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ACCA P4 Advanced Financial Management December 2011 Exams.

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Presentation on theme: "ACCA P4 Advanced Financial Management December 2011 Exams."— Presentation transcript:

1 ACCA P4 Advanced Financial Management December 2011 Exams

2 Capital asset pricing model CAPM basics Arbitrage

3 CAPM basics 1 The CAPM formula E (r i ) = R f + β i (E (rm) – R f ) Where E (r i ) is expected return from security / project R f is risk-free rate of return E(r m ) is expected return from market β i is beta factor of security / project (E (r m ) – R f ) is market premium for risk This formula is given in the exam. Slide 3

4 CAPM basics 2 Capital asset pricing model Based on a comparison of the systematic risk of individual investments with the risks of all shares in the market CAPM assumes: Investors / companies require return in excess of risk-free rate Unsystematic risk can be diversified away and no premium is required for it Investors / companies require a higher return from investments where systematic risk is greater

5 CAPM Basics 3 Beta factor of portfolios Portfolio consisting of all (non risk-free) securities on stock market will have beta factor of 1 Portfolio consisting entirely of risk-free securities will have beta factor of 0 Beta factor of investors portfolio is weighted average of beta factors of securities in portfolio Investors should decide on desired β levels, invest in low β shares when returns falling, high β shares when returns rising

6 CAPM Basics 4 Investors should consider international diversification through investment in different countries or multinationals Market segmentation may complicate situation Slide 6

7 CAPM Basics 5 Problems with CAPM Assumptions unrealistic? Zero insolvency costs Investment market efficient Investors hold well-diversified portfolios Perfect capital market Slide 7

8 CAPM Basics 6 Problems with CAPM continued Required estimates difficult to make: Excess return Risk-free rate (govt. securities rates vary with lending terms) β factors difficult to calculate Hard to determine risk-free rate, systematic risk and expected return on market portfolio Slide 8

9 CAPM Basics 7 CAPM and returns CAPM can be used to calculate the required return on projects Particularly projects with significantly different business risk characteristics to a companys current operations CAPM produces a discount rate based on systematic risk and can be used to compare projects of different risk classes CAPM assumes companys investors wish investments to be evaluated as if they are capital market securities Slide 9

10 CAPM Basics 8 Limitations of CAPM in investment decisions Hard to estimate returns under different economic environments CAPM is single period, but investments are evaluated over time Difficult to model complications in decision-making Slide 10

11 CAPM Basics 9 Geared betas May be used to obtain an appropriate required return when an investment has differing business and finance risks from the existing business Slide 11

12 CAPM Basics 10 Where: β a = asset (or ungeared) beta β e = equity (or geared) beta β d = beta factor of debt in the geared company V d = market value of debt in the geared company V e = market value of equity capital in the geared company T = rate of corporate tax Slide 12

13 CAPM Basics 11 Weaknesses in the formula Difficult to identify firms with identical operating characteristics Estimate of beta factors not wholly accurate Assumes that cost of debt is risk-free Does not include growth opportunities Differences in cost structures and size will affect beta values between firms Slide 13

14 Arbitrage 1 Arbitrage pricing theory The theory assumes that the return on each security is based on a number of independent factors

15 Arbitrage 2 Where E (r j ) is expected return on security B 1 is sensitivity to changes in Factor 1 F 1 is difference between Factor 1 actual and expected values B 2 is sensitivity to changes in Factor 2 F 2 is difference between Factor 2 actual…e is a random term Main problem – identifying macroeconomic factors and risk Slide 15

16 Arbitrage 3 Factor analysis Analysis used to determine factors to which security returns are sensitive Four key factors indicated by research are: Unanticipated inflation Changes in industrial production levels Changes in risk premiums on bonds Unanticipated changes in interest rate term structure Slide 16

17 Arbitrage 4 Arbitrage trading Trading will occur if certain combinations of securities are expected to produce higher returns than indicated by risk sensitivities Slide 17

18 Chapter 1 The role and responsibility of senior financial executive Financial management Financial planning

19 Financial management 1 Financial objectives The prime financial objective is to maximise the market value of the companys shares Primary targets are profits and dividend growth Other targets may be the level of gearing, profit retentions, operating profitability and shareholder value indicators Slide 19

20 Financial management 2 Why profit maximisation is not a sufficient objective Risk and uncertainty Profit manipulation Sacrifice of future profits? Dividend policy Slide 20

21 Financial management 3 Non-financial objectives Non-financial objectives do not negate financial objectives However they do mean that the primary financial objectives may be modified They take account of ethical considerations Slide 21

22 Financial management 4 Examples - non-financial objectives Employee welfare Management welfare Societys welfare Service provision Responsibilities towards customers / suppliers Slide 22

23 Financial management 5 Investment decisions Investment decisions include: New projects Takeovers Mergers Sell-off / Divestment Slide 23

24 Financial management 6 The financial manager must: Identify decisions Evaluate them Decide optimal fund allocation Slide 24

25 Financial management 7 Financing decisions Financing decisions include: Long-term capital structure Need to determine source, cost and risk of long-term finance Short-term working capital management Balance between profitability and liquidity is crucial Slide 25

26 Financial management 8 Dividend decisions Dividend decisions may affect views of the companys long- term prospects, and thus the shares market values Payment of dividends limits the amount of retained earnings available for re-investment Slide 26

27 Financial planning 1 Strategic planning The formulation, evaluation and selection of strategies to prepare a long-term plan of action to attain objectives Strategic decisions should be suitable, feasible and acceptable Long-term direction Matching activities to environment / resources Slide 27

28 Financial planning 2 Key elements of financial planning Planning involves a long horizon, uncertainties and contingency plans Consideration of which assets are essential and how easily assets can be sold Long-term investment and short-term cash flow Surplus cash How finance raised Profitable Slide 28

29 Financial planning 6 Strategic analysis means analysing the organisation - its resources, competences, mission and objectives Strategic choice involves generating and evaluating strategic options and selecting strategy Slide 29

30 Financial planning 7 Strategic cash flow management Planning involves a long horizon, uncertainties and contingency plans Strategic fund management Consideration of which assets are essential and how easily assets can be sold Slide 30

31 Financial planning 8 Strategic planning Selection of products / markets Target profits Purchase of major non-current assets Debt / equity mix Growth v dividend payout Slide 31

32 Financial planning 9 Tactical planning Other non-current asset purchases Efficient / effective resource usage Pricing Lease v buy Scrip v cash dividends Slide 32

33 Financial planning 10 Tactical planning and control Conflict may arise between strategic planning (need to invest in more expensive machinery, R&D) and tactical planning (cost control) Slide 33

34 Financial planning 11 Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups' Slide 34

35 Financial planning 12 Stakeholder goals Shareholders –Providers of risk capital, aim to maximise wealth Suppliers –To be paid full amount by date agreed, and continue relationship (so may accept later payment) Long-term lenders –To receive payments of interest and capital by due date Slide 35

36 Financial planning 13 Stakeholder goals continued Employees –To maximise salaries and benefits; also prefer continuity in employment Government –Political objectives such as sustained economic growth and high employment Management –Maximising their own rewards Slide 36

37 Chapter 2 Financial strategy formulation Assessing corporate performance Financial strategy Risk and risk management

38 Assessing corporate performance 1 Probability and return Return on capital employed Profit margin Asset turnover Debt and gearing Debt ratio (Total debts: Assets) Gearing (Proportion of debt in long-term capital) Interest cover Cash flow ratio (Cash inflow: Total debts) Slide 38

39 Assessing corporate performance 2 Liquidity ratios Current ratio Acid test ratio Inventory turnover Receivables days Payables days Slide 39

40 Assessing corporate performance 3 Stock market ratios Dividend yield Interest yield Earnings per share Dividend cover Price / earnings ratio Slide 40

41 Assessing corporate performance 4 Comparisons with previous years % growth in profit % growth in turnover Changes in gearing ratio Changes in current / quick ratios Changes in inventory / receivables turnover Changes in EPS, market price, dividend Slide 41

42 Assessing corporate performance 5 Remember however Inflation – can make figures misleading Results in rest of industry / environment, or economic changes Comparisons with companies in same industry These can put improvements on previous years into perspective if other companies are doing better Also can provide further evidence of effect of general trends Eg growth rates, retained profits, non-current asset levels Slide 42

43 Assessing corporate performance 6 Comparisons with companies in different industries Investors aiming for diversified portfolios need to know differences between industrial sectors Sales growth Profit growth ROCE P/E ratios Dividend yields Slide 43

44 Assessing corporate performance 7 Economic Value Added (EVA TM ) EVA TM = NOPAT - (cost of capital x capital employed) Adjustments to NOPAT Add: –Interest on debt –Goodwill written off –Accounting depreciation –Increases in provisions –Net capitalised intangibles Slide 44

45 Assessing corporate performance 8 Adjustments to capital employed Add: –Cumulative goodwill written off –Cumulative depreciation written off –NBV of intangibles –Provisions Slide 45

46 Assessing corporate performance 9 Types of sources of funds Shares Ownership stake Equity (full voting rights) Preference (prior right to dividends) All companies can use rights issues Listed companies can use offer for sale / placing Slide 46

47 Assessing corporate performance 10 Debt / Bonds Fixed or floating rate Zero coupon (no interest) Convertible loan stock Bank loans Security over property may be required Slide 47

48 Assessing corporate performance 11 Comparison of finance sources When comparing different sources of finance, the following factors will generally be important: Cost Flexibility / time period available Commitments Uses Speed / availability Certainty of raising amounts Slide 48

49 Assessing corporate performance 12 Estimating cost of equity Theoretical valuation models, eg Capital Asset Pricing Model (CAPM) or Arbitrage Pricing Theory (APT) Bond-yield-plus-premium approach: adds a judgmental risk premium to the interest rate on the firms own long-term debt Market-implied estimates using discounted cash flow (DCF) approach (based on an assumption on earnings growth rate of earning of the company) Slide 49

50 Assessing corporate performance 13 Practicalities in issuing new shares Costs Income to investors Tax effect Effect on control Slide 50

51 Assessing corporate performance 14 Ethical framework for business In order of priority: (1)Economic responsibility (2)Legal responsibility (3)Ethical responsibility (4)Philanthropic responsibility Slide 51

52 Financial strategy 1 Suitability of capital structure Company financial position / stability of earnings Need for a number of sources Time period of assets matched with funds Change in risk-return Cost and flexibility Tax relief Minimisation of cost of capital Slide 52

53 Financial strategy 2 Feasibility of capital structure Whether lenders are prepared to lend (security) Availability of stock market funds Future trends Restrictions in loan agreements Maturity of current debt Slide 53

54 Financial strategy 3 Acceptability of capital structure Risk attitudes Loss of control by directors Excessive costs Too heavy commitments Slide 54

55 Financial strategy 4 Pecking order Retained earnings Debt Equity Slide 55

56 Financial strategy 5 Dividend policy Dividend decisions determine the amount of, and the way in which, a companys profits are distributed to its shareholders Ways of paying dividends Cash Shares (stock) Share repurchases Slide 56

57 Financial strategy 6 Theories of why dividends are paid Residual theory Target payout ratio Dividends as signals Tax implications Agency theory Slide 57

58 Risk and risk management 1 Types of risk Systematic and unsystematic Business Financial Political Economic Fiscal / regulatory Operational Reputational Slide 58

59 Risk and risk management 2 Risk management Over-riding reason for managing risk is to maximise shareholder value Risk mitigation The process of minimising the likelihood of a risk occurring or the impact of that risk if it does occur Slide 59

60 Risk and risk management 3 Portfolio theory Used to reduce unsystematic risk by diversification Hedging Financial – use financial instruments Operational – real options Slide 60

61 Chapter 3a Conflicting stakeholder interests Stakeholders Corporate governance

62 Stakeholders 1 Separation of ownership and management: Ordinary (equity) shareholders are owners of the company, but the company is managed by its board of directors Central source of stakeholder conflict: Difference between the interests of managers and those of owners Slide 62

63 Stakeholders 2 Sources of stakeholder conflict Short-termism Sales objective (instead of shareholder value) Overpriced acquisitions Resistance to takeovers Relationships with stakeholders may be difficult Slide 63

64 Stakeholders 3 The transaction costs economics theory This postulates that the governance structure of a corporation is determined by transaction costs The transactions costs include search and information costs, bargaining costs and policing and enforcement costs Slide 64

65 Corporate governance 1 Agency theory Proposes that individual team members act in their own self- interest Individual well-being however depends on the well-being of other individuals and on the performance of the team Corporations are sets of contracts between principals (suppliers of finance) and agents (management) Slide65

66 Corporate governance 2 The agency problem Managers dont have significant shareholdings, what stops them under-performing and over-rewarding themselves? Goal congruence Accordance between the objectives of agents acting within an organisation and the objectives of the organisation as a whole Slide 66

67 Corporate governance 3 Management incentives may enhance congruence: Profit-related pay Rights to subscribe at reduced price Executive share-option plans However management may adopt creative accounting Sound corporate governance is another approach Slide 67

68 Corporate governance 4 UK Corporate Governance Code (formerly The Combined Code) Directors responsible for corporate governance Board of Directors Meet regularly Matters refer to board Division of responsibilities Committees – audit, nomination, remuneration Slide 68

69 Corporate governance 5 Executive directors Limits on service contracts Emoluments decided by remuneration committee and fully disclosed Non-executive directors Majority independent No business / financial links Dont participate in options Appointed for specified term Slide 69

70 Corporate governance 6 Auditors provide external assurance Financial reports link directors to shareholders and other users Accountability and audit Audit committee of non-executive directors Consider need for internal audit function Accounts contain corporate governance statement Directors review and report on internal controls Slide 70

71 Corporate governance 7 Annual general meeting 20 days notice Separate resolutions on separate issues All committees answer questions Slide 71

72 Corporate governance 8 The Higgs report stresses the importance of the board including a balance of executive and non-executive directors No individual or small group can dominate decision-making The report also lays down criteria for establishing the independence of non-executive directors Also stresses the need to separate the roles of Chairman and Chief Executive Slide 72

73 Corporate governance 9 International comparisons USA By means of Stock Exchange regulation, stringent reporting requirements, tightened by Sarbanes-Oxley The US system is based on control by legislation/regulation, more rules on directors duties than in UK Major creditors are often on boards Slide 73

74 Corporate governance 10 Europe By means of tax law Also two tier board system to protect shareholder interests In Germany, banks have longer term role, may have equity stake Separate supervisory board has workers and shareholders representatives Slide 74

75 Corporate governance 11 Japan Flexible approach to governance, low level of regulation All stakeholders collaborate Stock market is less open, more links with banks than in UK Policy boards (long-term) Functional boards (executive) Monocratic boards (symbolic) Slide 75

76 Corporate governance 12 Management culture Management culture comprises views on management and methods of doing business Multinationals may have particular problems imposing the parent companys culture overseas eg American practices in Europe Slide 76

77 Chapter 3b Ethical issues in financial management Ethical dimension Ethical aspects

78 Ethical dimension Ethical considerations are part of the non-financial objectives of an organisation They will tend to include: Employee and management welfare Welfare of society Responsibilities to customers and supplies Leadership in R & D Minimum standard of service provision Slide 78

79 Ethical aspects 1 Business ethics Human resource management Minimum wage, discrimination Marketing Social and cultural impact Market behaviour Dominant position, treatment of suppliers and customers Slide 79

80 Ethical aspects 2 Business ethics continued Product development Animal testing, sensitivity to culture of different countries and markets Slide 80

81 Chapter 3c Environmental issues Business practice Regulation

82 Business practice 1 Green issues and business practice Direct environmental impacts on business – eg: –Changes affecting costs or resource availability –Impact on demand –Effect on power balances between competitors in a market Indirect environmental impacts - eg: –Legislative change; pressure from customers or staff as a consequence of concern over environmental problems Slide 82

83 Business practice 2 Environmental reporting Many companies produce an external report for external stakeholders, covering: –How business activity impacts on environment –An environmental objective (eg use of 100% recyclable materials within x years) –The company's approach to achieving and monitoring these objectives –An assessment of its success towards achieving the objectives –An independent verification of claims made Slide 83

84 Business practice 3 Companys environmental policy May include reduction / management of risk to the business, motivating staff and enhancement of corporate reputation Sustainability Refers to the concept of balancing growth with environmental, social and economic concerns Slide 84

85 Business practice 4 Triple bottom line decision making Triple bottom line reporting A quantitative summary of a companys economic, environmental and social performance over the previous year Slide 85

86 Business practice 5 Triple bottom line proxy indicators Economic impact Gross operating surplus Dependence on imports Stimulus to domestic economy by purchasing locally produced goods and services Slide 86

87 Business practice 6 Triple bottom line proxy indicators continued Social impact Organisations tax contribution Employment Environmental impact Ecological footprint Emissions to soil, water and air Water and energy use Slide 87

88 Regulation 1 Carbon trading Allows companies which emit less than their allowance to sell the right to emit CO 2 to another company 1997 Kyoto Protocol to the UNFCCC Advised signatories to reduce total greenhouse gas emissions by 2012, compared to 1990 levels EU15 reduction target: 8% Slide 88

89 Regulation 2 UNFCCC United Nations Framework Convention on Climate Change agreements: To develop programmes to slow climate change To share technology and co-operate to reduce greenhouse gas emissions To develop a greenhouse gas inventory listing national sources and sinks Slide 89

90 Regulation 3 Environment agency Mission: to protect or enhance environment, so as to promote the objective of achieving sustainable development Slide 90

91 Regulation 4 Environmental audit An audit that seeks to assess the environmental impact of a company's policies The auditor will check whether the companys environmental policy: Satisfies key stakeholder criteria Meets legal requirements Complies with British Standards or other local regulations Slide 91

92 Chapter 4 Trading and planning in a multi-national environment Trade Institutions International financial markets Global financial stability Multinationals strategy Risk

93 Trade 1 International trade World output of goods / services increased if countries specialise in production of goods / services in which they have a comparative advantage And trade to obtain other goods and services Slide93

94 Trade 2 Comparative advantage Countries specialising in what they produce, even if they are less efficient (in absolute terms) in production of all types of good This is the comparative advantage justification of free trade, without protectionism or trade barriers Slide 94

95 Trade 3 Barriers to market entry Product differentiation barriers Absolute cost barriers Economy of scale barriers The level of fixed costs Legal / patent barriers Slide 95

96 Trade 4 Protectionist measures Tariffs or customs duties Import quotas Embargoes Hidden subsidies Import restrictions Restrictive bureaucratic procedures Currency devaluations Slide 96

97 Trade 5 Why protect trade? To combat imports of cheap goods To counter dumping Infant industries might need special treatment Declining industries might need special treatment Protection might reduce a trade deficit Slide 97

98 Trade 6 Whats wrong with trade protection? Mutually beneficial trade may be reduced There may be retaliation Economic growth prospects may be damaged Political ill-will may be created The EU combines a free trade area with a customs union (mobility of factors of production) Slide 98

99 Institutions 1 World Trade Organisation – aims Reduce existing barriers to free trade Eliminate discrimination in international trade (in eg tariffs and subsidies) Prevent growth of protection by getting member countries to consult with others first Act as a forum for assisting free trade, and offering a disputes settlement process Establish rules and guidelines to make world trade more predictable Slide 99

100 Institutions 2 International Monetary Fund – aims Promote international monetary co-operation, and establish code of conduct for international payments Provide financial support to countries with temporary balance of payments deficits Provide for orderly growth of international liquidity Slide 100

101 Institutions 3 World Bank (IBRD) Supplements private finance and lends money on a commercial basis for capital projects Usually direct to governments or government agencies Bank for International Settlements (BIS) The banker for central banks Promotes co-operation between central banks Provides facilities for international co-operation Slide 101

102 International financial markets 1 Globalisation of financial markets has contributed to financial instability Despite facilitating the transfer of funds to emerging markets Slide 102

103 International financial markets 2 European Monetary System (EMS) – purposes To stabilise exchange rates between member countries To promote economic convergence in Europe To develop European Economic and Monetary Union (EMU) Slide 103

104 International financial markets 3 Arguments for EMU Economic policy stability Facilitation of trade Lower interest rates Preservation of the Citys position Slide 104

105 International financial markets 4 Arguments against EMU Loss of national control over economic policy The need to compensate for weaker economies Confusion in transition to EMU Lower confidence arising from loss of national pride Slide 105

106 Global financial stability 1 The global debt crisis arose as governments in less developed countries took on levels of debt above their ability to finance Resolving the global debt crisis Restructure or rescheduled debt Economic reforms to improve balance of trade Lending governments write off some of the debts Convert some debt into equity Slide 106

107 Global financial stability 2 Negative impacts on multinational firms Deflationary policies damage profitability Devaluation of currency Reduction in imports by developing countries Increased reliance on host countries for funding Slide 107

108 Multinationals strategy 1 Strategic reasons for Foreign Direct Investment (FDI) Market seeking / raw material seeking Production efficiency / technology seeking Knowledge seeking Political safety seeking Economies of scale / financial economies Managerial and marketing expertise Differentiated products Slide 108

109 Multinationals strategy 2 Ways to establish an interest abroad Joint ventures – industrial co-operation (contractual) or joint-equity Licensing agreements Management contracts Subsidiary Branches Slide 109

110 Multinationals strategy 3 Management contracts: A firm agrees to sell management skills – sometimes used in combination with licensing Can serve as a means of obtaining funds from subsidiaries, where other remittance restrictions apply Many multinationals use a combination of methods for servicing international markets Slide 110

111 Multinationals strategy 4 Multinationals financial planning Multinational companies need to develop a financial planning framework This is to ensure that the strategic objectives and competitive advantages are realised It will include ways of raising capital and risks related to overseas operations and the repatriation of profits Slide 111

112 Multinationals strategy 5 Finance for overseas investment depends on: Local finance costs, and any available subsidies Tax systems of the countries (best group structure may be affected by tax systems) Any restrictions on dividend remittances Possible flexibility in repayments arising from the parent / subsidiary relationship Slide 112

113 Multinationals strategy 6 A company raising funds from local equity markets must comply with the listing requirements of the local exchange Blocked funds Multinationals can counter exchange controls by management charges or royalties Control systems Large and complex companies may be organised as a heterarchy, an organic structure with significant local control Slide 113

114 Risk 1 Factors in assessing political risk Government stability Political and business ethics Economic stability / inflation Degree of international indebtedness Financial infrastructure Level of import restrictions Slide 114

115 Risk 2 Factors in assessing political risk continued Remittance restrictions Assets seized Special taxes and regulations on overseas investors, or investment incentives Slide 115

116 Risk 3 Dealing with political risk Negotiations with host government Insurance (eg ECGD) Production strategies Contacts with customers Financial management – eg, borrowing funds locally Management structure, eg joint ventures Slide 116

117 Risk 4 Litigation risks Can generally be reduced by keeping abreast of changes, acting as a good corporate citizen and lobbying Cultural risks Should be taken into account when deciding where to sell abroad, and how much to centralise activities Slide 117

118 Risk 5 Agency issues Agency relationships exist between the CEOs of multinationals conglomerates (the principals) and The strategic business unit (SBU) managers that report to these CEOs The interests of the individual SBU managers may be incongruent not only with the interests of the CEOs But also with those of the other SBU managers Slide 118

119 Risk 6 Agency issues continued Each SBU manager may try to make sure his or her unit gets access to critical resources And Achieves the best performance at the expense of the performance of other SBUs and the whole organisation Slide 119

120 Risk 7 Solutions to agency problems in multinationals Multiple mechanisms may be needed, working in unison Examples: Board of directors: separate ratification and monitoring of managerial decisions from initiation to implementation Executive incentive systems can reduce agency costs and align the interests of managers and shareholders This can be done by making top executives pay contingent on the value they create for the shareholders Slide 120

121 Chapter 5 DCF and free cash flow NPVs Internal rate of return Free cash flow

122 NPVs 1 Net present value The sum of the discounted cash flows less the initial investment Decision criteria Invest in a project if its net present value is positive ie when NPV > 0 Do not invest in a project if its net present value is zero or negative, ie when NPV 0 Slide 122

123 NPVs 2 Real and nominal discount factors What nominal rate (i) should be used for discounting cash flows if the real rate is r and the rate of inflation h? The net effect of inflation on the NPV of a project will depend on three inflation rates: the rates for revenues, costs, and the discount factor Use the Fisher equation (given in exam) (l + i) = (1 + r)(1 + h) Slide 123

124 NPVs 3 The tax effect on NPV Corporate taxes Value added taxes Other local taxes Capital expenditure tax allowances Slide 124

125 NPVs 4 Capital rationing Capital rationing problem exists when there are insufficient funds to finance all available profitable projects Case 1 Fractional investment allowed: rank alternatives according to the ratio of NPV to initial investment or the benefit cost ratio Slide 125

126 NPVs 5 Capital rationing continued Case 2 Fractional investment not allowed A more systematic approach may be needed to find the NPV maximising combination of entire projects subject to the investment constraint This is provided by the mathematical technique of integer programming Slide 126

127 NPVs 6 Capital rationing continued The multi-period capital rationing problem can be formulated as an integer programming problem The Monte Carlo method Amounts to adopting a particular probability distribution for the uncertain (random) variables that affect the NPV Then using simulations to generate values of the random variables Slide 127

128 NPVs 7 Project Value at Risk The minimum amount by which the value of an investment or portfolio will fall over a given period of time at a given level of probability Slide 128

129 Internal rate of return 1 IRR The discount rate at which NPV equals zero The IRR calculation also produces the breakeven cost of capital and allows calculation of the margin of safety If the cash flows change signs then the IRR may not be unique: this is the multiple IRR problem With mutually exclusive projects, the decision depends not on the IRR but on the cost of capital being used Slide 129

130 Internal rate of return 2 A project will be selected as long as the IRR is not less than the cost of capital Slide 130

131 Internal rate of return 3 Modified internal rate of return (MIRR) The IRR which would result without the assumption that project proceeds are reinvested at the IRR rate Calculate present value of the return phase (the phase of the project with cash inflows) Calculate the present value of the investment (the phase with cash outflows) Slide 131

132 Internal rate of return 4 MIRR continued Calculate MIRR using the following formula: This formula is given in the exam Slide 132

133 Internal rate of return 5 Re-investment rate The NPV method assumes that cash flows can be reinvested at the cost of capital over the life of the project The IRR assumes that cash flows can be reinvested at the IRR over the life of the project The IRR assumption is unlikely to be valid and so the NPV method is likely to be superior The better reinvestment rate assumption will be the cost of capital used for the NPV method Slide 133

134 Internal rate of return 6 Decision criterion If MIRR is greater than the required rate of return: ACCEPT If MIRR is lower than the required rate of return: REJECT Slide 134

135 Free cash flow 1 Free cash flow (FCF) Free Cash Flow = Earnings before Interest and Taxes (EBIT) less Tax on EBIT plus Non cash charges (eg depreciation) less Capital expenditures less Net working capital increases plus Net working capital decreases plus Salvage value received Slide 135

136 Free cash flow 2 Forecasting FCF Constant growth FCF0 is the free cash flow at beginning n is the number of years Slide 136

137 Free cash flow 3 Forecasting FCF continued Differing growth rates Forecast each element of FCF separately using appropriate rate Forecasting dividend capacity Dividend capacity of a firm is measured by its free cash flow to equity (FCFE) Slide 137

138 Free cash flow 4 Direct method of calculating FCFE Net income (EBIT - net interest - tax paid) Add depreciation Less total net investment Add net debt issued Add net equity issued Slide 138

139 Free cash flow 5 Indirect method Free cash flow Less (net interest + net debt paid) Add Tax benefit from debt (net interest x tax rate) Slide 139

140 Free cash flow 6 Firm valuation using FCF Value of the firm is the sum of the discounted free cash flows over the appropriate time horizon Assuming constant growth, use the Gordon model: Slide 140

141 Free cash flow 7 Terminal values and company valuation Value of the firm is the present value over the forecast period + terminal value of cash flows beyond the forecast period Firm valuation using FCFE Calculate value of equity (present value of FCFE discounted at the cost of equity) Calculate value of debt Value = value of equity + value of debt Slide 141

142 Chapter 6 Application of option pricing decisions in investment decisions Option concepts Real options

143 Options concepts 1 Options An option is a contract that gives one party the option to enter into a transaction Either at a specific time or within a specific future period at a price that is agreed when the contract is made Slide 143

144 Options concepts 2 The buyer of a call option acquires the right, but not the obligation, to buy the underlying at a fixed price The buyer of a put option acquires the right, but not the obligation, to sell the underlying shares at a fixed price In the money option:intrinsic value is +ve At the money option:intrinsic value is zero Out of the money option:intrinsic value is –ve Slide 144

145 Options concepts 3 Determinants of options values The higher the exercise price, the lower the probability that the call will be in the money As the current price of the underlying asset goes up, the higher the probability that the call will be in the money Both a call and put will increase in price as the underlying asset becomes more volatile Slide 145

146 Options concepts 4 Determinants of options values continued Both calls and puts will benefit from increased time to expiration The higher the interest rate, the lower the present value of the exercise price Slide 146

147 Real options 1 Strategic options – known as real options – arising from a project can increase the project value They are ignored in standard DCF analysis, which computes a single present value Option to delay When a firm has exclusive rights to a project or product for a specific period, it can delay taking this up until a later date For a project not selected today on NPV or IRR grounds, the rights to the project can still have value Slide 147

148 Real options 2 Option to expand When firms invest in projects allowing further investments later Or entry into new markets, possibly making the NPV +ve The initial investment may be seen as the premium to acquire the option to expand Slide 148

149 Real options 3 Option to abandon If the firm has the option to cease a project during its life Abandonment is effectively the exercising of a put option The option to abandon is a special case of an option to redeploy Slide 149

150 Real options 4 Option to redeploy When company can use its productive assets for activities other than the original one The switch will happen if the PV of cash flows from the new activity will exceed costs of switching Black-Scholes valuation When applying Black-Scholes valuation techniques to real options Simulation methods are typically used to overcome the problem of estimating volatility Slide 150

151 Real options 5 Slide 151

152 Real options 6 Determinants of options values Exercise price (P e ) Price of underlying asset (P a ) Volatility of underlying asset (s) Time to expiration (t) Interest rate (r) Intrinsic and time value Slide 152

153 Chapter 7 Impact of financing and APV method Duration Credit risk Credit enhancement Modigliani and Miller Other theories APV approach

154 Duration 1 Duration (Macaulay duration) The weighted average length of time to the receipt of a bonds benefits (coupon and redemption value) The weights are the present values of the benefits involved Properties of duration Longer-dated bonds have longer durations Lower-coupon bonds will have longer durations Lower yields will give longer durations Slide 154

155 Duration 2 Calculating duration 1) PV of cash flows for each time period by the time period and add together 2) Add the PV of cash flows in each period together Divide the result of step 1 by the result of step 2 Modified duration = Macaulay duration/1 + gross redemption yield Modified duration shares the same properties as Macaulay duration Slide 155

156 Credit risk 1 Credit risk (or default risk) The risk for a lender that the borrower may default on interest payments and / or repayment of principal Credit risk for an individual loan or bond is measured by estimating: Probability of default – typically, using information on borrower and assigning a credit rating (eg Standard & Poors, Moodys, Fitch) Recovery rate – the fraction of face value of an obligation recoverable once the borrower has defaulted Slide 156

157 Credit risk 2 Credit migration is change in the credit rating after a bond is issued Slide 157

158 Credit risk 3 Determinants of cost of debt capital Credit rating of company Maturity of debt Risk-free rate at appropriate maturity Corporate tax rate Slide 158

159 Credit risk 4 Credit spread The premium required by an investor in a corporate bond to compensate for the credit risk of the bond Yield on corporate bond = risk free rate + credit spread Cost of debt capital = (1 – tax rate)(risk free rate – credit spread) Slide 159

160 Credit risk 5 Option pricing models to assess default risk The equity of a company can be seen as a call option on the assets of the company with an exercise price equal to the outstanding debt Expected losses are a put option on the assets of the firm with an exercise price equal to the value of the outstanding debt Slide 160

161 Credit risk 6 From the Black-Scholes formula, the probability of default depends on three factors: The debt / asset ratio The volatility of the company assets The maturity of debt Slide 161

162 Credit enhancement Internal credit enhancement Excess spread Over-collateralisation External credit enhancement Surety bonds Letters of credit Cash collateral accounts Slide 162

163 Modigliani and Miller 1 MM theory (no tax) The use of debt would only transfer more risk to the shareholders, therefore will not reduce the WACC MM theory (with tax) Debt actually saves tax (due to tax relief on interest payments) therefore firms should only use debt finance Slide 163

164 Modigliani and Miller 2 MM and cost of equity Slide 164

165 Modigliani and Miller 3 Limitations of MM theory Too risky in reality to have high levels of gearing Assumes perfect capital markets Does not consider bankruptcy risks, tax exhaustion, agency costs and increased borrowing costs as risk rises Slide 165

166 Other theories 1 Static trade-off theory A firm in a static position will adjust their gearing levels to achieve a target level of gearing Problems with financial distress costs Direct financial distress costs Legal and admin costs associated with bankruptcy Slide 166

167 Other theories 2 Indirect financial distress costs Higher cost of capital Loss of sales Downsizing High staff turnover Agency theory Optimal capital structure is where benefits of debt received by shareholders matches costs of debt imposed on the shareholders Slide 167

168 Other theories 3 Pecking order theory Unlike the MM models, it based on the idea of information asymmetry: Investors have a lower level of information about the company than its directors do Shareholders use directors' actions as a signal to what directors believe about the company with their superior information Slide 168

169 Other theories 4 Predictions To finance new investment, firms prefer internal finance to external finance If retained earnings differ from investment outlays, the firm adjusts its cash balances or marketable securities first Before either taking on more debt or increasing its target payout rate Slide 169

170 Other theories 5 Predictions continued Internal finance is at the top, and equity is at the bottom, of the pecking order A single optimal debt equity ratio does not exist: a result similar to the MM model with no taxes Slide 170

171 APV approach 1 Adjusted present value (APV) approach The adjusted present value (APV) method of valuation is based on the Modigliani Miller model with taxation It assumes that the primary benefit of borrowing is the tax benefit And that the most significant cost of borrowing is the added risk of bankruptcy Slide 171

172 APV approach 2 Steps in applying APV Calculate the NPV as if the project was financed entirely by equity (use k e ) Add the PV of the tax saved as a result of the debt used to finance the project (use k d ) Subtract the cost of issuing new finance Slide 172

173 Chapter 8 International investment decisions NPV and international projects Exchange controls Exchange rate risks Capital structure

174 NPV and international projects 1 Purchasing power parity Absolute purchasing parity theory: Prices of products in different countries will be the same when expressed in the same currency Alternative purchasing power parity relationship: Changes in exchange rates are due to differences in the expected inflation rates between countries Slide 174

175 NPV and international investment 2 International Fisher effect This equation is given in the exam With no trade or capital flows restrictions, real interest rates in different countries will be expected to be the same Differences in interest rates reflect differences in inflation rates Slide 175

176 NPV and international investment 3 NPVs for international projects Alternative methods for calculating the NPV from an overseas project: Convert project cash flows into sterling and discount at sterling discount rate to calculate NPV in sterling terms OR Discount cash flows in host country's currency from project at adjusted discount rate for that currency Then convert resulting NPV at spot exchange rate Slide 176

177 NPV and international investment 4 Effect of exchange rates on NPV When there is a devaluation of sterling relative to a foreign currency, the sterling value of cash flows and NPV increase The opposite happens when the domestic currency appreciates Slide 177

178 NPV and international investment 5 Effect on exports A multinational company sets up a subsidiary in another country in which it already exports The relevant cash flows for evaluation of the project should account for loss of export earnings in the particular country Impact of transaction costs Transaction costs are incurred when companies invest abroad due to currency conversion or other administrative expenses These should also be taken into account Slide 178

179 NPV and international projects 6 Taxes in international context Host country Corporate taxes Investment allowances Withholding taxes Home country Double taxation relief Foreign tax credits Slide 179

180 NPV and international projects 7 Tax haven characteristics Low tax on foreign investment or sales income earned by resident companies Low withholding tax on dividends paid to the parent Stable government and currency Adequate financial services support facilities Slide 180

181 NPV and international projects 8 Subsidies The benefit from concessionary loans should be included in the NPV calculation as: The difference between repayment of borrowing under market conditions and repayment under the concessionary loan Slide 181

182 Exchange controls 1 Exchange controls – types Rationing supply of foreign exchange Payments abroad in foreign currency are restricted, preventing firms from buying as much as they want from abroad Restricting types of transaction for which Payments abroad are allowed, eg suspending or banning payment of dividends to foreign shareholders Eg parent companies in multinationals: blocked funds problem Slide 182

183 Exchange controls 2 For an overseas project, only the proportion of cash flows that are expected to be repatriated in the NPV calculation Slide 183

184 Exchange controls 3 Strategies Multinational company strategies to overcome exchange controls: Transfer pricing Where the parent company sells goods or services to the subsidiary and obtains payment Royalty payments adjustments When a parent company grants a subsidiary the right to make goods protected by patents Slide 184

185 Exchange controls 4 Loans by the parent company to the subsidiary: Setting interest rate at appropriate level Management charges Levied by the parent company for costs incurred in the management of international operations Slide 185

186 Exchange rate risks 1 Transaction exposure The risk of adverse exchange rate movements between the date the price is agreed and the date cash is received/paid Arising during normal international trade Slide 186

187 Exchange rate risks 2 Translation exposure Risk that organisation will make exchange losses when accounting results of foreign branches/subsidiaries are translated Translation losses can arise from restating the book value of a foreign subsidiarys assets at: –The exchange rate on the statement of financial position date – only important if changes arise from loss of economic value Slide 187

188 Exchange rate risks 3 Economic exposure The risk that the present value of a companys future cash flows might be reduced by adverse exchange rate movements Can be longer-term (continuous currency depreciation) Can arise even without trade overseas (effects of pound strengthening) Slide 188

189 Capital structure 1 Capital structure of a MNC Special factors Global taxation Exchange risk Political risk Business risk Slide 189

190 Capital structure 2 International borrowing options Borrow in the same currency as the inflows from the project Borrow in a currency other than the currency of the inflows, with a hedge in place Borrow in a currency other than the currency of the inflows, without hedging the currency risk This option exposes the company to exchange rate risk which can substantially change the profitability of a project Slide 190

191 Capital structure 3 Advantages of international borrowing Availability Many smaller domestic financial markets might lack the depth and liquidity to accommodate large or long-maturity debt issues Lower cost of borrowing in Eurobond markets Interest rates are normally lower than borrowing rates in national markets Slide 191

192 Capital structure 4 Advantages of international borrowing continued Lower issue costs Cost of debt issuance is normally lower than the cost of debt issue in domestic markets Slide 192

193 Chapter 9 Acquisitions and mergers vs growth Acquisitions and mergers Shareholder value issues

194 Acquisitions and mergers 1 Mergers and acquisitions - reasons Operating economies Management of acquisition Diversification Asset backing Earnings quality Slide 194

195 Acquisitions and mergers 2 Mergers and acquisitions - reasons continued Finance / liquidity Internal expansion costs Tax Defensive merger Economic efficiency Slide 195

196 Acquisitions and mergers 3 Factors in a takeover Cost of acquisition Form of purchase consideration Reaction of predators shareholders Accounting implications Reaction of targets shareholders Future policy (eg dividends, staff) Slide 196

197 Acquisitions and mergers 4 Vertical merger – backward merger With supplier – aim to control supply chain Vertical merger – forward merger With customer / distributor – aim to control distribution Horizontal merger The two merging firms produce similar products in the same industry – aim to increase market power Conglomerate merger Two firms in different industries – aim of diversification Slide 197

198 Acquisitions and mergers 5 Takeover strategy – what to acquire Growth prospects limited – younger company with higher growth rate Potential to sell other products to existing customers – company with complementary product Operating at maximum capacity – company making similar products operating below capacity Under-utilising management – company needing better management Slide 198

199 Acquisitions and mergers 6 Takeover strategy – what to acquire continued Greater control over supplies or customers – company giving access to customer / supplier Lacking key clients in targeted sector – company with right customer profile Improve balance sheet – company enhancing EPS Increase market share – important competitor Widen capability – key talents and / or technology Slide 199

200 Shareholder value issues 1 Failures to enhance shareholder value Why do many acquisitions fail to enhance shareholder value? Agency theory: Takeovers may be motivated by self- interested acquirer management wanting: –Diversification of management's own portfolio –Use of free cash flow to increase size of the firm –Acquisitions that increase firm's dependence on management –Value is transferred from shareholders to managers of acquiring firm Slide 200

201 Shareholder value issues 2 Hubris hypothesis Bidding company bids too much because managers of acquiring firms suffer from hubris, excessive pride and arrogance Market irrationality argument When a companys shares seem overvalued, management may exchange them for an acquiree firm ie merger The lack of synergies or better management may lead to a failing merger Slide 201

202 Shareholder value issues 3 Pre-emptive theory Several firms may compete for opportunity to merge with target to achieve cost savings Winning firm could improve market position and gain market share It can be rational for the first firm to pre-empt a merger with its own takeover attempt Window dressing Where companies are acquired to present a better short term financial picture Slide 202

203 Shareholder value issues 4 Synergy – Revenue synergy Acquisition will result in higher revenues, higher return on equity or longer period of growth for the acquiring company Revenue synergies arise from: (a)Increased market power (b)Marketing synergies (c)Strategic synergies Slide 203

204 Shareholder value issues 5 Synergy – cost synergy Results from economies of scale As scale increases, marginal cost falls leading to greater operating margins for the combined entity Sources of financial synergy Diversification Use of cash slack Tax benefits Debt capacity Slide 204

205 Shareholder value issues 6 Possible reasons for high failure rate of acquisitions Agency theory Valuation errors Market irrationality Pre-emptive theory Window dressing Slide 205

206 Chapter 10 Valuations for acquisitions and mergers Valuation issues Type I Type II Type III High-growth start-ups Intangible assets

207 Valuation issues 1 The over-valuation problem Paying more than the current market value, to acquire a company During an acquisition, there is typically a fall in the price of the bidder and an increase in the price of the target Overvaluation may arise as miscalculation of potential synergies or Overestimation of ability of acquiring firm's management to improve performance Both lead to a higher price than current market value

208 Valuation issues 2 Estimating earnings growth Gordon constant growth model: Slide 208

209 Valuation issues 3 Three ways to estimate g: Historical estimates: extrapolate past values Rely on analysts forecasts Use the companys return on equity and retention rate of earnings (g = ROE x retention rate) Slide 209

210 Valuation issues 4 Business risk of combined entity The risk associated with the unique circumstances of the combined company Affected by the betas of the individual entities (target and predator) and the beta of the resulting synergy Asset beta The weighted average of the betas of the target, predator and synergy of the combined entity Slide 210

211 Valuation issues 4 Geared equity beta Calculate value of debt (net of tax) Divide by value of equity Multiply the above by difference between beta of combined entity and beta of debt Add the above to the beta of the combined entity Slide 211

212 Valuation issues 5 Acquisitions and acquirers risk Acquisition type I – does not affect financial risk or business risk Acquisition type II – does affect financial risk but does not affect business risk Acquisition type III – affects both financial risk and business risk Slide 212

213 Type I 1 Type 1 valuations Methods of value company: (1)Book value-plus models (2)Market-relative models (3)Cash flow models, including EVA TM, MVA Slide 213

214 Type I 2 Book value-plus models Use statement of financial position as starting point Total Asset Value less Long-term and short-term payables = Company's Net Asset Value Book value of net assets is also 'equity shareholders' funds': the owners' stake in the company Slide 214

215 Type I 3 Market-relative models (P/E ratio) P/E ratio = Market value/EPS Market value = P/E ratio x EPS Decide suitable P/E ratio and multiply by EPS: an earnings- based valuation EPS could be historical EPS or prospective future EPS For a given EPS, a higher P/E ratio will result in a higher price Slide 215

216 Type I 4 High P/E ratio may indicate: Optimistic expectations Security of earnings Status Slide 216

217 Type 1 5 Q ratio The market value of company assets (MV) divided by replacement cost of the assets (RC) Q = MV/RC Equity version of Q: –Qe = MV – Market value of debt/RC – Total debt Slide 217

218 Type 1 6 Q ratio continued Points to note RC of capital is difficult to estimate so is proxied by the book value of capital The equity Q ie Q e is approximated as: Q e = Market value of equity/Equity capital If Q <1, management has destroyed the value of contributed capital: firm is vulnerable to takeover If Q >1, management has increased the value of contributed capital Slide 218

219 Type 1 7 Free cash flow model Step 1 Calculate Free Cash Flow (FCF) FCF = Earnings before interest and tax (EBIT) Less: Tax on EBIT Plus: Non-cash charges Less: Capital expenditures Slide 219

220 Type I 8 Free cash flow model continued Less: Net working capital increases Plus: Salvage values received Plus: Net working capital decreases Step 2 Forecast FCF and Terminal Value Slide 220

221 Type 1 9 Step 3 Calculate from cost of equity (K e ) and cost of debt (K d ) where T is the tax rate V d is the value of the debt V e is the value of equity Slide 221

222 Type I 10 Step 4 Discount free cash flow at WACC to obtain value of firm Step 5 Calculate equity value Equity Value = Value of the firm – Value of debt Slide 222

223 Type I 11 EVA approach EVA = NOPAT – (WACC x Capital Employed) Or, EVA = (ROIC – WACC) x Capital Employed where NOPAT = Net Operating Profits After Taxes ROIC= Return on Invested Capital WACC = Weighted average cost of capital Slide 223

224 Type I 12 EVA approach continued Value of firm = Value of invested capital + sum of discounted EVA Subtract value of debt from value of company to get value of equity Slide 224

225 Type I 13 Market value added (MVA) approach Shows how much management has added to the value of capital contributed by the capital providers MVA = Market Value of Debt + Market Value of Equity – Book Value of Equity MVA related to EVA: MVA is simply PV of future EVAs of the company If market value and book value of debt are the same, MVA is the difference between market value of common stock and equity capital of the firm Slide 225

226 Type II 1 Type II valuations – adjusted present value (APV) Acquisition is valued by discounting Free Cash Flows by ungeared cost of equity, then adding PV of tax shield APV = – Initial Investment + Value of acquired company if all-equity financed + PV of Debt Tax Shields If APV is +ve, acquisition should be undertaken Slide 226

227 Type II 2 APV calculation Step 1 –Forecast FCF (as previously) Step 2 –Forecast FCFs and Terminal Value Step 3 –Ungeared beta of firm is calculated from geared beta: Slide 227

228 Type II 3 Step 4 –Discount cash flow at ungeared cost of equity to obtain NPV of ungeared firm or project Step 5 –Calculate interest tax shields Step 6 –Discount interest tax shields at pre-tax cost of debt to obtain PV of interest tax shields Slide 228

229 Type II 4 Step 7 APV = NPV of ungeared firm or project Plus PV interest tax shields Plus excess cash and marketable securities Less market value of contingent liabilities = Market value of the firm Less: Market value of debt = MARKET VALUE OF EQUITY Slide 229

230 Type III 1 Type III iterative valuations Estimate value of acquiring company before acquisition Estimate value of acquired company before acquisition Estimate value of synergies Estimate beta coefficients for equity of acquiring and acquired company, using CAPM Estimate asset beta for each company Slide 230

231 Type III 2 Type III iterative valuations continued Calculate asset beta for combined entity Calculate geared beta of the combined firm Calculate WACC for combined entity Use WACC derived above to discount cash flows of combined entity post-acquisition Value of equity: difference between the value of the firm and the value of debt Slide 231

232 Type III 3 A problem with WACC If WACC weights are not consistent with the values derived, the valuation is internally inconsistent Then, we use an iterative procedure: –Go back and re-compute the beta using a revised set of weights closer to the weights derived from the valuation –The process is repeated until assumed weights and weights calculated are approximately equal Slide 232

233 High-growth start-ups 1 Valuation of high-growth start-ups Typical characteristics of start-ups: Few revenues, untested products, unknown product demand, high development / infrastructure costs Slide 233

234 High-growth start-ups 2 Steps in valuation Identify drivers eg market potential, resources of the business, management team Period of projection – needs to be long-term Slide 234

235 High-growth start-ups 3 Steps in valuation continued Forecasting growth Growth in earnings (g) = b x ROIC For most high growth start-ups, b = 1 and sole determinant of growth is the return on invested capital (ROIC) This is estimated from industry projections or evaluation of management, marketing strengths, and investment Slide 235

236 High-growth start-ups 4 Valuation methods Asset-based method not appropriate: Most investment of a start-up is in people, marketing and / or intellectual rights These are treated as expenses rather than capital Market-based methods also present problems: Difficult to find comparable companies; usually no earnings to calculate PE ratios (but price-to-revenue ratios may help) Slide 236

237 High-growth start-ups 6 Slide 237

238 Intangible assets 1 Intangible assets Differ from tangible assets as they do not have physical substance Examples of intangible assets Goodwill Brands Patents Customer loyalty Research and development Slide 238

239 Intangible assets 2 Market-to-book value Measures intangible assets as the difference between book value of tangible assets and market value of the firm Tobins q = Market value of firm/Replacement cost of assets Used to compare intangible assets of firms in same industry serving the same markets and with similar tangible non- current assets Slide 239

240 Intangible assets 3 Calculated intangible values (CIV) - calculates an excess return on tangible assets This is used to determine the proportion of return attributable to intangible assets Levs knowledge earnings method separates earnings deemed to come from intangible assets, which are then capitalised Slide 240

241 Intangible assets 4 Methods of valuing intangible assets Relief from royalties Premium profits Capitalisation of earnings Comparison with market transactions Slide 241

242 Intangible assets 5 Valuing product patents as options Identify value of underlying asset (based on expected cash flows) Identify standard deviation of cash flows Identify exercise price of the option Identify expiry date of the option Identify cost of delay (the greater the delay, the lower the value of cash flows) Slide 242

243 Chapter 11 Regulatory framework and processes Global issues UK and EU regulation Defensive tactics

244 Global issues 1 Agency problem The issues arising from the separation of ownership and control have potential impact on mergers and acquisitions Potential conflicts of interest Protection of minority shareholders Transfers of control may turn existing majority shareholders of the target into minority shareholders Target company management measures to prevent the takeover, which could run against stakeholder interests Slide 244

245 Global issues 2 Takeover regulation Protect the interests of minority shareholders and other stakeholders, and Ensure a well-functioning market for corporate control Slide 245

246 Global issues 3 Two models of regulation UK / US / Commonwealth countries Market-based model – case law-based, promotes protection of shareholder rights especially Continental Europe Block-holder' or stakeholder system – codified or civil law based Seeking to protect a broader group of stakeholders: creditors, employees, national interest Slide 246

247 UK and EU regulation 1 UK takeover regulation Mergers and acquisitions in the UK subject to: City Code Companies Acts 1985 and 2006 Financial Services and Markets Act 2000 Criminal Justice Act 1993 (insider dealing provisions) Slide 247

248 UK and EU regulation 2 City Code The City Code on Takeovers and Mergers: –Originally voluntary code for takeovers / mergers of UK companies –Now has statutory basis, in line with EU Takeover Directive –Administered by the Takeover Panel Slide 248

249 UK and EU regulation 3 City Code principles All offerees shareholders treated similarly Information available to all shareholders Shareholders given sufficient information / advice Shareholders given time to make decision Directors not to frustrate takeover No oppression of minorities Offer to all shareholders when control (30%) acquired Slide 249

250 UK and EU regulation 4 Competition Commission Office of Fair Trading thinks a merger may be against the public interest, it can refer to the Competition Commission The CC can accept or reject proposal, or lay down certain conditions, if competition substantially reduced Substantial lessening of competition tests: Turnover test (£70m min. for investigation by CC) Share of supply test (25%) Slide 250

251 UK and EU regulation 5 European Union Mergers will fall within jurisdiction of the EU (which will evaluate it, like the CC in UK) where, following the merger: (a)Worldwide turnover of more than 5bn per annum (b)EU turnover of more than 250m per annum Slide 251

252 UK and EU regulation 6 EU Takeovers Directive Effective from May 2006 – to converge market based and stakeholder systems Takeovers Directive principles Mandatory-bid rule: required at 30% holding, in UK Equal treatment of shareholders Squeeze-out rule and sell-out rights: in UK, 90% shareholder buys all shares Slide 252

253 UK and EU regulation 7 EU Takeovers Directive continued Principle of board neutrality Break-through rule: bidder able to set aside multiple voting rights (but countries can opt out of this) Slide 253

254 UK and EU regulation 8 Bid timetable summary Talks (optional) Announcement of offer then 28 days until Last date for posting of offer document = D day Last date for posting of offeree board circular – D day + 14 First closing date – D day + 21 Last date for announcements by offeree – D day + 39 Slide 254

255 UK and EU regulation 9 Bid timetable summary continued Earliest date for withdrawal of acceptances by shareholders – D day + 42 Last date for revision of offer – D day + 46 Last day an offer can be declared unconditional as to acceptances – D day + 60 Slide 255

256 UK and EU regulation 10 Consequence of share stake levels Any - company may enquire on ultimate ownership under s793 CA % - beneficial interests must be disclosed to company – Disclosure and Transparency Rules 10% - Shareholders controlling 10%+ of voting rights may requisition company to serve s793 notices Notifiable interests rules become operative for institutional investors and non-beneficial stakes Slide 256

257 UK and EU regulation 11 Consequence of share stake levels continued 30% - City Code definition of effective control. Takeover offer becomes compulsory 50% - CA 1985 definition of control (At this level, holder can pass ordinary resolutions) Point at which full offer can be declared unconditional with regard to acceptances Slide 257

258 UK and EU regulation 12 Consequence of share stake levels continued 75% - Major control boundary: holder able to pass special resolutions 90% - Minorities may be able to force majority to buy out their stake Equally, majority may be able to require minority to sell out Slide 258

259 Defensive tactics 1 Golden parachutes Compensation payments made to eliminated top-management of target firm Poison pill Attempt to make firm unattractive to takeover, eg by giving existing shareholders right to buy shares cheap White knights and white squires Inviting a firm that would rescue the target from an unwanted bidder. A white squire does not take control of the target Slide 259

260 Defensive tactics 2 Crown jewels Selling firms valuable assets or arranging sale and leaseback, to make firm less attractive as target Pacman defence Mounting a counter-bid for the attacker Litigation or regulatory defence Inviting investigation by regulatory authorities or Courts Slide 260

261 Chapter 12 Financing mergers and acquisitions Financing methods Effect of offer

262 Financing methods 1 Methods of financing mergers Payment can be in the form of: –Cash –Share exchange –Convertible loan stock Slide 262

263 Financing methods 2 Methods of financing mergers continued The choice will depend on: –Available cash –Desired levels of gearing –Shareholders' tax position –Changes in control Slide 263

264 Financing methods 3 Funding cash offers Methods of financing a cash offer: –Retained earnings – common when a firm acquires a smaller firm –Sale of assets –Issue of shares, using cash to buy target firms shares Slide 264

265 Funding methods 4 Funding cash offers continued –Debt issue – but, issuing bonds will alert the market to the intentions of the company to bid for another company –This may lead investors to buy shares of potential targets, raising their prices –Bank loan facility – a possible short-term strategy, until bid is accepted: then the company can make a bond issue –Mezzanine finance – may be the only route for companies without access to bond markets Slide 265

266 Funding methods 5 Use of convertible loan stock Problems with using debentures, loan stock, preference shares: –Establishing a rate of return attractive to target shareholders –Effects on the gearing of acquiring company –Change in structure of target shareholders' portfolios –Securities potentially less marketable, possibly lacking voting rights Slide 266

267 Funding methods 6 Convertible loan stock can overcome some such problems Offers target shareholders the opportunity to gain from future profits of company Slide 267

268 Funding methods 7 Mezzanine finance With cash purchase option for target company's shareholders, bidding company may arrange mezzanine finance Short-to-medium term Unsecured ('junior' debt) At higher rate of interest than secured debt (eg LIBOR + 4% to 5%) Often, giving lender option to exchange loan for shares after the takeover Slide 268

269 Funding methods 8 Cash or paper? – Company and existing shareholders Dilution of EPS May be a fall in EPS attributable to existing shareholders if purchase consideration is in equity shares Cost to the company Loan stock to back cash offer, tax relief on interest, lower cost than equity. May be lower coupon if convertible Gearing Highly geared company may not be able to issue further loan stock for cash offer Slide 269

270 Funding methods 9 Cash or paper? – Company and existing shareholders Control Major share issue could change control Authorised share capital increase May be required if consideration is shares; requires General Meeting resolution Borrowing limits increase General Meeting resolution required if borrowing limits need to change Slide 270

271 Funding methods 10 Cash or paper? – Shareholders in target company Taxation If consideration is cash, many investors may suffer CGT Income If consideration is not cash, arrangement must mean existing income is maintained Or be compensated by suitable capital gain or reasonable growth expectations Slide 271

272 Funding method 11 Cash or paper? – Shareholders in target company Future investments Shareholders who want to retain stake in target business may prefer shares Share price If consideration is shares, recipients will want to be sure that shares retain their values Slide 272

273 Effects of offer 1 EPS before and after a takeover If a company acquires another by issuing shares Then its EPS will go up or down according to the P/E ratio at which target company was bought If target company's shares bought at higher P/E ratio than predator company's shares, predator company's shareholders suffer fall in EPS If target company's shares valued at a lower P/E ratio, the predator company's shareholders benefit from rise in EPS Slide 273

274 Effects of offer 2 Buying companies with a higher P/E ratio will result in a fall in EPS unless there is profit growth to offset this fall Dilution of earnings may be acceptable if there is: –Earnings growth –Superior quality of earnings acquired –Increase in net asset backing Slide 274

275 Effects of offer 3 Post-acquisition integration A clear programme should be in place, re-defining objectives and strategy The approach adopted will depend on: The culture of the organisation The nature of the company acquired, and How it fits into the amalgamated organisation eg horizontally, vertically, or in diversified conglomerate? Slide 275

276 Chapters Reconstruction and reorganisation Financial reconstruction Divestment and other changes MBOs and buy-ins Firm value

277 Financial reconstruction 1 Capital reconstruction scheme A scheme where a company re-organises its capital structure, often to avoid liquidation Slide 277

278 Financial reconstruction 2 Steps in a capital reconstruction Estimate position of each party if liquidation is to go ahead Assess additional sources of finance Design reconstruction Calculate and assess new position, and compare for each party with first step Check company is financially viable A scheme of reconstruction needs to treat all parties fairly and offer creditors a better deal than liquidation Slide 278

279 Financial reconstruction 3 Providers of finance will need to be convinced that the return is attractive Company must therefore prepare cash / profit forecasts Creation of new share capital at different nominal value Cancellation of existing share capital Conversion of debt or equity Slide 279

280 Financial reconstruction 4 Leveraged recapitalisation A firm replaces most of its equity with a package of debt securities consisting of both senior and subordinated debt Used to discourage corporate raiders not able to borrow against assets of the target firm to finance the acquisition To avoid financial distress from a high debt level, the company should have stable cash flows Company should not require substantial ongoing capital expenditure to retain their competitive position Slide 280

281 Financial reconstruction 5 Leveraged buyouts A group of private investors uses debt financing to purchase a company or part of it The company increases its level of leverage but no longer has access to equity markets A higher level of debt will increase the companys geared beta; a lower level of debt will reduce it Slide 281

282 Financial reconstruction 6 Debt equity swaps In an equity / debt swap, shareholders are given the right to exchange stock for a predetermined amount of debt In a debt / equity swap, debt is exchanged for a predetermined amount of stock After the swap takes place, the preceding asset class is cancelled for the newly acquired asset class Slide 282

283 Financial reconstruction 7 Debt equity swaps continued Debt-equity swaps may occur because the company must meet certain contractual obligations A typical example is maintaining a debt / equity ratio below a certain number A company may issue equity to avoid making coupon and face value payments in the future Slide 283

284 Divestment and other changes 1 Demerger The splitting up of a corporate body into two or more separate bodies To ensure share prices reflect the true value of underlying operations Disadvantages of demergers Loss of economies of scale Ability to raise extra finance reduced Vulnerability to takeover increased Slide 284

285 Divestment and other changes 2 Sell-off The sale of part of a company to a third party, generally for cash Slide 285

286 Divestment and other changes 3 Reasons for sell-offs Strategic restructuring Sell off loss-making part Protect rest of business from takeover Cash shortage Reduction of business risk Sale at profit A divestment is a partial or complete reduction in ownership stake in an organisation Slide 286

287 Divestment and other changes 4 Spin-offs and carve-outs Spin-off A new company is created whose shares are owned by the shareholders of original company There is no change in asset ownership, but management may change In a carve-out, part of the firm is detached and a new companys shares are offered to the public Slide 287

288 Divestment and other changes 5 Advantages of spin-offs to investors Merger / takeover of only part of a business made easier Improved efficiency / management Easier to see value of separate parts Investors can adjust shareholdings Slide 288

289 Divestment and other changes 6 Going private When a group of investors buys all the companys shares The company ceases to be listed on a stock exchange Advantages of going private to company Costs of meeting listing requirements saved Company protected from volatility in share prices Company less vulnerable to hostile takeover bids Management can concentrate on long-term business Slide 289

290 MBOs and buy-ins 1 Management buy-outs The purchase of all or part of a business by its managers The managers generally need financial backers (venture capital) who will want an equity stake Venture capital Venture capitalists are often prepared to fund MBOs They typically require shareholding, right to appoint some directors and right of veto on certain business decisions Slide 290

291 MBOs and buy-ins 2 Reasons for company agreeing to MBO are similar to those for sell-off, also: When best offer price available is from MBO When group has decided to sell subsidiary, best way of maximising management co-operation Sale can be arranged quickly Selling organisation more likely to retain beneficial links with sold segment Slide 291

292 MBOs and buy-ins 3 Evaluation of MBOs by investors Management skills of team Reasons why company is being sold Projected profits, cash flows and risks Shares / selected assets being bought Price right? Financial contribution by management team Exit routes (flotation, share repurchase) Slide 292

293 MBOs and buy-ins 4 Performance of MBOs Management-owned companies typically achieve better performance Possible reasons: Favourable price Personal motivation Quicker decision-making / flexibility Savings on overheads Slide 293

294 MBOs and buy-ins 5 Problems with MBOs Lack of financial experience Tax and legal complications Changing work practices Inadequate cash flow Board representation by finance suppliers Loss of employees / suppliers / customers Slide 294

295 MBOs and buy-ins 6 Buy-ins When a team of outside managers mount a takeover bid and then run the business themselves Buy-ins often occur when a business is in trouble or shareholder / managers wish to retire Finance sources are similar to buy-outs They work best if management quality improves, but external managers may face opposition from employees Slide 295

296 Firm value 1 Unbundling and firm value Unbundling affects the value of the firm through changes in return on assets and the asset beta When firms divest themselves of existing investments, they affect the expected return on assets (ROA) This is due to the fact that good projects increase ROA and bad projects reduce it Investment decisions taken by firms affect their riskiness and therefore the asset beta β a Slide 296

297 Firm value 2 Growth rate following a restructuring: ROA is the return on the net assets of the company b is the retention rate D is the book value of debt E is the book value of equity i is the cost of debt T is the corporate tax rate Slide 297

298 Chapters 15 The treasury function in multinationals Markets Instruments The Greeks

299 Markets 1 Financial markets Direct / Indirect finance from lenders / savers: –Households –Firms –Government –Overseas –Invested in financial markets and financial intermediaries eg banks Slide 299

300 Markets 2 Funds from financial markets and financial intermediaries eventually reach borrowers / spenders: –Firms –Governments –Households –Overseas Slide 300

301 Markets 3 Capital markets In which the securities that are traded have long maturities, ie represent long-term obligations for the issuer Securities that trade in capital markets include shares and bonds Primary market: a financial market in which new issues are sold by issuers to initial buyers Secondary market: a market in which securities that have already been issued can be bought and sold Slide 301

302 Markets 4 Secondary markets can be organised as exchanges or over the counter (OTC) Where buyers and sellers transact with each other through individual negotiation Securities that are issued in an over the counter market and can be resold are negotiable securities Money markets Securities traded have short maturities, less than a year, and repayment of funds borrowed is required within a short period of time Slide 302

303 Instruments 1 Coupon bearing instruments Money Market Deposits Very short-term loans between institutions, including governments Either fixed – with agreed interest and maturity dates, or call deposits – with variable interest and deposit Can be terminated on notice Slide 303

304 Instruments 2 Coupon bearing instruments continued Certificate of Deposit (CD) Either negotiable or non-negotiable certificate of receipt for funds deposited at an financial institution For a specified term and paying interest at a specified rate Slide 304

305 Instruments 3 Coupon bearing instruments continued Repurchase Agreement (repo) Loan secured by a marketable instrument, usually a Treasury Bill or a bond Typical term: days Counterparty sells on agreed date and simultaneously agrees to buy back instrument later for agreed price Slide 305

306 Instruments 4 Discount instruments Treasury Bill (T-bill) Debt instruments issued by central governments with maturities ranging from one month up to one year Bankers Acceptances Negotiable bills issued by firms to finance transactions such as imports or purchase of goods Guaranteed (accepted) by a bank, for a fee Slide 306

307 Instruments 5 Discount instruments continued Commercial Paper (CP) Short-term unsecured corporate debt with maturity up to 270 days but typically about 30 days Used by corporations with good credit ratings to finance short term expenditure Slide 307

308 Instruments 6 Derivatives Forward rate agreement (FRA) Cash settled OTC forward contract on a short term loan Futures contract Standardised agreement to buy / sell asset at set date and price Interest rate future: underlying is debt security, or based on interbank deposit Slide 308

309 Instruments 7 Derivatives continued Interest rate swap Two parties exchange payments stream at one interest rate for stream at a different rate Interest rate option An instrument sold by option writer to option holder, for a price known as a premium Slide 309

310 The Greeks 1 Delta – change in call option price / change in value of share Gamma – change in delta value / change in value of share Theta – change in option price over time Rho – change in option price as interest rates change Vega – change in option price as volatility changes Delta hedging Determines number of shares required to create the equivalent portfolio to an option, and hence hedge it Slide 310

311 The Greeks 2 Gamma Higher for share which is close to expiry and 'at the money +ve gamma means that a position benefits from movement -ve theta means the position loses money if the underlying asset price does not move Vega Change in value of an option (call or put) resulting from a 1% point change in its volatility Slide 311

312 Chapters 16 Hedging forex risk FX markets Money market hedging Futures Swaps Options

313 FX markets 1 Exchange rates An exchange rate is the price of one currency expressed in another currency The spot rate at time t 0 is the price for delivery at t 0 A forward rate at t 0 is a rate for delivery at time t 1 This is different from whatever the new spot rate turns out to be at t 1 Slide 313

314 FX markets 2 Term and base currencies If a currency is quoted as say £/$1.50, the $ is the term (or reference) currency, the £ is the base currency Bank sells LOW buys HIGH For example, if UK bank is buying and selling dollars, selling (offer) price may be £/$1.50, buying (bid) price may be £/$1.53 Slide 314

315 FX markets 3 Direct quote is amount of domestic currency equal to one foreign currency unit Indirect quote is amount of foreign currency equal to one domestic unit Slide 315

316 FX markets 4 Forward exchange contracts A firm and binding contract between a bank and its customer For the purchase / sale of a specified quantity of a stated foreign currency At a rate fixed at the time the contract is made For performance at a future time agreed when contract is made Closing out is the process of the bank requiring the customer to fulfil the contract by selling or buying at spot rate Slide 316

317 FX markets 5 Netting The process of setting off credit against debit balances within a group of companies so that only the reduced net amounts are paid by currency flows Multilateral netting involves offsetting several companies balances Slide 317

318 FX markets 6 Forward rates as adjustments to spot rates Forward rate cheaper – Quoted at discount Forward rate more expensive – Quoted at premium Add discounts, or subtract premiums from spot rate Slide 318

319 FX markets 7 Interest rate parity Interest rate parity must hold between spot rates and forward rates (for the interest rate period) Otherwise arbitrage profits can be made: Slide 319

320 FX markets 8 Where f 0 = forward rate s 0 = spot rate i c = interest rate in overseas country i b = interest rate in base country Slide 320

321 Money market hedging 1 Future foreign currency payment Borrow now in home currency Convert home currency loan to foreign currency Put foreign currency on deposit When have to make payment (a)Make payment from deposit (b)Repay home currency borrowing Slide 321

322 Money market hedging 2 Future foreign currency receipt Borrow now in foreign currency Convert foreign currency loan to home currency Put home currency on deposit When cash received (a)Take cash from deposit (b)Repay foreign currency borrowing Slide 322

323 Money market hedging 3 Remember Slide 323

324 Futures 1 Futures terminology Closing out a futures contract means entering a second futures contract that reverses the effect of the first Contract size is the fixed minimum quantity that can be bought / sold Contract price is in US dollars eg $/£ Settlement date is the date when trading on a futures contract ceases and accounts are settled Basis is spot price – futures price Slide 324

325 Futures 2 Futures terminology continued Basis risk is the risk that futures price movement may differ from underlying currency movement Tick size is the smallest measured movement in contracts price (movement to fourth decimal place) Slide 325

326 Futures 3 Transactions not involving US dollars If trading one non-US dollar currency with another Sell one type of future (to get dollars) and buy other type (with dollars) Then reverse both contracts when receipt / payment made Slide 326

327 Futures 4 What type of contract? Receive currency on future date – NOW sell currency futures – ON FUTURE DATE buy currency futures Pay currency on future date – NOW buy currency futures – ON FUTURE DATE sell currency futures Receive $ on future date – NOW buy currency futures – ON FUTURE DATE sell currency futures Pay $ on future date – NOW sell currency futures – ON FUTURE DATE buy currency futures Slide 327

328 Futures 5 Advantages of futures Transaction costs lower than forward contracts Futures contract not closed out until cash receipt / payment made Slide 328

329 Futures 6 Disadvantages of futures Cant tailor to users exact needs Only available in limited number of currencies Hedge inefficiencies Conversion procedures complex if dollar is not one of the two currencies Slide 329

330 Futures 7 Set up process (a)Choose which contract (settlement date after date currency needed) and type (b)Choose number of contracts = Amount being hedged/Size of contract Convert using todays futures contract price if amount being hedged is in US dollars (c)Calculate tick size: Minimum price movement × Standard contract size Slide 330

331 Futures 8 Estimate closing futures price May have to adjust closing spot price using basis, assuming basis declines evenly over life of contract Hedge outcome Outcome in futures market Futures profit = Tick movement × Tick value × Number of contracts Slide 331

332 Futures 9 Net outcome Spot market payment (closing spot rate)(x) Futures profit / (loss) (closing spot rate unless US company)x Net outcome (x) Slide 332

333 Swaps 1 Currency swaps In a currency swap equivalent amounts of currency and interest cash flows are swapped for a period However the original borrower remains liable to the lender (counter party risk) A cross-currency swap is an interest rate swap with cash flows in different currencies Slide 333

334 Swaps 2 Advantages of currency swaps Flexibility – any size and reversible Can gain access to debt in other currencies Restructuring currency base of liabilities Conversion of fixed to / from floating rate debt Absorbing excess liquidity Cheaper borrowing Obtaining funds blocked by exchange controls Slide 334

335 Swaps 3 Risks of swaps Credit risk (Counterparty defaults) Position or market risk (Unfavourable market movements) Sovereign risk (Political disturbances in other countries) Spread risk (For banks which combine swap and hedge) Transparency risk (Accounts are misleading) Slide 335

336 Swaps 4 Example Edward Ltd wishes to borrow US dollars to finance an investment in the USA Edwards treasurer is concerned about the high interest rates the company faces as it is not well-known in the USA Edward Ltd should make an arrangement with an American company, Gordon Inc Gordon Inc is attempting to borrow sterling in the UK money markets Slide 336

337 Swaps 5 Example continued Gordon borrows US $ and Edward borrows £ The two companies then swap funds at the current spot rate At the end of the period, the two companies swap back the principal amounts at the spot rates / predetermined rates Edward pays Gordon the annual interest cost on the $ loan Gordon pays Edward the annual interest cost on the £ loan Slide 337

338 Swaps 6 FX swap A spot currency transaction that will be reversed by an offsetting forward transaction at a pre-specified date Slide 338

339 Options 1 Currency option A right to buy or sell currency at a stated rate of exchange at some time in the future Call – right to buy at fixed rate Put – right to sell at fixed rate Over the counter options are tailor-made options suited to a companys specific needs Traded options are contracts for standardised amounts, only available in certain currencies Slide 339

340 Options 2 Why option is needed Uncertainty of foreign currency receipts or payments (timing and amount) Support tender for overseas contract Allow publication of price lists in foreign currency Protect import / export of price-sensitive goods Slide 340

341 Options 3 Choosing the right option Complicated by lack of US dollar options UK company wishing to sell US dollars can purchase £ call options (options to buy sterling with dollars) Strike price – may need to use exercise price to convert US dollars Surplus cash If option contracts dont cover amount to be hedged, convert remainder at spot price on day of exercise or with formal contract Slide 341

342 Options 4 What type of contract? Receive currency at future date – buy currency put option NOW – sell currency on FUTURE DATE Buy currency at future date – buy currency call option NOW – buy currency at FUTURE DATE Receive $ at future date – buy currency call option NOW – buy currency on FUTURE Pay $ at future date – buy currency put option NOW – sell currency on FUTURE DATE Slide 342

343 Chapter 17 Hedging interest rate risk FRAs IR futures IR swaps IR options

344 FRAs 1 Interest rate risk Fixed v floating rate debt - change in interest rates may make borrowing chosen the less attractive option Currency of debt - effect of adverse movements if borrow in another currency Term of loan - having to re-pay loan at time when funds not available means need for new loan at higher interest rate Slide 344

345 FRAs 2 An FRA means that the interest rate will be fixed at a certain time in the future Loans > £500,000, period < 1 year means a borrowing rate can be fixed at 5.75% 3-6 FRA starts in three months and lasts for three months Basis point is 0.01% Slide 345

346 IR futures 1 Interest rate futures To hedge against interest rate movements The terms, amounts and periods are standardised The futures prices will vary with changes in interest rates Outlay to buy futures is less than buying the financial instrument Price of short-term futures quoted at discount to 100 per value (93.40 indicates deposit trading at 6.6%) Long-term bond futures prices quoted at % of par value Slide 346

347 IR futures 2 Example LIFFE three month sterling futures £500,000 points of 100% price Tick size will be: –£500,000 × 0.01% × 3/12 = £12.50 –A 2% movement in the futures price would represent 200 ticks –Gain on a single contract would be 200 × £12.50 = £2,500 Slide 347

348 IR futures 3 Step 1 set up process (a)Choose which contract: Date should be after borrowing / lending begins (b)Choose type: Assuming you are borrower sell if rates expected to rise, buy if rates expected to fall (c)Choose number of contracts: Exposure / contract size x Loan period / length of contract Calculate tick size: Min price movement as % length of contract / 12 months x contract size Slide 348

349 IR futures 4 Step 2 estimate closing futures price May have to adjust using basis Step 3 hedge outcome (a)Futures outcome –Opening futures price: –Closing futures price: –Movement in ticks: –Futures outcome: Tick movement × Tick value × Number of contracts Slide 349

350 IR futures 5 (b) Net outcome –Payment in spot market (X) –Futures market profit / (loss) X –Net payment (X) Slide 350

351 IR swaps 1 Interest rate swaps Agreements where parties exchange interest commitments In simplest form, two parties swap interest with different characteristics Each party borrows in market in which it has comparative advantage Slide 351

352 IR swaps 2 Uses of interest rate swaps Switching from paying one type of interest to another Raising less expensive loans Securing better deposit rates Managing interest rate risk Avoiding charges for loan termination Slide 352

353 IR swaps 3 Complications with interest rate swaps Bank commission costs One company having better credit rating in both relevant markets Should borrow in comparative advantage market but must want interest in other market Slide 353

354 IR swaps 4 Example Slide 354

355 IR swaps 5 Companies may decide to use a swap rather than terminating their original loans Costs of termination and taking out a new loan may be too high If LIBOR is at 8%, neither party will gain or lose Any rate other than 8% will result in gain / loss Slide 355

356 IR options 1 Interest rate options Grants the buyer the right to deal at an agreed interest rate at a future maturity date If a company needs to hedge borrowing, purchase put options If a company needs to hedge lending, purchase call options To calculate effect of options, use same proforma as currency options UK long gilt futures options (LIFFE) £100, ths of 100% Slide 356

357 IR options 2 Strike price is price paid for futures contract. Numbers under each month represent premium paid for options Put options more expensive than call as interest rates predicted to rise Slide 357

358 IR options 3 Interest rate caps, collars and floor Caps set an interest rate ceiling Floors set a lower limit to rates Collars mean buying a cap and selling a floor Slide 358

359 Chapter 18 Dividend policy in multinationals and transfer pricing Dividend policy Transfer pricing

360 Dividend policy 1 Dividend capacity The dividend capacity of a company depends on: after tax profits, investment plans, foreign dividends Free cash flow to equity (FCFE) FCFE = dividends that could be paid to shareholders = Net profit after tax + Depreciation + Foreign Dividends – Total Net Investment + Net Debt Issuance + Net Share Issuance Slide 360

361 Dividend policy 2 Factors affecting dividend repatriation Financing – how much needed for dividends / investment at home? Tax – often the primary reason for the firms repatriation policies Managerial control – regularised dividends restrict discretion of foreign managers (so reducing agency problems) Timing – to take advantage of possible currency movements (although these are difficult to forecast in practice) Slide 361

362 Dividend policy 3 Tax issues A companies subsidiaries foreign profits are liable to UK corporate tax, whether repatriated or not With a credit for tax already paid to the host country Similarly, the US government does not distinguish between income earned abroad and income earned at home It gives credit to MNCs headquartered in the US for tax paid to foreign governments Slide 362

363 Dividend policy 4 Timing of dividend payments Collecting early (lead) payments from currencies vulnerable to depreciation and late (lag) from currencies expected to appreciate This will mean benefit from expected movements in exchange rates Slide 363

364 Transfer pricing 1 Transfer price Prices at which goods or services are transferred from one process or department to another or from one member of a group to another Slide 364

365 Transfer pricing 2 Transfer price bases Standard cost Marginal cost: at marginal cost or with gross profit margin added Opportunity cost Full cost: at full cost, or at a full cost plus price Market price Market price less a discount Negotiated price, based on any of the other bases Slide 365

366 Transfer pricing 3 Using market value transfer prices Giving profit centre managers freedom to negotiate prices with other profit centres results in market based transfer prices Slide 366

367 Transfer pricing 4 Transfer price regulation Tax authorities often use an arm's length standard: Price intra-firm trade of multinationals as if it took place between unrelated parties acting in competitive markets Method 1 - use price negotiated between unrelated parties C and D as proxy for intra-firm transfer A to B Method 2 - use price at which A sells to unrelated party C as proxy Slide 367

368 Transfer pricing 5 Arms length pricing methods (tangible goods) Transaction-based Comparable uncontrolled price (CUP) Resale price (RP) Cost plus (C+) Profit based Comparable profit method (CPM) Profit split (S) Slide 368

369 Transfer pricing 6 Comparable uncontrolled price (CUP) Based on a product comparable transaction, possibly between different parties but in similar circumstances A method preferred by tax authorities Cost plus (C+) Appropriate mark-up (estimated from similar manufacturers) added to costs of production Measured using recognised accounting principles Slide 369

370 Transfer pricing 7 Resale price (RP) Tax auditor looks for firms at similar trade levels that perform a similar distribution function Method best used when distributor adds relatively little value, making it easier to estimate Profit margin derived from that earned by comparable distributors, subtracted from known retail price to determine transfer price Slide 370

371 Transfer pricing 8 Comparable profit method (CPM) Method is based on premise of similar financial ratios and performance of companies in similar industries Profit split (PS) Common when there are no suitable product comparables (CUP) or functional comparables (RP and C+) Profits on a transaction earned by two related parties are split between the parties Usually on basis of return on operating assets: operating profits to operating assets Slide 371

372 Chapter 19 Recent developments Developments in world financial markets Developments in world trade

373 Developments in world financial markets 1 The credit crunch The credit crunch first became a global issue in early 2007 Billions of dollars of sub-prime mortgages in the US Rise in interest rates caused defaults on such mortgages Collateralised debt obligations (CDOs) containing sub-prime mortgages sold onto hedge funds Value of CDOs fell due to defaults Huge losses by the banks Slide 373

374 Developments in world financial markets 2 Financial reporting Common accounting standards are increasing transparency and comparability for investors Improving capital market efficiency and facilitating cross- border investment Slide 374

375 Developments in world financial markets 3 Monetary policy In advanced economies, monetary policy has encompassed the task of controlling inflation Interest rates are commonly set by central banks independent of Government This enhances credibility and so lowers inflation expectations A low inflation environment is conducive to long-term business planning and investment Slide 375

376 Developments in world financial markets 4 The credit crunch and IFRS IAS 39: Entities must value financial assets and liabilities at fair value Markets collapse Banks forced to write down assets to fair value Reduction in lending capacity Further uncertainty Further write downs of assets to fair value and so on Slide 376

377 Developments in world financial markets 5 Tranching Where claims on cash flows are split into several classes (such as Class A, Class B) Benefits of tranching A good way of dividing risk Potential to make a lot of money from junior tranches Risks of tranching Very complex / may not be divided properly Rebuilding Slide 377

378 Developments in world financial markets 6 Credit default swaps Allows the transfer of third party credit risk from one party to another Similar to insurance policies Spread is similar to an insurance premium CDS market is unregulated Uses of CDS Speculation Hedging Slide 378

379 Developments in world financial markets 7 Trends in global financial markets Integration and globalisation – fostered by liberalisation of markets and technological change Creating more efficient allocation of capital and economic growth Growth of derivatives markets – advances in technology, financial engineering and risk management Led to enhanced demand for more complex derivatives products Slide 379

380 Developments in world financial markets 8 Securitisation – eg sale of loan books by banks Now a common form of financing, leading to increased bond issuance Convergence of financial institutions Abolition of barriers to entry in various segments of financial services industries Has led to conglomerates with operations in banking, securities and insurance Slide 380

381 Developments in world financial markets 9 Effects of financial sector convergence Economies of scale Economies of scope: a factor of production can be employed to produce multiple products Reduced earnings volatility Reduced search costs for consumers Slide 381

382 Developments in world financial markets 10 Money laundering A side effect of globalisation and the free movement of capital has been a growth in money laundering There has been increased legislation and regulation to combat it Slide 382

383 Developments in international trade 1 Trade financing has become easier for companies to obtain Financing for international trade transactions includes commercial bank loans within the host country Also loans from international lending agencies Trade bills may be discounted through foreign banks, for short-term financing Eurodollar financing is another method for providing foreign financing Slide 383

384 Developments in international trade 2 Eurodollar loans are short-term working-capital loans, unsecured and usually in large amounts The Eurobond market is widely used for long-term funds for multinational US companies In many countries, development banks provide intermediate- and long-term loans to private enterprises Slide 384

385 Developments in international trade 3 Regulation Globalisation creates incentives for governments to intervene in favour of domestic MNCs In respect of macroeconomic and macrostructural policies Pressure groups Trans-nationally networked pressure groups can influence the public and put pressure on governments to take measures against MNCs Slide 385

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