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P4 Advanced Financial Management

CH 1: Financial Strategy Formulation and the role and responsibilities of senior financial executive
Financial
Investment
Factors to
Methods of
Problems facing
Dividend
Dividend

Involve (planning): 1. Establish and identify objectives 2. identify alternative courses of action 3. evaluate 4. select 5.
Investment Appraisal + Financing Decision + Dividend Decisions
Cost, risk, flexibility, matching/purposes, amount involved, security
1. Prospectus 2. Placing (with issuing house/institutional investor) 3. Stock exchange introduction 4.Offer for Sale (To
Risk, Security, Marketability of ordinary shares, Tax considerations, Cost, Lack of information, Funding gap, maturity gap
Traditional theory Dividend payout influence the market value bc 1. Information content (Dividend signaling) 2.
Modigliani and Miller (M&M) value of the firm is determined by its future earning stream and thus dividends and retention

CH 2: Conflicting Stakeholders Interest


Stewardship
Agency Theory
Stakeholder
Cadbury Code

Mgtment as steward who prioritizes company's strategy


Mgtment as agent who prioritize own interest and will only watch out for company performance when both goals coincide.
Mgtment ahas duty of care that extend beyond shareholder to the wider public
Corporate Governance = System by which companies are directed and controlled

CH 3: Cost of Capital
Cost of Equity
Gordon's Growth
Cost of
Cost of debt
WACC

P0 = D0(1+g)/(Ke-g)
G = rb. Assumption: 1. Entity is entirely equity financed 2. Retained profit is the only source of finance 3. Constant
Kps = D(net)/P0(ex-div)
Irredeemable: Kb = Interest (1-T)/MVd(Ex-div); Redeemable: Kb = yield to maturity = internal rate of return
Basic Principles: Cost of capital required for investment appraisal = cost of raising more capital (historical cost of capital =

CH 4: Portfolio Theory and Capital Asset Pricing Model (CAPM)


CAPM
assess the investment from the viewpoint of well-diversified shareholders using beta factor (Systematic risk), Ke =
Assumptions
(1) All $H hold the market portfolio (2) Perfect Capital market (3) Investor can borrow and lend at risk free interest rate (4)
Advantages
1. Demonstrate unsystematic risk can be diversified away 2. best practical mtd for Ke of public company 3. Highlight
Limitations
1. Concentrate purely on systematic risk/diversified portfolio 2. Treats dividend and Capital gains as equally desirable to
CH 5: Theories of Capital Structure
Traditional
M & M 1958
M & M 1963
Risk of Debt
Beta Asset (Ba)

Debt => Increase financial risk and gearing, but is cheaper than equity
(No Tax) => All companies with the same earnings in the same risk class have the same future income stream and should
(With Tax) => Companies with higher gearing ratio have greater net future income stream purely due to tax shield: Vg = Vu +
1. Bankruptcy cost, 2. Agency cost (restrictive covenant), 3. Tax exhaustion, 4. Debt capacity
Reflects systematic business risk only

Beta Equity (Be) Reflects systematic business risk and financial risk. If all-equity co, Ba = Be; If geared co, Be>Ba => Ba = Be(E/E+D(1-T))
Project Specific Suitable for company diversifying into another industry/new investment (Affect both business and financial risk). Steps: 1.
Pecking Order
Firms have a preferred hierarchy of financing decisions based on convenience: RE, Straight debt, Convertible Securities,
CH 6: Reporting financial Performance, Investment Appraisal techniques and the use of FCF
Investment
Accounting Rate of Return (ARR = Annual profit post depreciation/Average investment), Payback period, Discounted
Appraisal
CF:NPV and IRR (Yield = a%+NPVa/(NPVa-NPVb)*(b5-a%))
Techniques
Modified Internal Adv: 1. eliminate multiple IRR 2. address the reinvestment issue facing IRR 3. Provides ranking which is consistent with
Rate of Return
NPV 4. Provide % instead of value; Steps to calculate: (1) Convert all investment phase output into a single equivalent
(MIRR)
payment at time 0 (2) All net cash inflow convert to single terminal receipt at the end of the project's life, reinvestment rate
using company's cost of capital (3) MIRR =(Outflow/inflow)^1/t 1
Discounted
Payback
Duration

Length of time the DCF required to recover the original cash outlay

Capital Rationing
Dual Values
Free Cash Flow
Free Cash Flow
Dividend cover
Risk

Hard vs Soft; Single period vs Multi-Period; Divisible (Profitability index/linear programming) vs Indivisible (Trial and error,
Shadow prices which reflects the change in the objective function as a result of having one more or less unit of the scarce
Cash that is not retained and reinvested in the business, available to be distributed to providers of capital = EBIT Tax +
Represents the funds available for distribution only to ordinary $H, measures the dividend capacity of the company = FCF
FCFE/Dividend paid
Mtds of treating = sensitivity analysis, probability estimate of CF, certainty equivalent, adjusting Discount rate, simulation modeling

Avg time taken to recover the CF on an investment. Steps: 1. Calculate value of each fcf and discounted at DF, 2. Calculate
each year's DCF as a proportion of the original outlay, 3. Take the time from the investment and multiply with the proportion
in (2), 4. Sum the weighted year values Duration. If duration is based upon the avg time to recover the initial capital
investment, DF = IRR; IF the duration is based upon the avg time taken to recover the PV of the project, DF = Chosen hurdle
rate.

CH 7: Impact of financing on investment decisions and Adjusted Present Values (APV)


APV
Monte Carlo
Value at Risk

Suitable when (1) New investment and thus operating risk changes (2) significant change in capital structure and financial
Maths model which include all combinations of potential variables associated with a project, resulting in the creation of a
Value attached to the downside of a price distribution (Stad deviation) and within a confidence level. At 95% confidence, X-

CH 8: Application of Option Pricing Theory in Investment Decisions

Option

Right to buy (CALL) or sell (PUT) a fixed amt of financial asset at a specific exercise price fixed today (Exercise or strike
price) on or before the maturity date. (In-the-Money) happens when mkt price > exercise price (Call) or market price <
exercise price (PUT). Out-of-the-money = opposite. At-the-money happens when market price = exercise price

Intrinsic value of
Factors
Black Scholes
Put-call parity
The Greeks
Real Options
BS Model to

Profit that the buyer of an ITM option could make id the option were to be exercised immediately.
Price of Underlying instrument, exercise price, prevailing interest rate, time to expiry of option, volatility of underlying item
Assumption and Limitations: 1. Returns on the stock is normally distributed, 2. std deviation (is
Price of put P = Price of call C Current value of underlying security Pa + PV of the exercise price Pee-rt
Assessment of sensitivity of factors influencing the value of the options: 1. Delta = Changes in Option premium/ Change in
Apply BS model in the evaluation of financial options of capital investment appraisal: Option to delay/expand/new
Pa = FV of assets of the company (PV of FCF), Pe = settlement values of outstanding liabilities (Assumes all company's

CH 9: International Investment and Financing Decisions


Steps of
1. Identity relevant CF in local currency, 2. Deal with inflation, 3. Deal with local tax, 4. Deal with inter co transaction such
FOREX rate
1. Purchasing Power Parity Theory (PPPT), S1 = So*(1+ho/I+h1), 2. International Fisher Effect, Fo = So*(1+i0/1+i1)
Cross Rate
Computation of exchange rate for a currency from the exchange rate of 2 other currencies
Exchange rate
1. Transaction risk = gains/losses made when settlement takes place at some future date of a foreign currency denominated
Overseas Projects Short-term: 1. Eurocurrency loan = loan given by a bank denominated in foreign currency, 2. Syndicated loan Market = 2 or
Factors
1. Acceptable level of gearing, 2. availability, 3. size, 4. availability of collateral security, 5. cost, 6. tax relief available, 7.
CH 10: Impact of capital investment on financial Reporting
Effects of
1. Financial Risk: Gearing ratio, 2. interest cover, 3. EPS
Double Taxation Occurs when the same income is taxed twice. DT relief ensure that tax payer finally suffer tax at no more than the higher of
CH 11: Acquisitions and Merger
Synergy
Failure of
Organic Growth
Acquisition
Post-acquisition
Earn-out
Methods of
Accounting for
Regulations of
Office of free
Takeover Defense

Occurs when >= 2 activities/processes complement each other to provide combined effect greater than individual parts: 1.
1. Agency theory, 2. Integration failure, 3. Over-optimistic, 4. Paying too high premium, 5. Inadequate investigation, 6. Never
Adv: 1. Avoid paying premium 2. Minimal risk, 3. careful planning, 4. No integration Prob
Adv: 1. Eliminate competition, 2. Avoid barriers to entry, 3. quicker rate of growth, 4. Synergy
A) Druker's Golden 5 Rules: 1. share common core of unity, 2. ask what can we offer them?, 3. treat target co's pdt and ppl
Purchase consideration = initial payment + balance depending upon the financial performance of the target co. Adv: 1.
For Predator, Depends on 1. Control, 2. Earnings per share, 3. Authorized shares 4. cost to the co, 5. gearing; For target co,
Goodwill: (Acquisition) recognized (Merger) no; Value of shares exchanged: (Acquisition) recorded at market value (Merger)
The city code of takeover and mergers- regulates acquisitions of quoted co in UK. Main obj: all Shareholders are treated
Responsible for ensuring acquisition will not result into monopoly. Competition commission has <= 6 months to conduct
1. Appeal to shareholders on undervaluation 2. Appeal to Competition Commission 3. White knight defence- find more

CH 12: Valuation for Acquisitions and Mergers


Types of
Asset Valuation
Intellectual
Market relative
Earnings Yield
Dividend
Free Cash Flow
Economic Value
Market Value
Valuation of high

1. Acquisition that do not disturb the acquirer's exposure to financial and business risk (Valuation model: 1. Asset Valuation
MV = Asset-liabilities using 1. NBV, 2. Net realisable value, 3. Net replacement cost Adv: Info available, reliable, simple
The value platform- IC = human capital, organisational capital and customer capital. Method of valuation: 1. Market-toPrice Earnings (P/E) Ratio => Share Price = EPS*PE. Adv: easy, convenient, and applicable to co without dividend, Disadv:
EY = 1/PE
Suitable for minority shareholder with no influence, P0 = D1/(Ke-g) Problems: Uncertainty of Ke, Difficult to forecast g,
Free cash flow to Equity (FCFE) = cashflow available to a co from operations aft interest expense, tax, repayment of debt and
EVA = NOPAT (Net operating PAT = PBIT+dep+write-off GW + Provision increase+capital cost replacement cost dep
Value added to business since it's formed = Market Cap NBV => Evaluation of management performance
Gordon's Growth Model where Revenue/Ke-g Cost/Ke-g = MV

CH 13: Corporate Reconstruction and Reorganisation


Capital Reduction Confirmation by court is not necessary for pte co id directors make a Solvency statement. Scheme: 1. reduce liability of
Reconstruction
Principles: 1. Creditors must be better off than liquidation, 2. Co must have good chance of financially viable, 3. Must be fair
Business
Unbundling = disposal of assets / non-core biz such as sell-offs, liquidation, spin-off/demerger, and management Buy-out
Buy-out finance VC/ mezzanine finance, clearing banks, pension etc. Depending on the factors: 1. financial performance, 2. Market of pdt 3.
Models of
1. z-score model (less than 1.8 = potential failure, more than 2.7 = success), 2. Zeta model (7 ratios for commercial
CH 14: The Role of the Treasury function in multinationals
Capital Market
Trading long term finance (Equity and debentures) Primary market = raise new finance + secondary function = existing
Floating in stock Adv: 1. Easier to raise cap 2. realise assets 3. reduction of risk 4. facilitate growth by acquisition 5. enhance co images 6.
Money Market
Market where ppl lend and borrow money for short period of time <1 year. Instruments: 1. coupon bearing instruments
Role of treasury 1. Liquidity management, 2. Funding management, 3. Currency management, 4. corporate finance
CH 15: The use of financial derivatives to hedge against FOREX risk
Direct Quote
Indirect Quote
Spot rate
Forward rate
Outright
Point Quotation
FOREX risk
Internal Hedging
External Hedging
Forward

No. of units of home currency to deal in one unit of foreign currency. If home = USD = variable currency, => ($1.725 / Euro
No. of units of foreign currency to deal in one unit of home currency. If home = USD, => (Euro 0.5797/$ 1)
Price at which FOREX can be bought or sold today
Rate quoted today for delivery at a fixed future date of specified amt of one currency agst another currency
Full price to all of it's decimal point is given
No. of point away from the outright quotation. Premium = subtract, Discount = added to spot rate
Currency risk = Transaction, Translation, and Economic risk
Invoicing in domestic currency, Matching, Netting (setting the debtors and creditors of all companies in the group resulting
Non-Derivative: 1. Forward Exchange contract, 2. Money Market Hedge, 3. Synthetic foreign exchange agreements (SAFE);
Binding contract btw co and bank to purchase or sell a specified quantity of Foreign currency at a rate of exchange fixed

Money Market
SAFE
Futures
Options
Pricing of
Currency Swap

Co borrow funds in one currency and exchange the proceeds for another currency. Steps: (Receipt of Foreign currency): 1.
No physical delivery of currency, difference between the non-deliverable forward (NDF) and spot rate is calculated and
Legally binding agreement btw 2 parties to buy or sell a standardised quantity of a specific financial instrument at a future
Right to buy (CALL) or sell (PUT) a particular currency at a specified exchange rate on a particular date or up to that date.
Adapted version of BS model = Grabbe variant, where Pa = Forward rate, Pe = Spot rate using direct quote, r = home risk
Agreement btw 2 parties to exchange equivalent amt of currency at a predetermined agreed rate for a period and then re-

CH 16: The use of financial derivatives to hedge against Interest Rate risk
Forward rate
Pre-agreed fixed interest rate for a specific level of borrowing for a given future period btw co and bank
Interest rate
Binding contract btw buyer and seller for delivery of agreed interest rate commitment on an agreed date at agreed price.
Options on
Right to buy or sell the related interest rate futures contract. Borrower = PUT, Investor = CALL. Steps: 1. What contract?
Interest Rate
Agreement to exchange their interest rate commitment. Benefits: 1. Lower than bank 2. Easy to organize 3. Flexible,
Interest Rate
Right to borrow or lend a notional amount for a given period at a specified interest rate on a specified future date. Borrower's
Interest Rate
Right to a series of compensation if interest rates increase above the exercise price at each interest fixing date = borrower's
Interest Rate
Right to a series of compensation if interest rates decrease below the exercise price at each interest fixing date = Lender's
Interest Rate
Combination of purchasing interest rate cap and sell floors or vice versa to specify the range in which interest rate fluctuate.
Swaption
Option to enter into an interest rate swap or currency swap = protection with flexibility. But once exercised irreversible
Macaulay's
Total weighted avg time for recovery of a payment and principal in relation to the current market price of bond. Steps: 1. FCF,
CH 17: Dividend Policy in Multinationals and Transfer Pricing
Dividend
Measured by Dividend cover, depending on: 1. Liquidity, 2. Control (Using RE to fund new investment can retain co control),
Transfer pricing Objective: 1. fair, 2. motivate division manager, 3. retain divisional autonomy, 4. ensure overall group profit 5. Goal
TP in
Based on 1. Fund positioning effect, 2. Income tax effect (Min, but must reflect an arm's length price 1. Comparable
CH 18: Other forms of Risk
Political Risk
Impossible to quantify, manage by investment structuring, local borrowing, negotiation with govt, and being good citizen
Economic risk
Govt spending policy, recession, unemployment, international trading condition, currency
Regulatory Risk Anti-monopoly law, Health and Safety law, Copy right law, employment legislations
Fiscal risk
Increase of tax, import duty, WHT etc
Credit
Factors: Credit policy of organization, Credit limit and term, Credit assessment procedures, debt collection procedures
Kaplan- Urwitz Determine the credit score of a co. S > 6.76 = AAA, S >0 = BB
Credit Spread
Premium over an equivalent return on risk free bond to compensate the investor for credit risk = Rf+S (Rf = risk free rate, S =
CH 19: Economic Environment for Multinationals
Adam Smith
David Ricardo
Trade Bloc

Absolute Advantage
Comparative Advantage
Free trade area, Customs Unions, Common Market

WTO, MNC, Free Trade vs Protectionism, Balance of payment, IMF, EMS, Currency crisis, Counter trade
Source of finance Bank Overdraft, Bill of exchange, Promissory note, documentary letters of credit, factoring, forfaiting (Banker's guarantee),