Knowledge Recap (FM to AFM)

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To understand the difference between the two exams and help guide your preparation, read this
article.

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The table below maps the AFM syllabus to FM Chapters.

AFM Syllabus Area FM Chapter

A Role of senior financial adviser in the Chapter 1: The Financial Management

multinational organisation Function
Chapter 2: The Financial Management
Environment
Chapter 19: Ratio Analysis

B Advanced investment appraisal Chapter 3: Investment Decisions

Chapter 4: Discounted Cash Flow Techniques
Chapter 5: Relevant Cash Flows
Chapter 6: Applications of Discounted Cash
Flow Techniques
Chapter 7: Project Appraisal Under Risk
Chapter 8: Equity Finance
Chapter 9: Debt Finance
Chapter 10: Cost of Capital
Chapter 11: Weighted Average Cost of
Capital and Gearing
Chapter 12: Capital Asset Pricing Model

C Acquisitions and mergers Chapter 18: Business Valuation

E Treasury and advanced risk management Chapter 15: Cash Management

techniques Chapter 17: Risk Management
Chapter 1: Role of Financial Strategy
Objective: To introduce the role and operating environment of the senior financial executive.

1.1 To Achieve Organisational Goals

A company will usually have a vision, whether articulated or not, that is the foundation of the
company, and should set out its direction and values.
The corporate mission should set out what the organisation exists to do and establish clear
company aims and goals.

Definition

Strategy – a plan of action designed to achieve a long-term organisational goal or

aim.

A corporate strategy might ask:

 What business should we be in?
o What are our special organisational abilities, through which we can
create shareholder value?
o What business sector are these abilities best applied to?
 How should we allocate our various capitals to our business(es)?
 How can we best design our organisation? Should we be centralised or decentralised?
  How should we manage risk and return and create incentives?
A business strategy might ask:
 What corporate culture will best assist in achieving our aims?
 How should we compete?
 How should we organise our strategic business units?
An operational strategy might ask:
 How should our strategic business units operate?
 What functions should be outsourced?
 What incentive schemes should be offered to staff?

1.2 Financial Management

The objective of a financial strategy is to achieve a financial goal or aim and usually includes the
utilisation and management of financial resources, through the process of financial management.
Financial strategies include:
 The investment decision;
 The financing decision;
 The dividend decision;
 Risk management.
Strategies can be long or short term. For example, liquidity management is a short-term financial
strategy whereas the gearing and dividend decisions are long-term financial strategies.
A financial resource is money available to a business (e.g. cash, borrowing capacity, investments
or credit lines). Financial resources are used with the other capitals (human, intellectual, etc) to
achieve strategic objectives. The management of “financial resources” is often used to mean the
management of the company’s assets and liabilities, whether monetary or non-monetary.
Strategies may be expressed as plans, statements, budgets, forecasts (including cash flow
forecasts). The achievement of strategies requires internal controls. Collectively, such strategies
and controls amount to the management of financial resources.
Non-financial strategies include HR strategy, marketing strategy, product development strategy,
etc.

2.1 Corporate Objectives in Practice

In practice, companies are likely to have a variety of different objectives, which may include a
number of the following:
 profit targets;
 market share targets;
 share price growth;
 local and environmental concerns;
 contented workforce;
 meeting short-term targets; and
 long-term plans.
These objectives can be classified as follows:
Profit goals – objectives which lead directly to increased profits (e.g. cost reduction
measures);
 Surrogate profit goals – objectives which lead indirectly to increased profits (e.g.
maintaining a contented workforce);
 Constraints on profit – objectives which restrict profit (e.g. ensuring that the company's
operations do not harm the environment);
 Dysfunctional goals – objectives which do not provide a benefit even in the long run
(e.g. the pursuit of market leadership at all costs).
A company may aim at either maximising or satisficing these objectives:
 Maximising involves seeking the best possible outcome;
  Satisficing involves finding an adequate outcome.
Criticisms of profit maximisation include the following:
 Maximising shareholders’ wealth ignores the interests of other stakeholders such as
employees, customers and arguably, society as a whole.
 In the case of unlisted companies, even the shareholders may not require maximised
returns. For example, some closely held companies are run as "lifestyle firms" whose
main objective is to provide their owners with the opportunity to earn a living while
pursuing a particular lifestyle.

2.2 Maximisation of Shareholders' Wealth

The maximisation of shareholder wealth is a single corporate objective that can help managers in
decision-making.
Shareholder wealth is the combination of dividend and share price growth – together referred to as
Total Shareholder Returns (TSR).
The objective of maximising shareholder wealth can be justified in the following ways:
 The company which provides the highest returns for its investors will find it easiest to
raise new finance and grow in the future. If a company does not provide competitive
returns it will inevitably decline.
 The directors of a company have a legal duty to run the company on behalf of the
shareholders. It is generally considered a reasonable assumption that the shareholders
of listed companies (mainly institutional investors) seek to maximise wealth.
Activity 1 NPV, Payback and Time
Required:

Discuss whether the maximisation of net present value (NPV) will always maximise
shareholder’s wealth. You should make reference to payback and the issue of long-versus
short-term returns in your discussion.
*Please use the notes feature in the toolbar to help formulate your answer.
Net present value (NPV) links directly to the amount of shareholder wealth created or destroyed.
However, it does not always capture the value of real life flexibility and choice (“real options”) such
as the option to expand.
NPV can also give an erroneous result if capital, or some other resource, is rationed. In such
cases the NPV per unit of scarce resource should be maximised.
Directors should also consider short term factors when considering projects. Issues such as
liquidity and insolvency may mean that a viable long-term project is unwise if it “bets the
company”/creates risks that may mean the company does not survive to see the longer term.
Payback measures how long it takes for the surplus cash flows of a project to repay the original
investment. It ranks investments with a short payback period more highly than those that take
longer to pay back – but it ignores cash flows after the payback period.
In this sense, money now has a higher value than money later, which is something that payback
measures (albeit in a simplistic way).
Payback also captures, to some extent, the “value of the reinvestment option”. The sooner capital
is returned, the sooner the company can choose where to reinvest that capital. In a highly dynamic
environment, whether that volatility is driven by political technological or other issues, that option
will be particularly valuable.

2.3 Communication to Stakeholders

Effective communication and communication strategy are essential to implementing financial
policies and realising corporate goals. Communications with stakeholders must take into account
the following:
  Whether they are internal stakeholders (i.e. whose interests are derived from a direct
relationship such as ownership or employment) or external stakeholders (i.e. who are
affected by the actions and outcomes of the business, such as creditors, suppliers,
customers and the wider public).
 How they rank in terms of power over, and their level of interest in, the entity’s activities.
For example, the high-power/high-interest (“key”) stakeholders, such as senior
executives; and major creditors, suppliers and customers, need regular communications
to be kept informed.
 The purpose of the communication, for example:
o To attract new business;
o To change attitudes or believers (e.g. when implementing change);
o To provide information;
o To raise awareness of a situation;
o To request a decision;
o To support a policy position.
 The most appropriate medium that balances the specific needs of the communication
(e.g., confidentiality and urgency) with the needs of the stakeholders (e.g., to be
respectful of their time).
Exam advice

Question 1 in the exam typically requires making a report to a board of directors. Marks for the
professional skill of communication will be available for:
General report format and structure (use of headings/sub-headings and an
introduction);
 Style, language and clarity (appropriate layout and tone of report response,
presentation of calculations, appropriate use of the tools); and
 Effectiveness of communication (answer is relevant, specific, and focused on the
requirement).
Where relevant, marks for communication skills may also be available for adhering to specific
requests referenced in the scenario.

How an organisation discloses information and consults with stakeholders to promote better
awareness and understanding of its strategies and policies may be formalised in a Public
Information Policy (PIP) adopted by the board.
Typical content of a PIP might include the following:

Guiding Principles Target Groups

 Accountability  Customers
 Clarity  Employees
 Efficiency  Investors
 Transparency  Governmental organisations
 Feedback and stakeholder  Non-governmental organisations
engagement  General public

Communication Channels Governance and Operational Activities

 Annual Report  Governing bodies

 Advertising and  Lending, borrowing and treasury operations
sponsoring  Financial information
 Customer magazine  Sustainability reporting
 Intranet  Ethical conduct
 Media activities
 Communication Channels Governance and Operational Activities

 Newsletter
 Seminars
 Website

3.1 Agency Theory

Agency theory examines the duties and conflicts that occur between the parties in a company that
have an agency relationship, for example:

A company can be viewed as a set of contracts between each of these various interest groups.
The company will not succeed unless the interests of each group are met to at least an adequate
level.

3.2 Stakeholders

Companies are made up of a variety of different interest groups or stakeholders, all of whom are
likely to have different interests in, and objectives for, the company, for example:
While shareholders are clearly the key stakeholder, modern corporate governance suggests that
directors should take into account the objectives of a wider range of interested parties. Directors
are therefore expected to show responsibility:
 to creditors (e.g. reasonable payment terms);
 to employees (e.g. health and safety); and
 to customers (e.g. reliable products/services at a fair price);
 to society as a whole (e.g. minimising pollution, investing in social projects). This is
encompassed by corporate social responsibility (CSR) and embodied in Ethical, Social
and Governance (ESG) metrics such as the Dow Jones Sustainability Index and the
FTSE4Good Index Series.
Therefore, the corporate objective may become satisficing (i.e. producing satisfactory rather than
maximum returns for stakeholders). With the rise of the "ethical investor" on world stock markets, it
appears that many shareholders are willing to accept slightly lower returns in exchange for the
companies they invest in following a wide range of both financial and non-financial objectives.
Ways in which an organisations’ investment and financing strategies and decisions may affect
stakeholders include the following:
 Companies with strong ESG principles may record higher performance and credit rating
and perform better during crises. For example, investing in positive environmental
impact can increase revenue growth and market expansion;
 Serving stakeholders can be a source of competitive advantage. For example,
companies that avoided or limited layoffs at the start of the COVID-19 pandemic were
better positioned to resume production/services when consumer demand recovered;
 Increasing employee wages and providing scholarships/apprenticeships increases
employee engagement while reducing the costs associated with labour turnover;
 Actions that the risk of government intervention (e.g. on environmental issues) can
translate into shareholder value;
 Creating common goals with stakeholders can deliver higher returns. For example,
sharing expertise with suppliers can increase productivity and reduce waste.

3.3 Directors and Shareholders

3.3.1 The Agency Issue
In larger companies the shareholders entrust the management of the company to the directors –
referred to as the separation of ownership and control. The directors are employed to manage
the company on behalf of the shareholders and are duty bound to promote the company’s
success. Directors must act, in good faith, and consider the likely consequences of their decisions
for all stakeholders.
Directors will have their own personal objectives such as:
 increasing personal remuneration levels;
 maximising bonus payments;
 empire building;
 job security.
In addition to the personal aspects shown above, a small number of directors have been guilty of
not fulfilling their duties by:
 creative accounting; by choosing creative accounting policies the directors can flatter or
“window dress” the accounts.
 hiding corporate activity (e.g. using special purpose vehicles).
 takeovers; in defending the company from takeovers some directors have been accused
of trying to protect their own jobs rather than acting in the interests of their shareholders.
 disregard for environmental issues; directors may allow processes which emit pollution
or test products on animals.

3.3.2 Agency Costs

If directors follow personal objectives which conflict with those of their shareholders this leads
to agency costs (i.e. lost potential returns for shareholders). This can be referred to as "the
agency problem".

Definition

Corporate governance – the system by which companies are directed and

controlled.
Good corporate governance procedures should be implemented to minimise the effect of agency
costs. Unfortunately, the implementation of corporate governance brings its own costs (particularly
in the case of the Sarbanes-Oxley Act) and hence a cost-benefit approach should be followed to
determine an appropriate level of control over directors.
It can be argued that:
Actual return to shareholders = Maximum potential return − Agency costs
Most shares in listed companies are held by institutional investors (e.g. pension funds). Fund
managers have often been guilty of operating in a very passive way, for example not even using
the proxy voting rights given to them by the fund's investors. Until there is a rise in shareholder
activism it remains likely that some directors will continue to work in their own best interest.

3.4 Goal Congruence

Goal congruence is when the interests of stakeholders align with the best interests of the company
as a whole.
For example, managers should be encouraged to aim for long-term growth and prosperity rather
than short-term reported profitability, as this should ensure both shareholder wealth maximisation
and their own job security.
Methods of encouraging goal congruence between directors and shareholders:
  Executive Share Option Plans (ESOPs) – both directors and shareholders will then
benefit from a rising share price. However, the evidence is mixed regarding the success
of such schemes in motivating directors to improve performance (e.g. a company's
share price may rise due to a general rise in the stock market rather than the quality of
its management).
 Long-term incentive plans – paying a bonus to directors if over several years the
company's performance is good when benchmarked against that of competitors.
 Transparency in corporate reporting.
 Improved corporate governance (e.g. through the appointment of truly independent
non-executive directors).
 Increased shareholder activism (e.g. using voting rights).

4.1 Ethical Contexts for the Financial Executive or Adviser

4.1.1 Main Principles
The main principles of ethical conduct are:
 Act with integrity.
 Be a credit to the profession.
 Use independent professional judgement.
 Be competent.

4.1.2 Fundamental Responsibilities

A senior financial executive/adviser should:
 Know and comply with laws, regulations, ethical codes and professional standards.
 Not knowingly participate or assist others in any violation of applicable regulations or
ethical codes.

4.1.3 Relationship with the Profession

A senior financial executive/adviser should:
 Use ACCA designation with dignity.
 Not engage in any act which adversely reflects on one's honesty, trustworthiness or
professional competence.

4.1.4 Relationship with the Employer

Professional accountants must inform employers of their obligation to comply with the ACCA Code
of Ethics and Conduct. They must:
 Not undertake any independent practice in competition with their employer without their
employer's consent and the consent of the client.
 Disclose to their employer all matters that could be reasonably expected to impair their
ability to render an unbiased and objective opinion.
 Disclose to their employer all monetary and other benefits received for services other
than the usual compensation paid by their primary employer.

4.1.5 Interaction with Clients

Professional accountants must:
 Put their client's interest before their own;
 Have a reasonable and adequate basis for stating opinions;
 Use reasonable judgement to include relevant facts, distinguish between fact and
opinion and use independence and objectivity in making opinions.
4.1.6 Compliance with Anti–Money-Laundering (AML) Legislation
Definition

Money laundering concealing, disguising, converting, or transferring criminal

property.
The definition of money laundering is often broad and may cover activities associated with the
movement of money or assets derived from, or associated with, illegal activity. Illegal activity may
range from terrorism to tax evasion, depending on the jurisdiction concerned, and may include
activities in other countries. The money laundering activity itself includes arranging or facilitating
financial transactions, creating offshore accounts, registering a company, or the distortion of
financial information where these activities are associated with illegal activity. Parties who do not
benefit directly from money laundering can still be guilty of an offence.
Usually, the law will identify entities conducting a regulated activity (e.g. banks, those dealing in
high-value items like property and accountants). These entities are required to comply with
detailed AML procedures, and to be supervised by a supervisory body. The ACCA is one example
of a supervisory body. However, AML legislation usually applies to all businesses and imposes an
obligation to report suspicions of money laundering to the relevant authority, without notifying the
client of those suspicions.
To determine whether a client is likely to be involved in money laundering will usually involve a
risk-based approach. Like any risk assessment process, AML processes will require the following:
 Identify, describe and evaluate the risks relevant to the business: in what manner might
a company become associated with money laundering?
 Create and implement controls and procedures, for example:
o ”Know Your Customer” (KYC) requirements;
o internal reporting requirements for staff to report suspicious
transactions or client customers; and
o establish a suitable culture of reporting.
 Monitor those controls through documentation, testing and regular review and record
those actions.
 Train staff in these systems and controls and modify controls in response to experience
and changes in the environment.
Banks and legal firms will usually require a new client to rigorously prove their identity before they
will deal with them/open an account in their name, and will often require the source of large sums
of money to be evidenced (e.g. by producing bank statements, accounts, sale documents, etc).

4.1.7 International Aspects

Specific ethical issues may arise for businesses operating overseas. The following questions may
have to be faced:
 Should "facilitation payments" be made to local officials to overcome problems with "red
tape" (e.g. for customs clearance)?
 Is it acceptable to use transfer pricing internationally to minimise tax liabilities?
 Should assets be transferred into offshore companies to shield them from capital gains
tax on disposal?
 If laws overseas are more relaxed than at home (e.g. regarding the employment of child
labour) should the company follow the more relaxed local laws or apply the business
practices of its home country?
 Sensitivity to local business practices (e.g. in the Islamic world Sharia law prohibits the
payment/receipt of interest and investing in "immoral" activities, such as alcohol and
gambling. Raising debt finance may still be possible through the issue of sukuk Islamic
bonds which claim Sharia compliance through paying returns based on a profit share of
the underlying project, as opposed to a market-based interest rate.)
 Exam advice

There may be no right or wrong answer to such questions, but a good exam answer should
identify the key issues and the various alternative courses of action, and then express an
opinion on which course to follow. The opinion should respect the requirements of the
ACCA Code of Ethics and Conduct.

4.2 Ethical Decision-making

There are many models and approaches for the classification and description of moral and ethical
decision making. For example:
 Rest's four-component model;
 Albrecht's Ethical Development Model (EDM); and
 IAESB Ethics Education Framework.

4.2.1 Rest's Model

This four-component model is as follows:

It must be recognised that there is a moral issue involved. The decision-maker must
Step be able to appreciate that the selection of a particular course of action will affect the
1 welfare of other interested parties.

Step
2 The decision-maker must be able to select an appropriate action.

Step The decision-maker must attach priority to moral values, rather than, for example,
3 acting out of self-interest.

Step The decision-maker must have sufficient moral strength to implement the resolution
4 identified in the previous steps.
Based on Rest, 1986
Example 1 Charitable Contributions

The decision of a company not to make a donation to a charity could be based on prejudice or
self-interest. This is not then a moral decision.
Alternatively, it could be based on an ethical position that supporting the charity may help the
plight of those who are disadvantaged and/or prevent others suffering similarly.
Whether a donation is made does not give insight into the motive. A donor may give without
much thought through embarrassment or a belief that it is wrong to rebut a call for help. The
decision could be motivated by a considered ethical stance or by self-interest or some other
non-ethical position.

4.2.2 Albrecht's Ethical Development Model (EDM)

The Ethical Development Model (EDM) is another progressive model which sets out the life
development of an ethical perspective. Developed by Albrecht et al. it has four levels:

A foundation level. Appreciates the difference between right and

1. Personal ethical wrong and understands the basic principles of integrity and
understanding empathy.
 This is the first of two levels in which professional education has
2. Application of ethics to a role to play in translating and applying ethics to the business
business situations context.

This requires individuals to develop ethical strength and moral

3. Ethical courage conviction to act appropriately in "questionable" situations.

Building on (3), the ethical leader has the capacity to inspire

4. Ethical leadership others to develop their own ethical awareness.

4.2.3 IAESB Ethics Education Framework

The International Accounting Education Standards Board (IAESB) is an independent standard-
setting board of the IFAC. The Ethics Education Framework as developed by the IAESB is a four-
stage learning continuum to be applied by all professional accountants throughout their careers.
Ethical sensitivity and ethical judgement require professional accountants to develop:
 the ability to recognise an ethical threat or issue;
 an awareness of alternative courses of action leading to an ethical solution; and
 an understanding of the effects of each alternative course of action on stakeholders.
Doing so improves professional judgement by sharpening ethical decision-making skills through
the application of ethical theories, social responsibilities, codes of professional conduct and ethical
decision-making models (EDMM).

4.3 Ethical Decision-making Models (EDMM)

4.3.1 Issues Addressed
The two basic issues to be addressed in ethics are determining:
 the right motive; and
 the right action.
EDMMs have been developed from conceptual approaches, to provide a method of practically
applying a framework to resolve ethical dilemmas.
The role of EDMMs is to provide a more systematic analysis enabling comprehensible judgement,
clearer reasons and a justifiable and more defensible action than would have otherwise been the
case.

4.3.2 Tucker's 5-Question Model

Tucker’s model asks five questions about a business decision which must be answered in the
affirmative to confirm that the decision is ethical. Is the decision:
1. Profitable (But compared to what?)
2. Legal (What framework was used?)
3. Fair (From whose perspective? Consider stakeholders.)
4. Right (Based on what ethical position?)
5. Sustainable (Or environmentally sound?)
Tucker's model actually creates more questions than it asks. It encourages debate over conflicting
ethical approaches, the stakeholders involved and sustainability and is therefore more appropriate
to use when considering organisational problems rather than professional or individual situations.
Activity 2 Tucker's Model
Your company owns a number of large properties in various major cities. The real estate assessor
in one city offers, for a fee, to underestimate the value of your building and so you will save
substantial annual taxes assessed on property value. This is common practice in the region.

Required:
Use Tucker's model to determine whether you ought to pay the fee.
*Please use the notes feature in the toolbar to help formulate your answer.
4.3.3 ACCA Ethical Conflict Resolution
Applying the ACCA's Code of Ethics and Conduct, professional accountants should consider:
 the relevant facts;
 the ethical issues involved;
 related fundamental principles;
 the organisation’s established procedures;
 the action that can be followed and the probable outcome;
 alternative courses of action and their consequences; and
 internal and external sources of consultation available (e.g. ethics partner, audit
committee).
If a significant conflict cannot be resolved, consulting legal advisers and/or ACCA should be
considered. Such consultation can be sought without breaching confidentiality.
If, after exhausting all possibilities, the ethical conflict remains unresolved, members should,
where possible, refuse to remain associated with the matter creating the conflict.

4.4 Ethics: Agency Issues and Stakeholder Conflicts

The ability of an organisation's management to implement its ethical framework can potentially be
undermined by agency issues and conflicts between stakeholder groups. Management should
identify and resolve conflicts quickly to avoid any potentially damaging public debate about the
organisation's ethics.

4.4.1 Agency Issues and Ethics

Agency issues are particularly likely to affect a quoted company's ethical framework where there is
significant divorce of ownership and control. The directors (as agents) are in a quite different
ethical position compared with their shareholders (the principal) as:
 the directors' ethical performance is scrutinised by the public and potentially by
investigative journalists. Any alleged wrongdoing can lead to serious damage to a
director's personal reputation;
 the shareholders, being separate from the running of the business, cannot be easily
held responsible for any ethical lapses in the company. Furthermore, most shares in
quoted companies are held by institutional investors who will have their portfolios
diversified across many companies.
Therefore, company directors (and indeed the entire workforce) may tend to take a very cautious
approach towards ethics, even verging on paranoia, as their own reputation is very closely linked
to that of their company. Institutional investors, on the other hand, may take a more relaxed view
of ethics as they are shielded from personal scrutiny and, in any case, would only hold a small
percentage of their fund's wealth in the shares of one particular company.
If the directors come under pressure from shareholders to relax the company's ethical guidelines,
appropriate responses could include:
 quoting relevant legislation which imposes penalties for contravention (e.g. for US-
registered companies, the Foreign Corrupt Practices Act prohibits the payment of bribes
anywhere in the world);
 encouraging ethical investment funds to take shareholdings in the company, whose
ethical stance is more likely to be aligned with that of the directors.

4.4.2 Stakeholder Conflicts

Although shareholders are a company's primary stakeholder, there are also potential conflicts with
other groups:
 Consumers may boycott the company's products if it is discovered that the products
were made in exploitative working conditions. A strategy to mitigate this risk could be to
arrange manufacturing through a subcontractor. (However, this is no guarantee of
isolating the company from reputational risk.)
 Governments may take action against businesses that use aggressive tax avoidance
schemes. For example, in July 2021, the UK’s HMRC published new proposals to tackle
promoters of marketed tax avoidance schemes (i.e. contrived schemes that are sold to
one or more individuals and employers for a fee, with the aim of reducing their tax
liabilities). Under the proposals, HMRC will be able to petition the Court to wind up
companies that promote tax avoidance.

5.1 Sustainability
 Definitions

Sustainability – is not a fixed state of harmony, but rather a process of change in which the
exploitation of resources, the direction of investments, the orientation of technological
development and institutional change are made consistent with future as well as present needs.
Corporate sustainability – a business approach that creates long-term shareholder value by
embracing opportunities and managing risks from economic, environmental and social
developments.
Sustainable development – development that meets the needs of the present without
compromising the ability of future generations to meet their own needs.
Sustainable finance – the process of taking environmental, social and governance (ESG)
considerations into account when making investment decisions in the financial sector, leading to
more long-term investments in sustainable economic activities and projects.

5.1.1 Sustainable Development

Examples of sustainable development:
 Using or adapting existing facilities, rather than building "from scratch".
 Environmentally friendly building and design.
 Minimisation of adverse effects on nearby residents.
 Protection of native vegetation (e.g. forests, wetlands, flora).
 Minimisation of non-renewable waste with recycling encouraged.
 Minimisation of non-renewable energy use (e.g. replacing coal, oil and gas with solar,
wind or other renewable sources).
 Minimisation of pollution (or cleaning up if it exists).
 Construction on "brownfield sites" (i.e. those previously used as industrial/commercial
sites) – leaving "greenfield" (i.e. undeveloped) land untouched.

5.1.2 ESG Investing

ESG investing (also called “sustainable investing”, “impact investing”, “ethical investing”, etc)
prioritises ESG factors and performance alongside the profits of an organisation. It considers both
the material risks and opportunities businesses face related to these factors. It prioritises a long-
term outlook over short-term profits with high environmental and social costs.
This style of investing aims to preserve rather than deplete the environmental and human
resources businesses depend on, while still making profits.
A review of ESG issues provides a deeper, more penetrating risk analysis, AND systematically
considering ESG issues will likely lead to more complete investment analyses and better-informed
investment decisions.

5.1.3 ESG Criteria

ESG criteria for the environment are used to measure an organisation’s environmental risks and
harm to the environment.
 Environmental criteria cover the main environmental risks facing society: climate
change, water security, environmental health risks, the waste burden, and biodiversity
loss and extinction.
 Environmental issues are often interconnected risks which improve with a proactive
approach to managing them. Organisations should do more than merely meet the bare
minimum standard. Instead, they can earn higher ESG ratings by taking actions that
improve the environment.
 Business leaders who understand the benefits brought by the physical environment and
natural resources will strategically pursue business in a way that preserves these
valuable assets for generations to come.
Social ESG criteria highlight an organisation’s relationships with the many groups of people it
engages with (see stakeholders in s.3.2).
 The aim is to improve overall social wellbeing in a number of ways. For instance, an
organisation may seek to lessen inequalities, ensure human rights, and protect worker
and community health and safety.
 Social wellbeing helps organisations to build inclusive, fair and positive operations,
which foster thriving communities.
 Social criteria span the organisation from the executive offices to the supply chain
factories.
 Employee policies and benefits, due diligence, and supplier contracts are all used to
leverage the social values embedded in corporations.
 Organisations that go beyond ensuring that the bare minimum of rights are maintained,
can build a supportive work culture with their flexible work conditions, time devoted to
professional development and internal promotion opportunities.
The core of the governance ESG criteria lies in business leadership and transparency.
 ESG governance include the policies for inviting diverse board of directors, upholding
corporate accounting standards, executive compensation, public disclosure, conflicts of
interest, and other legal and ethical concerns.
 Governance also covers the policies used to promote organisational fairness through its
system of internal control. This prevents illegal activities from bribery and corruption to
tax evasion.
Environmental criteria Social criteria Governance criteria

 Board composition
 Executive
 Human rights and compensation
child labour  Tax strategy
 Climate change  Living wages  Bribery and
 Carbon and  Worker health and corruption
greenhouse gas safety  Lobbying and
(GHG) emissions  Diversity, equity, political
 Energy efficiency and inclusion contributions
 Water consumption  Data protection  Transparency and
 Air and water and privacy public disclosures
pollution  Employee and  Whistleblower
 Biodiversity loss and customer schemes
protection satisfaction  Codes of conduct
 Deforestation  Community  Supply chain
 Waste management relations management
 Product life cycle  Stakeholder  Risk and crisis
analysis engagement management
Not all factors can easily be categorised into an “E,” “S,” or “G” category, as they often have
interconnected impacts. For example, reducing GHG emissions is considered important for climate
change and the environment, but it also improves community health, which is a social
consideration.
Increasingly, businesses are also called upon to report the financial risks and opportunities linked
to ESG factors. This way, they are not considered in isolation from a company’s “bottom-line”.
However, companies may struggle to quantify ESG factors in financial terms.

5.2 Triple Bottom Line Reporting (TBL or 3BL)

The phrase “triple bottom line” was coined by John Elkington, co-founder of the business
consultancy SustainAbility. It is an expanded baseline for measuring performance.
Triple bottom line accounting attempts to measure and report corporate performance against
economic, social and environmental benchmarks in order to show improvement or to make more
in-depth evaluation. (Adding governance to the bottom line makes it "Quadruple Bottom Line
reporting".)
It can be viewed as:
 a reporting device (e.g. information presented in annual reports); and/or
 an approach to improving decision making and the activities of organisations (e.g. by
providing tools and frameworks for considering the economic, environmental and social
implications of decisions, products, operations, future plans).

Advantages Disadvantages

 There are currently few standards

 Makes transparent the organisation's for measuring these effects.
decisions that explicitly consider  Usefulness and comparability, as
effects on the environment and there is significant variability in
people, as well as on financial capital. disclosure (content and quality).
 More informed decision making as  The difference between the
decision-makers can quantify trade- economic bottom line and the
offs between different aspects of financial bottom line is often
sustainability. blurred.
 Improved relationships with key  Increase in annual reporting costs
stakeholders and improved risk with disproportionate costs for
management through consultation. smaller entities.
 Specific commercial advantages (e.g.  Potential exposure to risk and
competitive advantage with liability relating to the reliability of
customers, suppliers and providers of the report's content (unless audit
finance). is mandatory).
 Enhancement of reputation and brand.  Potential bias in voluntary
May result in attracting and retaining presentation (e.g. including only
employees with sustainable values. favourable information).

Such indicators can distil complex information into a form which is accessible to stakeholders.
(Organisations report on indicators that reflect their objectives and are relevant to stakeholders.)
One difficulty in identifying and using indicators is consistency in an organisation, over time and
between organisations at any point in time (important for benchmarking).
Activity 3 TBL Reporting

The board of directors of Triple Tipple are discussing whether to adopt a triple bottom line (TBL)
reporting system, increasingly used by the company's competitors. The board would like to
demonstrate the company's commitment to sustainable development but is concerned that the
costs of TBL reporting would exceed the benefits, particularly as TBL reporting is not mandatory
for external reporting purposes.

Required:
a. Explain what TBL reporting involves and how it would help demonstrate Triple
Tipple's sustainable development. Include examples of measures that can be used in
a TBL report.
b. Discuss how producing a TBL report may help management improve the financial
performance of the company, providing examples where appropriate.
*Please use the notes feature in the toolbar to help formulate your answer.

6.1 Need for Risk Management

Definition

Risk – the variability (volatility) of returns, both positive and negative, that can be quantified
through statistical measures (e.g. probabilities, standard deviations and correlations between
different returns).

6.1.1 Theory
Risk management is about decisions made to change the volatility of returns (e.g. swapping
exposure to variable interest rates to fixed rates – for a fee).
Risk should be managed if it increases the value of a company (i.e. the NPV of its future cash
flows discounted by the investor’s required rate of return). A higher market value can either be
generated by:
 increasing the future cash flows and/or
 reducing investors’ required rate of return.
Therefore, a risk management strategy that increases NPV at a lower comparative cost would
benefit the company.

6.1.2 In Practice
It sounds sensible that management should attempt to reduce an organisation’s risk exposures.
However, implementing a default policy of hedging all risks is unlikely to be effective for the
following reasons:
 Hedging may give short-run but not long-run protection. For example, the exchange rate
in derivatives contracts (e.g. forwards, futures and swaps) will follow the same long-term
trend as the exchange rate in the spot market. In the end, if an exporter faces an
appreciating domestic currency it will find its margins under pressure either with or
without hedging the exchange rate.
 Hedging incurs costs – both the transactions costs of using derivatives, for example,
and the higher salary costs of employing specialist risk managers.
 The shareholders may have already hedged many risks – in the case of a listed
company the majority of shares are likely to be held by institutional investors who will
hold well-diversified equity portfolios (e.g. including shares in both exporters and
importers). Hence, shareholders may have natural protection against some forms of
risk, in which case, corporate risk management will only add costs and not benefits.
So why, in practice, do many organisations engage in significant amounts of risk management?
There are numerous explanations:
 In the case of privately held companies, the shareholders may have significant amounts
of their personal wealth invested in an individual company (i.e. the shareholders are
exposed to total risk as opposed to only systematic risk). In this case, risk management
at the corporate level may indeed reduce the risk of the shareholders.
 In the case of listed companies, although shareholders may be well diversified and only
exposed to systematic risk, the company's management work only for that specific
company and not for a portfolio of companies (i.e. their bonuses or share option plans
are exposed to total risk). Management may therefore become highly risk-averse and
attempt to hedge their personal risk – incurring agency costs for their shareholders.
 Progressive corporate tax systems – in many countries, the tax rate on large profits is
significantly higher than the tax rate on lower profits. In this case, there could be a valid
argument for using risk management to "smooth" reported profits in order to reduce the
long-run tax burden. Care must be taken to avoid cosmetic smoothing of reported profits
(i.e. accounting manipulation).
 Reduction in cost of capital – corporate diversification may lead to financial synergy as
smoother group cash flows may lead to an improved credit rating and a lower cost of
debt. Care must be taken to ensure that the control premium paid on acquisitions does
not exceed the value of synergy.
 Financial distress costs – where a company experiences cash flow problems it can find
that its costs of doing business rise (e.g. suppliers may refuse to give credit; customers
may lose faith in any warranties given on the company's products). Risk management
may be justified in reducing the risk of financial distress.

6.2 Conflicts Between Equity and Debt Investors

Equity investors are, of course, participating investors in that their returns are linked to the
underlying volatility of profits (i.e. they absorb the company's level of business risk). However, the
equity investors' downside risk is restricted to some degree by their limited liability status (i.e. if the
company cannot pay its debts the shareholders cannot be forced to inject more capital).
Debt investors, on the other hand, receive fixed contractual payments of interest and principal (i.e.
they are not exposed to business risk). The main risk faced by debt investors is that the company
cannot service the debt (i.e. default risk/credit risk).
The different positions of equity and debt investors can lead to differing attitudes towards the level
of risk-taking by the company. This is particularly the case where the value of the company's
assets is close to the level of its liabilities:
 Shareholders may develop an "appetite” for risk and encourage the management to take
high risks.
o If the company's high-risk strategies succeed, the value of assets
would "spike up" above the level of liabilities and the equity rises in value.
o If the gamble fails and the value of assets collapses, shareholders can
walk away under the protection of limited liability.
o Overall, shareholders have high upside potential and limited downside
risk.
 Debt investors would be highly risk averse as any fall in asset value would reduce the
recoverability of their debt, whereas any rise in asset value would not lead to any extra
return on the debt (i.e. debt investors have high downside risk and no upside potential).

6.3 Types of Risk and Risk Mitigation Business risk –

volatility of operating cash flows. This is driven by (i) sales volatility (ii) level of operational gearing
(i.e. proportion of fixed to variable operating costs). Hence the key strategies for reducing
exposure to business risk are:
  reposition the company's product lines into "defensive industries" (i.e. those sectors
relatively unaffected by the economic cycle such as food, clothes and pharmaceuticals);
 convert fixed costs into variable costs (e.g. by means of outsourcing).
Financial risk – the increased volatility of returns to equity due to priority of fixed interest
payments on debt. Obviously, this can be reduced through lowering the company's level
of financial gearing, although this should be balanced against the loss in tax saving.

Definition

Credit (default) risk – is a measure of creditworthiness (i.e. the potential that a borrower will fail
to meet its obligations in accordance with agreed terms of a loan).
Credit risk becomes significant at high perceived levels of debt. Obviously, this can be reduced by
a reduction in financial gearing but alternative methods include:
 diversifying operations to smooth cash flows;
 diverting low-risk cash streams into a ring-fenced special purpose vehicle (SPV),
(protected should the company itself becomes bankrupt). The SPV then "securitises" its
future cash stream (i.e. issues bonds backed by the stream). These asset-backed
securities should attract an investment-grade credit rating.
Reputational risk – damage to the brand value due to poor corporate behaviour (e.g.
environmental damage or use of child labour). Mitigation strategies could include implementing
Corporate Social Responsibility or using a public relations agency.
Definition

Operational risk – the risk of loss resulting from inadequate or failed internal processes, people
and systems or from external events.
– Basel Committee
An example of an operational risk for an investment bank is the risk of a "rogue trader" (i.e. a
securities trader who engages in speculative trading with authorisation). Mitigation could include
the use of models to control the trading of instruments — who is authorised to trade them, when
they can trade them and how much in a given period. In particular, the limit of a trade needs to be
carefully set and monitored; not only to protect the bank, but also to satisfy regulators.

Exhibit 1 Risk Management and Internal Control Systems

A company's systems of risk management and internal control will include:

risk assessment;

management or mitigation of risks, including the use of control processes;

information and communication systems; and

processes for monitoring and reviewing their continuing effectiveness.

When determining the principal risks, the board should focus on those risks that, given the
company’s current position, could threaten the company’s business model, future performance,
solvency or liquidity, irrespective of how they are classified or from where they arise. The board
should treat such risks as principal risks and establish clearly the extent to which they are to be
managed or mitigated.
Risks will differ between companies but may include financial, operational, reputational,
behavioural, organisational, third party, or external risks, such as market or regulatory risk, over
which the board may have little or no direct control.
Source: The Financial Reporting Council’s Guidance on Risk Management, Internal Control and
Related Financial and Business Reporting.
Fiscal risk – impact of unexpected events adversely affecting the government's fiscal strength and
hence the business climate (e.g. commodity exporting nations are highly exposed to volatile
commodity prices). The fiscal risk of different countries can be assessed using reports from the
IMF or the EIU (Economist Intelligence Unit).
Regulatory risk – risk of government regulation adversely affecting the business (e.g. price caps
on privatised natural monopolies, compulsory compliance with corporate governance codes,
blocks or restrictions placed on mergers and acquisitions). Regulatory risk may be managed
through political lobbying.
Project risk – the risk that project cash flows are not in line with expectations. Project risk can be
managed by:
 appointing an experienced project manager;
 carefully selecting contractors;
 appointing a steering committee to monitor deadlines and cost levels; and
 post-completion audit to review and improve the process in the future (see Chapter 6).
Currency risk (see Chapter 14).
Interest rate risk (see Chapter 15).
Political risk (see Chapter 17).

Activity 4 Financial and Business Risk

Required
Explain the relationship between financial risk and business risk. Explain how risk
diversification and mitigation may contribute to a risk management strategy.
*Please use the notes feature in the toolbar to help formulate your answer.
To generate a return greater than the risk-free rate, stakeholders, including shareholders, must
accept risk, usually as a mix of financial risk and business risk.
Directors should focus on the business risks that they believe the company has a superior ability
to manage: this will drive the areas of business that the company chooses to operate in. Such
business risks, which might be driven by competitor action, demand, suppliers and the general
economic environment, will generate a degree of volatility in profits and cash flows.
Financial risk is generated by decisions concerning the choice of finance including the debt to
equity ratio, fixed or variable debt, the currency of debt and/or the duration of debt.
Businesses would not usually want to carry both high levels of business and financial risk
simultaneously.
Risk management commences with the identification, assessment and measurement of risk.
Identified risks must then be managed: either avoided altogether, accepted, retained and
managed, or retained and transferred.
Risk mitigation is any process that reduces the risks a business would otherwise face. Risk
diversification is a type of risk management in which the impact of a risk is reduced by seeking
exposures to offsetting risks or risk positions subject to different risk drivers (e.g. geographical
spread, technological spread, product markets, etc).
Risks that the directors believe they have a superior ability to manage will be accepted, although
even risks that are accepted are usually managed in some way, if only by monitoring.

6.4 Risk Mitigation, Hedging and Diversification

Risk mitigation, hedging and diversification are all strategies designed to manage an
organisation's exposure to various risks. The nature of each of these strategies can be
distinguished as follows:
 Risk mitigation is any activity designed to reduce either the impact or the probability of
an adverse impact of a risk. Such activity can include management controls, hedging or
avoiding the risk entirely. For example, prior to setting up an overseas subsidiary
political risk may be mitigated by contacting overseas officials and seeking agreements
on matters such as repatriation of funds and the level of transfer prices or management
charges.
  Risk hedging is an activity designed to reduce a risk faced by a company. Narrowly,
this may be achieved by financial instruments (e.g. derivatives) but, more broadly, it may
be achieved by corporate strategies such as buying inputs in the same currency as is
generated by sales.
 Risk diversification refers to diversification either domestically into other industries
(conglomerate diversification) or other countries (international diversification). As
previously explained, if shareholders are institutional investors (e.g. fund managers)
they will have already used personal portfolio diversification to remove almost all
industry-specific unsystematic risk and, in the case of global fund managers, country-
specific unsystematic risk. There is, therefore, an argument that if its shareholders are
diversified, the company should specialise.
This does not, however, mean that corporate diversification is never justified. For example:
 significant synergy may be obtained through buying competitors, suppliers or
distributors;
 diversified groups have lower financial distress risk, may achieve an enhanced credit
rating and may pay less tax in a progressive tax system due to reporting "smoother"
profits.

 6.5 Developing a Framework for Risk Management

 6.5.1 Elements
 There are many examples of risk management systems and processes that have been
developed by various organisations. In general, a risk management process should, at the
very least, incorporate the following elements:


 Activity 5 Risk Management System

  Required:

 Discuss the possible advantages and disadvantages of setting up a risk
management system to identify, classify and avoid or manage risk.
 *Please use the notes feature in the toolbar to help formulate your answer.
 6.5.2 Risk Management Standard
 The Institute of Risk Management published a Risk Management Standard in 2002, which
depicts the risk management process as follows:

Syllabus Coverage
This chapter covers the following Learning Outcomes.

A. Role of the Senior Financial Adviser in the Multinational Organisation

1. The role and responsibility of senior financial executive/adviser
1. Develop strategies for the achievement of the company's goals in line with its agreed
policy framework.
2. Recommend strategies for the management of the financial resources of the company
such that they are utilised in an efficient, effective and transparent way.
3. Advise the board of directors of the company in setting the financial goals of the
business and in its financial policy development, with particular reference to:
4. Communicating financial policy and corporate goals to internal and external
stakeholders.
2. Financial strategy formulation
4. Explain the theoretical and practical rationale for the management of risk.
5. Assess the organisation's exposure to business and financial risk including operational,
reputational, political, economic, regulatory and fiscal risk.
6. Develop a framework for risk management comparing and contrasting risk mitigation,
hedging and diversification strategies.
3. Corporate environmental, social, governance (ESG) and ethical issues
1. Assess an organisation’s commitment to ESG criteria when undertaking business,
financial and investment decisions, and discuss and recommend how conflicts between
the criteria may be resolved.
2. Assess the impact on the physical environment and the sustainability of natural
resources arising from alternative organisational business, financial and investment
decisions.
3. Examine how the organisation manages its stakeholder groups as part of its social
responsibilities.
4. Assess and advise on the impact of investment and financing strategies and decisions
on the organisations' stakeholders.
5. Explore the areas within the ethical and governance framework of the organisation
which may be undermined by agency issues and/or stakeholder conflicts and establish
strategies for dealing with them.
6. Recommend appropriate strategies for the resolution of stakeholder conflict in specific
situations and advise on alternative approaches that may be adopted.
7. Assess the impact of ethical and governance issues on the financial management of the
organisation.
8. Recommend an ethical framework for the development of an organisation's financial
management policies, which is grounded in the highest standards of probity and is fully
aligned with the ethical principles of the Association
4. Management of international trade and finance
6. Discuss the significance to the organisation of the international regulations on money
laundering.

Summary and Quiz

 A strategy is a plan of action designed to achieve a long-term organisational goal or aim.
 The objective of a financial strategy is to achieve a financial goal or aim and usually
includes the utilisation and management of financial resources, through the process of
financial management.
 A company may aim to maximise or satisfice corporate objectives.
 Most traditional finance theory is built on the assumption that a company's objective is to
maximise the wealth of its shareholders.
 However, modern CSR/ESG suggests that directors should also take into account other
stakeholders and therefore also follow a range of non-financial objectives (e.g.
employee satisfaction, reducing environmental impacts).
  Such non-financial objectives may be in conflict with maximising shareholder wealth.
Therefore, the overall objective may be to produce satisfactory returns for shareholders,
while attempting to meet the demands of other interest groups.
 In practice, managers may also have personal objectives which conflict with their
responsibilities as agents of the shareholders. This creates agency costs for the
shareholders.
 Well-designed remuneration systems and good corporate governance should reduce
agency costs to an acceptable level.
 One aspect of CSR/ESG involves ethical corporate behaviour – the "good corporate
citizen".
 CSR/ESG also involves the creation of a sustainable business model which balances
not only financial but also social and environmental performance. Reporting these three
areas of performance can be achieved using the TBL approach.

Technical Articles
ACCA provide technical articles and other resources to guide and help students.
This chapter includes the relevant content of the following related technical articles available at the
time of writing (January 2023):
 Risk management
For more recent articles and other resources please visit the ACCA global website.

Chapter 2 : Security Valuation and Cost of Capital

Visual Overview
Objective: To develop a valuation model for shares and bonds that facilitates estimation of equity
and debt costs, and to consider the relationship between short- and long-term interest rates.

1.1 Introduction Efficiency can be looked at in four different but

complementary ways:
1. Allocative efficiency:
Does the market attract funds to the best companies?
2. Operational efficiency:
Does the market have low transaction costs and a convenient trading platform? These
promote a "deep" market with high liquidity (i.e. a high volume of transactions).
3. Informational efficiency:
Is all relevant information available to all investors at low cost?
4. Pricing efficiency:
Do share prices quickly and accurately reflect all known information about the
company? This is also referred to as information-processing efficiency.
Most research on market efficiency has focused on pricing efficiency. A market which prices
assets efficiently will respond quickly and proportionately to all information available, so that all
assets are priced fairly at all times. The most well-known model is the Efficient Market Hypothesis.

1.2 Efficient Market Hypothesis

The value of a share is based on expectations of future cash flows from owning that share (usually
in the form of dividends or share buybacks, see Chapter 12).
The strength of the link between the performance of the company and the share price will depend
on the pricing efficiency of the capital markets.
The Efficient Market Hypothesis (EMH) considers three potential levels of efficiency: weak, semi-
strong and strong.

1.2.1 Weak-form Efficiency

In a weak-form efficient market, current share prices reflect all the information contained in the
record of past prices.
If this level of efficiency has been achieved it should not be possible to forecast price movements
by reference to past trends (i.e. "chartists" (also known as technical analysts) should not be able to
consistently out-perform the market).
The way to consistently "beat" a weak-form efficient market is by analysis of publicly available
information such as financial statements (i.e. fundamental analysis).

1.2.2 Semi-strong form Efficiency

In a semi-strong form efficient market, share prices reflect all information currently publicly
available. Therefore the price will alter only when new information is published. By definition, new
information is unpredictable and equally likely to be either good or bad. Share prices will therefore
follow a “random walk with drift”, with the “drift upward” representing a fair return for the risk of the
share.
Therefore, an investor can only beat the market (i.e. gain an unfair return) using inside
information (i.e. significant non-public information). This is known as insider trading, which is
illegal in most markets and is unethical in any market.

1.2.3 Strong-form Efficiency

In a strong-form efficient market, share prices reflect all information, published and unpublished,
that is relevant to the company.
If this level of efficiency has been reached, share prices cannot be predicted and gains through
insider dealing are not possible as the market already knows everything.
In major markets (e.g. the London or New York stock exchanges) there are strict rules outlawing
insider dealing. Most of the time, such markets are assumed to be semi-strong form efficient.

1.3 Implications for Financial Managers

The level of efficiency of the stock market has significant implications for financial managers:
 The timing of new issues
Unless the market is fully efficient the timing of new issues remains important. This is
because the market does not reflect relevant insider information, and hence advantage
could be obtained by making an issue at a particular point in time just before or after
additional information becomes available to the market. However, exploiting insider
advantage in this way, even for the benefit of current shareholders rather than
themselves, may damage the reputation of managers in the market.
 Project evaluation
If the market is not fully efficient, the price of a share is not fair, and therefore the rate of
return required from that company by the market cannot be accurately known. If this is
the case, it is not easy to decide what rate of return to use to evaluate new projects.
 Creative accounting
Unless a market is fully efficient creative accounting can still be used to mislead
investors.
 Mergers and takeovers
Where a market is fully efficient, the price of all shares is fair. Hence, if a company is
taken over at its current share value the purchaser cannot hope to make any gain
unless economies can be made through scale or rationalisation when operations are
 merged. Unless these economies are very significant an acquirer should not be willing
to pay a significant premium over the current share price.
 Validity of current market price
If the market is fully efficient, the share price is fair, so there should be no need to
discount new issues to attract investors.

1.4 The Paradox of Efficient Market Market efficiency relies

on investors actively researching public information to find under- or over-priced shares.
However, if the market is efficient, there will be no such mispriced shares. This is the paradox of
efficient markets − investors must believe that the market is inefficient in order for it to become
efficient.

1.5 Behavioural Finance

Definition

Behavioural finance – the influence of psychology on the behaviour of financial

practitioners.
- Sewell, 2005

1.5.1 Assumptions
Behavioural finance attempts to explain:
 How decision makers take financial decisions in real life; and
 Why their decisions might not be rational.
Behavioural finance challenges whether decision makers (e.g. investors and financial managers):
 in reality, only seek to maximise their own utility;
 take financial decisions based on analysis of relevant information;
 are:
o rational;
o objective; and
o risk-neutral.

1.5.2 Maximisation of Utility

Rational decision making implies that investors’ decisions will aim to maximise long-term wealth
and, hence, their utility. However, behavioural factors may influence investors to take decisions
that are not the “best” due to preferences based on non-financial factors. For example, investors
may avoid “sin stocks” (i.e. companies operating in sectors that they regard as unethical).
 Cognitive dissonance – Is the mental conflict that arises when an attitude or belief is
plainly contradicted by new information or evidence. For example, some investors hold
on to shares with prices that have fallen and are unlikely to recover rather than
recognise that their investment decision was a poor one.
 Loss aversion bias – When a purchaser is unwilling to let someone else have what
they have been trying to acquire. In contested takeovers, for example, the acquisition
price is then bid up to an unreasonable level because winning the competition is the
greater source of satisfaction.

1.5.3 Analysis of Relevant Information

Behavioural finance next looks at the basis that investors use to take decisions. It suggests that
decisions may not be based on an assessment of relevant financial information, but on other
grounds.
  Anchoring – When valuing shares, some investors put excessive faith in historical
relationships. For example, assuming that the share was fairly valued based on its price-
earnings ratio at some "anchor" point in the past.
 Gambler’s fallacy – Belief that shares should be sold on the grounds that they have
gained in value for “long enough” and their price must therefore soon start to fall, even if
rational analysis suggests that the rise in price will continue.
 Positive feedback and extrapolative expectations – Stock market "bubbles" (and
"crashes") may be explained by the presence of "positive-feedback traders" who buy
shares after prices have risen and sell after prices fall. Such "uninformed" traders
develop "extrapolative expectations" about prices − simply because prices rose (fell) in
the past and a trend has been established investors extrapolate the trend and anticipate
greater future price appreciation (falls).
"Informed" traders can exploit this trend-chasing behaviour of the uninformed traders.
The informed trader can buy into the trend, pushing prices even further away from
fundamental value, in the expectation that uninformed investors will follow like a "herd"
and allow the informed trader to then sell at a profit. The informed trader therefore
creates additional instability.
 Noise trading – Basing decisions on something other than a fundamental analysis of
the company’s performance and prospects (e.g. using analysis of past share prices as a
basis for predicting the future).
 Entrapment – Making further investment to ensure a strategy is successful, rather than
admitting defeat and taking steps to mitigate losses.

1.5.4 Rational, Objective and Risk-neutral Analysis

Investors may base their decision on an analysis of available information, but behavioural finance
has highlighted that this analysis can be subjective. There are many aspects to this:
 Overconfidence – Investors are overconfident about their trading abilities, significantly
overestimating the accuracy of their forecasts. Overconfidence may be caused, at least
in part, by "self-attribution bias" (i.e. belief that their own skill explains any successes in
stock picking, but that any failures are simply due to bad luck). Over confidence may
therefore lead to excessive trading because investors believe that they can pick winners
and beat the market. Ironically, inexperienced investors are more confident that they can
beat the market than experienced investors.
 Representativeness is the making of judgements based on stereotypes (i.e. the
tendency to see identical situations where none exist). Investors tend to give too much
weight to share price movements and not enough to economic fundamentals.
o If a share has suffered a series of poor returns, investors assume that
this pattern is representative for that company and will continue in the future.
o Similarly, investors are too optimistic about shares that have had a lot
of recent success. This may explain why investment funds with high past
performance attract more capital even though past performance is a poor
predictor of future performance (poor-quality managers can produce high
returns purely by chance).
 Momentum effect – A period of rising share prices may result in a general feeling of
optimism that price rises will continue and an increased willingness to invest in
companies that show prospects for growth. This is likely to lengthen periods of stock
market boom (or bust).
 Conservatism – Investors are resistant to changing an opinion, even when presented
with convincing new information. When a company reports unexpectedly high profits
investors do not revise their earnings forecasts enough to reflect the new information, so
one positive earnings surprise is followed by another positive earnings surprise.
 Narrow framing – Many investors take a "narrow frame" rather than look at the broader
picture. For example, an investor may focus excessively on short-run losses or price
 falls of a single share even though it represents only a small proportion of his total
wealth. Narrow framing causes investors to overestimate the risk they face.
If an investor took a broader frame, he would realise that the equity market rises in the
long term and, by viewing the portfolio as a whole, he need not worry excessively about
a few shares that have performed poorly.
 Ambiguity aversion – Investors are excessively fearful when they feel that they do not
have very much information. This may explain the avoidance of overseas shares despite
the benefits of international diversification.
 Regret aversion – Experimental psychologists have observed that people will forgo
benefits within easy reach in order to avoid a small chance of failure. For example,
some people hold all their savings in cash despite the fact that, in the long run, there is
little risk of losses if invested in a diversified share portfolio.
 Confirmation bias – People look for information that agrees with their existing view and
ignore any information that conflicts with that view. For example, investors are
increasingly turning to social media in search of information that aligns with an
investment decision that they are considering. Interpreting the information as a
confirmation of their currently held belief (e.g. that a share price cannot fall any further)
may lead to rash and irrational decisions.
 Availability bias – People tend to focus excessively on a particular fact or event at the
expense of seeing the bigger picture. If, for example, a high-profile IT company reports
poor results, investors might abandon the whole sector, ignoring the probability that it
contains some companies with excellent prospects.
 Miscalculation of probabilities – Experiments have shown that people attach too low
a probability to likely outcomes and too high a probability to unlikely outcomes.

1.5.5 Implications for the Efficient Markets Hypothesis

Some investor behaviours do appear to challenge the efficient markets hypothesis. For example,
positive feedback traders (see s.1.5.3) drive share prices away from their fundamental fair value.
However it is possible that other behaviours actually promote market efficiency. For example,
overconfidence encourages investors to actively trade shares, creating market liquidity, which is a
prerequisite for pricing efficiency.
Critics of the behavioural finance approach have argued that even if individuals make irrational
decisions when left by themselves, participating in finance markets helps discipline them to act
rationally by giving them opportunities to learn from their experiences.

2.1 General Model

Key Point

The DVM implies that the market value of a share or other security is equal to the present value
of the future expected cash flows from the security discounted at the investor's required rate of
return.
A security is any traded investment (e.g. shares and bonds).
2.3 Constant Dividend Growth
If dividends are forecast to grow at a constant rate in perpetuity, where g = growth rate:

D0= most recent dividend

D1= dividend in one year

Exam advice

Many relatively easy marks are often available in the exam for performing cost of capital
calculations.

2.4 Assumptions Underlying the DVM

Underlying assumptions of the model include:
 All investors have the same expectations and therefore the same required rate of return.
 Perfect capital market assumptions including:
 o rational investors;
o no transactions costs;
o large number of buyers and sellers of shares;
o no individual can affect the share price; and
o all investors have all available information.
 Dividends are paid just once a year and one year apart.
 Dividends are either constant or are growing at a constant rate.

2.5 Uses of the DVM

The model can be used to estimate the theoretical fair value of shares in unlisted companies
where a quoted market price is not known.
However if the company is listed, and the share price is therefore known, the model can be used
to estimate the required return of shareholders, re, which is the company's cost of equity finance,
ke.
 3.3 Growth From Past Dividends
Historical growth and use this to predict future growth:
 If dividends have grown at 5% in each of the last 20 years, predicted future growth is
5%.
 If uneven but steady growth − take an average overall growth rate.
 If there is a discontinuity in growth rate − take the most recent evidence.
 For a new company with very high growth rates − take account of the fact that it is
unlikely to produce such high growth in perpetuity.
 If no pattern − do not use this method (i.e. dividends up one year, down the next).
Activity 2 Growth Using Extrapolation
A company has paid the following dividends over the last five years:
 Dividend per share

20X0 $1.00

20X1 $1.10

20X2 $1.25

20X3 $1.36

20X4 $1.45
Required:
Estimate the growth rate and the cost of equity if the current (20X4) ex-div market value is
$10.50 per share.
*Please use the notes feature in the toolbar to help formulate your answer.
 4.1 Terminology
Definition

Bond – a fixed income instrument that represents a loan made by an investor to a

borrower.
A bond is a security (so tradable) instrument that evidences a company's debt. The instrument can
be in paper or electronic form.
A bond usually pays a fixed rate of interest and it may be secured or unsecured. If quoted, it will
trade on an exchange at a price determined by that market.

Exam advice

In the exam the nominal value of one bond is usually $100. Bonds can also be referred to as
loan notes.

 The coupon rate is the interest rate printed on the bond certificate.

 Nominal value is also known as par or face value.

 Market value (MV) is normally quoted as the MV of a block of $100 nominal value.
Example 4 Bond Terminology

10% bonds quoted at $95 means that a $100 block is selling for $95 and annual interest is $10
per $100 block.

 Market value (ex-int) is where interest has just been paid.

 Market value (cum-int) includes the value of accrued interest which is just about to be paid.
4.2.2 Cost of Irredeemable Bonds
Although the interest yield is the company's pre-tax cost of irredeemable debt, the post-tax cost
will be lower due to the tax saving on the coupon payments (the “tax shield”).

Example 5 Tax Shield of Debt Interest

Consider two companies with the same earnings before interest and tax (EBIT). The first
company uses some debt finance, the second uses no debt.
 Example 5 Tax Shield of Debt Interest

$ $

EBIT
100 100

Debt interest
(10)

Profits before tax

90 100

Tax @ 33%
29.70 33

$3.30 difference

Therefore

Effective cost of debt

&

Debt interest
10.00

Less: tax shield

(3.30)

Effective cost of debt

6.70

Because of tax relief, the cost to the company is less than the required return of the bondholders.

Exam advice

An exam question will state whether to assume that tax is paid, and therefore tax relief received, in the
year interest is paid (i.e. “instant”) or at the end of the following year.

If the debt is irredeemable:

Where Tc = corporate tax rate as a decimal

Key Point

kd is used to denote the pre-tax cost of debt.

Activity 6 Cost of Irredeemable Debt

12% undated bonds with a nominal value of $100 are quoted at $92 cum-interest. The company
tax rate is 33%

Require
Calculate:
a. the return required by the bond holders; and
 b. the cost to the company.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Return required by debt holders
r = Interest/MV ex-int = 12/(92−12) = 15%
Return required by bondholders = 15%
b. Cost to the company:
kd = Int(1−T)/MV ex-int = 12(1−0.33)/(92−12) = 10.05%

4.3 Redeemable Bonds

4.3.1 Valuation of Redeemable Bonds
The market value of a redeemable (“dated”) bond should equal the present value of the coupon
interest (paid each year until maturity) and the redemption price (paid at maturity), discounted at
the investors' required rate of return.
The bondholder’s required return on a redeemable bond is also referred to as its Yield to Maturity
or Gross Redemption Yield. It equates to the company’s pre-tax cost of the redeemable bond, k d.

Activity 7 Valuation of Redeemable Bond

A company has in issue 8% $100 nominal value bonds redeemable at a 5% premium in 10 years' time. 4%
$100 treasury notes are trading at $98 and are redeemable at par after one year; the yield curve is flat and
the corporate credit spread is 388 basis points.

Required:
Calculate the market price of each bond.
*Please use the notes feature in the toolbar to help formulate your answer.

4.3.2 Cost of Redeemable Bonds

The cash flows for a redeemable bond are not a perpetuity because the principal will be repaid.
However, the following general rule can be applied:

Key Point

The cost of any source of funds is the IRR of the cash flows associated with that source.
 Looking at the return from an investor's point of view, interest payments are gross.
  The IRR is found as usual, using linear interpolation, which is available as a spreadsheet
formula in CBE:
IRR =IRR(values;[guess]), where:
o values (required) – is the range of cash flows
o guess (optional) – is a rate close to the result of the IRR, as a decimal.
Example 6 IRR Spreadsheet Functionality

A 7% bond redeemable at par has a current market price of $107.40 for $100. Time to maturity
is seven years.
Tabulating to cash flows:

Year CF

0 −107.4

1 7

2 7

3 7

4 7

5 7

6 7

7 107

IRR 5.7%
Using the IRR formula =IRR(B2:B9) gives 5.7%

Activity 8 Cost of Redeemable Debt

A company has in issue $200,000 7% bonds redeemable at a premium of 5% on 31 December 20X6.
Interest is paid annually on 31 December. It is currently 1 January 20X3 and the bonds are trading at $98
ex-interest.

Required:
Calculate the cost of debt for investors.
*Please use the notes feature in the toolbar to help formulate your answer.
“Long-hand” calculation
Time Cash flow PV @ 10% PV @ 5%

0 (98) (98) (98)

1–4 7 22.19 24.82

4 105 71.72 86.42

(4.09) 13.24
IRR = 5% + 13.24/(13.24 + 4.09) x (10% – 5%) = 8.8%
Using the IRR spreadsheet formula, where B7=IRR(B2:B6)
Year CF

0 −98
 1 7

2 7

3 7

4 112

IRR 8.7%

Required return of the

Gross redemption
redeemable = IRR of pre-tax cash flows =
yield
bondholder from the bond
Gross Redemption Yield is also referred to as the Yield to Maturity (YTM)

4.4 Semi-annual Interest Payments

In practice, bond interest is usually paid every six months rather than annually. This practical
aspect can be built into calculations for the cost of debt as follows:
 If interest payments are every six months, the IRR of the bond's cash flows should be calculated
on the basis of each time period being six months.
 The IRR, or cost of debt, will then be a six-month cost of debt and must be adjusted to
determine the annual cost of debt.

Activity 9 Effective Annual Cost

A company has in issue 6% bonds, the interest on which is paid on 30 June and 31 December
each year. The bonds are redeemable at par on 31 December 20X9. It is now 1 January 20X7 and
the bonds are quoted at $96 per $100 nominal value.

Required
Calculate the effective annual cost of debt, .

*Please use the notes feature in the toolbar to help formulate your answer.
Time 0 is 1 January 20X7. Interest payments are due:
30 June X7 Time 1

31 Dec X7 Time 2

etc

31 Dec X9 Time 6
Each interest payment will be just half of the coupon rate, $3 each 6 months.
Time Cash flow PV @ 3% PV @ 5%

0 (96) (96) (96)

1–6 3 16.25 15.23

6 100 83.75 74.62

4.00 (6.15)
IRR = 3 + [4.00/(4.00 + 6.15) × (5 − 3)] = 3.79%. This is the semi-annual cost of debt.

Therefore, the effective annual cost of debt

4.5 Convertible Bonds

4.5.1 Valuation of Convertible Bonds

Convertible bonds allow the investor to choose between redeeming them at some future date or
converting them into a predetermined number of ordinary shares in the company.

Key Point

MV (ex-interest) = present value of future interest payments and the higher

of:
i. redemption value; or
ii. forecast conversion value,
discounted at the bondholder's required rate of return.

To estimate the market value, it is first necessary to predict whether the investor will choose
redemption or conversion. The redemption value will be known with certainty, but the future share
price can only be estimated.
Other amounts that may be calculated for convertibles:
 Floor value = the value assuming redemption;
 Conversion premium = market value − current conversion value.

Activity 10 Valuation of Convertible Debt

A company has in issue 9% bonds which are redeemable at their nominal value of $100 in five
years' time. Alternatively, each bond may be converted on that date into 20 ordinary shares. The
current ordinary share price is $4.45, and this is expected to grow at a rate of 6.5% per year for
the foreseeable future. Bondholders' required return is 7% per year.

Required:
Activity 10 Valuation of Convertible Debt

A company has in issue 9% bonds which are redeemable at their nominal value of $100 in five
years' time. Alternatively, each bond may be converted on that date into 20 ordinary shares. The
current ordinary share price is $4.45, and this is expected to grow at a rate of 6.5% per year for
the foreseeable future. Bondholders' required return is 7% per year.

Required:
Calculate the following values for each $100 convertible bond:
i. market value;
ii. floor value; and
iii. conversion premium.
*Please use the notes feature in the toolbar to help formulate your answer.
i. Market value
Expected share price in five years' time = 4.45 x 1.0655 = $6.10 Forecast conversion
value = 6.10 x 20 = $122
Compared with redemption at par value of $100, conversion will be preferred.
Today's market value is the PV of future interest payments, plus the PV of the forecast
conversion value:
 ii. Floor value
Floor value is the PV of future interest payments, plus the PV of the redemption value:

iii. Conversion premium

Current conversion value

Conversion premium =
This is often expressed on a per share basis (i.e. 34.89/20 = $1.75 per share).

4.5.2 Cost of Convertible Bonds

To find the cost of convertible debt, , find the IRR of the following cash flows:
Time $

0 Market value (ex-interest) x

1−n Gross interest payment (x)

n Higher of redemption value/forecast conversion value (x)

4.6 Bond Duration

4.6.1 Bond Values and Interest Rate Changes
When market interest rates (yields) fall the market price of bonds rises (because the present value
of the bonds' fixed future cash flows rises). When yields rise the price of bonds falls.
The change in bond price is approximately the same in either direction for a small rise/fall in yield.
For larger changes in yield the change in price is greater for falls in yield than for rises in yield.
Therefore the relationship between yields and bond prices is not linear, but convex.

4.6.2 Macaulay Duration

Duration measures the average time it takes for a bond to pay its coupons and principal. It
recognises that bonds which pay higher coupons effectively mature earlier compared to bonds
which pay lower coupons, even if the redemption dates of the bonds are the same.
This is because a higher proportion of the higher coupon bonds' income is received sooner.
Therefore these bonds are less sensitive to interest rate changes and will have a lower duration.
Duration is often expressed in years − known as the Macaulay duration.
Macaulay duration = the weighted average of the number of years in the bond's life, with the
weighting factor being the present value of the flows in each year (discounted at the yield to
maturity).
Higher Macaulay duration indicates higher bond price volatility.

4.6.3 Modified Duration

Modified duration gives the approximate percentage price change in a bond for a 1% change in
yield and is calculated as:
, where YTM = bond's yield to maturity.

However modified duration is not totally accurate as it assumes a linear relationship between yield
and price (i.e. it ignores convexity, see s.4.6.4).
Therefore, duration will predict a lower price than the actual price and for large changes in interest
rates this difference can be significant.
If interest rates fall, duration will understate the rise in bond prices; whereas, if interest rates rise
duration will overstate the fall in bond prices.

4.6.4 Convexity
The price change predicted by modified duration needs to be adjusted by the convexity measure
to make the calculation more accurate:

Total % price change = ± change due to duration + change due to convexity

Even after correcting for convexity duration can only measure the change in bond price if the
change in interest rates does not lead to a change in the shape of the yield curve. This is because
duration is an average measure based on the bond's gross redemption yield (yield to maturity).
If there is a non-parallel shift in the yield curve (i.e. the shape of the yield curve changes) duration
can no longer be used to assess the change in bond value.

4.6.5 Factors Affecting Duration

Factors affecting duration include the following:
 Term to maturity − longer dated bonds have longer durations and hence higher price volatility.
 Coupon − lower coupon bonds have longer durations and hence higher price volatility (the
duration of a zero-coupon bond equals its term to redemption).
 Yield − bonds with low yields have longer durations and hence higher price volatility.

Activity 11 Duration
A 6% coupon bond (paid annually) has three years to maturity. Yield to maturity is 10%, $1,000
nominal value.

Required Calculate:

a. Macaulay duration;
b. Modified duration;
c. The actual % change in bond price for a 1% rise/fall in yield.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Macaulay duration
 Yea
r $ DF@ 10% PV Year x PV

1 60 0.909 54.54 54.54

2 60 0.826 49.56 99.12

796.0
3 1,060 0.751 6 2,388.18

900.1
6 2,541.84

b. Macaulay duration years

c. Modified duration
Modified duration = 2.82/(1+0.10) = 2.56
d. Actual % change in bond price for a 1% rise/fall in yield
Recalculate bond price if yield rises to 11%:
Yea
r $ DF PV

1 60 0.901 54.06

2 60 0.812 48.72

3 1,060 0.731 774.86

877.64

% fall in bond price modified duration

Recalculate bond price if yield falls to 9%:
Yea
r $ DF PV

1 60 0.917 55.02

2 60 0.842 50.52

3 1,060 0.772 818.32

923.86
Rise in bond price (923.86 − 900.16)/900.16 = 2.63% ≈ modified duration
Key Point

Duration overstates falls in bond prices when interest rates rise but understates rises in bond prices
when interest rates fall. This is because duration assumes a linear relationship between yields and bond
prices, whereas the true relationship is convex.

5.1 Yield Curve Theory

The return provided by a security will alter according to the length of time before the security
matures.
If, for example, a graph is drawn showing the yield-to-maturity/redemption yield of various
government securities against the number of years to maturity, a "yield curve" such as the one
below might result.
The shape of the curve can be explained by the following complementary theories:
 Expectations theory
If interest rates are expected to increase in the future, a curve such as that above may
result. The curve may invert if interest rates are expected to decline.
 Liquidity preference theory
By investing for a longer period the investor is deferring his consumption and requires a
higher yield as compensation.
 Market segmentation theory
The interest rate at each point on the yield curve represents the price of money with that
term to maturity, as determined by the supply and demand for funds with that term to
maturity. If there are few investors seeking to invest long term, but many borrowers
wishing to borrow long term, the price of long-term money will be high and the yield
curve is likely to be upward sloping.
Market segmentation theory is also known as the “preferred habitat” theory as different
types of market participant influence different segments of the yield curve (e.g. pension
funds typically invest longer term).
 Risk
Risky debt will have a higher yield, at all terms to maturity, than risk-free government
debt. Therefore there will be a different yield curve for each class of debt, by risk.
However, as default risk may be more significant on corporate debt, the corporate yield
curve may rise more steeply than the government yield curve.

5.2 Estimating the Spot Yield Curve

A spot interest rate is the rate for borrowing money today to be repaid by a single sum on a
specific future date.
It is calculated by finding the discount rate that makes the present value of a zero-coupon bond
equal to its price (i.e. the zero-coupon interest rate).
For example, the one-year spot rate is the rate for borrowing money today to be repaid with a
single amount after one year; the two-year spot rate is the rate for borrowing money today to be
repaid with a single sum after two years (i.e. with zero coupon paid during the loan's life).
Ideally, spot interest rates could be found directly as the quoted yield to maturity (gross
redemption yield) of zero-coupon bonds of various maturities.
In practice, most government (and corporate) bonds pay coupon (i.e. are not repaid as a single
sum). In this case, spot rates cannot be directly observed and have to be implied using a process
known as bootstrapping:
 First find the YTM on a one-year government bond.
Assuming coupon is paid annually (as opposed to semi-annually) this one-year bond is in fact
repaid by a single sum (i.e. its YTM is by definition the one-year spot rate).
 Then find the market price of a two-year government bond.
The market price should theoretically equal the present value (PV) of the first-year coupon
(discounted at the one-year spot rate) plus the PV of the second-year coupon and redemption
value (discounted at the two-year spot rate). As the one-year spot is known the two-year spot
can be calculated.
 Then find the market price of a three-year government bond. This should equal:
o the PV of the first-year coupon (discounted at the one-year spot rate) plus
o the PV of the second-year coupon (discounted at the two-year spot rate) plus
o the PV of the third-year coupon and redemption value (discounted at the
three-year spot rate, which can now be calculated).
 The process continues for as long as required.
Example 7 Bootstrapping

The following data has been collected on government treasury notes (annual coupon, $100
nominal and redemption value):

Years to redemption Coupon Market Price

One 7% $103

Two 6% $102

Three 5% $98

Required:

Determine the annual spot yield curve.

Solution
The one-year treasury note will produce a single future sum of $107 (principal + coupon) after
one year. Therefore its yield equals the one-year spot rate (s1).
s1 = (107/103) − 1 = 3.88%
The two-year spot rate can be implied by "stripping" the two-year treasury note into its
constituent cash flows and discounting each at the relevant spot rate (where s2 = two-year spot
rate):
102=(6/1.0388) + ((106/(1 + s2)2)
96.22=((106/(1 + s2)2)
s2=√(106/96.22) − 1 = 4.96%
Note: Cash flow is $6 ($100 × 6%; interest) in Year 1 and $106 (interest + principal) in Year 2.
Similarly, the market value of the three-year treasury should equal the first-year coupon
(discounted at the one-year spot) plus the second-year coupon (discounted at the two-year
spot) plus the repayment of principal and third-year coupon (discounted at the three-year spot).
98=(5/1.0388) + (5/(1.04962)2) + ((105/(1 + s3)3)
88.6
=((105/(1 + s3)3)
5
s3=
The annual spot yield curve is therefore:

Year 1 3.88%
 Example 7 Bootstrapping

Year 2 4.96%

Year 3 5.80%

5.3 Valuing Corporate Bonds Using Spot Rate:

An accurate approach to bond valuation is to "strip" a bond into its constituent cash
flows and discount each cash flow separately at its related spot rate.
Once the theoretical market value of the bond has been found, its YTM can be estimated (i.e. the
equal annual rate that would discount the bond's cash flows to the market price).
Activity 12 Spot Curve Valuation
A three-year, 5% coupon corporate bond ($100 nominal and redemption value) has the following
spread above the treasury spot rates from example 7(bps = basis points):

Year Spread (bps)

One 29

Two 41

Three 55

Required;
a. Value the bond based on the corporate spot curve.
b. Estimate the bond's yield to maturity.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Corporate Spot Curve
Yea Spread Treasury Corporate Present
r (bps) spot spot $ value

1 29 3.88% 4.17% 5 5/1.0417 = 4.80

2 41 4.96% 5.37% 5 5/1.05372 = 4.50

3 55 5.80% 6.35% 105 105/1.06353 = 87.29

96.59
b. YTM
Tim
e $ 6% DF PV $ 7%DF PV $

(96.59
0 (96.59) 1 ) 1 (96.59)

1-3 5 2.673 13.36 2.624 13.12

3 100 0.84 84 0.816 81.60

0.77 (1.87)
YTM = IRR = 6% + 0.77/(0.77 + 1.87) = 6.29%
Syllabus Coverage
This chapter covers the following Learning Outcomes.

A. Role of the Senior Financial Adviser in the Multinational Organisation

2. Financial strategy formulation
1. Advise on the impact of behavioural finance on financial strategies/securities prices and why
they may not follow the conventional financial theories.

B. Advanced Investment Appraisal

3. Impact of financing on investment decisions and adjusted present values
1. Calculate the cost of capital of an organisation including the cost of equity and cost of debt,
based on the range of equity and debt sources of finance. Discuss the appropriateness of using
the cost of capital to establish project and organisational value, and discuss its relationship to
such value.
1. Assess an organisation's debt exposure to interest rate changes using the simple Macaulay
duration method and modified duration methods.
1. Discuss the benefits and limitations of duration including the impact of convexity.
1. Assess the organisation’s exposure to credit risk, including:
1. Estimate the organisation’s current cost of debt capital using the appropriate term
structure of interest rates and the credit spread.
4. Valuation and the application of free cash flows
1. Apply appropriate models, including term structure of interest rates, the yield curve and credit
spreads, to value corporate debt.

Summary and Quiz

 The Efficient Markets Hypothesis concerns the pricing efficiency of the capital markets (i.e. what
information is included in the price of securities).
 Behavioural finance challenges whether, for example, investors are rational and take financial
decisions based on relevant information.
 If capital markets are perfect the sale/purchase of any security must be a zero NPV transaction
(i.e. market price = present value of future cash flows discounted at investors' required return).
 This general rule can be specifically applied to shares to develop the Dividend Valuation Model
(DVM) and also to bond valuation.
 If the market price of a security is already known, the model can be rearranged to find the
required return of investors' (i.e. the company's cost of equity and debt finance).
 Bond duration measures the sensitivity of a bond's price to a change in yield.
 The term structure of interest rates deals with the relationship between short- and long-term
interest rates. Everything else being equal, long-term rates should be higher to compensate
investors for their loss of liquidity. However, other factors (e.g. expectations and segmentation
theory) can produce an inverted yield curve.
 A spot interest rate refers to the rate that would apply if money borrowed today is to be repaid by
a single sum.
 As spot interest rates cannot usually be directly observed, they have to be implied through the
process of bootstrapping.

Chapter 3 WACC and Cost of Capital

Visual Overview
Objective: To evaluate and apply various capital structure theories to estimate an organisation's
weighted average cost of capital (WACC) and discuss practical influences on gearing.

1.1 Calculation of WACC

A company's long-term finance is usually a mixture of both equity and debt (i.e. using some
degree of financial gearing/leverage). The average cost of long-term finance is known as the
WACC − the weighted average cost of capital.
Calculating the cost of equity and the cost of various types of corporate debt have already been
covered (Chapter 2).
 Key Point

The post-tax cost of debt = kd(1 − T).

At any moment in time a company can estimate its existing WACC.
The existing WACC may be a suitable discount rate for estimating the NPV of potential projects −
but is not automatically the appropriate rate.

1.2 Use of WACC in Project Evaluation

Therefore, a company's existing WACC can only be used as the discount rate for a potential
project if that project does not change the company's:
 Gearing level (i.e. financial risk);
 Operational risk (i.e. business risk). (Important concepts of business and financial risk are dealt
with in the next section.)

Activity 1 Estimating WACC

A company has in issue:
45 million $1 ordinary shares
10% irredeemable bonds with a book value of $55 million.
The bonds are trading at their nominal value.

Share price $1.50

Dividend $0.15 (just paid)

Dividend growth 5% per annum

Company tax rate 33%

1.3 Limitations of Using WACC

The calculation of WACC depends on the accuracy of the inputs to the formula (ke, kd, Ve, Vd and Tc). The
accuracy of each of these will depend on the models and assumptions used to find them. For example:

 – Was this calculated using the capital asset pricing model (CAPM) or the DVM? How was
the growth rate of dividends determined?

 − is this likely to be constant over the project life?

 − if a market price is used, is the market efficient? If the company is unquoted, how has
this been estimated?

 − will this be constant over the life of the loan?

These problems are particularly acute for unquoted companies which have no share price
available and often make irregular dividend payments. In this case it may be advisable to:
 Estimate the WACC of a quoted company in the same industry and with similar gearing; and
 Add a (subjective) premium to reflect the higher return required by investors in unquoted
companies due to the perceived higher risk.
1.4 Effects of Gearing
The existing WACC reflects the current risk profile of the company.
Definitions

Business risk – the volatility of operating profit or, more specifically, operating cash flows due
to the nature of the industry, country and level of operational gearing (i.e. proportion of fixed to
variable operating costs).
Financial risk – the additional variability in the return to equity as a result of introducing debt
(i.e. using financial gearing). Interest on debt is also a fixed cost, which leads to even more
volatile profits for shareholders.
As a company introduces debt into its capital structure two things happen.

The effect of increased financial gearing on the WACC depends on the relative sizes of these two
opposing effects.
There are two main schools of thought:
 Modigliani and Miller's theories (see s.3); and
 Static trade-off Theory (see s.4).

2.1 Mathematical Model

Modigliani and Miller (MM) constructed a mathematical model to attempt to provide a basis for
financial managers to make finance decisions.
Mathematical models predict outcomes that would occur based on simplifying assumptions.
Comparison of the model's conclusions to the real world observations then allows researchers to
understand the impact of the simplifying assumptions. By relaxing these assumptions in turn the
model can be moved towards real life.
MM's assumptions include:
 Rational investors.
 Perfect capital markets.
 No tax (either corporate or personal) − although they later relaxed the assumption of no
corporate tax.
 Investors are indifferent between personal and corporate borrowing.
 There is a single risk-free rate of borrowing.
  No financial distress risk (i.e. no risk of default) even at very high levels of debt.
 Corporate debt is irredeemable.
 No agency costs (i.e. directors continue to put shareholders' interests first even at high levels of
debt).
Exam advice

You will not be required to prove MM, just to apply it. The formula for adjusting the cost of equity for a
change in financial gearing is provided in the exam.

2.2 Theory Without Tax

2.2.1 Two Propositions
MM considered two companies − both with the same size and in the same line of business
therefore both having the same level of business risk.
 One company was ungeared – Co U
 One company was geared – Co G
MM's basic theory was that because each company would have the same operating profit it would
have the same total market value (V) and the same WACC (proposition 1):

MM argued that the individual costs of capital would change as gearing changed in the following
manner:

 would remain constant whatever the level of gearing;

 would increase at a constant rate as gearing increased due to the increased financial
risk (proposition 2);

 the rising would exactly offset the benefit of the cheaper debt in order for the WACC to
remain constant.
2.2.2 Graphically

2.2.3 Conclusions
Three conclusions can be drawn from the without tax theory:
 Only investment decisions affect the value of the company.
 The value of the company is independent of the finance decisions.
 There is no optimal gearing level.
Of course, this is not true in practice because the assumptions are too simplistic. There are
obvious differences between the real world and the model.
MM did not claim that gearing does not matter in the real world. They said that gearing should not
matter in a world where their assumptions were correct. They then relaxed these assumptions to
see how the model predictions would change.
The first assumption relaxed was the no corporate tax assumption.
2.3 Theory with Tax

Example 1 Gearing

Consider two companies, one ungeared, U Co, and one geared, G Co, both of the same size

and level of business risk. Assume the debt in G Co has a term of 10 years, a of 5%, a
market value of $400 million and is to be repaid wholly at the end of the 10 years.
U Co

$m

EBIT 100

Interest –

PBT 100

Tax @ 35% 35

Dividends 65

Returns to the investors:

Equity 65

Debt –

Total return 65
The investors in G Co receive $7million more than the investors in U Co due to the tax relief on
debt interest (the tax shield).

Tax shield per year=

=required return of debt holders

where
=current market value of the debt
T =tax rate
The required return on the debt reflects the riskiness of these debt cash flows (which are less

risky than G Co as a whole). The appropriate discount rate is therefore .

Discounting the annual tax shield for 10 years at gives a tax shield value of:

Therefore, G Co will be worth $54.05 million more than U Co.

In the theory with tax model:

 rises (as before) to reflect the increased uncertainty in cash to equity; and

 is constant as MM ignore the risks of financial distress.

MM recognised that operating profits are distributed three ways: to equity, debt and tax.
 MM argued that taking on more debt reduced the tax payments (as shown above).
 So the after tax cash due to debt plus equity rises with debt.
 As the risk of the company has not changed (as the risk of financial distress is ignored), WACC
must fall and the value must rise, as shown in the following graphs.

2.3.1 Graphically
2.3.3 Conclusions
MM's theory with tax implies that there is an optimal gearing level and that this is to maximise debt
in the capital structure to generate maximum value for the shareholders.
This is not true in practice; companies do not gear up as much as possible as there are obviously
other factors to consider, the most important being default risk.
MM's theory with tax provides the foundations of the adjusted present value (APV) and adjusted
WACC models introduced later. However, the model is flawed because it ignores many real world
factors such as:
 the risk of financial distress, as discussed above;
 the type and quality of assets for debt security that the company can offer;
 the personal tax position of the shareholders and debt holders and whether there are tax
advantages or disadvantages personally to holding particular securities;
 tax exhaustion, which in this case means the company lacks sufficient taxable profit to fully
utilise the interest tax shield;
 the issue costs associated with new debt or equity finance, which links directly to the pecking
order theory (see s.4.1);
 market sentiment − the market’s appetite for risk varies, as does government policy;
 existing bond covenants that may restrict further borrowing;
 agency costs that may favour the moderate use of debt finance (see s.5), as debt comes with
restrictive covenants that prevent managers taking excessive risks;
 how the market may interpret the issue of debt as “good” as compared to the issue of equity
(see s.4.2).

3.1 Capital Structure

The static trade-off theory of capital structure refers to the idea that a company chooses how much debt
finance to use by balancing the relative costs and benefits of debt.
 The relevant benefit of debt is the tax saving on interest payments.
 The relative costs of using debt include:
 o Agency costs − as financial gearing rises, debt contracts include increasingly
restrictive covenants (e.g. forcing the company to stay in low-risk projects or limiting
dividend payments). The resulting loss in potential shareholder wealth is referred to
as agency costs.
o Financial distress costs − when stakeholders perceive the level of gearing to
be dangerous the company's cost of operating the business may rise as suppliers
refuse credit, staff leave, potential customers lose faith in products sold under
warranty or guarantee, etc.
o Bankruptcy costs − if a company defaults on its debt it will either incur the
costs of going through a capital reconstruction scheme or the costs of being
liquidated.

4.1 Issue Costs

Pecking Order Theory is concerned with the different issue costs incurred when raising new finance. It
starts by observing that:
 The cheapest source of new finance is retained equity, as it has no issue costs. This is a form of
equity, since retained earnings would otherwise be distributable as a dividend to shareholders.
 A bond issue or bank loan is the next cheapest source of new finance. These are forms of debt.
 The most expensive source of new finance is a fresh equity issue. An initial public offering (IPO)
on a regulated exchange typically incurs issue costs of between 3% and 5% of the amount
raised.
Pecking Order Theory proposes that companies will choose the cheapest available source of new
finance first.
 New start-up companies have no retained earnings and cannot borrow (as their earnings are too
uncertain and they have little security to offer lenders). They are therefore typically heavily equity
financed, either by their owners or private equity.
 As they grow, companies will seek debt in preference to new equity as it is cheaper, quicker and
easier to issue, up to the limit of their debt capacity. Companies with few assets to offer as
security may skip this stage in their development (e.g. IT companies), at least until they become
established.
 Well established, stable companies can finance their expansion with retained earnings.
Therefore, in the absence of active management of their gearing ratio, they will become heavily
equity financed. This is known as “gearing drift”, and one of the jobs of the Treasurer is to
counter this.

4.2 Signalling
Managers should know more about the company and its projects than the market does. The
market therefore sees a decision on the form of new finance as a “signal” about the strength of the
underlying company cash flows.
 If managers believe project/company cash flows are strong, they are more likely to commit to
the payment of interest. Debt, unlike equity, has a contractual obligation to pay interest and
carries a threat of liquidation if it is not paid. The market therefore sees the use of debt as a
“good” signal about the company.
 If managers believe the project/company cash flows are weak, they are more likely to seek
equity funding, for which the payment of dividends is discretionary. Equity issues are therefore a
“bad” signal. New equity issues are accompanied by lots of management information (e.g. a
prospectus) for exactly this reason. On the announcement of a new equity issue, a company’s
share price is more likely to fall than rise.
Pecking order theory has had some success in explaining the gearing levels in different industries.

5.1 Capital Structure

Research has found that moderate levels of debt can actually reduce the level of agency costs for the
following reasons:
  the existence of debt encourages company directors to practice sound financial discipline (e.g.
careful cost control);
 debt investors, especially banks, implement their own monitoring systems (e.g. requiring regular
cash flow forecasts). This reduces the level of monitoring required by the equity investors.
However at high levels of gearing these benefits may become out-weighed by other problems for
the equity investors:
 increasingly onerous debt covenants restrict the directors' ability to undertake any projects
except those of very low risk. This limits potential gains for equity investors.
 potential costs of financial distress − if the company is perceived to be at risk of default:
o Suppliers may refuse credit;
o Key employees might leave;
o Customers may lose faith in any warranties given on the products, etc.
If the company actually does default it may go through a capital reconstruction (the costs of which
would also be borne by the shareholders) or be forced into liquidation (in which case equity
investors rank last for repayment of capital).
Therefore there may be an optimal capital structure in terms of minimising agency costs, although
research is mixed as to where this optimal point may lie.

Syllabus Coverage
This chapter covers the following Learning Outcomes.

A. Role of the Senior Financial Adviser in the Multinational Organisation

1. The role and responsibility of senior financial executive/advisor
1. Advise the board of directors or management of the organisation in setting the financial goals of
the business and in its financial policy development with particular reference to:
1. Minimising the cost of capital
2. Financial strategy formulation
1. Recommend the optimum capital mix and structure within a specified business context and
capital asset structure.

B. Advanced Investment Appraisal

3. Impact of financing on investment decisions and adjusted present values
1. Calculate the cost of capital of an organisation, including the cost of equity and cost of debt,
based on the range of equity and debt sources of finance. Discuss the appropriateness of using
the cost of capital to establish project and organisational value, and discuss its relationship to
such value.
1. Assess the impact of financing and capital structure upon the organisation with respect to:
1. Modigliani and Miller propositions, before and after tax
2. Static trade-off theory
3. Pecking order theory
4. Agency effects.

Summary and Quiz

 WACC estimates the company's average cost of long-term finance.
 It is therefore a potential discount rate to use for the calculation of the NPV of possible projects.
However the existing WACC should only be used if the project would not change the company's
business risk or level of gearing (i.e. financial risk).
 There are various, and conflicting, models of how financial gearing affects the WACC –
Modigliani and Miller with and without tax and static trade-off theory.
 Pecking order theory seeks to explain the gearing characteristics of companies at various
stages in their development by looking at the differing costs of raising different forms of new
finance.
Chapter 4: CAPM & Betas
Objective: To apply CAPM and the relationship between equity and asset betas to calculate project-
specific discount rates for investment decisions.

1.1 Investment risk

Definition

Investment risk− uncertainty or variability of an investment's

returns.
 The amount of risk an investment has depends on the variability of the returns around the
average return (often measured by the standard deviation of returns).

1.2 Investors and Risk

 Investors are assumed to be risk averse.
 Investors in general will seek to maximise return in relation to unavoidable risk. This is referred
to as "mean–variance efficiency" and is used in the derivation of the Capital Asset Pricing Model.
2.1 Diversification and Systematic Risk
CAPM was developed in the 1960s as a part of “modern portfolio theory”, which states that each
investment has varying amounts of:
 Unsystematic or unique risk which can be “diversified away” because such risks are
uncorrelated (i.e. good and bad news from companies with differing positive and negative
exposures to an unsystematic risk will cancel out). For example, if the price of copper rises,
prices of shares in copper mining companies will rise, but the price of shares in manufacturing
companies that use copper will fall.
 Systematic or market risk, which cannot be diversified away. For example, both the copper
mining company and the manufacturer will be exposed to interest rate rises and the state of the
economy generally.
Therefore, a portfolio of shares has a total risk that is made up of these two types of risk. As more
different shares are added to the portfolio, the unsystematic risk is diversified away and the
amount of total risk reduces to approach systematic risk.

This means that investors should only be rewarded for risks they cannot avoid − systematic risk.

Different shares have different systematic risks which are measured by (beta):

 A supermarket chain will have a low because people will always buy food, regardless of
the state of the economy.

 A mobile phone company will have a higher because, during a recession, people will delay
buying new mobile phones.
Just because a company has high total risk does not mean it will require a high return. For
example, a company seeking to discover and mine gold (a gold exploration company) may have
high risk, but most of that risk can be diversified away by investing in several gold exploration
companies. Diversification is often achieved by investing in different business sectors, but as this
example shows, some risks can be diversified by investing in several companies within the same
sector. A similar result might happen if a company invested in several pharmaceutical companies
all seeking to find a drug to treat a particular disease.
Because the company specific risk element of total risk can be diversified away, the investor will
only be rewarded for systematic risk. The systematic risk of a gold exploration company reflects
how the profits of the company change with changes in the state of the economy. The price of gold
is not well correlated with the state of the general economy, and often rises during times of crisis.
So a gold exploration company’s profits are also not correlated with the state of the general
economy − the company will have a small amount of systematic risk. The corresponding required
rate of return on a gold exploration company is therefore likely to be low.

2.2 Beta (β)

Beta is a measure of the systematic risk of an individual financial asset. For a typical share, beta
lies between 0.2 and 1.6:

Systematic risk (β) Return

Risk-free asset 0 Risk-free return, rf

“Neutral” share 1 Market return, rm

“Defensive” shares Less than 1 Between rf and rm

“Aggressive”
shares Greater than 1 Greater than rm
The market return is the return on the market portfolio (i.e. a fully diversified portfolio with a
representative sample of all traded shares).
2.3 Security Market Line
The security market line (SML) shows the relationship between systematic risk, as measured by ,
and required return:

E(rm) is the expected/required return of the market portfolio, M.

 Any share with a return above the SML (e.g. A on the graph above) will be sought after. This will
drive up its price and hence reduce its expected return, until it earns only the required return
indicated by the SML.
 Any share with a return below the SML (e.g. B) will be sold. This will drive down the price and
hence increase the expected return, until it earns the required return indicated by the SML.
2.5 Assumptions and Limitations of CAPM

2.5.1 Assumptions
The following assumptions are necessary for CAPM to hold true:
 Capital markets are informationally efficient (i.e. all information about shares has been
incorporated in current share prices). This means that:
o Investors are rational;
o Information is freely available at zero cost;
o Transaction costs are zero;
o Corporate and personal taxes are the same;
o There is sufficient depth to the market that prices are transparent.
 Investors are able to borrow and lend at the risk-free rate.
 The market is “mean-variance efficient”, which means that investors are risk averse and seek
investments with minimum risk at their chosen level of return or maximum return at their chosen
level of risk. However, some investors buy lottery tickets, a market that is clearly not “mean-
variance efficient”.
 It is possible to construct a fully diversified portfolio. This assumption ignores the reality that
there are many classes of asset beyond just shares (e.g. bonds, property, fine art, antiques, etc)
and that some assets that are personal/cannot be traded affect the investor’s exposure to risk
(e.g. an investor’s professional qualifications).

2.5.2 Limitations
The following are limitations on the usefulness of CAPM:
 The variables used by the model:
o Beta values, which are measured using historical data, remain stable over
time.
o The market premium for risk remains stable over time.
o A risk-free security exists − short-term government debt is usually used, but is
this really risk free?
o Lack of data for the model. For example, when using CAPM to find the
required return for an unlisted company, is a “proxy” (i.e. a similar listed company)
 available to estimate a beta equity? And are such “similar” companies sufficiently
similar?
 All of a company's shareholders are assumed to hold well-diversified portfolios. However,
because it is not possible to be fully diversified, there are other factors (not just beta) that
determine the required return on a share.
Empirical research has identified the following small but statistically significant anomalies between
the real world and CAPM predictions:
 Returns on high P/E ratio companies are lower than predicted;
 Smaller company returns are higher than predicted;
 High beta companies have lower returns and low beta companies higher returns than predicted.
Research also shows that markets exhibit momentum − shares with excess returns, compared to
CAPM, tend to continue to exhibit excess return (and vice versa for underperforming shares).

2.6 Implications for Financial Management

CAPM is an approximation and not fool-proof. Like any tool, it has limitations. One of the most important
limitations is the user − a human being subject to the behavioural problems explored by behavioural finance
(see Chapter 1). CAPM is overly simple should be used with caution in the real world.
 Shareholders in unquoted companies may not hold diversified portfolios (e.g. a large proportion
of their wealth may be invested in in a single family-owned company). In this case, shareholders
may benefit if the company diversifies across different projects to reduce unsystematic risk.
 Financial managers in large quoted companies are unlikely to benefit shareholders by
diversifying operations to reduce risk. It is cheaper and easier for shareholders to maintain a
diversified portfolio of shares than it is for companies to maintain a diversified portfolio of
projects.
 Most shares in quoted companies are held by institutional investors (e.g. fund managers). Such
professional investors will usually hold a diversified portfolio (i.e. they have already removed
unsystematic risk through the fund's diversification).
Therefore, the implications of CAPM for the financial manager of a quoted company are that the
company:
 Should specialise, not diversify;
 Needs to compensate shareholders only for the systematic risk they face.

3.1 Betas and Gearing

An equity beta is the beta of a share in a company. As it reflects the systematic business risk and
the financial risk of that share, it is influenced by the company’s gearing. When used in CAPM, an
equity beta (βe) gives ke, the cost of equity.
An asset beta is a measure of only the systematic business risk of a company or share.
Businesses in the same industry are usually assumed to have the same systematic business risk,
so the same asset beta. When used in CAPM, an asset beta (βa) gives kie, the cost of equity in
an ungeared company.
3.3 Risk-adjusted Discount Rates
A company's existing WACC is only the appropriate discount rate for a project if that project has
the same level of business risk as the company’s existing activities. If the project has a different
business risk (e.g. is in a different industry or country), a discount rate to reflect the business risk
of that project is required.
One approach to finding an appropriate discount rate for a new project with a different business
risk is to identify a proxy or benchmark company in a similar industry and identify its equity beta.
As the proxy company is likely to have a level of gearing that differs from the company considering
the project, the proxy equity beta must be adjusted for the different financial risk.
This requires the asset beta formula to be used:
 to "degear" the proxy beta to find the asset beta; and
 to "regear" the asset beta to reflect the financial risk of the company considering the project.
Exam advice

An exam question will usually state that the beta of debt should be assumed to be zero. This is because,
typically, the debt beta is small and any error introduced by this assumption is small. This simplifies,
significantly, the calculations as the second “half” of the exam formula becomes zero.

Activity 3 Risk-adjusted WACC

Suppose that Acorn from the previous activity has a gearing ratio of 1:2. It still wishes to enter into
the same computer manufacturing project.

Required:
Calculate the discount rate that Acorn should use for a computer manufacturing project.
*Please use the notes feature in the toolbar to help formulate your answer.
Syllabus Coverage
Congratulations, you have covered the following Learning Outcomes:

B. Advanced Investment Appraisal

1. Discounted cash flow techniques
1. Evaluate the potential value added to an organisation arising from a specified capital investment
project or portfolio using the net present value (NPV) model. Project modelling should include
explicit treatment and discussion of:
1. Risk adjusted discount rates
3. Impact of financing on investment decisions and adjusted present values
1. Calculate and evaluate project specific cost of equity and cost of capital, including their impact
on the overall cost of capital of an organisation. Demonstrate detailed knowledge of business
and financial risk, the capital asset pricing model and the relationship between equity and asset
betas.
Summary and Quiz
 Risk is the uncertainty or variability of an investment's returns.
 The type of risk that can be eliminated by holding a well-diversified portfolio is referred to as
unsystematic risk.
 The market portfolio is not risk-free; the market itself rises and falls with economic factors. This
element of risk cannot be removed from equities and is known as systematic risk.
 Although systematic risk cannot be removed it can be measured using beta factors.
 Beta factors can be used in the CAPM formula to estimate the required return on a particular
company.
 CAPM is an alternative to the Dividend Valuation Model (DVM) for estimating a company's cost
of equity.
 More importantly CAPM can also be used to estimate how the cost of equity will change if the
company changes its level of business risk or financial risk.
 Hence CAPM is useful for calculating project-specific discount rates.
Chapter 5: Basic Investment Appraisal
Objective: To revise investment appraisal methods including discounted cash flow (DCF) techniques which
allow for inflation and taxation.

1.1 Purpose of Investment Appraisal

The purpose of investment appraisal is to determine whether an investment project gives an
adequate financial return. This return can be measured in a variety of ways but the most common
are either by measuring the profitability of the investment or the cash flows from the investment.
Profits can be distorted by selection of different accounting policies and therefore methods based
on cash flows are preferable.

1.2 Payback Period

Definition

Payback period – the time it takes for the operating cash flows from a project to equal the initial
investment.

Key Point

Decision rule:
If payback period is less than target ACCEPT

If payback period is greater than target REJECT

 Example 1 Payback Period

Investment $1.4m

Annual operating cash flow $0.3m

Project life 10 years

Payback period years

(or five years if cash flows are assumed to arise at year ends.)

Advantages Disadvantages

 Simple to calculate.  Ignores cash flows after

 Easy to understand. payback period;
 Concentrates on earlier flows which are:  Target period is subjective;
o more certain;  Gives little information about
o more important if there are change in shareholder wealth;
liquidity concerns.  Ignores the time value of
 Emphasises the importance of recovering the money. (although using
original capital as soon as possible to exploit any discounted payback deals with
new investment options. this).

Definition

Discounted payback period – the time it takes for the present values of the operating cash flows from
a project to equal the initial investment.

1.3 Return on Capital Employed (ROCE)

Definition

Return on Capital Employed (ROCE) – the earnings of a project expressed as a percentage of the
capital outlay or average investment.
This is also referred to as Return on Capital Employed (ROCE) or Return on Investment (ROI) or
Accounting Rate of Return (ARR). It is a financial accounting measure based on the statement of
profit or loss and statement of financial position.
It therefore includes:
 Sunk costs (money already spent);
 Net book values of assets;
 Depreciation and amortisation;
 Allocated fixed overheads.
 Key Point

Decision rule:

If ROCE is less than target REJECT

If ROCE is greater than target ACCEPT

Activity 1 Return on Capital Employed

Initial investment $200m
Scrap value at end $20m
Cash flows Year 1 $100m
Year 2 $50m
Year 3 $50m
Year 4 $50m

Advantages Disadvantages

 Different methods of calculation may cause

confusion;
 Uses readily available  Based on profits rather than cash. Profits are
accounting information; easily manipulated by accounting policy;
 Simple to calculate and  Ignores time value of money;
understand;  Target rate is subjective;
 Often used by financial  A relative measure (%) − gives little information
analysts to appraise about the absolute change in shareholders'
performance. wealth.
2.1 Time Value of Money
Investors prefer to receive $1 today rather than $1 in one year. This concept is referred to as the
"time value of money" (or "time preference").There are several reasons for this preference:
 Liquidity preference − if money is received today it can either be spent or reinvested to earn
more in the future. Hence investors have a preference for having cash/liquidity today.
 Risk − cash received today is safe, future cash receipts may be uncertain.
 Inflation − cash today can be spent at today's prices but the value of future cash flows may be
eroded by inflation.
Key Point

DCF techniques take account of the time value of money by restating each future cash flow in terms of its
equivalent value today.

2.2 Discount Factors

2.2.1 Single Cash Flow
To find the present value (“today’s money”) of a cash flow received at the end of n periods,
discounted at r% each year, multiply by this discount factor:

or (shown at the top of the present value table in the exam).

An annuity may begin at time 0 (i.e. today). This simply means that there is an additional cash flow
at T0 which will always have a discount factor of 1. Therefore 1 should be added to the annuity
factor taken from the tables.
Exam advice

The formula for the present value of an annuity and annuity factors calculated for discount rates of 1%
to 20% for up to 15 years are provided in the exam.
Exam advice
3.1 Procedure
To appraise a project:
 Forecast the relevant cash flows from the project.
 Estimate the required return of investors (i.e. the discount rate). The required return of investors
represents the company's cost of finance, also referred to as its cost of capital.
 Discount each cash flow (receipt or payment) to its present value (PV).
 Sum present values to give the NPV of the project.
 If NPV is positive, accept the project as it provides a higher return than required by investors.

3.2 Meaning
NPV shows the theoretical change in the $ value of the company due to the project. It therefore
shows the change in shareholders' wealth due to the project.
Since the assumed key objective of financial management is to maximise shareholder wealth,
NPV is considered the most relevant technique in business decision making.

3.3 Cash Budget Pro Forma

3.5 Spreadsheet Formula

The NPV function in the exam spreadsheet can be used to calculate the NPV of an investment
based on a supplied discount rate and a series of future cash flows.
NPV =NPV(rate,value1,[value2],…]), where:
 rate (required) − is the discount rate given as a decimal
 value1 (required) − the item, cell reference or range of cash flows to be discounted
 value2,… (required) - additional numbers, cell references or ranges to be discounted.
How to layout an NPV appraisal in a spreadsheet and use the NPV function is assumed
knowledge of Financial Management.

Key Point

A step-by-step spreadsheet exercise for the calculation of a net present value is available in
the support resources for Financial Management Further support for CBE.

4.1 Definition
IRR is a discount rate which, when used to convert future cash flows to their present values,
results in an NPV of zero. It represents the average annual cash return from a project and
therefore shows the highest finance cost that can be accepted for the project.

Key Point

Decision rule:

If IRR is greater than the cost of capital ACCEPT

If IRR is less than the cost of capital REJECT

 Exam advice

The formula for estimating IRR provides a reasonable estimate, but take care with + and − signs.
Graphically

4.2.2 Spreadsheet Functionality

As illustrated in Chapter 2 Example 6, the IRR for a series of cash flows can be calculated using
the IRR function.
It is important to note, however, that the IRR function assumes that all cash flows occur
at equal time periods such an annually or monthly.
Also, if cash flows do not follow the conventional pattern (e.g. outflow(s) followed by only inflows)
and there are multiple solutions (see s.4.3), the IRR function will only display the first one that it
finds.

4.3 Unconventional Cash Flows

If cash outflows are followed by inflows and then more outflows, the situation of "multiple IRR" may
arise:
The project appears to have two different IRRs − in this case IRR is not a reliable method of
decision-making.

4.4 NPV v IRR

NPV IRR

 A relative measure (%)

 If IRR exceeds target %, accept
 An absolute measure($)  If IRR is less than target %,
 If NPV exceeds 0, accept reject
 If NPV is less than 0, reject  Does not show absolute
 Shows $ change in value of company/wealth of change in wealth
shareholders  May be multiple solutions
 A unique solution (i.e. a project has only one  Assumes that project cash
NPV) flows can be reinvested at the
 Always reliable for decision-making (as long as IRR
real options are allowed for − see Chapter 13)  Not always reliable

5.1 General Rule

Include only those future cash inflows and out flows which are affected by the decision. This
means using only future, incremental cash flows.
Incremental cash flows means the cash flows that change because the project is undertaken (e.g.
cash from sales and operating costs such as materials and labour).
Do not include financing cash flows because the cost of finance is measured in the cost of
capital/discount rate − finance costs are taken into account by the discounting process itself.
Specifically, exclude:
 sunk costs (i.e. money already spent);
 historic costs (e.g. of acquiring an asset);
 non-cash flows (e.g. depreciation);
 book values (e.g. FIFO/LIFO inventory values);
 unavoidable costs (e.g. money already committed and apportioned fixed costs);
 finance costs (e.g. interest).
Specifically, include:
  all opportunity costs and revenues. For example, where there is "cannibalisation" (i.e. where the
launch of a new product will reduce the sales of an existing product) the lost contribution is an
opportunity cost and should be shown as a cash outflow.
5.2 Tax System

5.2.1 Effect on Investment Appraisal

Taxation has two effects in investment appraisal:

 Depreciation expense from the financial statements

is not a tax-allowable deduction.
 Instead businesses can claim tax-allowable depreciation
(TAD).
o TAD is given as a percentage that may
be applied to a reducing balance or on a
 Operating results = Revenues − straight-line basis – exam questions
operating costs will specify the policy.
 Any tax relief on finance costs is o No TAD is given in the year of disposal;
taken into account in the a balancing allowance/charge is given instead
discount rate/cost of capital. (i.e. a tax loss/gain on disposal).

5.2.2 Timing of Tax Cash Flows

The timing of tax cash flows is complex. Some exam questions will specify that tax is paid in the
year of taxable profits, others will indicated that tax is paid "one year in arrears" (i.e. in the
following year):

 Assume the initial net revenues (revenues − operating costs) are received at the end of year 1

:
 o Tax assessed at

o Tax paid (assuming tax is paid one year in arrears).

 Assume the asset bought at start of year 1 (i.e. ):

o First TAD received at (date of next tax assessment)

o Reduces tax payment at .

Example 5 Tax Savings

An asset is bought for $5,000 at the start of an accounting period. It is sold at the end of the
third accounting period for $1,000.
The company tax rate is 30% and tax is paid one year in arrears. Tax-allowable depreciation is
available at 25% reducing balance, with a balancing adjustment in the year of disposal.
Determine the tax savings available and when they arise.
Solution
Tax saving @30% Timing

$ $

Cost 5,000
Year 1 TAD 25% (1,250)
375

Tax book value c/f 3,750

Year 2 TAD 25% (938)
281

Tax book value c/f 2,812

Year 3 Disposal (1,000)

Balancing allowance 1,812 544

Activity 4 Tax Cash Flows

Efex Co buys a new machine costing $50,000 which has a disposal value of $25,000 at the end of
four years. Tax-allowable depreciation is available on a straight-line basis at 20% on cost, with a
balancing adjustment in the year of disposal. The company tax rate is 35% and tax is paid without
delay.

Required:
Calculate the tax effects associated with the machine and state in which year tax is
saved/paid.
*Please use the notes feature in the toolbar to help formulate your answer.
$ Timing

Tax-allowable depreciation 10,000

(Years 1–
Annual tax saving 3,500 3)
 Tax written-down value at disposal (end of third year − carried forward

into fourth year) 20,000

Taxable gain on disposal 5,000

Tax paid on balancing charge 1,750 (Year 4)

5.2.3 Other Assumptions
Other simplifying assumptions include:
 Tax rate is constant.
 Sufficient taxable profits are available to use all tax deductions in full.
 Working capital flows have no tax effects. For example, if accounts receivable increase this does
not change the tax situation as tax is charged when revenues are recorded rather than when the
cash is received.

5.2.4 Tax Exhaustion

Tax exhaustion arises when a company does not have sufficient profits to fully utilise available tax-
allowable depreciation (i.e. where deducting tax-allowable depreciation leads to a tax loss).
The usual assumption in exam questions is that the company has sufficient profits elsewhere in its
business to fully utilise tax-allowable depreciation on a new project. However, if the company and
the project are essentially one and the same, there will be no other business; so losses could only
be carried forward. The impact of tax exhaustion would then depend on the relevant tax
legislation. There are three main possibilities for unused tax-allowable depreciation:
1. it is simply lost;
2. it can be carried back against profits in previous years;
3. it can be carried forward to potentially use against future project profits.

Exam advice

A question will say whether losses should be carried forward or can be offset against other profitable
projects in the year that the loss arises.

5.3 Inflation
5.3.1 Real and Money (or Nominal) Interest Rates
When dealing with inflation, it is important to distinguish between real and money (nominal)
interest rates:
 The real rate of interest reflects the rate of interest that would be required in the absence of
inflation. The market rarely quotes a real rate of interest.
 Money (or nominal) rate of interest reflects the real rate of interest adjusted for the effect
of general inflation as measured, for example, by the Consumer Price Index (CPI) or the
Eurozone Harmonised Index of Consumer Prices (HICP).
Exam advice

Assume that any interest rate given in the exam is a nominal rate unless the question explicitly states
that it is a real rate.
 Example 6 Nominal (Money) Return Required

Suppose you invest $100 today for one year and, in the absence of inflation, you require a return of 5%.
The inflation rate is expected to be 10% over the coming year.
In one year, in the absence of inflation, you require:

To maintain the purchasing power of your investment (i.e. to cover inflation) you require:

You therefore require a money return of over the year.

Money rates, real rates and general inflation are linked by the Fisher formula:

(1 + money rate) = (1 + real rate)(1 + general inflation rate)

(1 + i) = (1 + r)(1 + h)

i = nominal/money interest rate

r = real interest rate
h = general inflation rate

Exam advice

This is provided in the exam in the formulae sheet.

Applying the Fisher formula to Example 6:
(1 + i) = (1.05) (1.1) = 1.155
Therefore, i = 15.5%

5.3.2 General and Specific Inflation Rates

A specific inflation rate is the rate of inflation on an individual item (e.g. wage inflation, materials
price inflation).
The general inflation rate is a weighted average of many specific inflation rates.

5.4 Cash Flow Forecasts

If there is inflation in the economy, there are two possible approaches:
1. Discount today’s money (“real”) cash flows at a real cost of capital; or
2. Discount money (or nominal) cash flows at a nominal cost of capital.

5.4.1 Real Cash Flows

Cash flows are expressed at today's prices (i.e. before the effects of inflation). These are then
discounted at a real rate excluding general inflation. Use the Fisher formula (see above) if
necessary to calculate a real rate from a nominal (or money) rate and the general inflation rate.
Key Point

This method only works if ALL cash flows are inflating at the same general rate of
inflation.
 Example 7 Real Cash Flows

A new three-year project:

 requires an initial investment of $5 million at time 0, with a scrap value of $1m at the end of
year 3 in today’s money terms;
 is expected to generate sales revenues of $10m per year for the next 3 years, growing at the
general rate of inflation;
 is expected to incur costs of $5m in year 1, $4m in year 2 and $5m in year 3, growing at the
general rate of inflation.
The real weighted average cost of capital is 3%.
Calculate the NPV of the project using the real discount rate. Ignore tax.
Solution
Discounted real cash flows ($m)

Time

Revenues 10 10

Costs (5) (4)

Capex (5)

Relevant cash flows (5) 5 6

DF at 3% 1.000 0.971 0.943

PV (5.000) 4.855 5.658

NPV 11.00

5.4.2 Money (Nominal) Cash Flows

Cash flows are inflated to future price levels using the specific inflation rate for each type of
revenue/cost. This produces a forecast of the physical amount of money that the company will
receive or pay on the relevant future date.
These nominal (or money) cash flows are discounted at a nominal (or money) cost of capital.

Example 8 Money Cash Flows

A new three-year project:

 requires an initial investment of $5m at time 0, with a scrap value of $1m at the end of year 3;
 is expected to generate revenues of $10m for each of the next 3 years, at current prices;
these revenues are expected to rise at 5% per year;
 is expected to incur costs of $5m in year 1, $4m in year 2 and $5m in year 3, at current
prices; these costs are expected to rise at 3% in year 1, 6% in year 2 and 5% in year 3.
The general inflation rate is expected to be 4% for the next 3 years and the real weighted
average cost of capital is 6%.
Calculate the NPV of the project by discounting nominal cash flows. Ignore tax.
Solution
Discounted nominal cash flows ($m)

Revenues (W1) 10.500 11.025

 Example 8 Money Cash Flows

Costs (W2) (5.150) (4.367)

Capex (5.000)

Relevant cash flows (5.000) 5.350 6.658

DF at 10% ((1.06 × 1.04) − 1) 1.000 0.909 0.826

PV (5.000) 4.863 5.500

NPV 10.50
WORKINGS

1. Revenues

Current prices 10 10 10

× inflation factor (1 + 5%) (1 + 5%)2 (1 + 5%)3

= Nominal revenues 10.500 11.025 11.576

2. Costs 3.

Current prices 5 4 5

× inflation factor (1 + 3%) (1 + 3%)(1 + 6%) (1 + 3%)(1 + 6%) (1 + 5%)

= Nominal costs 5.150 4.367 5.732

5.5 Working Capital

Movements in working capital need to be incorporated into investment appraisals. Cash flows are
derived as follows:
 Increase in net working capital = cash outflow; Decrease in net working capital = cash inflow.
 Unless the question states otherwise assume that working capital is "released" at the end of a
project (i.e. the investment in working capital falls to zero) creating a cash inflow.
 Assume that changes in the level of working capital have no tax effects. This is a realistic
assumption because tax will be charged when net revenues accrue rather than when the cash is
received.

Activity 5 Working Capital

Sales of a new product are forecast at $100,000 in the first year, increasing by a 10% compound
rate per annum. The product has a four-year life cycle. Working capital equal to 15% of annual
sales is required at the start of each year. The company's contribution margin is 40% and no
incremental fixed costs are expected.

Required:
Determine the relevant operating cash flows after allowing for working capital.
*Please use the notes feature in the toolbar to help formulate your answer.
 $ $ $ $ $

Contribution (40% × Sales) 40,000 44,000 48.400 53,240

Cash re working capital (W) (15,000) (1,500) (1,650) (1,815) 19,965

Total cash flow (15,000) 38,500 42,350 46,585 73,205

WORKING

Sales 100,000 110,000 121,000 133,100

Level of working capital 15,000 16,500 18,150 19,965 0

Cash invested in working capital (15,000) (1,500) (1,650) (1,815) 19,965

6.1 Relevance
Particularly in the case of a listed company, it is essential for the board of directors to evaluate the
potential impact of significant capital expenditure (and related financing) on the published financial
statements. With most stock markets operating at the semi-strong level of pricing efficiency, the
company's share price would have adjusted already on the initial public announcement of the
project but the market will subsequently adjust its expectations once the actual effects on the
financial statements are reported.
Of specific relevance is the impact of the project and its financing on key ratios used by the
financial analysts who advise major institutional investors whether to buy, sell or hold the
company's shares:
 Earnings per share (EPS);
 Return on equity (ROE) and/or return on capital employed (ROCE);
 Financial gearing and interest cover.
Of equal importance is the impact of projects and their financing on financial ratios used to assess
debt conditions (financial covenants). If any of these are breached, the company will be “in default”
(of its debt conditions) and the lender may seek the immediate repayment of the loans/bonds or
require the company to take immediate steps to address the issues.
In the case of closely held private companies, the effects on financial statements may be less
critical. Shareholders who are also the managers would have full information about the company's
current underlying position and performance, irrespective of what is recorded in the historical
financial statements.
See Chapter 18 for detailed consideration of ratios relevant to this exam.

6.2 Impact of the Project

The capital expenditure will initially be recorded, at cost, in the statement of financial position as a
non-current asset (or assets) according to its nature (i.e. tangible and/or intangible).
Over time, the carrying value of the non-current asset will be affected by:
 Depreciation (or amortisation)policy;
 Revaluation policy (particularly in the case of property);
 Results of impairment reviews (i.e. impairment losses).
Most projects would also require an investment in working capital, which also increases the net
current assets in the statement of financial position.
Use of the asset(s) in operations should lead to an increase in revenues, cash operating costs and
depreciation (or amortisation) expense, but overall operating profit (earnings before interest and
tax) would be expected to rise.

6.3 Mode of Financing

The overall reported impact of a project is highly dependent on the mode of financing and,
assuming the directors follow pecking order theory, the relative effects would be as follows:

6.3.1 Internal Equity Finance

Internal equity would already be reflected in retained earnings in the statement of financial
position. However, to finance a project, the retained earnings would have to be represented by
cash (or cash equivalents), which would then fall to the extent of the capital expenditure and
required investment in working capital.
Although the project itself should produce an overall increase in EBIT, this may, to some extent,
be offset by lost income on cash equivalents.

6.3.2 Debt Finance

Initially, non-current liabilities would increase to the extent of the capital expenditure and required
investment in working capital.
This will lead to a potentially large rise in financial gearing. However, over the life of the project the
reported financial gearing is likely to fall from its initial level due to:
 additional retained earnings leading to a rise in equity;
 repayments of debt (e.g. under an amortising loan or lease).
Interest on debt will to some extent offset the increase in EBIT due to the project. However, the
additional interest will lead to additional tax shield.

6.3.3 External Equity Finance

If new shares are issued (e.g. in a rights issue), the value of equity in the statement of financial
position will increase, and debt will remain unchanged. Hence reported financial gearing will
initially fall. Gearing may continue to fall over the project's life due to additional retained earnings.
The additional EBIT created by the project will not be offset by additional interest expense, or by
lost interest on deposits, and hence total earnings would be maximised under this mode of
finance.
However, ROE and EPS may fall, depending on the profitability of the project, due to the higher
level of equity and additional shares in issue.

Syllabus Coverage
Congratulations, you have covered the following Learning Outcomes:

B. Advanced Investment Appraisal

1. Discounted cash flow techniques
1. Evaluate the potential value added to an organisation arising from a specified capital investment
project or portfolio using the net present value (NPV) model. Project modelling should include
explicit treatment and discussion of:
1. Inflation and specific price variation
2. Taxation including tax-allowable depreciation and tax exhaustion
1. Establish the potential economic return using internal rate of return (IRR) and advise on a
project's return margin. Discuss the relative merits of NPV and IRR.
3. Impact of financing on investment decisions and adjusted present values
 1. Assess the impact of a significant capital investment project upon the reported financial position
and performance of the company taking into account alternative financing strategies.
Summary and Quiz
 Payback and ROCE are commonly used in practice. However, neither method informs
management of the absolute change in shareholders' wealth due to a particular project.
 As well as being able to calculate payback and ROCE, it is therefore vital that you can also
explain why they are not acceptable methods of project appraisal.
 Discounted cash flow techniques are arguably the most important methods used in financial
management.
 DCF techniques have two major advantages: (i) they focus on cash flow, which is more relevant
than the accounting concept of profit, and (ii) they take into account the time value of money.
 NPV must be considered a superior decision-making technique to IRR as it is an absolute
measure which tells management the change in shareholders' wealth expected from a project.
 The golden rule − only discount incremental, non-financing cash flows.
 Depreciation is not a relevant cash flow for project evaluation− it is not a cash flow.
 Do not discount finance costs − the cost of finance is measured in the discount rate and is
therefore already taken into account.
 Although tax is charged on the operating returns of a project, a company may have savings from
tax-allowable depreciation.
 When dealing with inflation, inflate cash flows and use a nominal discount rate (except in the
unusual situation that all cash flows are inflating at the general inflation rate).
 Changes to working capital balances are relevant cash flows.

Chapter 6 : Advance Investment Appraisal

Objective: To recognise and understand advanced capital budgeting techniques.

1.1 Use
APV is used to appraise investments whose financing package disturbs the company's existing
capital structure (i.e. financial risk). It can also deal with a change in business risk.
It is often described as the "divide and conquer" approach in that it separates the "base" benefits
of the project from its "side-effects".
APV is based on Modigliani and Miller's assertion that the value of a geared company = value of
an ungeared company + present value of tax shield. Applied at a project level:

APV = Project value if all equity + Present value of the tax shield ± Present value of other
 financed from any debt side effects

1.2 Approach
There are two parts to the calculation of APV:
1. Calculate the operational value of the project as if it were being financed only by equity – "Base
Case NPV".
Key Point

Operating cash flows are discounted at a cost of equity ungeared representing the project's
level of business risk.

2. Calculate the present value of the "side effects". For example:

 value of the tax shield on interest on debt finance for the project;
 issue costs from raising external finance;
 value of government subsidies (e.g. loans received below commercial interest rates).

Exam advice

 The amount of debt should be grossed up to cover its issue costs (unless otherwise stated).
 The tax shield and value of subsidies should be discounted at the company's commercial pre-
tax cost of debt.

Activity 1 Adjusted Present Value

Blades Co is considering diversifying its operations away from its main area of business (food
manufacturing) into the plastics business. It wishes to evaluate an investment project which
involves the purchase of a moulding machine costing $450,000. The project is expected to
produce net annual operating cash flows of $220,000 for each of the three years of its life. At the
end of this time its scrap value will be zero.
The assets of the project will support debt finance of 40% of its initial cost (including issue costs).
The loan capital plus interest is to be repaid in three equal annual instalments. The balance of
finance will be provided by a placing of new equity. Issue costs will be 5% of funds raised for the
equity placing and 2% for the loan. Issue costs are tax allowable.
The plastics industry has an average equity beta of 1.356 and an average debt: equity ratio of 1:5
at market values. Blades' current equity beta is 1.8 and 20% of its long-term capital is represented
by debt which is generally regarded to be risk-free.
The risk-free rate is 10% per annum and the expected return on the market portfolio is 15%.
Profits are taxed at 35%, payable one year in arrears. Tax allowable depreciation is immediately
available on the machine at 70% on cost, with the balance written off over the three-year project
life. The company is certain that it will earn sufficient profits against which to offset these
allowances.

Required:
Appraise the investment project using:
a. the current WACC;
b. a WACC adjusted for business and financial risk;
c. Adjusted Present Value (APV).
*Please use the notes feature in the toolbar to help formulate your answer.
Firstly identify the operating cash flows:
 Operating Cash Flows Year 0 Year 1 Year 2 Year 3 Year 4
$000 $000 $000 $000 $000
Equipment (450)
Saving on TAD (W) 110.25 15.75 15.75 15.75
Operating cash flows 220.00 220.00 220.00
Tax on operating cash
flows (77.00) (77.00) (77.00)
(450) 330.25 158.75 158.75 (61.25)
$ Tax @
WORKING $ 35%
Cost of machine 450,000
(315,000
Initial allowance (70%) ) 110,250
135,000
Tax allowable depreciation straight line for the next 3 years 45,000 15,750
Activity 2 APV with Subsidised Finance
Gilmore Co has a potential $25 million investment that would represent a diversification away from
its existing activities and into the printing industry. Of the investment, $6 million would be financed
by internal funds, $10 million by a rights issue and $9 million by long-term loans. The investment is
expected to generate pre-tax operating cash inflows of $5 million per year, for a period of 10
years. The residual value at the end of year 10 is forecast to be $7 million after tax.
As the investment is in an area that the government wishes to develop, a 10-year subsidised loan
of $4 million at 6% interest is available. Another $5 million of debt would be raised with a 10-year
bank loan at 8% which is Gilmore's usual borrowing rate. Both borrowings are to be repaid in full at
the end of 10 years.
Gilmore's equity beta is 0.85 and its financial gearing is 60% equity, 40% debt by market value.
The average equity beta in the printing industry is 1.2, and average gearing is 50% equity, 50%
debt by market value. The risk-free rate is 5.5% per year and the market return is 12% per year.
Issue costs are estimated to be 1% for the bank loan and 4% for the rights issue. There are no
issue costs on the subsidised loan. Issue costs are not tax allowable.
The corporate tax rate is 30%. Tax is paid in the year of returns and tax allowable depreciation
may be ignored.

Required:

a. Estimate the APV of the proposed investment.

b. State three circumstances in which APV may be a better method of evaluating a capital
investment than NPV.
*Please use the notes feature in the toolbar to help formulate your answer.
a. Adjusted Present Value (APV)
A project–specific asset beta is required to find the ungeared cost of equity for the "base
case NPV".
Therefore, ungear the equity beta of the printing industry, assuming the beta of debt is
zero:
1.3 Comparison of NPV and APV
When evaluating a project with different business risk, the NPV and APV approaches can be
compared as follows:

NPV APV

Step 1 Cash flows

Identify cash flows. Identify cash flows.

Step 2 Base case NPV

Take of benchmark company in target Take of benchmark company in target

industry and degear. Gives . industry and degear. This gives .

Regear to take account of project

gearing. Put into CAPM, gives ungeared.

This gives which reflects project finance

and project risk. Discount operating cash flows at ungeared.

Total of discounted cash flow is "base case"

NPV.
Use in CAPM to calculate geared.

Calculate post-tax cost of debt.

Calculate WACC.
Step 3 PV of adjustments

Discount tax savings on debt interest at the pre-

Discount cash flows. tax cost of debt.

Accept project if positive NPV.

Discount issue costs at the pre-tax cost of debt.

Step 4 APV

APV is the sum of Steps 2 and 3. If positive

accept project.

1.4 Critique of APV

 Critics of APV point out that by valuing a project as a stand-alone entity it ignores the impact of
a change in capital structure on the value of the company's existing operations.
The correct procedure would therefore be as follows:
1. Value the company pre-project at its existing WACC.
2. Revalue the company with the new project included, at the company's post-project WACC.
3. NPV of project = 2 − 1 − cost of investment.
This type of stepped approach to valuation is particularly important in the case of large strategic
investments (e.g. mergers and acquisitions).
2.1 Types of Capital Rationing
Capital rationing: a situation in which there is not enough finance (capital) available to undertake
all available positive NPV projects. Therefore, capital has to be rationed.
Hard capital rationing: the capital markets impose limits on the amount of finance available (e.g.
due to high perceived risk of the company).
Soft capital rationing: the company sets internal limits on finance availability (e.g. to encourage
divisions to compete for funds).
Single-period capital rationing: capital is in short supply in only one period.
Multi-period capital rationing: capital is rationed in two or more periods.

2.2 Single-period Capital Rationing

2.2.1 Divisible Projects
If projects are divisible (i.e. any portion of a project may be undertaken) the correct method is to
calculate a profitability index for each project and then to rank them according to this measure.

Activity 3 Divisible Projects

Projects A B C D
$000 $000 $000 $000

NPV 100 (50) 84 45

Cash flow at t0 (50) (10) (10) (15)

Cash is rationed to $50,000 at T0. Projects are divisible.

Required:
Determine the optimal investment plan.
*Please use the notes feature in the toolbar to help formulate your answer.

If projects are non-divisible, the optimal investment plan can only be found using trial and error
(i.e. trying different combinations of projects until the maximum possible NPV is found).
Activity 4 Non-divisible Projects
Detail as for Activity 3, but assume that projects are non-divisible.
*Please use the notes feature in the toolbar to help formulate your answer.
This can only be solved by trial and error.
Possible
combinations NPV

$000

A only 100

C+D 129
Therefore, choose C + D.

2.2.3 Mutually Exclusive Divisible Projects

Where two or more particular projects cannot be undertaken at the same time (e.g. because they
use the same land). In this case:
1. Divide projects into groups; with one of the mutually exclusive projects in each group.
2. Calculate the highest NPV available from each group (assume projects are divisible unless told
otherwise).
3. Choose the group with the highest NPV.
Activity 5 Mutually Exclusive Divisible Projects
As for Activity 3, but C and D are mutually exclusive.
Group 1 Group 2

$000 $000

A B C A B D

NPV 100 (50) 84 100 (50) 45

Investment 50 10 10 50 10 15

Index 2 (5) 8.4 2 (5) 3

Rank 2 Reject 1 2 Reject 1

Plan: NPV Capital NPV Capital

50 50

Accept C 84 (10) Accept D 45 (15)

Accept 0.8A 80 (40) Accept 0.7A 70 (35)

164 115
Therefore, accept: C and 0.8A

2.3 Multi-period Capital Rationing

If investment funds are expected to be restricted in more than one period, neither the profitability
index nor trial-and-error approaches can be used, as they do not take into account the restriction
on finance in future periods.
If projects are divisible, a linear programming model must be formulated and solved. If there are
only two projects, the solution can be found graphically. Three or more variables require a
computer solution.
Activity 6 Linear Programming
A company is considering investment in two projects both of which are divisible. However, neither
project can be deferred.
The cash flows of the two projects are:

Year Project A Project B

0 (20,000) (40,000)

1 (40,000) (20,000)

2 (60,000) –

3 200,000 120,000
The company's cost of capital is 10%.
The funds available to the company are restricted as follows:

Year

0 $40,000

1 $50,000

2 $40,000

Required:
State the constraints and objective function to identify the optimum investment policy to
maximise NPV.
*Please use the notes feature in the toolbar to help formulate your answer.
 a = the proportion of project A to be undertaken
b = the proportion of project B to be undertaken

You would not be expected to draw a graph in your exam, but it is possible you might be expected
to interpret such a graph.
Optimal solution
From the graph, the objective function is maximised at point O. This is where 60,000a = 40,000
i.e. undertake 2/3 of project A. At this intersection with the year 0 constraint, the proportion of
project B to be undertaken is also 2/3.
 Exam advice

In the exam, multi-period capital rationing will be limited to discussion

only.

A computer provides the solution of the above problem as follows:

Project Proportion

A 0.988

B 0

C 0.719
Shadow prices:
1st constraint (the $40,000 first year budget) = 0.922
2nd constraint (the $35,000 second year budget) = 0.3755
Interpretation of solution
The solution indicates that 0.988 of Project A and 0.719 of Project C should be initiated. This
investment plan uses all the funds available in the first year and the second year.
The resulting value of objective function, NPV = $50,244
The shadow prices indicate the amount by which the NPV could be increased if the budgetary
constraints could be relaxed.
For every $1 increase in finance in the first year, $0.922 extra NPV would be obtained. For every
$1 relaxation of the constraint in the second year, $0.3755 extra NPV would be obtained.
The shadow prices indicate that extra funds in the first year are worth approximately three times
those in the second year. This fact may give management some guidance in their considerations
of various alternative sources of capital.
It is assumed that each project is divisible and that there is a linear relationship between the
proportion of each project undertaken and the NPV generated.
3.1 Limitations of Traditional IRR
Traditional IRR has a major limitation as it implies that the cash flows from a project can be
reinvested at the IRR itself. This may be an over-optimistic assumption, particularly when the IRR
is significantly higher than the company's required rate of return (i.e. cost of capital).
Furthermore, traditional IRR can be a multiple solution. A project may have two IRRs, particularly if
there are cash outflows at the end of the project's life (e.g. decommissioning costs).
Modified Internal Rate of Return (MIRR) overcomes these problems and assumes that the cash
flows arising from a project (excluding the initial investment) are reinvested at the company's
required rate of return. However, MIRR shares a weakness with traditional IRR in that it gives no
indication of the absolute change in shareholder's wealth. MIRR will give the same accept/reject
decision as NPV for a single project, but will not necessarily agree with NPV when comparing
mutually exclusive projects or when capital rationing exists.

3.2 Alternative Methods of Calculation

3.2.2 Spreadsheet Formula
The MIRR function in the exam spreadsheet calculates the MIRR for a series of cash flows.
MIRR =MIRR(values,finance_rate,reinvest_rate), where:
 values (required) − is the range of cash flows
 finance_rate (required) − the rate used on the cash outflows
 reinvest_rate (required) − the rate used on the cash inflows.
Example 2 MIRR Function

A project requires an initial investment of $1,000, and offers cash returns of $400, $600, and $300 at the
end of years one, two and three respectively. The company’s cost of capital is 10%.
Assuming the reinvestment rate is also 10%, gives MIRR = 13.0%

If the reinvestment rate exceeds the finance rate, MIRR will be higher. For example, if reinvestment rate i
12%, MIRR = 13.8%

4.1 Traditional Measures

Traditional measures of project liquidity have significant weaknesses:
 Payback period – ignores the time value of money and ignores cash flows beyond the payback
date.
 Discounted payback – takes into account the time value of money, but still ignores post-payback
cash flows.
Clearly, there is a need for measures which take into account cash flows over the whole life of the
project.

4.2 Project Macaulay Duration

The duration of a project is the average time over which the project delivers its present value. The
"Macaulay duration" of a project is the weighted average duration of the project's futures cash
flows.
The method involves the following steps:
 Calculate the present value of each future cash flow.
 Express each year's discounted cash flow as a proportion of the total present value of the
project's returns.
 Multiply each proportion by the relevant year.
 Sum the weighted years.
 5.1 Probability Analysis
5.1.1 Terminology
Definition

Independent events – the occurrence of one event does not affect the occurrence of other
events.
Conditional (dependent) events – the occurrence of one event affects the occurrence of
subsequent events.
Mutually exclusive events – the occurrence of one event precludes the occurrence of another
event (i.e. they cannot both happen).
5.3.1 Advantages
 It gives an idea of the spread of possible results around the average.
 It can be used in further mathematical analysis. For example, estimating Value at Risk (VaR) on
an investment (i.e. the potential loss in value at a given level of confidence).

5.3.2 Limitations
 The calculation of standard deviation can be time-consuming.
 The exact meaning is not widely understood by non-financial managers.

5.4 Sensitivity Analysis

Definition

Sensitivity analysis – the analysis of changes made to significant variables in order to determine their
effect on a planned course of action.
In project investment, sensitivity analysis is used to analyse the impact of changes in the value of
an input variable (occasionally more than one input variable), assuming other inputs are kept
constant.
The cash flows, probabilities or cost of capital are varied until the decision changes (i.e. NPV
becomes zero). This will show the sensitivity of the decision to changes in those elements.
Therefore, the estimation of IRR is an example of sensitivity of the project’s NPV to changes in the
cost of capital.
Sensitivity analysis can also be referred to as "what if?" analysis.

5.4.1 Method
1. Calculate the NPV of the project on the basis of best estimates.
2. For each element of the decision (cash flows, cost of capital), calculate the change necessary
for the NPV to fall to zero.
The sensitivity can be expressed as a percentage change.
For an individual cash flow in the computation:
 Key Point

For a change in sales volume, the relevant “flow” should include all cash flows based on change in
revenue. This will include revenues and variable costs (i.e. contribution), tax effects and, potentially,
working capital.

Activity 12 Sensitivity Analysis

Mr Williams has just set up a company, JPR Manufacturing Company, and estimates its cost of
capital to be 15%. His first project involves investing $150,000 in equipment which has a life of 15
years and a final scrap value of $15,000.
The equipment will be used to produce 15,000 deluxe pairs of rugby boots per annum, generating
a contribution of $2.75 per pair. He estimates that annual fixed costs will be $15,000 per annum.
Ignore taxation.

Required:
a. Determine, on the basis of the above figures, whether the project is worthwhile.
b. Calculate what percentage changes in the following factors would cause your decision in
(a) to change and comment on your results:
i. initial investment;
ii. sales volume;
iii. fixed costs;
iv. scrap value;
v. cost of capital.
*Please use the notes feature in the toolbar to help formulate your answer.
Cash Flow PV
a. Time $ DF @ 15% $

0 Initial cost (150,000) 1 (150,000)

1−15 Contribution 41,250 5.847 241,189

1−15 Fixed costs (15,000) 5.847 (87,705)

15 Scrap value 15,000 0.123 1,845

5,329
5.4.2 Advantages of Sensitivity Analysis
 It gives an idea of how sensitive the project is to changes in any of the original estimates.
 It directs management attention to checking the quality of data for the most sensitive variables.
 It identifies the critical success factors for the project and directs project management.
 It can be easily adapted for use in spread sheet packages.
5.4.3 Limitations of Sensitivity Analysis
 Although it can be adapted to deal with multi-variable changes, it is normally used to examine
what happens when one variable changes and others remain constant.
 Assumes data for all other variables is accurate.
 Without a computer, it can be time-consuming.
 Probability of changes is not considered.

5.5 Monte Carlo Simulation

Traditional sensitivity analysis can be used if one project variable changes independently of all
others. However, some project variables may be interdependent (e.g. production volume and unit
costs).
Simulation is a technique which allows more than one variable to change at the same time. The
classic example of simulation is the "Monte Carlo" method which can be used to estimate not only
a project's NPV but also its volatility.

5.5.1 Outputs From Monte Carlo Simulation

The output from the simulation estimates multiple project outcomes and their associated
probabilities. These can be plotted on an outcome/probability graph, from which estimates can be
made of the mean return, the probability of a profitable outcome, etc. The output from the model is
unlikely to be a normal distribution.
In addition, the model can rank the significance of each variable in determining the project NPV.

5.5.2 Advantages of Monte Carlo

 Monte Carlo simulation provides more information about the possible outcomes and their
relative probabilities.
 It can be used to estimate the probability that the actual NPV will be negative.
 It can be used to calculate project Value at Risk (VaR).

5.5.3 Limitations of Monte Carlo

 Monte Carlo simulation is not a technique for making a decision, but only for obtaining more
information about the possible outcomes.
 It can be very time-consuming without a computer.
 It could prove expensive in designing and running the simulation, even on a computer.
 Simulations are only as good as the probabilities, assumptions and estimates made.
Activity 13 Monte Carlo Simulation

Monte Carlo simulation has produced the following outputs for a potential project:
 Expected NPV $1.964m
 Standard deviation of NPV $1.02m

Required:
Calculate the probability that the project will reduce shareholder wealth.
*Please use the notes feature in the toolbar to help formulate your answer.
The requirement is to find the probability that the project's NPV could fall to zero from its expected

level of $1.964m. This fall represents standard deviations below the mean.
Using the normal distribution tables (1.9 on the left row and 0.02 (the second decimal) on the top
column) gives 0.4726. Adding 0.5 (the other half of the normal distribution) gives 0.9726 i.e.
97.3%.
This means that there is a 97.3% chance that the actual NPV will not fall below zero i.e. there is a
2.7% chance that it will fall below zero.
5.7 Stress Testing
Stress testing is designed to test the sensitivity of a project's value at risk under the worst set of
outcomes that can reasonably be expected to occur.
This requires a careful evaluation of the worst possible outcomes – possibly by looking at the
response of the model to extreme external events (e.g. major currency or interest rate changes).

5.8 Reducing Risk

Methods of keeping project risk within acceptable levels:
 Setting a maximum (discounted) payback period in the initial screening process of potential
projects. The purpose of an initial screen is purely to save on the costs of detailed NPV
calculations – it is not because payback is a better method than NPV.
 Use of risk-adjusted discount rates for both NPV and discounted payback – a higher discount
rate should be applied to projects of higher risk, therefore reducing the influence of more distant
cash flows. Project-specific discount rates can be found using CAPM.
 Select projects with a combination of acceptable expected NPV and relatively low standard
deviation of NPV.
 It is tempting to mention all methods as a supplement to NPV. However, NPV should always be
seen as the primary assessment method (supplemented by real option values if necessary –
see Chapter 13) and the other methods as additional information when choosing between
projects with positive NPVs. If the NPV discount rate is correct, NPV should already have
allowed for risk.
 Focus attention on the critical success factors indicated by sensitivity analysis.
5.9 Project Monitoring and Control
A project "steering committee" should be set up to help control the project and ensure efficient use
of time and resources.
The steering committee should include a project leader and representatives from different areas of
the project.
A project manager should be appointed to oversee the project and be held accountable for any
time or cost overruns. The project manager should report to the steering committee.
Actual expenditure should be compared with budgets on a regular basis. This should ensure
effective management of resources through increased scrutiny.

5.10 Post-completion Audits

Definition

Post-completion audit (PCA) – an objective and independent appraisal of all phases of the capital
expenditure process regarding a specific project.
The main purposes of a PCA include:
 creating an incentive for better project control (since managers know they might be held
accountable later);
 improving the investment process; and
 assisting the assessment of performance of future projects.
A major requirement of a PCA is that the objectives of the investment project must be clear and an
adequate investment proposal should have been prepared. The objectives should also be stated,
wherever possible, in terms that are measurable.
The PCA should include an assessment of the reasons for any variance from the expected
performance, cost and time outcomes. This should improve future project control.
The PCA should also provide a source of information that will help future management decision
making.
Limitations of PCAs include:
 Time consuming and costly to complete.
 Sufficient resources are often not allocated to the task of completing PCAs.
 Sometimes seen as tools for apportioning blame.
 Managers may claim credit for all that went well in the project and blame external factors for
everything that did not.

Syllabus Coverage
Congratulations, you have covered the following Learning Outcomes:

A. Role of the Senior Financial Adviser in the Multinational Organisation

2. Financial strategy formulation
7. Establish capital investment monitoring and risk management systems.

B. Advanced Investment Appraisal

1. Discounted cash flow techniques
1. Evaluate the potential value added to an organisation arising from a specified capital investment
project or portfolio using the net present value (NPV) model. Project modelling should include
explicit treatment and discussion of:
1. Capital rationing. Multi-period capital rationing to be limited to discussion only
 2. Probability analysis and sensitivity analysis when adjusting for risk and uncertainty in
investment appraisal
3. Project duration as a measure of risk.
1. Outline the application of Monte Carlo simulation to investment appraisal. Candidates will not be
expected to undertake simulations in an examination context, but will be expected to
demonstrate an understanding of:
1. The significance of the simulation output and the assessment of the likelihood of
project success.
2. The measurement and interpretation of project value at risk.
1. Establish the potential economic return using modified internal rate of return and advise on a
project's return margin. Discuss the relative merits of NPV and IRR.
3. Impact of financing on investment decisions and adjusted present values
1. Apply the adjusted present value technique to the appraisal of investment decisions that entail
significant alterations in the financial structure of the company, including their fiscal and
transactions cost implications.

C. Acquisitions and Mergers

2. Valuation for acquisitions and mergers
1. Apply appropriate methods, such as: risk-adjusted cost of capital and adjusted net present
values to the valuation process where appropriate.
Summary and Quiz
 Traditional NPV calculated using WACC does not deal well with a project whose finance
significantly changes the company's capital structure.
 In this situation, it is preferable to use APV which splits the operational side of a project from its
financing implications and values each separately before finding the overall impact of the project
with the proposed financing.
 Multi-period capital is where cash for investment is a limiting factor for several years. In this
case, it is necessary to formulate a linear programming model and solve graphically.
 Traditional IRR assumes that project cash flows can be reinvested at the IRR itself – often an
optimistic assumption. Modified IRR makes the more realistic assumption that cash flows can be
reinvested at the cost of capital.
 Various measures of project liquidity can be calculated – listed in order of increased usefulness
– payback, discounted payback and duration.
 Project risk can be modelled using Monte Carlo simulation, the results of which can then be
used for VaR analysis.

Chapter 7: Business Valuation

Visual Overview
Objective: To estimate a company's total value or equity value in total, or the equity value of a
single share.
1.1 Reasons For
Business valuation methods may be needed:
 To determine the value of a private company (e.g. for a Management Buy Out (MBO) team).
 To determine the maximum price to pay when acquiring a listed company (e.g. in a merger or
takeover).
 To place a value on companies joining the stock market (i.e. Initial Public Offerings – IPOs).
 To value subsidiaries/divisions for possible disposal or spinoff.
Key Point

Quoted share prices are only relevant for minority

shareholdings.

1.2 Nature
Exam advice

You need to enter the exam with a range of methods at your disposal and choose the most
relevant depending what data is available and whether you are required to value a minority
stake or total equity.

Business valuation is not a precise exercise. There is often no unique answer to the question of
what it is worth (e.g. the value to the existing owner may be significantly different from its value to
a potential buyer).
There are a variety of different methods of valuing businesses which may produce very different
results. These can be used to determine a relevant range of prices:
 the minimum price the current owner is likely to accept;
 the maximum price the bidder should be prepared to pay.
The final price will result from negotiations between the parties.
The following methods of valuation may be considered:
 Asset valuation – where a summary of the assets less the liabilities of the business are valued
on some agreed basis.
  Relative valuation – this involves valuing an attribute of the company (e.g. its current level of
earnings or book value) in terms of the price the market is prepared to pay per dollar of that
attribute.
 Cash flow valuations – this identifies future cash flows (e.g. dividends or free cash flow) and
converts them to a present value.
The flow-based models that are examinable are:
 Dividend Valuation Model;
 Free Cash Flow.

2.1 Net Book Value (NBV)

The net book value method simply uses the "balance sheet" equation:

Equity = Assets – liabilities

Problems and weaknesses of this method include:
 Statement of financial position (balance sheet) values are often based on historical cost rather
than market values.
 Net book value (also called carrying amount) of assets depends on depreciation/amortisation
policies.
 Many key assets are not recorded on the balance sheet (e.g. internally generated goodwill).
For these reasons a valuation based on balance sheet net assets is not likely to be reliable.

2.2 Net Realisable Value (NRV)

The net realisable method estimates the liquidation value of the business:

Equity = Estimated net realisable value of assets − liabilities

This may represent the minimum price that might be acceptable to the present owner of the
business.
Problems and weaknesses of this method include:
 Estimating the NRV of assets for which there is no active market (e.g. a specialist item of
equipment).
 It ignores unrecorded assets (e.g. internally-generated goodwill).

2.3 Replacement Cost

Replacement cost can be viewed as the cost of setting up an identical business from nothing:

Equity = Estimated replacement cost of net assets

This may represent the maximum price a buyer might be prepared to pay.
Problems and weaknesses of this method include:
 Technological change means it is often difficult to find comparable assets for the purposes of
valuation.
 It ignores unrecorded assets (e.g. goodwill).
2.4 "Book Value-Plus"
The book value plus method seeks to factor in the value of unrecognised goodwill, using one of
the following formulae:

Equity value = Replacement cost of net assets + (m × annual profits)

Equity value = Replacement cost of net assets + (m × annual
revenue)
The factor m is agreed by negotiation and is designed to compensate the seller for the value of the
business good will.
This method of valuation is often used in practice to place a value on a small business.
5.1 Introduction
In theory, the present value of estimated future cash flows is the best method of valuation. This is
sometimes referred to as "fundamental valuation".
Problems and weaknesses of this method include:
 Estimating the future cash flows – particularly complex in mergers and acquisitions due to
synergy.
 Determining an appropriate discount rate taking into account the level of business risk and
financial gearing.
 Determining an appropriate time horizon for cash flows.
There are two models derived from two alternative definitions of Free Cash Flow: Free Cash Flow
to Equity (FCFE) and Free Cash Flow to the Firm (FCFF).
6.1 Difficulty in Valuing
Valuing a company at a "seed" stage is notoriously difficult as, to date, it will probably have made
losses and generated negative cash flows. Obviously the valuation should be based on the future
but, due to the uncertainty associated with high growth start-ups, forecasting the cash flows is very
subjective.
To avoid forecasting there may be the temptation to use multiples and, in practice, high growth
start-ups are often valued as a multiple of revenues, taking the multiple from a listed proxy
company. However this methodology is weak as:
 the proxy itself may be under-valued or, more likely, over-valued (e.g. the speculative bubble
that occurred in high tech shares on the NASDAQ exchange in the 1990s). Many commentators
believe there is a current second wave of [Link] over-valuations.
 a suitable proxy may not exist as start-ups tend to be unique in nature (e.g. involved in a new
technology).
Therefore a cash-flow based valuation should be attempted. A possible methodology was
developed in 2000 by Alexander Chepakovich.

6.2 Chepakovich Model

The Chepakovich valuation model uses the discounted cash flow valuation approach. The model
was designed for valuation of "growth stocks" (ordinary/common shares of companies
experiencing high revenue growth rates) and has been successfully applied to the valuation of
high-tech companies, even those that do not generate profit yet.
The key feature of the Chepakovich model is separate forecasting of fixed and variable costs. The
model assumes that:
 fixed costs will rise in total at a predetermined rate (e.g. the inflation rate);
 variable costs are set at a fixed percentage of revenues (subject to efficiency improvements in
the future − when this can before seen).
This feature allows the valuation of start-ups and other high-growth companies on a fundamental
basis. Such companies initially have high fixed costs (relative to revenues) and small or negative
net profits. However, high rates of revenue growth ensure that contribution (revenues minus
variable costs) will grow rapidly, while fixed costs will remain constant. This process will eventually
lead the company to predictable and measurable future profitability and cash generation.
Unlike other methods of valuation of loss-making companies, which rely primarily on use of
multiples and therefore provide only relative valuation, the Chepakovich model estimates intrinsic
(i.e. fundamental) value.

6.2.1 Forecast Performance of a Loss-making but Fast-growing Company

6.2.2 Other Features of the Chepakovich Model

Incremental investment in tangible and intangible assets is set as a function of revenue growth.
Forecast revenues are driven by the company's organic growth rate − this means that historical
revenue growth rates must be adjusted for effects of acquisitions/divestments.
Long-term convergence of company's revenue growth rate to that of GDP − based on the
assumption that over or underperformance by individual companies will be eliminated in the long
run).

Definition

Gross domestic product (GDP) – a monetary measure of all goods and services produced in a country for a
specific period (normally a year).
The actual cost of share-based remuneration of employees is subtracted from cash flows − the
cost is determined as the difference between the market price of the shares and the amount
received from selling them to employees.
It is assumed that over time the company's capital structure will converge to the optimal level of
financial gearing (i.e. the WACC will fall to its minimum).
A different discount rate is applied to each future cash flow − representing the required return of
investors at that specific point in time.
7.1 Considerations
When valuing any business it is important not only to provide a range of theoretical values (using
any of the methods discussed above) but also to consider the practical implications of any further
information available.
For example:
 Are all of the assets of the business recorded? Particularly in the service sector there are likely
to be many human resource assets.
 Will key employees leave after the acquisition and what effect would this have on the value?
 Do key staff have long service contracts?
 Do surplus staff have long service contracts with early termination penalties?
 When forecasting future figures can these be based on past figures or does the acquirer plan to
make significant changes to the business?
 Who is the value being estimated for, the buyer or the seller?
 Are there any restrictive covenants in the target company's debt agreements regarding
takeovers – or even " poison pills"?
 Are there other bidders who are likely to push up the price?

Syllabus Coverage
Congratulations, you have covered the following Learning Outcomes:

B. Advanced Investment Appraisal

4. Valuation and the use of free cash flows
1. Apply asset based, income based and cash flow based models to value equity.
2. Forecast an organisation's free cash flow and its free cash flow to equity (pre- and post-capital
reinvestment).
3. Advise on the value of an organisation using its free cash flow and free cash flow to equity under
alternative horizon and growth assumptions.

C. Acquisitions and Mergers

2. Valuation for acquisitions and mergers
1. Estimate the potential near-term and continuing growth levels of a corporation's earnings using
both internal and external measures.
1. Discuss, assess and advise on the value created from an acquisition or merger of both quoted
and unquoted entities using models such as:
1. "Book value-plus" models
2. Market based models
3. Cash flow models, including free cash flows.
1. Apply appropriate methods, such as: changing price-earnings multipliers resulting from the
acquisition or merger, to the valuation process where appropriate.
2. Demonstrate an understanding of the procedure for valuing high-growth start-ups and
lossmaking companies.

Summary and Quiz

 Business valuation is not a science − different analysts use different techniques.
 There are many problems with asset-based methods (e.g. unrecorded assets).
 Relative valuation models include P/E multiples (must be adjusted downwards for an unquoted
company) and earnings yield and dividend yield (must be adjusted upwards for an unquoted
company).
 The market to book ratio is an interpretation of Tobin's Q ratio.
 Cash flow-based methods are considered to be the superior approach for valuing equity in total.
The Chepakovich model is a model adapted for "seed" companies.
Chapter 8 : Mergers & Acquisitions
Visual Overview
Objective: To understand mergers and acquisitions as alternatives to organic growth and the
various methods of analysing, financing and preventing their implementation.

1.1 Organic Growth v External Growth

If the strategy of a company is for long-term growth, this can come from:
 organic growth – development of new projects financed by retentions or new debt/equity; or
 external growth – buying existing projects by acquiring another business.

1.1.1 Difference Between an Acquisition and a Merger

In an acquisition, one company (the predator) buys the share capital of another company (the
target or victim); creating a parent and subsidiary in a group. Both companies continue to exist as
legal entities.
In a merger, two companies of similar size pool their net assets through a mutually beneficial
combination in which neither of the original parties is dominant.
In financial management, the classification is not usually critical. It is more relevant in financial
reporting where merger accounting tends to report better results than acquisition accounting.
(Hence International Financial Reporting Standards do not permit merger accounting.)

Exam advice

For the AFM exam, the terms "merger" and "acquisition" are equivalent.

1.1.2 Advantages of Acquisitions

 Speed − often quicker than organic growth.
  Entry costs − if the cost of entering a new market is high it may be better to acquire a business
already operating in that market.
 Barriers to entry − acquisition may be the only method of entry into a new market.
 Risk − organic growth may be riskier than acquiring an existing business.
 Undervaluation – "asset stripping" may be possible in an acquisition.

1.1.3 Disadvantages of Acquisitions

 Cost − the control premiums paid over the existing market price are considerable, typically
between 15% and 40%;
 Shareholder wealth − if the bidder pays more for the target company than the value generated
for the predator this will reduce the bidding company shareholders' wealth.
 May attract the attention of regulatory authorities if there are concerns about damage to the
public interest.

1.2 Criteria for Selecting Target

The key factors to consider when choosing an appropriate target for an acquisition include:
 Price – if the target company is listed on the stock market does it currently appear to be
undervalued or overvalued?
 Expected control premium – quoted share prices reflect the price for a minority shareholding.
When majority control is sought the shareholders of the target company may expect a significant
premium above the quoted price.
 Potential synergy benefits – discussed later in more detail.
 Transaction costs – legal fees, due diligence costs, etc.
 Potential intervention by regulators – combining the business undertakings may be viewed as
against the public interest (e.g. if it could create monopoly power).

1.3 Evaluating a Proposed Acquisition

1.3.1 Classifications
The corporate and competitive nature of a proposed acquisition can be evaluated by reference to
the following classifications:
 Horizontal integration where the proposed strategy is to acquire a competitor, presumably in
an attempt to gain pricing power and potentially restrict the range of products.
 Vertical integration backward acquiring a key supplier in order to cut out its profit margin and
potentially to gain exclusivity of supply.
 Vertical integration forward acquiring a key distributor, potentially to prevent it from selling
competitors' products.
 Conglomerate acquisition of a company in an unrelated business sector. This strategy may be
justified if the parent is "closely held" (i.e. its shareholders have invested a large proportion of
their personal wealth).In this case, shareholders face total risk (as opposed to only systematic
risk) that can be reduced through their company becoming a conglomerate. (This argument
does not hold for a listed company in which most shares are held by institutional investors who
have already diversified all unsystematic risk exposures.)

1.3.2 Potential Risks

A proposed acquisition can also be evaluated in terms of the potential risks that may be attached
to the transaction itself. Each risks would need to be explicitly considered as part of a due
diligence investigation to ensure that they are either mitigated or avoided.
 Disclosure risk: It is important to ensure that the information on which the acquisition is made
is reliable and fairly represents the potential earning power, financial position and cash
generation of the target company. As part of a due diligence exercise, it would be necessary to
ensure that the financial accounts have not been unduly manipulated to give a more attractive
view of the business than the underlying reality would support.
 Valuation risk: A substantial acquisition has the potential to alter the acquirer's exposure to
financial risk or its exposure to business risk. This in turn can affect the value its equity investors
 place on its existing operations. In this case, it is important to value the target company
"embedded" with the acquirer as opposed to being a stand-alone entity. This is developed
further in the next section of these notes.
 Regulatory risk: An acquisition may raise concern with the government or with other regulatory
agencies if it is seen to be against the public interest. This is particularly likely in the case of
horizontal integration where the combined market share may be perceived as being unfair. This
is developed further in the next section of these notes.

1.3.3 Impact on Shareholders

For a proposed acquisition to be approved by both sets of shareholders (i.e. the acquirer and the
target), the bid price being offered and the form of payment must allow for a reasonable return to
both groups.
From the viewpoint of the bidding company's shareholders it is essential that the expected post-
acquisition value of each share is above the current share price, leading to a reasonable capital
gain. (Forecasting the post-acquisition share price is the focus of the next section of this chapter.)
From the viewpoint of the target company's shareholders the form of payment becomes
particularly relevant:
 If cash is offered for their shares, a simple comparison to the current share price would reveal
their instant capital gain or loss. However, if the target company is not listed, the bid price would
have to be compared to its estimated equity value, thereby introducing a large degree of
uncertainty.
 If the proposed form of payment is a "share-for-share exchange", the current value of shares in
the target should be compared with the expected post-acquisition value of shares in the acquirer
(taking into account the proposed terms of the share swap).

1.3.4 Other Criteria

Other relevant aspects may include:
 Combined market power of the entities - this may allow setting price increases and
rationalisation of the product range. However, these potential benefits also carry regulatory risk,
and a strategic partnership may be advisable as opposed to a business combination.
 Skills transfer - each company may have particular strengths that can be transferred into the
other as part of an internal benchmarking process leading to best practice throughout the group.
 Disposal of surplus assets - if there is overlap or even duplication of activities (e.g. research and
development), there is potential for rationalisation.
 Security of supply chain - vertical integration backwards may not only reduce input costs but
lead to guaranteed security of the supply of key components.
 Utilisation of brought forward tax losses - the parent's tax system may allow brought forward
losses in a subsidiary to be offset against future group profits.

1.4 Synergy
Definition

Synergy - the concept that the combined value and performance of two companies will be greater than
the sum of the separate individual parts.
The motive for many mergers and acquisitions is to create incremental value through the
existence of synergy when two entities are combined.

1.4.1 Revenue Synergies

Revenue synergies may arise from:
 Monopoly power leading to possible price increases, although this may attract the attention of
regulators.
 Cross-selling opportunities (i.e. referring customers to products or services provided by other
group companies).
  Surplus assets - can be sold off and proceeds invested in new projects.
 Cash - buying a company with surplus cash to reinvest profitably.

1.4.2 Cost Synergies

Cost synergies may arise from:
 Economies of scale - for example bulk buying discounts.
 Economies of vertical integration - purchasing distributors and/or suppliers to remove
"middlemen".
 Economies of investment - use of common research and development, plant, etc.
 Economies of management - eradicating duplication by creating combined departments for
finance, marketing, etc.
 Skills transfer - sharing best practice to achieve productivity gains.

1.4.3 Financial Synergies

Financial synergies may arise from:
 Reduction in variability of cash flows - more stable cash flows might reduce borrowing costs and
through achieving a better credit rating. Furthermore the improved stability reduces the risk and
related costs of financial distress.
 Tax losses - reduced tax by acquiring a company with tax losses, although many tax jurisdictions
restrict the use of brought forward losses.
 Tax shield - acquiring a company with low gearing in order to gear up and gain the benefit of the
tax shield on debt interest.
 Internal hedging of interest rate and foreign exchange risk - the companies may, to some
degree, have opposite positions regarding fixed/variable rate debt and asset/liabilities in foreign
currencies. This leads to natural internal hedges.

1.4.4 Potential for Synergy

Evidence suggests that many mergers and acquisitions do not achieve the potential synergies
forecast and that shareholders in the target company take most of the benefits from any additional
value created.
Reasons for not achieving expected synergy include:
 The acquisition decision was based on incomplete or incorrect information;
 Unexpected costs and problems exist when combining two organisations with different
organisational structures, cultures and managerial styles;
 Managers are not given suitable incentives to achieve maximum synergies.
Furthermore, two arguments about creation of synergy are simply not valid:
 Risk reduction – diversification by a company can only reduce unsystematic risk. However if its
shareholders have balanced portfolios they have already removed all unsystematic risk and are
only concerned with systematic risk (which cannot be removed either by shareholder or
company diversification.)
 Bootstrapping – it may be argued that if a company with a high P/E ratio buys a company with
a low P/E ratio, the higher ratio will apply to the combined entity creating an immediate share
price gain. However in an efficient market a weighted average P/E ratio would be applied
weighted by the earnings of the two companies.

1.5 Predator Overpayment

Research has shown that, in many cases, the post-acquisition share price performance of the
acquiring company tends to be disappointing. If cash was paid to acquire the target then, looking
back, wealth has effectively been transferred from the acquirer's shareholders to the target's
shareholders.
Indeed, when potential acquisitions are initially announced (or rumoured) the acquirer's share
price often falls and the target's share price often rises in anticipation of the subsequent wealth
transfer.
Possible explanations for predator overpayment include:
 Overvaluation of the target company leading to excessive bid premiums being paid.
 Higher than forecast transaction costs.
 Higher than forecast costs of integrating the companies' systems.
 Actual synergy benefits being less than expected.
 Unforeseen negative synergy effects (e.g. due to cultural conflict).
 Agency problems, where the directors of the acquiring company are more interested in "empire
building" than in generating added value for their shareholders.
 Badly designed executive remuneration contracts. Such bonuses tend to be paid in advance,
with no requirement for them to be repaid if the acquisition is subsequently shown to be a failure
(e.g. awarding a bonus for "successfully" negotiating an acquisition).

1.6 Alternative Methods

Alternative methods as a way of obtaining a stock market listing include:
 Special Purpose Acquisition Companies (SPACs);
 Direct listings;
 Dutch auctions; and
 Reverse takeovers (s.1.7).

1.6.1 Special Purpose Acquisition Companies (SPACs)

Definition

Special Purpose Acquisition Company – a public shell company that raised funds through an
IPO and uses the proceeds to acquire a private company.

Source: SPACs: Special Purpose Acquisition Companies Listing a SPAC on Nasdaq (June
2020)
The sole purpose of a SPAC is to identify a target operating company and conclude a business
combination (a “de-SPAC transaction”). A SPAC has a limited time period in which to complete a
de-SPAC transaction. Acquisition is typically within 24 months from the date of pricing the IPO.
 Because a SPAC cannot know its target company at the time of its IPO, it will typically focus on
a particular industry or geography in seeking targets for the business combination.
 Because a SPAC has no operations, the disclosure in a SPAC IPO typically focuses on the prior
experience of the SPAC’s organisers/founders (referred to as “sponsors”), who are expected to
successfully find a target company and complete the de-SPAC transaction.
 Upon completion of the initial business combination, the target company effectively becomes a
publicly traded company.
If a merger is not completed within the designated timeframe, the SPAC is required to:
 liquidate and return the funds raised (held in an interest-bearing trust account) to investors; or
  seek the shareholders’ approval for an extension.
SPACs are subject to many of the same benefits and limitations as RTOs (s.1.7.3).

1.6.2 Direct Listings

Definitions

Direct listing – where a company joins a public market without the issue of any new shares or any marketing of
existing shares.
A direct listing (also known as an “introduction”) would generally suit a company which has already
raised capital through other means and has a wide shareholder base.
 Private investors, management and employees sell their existing shares to the public.
 No new capital is raised through the listing.
There are four main reasons why a company might consider a direct listing as a means of going
public:
1. To provide liquidity to all existing shareholders by allowing them to sell their shares freely.
2. To avoid dilution of EPS (because there are no new shares).
3. To conduct market-driven pricing (rather than a fixed price range negotiated beforehand for an
IPO).
4. To provide access to all buyers. Any investor can buy as many shares as they want in the
market.
The cost of the direct listing process is also much less that the cost of an IPO (e.g. avoiding fees
to investment banks).
For a direct listing to succeed, the company has to be attractive to the market, to increase the
number of people who are interested in investing in it. Companies that seek to use this method:
 should be consumer-facing with an established brand;
 need a business model that is easy to understand;
 should not require substantial additional capital.

1.6.3 Dutch Auctions

Definitions

Dutch auction – an auction in which the lowest price necessary to sell the entire offering becomes –
the price at which all securities offered are sold. Nasdaq

In finance, a dutch auction is a “price discovery process” to find the optimum selling price at which
to sell assets or securities. Unlike typical IPOs, the dutch auction strategy works without
investment banks or underwriters.
 The seller chooses the number of shares to be sold and the opening price, while the bidders
determine the selling price.
 The auction starts at the highest offering price (“bid”) and works down until all bids (quantity and
cost) have been submitted and all shares have been sold.
 The last or lowest bid becomes the offering price for all shares, which all investors must pay.
A modified dutch auction tender offer allows shareholders to indicate how many shares and at
what price, within a specified range, they wish to tender their shares.

Exhibit 1 Modified Dutch Auction Tender Offer

MIAMI--(BUSINESS WIRE)--The Hackett Group, Inc. (NASDAQ: HCKT) (“Hackett” or the

“Company”), a leading benchmarking, research advisory and strategic consultancy firm that
enables organizations to achieve Digital World Class™ performance, today announced that it
has commenced a modified “Dutch auction” tender offer to purchase up to $120 million in value
of its common stock at a price not greater than $23.50 nor less than $20.50 per share. The
 Exhibit 1 Modified Dutch Auction Tender Offer

tender offer begins today, November 9, 2022, and will expire at 12:00 midnight, New York City
time, at the end of the day on December 8, 2022, unless extended or terminated by the
Company.

1.7 Reverse Takeover (RTO)

1.7.1 Mechanics
An RTO is a method used by private companies to become publicly listed without resorting to an
IPO:
 The private company first buys enough shares to control a publicly listed company.
 The public company then buys the shares of the private company from the existing private
company shareholders, and pays for these shares using a fresh issue of shares in the public
company. The private company therefore becomes a subsidiary of the public company.
It is usual for the quoted company to be managed by the senior management team from the
previously unquoted company and to take the name of the previously unquoted company.

1.7.2 Benefits of Public Trading

 Easier access to capital markets – More finance is likely to be available and the cost of that
finance is likely to be lower than if the company was still unquoted.
 Higher company valuation – Investors are likely to attribute a higher value to the shares
because:
o They are deemed less risky as the company will have to abide by the relevant
rules and regulations.
o They are liquid and whenever they wish to sell there will be a willing buyer.
 Enhanced ability to carry out further takeovers – For example, through share-forshare
exchanges.
 Enhanced ability to use share based incentive plans – For example to attract and retain good
quality employees.
See Chapter 10 for further details of listing on a Stock Exchange.

1.7.3 Potential Benefits of an RTO

There are further potential benefits of an RTO when compared to a normal IPO.
 Speed – An IPO can often take between one and two years to complete whereas an RTO can
be completed in as little as 30 days. Furthermore:
o In an IPO, management may have less time to run the company to the
detriment of its growth prospects.
o In the time taken to prepare for an IPO, the market may deteriorate to the
extent that it is not finally worth completing.
o Where the IPO process is slow and there is usually a significant queue of
companies waiting to carry out an IPO (e.g. in China), an RTO allows a company to
jump this queue.
 Cost – An IPO is expensive due to the volume of work required by investment banks, sponsors,
accountants and other advisers. An RTO will usually cost less.
 Availability – In a market downturn it is not easy to convince investors to support an IPO.
However, studies have shown that the volume of RTO transactions is far more resilient to market
downturns (e.g. following the financial crisis). This is probably because, in an RTO, the deal is
fundamentally between the shareholders of the companies involved and, hence, market
sentiment has much less importance.
 Existing analyst coverage – A listed company subject to an RTO is likely to have existing
analyst coverage which usually continues after the RTO. However, companies that use an IPO
may struggle to get significant analyst coverage especially if they are smaller. Without
 reasonable analyst coverage, potential investors may not have much awareness of the company
and, hence, are unlikely to want to invest in the company.

1.7.4 Potential Drawbacks

 Lack of expertise – A company achieving a listing through an RTO may not have the expertise
to deal with all the compliance issues, whereas the longer IPO process provides a training
period.
 Reputation – An RTO may be viewed as a “poor man’s IPO”. Hence, companies that achieve
their listing in this way may be viewed less favourably by investors. US studies show that “RTO-
listed” companies generally have lower survival rates and underperform compared to traditional
“IPO-listed” companies.
 Risk – As a lower level of scrutiny is applied to an RTO compared to an IPO, investors must be
aware of the higher level of risk. In particular, the unquoted company must thoroughly
investigate the listed company to reveal all potential problems and liabilities.
 Regulation – There is still a significant amount of regulation involved as RTOs are, to some
extent, combinations of acquisitions and IPOs. For example, two regulatory issues that may
arise in the UK are:
1. Suspension : The Financial Conduct Authority may suspend trading in shares when
an RTO is announced or leaked, as there will generally be insufficient information
publicly available on the proposed transaction. (In particular, information on the
unquoted company.) As the listed company would no longer be able to keep the
market informed, it is more likely to walk away from the proposed transaction than
face suspension.
2. Mandatory offer : A shareholder in the unquoted company who, individually or with
closely connected persons, will hold 30% or more of the voting rights of the listed
company on completion of the transaction, is required to make a general cash offer
for the remaining shares in the listed company. This would obviously undermine the
reason for the RTO.
 Share price decrease – Many potential RTO targets are in that position because of past
problems. Hence, shareholders may be keen to “dump” their shares at the earliest opportunity
after the RTO has completed. Shareholders may therefore be required to guarantee to hold their
shares for a “lock-up” period.
 Cost strong> – There are still significant direct and indirect costs involved and the total cost can
be far more than originally anticipated.
 Investor relations – Although an RTO may benefit from existing analyst coverage, an RTO only
really introduce liquidity to a previously private company if there is real investor interest in the
company. In many cases, a comprehensive investor relations and investor marketing
programme will be required in order to generate this interest. This is another potential indirect
cost of an RTO.

2.1 General Principles

In the valuation of acquisitions, what is relevant is not the value of the target company as a
separate entity but the increase in value of the acquiring company after the acquisition has taken
place.
Significant transactions (e.g. mergers and acquisitions) are likely to disturb the acquiring
company's exposure to various types of risk (e.g. business, financial, default) and hence change
its cost of capital and its own value.
Therefore, the maximum price the acquirer should pay is the increase in its own value following
the acquisition. Only in very simple cases will this be the stand-alone value of the target company.

2.2 Types of Acquisition

The approach that should be taken to valuing a target company critically depends on whether the
transaction will disturb the acquirer's existing exposure to business or financial risk, as only in the
most simple cases will the value of the group be a simple sum of the value of the component
entities.
Any disturbance to the acquirer's risk exposures may have unintended consequences in that the
change in its cost of capital will alter the present value of its existing cash flows, thereby distorting
its existing valuation. Note that this is even before potential synergy effects, which are an
additional influence on valuation.

2.2.1 Potential Risk Disturbances to Be Evaluated

Business risk – Does the target company have higher/lower volatility of operating cash flows
compared to the acquirer? A simple comparison of each company's respective business in terms
of cyclical (high volatility) or defensive (low volatility) will give guidance here (and respective
political risk in the case of international M&As). However, bona fide evidence of different
underlying business risks would come from a comparison of each company's asset beta, which
would first require degearing their published equity betas (if known).
Financial risk – Will the method of financing the acquisition change the acquirer's existing capital
structure and so affect the company's costs of debt and equity? A comparison would be required
of the acquirer's existing debt-to-equity ratio (using market values) to the post-acquisition debt-to-
equity ratio. However, the post-acquisition gearing level cannot be known in advance of the
valuation exercise being completed, but the valuation cannot be done until the discount rate is
calculated, which itself requires knowledge of the final gearing level. Hence a circular (or
recursive) problem of "chicken and egg" emerges between cost of capital and valuation.
Furthermore, the amount of debt that may have to be raised to (partly) finance the bid is not known
until the target company has been valued, which again requires a discount rate reflecting the post-
acquisition gearing level − another recursive loop. Solutions to such circular problems come from
iterative valuation methods, discussed later.

2.2.2 Classification
Following a review of the proposed acquisition's effect on the above risks, the acquisition can be
classified into one of the following three categories:
 Type I – acquisitions that neither disturb the business risk of the acquiring company nor require
additional external financing, hence, no change to the acquiring company's existing cost of
capital.
 Type II – acquisitions that do not disturb business risk but do disturb the financial risk of the
acquirer.
 Type III – acquisitions that alter the company's exposure to business risk (and possibly its
exposure to financial risk).
The type of acquisition in turn determines the most appropriate method of valuation.

Exam advice

Acquisition will not be labelled as types, according to this classification, in exam questions.

2.3 Valuation of Type I Acquisitions

For valuing small unquoted companies, it may be acceptable to use simple asset-based models
(e.g. replacement cost, "book value-plus") or relative models (e.g. P/E multiples, price to book
ratios).
Theoretically, it is superior to use cash flow-based models. For example, dividend valuation model
(DVM), Free Cash Flow to Equity (FCFE), Free Cash Flow to the Firm (FCFF):
 Discount rates should be the acquiring company's WACC (if using FCFF) or its cost of equity
geared if using DVM or FCFE.
 If using FCFF, remember that the resulting valuation will be that of the target company in total
(i.e. its equity plus its debt). Usually, in acquisitions, it is the shares that are bought, not the
debts.
 Equity valuation = Total value of the company − Market value of debt.
2.4 Valuation of Type II Acquisitions
Adjusted Present Value (see Chapter 6) is the technique which appears to deal well with a change
in the level of debt. Steps would be:
1. Select the most appropriate asset beta - which depending on the circumstances could be the
target's, the predator's, or an industry benchmark - to find the cost of equity ungeared. Use this
to discount the forecast operating cash flows of the target company (including any synergy
benefits).
2. Calculate the present value of the tax shield on the target company's debt plus any debt raised
to finance the bid, discounted at the pre-tax cost of debt.
3. 1+3=APV = Total value of the target company (i.e. value of equity + value of debt).
4. Deduct market value of the target's debt to arrive at equity valuation (i.e. the maximum price to
offer for the target's equity).
An APV approach assumes the old and new companies are financially independent, which is
unlikely. Borrowings in each are likely to be guaranteed by the other, implying hidden subsidies or
costs.
3.1 Options Available
The main options available to a bidding company for buying the target's shares are:
 cash;
 ordinary shares;
 bonds;
 "hybrids" (e.g. convertible bonds).
It is common for a mixture of these to be offered.

3.2 Advantages and Disadvantages

3.2.1 Cash
To bidder To target

Advantages Advantages

 Price is certain.
 Does not change ownership/control.  Price is certain.
Disadvantages Disadvantages
 Liquidity problems.  Capital gains tax implications.

3.2.2 Ordinary Shares

To bidder To target

Advantages Advantages

 Preserves cash/avoids borrowing.  No capital gains tax (until shares

Disadvantages sold).
 Value is uncertain.  Maintains ownership stake (to share
 Wider share ownership reduces in future growth).
control/dilutes voting power. Disadvantages
 Dilution of EPS  Value is uncertain.

3.2.3 Bonds
To bidder To target

Advantages Advantages

 Preserves cash.
 Reasonably certain value.  No capital gains tax (initially).
 Does not change  Reasonably certain value.
ownership/control. Disadvantages
Disadvantages  Changes character of investment (i.e. no longer
 Increases gearing. owners).

3.2.4 Convertible Bonds

To bidder To target

Advantages Advantages

 Preserves cash.  No capital gains tax (initially).

Disadvantages Disadvantages
 Increases gearing.  Changes character of
  Uncertain eventual outcome (e.g. future
reduction in majority shareholding depends on investment (but option to
exercise of conversion rights). convert back to equity).

3.3 Case Study – Acquisition Finance

The acquisition committee of Imperial Co, a listed company, is considering making takeover bids
for two competitors, Astral Co (listed) and Zandra Co (unlisted). Summarised financial data is
given below for the three companies:
Statement of Financial Position as at 31 March 20X4
Imperia Astra Zandr
l l a
$m $m $m
Non-current assets 50 8.6 6.4
Current assets 431 6.7 9.5
93 15.3 15.9
Financed by
Ordinary shares2 17 5.0 2.8
Reserves 30 1.3 3.7
47 6.3 6.5

Long-term debt
Current liabilities 27 3.0 3.9
93 15.3 15.9
Notes:
1. Including $5 million cash
2. Nominal values: Imperial, $0.50; Astral and Zandra, $1
3. 8% bonds currently trading at $80 per $100 nominal
4. 11% bonds currently trading at $110 per $100 nominal
5. 7-year 10% bank loan
6. Imperial Astral Zandra

P/E ratio at 31 March 20X4 18.4:1 18.7:1 –

Earnings before interest and tax for year ended 31 March

20X4 $10 million $1.5 million $1.4 million
The bid price for Astral will be based on its market capitalisation and it is believed that Zandra can
be fairly valued using a price-to-book ratio of 2. In addition, a 12% control premium will be offered
for each company.
The corporation tax rate is 35%.

Required:
Discuss and analyse alternative payment terms that might be offered to the shareholders of
Astral and Zandra and the implications of these terms for the shareholders of Imperial.

Case Study – Solution

Alternative Payment Terms
Payment may be made in cash, preference shares, some form of debt, often with a conversion or
warrant option attached, ordinary shares or some combination of these.
From the target shareholders' perspective, cash provides a known, precise sum, and might be
favoured for this reason. However, in some countries payment in cash might lead to an immediate
capital gains tax liability for the investor. Furthermore, as Imperial currently has only $5 million in
cash, neither of the potential bids could be made in cash without significant new external finance
being raised. If this took the form of additional borrowing this could lead to an unacceptable rise in
Imperial's level of financial risk, and potentially credit risk. If a rights issue is used this would be
costly in terms of issue costs and also potentially too time consuming if the acquisitions need to be
made quickly.
Payment using preference shares or debt is not always acceptable to a target's shareholders, as
these modes of payment fundamentally alter the characteristic and risk of their investment, moving
them from being participating investors with voting rights to a fixed return with little upside
potential. From Imperial's viewpoint, preference shares would be particularly unattractive as they
carry no tax shield. If fixed return finance is proposed, it should take the form of bonds as the
interest expense would be tax allowable.
Payment with ordinary shares, in the form of a share-for-share exchange, offers a target's
shareholders continuation in ownership, albeit in the parent. This defers capital gains tax for the
target's investors until they ultimately dispose of their new shares. The terms of the share swap
will be in the form of a fixed ratio of acquirer's shares for the target's shares. However, relative
share prices are likely to change during the period of the bid and the owner of shares in the target
company will not know the precise post-acquisition value of the bid.
Ideally a bidder would like to tailor the form of the bid to that favoured by major investors in the
potential target company. "Mixed mode" payment could be offered; for example, a combination of
cash and shares.
Alternatively, the target's investors may be given a choice in the method of payment, with the logic
that different forms of payment might be attractive to different types of investors. This could
influence the success or failure of both bids, but is problematic for the bidder in that the cash
needs and number of shares to be issued are not known in advance, and the company's capital
structure may change in an unplanned manner.
4.1 Strategy
 Identify potential target.
 Approach board of directors in confidence to judge reaction.
 Determine price to offer.
 Determine terms of the offer.
 Determine tactics of acquisition. Possible tactics include:
o dawn raid;
o offer in accordance with the City Code.
4.2 Dawn Raid
In a dawn raid:
 The predator buys a substantial number of shares on the open market (typically first thing in the
morning when the stock market opens for business).
 Once 30% of shares are obtained, a formal offer must be made to the other shareholders.
Because the bidding company builds a substantial stake in its target at the prevailing stock market
price, any takeover costs are likely to be significantly lower than if the intention to acquire the
target had been announced.
4.3 City Code on Takeovers and Mergers
The UK City Code on Takeovers and Mergers is an example of regulation. It began as a voluntary
code, but is now part of UK law. The Code requires that all shareholders in a company should be
treated equally, regulates when and what information companies must and cannot release publicly
in relation to the bid, sets timetables for certain aspects of the bid, and sets minimum bid levels
following a previous purchase of shares.
The general approach to an offer under the City Code is:
 bidder puts offer to the board of the target;
 as soon as a firm offer is made shareholders must be informed by press notice;
 an announced offer cannot be withdrawn;
 directors must act in the interests of the shareholders;
 all documentation must be prepared with the same care as a prospectus;
 shareholders must be informed of all relevant facts; and
 once 30% of shares have been acquired an offer (which must include a cash alternative) must
be made to the remaining shareholders.
Under UK law, once 90% of the shares in the target company have been acquired the predator
can force the remaining 10% target to sell their minority stake.

4.4 Competition Law

Regulators may have wider concerns than the fair treatment of shareholders. The impact on other
stakeholders may need to be considered, in particular the impact on the public if the combined
entity could dominate the market and cut consumer choice and/or raise prices.
Competition law is founded on "the need to avoid the establishment of market structures which
may create or strengthen a dominant position". The market shares of the merging companies can
be assessed and added; a combined market share above 25% is often used as an indicator that
there may be a reduction in competition.
The entities involved could challenge the regulator's definition of the market. For example, if the
world's two major cola producers were to merge their share of the global cola market would be
very large – but their share of the total soft drinks market would be relatively small.

4.5 Merger and Acquisition Activity in Different Countries

Merger activity is much more prevalent in the UK and US than in Germany or Japan. This is
because in Germany and Japan a large proportion of a company's shares are often held by banks
that would not consider selling to a predator. Whereas, shares in the UK are usually held by
institutional investors who will realise a profit if the price is right.
Some argue that the UK situation is better as it leads to a competitive "market for corporate
control", which may lead to allocative market efficiency. Others argue that it distracts senior
management from the task of maximising long-term value and facilitates a “get rich quick”
mentality.

4.6 Regulatory Devices in Takeovers

The regulation of takeovers depends on the jurisdiction of the transaction (e.g. UK specific laws in
s.4.3). However, the main global provisions often include the following:
 Equitable treatment of shareholders – all takeover codes are designed principally to ensure that:
o the target company's shareholders are treated fairly and are not denied an
opportunity to decide on the merits of a takeover; and
o shareholders of the same class are given equal treatment by an acquirer.
 Mandatory bid – an investor that builds a holding to create effective control of a company (more
than 30% of the shares in UK law) must offer to buy the remaining shares on terms as good as
its most recent purchases. Minority shareholders may have concerns that the company will be
 run as directed by the controlling shareholder and it is therefore fair to allow them to sell out at
the price that the new controlling shareholder paid before the change of control.
 "Squeeze out" – in many countries (notable exceptions being the US and China), once an
investor has acquired almost complete control of a company (typically 90–95% of the shares)
the remaining minority shareholders can be forced to sell.
 "Board neutrality rule" – once a bid has been announced the board of the target company must
not deny the shareholders the opportunity to decide on its merits. Also called the “non-frustration
rule” this means that the board cannot take any action that could potentially frustrate the bid
without shareholder approval. The board may, however, still seek out another more favourable
bidder or complete measures begun pre-bid.
 "Breakthrough provisions" – the takeover code may include mechanisms to defeat various pre-
bid defences such as:
o share structures which give minority shareholders disproportionate voting
rights; and
o restrictions on share transfers in the company.
5.1 Hostile Bids
In some instances, a merger will be agreed by both boards and the target company’s directors will
recommend the shareholders to accept the offer. However, in many instances the bid will not be
initially accepted either because the directors fear for their own futures or because they are
holding out for a higher price.

5.2 Defences Before a Bid Is Made

If a company wishes to avoid the attention of a bidder, there are a number of actions that it can
take to appear less attractive (i.e. “pre-offer” defences):
 Minimise cash holdings;
 Hold strategic cross-shareholdings with other companies (common in Japan);
 "Poison pills" that dilute the acquirer’s interest and increase the cost of the bid. There are two
main types in which existing shareholders (only) have a right to purchase shares at a discount:
o In the target company (i.e. a “flip-in” poison pill);
o In the acquiring company if the bid is successful (a “flip-over” poison pill);
 "Golden parachutes" – where the directors have the right to leave with substantial cash bonuses
and/or share options if the business is taken over;
 "Crown jewels" – sell off (and leaseback if necessary) assets that might make the company
attractive to predators;
 "Fat man" − grow the company to such a size that it would not be practical for anybody to buy.

5.3 Defences After a Bid Is Made

If a bid is initially rejected, the following defences are common (i.e. “post-offer” defences):
 statements to current shareholders, for example:
o the terms of the offer are unacceptable;
o there is no logic/synergy to the merger;
o the target's shares are undervalued and bidder's overvalued; or
o simply appealing to the loyalty of the shareholders;
 seeking a bid from a friendly third party – a "white knight";
 claiming that the bid is contrary to the City Code;
 appealing to the Competition and Markets Authority that the bid is against public interest;
 "Pac-Man defence" – bid for the predator (i.e. an aggressive rather than defensive tactic). This
tactic suggests that the target’s management is in favour of the acquisition but is contesting
which company should gain control of the other.

6.1 Reasons for Failure

Many mergers and acquisitions fail, so if a deal is agreed upon, management must carefully
monitor it. The most common reasons for failure of mergers and acquisitions include:
  Over-optimistic assessment of potential economies of scale and inaccurate evaluation of future
resource needs resulting in overpayment (see s.6.2).
 An inefficient amalgamation of the two parties due to unrealistic expectations. Different ideas
about the new organisation's future can lead to disagreements and conflict post-merger. For
example, each party will likely have its culture, values, and operational setup. The combined
endeavour will probably fail if these cannot be aligned to unite the parties.
 Insufficient appreciation of the problems of the merger, in particular personnel and
communication problems. For example, if redundancies are expected, the best staff may leave,
leaving the company with lower-quality staff.
 Excessive concern with matters such as the dominance of the boards of directors rather than
developing a management plan.
 Problems of determining value and terms of the offer. It is common for a party struggling
financially to hide this during negotiations.
 Incompatibility of systems/processes may make integration more difficult than expected. Also, if
integration processes are not properly planned, the two parties may remain separate and unable
to work together effectively. This can confuse and frustrate employees, customers and
shareholders.
 Incompatibility of the two companies because of different strategies, different business models,
or even different values or cultures.
Understanding the cultural and operational differences between the companies is essential to the
integration process:
 To design an appropriate organisational structure;
 To shorten the transition processes;
 To reduce integration costs; and
 To retain key employees.

 Different styles slow decision-making

 Decision-making style (e.g. top-down vs and can lead to no decisions or failure
participative) to implement them.

 Leadership style (e.g. autocratic,  A change in leadership style can lead to

democratic, laissez-faire) employees leaving.

 Any resistance has negative impacts

 Ability to change (e.g. willingness vs (e.g. reduced productivity, poor
resistance) performance, absenteeism, conflict).

 Core values and operational norms (e.g.  Performance will deteriorate if views on
hierarchical structure and role what to do and how to do it are not
definitions vs informal relationships) aligned.

6.2 Problem of Overvaluation

Research suggests that in many cases the directors of the acquiring company overvalue the target
company's equity and hence offer a final bid price above fair value.
Various explanations for the problem of overvaluation have been suggested:
 Merger and acquisition (M&A) activity tends to go through cycles, often driven by the relative
availability of cheap credit. At the peak of a wave of M&A activity there may be several potential
bidders for a target company, thereby bidding up the price.
 Investment banks earn a large proportion of their fees from M&As and may encourage their
clients to engage in potentially expensive acquisitions.
 Insights from behavioural finance theory show that directors of the acquiring company tend to
suffer from:
 o overconfidence in the potential for synergy benefits; and
o confirmation bias (i.e. choosing the valuation model that appears to confirm
the value they think the target company is worth).
 Management following personal goals of "empire building" as opposed to working in the best
interests of shareholders – overstating the potential value of the target company may be a
strategy used by management to secure shareholders' approval for the bid.
 Miscalculations of synergies – either overstating synergy benefits or ignoring potential "negative
synergies" caused by, for example, cultural conflict or incompatible IT systems.
 Overconfidence in the ability to improve performance of the target company – the acquiring
company's managers may claim that, once under their control, the target company will be valued
by the market on the same P/E ratio as the acquirer. This "bootstrapping" argument may be
naive.

Syllabus Coverage
This chapter covers the following Learning Outcomes.
C. Acquisitions and Mergers
1. Acquisitions and mergers versus other growth strategies
1. Discuss the arguments for and against the use of acquisitions and mergers as a
method of corporate expansion.
2. Evaluate the corporate and competitive nature of a given acquisition proposal.
3. Advise upon the criteria for choosing an appropriate target for acquisition.
4. Discuss the reasons for the frequent failure rate of acquisitions to enhance
shareholder value as expected, including the problem of overvaluation.
5. Evaluate, from a given context, the potential for synergy separately classified as:
1. Revenue synergy
2. Cost synergy
3. Financial synergy.
6. Evaluate the use of alternative methods as a way of obtaining a stock market listing;
including special purpose acquisition companies (SPACs), direct listings, dutch
auctions and reverse takeovers.
2. Valuation for Acquisitions and Mergers
1. Discuss, assess and advise on the value created from an acquisition or merger of both quoted
and unquoted entities …
… Taking into account the changes in the risk profile and risk exposure of the acquirer
and the target entities.
3. Regulatory framework and processes
1. Demonstrate an understanding of the principal factors influencing the development of the
regulatory framework for mergers and acquisitions globally and, in particular, be able to compare
and contrast the shareholder versus the stakeholder models of regulation.
2. Identify the main regulatory issues which are likely to arise in the context of a given offer and
1. assess whether the offer is likely to be in the shareholders’ best interests
2. advise the directors of a target entity on the most appropriate defence if a specific
offer is to be treated as hostile.
4. Financing acquisitions and mergers
1. Compare the various sources of financing available for a proposed cash-based acquisition.
2. Evaluate the advantages and disadvantages of a financial offer for a given acquisition proposal
using pure or mixed mode financing and recommend the most appropriate offer to be made.
3. Assess the impact of a given financial offer on the reported financial position and performance of
the acquirer.
Summary and Quiz
 Many company directors view mergers and acquisitions as the key to maintaining a high level of
growth for the business.
 However, there is significant empirical evidence to suggest that many real life mergers and
acquisitions actually destroy wealth for the bidding company's shareholders.
  Either the premium paid for control is too high and/or the expected synergies of combining the
companies do not materialise.
 Alternative methods as a way of obtaining a stock market listing include special purpose
acquisition companies (SPACs), direct listings, dutch auctions and reverse takeovers.
 A SPAC is a public shell company that raised funds through an IPO and uses the proceeds to
acquire a private company.
 In a direct listing, a company joins a public market without the issue of any news shares or any
marketing of existing shares.
 In a dutch auction, the lowest price necessary to sell the entire offering becomes the price at
which all securities offered are sold.
 It is critical that a target company is accurately valued. However, this tends to be complicated,
partly due to problems in forecasting synergy benefits, but also because adding another
company to the group is likely to disturb the group's WACC and hence the value of existing
operations.
 Mergers and acquisitions can be financed like any other project (internal equity, raising external
debt or equity), but with the additional option of using a share-forshare exchange.
 Which methods of defence against hostile takeover can be used depends on whether the bid
has already been announced.

Chapter 9: Corporate Reconstruction & Re-organisation

Visual Overview
Objective: To estimate credit risk and formulate plans for rescuing a company from financial
distress, including methods of divestment.

1.1 Introduction
For financial managers, it is just as important to understand how the debt market works as it is to
understand the operation of the equity market.
 For debt, what is important is whether a borrower will default on a loan. This is "credit risk".
 Default occurs when the borrower breaches its contract with the lender. For a bond, there are
many reasons why default can occur (e.g. non-payment, breach of financial covenant,
misrepresentation, cross default, insolvency or a material adverse change).
 When default occurs, two variables influence the potential loss to the lender:
1. the chance of default occurring; and
2. the proportion of the debt that can then be recovered upon default.
Recoverability is influenced by, for example:
 o the nature of the company's assets and their saleability;
o the priority of the lender; and
o any guarantees that may be in place.
 For the largest loans, or where the borrower is considering a bond issue, the borrower will need
to obtain a credit risk assessment from a rating agency (see s.1.3).
There are three main approaches to credit risk analysis:
1. Ratio analysis – in 1966 William Beaver showed that operating cash flow divided by total
outstanding debt successfully predicted default within five years with over 70% accuracy.
Edward Altman later developed the more sophisticated "Z-score" multivariate model
(calculations would not be required in the exam). A common criticism of all these models is that
they have weak theoretical support.
2. Ratings agencies approach – agencies use their own criteria to assess a company's credit rating
(see s.1.3).
3. "Structural models" – these rely on an assessment of the underlying volatility of the business
assets of a company or its ability to generate cash, and hence the likelihood that it will not be
able to pay interest or repay principal on the due date.

1.2 Ratings Agencies

Among the criteria used by agencies to establish a company's credit rating are the following:
industry risk, country risk, earnings protection, financial flexibility and evaluation of the company's
management.
 Industry risk – measures the resilience of the company's industrial sector to changes in the
economy. The following factors could be used in measuring this risk:
o Impact of economic changes on the industry in terms of how successfully the
companies in the industry operate under differing economic outcomes;
o How cyclical the industry is and how large the peaks and troughs are;
o How the demand shifts in the industry as the economy changes.
 Country risk – measures the entity’s exposure to negative aspects of the countries in which it
operates. To assess this the following factors could be used:
o Risk of appropriation of assets, blocked remittances or currency controls;
o Level of transparency in business dealings and financial reporting;
o Level of political stability.
 Earnings protection – measures how well the company will be able to maintain or protect its
earnings in changing circumstances. The following factors could be used to assess this:
o Differing range of sources of earnings growth;
o Diversity of customer base;
o Profit margins and return on capital;
o Level of operational gearing (i.e. the proportion of fixed to variable operating
costs). Companies with heavy fixed costs will find their profits highly exposed to
falling revenues.
 Financial flexibility – measures how easily the company is able to raise the finance it needs to
pursue its investment goals. To assess this, the following factors could be used:
o Evaluation of plans for financing needs and range of alternatives available;
o Relationships with finance providers (e.g. banks);
o Operating restrictions that currently exist as debt covenants.
 Evaluation of the company's management − considers how well the managers are planning for
the future of the company. To assess this, the following factors could be used:
o The company's planning and control policies;
o Management succession planning;
o The qualifications and experience of the managers;
o Performance in achieving financial and non-financial targets.
1.3 Estimating Credit Spread
1.3.1 Rating Agency Credit Ratings
The three most active rating agencies in the financial markets are S&P (Standard and Poor), Fitch
and Moody. Each credit rating agency has its own rating scale for different instruments or markets
(e.g. S&P rates countries, issuers, corporate bonds, short-term debt and ESG performance).
There are many other agencies that provide information on smaller companies in a particular
country, and some that offer this service internationally.

Exhibit 1 S&P Rating Scale for Long-term Corporate Bonds

Letter Grade Category Capacity to repay

AAA Investment grade Extremely strong
AA Investment grade Very strong
A Investment grade Strong
BBB Investment grade Adequate
BB Junk/Speculative grade Faces major future uncertainty
B Junk/Speculative grade Faces major uncertainties
CCC Junk/Speculative grade Currently vulnerable
CC Junk/Speculative grade Currently highly vulnerable
C Junk/Speculative grade Has filed for bankruptcy
D Junk/Speculative grade In default
Ratings AA to CCC may be modified by the addition of a plus (+) or minus (-) sign to show
relative standing within the rating categories.

Each rating reflects a combination of the probability of default and the loss given default.
Given the credit rating, lenders will require an interest rate premium (“credit spread”) in addition to
the yield on equivalent treasury bonds. Typically a table of credit spreads will look like this:

Remaining term, in years, premium in basis points

Ratin
g 1 2 5 10 25

AA 10 12 15 20 30

A 15 18 22 30 45

BBB 60 70 90 120 150

BB 120 140 180 240 300

 If the yield on equivalent treasury bonds (i.e. “risk-free” rate) was 2%, a 5-year BBB bond would
be issued at: 2% + 90bp = 2.90%
 For bonds with a remaining term (“tenor”) not listed on the table, the rate may have to be
estimated from the table. For instance, a 15-year A-rated bond might be estimated to have a
credit spread of:
2.1 Background
A capital reconstruction may be required when a company has experienced financial difficulties
which have weakened its statement of financial position/balance sheet and drained its resources.
Indicators that a capital reconstruction may be needed include:
 The company may have good prospects in the future but is currently unable to exploit the
opportunities available because of lack of cash.
 The statement of financial position is characterised by:
o a debit balance on retained earnings due to accumulated losses;
o low net assets per share;
o fully-utilised overdraft facilities which are technically repayable on demand.
 Existing shareholders may at present be unwilling to inject more cash due to the debit balance
on retained earnings preventing the payment of dividends.

2.2 Types of Capital Reconstruction

A broad distinction can be made between:
  Internal reconstruction which involves the elimination of a debit balance on retained earnings
(i.e. accumulated trading losses) against share capital and non-distributable reserves (i.e.
“capital reduction”). This allows dividends to be paid in the near future and helps to attract new
equity finance.
 External reconstruction arrangements that affect the rights of creditors and other stakeholders
(e.g. cancellation of debt in exchange for shares). This more complex type of reconstruction may
also involve the liquidation of the old company and the sale of some of its assets to a newly
formed company. This may involve legal and ethical issues and legal advice should always be
sought for such reconstructions.

2.3 Formulating a Scheme

Elements of a scheme may include:
 write off retained earnings debit balance;
 write off any impaired intangible assets (e.g. goodwill, development expenditure);
 revalue other assets;
 reorganise capital structure (e.g. write off debt in exchange for equity);
 ensuring the new company has a viable future, perhaps by raising adequate additional new
finance.
In formulating a scheme, each class of share and each class of creditor must be considered
individually. The scheme must be shown to work for all groups:
 Secured creditors with adequate value in the assets over which they have security are likely to
be offered value close to their current debt, but perhaps in the form of equity and perhaps in
association with additional cash contributions.
 Preference shareholders may have to forego arrears of preference dividend in return for a
promise of a higher coupon rate in the future.
 Ordinary shareholders would rank last upon liquidation, therefore it will not normally be
necessary to be too generous to them in reorganisation.

2.4 Impact on Stakeholders

Exam advice

Exam questions may present you with a proposed restructuring programme and require you to evaluate
its impact on the company and/or various stakeholders.
The approach to take is to identify the position of each class of investor if the company goes into
liquidation and compare against their positions post-reconstruction (i.e. if the company is saved).
 Is each investor no worse off under reconstruction than under liquidation (i.e. will investors vote
to accept the scheme)? Each class of investor will compare the risks and potential rewards they
would face under the reconstruction with the likely payout to them if the company were
liquidated. In many jurisdictions, 75% agreement is needed from creditors for a complex
reconstruction to receive court approval.
 Is sufficient new finance raised to meet the costs of the reconstruction, repay the parties to be
repaid under the reconstruction and ensure a viable future for the reconstructed company?
 Is the predicted income of the reconstructed company sufficient to meet the predicted interest
and dividend payments?
Before giving advice or making a recommendation it will be important to challenge or assess
assumption provided. For example, whether forecasts of income/costs under reconstruction seem
reasonable based on the available evidence.

3.0 Terminology
Portfolio restructuring involves the acquisition or divestment of subsidiaries, large groups of
assets and/or business units.
 Definitions

Unbundling – the unravelling of closely connected businesses or processes, usually as a

precursor to (and associated with) divestment of non-core businesses to focus on the core
business.
Divestment – the sale of assets or businesses, wholly or in part, often in an attempt to generate
cash or reduce losses.
Demerger – splitting a company into two or more independent units and allocating shares in
each new company to existing shareholders, on the assumption that the separate companies
will be worth more to the shareholders than the original company.

3.1 Reasons for Divestment

There are many reasons for divestment:
 To raise significant cash − to improve liquidity or to pay off debts and reduce gearing.
 To focus on core activities − which can be expanded to generate economies of scale.
 To dispose of operations giving poor returns/unacceptable level of risk.
 As a "crown Jewels" defence against hostile takeover (i.e. selling those assets which predators
are most interested in).

Activity 2 Portfolio Restructuring

Discuss how a reduction in the number of business sectors that a company is involved in may
change the nature of its shareholders.
*Please use the notes feature in the toolbar to help formulate your answer.
A company that reduces the number of business sectors that it is involved in, reduces its level of
internal diversification and becomes more narrowly focused. This is an example of portfolio
restructuring (as opposed to organisational restructuring of divisions, subsidiaries, business
processes, etc).
Undiversified shareholders may benefit from business sector diversification by the company, so
may choose to sell shares in a company which reduces its level of internal diversification.
Shareholders who hold a diversified portfolio should not value diversification by individual
companies, since they have already reduced their exposure to company specific risk. Institutional
shareholders generally hold well diversified portfolios.
Institutional investors usually see a focus by a company on fewer business sectors as allowing a
company’s management to focus on business areas where the company has a special advantage
and can therefore generate the greatest return.
It is also easier to assess the performance of a company where that company focuses on only one
or two sectors.
3.3 Demergers
A demerger assumes that shareholder wealth can be increased by splitting the group. This is an
example of realising a “conglomerate discount” (the opposite of a synergistic benefit), since it
reflects the assumption that the sum of the separate parts is greater than the value of the merged
entity. This can happen because:
 independent specialist managers may perform better than a single management structure,
perhaps because different management styles or strategies are appropriate to the two different
businesses;
 there is some conflict between the existing divisions that is holding both back from realising
maximum value;
 head office costs are not offering economies of scale and cannot be brought under control;
 there is a regulatory requirement to divest a part of a business following an acquisition;
 there is greater clarity to the market concerning the respective values of the two separate
companies.
Rather than selling a part of the business (which would be a divestment) the existing shareholders
receive shares in the new company as well as continuing to hold shares in the original company,
so no new cash is raised.

3.4 Spin-off
Definition

Spin-off – the “splitting” (they may already be separate subsidiaries) of a business into two or more
independent units and the sale of one such unit as a separate company.
A spin-off is one type of unbundling:
 If the shares in the company created by the spin-off continue to be owned by the current
shareholders, it is a demerger.
 If the company created by the spin-off is sold for cash, this is an example of a divestment.
4.1 Introduction
An MBO is the purchase of part or all of a business by the existing management. As the
management team usually has limited resources, a substantial amount of external capital is
usually required.

4.2 Reasons for the Development of the MBO

 Government policy: many governments have come to recognise the importance of supporting
the growth of small and medium enterprises. An MBO's management team is often highly
ambitious, experienced and fits the profile of a company that government is looking to support.
 Availability of funding: the growth of venture capital funds has created a sector looking for
high-risk/high-return investments, of which an MBO is one example.
 Disposal of non-core subsidiaries: The tendency of groups to focus on core activities and
dispose of non-core subsidiaries has led to a supply of companies for MBOs.
 Management desire: The desire of management teams to be liberated from the chains of a
large organisation (and to get rich) has meant that there is no shortage of aspiring risk takers.

4.3 Ideal MBO Candidate

The ideal MBO candidate is a company in a relatively low-risk environment. This will enable the
providers of finance (e.g. venture capitalists) to realise a satisfactory return without substantial risk
that the company will fail. Desirable characteristics for a company to have are:
 a stable or growing market;
 stable cash flows;
 large asset backing as security for loans;
 the ability to restrict capital expenditure over the years subsequent to the buyout to minimise
cash outflow;
  the ability to squeeze working capital in the early years to generate additional cash to pay back
loan finance;
 the existence of surplus assets which can be sold to pay down debt;
 a strong, well-balanced, motivated and committed management team;
 an "exit route" (e.g. the company should be of sufficient size for an IPO or should be an
attractive purchase for other acquisitive companies).
4.4 Commercial Aspects of Buyouts
It is important to ensure that a deal is feasible from the very start. This means that all parties must
be serious about making the deal work. The vendor must be willing to sell, the management willing
to buy and there must a good prospect that the finance will be available.

4.4.1 Financiers and Advisers

Before making an offer and negotiating with the vendor, the management team should meet with
the potential financiers who can inspect the business plan and establish whether finance is likely
to be available or not.
It may be useful to use professional advisers at this stage (e.g. accountants or lawyers). The risk
is that heavy fees will be incurred which will need to be met by the management personally if the
bid does not succeed. Accountants may make their fee contingent on a successful deal being
completed, but in such instances the fee will be higher.

4.4.2 Offer to the Vendors

After meeting with the potential financiers, an offer can be made to the vendors. This will include
details of the following:
 the assets or shares to be purchased;
 trademarks or other brand names to be included in the deal;
 the employees and attached obligations (e.g. redundancy payments) to be included in the deal;
 pre-conditions for the sale (e.g. an investigation or tax clearances);
 the purchase price and payment terms.
The problem for the management team is that there is only one potential target. However, the
financiers will be looking at a range of options and the vendor will possibly have a number of
potential purchasers. The management team will therefore need to strengthen its own position by
stressing the benefits of having an MBO and by having alternative courses of action (e.g. walking
out and setting up a new business).

4.5 Financial Aspects of Buyouts

4.5.1 Gearing Levels
An MBO is usually financed by a mixture of debt and equity with the MBO team putting its own
money in.
 Relatively high levels of debt finance may be required. The gearing (D/E) ratio can easily be 5:1,
although 10:1 is not rare and 20:1 has been known. For this reason such deals are often
referred to as “highly leveraged MBOs”.
 High gearing requires a strong cash flow to enable interest payments to be met. The equity
investment of the buyout team, together with debt secured on the assets of the business and/or
individual team members, are unlikely to be enough. Venture capital funding, often as a mix of
mezzanine finance and preference shares, is likely to be needed.
 Venture capitalists will often nominate a non-executive director to the board and may also insist
on nominating a new finance director. The venture capitalist's continued funding will be
conditional on meeting tough medium- and long-term targets and they will usually expect the
management team to be financially committed (“having skin in the game”).
 4.5.2 Equity Finance
Equity finance will be split between the management team, the venture capitalist, and possibly
other shareholders.
Typically the venture capitalist will initially hold redeemable preference shares with an option to
convert to equity shares at a later date. In this way the venture capitalist ensures that if the
company goes bankrupt, it will be paid out ahead of the management team; but, if the company is
successful, it will share in that success.
The management team will hold ordinary shares in the company, so will rank last if the company
fails.

4.5.3 Debt finance

There are likely to be a number of tranches of debt.
 Secured debt provided by banks will take first charge fixed and/or floating security. This is the
cheapest source of debt finance and will be repaid ahead of other creditors.
 Mezzanine finance provided by the venture capitalist will consist of high-yield debt finance often
with a conversion option (an “equity kicker”) into equity shares of the company. In a large MBO
this might be “securitised”, in which case it would be called “junior” or “subordinated” debt.
Typically such debt will rank behind the secured debt but ahead of unsecured debt in a
liquidation. In this way the venture capitalist seeks to protect at least some of its investment if
the company fails.
 Unsecured creditors (usually trade creditors) will, often unknowingly, be heavily exposed to the
success or failure of the company, as they rank after the mezzanine finance if the company fails.
4.6 Exit Routes
4.6.1 Possibilities
The two main exit routes whereby investors can realise their capital gain are:
1. Flotation (IPO); or
2. Trade sale to another company.
The attractiveness of each depends on market conditions at the time of sale, the industry involved
and the initial reasons for the MBO. Sometimes an MBO will be a mechanism through which a
company can temporarily divest itself of a subsidiary while that business undergoes radical (and
reputationally risky) transformation; knowing that if the process is successful, the original parent is
likely to buy the transformed business back at the end of the process.

4.6.2 Exit – Flotation or Trade Sale?

Factor Flotation Trade sale

Size of company Relatively large Any size

Timing of exit Market determined Flexible

Business weaknesses Unacceptable Can be accommodated

Management quality Essential Not essential, but will be reflected in the price

Realisation Can be partial Full

Price Depends on market sentiment Possibly at a control premium

Activity 4 MBO and MBI

Jeremy Co listed on the national stock exchange five years ago. Prior to listing, the company had
about 100 closely linked shareholders, for most of whom the shareholding represented their
principal equity investment. Since listing, most of these shareholders have sold their holdings, and
Jeremy Co is now owned principally by institutional investors.
Since listing, Jeremy Co has undergone significant portfolio and organisational restructuring. This
has resulted in Jeremy Co reducing the number of business sectors it is invested in from 20 to just
two: vehicle parts and distribution logistics. Jeremy Co’s share price has grown strongly since
listing.
Jeremy Co recently sold Tony Co, a subsidiary company, through a management buy-in (MBI), in
preference to a management buy-out (MBO).

Required:
Explain the differences between an MBO and an MBI. Suggest why Jeremy Co’s board of
directors might have chosen to sell Tony Co through an MBI rather than an MBO.
*Please use the notes feature in the toolbar to help formulate your answer.
A management buy-out (MBO) occurs when the management of a business buys that business
from the current owners of the business. Hence Tony Co’s current management team would be
buying Tony Co from Jeremy Co.
A management buy-in (MBI) occurs when a management team not currently associated with Tony
Co or Jeremy Co buy that business from the current owners of the business.
Jeremy Co’s board of directors may have preferred an MBI because they believed:
 Internal management could act prejudicially to Jeremy Co in the future, should co-operative
working be required (e.g. if there was a history of conflict between Tony Co’s management and
head office).
 The MBI team would offer a higher price for the company.
 The external management team had available finance in place, so could close the deal more
quickly.
 Tony Co’s current management team lacked the expertise, innovative approaches and
strategies needed to develop Tony Co.
 The MBI team had skills and expertise lacking in the current management.

Syllabus Coverage
This chapter covers the following Learning Outcomes.

B. Advanced Investment Appraisal

3. Impact of financing on investment decisions and adjusted present values
1. Assess the organisation's exposure to credit risk, including:
1. Explain the role of, and the risk assessment models used by, the principal rating
agencies
2. Estimate the likely credit spread over risk free

D. Corporate Reconstruction and Re-organisation

1. Financial reconstruction
1. Assess an organisational situation and determine whether a financial reconstruction is an
appropriate strategy for a given business situation.
2. Assess the likely response of the capital market and/or individual suppliers of capital to any
reconstruction scheme and the impact their response is likely to have upon the value of the
organisation.
2. Business re-organisation
1. Recommend, with reasons, strategies for unbundling parts of a quoted company.
2. Evaluate the likely financial and other benefits of unbundling.
3. Advise on the financial issues relating to a management buy-out and buy-in.
Summary and Quiz
 The "Big 3" credit ratings agencies, Fitch, Moody and Standard & Poor, assess credit risk using
factors such as industry risk, country risk, earnings protection, financial flexibility and quality of
management.
  The credit spread on debt will depend on the debt rating and the time to maturity (“tenor”) of that
debt.
 If management or stakeholders identify a significant risk of bankruptcy, steps should obviously
be taken to avoid this. Company law in many countries allows some form of capital
reconstruction (e.g. exchanging debt for equity).
 Even a healthy company may wish to restructure its operations, perhaps to focus on core
activities or to separately quote potentially undervalued segments of the business.
 Divestment of non-core activities can take various forms such as MBO, sale to another company
or to private equity investors.

Chapter 10: Equity Issues

Visual Overview
Objective: To understand domestic and international capital markets and how companies issue
equity in them.

1.1 The Stock Exchange

The Stock Exchange is responsible by law for controlling companies that are listed and those that
are applying for a listing. The Exchange's rules serve to ensure that:
 Applicants are suitable for a listing;
 Securities are brought to the market in a way that ensures open and fair trading;
 There is a balance between providing issuers with capital and protecting investors;
 Relevant information is provided by companies.

1.2 Reasons for Wanting a Listing

1.2.1 Benefits of a Listing (Flotation)
 Exit route – Flotation of the company will enable investors to realise their investment. This may
be a major factor where the company has venture capital or private equity investors who need to
realise their gains within a set time scale. One of the first questions a venture capitalist will ask
when assessing a business is the feasibility of various exit routes, including flotation.
 Immediate source of long-term capital for the business – The company will be able to issue new
shares and obtain long-term capital. This will enable the business to expand, make acquisitions
and/or reduce gearing levels.
 On-going source of capital – The ability to issue new shares in the future, subject to investor
sentiment, or to issue listed debt will give the company more flexibility in its financing options.
This will translate into lower costs and will assist the company in its expansion plans.
 Share-for-share acquisitions – The ability to issue shares as consideration when making an
acquisition will give the company more options when implementing a strategy of growth.
  Raised profile – The listing will give the company more credibility with potential customers and
suppliers and will also be a source of publicity, leading to lower costs and higher revenues.
 Share incentive schemes – It will be easier to introduce share option schemes (for employees
and/or directors), since there is a readily ascertainable market price and a liquid market in which
to dispose of a holding.
 Personal factors – The directors may value the prestige of being the directors of a listed
company.
1.2.2 Costs of a Listing
The costs associated with a listing include the following:
 Time and cost spent preparing for flotation – Planning a flotation is a lengthy procedure
(typically at least six months). Throughout this time, a significant amount of management effort
will need to be diverted into the flotation process.
 The cost of the flotation itself – The flotation process itself is very expensive, involving fees to
advisers, the Stock Exchange and the underwriters and various other expenses.
 The on-going costs of maintaining a listing – These include the on-going fees to be paid to the
Stock Exchange and higher compliance costs. For example, to satisfy the UK Corporate
Governance Code or (even more expensive) the US Sarbanes-Oxley Act.
Furthermore, significant management time will be spent communicating with investors
and ensuring that the company is being marketed properly.
1.2.3 Potential Drawbacks
The following are potential drawbacks, other than costs, associated with a listing:
 Satisfying the needs of external shareholders – The needs of external shareholders will
depend on the nature of those investors – whether they want income or capital growth, whether
they are pension funds, insurance companies, unit trusts/mutual funds or private investors. The
company will need to identify their needs and tailor the strategy of the company to meet those
requirements.
However, the pressure to achieve short-term results may damage the long-term
development of the business – a problem often referred to as "short-termism".
 Accountability – The requirement to have non-executive directors on the board and to justify
performance, executive pay and other decisions to outside shareholders may be an interference
to directors used to running the company their own way.
 Lack of privacy – The disclosure requirements set by the Stock Exchange, and the fact that the
company is subject to the attention of analysts and the public in general, means that the
company will not have the benefits of secrecy and discretion available to a private company.
 The risk of takeover – If the directors do not perform satisfactorily, the company may be taken
from them and sold to a (possibly hostile) predator.
They may feel a great sense of loss if they had built up the company from start-up –
although the pain may be cushioned by "golden parachutes".
 Different culture – The culture of the business is likely to change because the directors will be
answerable to outside shareholders.
Previously, the business may have been run as a "lifestyle" company, with generous
benefits to the directors and their families. Such advantages may disappear on listing.
 Tax planning for investors – The scope for tax planning is much wider in an unquoted company
with a small group of shareholders and an uncertain market value.
1.4 London Stock Exchange Regulations
The conditions for a listing on the London Stock Exchange are published by the UK Listing
Authority (UKLA) – a department of the Financial Conduct Authority. The conditions below are for
the Main Market – less strict conditions apply to the AIM (Alternative Investment Market):
 Company history: The company must usually have three years of audited, unqualified
published accounts under substantially the same management.
 Directors: The directors must have appropriate experience to run the business and be
sufficiently independent.
 Working capital: The directors must confirm in writing that the company has sufficient working
capital for its needs.
 Controlling shareholder: If there is a controlling shareholder, the directors must demonstrate
their independence from that shareholder.
 Market value of securities to be listed: Usually, a minimum free float of £700,000 for equity
shares (i.e. value available to the general public).
 Public shareholders: Usually, 25% of shares must be in public ownership.

1.5 Role of the Sponsor

The sponsor is usually a member firm of the Stock Exchange. The sponsor's responsibilities
include ensuring that:
 the company complies with the Stock Exchange rules; and
 the directors understand their responsibilities.
Exam advice

It is not necessary to know all details but knowledge of the main steps in a listing, the parties
involved and the types of share issue (see below) is essential.

2.1 Companies with an Existing Listing

For a company which already has a listing, the Stock Exchange is concerned to protect the
interests of existing shareholders. It therefore requires that the company gives existing
shareholders pre-emption rights (i.e. the right to purchase new shares in the company in
preference to other investors).
This means that the usual method of issuing shares for a company which already has a listing is
the rights issue. However, the Stock Exchange permits other methods to be used in certain
circumstances.
2.2 Forms of Initial Public Offer
The objective of the Stock Exchange is to ensure the marketability of the shares when listed. The
major methods which may be used are:
 Offer for Subscription – the company sells new shares directly to the public.
 Offer for Sale – new shares are sold to an intermediary who then sells to the general public.
 Placing (placement) – new shares are sold to specific individuals (to obtain a listing there must
be more than five individuals.)
 Introduction – no new shares are issued, two market makers simply agree to trade existing
shares. This method is often used when a company de-merges.
Whichever method is used, there must be a least two market makers willing to make a market in
the securities, of which at least one must be independent of the sponsor or other advisers.

3.1 Listing on Junior Exchange/Exchange for New Start Ups

There are many local exchanges that offer a market in the securities of companies that do not
qualify for a main exchange listing. One such is the Alternative Investment Market in London. AIM
is a subsidiary of the London Stock Exchange. Specifically tailored to growing businesses, AIM
combines the benefits of a public quotation with a flexible regulatory approach.
Although AIM requires companies to retain a nominated advisor, other regulation is minimal. It
requires no trading history, no pre-vetting by a UK government regulator or the exchange, and no
minimum free float or public ownership.
Recent developments in crowdfunding and, in particular, Initial Coin Offerings (see later) have
broadened the investment opportunities for small investors.

3.2 Unquoted Equity Finance

Alternatives to listing on either the Main Market or AIM are to use:
 Private equity finance: private equity investors buy private companies, actively manage them
to improve performance, then list them on the market or sell to another investor.
 Venture capital: venture capital funds provide "seed" finance to start-ups or second-stage
growth finance. Unlike private equity investors, venture capitalists do not always expect to take
full control of the company.
 Business angels: individual venture capitalists who are often wealthy, retired entrepreneurs.
Advantages Disadvantages

 An equity investor can be selected whose vision for the

business matches that of the existing
shareholders/directors.
 The investor may have existing business interests in  Dilutes the interests
connected fields, creating possibilities of shared research of existing
and development, transfer of management skills (i.e. shareholders.
"synergy").  New investors may
 A private investor may be prepared to take a more long- demand a seat on the
term view than institutional investors on the stock market. board.

3.3 Debt Finance

Relative advantages and disadvantages of debt finance as compared to equity include:

Advantages Disadvantages

 Lower issue costs.  Only available in limited quantities up to

 Providers of debt take less risk acceptable gearing levels.
than shareholders and hence  Leads to financial risk for shareholders (i.e.
require lower returns. more volatile profits due to the presence of
 Interest is tax allowable – the "tax committed interest costs).
  Exposes the company to the risk of
shield". insolvency should operating profits and cash
 Leaves control of the company with flows fall – financial distress risk.
existing shareholders.  Restrictive debt covenants may limit the
 Ensures that all the benefits of company's flexibility – leading to …
success stay with the existing  … "agency costs" for shareholders (i.e. sub-
shareholders. optimisation of returns).
Issues relating to debt finance are detailed in the next chapter.

Syllabus Coverage
This chapter covers the following Learning Outcomes.

A. Role of the Senior Financial Adviser in the Multinational Organisation

5. Strategic business and financial planning for multinationals
1. Advise on the development of a financial planning framework for a multinational taking into
account compliance with national regulatory requirements (for example the London Stock
Exchange admission requirements).

B. Advanced Investment Appraisal

3. Impact of financing on investment decisions and adjusted present values
1. Identify and assess the appropriateness of the range of sources of finance available to a
company including equity, hybrids, venture capital, business angel finance and private equity.
Including assessment on the financial position, financial risk and the value of an organisation.
5. International investment and financing decisions
1. Assess and advise on the costs and benefits of alternative sources of finance available within
the international equity markets.
Summary and Quiz
 The main advantages of a listing include sources of capital, raised profile for the company and
exit route for the investors. The main disadvantages include costs, additional accountabilities
and scrutiny and increased risk of takeover.
 The rules for listing shares on a major market (e.g. LSE) are inevitably detailed and strict to give
potential investors sufficient protection and maintain confidence in the market.
 A sponsor must make written confirmations concerning the directors' responsibilities.
 AIM is a market suitable for smaller growing companies operating in any business sector
throughout the world.
 Sources of unquoted equity finance include private equity, venture capital and business angels.

Chapter 11: Debt Issues

Visual Overview
Objective: To understand domestic and Euro debt markets and how companies issue debt in
them.
1.1 Financial Intermediaries
Definition

Financial intermediaries – organisations in the debt market which bring together potential lenders and
potential borrowers.
The following financial institutions act as financial intermediaries:
Commercial banks and building societies (i.e. deposit takers).
 Investment banks – provide banking services to corporate clients, including advice on areas
such as share issues and acquisitions.
 Insurance companies – receive premium income before having to settle claims. The timing
difference between these will vary with the risk: short-term for motor insurance, long-term for life
insurance. Insurance companies therefore invest over different periods.
 Collective investment schemes – attract investors and then reinvest the funds raised into
other companies.
 Pension funds – have predictable cash outflows and can invest in the long term.
 Finance companies – provide business and domestic credit, lease finance and
factoring/invoice discounting services. These companies are often a subsidiary of another
financial institution.

1.2 Role of Financial Intermediaries

Financial intermediaries are important as they carry out the following roles:
 Aggregation – small deposits are combined and lent to large borrowers.
 Maturity transformation – a continuing stream of short-term deposits can be used to lend monies
in the long term.
 The risks of many borrowers are spread across many lenders.
 Providing a liquid market with flexibility and choice for both lenders and borrowers.
 Providing instruments to business for hedging risk (e.g. forward contracts, options and swaps).

1.3 The Money Market

Money market instruments are negotiable (tradeable) financial instruments with maturities of less
than one year.
The money market has no single physical location: trades are made by phone/online between
money market participants.
The money markets are sometimes divided into:
 Wholesale money markets – for the trade of large amounts of short-term, fixed interest debt by
central banks, banks, other financial intermediaries and large companies.
 Eurocurrency markets – where large banks and companies trade currency deposits outside
their country of origin.
 Retail money markets – for smaller deposits by companies and individuals in money market
funds (collective investment vehicles specialising in money market instruments) or short-term
government debt.
Some of the instruments traded on the money market include:
 Commercial paper – unsecured promissory note (usually) issued by companies (and
governments, banks and others).
 Certificate of deposit (CD) – a negotiable (tradable) fixed-rate bank deposit in any
denomination with a maturity date ranging from three months to five years.
 Treasury bills – debt issued by Government with a maturity of one, three, six or 12 months. The
minimum denomination for UK Treasury bills is £5,000.
Definition

Promissory note – an unconditional promise by the issuer to pay a fixed sum on a set future date to a
designated person or to the bearer. The bearer is the person who has possession of the instrument.

2.1 Bank Overdraft

A bank overdraft is a borrowing facility associated with a current account. In jurisdictions where a
bank overdraft is allowed, it is often the liquidity fallback of choice for SMEs.

Advantages Disadvantages

 Flexible.  Usually technically repayable on demand.

 Provides instant finance.  Expensive if used regularly.

2.2 Trade Credit

If a supplier offers a period of interest-free credit, it would be appropriate to use this source of
finance unless early payment discounts are sacrificed.

Advantages Disadvantages

 Generally  May lose settlement (prompt payment) discounts.

cheap.  Temptation to delay payment beyond formal payment terms may
 Flexible. trigger penalties or lose supplier goodwill.

2.3 Commercial Paper

Definition

Commercial paper – short-term unsecured debt issued by high-quality companies. The paper can then
be traded by investors on the secondary market.
Commercial paper is appropriate for financing short-term liabilities.
 Advantages Disadvantage

 Large sums can be raised

relatively cheaply.  Only available to large companies with investment-
 No security is required. grade credit ratings (i.e. BBB– or higher).

2.4 Supply Chain Finance

Definition

Supply Chain Finance (SCF) – the use of financial instruments, practices and technologies to optimise
the management of the working capital and liquidity tied up in supply chain processes for collaborating
business partners.
SCF works best when the buyer (typically larger company) has a better credit rating than the seller
(typically smaller company). A bank then lends at a low interest rate to the supplier on the basis of
an invoice that is supported by a guarantee of repayment by the buyer. This “reverse factoring”
process is highly automated, with the buyer entering into the system the invoices that they are
prepared to guarantee.
The growing popularity of SCF has been largely driven by the increasing globalisation and
complexity of the supply chain, especially in industries such as automotive, manufacturing and the
retail sector.

Advantages Disadvantage

 Allows SMEs to benefit from the

superior credit rating of their
larger customers.
 The bank provides attractive  Large companies may abuse their power by
payment terms for both supplier demanding lower prices from suppliers in
and buyer. exchange for arranging SCF.

3.1 Bank Loans

Companies agree borrowings from the bank at a fixed rate, for a specified period and with an
agreed repayment schedule.
Advantage
 As the loan is for a fixed term, there is no risk of early recall (unlike overdrafts that can be
called).
 Set payment dates and rates mean costs and cash flows are known and certain.
 Successfully paying off a medium-term loan can help improve a credit rating to obtain additional
loans.
Disadvantages
 Inflexible as rates and payment dates fixed.
 May require security/collateral, so harder to qualify for.
 May impose restrictive covenants (e.g. limits on dividend payments or further borrowing).

3.2 Leasing
Under a lease contract, the lessee has the right to use an asset which is owned by the lessor, in
exchange for a series of payments.
Advantages
 There are many willing providers, often associated with asset manufacturers and therefore
offering attractive terms.
  Matches finance to the asset.
 Very flexible packages available, some of which include maintenance.
Disadvantage
 May be costly.
Effect on Financial Statements
IFRS 16 Leases requires that:
 For any lease with a term of more than 12 months, the right-of-use asset (and lease liability) are
recognised in the statement of financial position;
 For short leases (12 months or less) the lease payments as simply treated as rental expense.

Key Point

Buying an asset financed by debt or leasing it for more than 12 months will have similar initial impact on
gearing and interest cover.
3.4 Mortgage Loan
A mortgage loan is a loan secured by property. Although a mortgage may be appropriate for
financing commercial real estate there are likely to be restrictive covenants concerning the use of
the property and its potential disposal.
Advantages
 Given the security, the loan will have a lower rate of interest than other debt.
 Institutions will be willing to lend over a longer term.
 The company still owns the property so any appreciation in value accrues to the company.
Disadvantage
 It is more difficult to sell a mortgaged property if planning to relocate.
 Default may result in forced sale of significant business asset in order to repay loan.

4.1 Preference Shares

Definition

Preference shares – shares with a fixed rate of dividend which have a prior claim on profits available for
distribution.
Preference ("preferred”) shares are legally equity. They are often treated as debt (e.g. under
International Financial Reporting Standards) as they are similar in nature to debt.
Some of the common features found for preference shares include:
 The shares have a fixed percentage dividend payable before ordinary dividends. This
preference share dividend is expressed as a percentage of nominal value.
 The dividend is only payable if there are sufficient distributable profits. If the shares are
cumulative preference shares, however, the right to receive dividends which were not paid is
carried forward (this is known as cumulative preference dividends). Any arrears of dividend are
then payable before ordinary dividends.
 As for ordinary dividends, preference dividends are not deductible for corporate tax purposes.
The preference dividends are considered a distribution of profit rather than an expense.
 For a tax-paying company, preference shares are unlikely to be an appropriate source of finance
as the lack of tax shield damages the potential value of the firm. (Less than 5% of companies
listed on the London Stock Exchange have preference shares in issue.)
 On liquidation of the company, preference shareholders rank before ordinary shareholders and
after debt holders.
Advantages
 No voting rights; therefore no dilution of control.
 Compared to the issue of debt:
o dividends do not have to be paid in any specific year (e.g. if profits are poor);
o preferred shares are not secured on company assets; and
 o non-payment of dividend does not give holders the right to appoint a
liquidator.
Disadvantages
 Preferred dividends are not tax deductible (unlike interest on debt).
 To attract investors to buy preferred shares, the company needs to pay a higher return to
compensate for the additional risk compared to debt.

4.2 Bonds
Definition

Bond – a negotiable security evidencing a debt governed by a contract which specifies, for example, the
coupon rate, repayment schedule, security (if any), principal value, seniority (if subordinate to other debt)
and other covenants.
The terms "debenture", "loan note" and "bond" all basically refer to the same thing (i.e. a written
acknowledgement of a company's debt which can then be traded). Bonds may be secured by:
 a fixed charge over a specified asset (e.g. a specific building) which cannot therefore be sold
unless the debt is repaid; or
 a floating charge over a class of asset which changes (e.g. inventory). On default, the floating
charge “crystallises” as a fixed charge, and the asset class can no longer be traded until the
debt is repaid.
Holders of unsecured bonds have the same rights as unsecured trade creditors.
In the UK, bonds are usually issued with a nominal (par) value of £100. They can then be traded
on the bond market and reach a market price. Hence, if a bond is "selling at a premium" of 15%,
this means that a bond with a nominal value of £100 is currently selling for £115.
Interest is usually a fixed coupon expressed as a percentage of the bond's nominal value.
The most common process of issuing bonds is through underwriting − one or more investment
banks or broker-dealers, forming a syndicate, buy an entire issue of bonds from an issuer and re-
sell them to investors. The syndicate takes the risk of being unable to sell on the issue to
investors.
Bonds are an appropriate source of long-term debt for a tax-paying listed company as:
 unlike preference dividends, the coupon interest on bonds creates a tax shield for the issuer;
 the interest rate on a bond is likely to be lower than on an equivalent bank loan.
4.4 Zero-coupon Bonds
Definition

Zero-coupon bonds – bonds issued at a discount to nominal value and which pay no coupon.
Advantages to borrowers
 No cash payout until maturity.
 Cost of redemption known at time of issue.
 Return received wholly in the form of the capital gain over the life of the bond.

4.5 Convertibles
Definition

Convertibles – bonds or preference shares which can be converted into ordinary shares. An example of
hybrid or mezzanine finance (i.e. that has characteristics of both debt and equity).
Issuing convertible debt may be appropriate if management wishes to raise debt but without
increasing reported financial gearing to perceived dangerous levels. IFRS splits convertible debt
between liability (the present value of the debt's future cash flows) and equity (the difference
between the issue price and the value of the liability).
Convertible bonds and convertible preference shares:
 Pay a fixed coupon or dividend until converted.
 May be converted into ordinary shares:
o on, or by, a pre-determined date;
o at a pre-determined rate (the conversion ratio); and
o at the option of the holder.
 Conversion ratio may change during the period of convertibility – to stimulate early conversion.
Advantages
 To investors – a relatively low risk investment with the opportunity to make high returns on
conversion to ordinary shares.
 To issuing company − lower coupon rate than equivalent “straight” debt as the conversion option
usually has significant value.

4.6 Warrants
Definition

Warrant – the right, but not the obligation, given to the investor, to purchase new shares at a future date
at a fixed price. This fixed price is also called the exercise or subscription price.
Warrants have the following features:
 When attached to bonds, to make them more attractive, the bond becomes hybrid or mezzanine
finance.
 They are an option to buy shares in the company, issued by the company.
 They may be separated from the underlying debt and traded independently.
Key Point

Warrants are share options attached to debt. The debt itself is not convertible. A warrant "sweetens" a
new debt issue and makes it more attractive to investors.
Warrants offer several advantages for the issuing company:
 When initially attached to the bond, the coupon rate on the bond will be lower than for
comparable straight debt. This is due to the investor gaining the additional benefit of potentially
being able to purchase equity shares at an attractive price.
  They may make an issue of unsecured debt possible when the company's assets are
inadequate to secure the debt.
 They are a way of issuing equity (albeit with a delay) without the usual negative signal
associated with an equity issue.
4.7 Securitisation
Definition

Securitisation – the creation and issuance of tradable securities (e.g. bonds) that are backed by the
income generated by an asset, a loan, a public works project or other revenue source.
Securitisation offers the originator of the assets the ability to access additional funding. If the
assets are transferred to a Special Purpose Vehicle/Entity (SPV/SPE), the originator may also:
 remove assets from its statement of financial position; and
 transfer most, if not all, potential uncertainty associated with the returns on these assets to new
investors.
The classic example of securitisation is where a bank (the originator) packages a pool of the loans
given to homeowners into "Mortgage Backed Securities". The MBS is then issued through a ring-
fenced SPE/SPV that is protected if the bank collapses, and which protects the bank from any loss
in the value of the assets:
 The SPE achieves a high credit rating as in future it will collect the cash from the underlying
mortgages, and it cannot be touched if the bank gets into financial distress.
 The finance raised by selling the MBS is then transferred back to the bank which can then use it
to grant more loans to customers.
Advantages
 Converts an illiquid asset (e.g. loans granted to homeowners) into a liquid asset (i.e. cash) for
the originator.
 Credit enhancement – achieving a high credit rating through the use of SPEs. Securitisation
may be appropriate to enhance credit ratings as low-risk cash flows (e.g. rental income from
commercial property) are diverted into a "ring-fenced" SPV. The SPV then issues bonds backed
by the future cash flow stream. Such bonds typically achieve an investment-grade credit rating.
Disadvantages
 The SPE may be opaque, particularly if set up in a lightly regulated offshore regime – therefore
difficult for investors in an SPE and the securities it issues to independently analyse the credit
risk.

4.8 Crowdfunding
Definitions

Crowdsourcing – using a large, evolving, relatively open group of people (usually assembled via the
internet) to provide goods, services or finance.
Crowdfunding – is crowdsourcing to fund a project. Under crowdfunding there is no financial
intermediary: each individual in the crowd has a direct relationship with the entity that is funded.
A platform may introduce the parties, and may contribute in some way to the ongoing relationship
between them, but the platform is not acting as a financial intermediary.
Crowdfunding may:
 offer a reward, equity, debt, “coin”, or simply seek donations;
 be unregulated, regulated or illegal, depending on the type of crowdfunding and the jurisdiction.
For companies, equity-, debt- and coin-based forms are most relevant.

4.8.1 Equity- and Debt-based Crowd funding

Equity or debt crowdfunding tends to be regulated under traditional securities regulations or to
have their own special rules.
Traditional securities regulations either limit investment to sophisticated investors or require
registration, licensing and a formal process to be undertaken (usually including the publication of a
prospectus). This is not usually practical for crowdfunding.
Special rules for crowdfunding have been introduced in many countries, for example UK (2011),
the US (2016) and Malaysia (2015). These rules often limit crowdfunding to specific platforms.
Debt-based crowdfunding is often called peer-to-peer (P2P) lending. Some governments saw P2P
lending as an opportunity to by-pass the banks in the wake of the 2009 global financial crisis and
encouraged P2P lending growth, which can now measure total loans in the billions of dollars.

4.8.2 Peer-to-peer Lending

Definition

Peer-to-peer (P2P) lending – a method of debt financing that enables individuals to lend money to small
businesses without the use of an official financial institution as an intermediary.
Advantages
 P2P loans give businesses access to financing when banks refuse credit or would charge very
high interest rates.
 By effectively cutting out the middleman (i.e. the formal banking system), P2P loans can offer
relatively attractive interest rates to both lenders and borrowers.
Disadvantages
 In some countries, P2P lending is unregulated; investors have lost significant sums.
 In some countries, P2P lending is illegal.

4.9 ICOs and STOs

4.9.1 Initial Coin Offering (ICO)
Definition

Initial coin offering (ICO) – the first sale of coins (or tokens) in exchange for a payment, which may be
made in a cryptocurrency (e.g. bitcoin) rather than a fiat currency (i.e. legal tender).
Like an IPO, an ICO raises finance for a new venture. However, an ICO:
 Offers investors either a new cryptocurrency coin (of unproven value) or access to an as yet
written app or currently unprovided service. The investor is not buying either an ownership
interest or debt.)
 Often allows investors to make payment in a cryptocurrency, usually bought with “real money"
as part of the transaction.
The issue is marketed to investors based on a “white paper” (not a prospectus), usually through a
website. Details include, for example:
 the concept of the venture/business idea/business model;
 the amount of money needed;
 the number of tokens that can be created;
 how much of the tokens will be kept by the founders.
Advantages
 Simple and inexpensive way of funding new ideas provides a low barrier to entry.
 Raises funds more quickly than traditional methods.
 Investors can track the process of ICOs daily.
 Anyone can invest in ICO.
 Helps drive innovation.
Disadvantages
 A lack of regulation/controls and no need for collateral makes ICOs high risk/open to scams.
 High risk business models are the norm: a new cryptocurrency may never acquire a value and a
new entity may lack the skills needed to succeed.
4.9.2 Security Token Offering (STO)
A Security Token Offering (STO) is quite similar to an ICO in that both are fundraising methods for
start-ups. However, STOs must adhere to the requirements of regulated securities markets,
including Anti-Money Laundering requirements, before launching the STO.
STOs are technically asset-backed, which means they must have some monetary value in the real
world; this is safer for investors and increases their trust.
Categories of security token
There are three main categories of security token:
 Asset-backed tokens – give ownership rights over valuable tangible or intangible objects and in
digital form. Assets can be anything: property, company shares, commodities (e.g. oil), art,
carbon credits, etc.
 Debt tokens accrue interest equivalent to interest on a short-term loan.
 Equity tokens are similar to shares but without the traditional mechanisms for recording and
transferring ownership such as share certificates.
Advantages
Some advantages of STO are:
 Lower initial investment than an IPO; an STO is much cheaper since it cuts out all middlemen
and brokerage and smart contracts eliminate the need for expensive legal counsel.
 STO are digital assets that can be used to divide significant assets into smaller assets. This
makes it easier for an investor to have fractional ownership of a product.
 Because security tokens are issued on blockchains, they are also transparent, divisible, quick to
settle and have no downtime whatsoever
 Regulation by the securities market ensures the security of the investor. Trust in their asset’s
safety attracts more investors.

4.10 Green Finance

Definition

Green finance – any structured financial activity that has been created to ensure a better
environmental outcome.
– World Economic Forum
Green finance integrates environmental protection with economic profits, emphasising “green” and
“finance”. It involves collecting funds for addressing climate and environmental issues (“green
financing”), on the one hand, and improving the management of financial risk related to climate
and the environment (“greening finance”), on the other.
The key aspect of green finance is the commitment to investing the funds raised in green assets
such as:
 renewable power generation;
 low carbon transport/low carbon buildings;
 sustainable water management/waste management/land use;
 climate change adaptation;
 resilience measures such as flood defences.
The predominant financial instruments in green finance are debt and/or equity, for example:
 Green bonds;
 Green loans;
 Green convertible bonds.
There is a code of conduct that defines what constitutes a green bond. To qualify, a bond must:
 adhere to criteria on the use of proceeds;
 have a process for project evaluation and selection;
 ensure proper management of any proceeds; and
 offer detailed reporting.
Sustainable green features (e.g. solar panels, wind turbines, e-vehicles) are not without cost,
especially when first introduced. A once-common assumption and concern for investors was that
sustainable investing is at the expense of financial returns. However, sustainable investment
approaches can enhance risk-return profiles (e.g. through improved risk management) and long-
term performance to match or even outperform comparable traditional investments.
Green sources can also be found in Islamic finance, for example, the green sukuk (see s.3.6
in Chapter 16).

5.1 Characteristics
Definition

Euromarkets – large, over the counter, international financial markets which are located outside the
country in whose currency the deposit, borrowing or financial instrument is denominated.
The word "Euro" in this context does not refer to the European single currency. It means foreign
and indicates that the deal is denominated in a different (foreign) currency. Usually the currency is
also specified (e.g. eurodollar, euroyen, eurosterling).
As a source of funds, these markets in the EU are only open to Governments, banks and the very
largest companies with the best credit ratings. They are operated by the largest investment banks
and offer a broadly unregulated market.
Compared to domestic markets:
 The Euromarkets are more competitive and innovative.
 Margins are tighter, and so rates more attractive.
 Large sums can be borrowed very quickly with lower issue costs (normally) than in national
markets.
 Loans and securities are generally unsecured, since borrowers are of high credit standing.
 Interest is paid gross, without deduction of tax.
 The market is self regulated through the International Capital Market Association.
Access to the Euromarkets can be a key competitive advantage for a large multinational company
as many domestic financial markets lack sufficient depth and liquidity to accommodate large debt
issues or issues with long maturities.
The Euromarkets include both bank finance and securitised debt markets.

5.2 Eurocurrency and Eurocredit Markets

These are markets in which international banks accept deposits and may make loans in a
Eurocurrency:
 If a loan is short term, this would be a Eurocurrency loan.
 If a loan is medium to long term, this would be a Eurocredit loan.

5.3 Eurocurrency Securities

As for domestic markets, Euromarket securities can have fixed or variable interest rates. Similar
instruments are issued (e.g. eurocommercial paper, euronotes, euro mediumterm notes,
eurobonds, etc).

5.3.1 Eurobonds
Definition

Eurobonds – long-term tradable bearer bonds issued in a currency that differs from the place where it
was issued.
Characteristics of Eurobonds include the following:
  Typical issue fees will be under 2%.
 Typically unsecured.
 Issued only by high-quality borrowers (governments, banks and multinationals).
 Bearer form means that there is no register of investors.
 Most Eurobonds are held to maturity, so the secondary market is small.

Syllabus Coverage
This chapter covers the following Learning Outcomes.

B. Advanced Investment Appraisal

3. Impact of financing on investment decisions and adjusted present values
1. Identify and assess the appropriateness of the range of sources of finance available to an
organisation including debt, lease finance, asset securitisation and security token offerings.
1. Discuss the role of green finance for organisations pursuing an environmental/ sustainable
agenda.
5. International investment and financing decisions
1. Assess and advise upon the costs and benefits of alternative sources of finance available within
the international bond markets.

Summary and Quiz

 Financial intermediaries bring together potential lenders and potential borrowers (e.g. banks).
 The maximum term for lending and borrowing on the money market is normally one year.
 Sources of medium-term finance include loans and leasing arrangements.
 Long-term debt securities includes bonds. Preference shares may also be regarded as debt
rather than as equity.
 Large, creditworthy multinational companies may prefer to use the Euromarkets to achieve
lower interest rates and access large sums relatively quickly.
 The Euromarkets are large, over the counter, international financial markets located outside the
country in whose currency the deposit, borrowing or financial instrument is denominated.

Chapter 12: Dividend Policy

Visual Overview Objective: To understand theories and
practical approaches to dividend policy, including dividends for a multinational
organisation.
1.0 Introduction
The board of directors must decide when to pay a dividend and when to retain earnings in the
company.

1.1 Dividend Irrelevance Theory

According to Modigliani and Miller, in a perfect capital market the dividend policy is irrelevant to
shareholders' wealth.
This follows directly from their assumption in their earlier “without tax” theory of gearing
(see Chapter 3) that the value of a company derives solely from its project cash flows and their
associated risk. Neither the financing decision nor the dividend decision affects the company’s
projects; so neither will affect shareholder wealth.
If dividends are reinvested at the equity required rate of return: the share price will not change
from cum-div to ex-div, so no shareholder value is lost.
MM assessed the issue of “clienteles” with a thought experiment:
 If no dividend is paid, and shareholders want income, they can manufacture their own "home-
made" dividend either by:
o selling some shares; or
o borrowing against the value of the shares as security.
 If a dividend is paid and they want capital gains, they can either:
o buy more shares with the dividend; or
o invest the dividend in other securities with equivalent risk for the same return.
A perfect capital market has rational investors, no transaction costs, no tax distortions, no
information costs and an active market. In reality, all these assumptions are contentious.

1.2 Drivers of Dividend Polices

1.2.1 Signalling
Directors know more than shareholders about the state of the company’s current condition and
future earnings potential. Setting the dividend is an example of a discretionary decision which
carries real consequences – the company loses cash. Therefore this is an important signal to the
market about the health of the company. An unexpected rise in dividends per share will usually
lead to a share price rise and vice versa.

1.2.2 Clientele Theory

There are groups (clienteles) of shareholders who seek different dividend policies. One clientele
group seeks capital gains, whilst another seeks income, whether for tax reasons or to meet
cash/saving needs.
A particular company’s historical dividend policy may have attracted a particular clientele.
Changing that policy may lead to a change of clientele, which may incur transaction costs for
investors and therefore a fall in the share price.

1.2.3 Cum-div and Ex-div Share Values

When an expected dividend is paid out, the share price should fall from its cum-div price to its ex-
div price. The difference should be the dividend per share. However, the wealth of the
shareholders has not changed: before the dividend they owned shares; after the dividend they
own shares and cash.
The assessment of dividend policies should consider the value of shareholders’ wealth, including
any dividend paid, and not just at the value of the company.
1.2.4 Bird-in-the-Hand Theory/Fallacy
A shareholder’s preference for cash now rather than cash later appears to support dividends now
rather than dividends later. It may also be that shareholders value the choice between reinvesting
in the company or buying shares in a different company.
However, money retained in the company will earn a return, Ke, which should be sufficient to
compensate the investor for their risk. Only if retained earnings are invested in negative NPV
projects would dividends now be worth more than the discounted value of dividends later.

1.2.5 The Dividend Valuation Model

The growth rate of future dividends depends on the retention ratio (i.e. proportion of profits
reinvested) and the return on reinvested profits. (See Chapter 7 for Gordon’s growth
approximation, g=bre)
So higher dividends today will reduce the long-term growth rate and vice versa.

1.3 Alternative Dividend Policies

1.3.1 Stable Dividend
A stable dividend means maintaining either a constant dividend per share or a constant dividend
growth rate. This policy avoids surprises and signals stability to shareholders. It therefore supports
a stable share price and is a common approach for quoted companies. The policy should reflect
the directors’ long-term estimate of what is affordable, despite any short-term fluctuations in
earnings.

1.3.2 Constant Payout Ratio

A constant payout ratio means paying a dividend which represents a constant proportion of each
year’s earnings. Although this approach sounds logical it creates uncertainty and is therefore
rarely adopted by quoted companies.

1.3.3 Residual Dividend Policy

Under the residual dividend policy, retained earnings are used to fund all positive NPV projects
and any remaining earnings not needed to fund such projects are paid out as a dividend.
This clearly links to Pecking Order Theory (i.e. retained earnings are the cheapest source of new
finance, so should be used to fund projects first).
A residual dividend policy is likely to lead to fluctuating dividends, so although it may excuse a cut
in an otherwise stable dividend pattern, it is not common for quoted companies. When it is used, it
is likely to be accompanied by detailed information to support the decision, since this is effectively
a form of new equity issue (see signalling in Chapter 3).

1.3.4 Zero Dividend Policy

A high growth company may find that, in early years, all surplus cash can be profitably reinvested
back into the business – particularly if the company lacks access to external finance.
At some point, however, margins will fall and the company will find fewer positive NPV projects
available and hence should start paying dividends.
Such companies can still be valued by the DVM, but with a delay to the payment of dividends.
However, predicting when dividends will begin to be paid is difficult.

1.4 Other Distribution Methods

Like the payment of dividends, these methods also require the company to have sufficient
distributable reserves and sufficient liquidity to fund the distribution.
1.4.1 Share Buyback Programmes
The buyback can be performed either by writing directly to all shareholders with an offer to buy
shares at a fixed price (a "tender offer") or by purchasing shares on the stock market at the
prevailing price.
 The shares are either cancelled (and a non-distributable reserve created) or held by the
company as treasury shares for possible future reissue. If held by the company the shares carry
no voting rights or dividend.
 Distributable reserves must be reduced by the full value of the buyback.
 The result of a buyback programme is that there will be fewer shares in issue hence ratios such
as Earnings per Share (EPS) and Return on Equity (ROE) should rise.
Share buyback programmes tend to be viewed favourably by investors because:
 They signal that:
o the company is generating surplus cash;
o the directors are not prepared to gamble surplus cash in marginal projects or to
waste it on extravagant executive perks;
o the director’s perceive the current share price to be undervalued and therefore
buying those shares is a “‘good investment”;
o the directors are giving shareholders a choice to invest elsewhere; and
o the company lacks positive NPV projects to invest in.
 Buybacks are usually classified as capital gains rather than income and, in many countries,
investors are taxed at a lower rate on capital gains.

1.4.2 Special Dividends

If a quoted company announces a larger than expected dividend, this may raise market
expectations that future dividends will also be higher.
Therefore, to avoid creating expectations of an unsustainable level of dividend, a larger dividend
may be announced as a "special" dividend – basically a bonus dividend.
The directors are telling the market that, from time to time, any exceptional cash surplus will be
returned in this way, but that this should not be built into dividend per share forecasts.
 Like a buyback, the company distributes cash.
 All shareholders will receive cash (whereas, under a buyback, only those who sell receive cash).
So:
o There is no undervalued share price signal that is associated with a buyback.
o The distribution will be taxed as income.

1.4.3 Scrip Dividends

A scrip dividend is where the company gives its shareholders a choice of:
 cash dividend; or
 shares in lieu of cash.
If shareholders choose additional shares, the company retains more cash in the business for
reinvestment − the preferred source of finance under pecking order theory.
Shareholders may opt for the additional shares as a means of increasing their holding without
incurring trading commissions.
Signalling issues:
 The company issues equity without an associated negative signal;
 The dividend saved can be unpredictable.
2.3 Legal Restrictions on Use of Dividend Capacity
Typically companies may only distribute accumulated realised profits. This means that a company
may pay a dividend in periods in which it has made a loss as long as it has made sufficient profit in
earlier periods to absorb this loss and leave a credit balance of retained earnings.
Depending on local legislation it may, in specific circumstances, be permitted to write off a
brought-forward debit balance on retained earnings. For example, as part of a capital
reconstruction scheme. This would allow a firm with brought-forward losses to quickly resume the
payment of dividends once it moves back into profitability. The ability to resume dividends may be
essential in attracting new equity finance.
3.1 Management of Blocked Remittances
If a multinational company finds that remittances are blocked, it may have to consider other
methods of transferring profit from the overseas subsidiary to the parent.
 Manipulation of transfer prices for goods or services supplied by the parent to the subsidiary.
However, either the subsidiary’s and/or the parent's jurisdiction may require the transfer price to
be set at "arm's length" which may limit the amount of profit that can be extracted using this
method. Members of the OECD require transfer prices to be set at arm's length (see Chapter
17).
  Charging management fees from the parent to the subsidiary. This may be easier to justify in the
early years of investment but more difficult in later years if local managers have replaced
expatriates.
 Royalty payments or licence fees for the use of patents or intellectual capital owned by the
parent. This method can be particularly flexible in the "new economy" where fees for human
capital are more subjective than for physical goods.
 Financing the overseas subsidiary with loans from the parent and hence extracting profits in the
form of interest as opposed to dividends.
However, each of the above methods must be carefully reviewed before implementation for their
potential to expose the firm to:
 Reputational risk: Ethical investors may dump the parent 's shares if it is suspected of
circumventing overseas regulations. Furthermore, consumers may boycott its products.
 Political risk: The host government may react aggressively to schemes and potentially
appropriate its assets.
 Legality: All of these methods may be subject to anti-avoidance legislation, so legal advice is
always required.

Syllabus Coverage
This chapter covers the following Learning Outcomes.

A. Role of the Senior Financial Adviser in the Multinational Organisation

1. The role and responsibility of senior financial executive/advisor
1. Advise the board of directors or management of the organisation in setting the financial goals of
the business and in its financial policy development with particular reference to:
1. Distribution and retention policy
2. Financial strategy formulation
1. Recommend appropriate distribution and retention policy.
5. Strategic business and financial planning for multinationals
1. Advise on the development of a financial planning framework for a multinational organisation
taking into account:
1. The mobility of capital across borders and national limitations on remittances and
transfer pricing.
6. Dividend policy in multinationals and transfer pricing
1. Determine a corporation's dividend capacity and its policy given:
1. The corporation's short- and long-term reinvestment strategy.
2. The impact of capital reconstruction programmes such as share repurchase
agreements and new capital issues on free cash flow to equity.
3. The availability and timing of central remittances.
4. The corporate tax regime within the host jurisdiction.
2. Advise, in the context of a specified capital investment programme, on a company's current and
projected dividend capacity.

Summary and Quiz

 Dividend policy is of course closely linked to financing and investing strategy. If company
managers follow pecking order theory they are likely to view the dividend as the residual cash
available after financing all positive NPV projects. However, this may lead to a volatile dividend
which can cause practical problems for a listed company. It may be better to use the surplus for
a share buyback programme.
 International groups also have to make decisions about the level of dividends paid by
subsidiaries to the parent. This may be affected by overseas government policy which may
restrict the payment of dividends to a foreign parent or impose high withholding taxes.
Chapter 13: Options
Visual Overview
Objective: To understand and value options, and discuss how various factors influence option
value.

1.1 Terminology
Definitions

Option – a contract giving one party the right, but not the obligation, to buy or sell an underlying
asset (the underlying) at an agreed price, on or before a specified date (expiry date). The
purchaser/holder of the option can either exercise their right or let it lapse (i.e. not exercise).
Call option – an option that gives the holder the right to buy the underlying asset.
Put option – an option that gives the holder the right to sell the underlying asset.
Exercise (strike) price – the price at which the underlying asset can be bought or sold when
exercising the option.
Option premium – the amount the purchaser of the option must pay to buy the option. Also
referred to as the price of the option, the premium must not to be confused with the exercise
price. In a perfect market, it should represent the value of the option.
Writer – the seller of an option who receives the premium.
European-style options – options which can only be exercised on the expiry date.
American/US-style options – options which can be exercised at any time prior to and on the
expiry date.
Mid-Atlantic/Bermuda options – options which can be exercised on any one of a pre-set
series of dates.

1.2 Exchange-Traded v Over-the-Counter

1.2.1 Exchange-Traded Options (ETOs)
Definition

Exchange-traded (listed) options – any options contract that is listed on a public trading exchange.
The positive features of ETOs are:
 bought and sold on a recognised exchange (through a broker);
 price transparency (i.e. quoted premium should represent fair value);
 can be easily resold during their lifetime before expiry.
The potential drawbacks of ETOs are:
 only available in standardised contract sizes;
 available on a limited number of underlying assets;
 limited number of exercise prices and expiry dates;
 obtained via a broker who will charge a small commission.

1.2.1 Over-the-Counter (OTC) Options

OTC options are available from banks by individual negotiation. The positive features are:
 option can be customised to the purchaser's specific requirements;
 option can be for any size, exercise price, expiry date, etc;
 may include “exotic” features (e.g. barrier options, Bermuda options or Asian options).
Potential drawbacks of OTC options are:
 not transferable/non-negotiable (i.e. cannot be resold);
 early cancellation of the contract will incur significant penalties;
 more expensive than exchange-traded options.

1.3 Underlying Security

Options may be described by the underlying security, for example:
 Stock options on shares in a public listed company;
 Index options (e.g. on the S&P 500);
 Commodity options (e.g. gold, oil, wheat, coffee);
 Currency options (see Chapter 14);
 Futures options (see Chapter 15);
 Basket options on a group of securities, commodities or securities.

1.4 Uses of Options

1.4.1 Speculate or Hedge?
Both put options (a right to sell) and call options (a right to buy) can be bought or sold.
To be a seller of put or call options is rather like being an insurance company: the maximum gain
is the insurance premium received from the customer but the possible loss is greater than the
premium and can be unlimited.
However, it is most common in the exam to be buying options. If an option has been purchased
and the premium paid, there are two possible outcomes – the option will be exercised or allowed
to lapse.
 The option will be exercised if it is financially worth exercising ("in the money"). For example IF
the option holder has a right:
o to sell shares for $55 and the current price is $53; or
o to buy shares for $53 and the current price is $55.
 The option holder will allow the option to lapse if it would not be profitable to exercise it ("out of
the money"). The only loss incurred by the option holder is the premium already paid.
  If an option is exercised (or sold before its expiry), the profit or loss on the option will be the
value of the option on exercise (or sale) less the initial premium.
Exam advice

In the exam, the timing difference between these two amounts is IGNORED.

Options can be used either:

 To speculate (i.e. take a bet on whether the price of an asset will rise or fall); or
 As a hedging instrument (i.e. to take an offsetting position to an underlying exposure). The
overall hedge outcome will be the value of the hedged item plus the outcome of the option (see
s.1.5).
Exam advice

The focus in the exam is likely to be on hedging (i.e. managing risk) rather than on taking
risk.

1.4.2 Hedging: Protective Put or Protective Call?

Definitions

A long (position) – buying an asset with the expectation it will increase in value.
A short (position) – selling an asset with the intention of repurchasing it at a lower
price.
If a company is “long” in the underlying asset (i.e. either the company owns it or has an obligation
to sell that asset in the future), it should buy a “protective put” option (and pay an up-front
premium).
 A put option gives the right, but not the obligation, to sell at a fixed price on or by a fixed future
date.
 If the price falls below the option strike price then, on maturity, the company will exercise the
option.
Example 1 Protective Put

Assuming a $1 premium for a put option (right to sell) with a strike price of $5:

Share price Strike price Exercise? Gain/loss Overall position

3 5 Yes 2 3+2−1=4

4 5 Yes 1 4+1−1=4

5 5 Indifferent 0 5+0−1=4

6 5 No 0 6+0−1=5

7 5 No 0 7+0−1=6
 Example 1 Protective Put

If a company is “short” in the underlying asset (i.e. it has an obligation to buy that asset in the
future), it should buy a “protective call” option (and pay an up-front premium).
 A call option gives the right, but not the obligation, to buy at a fixed price on or by a fixed future
date.
 If the price rises above the option strike price, the company will exercise the option.
Activity 1 Put or Call?
For each of the following, state whether the company should purchase a protective call option or a
protective put option to hedge the exposure:
a. The company is concerned that the price of currently held shares in Trail Co may fall.
b. The company intends to buy copper for its factory in six months’ time on the open market.
c. The company will sell the copper produced by its copper mine in six months’ time on the open
market.

*Please use the notes feature in the toolbar to help formulate your answer.
a. There is a “long” position (the company owns the asset), so the company would buy a put option as
a hedging instrument
b. There is a “short” position (the company is due to buy the asset), so would buy a call option as a
hedging instrument.
c. There is a “long” position (the company is due to sell the asset, even though it has yet to acquire
it), so would buy a put option as a hedging instrument.
1.4.3 Options Collar
Option premiums can be very expensive. To save option premium costs on a “protective
position”, a company “long” the underlying asset can simultaneously:
 buy a put option at one exercise price, paying a premium; and
 sell a call option at a higher exercise price, receiving a premium.
The net cost of this “collar” will be the cost of the put option premium paid less the call option
premium received.
What are the possible outcomes?
 If the price falls, the put option will protect against the fall.
 If the price rises, the call option will be exercised against the company; it will lose potential gains
above the call option exercise price.
 The hedge outcome (hedged item + hedging instrument) will be between the two option strike
prices, less the net premium.
To save option premium costs, A company “short” the underlying asset will buy a call and sell a
put (at a lower exercise price). The hedged outcome will be between the two option strike prices,
plus the net premium.

2.1 Terminology
Definitions

In the money – an option that possesses intrinsic value.

Out of the money – an option that only contains extrinsic value.
At the money – an option is at the money if the current market price of the underlying asset is the same
as the exercise price.

2.2.1 In the money (ITM):

 A call option is ITM if the current market price of the underlying asset is above the exercise
price.
 A put option is ITM if the current market price of the underlying asset is below the exercise price.

2.2.2 Out of the money (OTM):

 A call option is OTM if the current market price of the underlying asset is below the exercise
price.
 A put option is OTM if the current market price of the underlying asset is above the exercise
price.
Key Point

In options trading, the difference between ITM and OTM depends on the exercise price relative to the market value
of the underlying asset, called its “moneyness”.

Example 2 Equity Options Prices

Extract from exchange-traded equity options prices on 4 February:

Calls Puts
Apr Jul Oct Apr Jul Oct
Amber Co 460 40 6

500 22 21
Each option contract is to buy (call) or sell (put) 1,000 shares in Amber Co at an exercise price of either
460 cents per share or 500 cents per share. The option can be exercised before the end of April, July or
October depending on which expiry date is selected.
 Example 2 Equity Options Prices

The figures below the month columns are the premiums (i.e. the cost of buying each option).
Assume the market price of a share in Amber Co on 4 February is 490 cents.

Activity 2 In or Out of the Money?

Using the information in Example 2, answer the following:
a. Is a July call option at an exercise price of 500 cents in or out of the money?
b. Is an April put option at an exercise price of 460 cents in or out of the money?
c. Is an October call option at an exercise price of 460 cents in or out of the money?

*Please use the notes feature in the toolbar to help formulate your answer.
(a) July call option @ 500 cents
Is out of the money as the exercise price is higher than the current market price.
(b) April put option @ 460 cents
Is out of the money as the exercise price is below the current market price.
(c) October call option @ 460 cents
Is in the money as the exercise price is below the current market price.

2.2 Intrinsic Value of an Option

Definition

Intrinsic value – an option's basic or fundamental price or value. It is the profit that a purchaser could make if the
option were exercised immediately.
An option will only have an intrinsic value if it is ITM. If it is OTM, the intrinsic value is zero as it
would not be exercised (i.e. the intrinsic value cannot be negative).

Activity 3 Intrinsic Value

Using the Amber Co traded option prices from Example 2, determine the intrinsic value of the
following options:
a. A July call option at an exercise price of:
i. 460 cents;
ii. 500 cents.
b. An October put option at an exercise price of:
i. 460 cents;
ii. 500 cents.

*Please use the notes feature in the toolbar to help formulate your answer.
a. July call option
i. @ 460 cents
This would be exercised as the shares would be bought @ 460 cents, and they have a current
market value of 490 cents
Intrinsic value =490-460 = 30 cents
ii. @ 500 cents
Currently, this would not be exercised as shares that are only currently worth 490 cents will not be
bought @ 500 cents. The intrinsic value is therefore zero.
b. October put option
i. @ 460 cents
This would not be exercised as this gives the right to sell shares worth 490 cents currently for just
460 cents.
Intrinsic value = zero
ii. @ 500 cents
This would be exercised as it gives a right to sell share worth 490 cents for 500 cents.
Intrinsic value = 500-490 = 10 cents
2.4 Summary of Factors Affecting Option Prices
Increase in Price of Call Price of Put
Exercise price Decreases Increases

Price of underlying asset Increases Decreases

Volatility Increases Increases

Time to expiry Increases Increases

Interest rate Increases Decreases

3.0 Option Pricing Models

Option pricing models are mathematical models that use specified variables to calculate the
theoretical value of an option, as an estimate of what an option should be worth using all known
inputs (i.e. a fair value). The ability to estimate of the fair value of an option enables finance
professionals to adjust their trading strategies and portfolios.
Monte-Carlo simulation (Chapter 6) is a sophisticated method that may be used to simulate
possible future prices that are then used to calculate the expected option payoffs. One of the best
known and commonly used models is, however, the model developed by Fischer Black and Myron
Scholes in 1973.
Exam advice

The values of s and r will always be given in an exam question.

The formulae, Standard Normal Distribution Table and a BSOP calculator are all available in the
exam. However, you must still be able to discuss the drivers of option value and the underlying
assumptions, application and limitations of the BSOP model.
Example 4 BSOP calculator
A BSOP calculator will be provided as a spreadsheet if relevant:

Populating the row of variables with the values from Example 3 gives:

The value of the call option is then $1.86.

3.4 Interpreting the Output

In practice, financial managers often use spreadsheets or online tools to quickly and accurately
perform BSOP model calculations. However it is clearly essential that the manager can correctly
identify the inputs for the model and interpret the output.
4.0 “The Greeks”
Both speculators and risk managers need to know how much an option's price will change if there
is a change in a key factor (e.g. in the price of the underlying asset).
The sensitivity of option values to such factors is measured by "the Greeks". The discussion in the
following sections assumes that the underlying asset is a share.
4.4 Theta
Definition

Theta – the measure of value lost over time, usually expressed as the amount of loss per day.

4.5 Summary of the Greeks

Change in Regarding

Delta Option value Share price

Gamma Delta Share price

Theta Option value Time

5.2 Real Option Archetypes
A company project or strategy may potentially have one or more of the following types of
embedded real option:
 Delay option – for example a construction company may have a "call" option to buy a piece of
land for potential development. The option gives value in that the company can "wait and see"
what happens to market conditions before deciding whether to "strike" the option and buy the
land, or "lapse" the option and walk away.
 Abandonment option – also called a "withdrawal" or "exit" option, this is the option to sell the
project to a third party for a pre-agreed price. This therefore has the characteristics of a "put".
 Expansion option – also called a "growth" or "learning" option, this is the ability to expand
production or service in the future (e.g. a cable TV provider may have spare capacity that could
be used to launch new services such as Internet, phone, etc). Hence the initial project provides
the company with the option to "call" future projects.
 Redeployment option − also called a "flexibility" option, this is where the project assets can be
switched into an alternative activity (e.g. Flexible Manufacturing Systems can be easily re-tooled
to make alternative products). Hence the assets in the project can be "called" to perform
alternative functions.
Exam advice

Candidates are only expected to explain and compute an estimate of the value attributable to
the delay, abandon and expand options and to explain (but not compute the value of)
redeployment or switching options.

Example 5 Real Option to Expand

A company is considering a 10-year project which can be viewed as two phases:

Phase 1 Phase 2

Starts Now After two years

Investment $600m $300m

$647.8
PV of annual returns m $200.6m

NPV $47.8 $(43)

 Example 5 Real Option to Expand

(For simplicity, tax, inflation and other real world complications have been ignored.)
Although phase 2 does not seem worthwhile the option to carry it out can only add value (as an option ca
never have a negative value). If the cash flows expected from phase 2 were to become favourable, the
company will be able to carry it out and reap the benefit. Hence, the overall NPV will be $47.8m plus the
value of the option to carry out phase 2.
To value the Phase 2 option, first attribute figures to the inputs required for the BSOP model:
Pe = the investment required = $300m
Pa = the PV of the net cash inflows currently forecast to arise = $200.6m
t = the time until it begins = 2 years
s = the volatility − assumed to be 0.4
r = the risk-free rate − assumed to be 5% i.e. 0.05 as a decimal
The option value can now be found using the BSOP calculator:

The value of the call option is $24.2m.

Therefore, the NPV for the project with the option to expand = $47.8m + $24.2m = $72m.
The attractiveness of the project arises because phase one of the project is itself attractive and the
company can potentially benefit if the phase two expansion finally becomes worthwhile.

Activity 7 Option to Abandon

A company has developed a new process with the following data:
Conventional NPV $10m
Capital expenditure $90m
10-year life
Volatility of the project's future cash flows = 45%
Risk-free rate = 5%
The company has the option to abandon the project at any time and sell the technology for an
estimated $40m.

Required:
Use the Black-Scholes model to estimate the value of the abandonment option and the total
value of the project.

*Please use the notes feature in the toolbar to help formulate your answer.
Pa, the underlying asset value is $100m (i.e. investment $90m + NPV $10).
Pe, the selling price of exercising the option is $40
r = 0.05, t = 10 years and s = 0.45
Using the BSOP calculator:

The option to sell, a put option, is $5.03m.

Therefore, the value of project with the option to abandon = 10 + 5.03 = $15.03m. This is still
conservative as the option is American style in nature, but has been valued as European style.

Activity 8 Option to Delay

Paradise Villas, an Indian property development company, has gained planning permission for the
development of a complex of holiday apartments in a southern state of India. The project has an
expected net present value of $4 million at a cost of capital of 10% per annum.
Paradise Villas has an option to acquire the necessary land at an agreed price of $24 million,
which must be exercised within the next two years. Immediate building of the complex would be
risky as the main purchasers of the apartments would be foreigners and, at present, there are
uncertainties over the legality of property sales to foreigners. As a result, the project has a volatility
attached to its future cash flows of 25%.
Within the next two years, an announcement by the state government will be made about the
rights of foreigners to purchase property.
The risk-free rate of interest is 5% per annum.
Required:

Activity 9 Option to Expand

Bevvy is considering introducing a new fruit smoothie to the US market. The smoothie would
initially be introduced only in the major cities with an investment costing $500 million, but the
present value of the cash flows from this investment would be only $400 million.
However, if the initial introduction of the smoothie works out well, Bevvy could go ahead with a full-
scale introduction to the entire market with an additional investment of $1 billion any time over the
next five years. Although the current expectation is that the present value of cash flows from
making this additional investment is only $750m, there is considerable uncertainty about the
potential for the smoothie.
The annualised standard deviation in the value of listed companies in the soft drinks industry is
34.25%.
The yield to maturity on five-year Treasury notes is 6%.
5.3 Limitations of ROPT
Supporters of ROPT argue that a focus on the value of flexibility provides a better measure of
projects that may otherwise appear uneconomical using traditional NPV. However critics of ROPT
make the following points:
 The BSOP model was designed for valuing financial options (e.g. share options) as opposed to
real options in physical company projects. In the real economy, its assumptions may not hold, in
particular:
o The returns from company projects are unlikely to follow the normal
distribution.
o Real options may be American style (i.e. available for exercise at any
time until their expiry date) rather than European style. In this case, Black-Scholes
would tend to undervalue real options.
Exam advice

Calculations involving binomial models (complex decision trees) that are more accurate for
valuing American options are not examinable.
 When applying ROPT, great care must be taken not to double-count the project's NPV. In many
cases, the embedded option will not be "detachable" from the project (i.e. the company could
not simultaneously sell the option and undertake the project).
 This is a particular issue in the case of a "delay" or "wait and see option" – part of the value of
this option to "call" the project may be its positive intrinsic value (i.e. the NPV of the project if it
started today). Adding the total value of the option to the project NPV may therefore double-
count the NPV.
 In this case, it would be more reasonable to suggest that:
Total value of the project = Traditional NPV + Time value of the option to delay
Exam advice

This argument is debatable. Furthermore, it does depend on the specific circumstances in the
scenario. In the exam, you will have to use judgement as to whether to add the total value or
just the time value of an embedded option. There may be no unique "correct" answer – so
explain your thought process and write any assumptions you make.

 If the Efficient Markets Hypothesis (EMH) holds:

o investors will be aware of which companies are dynamic and have the
flexibility granted by real options;
o investors will be attracted to such companies, bidding up the price of their
shares and bonds;
o dynamic companies will therefore achieve a relatively low WACC; and
o lower WACC increases project NPV (i.e. traditional NPV will already take into
account the value of real options).
Syllabus Coverage
This chapter covers the following Learning Outcomes.

A. Role of the Senior Financial Advisor in the multinational organisation

1. The role and responsibility of senior financial executive/advisor
1. Advise the board of directors or management of the organisation in setting the financial goals of
the business and in its financial policy development with particular reference to:
1. The management of risk

B. Advanced Investment Appraisal

2. Application of option pricing theory in investment decisions
1. Apply the Black-Scholes Option Pricing (BSOP) model to financial product valuation and to
asset valuation:
1. Determine and discuss, using published data, the five principal drivers of option value
(value of the underlying, exercise price, time to expiry, volatility and the risk-free rate)
2. Discuss the underlying assumptions, structure, application and limitations of the
BSOP model.
2. Evaluate embedded real options within a project, classifying them into one of the real option
archetypes.
3. Assess, calculate and advise on the value of options to delay, expand, redeploy and withdraw
using the BSOP model.
4. Valuation and the use of free cash flows
 1. Explain the role of option pricing models, such as the BSOP model in the assessment of the
value of equity, the value of debt and of default risk.

E. Treasury and Advanced Risk Management Techniques

1. The role of the treasury function in multinationals
1. Discuss the operations of the derivatives market, including:
1. Risks such as delta, gamma, vega, rho and theta, and how these can be managed.
Summary and Quiz
 The holder/buyer of an option has the right, but not the obligation, to buy (if calls) or sell (if puts)
the underlying asset at a fixed price (the strike/exercise price) on (if European style) or before (if
American style) an agreed date (the expiry date).
 The value of an option is reflected in its premium (i.e. price) and has two main components –
intrinsic value and time value.
 Black and Scholes produced the most famous model for valuing options – designed for
European call options but easily converted to puts using put-call parity. The value of American
options is usually close to their European equivalent.
 "The Greeks" analyse how the price of an option varies with key factors. The most famous
Greek is delta – popular with fund managers for setting up perfectly hedged portfolios to protect
against short-term volatility.
 A project may be undervalued by failing to capture the potential benefits of embedded strategic
options. Real Options Pricing Theory (ROPT) attempts to put a monetary value on options to
delay, abandon, expand or redeploy a project. The BSOP model can also be used to value
options embedded in company projects.
 Merton later applied the BSOP model to valuing corporate debt.