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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 (ri) = Rf + βi (E (rm) – Rf)
Where E (ri) is expected return from security / project Rf is risk-free rate of return E(rm) is expected return from market βi is beta factor of security / project (E (rm) – Rf) is market premium for risk This formula is given in the exam.

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 investor’s 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

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

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

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 company’s current operations CAPM produces a discount rate based on systematic risk and can be used to compare projects of different risk classes CAPM assumes company’s investors wish investments to be evaluated as if they are capital market securities

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

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

12 CAPM Basics 10 Where: βa = asset (or ungeared) beta
βe = equity (or geared) beta βd = beta factor of debt in the geared company Vd = market value of debt in the geared company Ve = market value of equity capital in the geared company T = rate of corporate tax

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

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 (rj) is expected return on security
B1 is sensitivity to changes in Factor 1 F1 is difference between Factor 1 actual and expected values B2 is sensitivity to changes in Factor 2 F2 is difference between Factor 2 actual…e is a random term Main problem – identifying macroeconomic factors and risk

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

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

18 The role and responsibility of senior financial executive
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 company’s shares Primary targets are profits and dividend growth Other targets may be the level of gearing, profit retentions, operating profitability and shareholder value indicators

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

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

22 Financial management 4 Examples - non-financial objectives
Employee welfare Management welfare Society’s welfare Service provision Responsibilities towards customers / suppliers

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

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

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

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

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

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

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

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

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

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

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)

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

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

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

37 Financial strategy formulation
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)

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

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

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

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

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

44 Assessing corporate performance 7
Economic Value Added (EVATM) EVATM = 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

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

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

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

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

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 firm’s 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)

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

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

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

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

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

55 Financial strategy 4 Pecking order Retained earnings Debt Equity

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

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

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

59 Risk and risk management 2
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

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

61 Conflicting stakeholder interests
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

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

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

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)

66 Corporate governance 2 The agency problem
Managers don’t 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

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

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

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 Don’t participate in options Appointed for specified term

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

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

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

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

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

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)

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 company’s culture overseas eg American practices in Europe

77 Ethical issues in financial management
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

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

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

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

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

84 Business practice 3 Company’s 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

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

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

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

88 Regulation 1 Carbon trading
Allows companies which emit less than their allowance to sell the right to emit CO2 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%

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

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

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 company’s environmental policy: Satisfies key stakeholder criteria Meets legal requirements Complies with British Standards or other local regulations

92 Trading and planning in a multi-national environment
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

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

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

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

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

98 Trade 6 What’s 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)

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

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

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

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

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)

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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)

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

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

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

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

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

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

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

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)

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

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

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

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

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

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)

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

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)

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:

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

142 Application of option pricing decisions in investment decisions
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

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

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

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

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

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

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

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

151 Real options 5

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

153 Impact of financing and APV method
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 bond’s 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

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

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 & Poor’s, Moody’s, Fitch) Recovery rate – the fraction of face value of an obligation recoverable once the borrower has defaulted

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

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

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)

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

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

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

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

164 Modigliani and Miller 2 MM and cost of equity

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

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

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

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

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

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

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

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

173 International investment decisions
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

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

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

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

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

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

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

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

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

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

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

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

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

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 subsidiary’s assets at: The exchange rate on the statement of financial position date – only important if changes arise from loss of economic value

188 Exchange rate risks 3 Economic exposure
The risk that the present value of a company’s 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)

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

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

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

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

193 Acquisitions and mergers vs growth
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

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

196 Acquisitions and mergers 3
Factors in a takeover Cost of acquisition Form of purchase consideration Reaction of predator’s shareholders Accounting implications Reaction of target’s shareholders Future policy (eg dividends, staff)

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

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

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

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

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 company’s 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

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

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

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

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

206 Valuations for acquisitions and mergers
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:

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

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

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

212 Valuation issues 5 Acquisitions and acquirer’s 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

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 EVATM, MVA

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

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

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

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

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 Qe is approximated as: Qe = 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

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

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

221 Type 1 9 Step 3 Calculate from cost of equity (Ke ) and cost of debt (Kd) where T is the tax rate Vd is the value of the debt Ve is the value of equity

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

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

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

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

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

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:

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

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

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

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

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

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

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

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

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)

237 High-growth start-ups 6

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

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 Tobin’s ‘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

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 Lev’s knowledge earnings method separates earnings deemed to come from intangible assets, which are then capitalised

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

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)

243 Regulatory framework and processes
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

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

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

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)

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

249 UK and EU regulation 3 City Code principles
All offeree’s 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

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%)

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

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

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)

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

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

256 UK and EU regulation 10 Consequence of share stake levels
Any - company may enquire on ultimate ownership under s793 CA 2006 3% - 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

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

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

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

260 Defensive tactics 2 Crown jewels
Selling firm’s 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

261 Financing mergers and acquisitions
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

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

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 firm’s shares

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

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

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

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

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

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

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

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

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

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

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?

276 Reconstruction and reorganisation
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

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

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

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

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 company’s geared beta; a lower level of debt will reduce it

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

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

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

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

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

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 company’s shares are offered to the public

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

289 Divestment and other changes 6
Going private When a group of investors buys all the company’s 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

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

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

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)

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

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

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

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 βa

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

298 The treasury function in multinationals
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

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

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

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

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

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

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

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 Banker’s Acceptances Negotiable bills issued by firms to finance transactions such as imports or purchase of goods Guaranteed (accepted) by a bank, for a fee

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

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

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

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

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

312 Hedging forex risk Chapters 16 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 t0 is the price for delivery at t0 A forward rate at t0 is a rate for delivery at time t1 This is different from whatever the new spot rate turns out to be at t1

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

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

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

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

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

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:

320 FX markets 8 Where f0 = forward rate s0 = spot rate
ic = interest rate in overseas country ib = interest rate in base country

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

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

323 Money market hedging 3 Remember

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

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)

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

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

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

329 Futures 6 Disadvantages of futures Can’t tailor to user’s exact needs
Only available in limited number of currencies Hedge inefficiencies Conversion procedures complex if dollar is not one of the two currencies

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 today’s futures contract price if amount being hedged is in US dollars (c) Calculate tick size: Minimum price movement × Standard contract size

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

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)

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

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

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)

336 Swaps 4 Example Edward Ltd wishes to borrow US dollars to finance an investment in the USA Edward’s 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

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

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

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 company’s specific needs Traded options are contracts for standardised amounts, only available in certain currencies

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

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 don’t cover amount to be hedged, convert remainder at spot price on day of exercise or with formal contract

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

343 Hedging interest rate risk
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

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%

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

347 IR futures 2 Example LIFFE three month sterling futures £500,000 points of 100% price 92.50 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

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

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

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

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

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

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

354 IR swaps 4 Example

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

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%

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

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

359 Dividend policy in multinationals and transfer pricing
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

361 Dividend policy 2 Factors affecting dividend repatriation
Financing – how much needed for dividends / investment at home? Tax – often the primary reason for the firm’s 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)

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

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

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

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

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

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

368 Transfer pricing 5 Arm’s 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)

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

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

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

372 Recent developments Chapter 19 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

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

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

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

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

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

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

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

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

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

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

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

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

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