos. Year 1 2 3 4 Cost (000) 432 467 504 544 Exchange rate 233.3 354.3 496.0 647.6 Cost peso(m) 101 165 250 352
x x x x
= = = =
Local labour costs

Axmines share currently (50% x 1,000m) local inflation prices. Year 1 2 3 4 Inflation % 80 64 51.2 41.0 Labour costs peso(m) 900 1,476 2,232 3,147 =
o bo
0 s2
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p gs
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500m pesos increasing by
UK taxation
UK tax 35% (20% paid abroad) 15% of foreign taxable income to be paid in UK. Year 1 724 233 .3 1,374 354 .3 2,270 496 3,412 647 .6 x 15% 000 465
15%
582
15%
686
15%
790
453
Net present value calculation

Year: Peso (m) Investment Sales Labour Supervisors Deduct WDA Taxable Tax (20%) Add back WDA Remitted Exchange rate 000 Received UK tax Net cash flow Discount factor (14%) Present value Net present value 0 (800) 1,925 (900) (101) (200) 724 ____ (800) 140 (5,714) (5,714) 1.000 (5,714) 200 924 233.3 3,961 3,961 0.877 3,474 3,215 (1,476) (165) (200) 1,374 (145) 200 1,429 354.3 4,033 (465) 3,568 0.769 2,744 4,952 (2,232) (250) (200) 2,270 (275) 200 2,195 496.0 4,425 (582) 3,843 0.675 2,594 7,111 (3,147) (352) (200) 3,412 (454) 200 3,158 647.6 4,876 (686) 4,190 0.592 2,480 1 2 3 4 5
(682) ____ (682) 796.3 (856) (790) (1,646) 0.519 (854)
+4,724,000
(c)
Effect of hyper-inflation
If the purchasing power parity theory holds true, then rapidly increasing inflation during the period of the joint venture is likely to lead to a higher net present value for the project. The sales, wages and supervisory costs all increase at a constant rate per annum, so it is immaterial in NPV terms whether the national inflation is low or high, but the favourable effect comes from the tax payment.
o bo
0 s2
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p gs
o t.c
The writing down allowance is calculated on the original cost of the machinery, so there is some benefit lost as inflation rises. However this loss will be more than compensated by the one year delay in payments of taxation. The higher that inflation is, the lower the tax payment becomes in real terms, so that the expected NPV of the project will rise as the inflation level rises. If the governments previous attempts at controlling inflation have failed, it is likely that so will the current inflation reduction programme, leading to a more attractive NPV prospect.
454

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ACCA Papero P4 sp

s ok Advanced Financial o eb Management 0 20 0 log .b

Class Notes June 2011

Typeset by Debbie Crossman

VALUATIONS, ACQUISITIONS AND MERGERS SECTION 1

Introduction to the paper

Aim of the Paper

Outline of the syllabus

Format of the Exam Paper

Formulae & tables provided in the examination paper

Two asset portfolio sp =

The Capital Asset Pricing Model

The asset beta formula

Ve Vd (1 - T) a = e + d (Ve + Vd (1 - T)) (Ve + Vd (1 - T ))

The Growth Model

e Gordons growth approximation

The weighted average cost of capital

The Fisher formula

Purchasing power parity and interest rate parity

Modified Internal Rate of Return

The Black Scholes Option Pricing Model

ln(Pa /Pe ) + (r + 0.5s 2 )t s t

The Put Call Parity relationship

Present value table

0.564 6 0.513 7 0.467 8 0.424 9 0.386 10

discount rate number of periods

m co 5.206 ot. 5.747

4.355 6 4.868 7 5.335 8 5.759 9 6.145 10

Standard normal distribution table

0.4943 0.4957 0.4968 0.4977 0.4983

0.4945 0.4959 0.4969 0.4977 0.4984

Issues in corporate governance

INTERNATIONAL COMPARISONS OF CORPORATE GOVERNANCE -- 36

Stakeholders (user groups) and their goals

Management and employees

The government Environmental pressure groups The general public

THE UK CORPORATE GOVERNANCE CODE Code of best practice

A.2 Division of Responsibilities

A.3 The Chairman

A.4 Non-executive Directors

Section B: Effectiveness B.1 The Composition of the Board

B.2 Appointments to the Board

B.5 Information and Support

Section C: Accountability C.1 Financial and Business Reporting

C.2 Risk Management and Internal Control

C.3 Audit Committee and Auditors

Section D: Remuneration D.1 The Level and Components of Remuneration

Section E: Relations with shareholders E.1 Dialogue with Shareholders

E.2 Constructive Use of the AGM

The design of performance-related remuneration for executive directors

Disclosure of corporate governance arrangements

The UK Corporate Governance Code

o sp C.3.3 Provision log The 0.b annual report

This requirement overlaps with a number of different provisions of the Code:

Engagement principles for institutional shareholders

Principle 1: Dialogue with companies

United States of America

Advanced investment appraisal section 1

CONGO LTD --------------------------------------------------------------- 44 INFLATION AND DISCOUNTED CASH FLOW -------------------------- 48

TAXATION AND INVESTMENT APPRAISAL ---------------------------- 50 CAPITAL RATIONING ---------------------------------------------------- 52

INVESTMENT APPRAISAL TECHNIQUES

Accepted techniques are

(10,000) _ (10,000) 5,000