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ACCA PasscardsPaper P4Advanced Financial Management

Passcards for exams up to June 2015

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Professional Paper P4Advanced Financial Management

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First edition 2007, Eighth edition June 2014ISBN 9781 4727 1132 8

e ISBN 9781 4727 1188 5

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Published byBPP Learning Media LtdBPP House, Aldine Place142-144 Uxbridge RoadLondon W12 8AA

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All rights reserved. No part of this publication may bereproduced, stored in a retrieval system or transmitted, inany form or by any means, electronic, mechanical,photocopying, recording or otherwise, without the priorwritten permission of BPP Learning Media.

BPP Learning Media Ltd

2014

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Page iii

ContentsPreface

Welcome to BPP Learning Medias ACCA Passcards for Professional Paper P4 Advanced FinancialManagement. They focus on your exam and save you time. They incorporate diagrams to kickstart your memory. They follow the overall structure of BPP Learning Medias Study Texts, but BPP Learning Medias ACCA

Passcards are not just a condensed book. Each card has been separately designed for clear presentation.Topics are self contained and can be grasped visually.

ACCA Passcards are still just the right size for pockets, briefcases and bags.Run through the Passcards as often as you can during your final revision period. The day before the exam, tryto go through the Passcards again! You will then be well on your way to passing your exams.

Good luck!

(000)ACP4PC14_FP_Ricoh.qxp 5/29/2014 2:47 PM Page iii

ContentsPreface

Page1 The role and responsibility of senior

financial executive 12 Financial strategy formulation 73a Conflicting stakeholder interests 173b Ethical issues in financial management 233c Environmental issues 254 Trading and planning in a multinational

environment 315 DCF 416 Application of option pricing theory in

investment decisions 477a Impact of financing and APV method 517b Valuation and free cash flows 658 International investment decisions 73

Page9 Acquisitions and mergers vs growth 8110 Valuation for acquisitions and mergers 8711 Regulatory framework and processes 9912 Financing mergers and acquisitions 1051314 Reconstruction and reorganisation 11115 The treasury function in multinationals 11916 Hedging forex risk 12317 Hedging interest rate risk 13518 Dividend policy in multinationals and

transfer pricing 14319 Recent developments 149

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1: The role and responsibilityof senior financial executive

Topic List

Financial management

Financial planning

Senior financial executives are required to make crucialdecisions, including those related to investment,distribution and retention.

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Financialmanagement

Financialplanning

Financial objectivesThe prime financial objective is to maximise the market value of the companys shares. Primary targets are profits and dividend growth. Other targetsmay be the level of gearing, profit retentions, operatingprofitability and shareholder value indicators.

Risk and incertainty Profit manipulation Sacrifice of future profits? Dividend policy

Why profit maximisation is not asufficient objecture

Non-financial objectivesNon-financial objectives do not negate financialobjectives, but they do mean that the primaryfinancial objectives may be modified. They takeaccount of ethical considerations.

Employee welfare Management welfare Societys welfare Service provision Responsibilities towards customers/suppliers

Examples


1: The role and responsibility of senior financial executivePage 3

Investment decisions include: New projects Takeovers Mergers Sell-off/DivestmentThe financial manager must: Identify decisions Evaluate them Decide optimal fund allocation

Financial decisions include: Long-term capital structureNeed to determine source, costand risk of long-term finance. Short-term working capital

managementBalance between profitability andliquidity is crucial.

Dividend decisions may affectviews of the companys long-termprospects, and thus the sharesmarket values.Payment of dividends limits theamount of retained earningsavailable for re-investment.

Investment decisions

Financing decisions

Dividend decisions


Financialplanning

Financialmanagement

The formulation, evaluation and selection ofstrategies to prepare a long-term plan of action toattain objectives. Strategic decisions should besuitable, feasible and acceptable.

Long-term direction Matching activities to environment/resources

Key elements of financial planning

Planning involves a long horizon, uncertainties andcontingency plans.

Consideration of which assets are essential andhow easily assets can be sold.

Long-term investment and short-term cash flow Surplus cash How finance raised Profitable

Strategic analysis means analysing theorganisation in its environment, its resources,competences, mission and objectives.

Strategic choice involves generating and evaluatingstrategic options and selecting strategy.

Strategic planning

Strategic cash flow management

Strategic fund management


1: The role and responsibility of senior financial executivePage 5

Strategic

Tactical

InvestmentSelection of products/marketsTarget profitsPurchase of major non-currentassetsOther non-current assetpurchasesEfficient/effective resourceusagePricing

DividendGrowth v dividend payout

Scrip v cash dividends

FinancingDebt/equity mix

Lease v buy

Tactical planning and controlConflict may arise between strategic planning (needto invest in more expensive machinery, research anddevelopment) and tactical planning (cost control).


Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups'.Stakeholder goals

Shareholders Providers of risk capital, aim to maximisewealth

Suppliers To be paid full amount by date agreed,and continue relationship (so may acceptlater payment)

Long-term lenders

To receive payments of interest andcapital by due date

Employees To maximise salaries and benefits; alsoprefer continuity in employment

Government Political objectives such as sustainedeconomic growth and high employment

Management Maximising their own rewards

Financialplanning

Financialmanagement


2: Financial strategy formulation

Topic List

Assessing corporate performance

Financial strategy

Arbitrage

Risk and risk management

Formulating the correct financial strategy is crucial forbusiness success. The four main areas of financialstrategy are capital structure policy, dividend policy, riskmanagement and capital investment monitoring.


Financialstrategy

Risk and riskmanagement

ArbitrageAssessing corporateperformance

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)

Liquidity ratios Current ratio Inventory turnover Receivables days

Acid test ratio Payables days Return on capital employed

Profit margin Asset turnover

Profitability and return

Dividend yield Interest yield Earnings per share Dividend cover Price/earnings ratio

Stock market ratios


2: Financial strategy formulationPage 9

Comparisons with companiesin different industries

Investors aiming for diversifiedportfolios need to know differences between industrial sectors.

Sales growth Profit growth ROCE P/E ratios Dividend yields

Comparisons with other companies in same industry

These can put improvements onprevious years into perspective ifother companies are doing better,and provide further evidence ofeffect of general trends.

Growth rates Retained profits Non-current asset levels

Comparisons with previous years

% growth in profit % growth in revenue Changes in gearing ratio Changes in current/quick ratios Changes in inventory/

receivables turnover Changes in EPS, market price,

dividendRemember however Inflation can make figures

misleading Results in rest of

industry/environment, or economic changes


Financialstrategy



Economic Value Added (EVATM)EVATM = NOPAT (cost of capital capital employed)

Add: Cumulative goodwill written off Cumulative depreciation written off NBV of intangibles Provisions

Adjustments to capital employed

Add: Interest on debt Goodwill written off Accounting depreciation Increases in provisions Net capitalised intangibles

Adjustments to NOPAT



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

Debt/Bonds Fixed or floating rate Zero coupon (no interest) Convertible Bank loans Security over property may be required

When comparing different sources of finance, forexample different categories of debt, the followingfactors will generally be important:

Cost Flexibility Commitments Uses Speed/availability Certainty of raising amounts Time period available

Comparison of finance sources


Financialstrategy



Costs Income to investors Tax Effect on control

Practicalities in issuing new shares Theoretical valuation models, eg Capital Asset

Pricing Model (CAPM) or Arbitrage PricingTheory (APT)

Bond-yield-plus-premium approach: adds ajudgmental risk premium to the interest rate onthe firms own long-term debt

Market-implied estimates using discounted cashflow (DCF) approach (based on an assumptionon the growth rate of earnings of the company)

Estimating cost of equity


Financialstrategy



2: Financial strategy formulation

Pecking order Retained earnings Debt Equity

Whether lenders are prepared to lend (security) Availability of stock market funds Future trends Restrictions in loan agreements Maturity of current debt

Feasibility of capital structure

Risk attitudes Loss of control by directors Excessive costs Too heavy commitments

Acceptability 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

Suitability of capital structure

Page 13


Financialstrategy



Dividend policyDividend decisions determine the amount of, andthe way in which, a companys profits are distributedto its shareholders.

Cash Shares (stock) Share repurchases

Ways of paying dividends

Residual theory Target payout ratio Dividends as signals Taxes Agency theory

Theories of why dividends are paid


ArbitrageFinancialstrategy


Assessing corporateperformance


CAPM exam formula Arbitrage pricing theoryThe theory assumes that the return on each securityis based on a number of independent factors.

E (rj) is expected return on security

B1 is sensitivity to changes in Factor 1

F1 is difference between Factor 1 actual andexpected valuese is a random term

Factor analysisAnalysis used to determine factors to which securityreturns are sensitive. Research indicates: Unanticipated inflation Changes in industrial production levels Changes in risk premiums on bonds Unanticipated changes in interest rate term

structure

r = E(rj) + B1F1 + B2F2 ... + e

E(ri) = Rf + i(E(rm) Rf)



Financialstrategy


Overriding reason for managing risk is to maximiseshareholder value.

Systematic and unsystematic Business Financial Political Economic Fiscal Regulatory Operational Reputational

Types of risk Risk management

The process of minimising the likelihood of a riskoccurring or the impact of that risk if it does occur.

Risk mitigation


3a: Conflicting stakeholder interests

Topic List

Stakeholders

Corporate governance

Governance of a modern corporation can give rise toconflicts between the various stakeholders of the firm.

Be prepared to answer questions on key concepts suchas agency theory or goal congruence, or developmentsin corporate governance.

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Corporategovernance

Stakeholders

Separation of ownership and management: ordinary(equity) shareholders are owners of the company, butthe company is managed by its board of directors.

Central source of stakeholder conflict: differencebetween the interests of managers and those of owners.

Transaction costs economicsThe transaction costs economics theorypostulates that the governance structure of acorporation is determined by transaction costs.

Short-termism Sales objective (instead of shareholder value) Overpriced acquisitions Resistance to takeovers Relationships with stakeholders may be difficult

Sources of stakeholder conflictThe transactions costs include search andinformation costs, bargaining costs and policingand enforcement costs.


Corporategovernance

Stakeholders

3a: Conflicting stakeholder interestsPage 19

Agency theory Goal congruenceProposes that, whilst individual team members actin their own self-interest, individual well-beingdepends on the well-being of other individuals andon the performance of the team.

Is accordance between the objectives of agentsacting within an organisation and the objectives ofthe organisation as a whole.

Corporations are set of contracts between principals(suppliers of finance) and agents (management).

The agency problem

Management incentives may enhance congruence:

Profit-related pay Rights to subscribe at reduced price Executive share-option plans

BUT management may adopt creative accounting.Sound corporate governance is another approach.

If managers dont have significant shareholdings,what stops them under-performing and over-rewarding themselves?


Corporategovernance

Stakeholders

UK Corporate Governance Code

Executive directors

Limits on service contracts,emoluments decided byremuneration committeeand fully disclosed

DIRECTORS responsible forcorporate governance

AUDITORS provide external assurance

OTHER USERS(employees, creditors)

FINANCIAL REPORTINGSYSTEM links SHAREHOLDERS

Meet regularly Matters refer to board Division of responsibilities Committees audit, nomination,

remuneration

Board of directors

Majority independent No business/financial links Dont participate in options Appointed for specified term

Non executive directors


3a: Conflicting stakeholder interestsPage 21

The Higgs Report stresses the importance of the board including a balance of executive and non-executivedirectors such that no individual or small group can dominate decision-making. The report also lays down criteria for establishing the independence of non-executive directors, and stresses the need to separate theroles of Chairman and Chief Executive.

Audit committee of non-executive directors Consider need for internal audit function Accounts contain corporate governance statement Directors review and report on internal controls

Accountability and audit

20 working days notice Separate resolutions on separate issues All committees answer questions

Annual general meeting


Corporategovernance

Stakeholders

Stock market is less open, morelinks with banks than in UK.Policy boards (long-term)Functional boards (executive)Monocratic boards (symbolic)

In Germany, banks have longer-term role, may have equity stake.Separate supervisory board hasworkers and shareholdersrepresentatives.

The US system is based oncontrol by legislation, regulation,more rules on directors dutiesthan in UK. Major creditors areoften on boards.

USA

Management culture

By means of Stock Exchangeregulation, stringent reportingrequirements, tightened bySarbanes-Oxley.

JapanFlexible approach to governance,low level of regulation. Allstakeholders collaborate.

EuropeBy means of tax law. Also two-tierboard system to protect shareholderinterests.

Management culture comprises views on management and methods of doing business. Multinationals may haveparticular problems imposing the parent companys culture overseas eg American practices in Europe.

International comparisons


Ethics have become increasingly important in formulatingfinancial strategies. Financial managers must rememberto build ethical considerations into the decision-makingprocess.

3b: Ethical issues in financial management

Topic List

Ethical aspects

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Ethical aspects

Businessethics

Marketing

Market behaviour Dominant position, treatment ofsuppliers and customers

Social and cultural impact

Product development Animal testing, sensitivity toculture of different countriesand markets

Human resourcemanagement Minimum wage, discrimination


3c: Environmental issues

Topic List

Business practice

Regulation

You could be asked to discuss how the financial managerneeds to take into account environmental issues whenformulating corporate policy.

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RegulationBusinesspractice

Green issues and business practice

Sustainabilityrefers to the concept of balancing growth withenvironmental, social and economic concerns.

Companys environmental policy may include reduction/management of risk to thebusiness, motivating staff and enhancement ofcorporate reputation.

Environmental reportingMany companies produce an external report for externalstakeholders, 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

Direct environmental impacts on business eg: Changes affecting costs or resource

availability Impact on demand Effect on power balances between competitors

in a marketIndirect environmental impacts: eg, legislativechange; pressure from customers or staff as aconsequence of concern over environmentalproblems.


3c: Environmental issuesPage 27

Economic

Environmental Social

Triple bottom line reporting: a quantitativesummary of a companys economic,environmental and social performance over theprevious year.

Triple bottom line proxy indicators Economic impact Gross operating surplus Dependence on imports Stimulus to domestic economy by purchasing

locally produced goods and servicesSocial impact Organisations tax contribution EmploymentEnvironmental impact Ecological footprint Emissions to soil, water and air Water and energy use

Triple bottom line decision making



Financialcapital

Manufacturedcapital

Intellectualcapital

Humancapital

Social andrelationship

capital

Naturalcapital

Integrated reporting


3: Environmental issuesPage 29

Principles of integrated reportingIntegrated reports should be based on a number ofprinciples:

Strategic focus and future orientation Connectivity of information Stakeholder responsiveness Materiality Conciseness Reliability and completeness Consistency and comparability

Integrated thinking involves consideration of the interrelationships between operating and financialunits and the capitals the business uses.

Organisational overview and external environment Governance structure and value creation Business model Opportunities and risks Strategy and resource allocation Performance achievement of strategic objectives

and impact on capitals Basis of preparation and presentation

Contents of integrated report



Carbon trading

UNFCCC

allows companies which emit less than their allowance tosell the right to emit CO2 to another company.

obliged signatories to reduce total greenhouse gas emissionsby 2012, compared to 1990 levels. EU15 reduction target: 8%.

1997 Kyoto Protocol to the UNFCCC

Mission: to protect or enhance environment,so as to promote the objective of achievingsustainable development.

Environment Agency

is an audit that seeks to assess theenvironmental impact of a company's policies.

Environmental audit

The auditor will check whether the companysenvironmental policy: Satisfies key stakeholder criteria Meets legal requirements Complies with British Standards or other

local regulations

United Nations Framework Convention on Climate Changeagreements: To develop programs to slow climate change To share technology and cooperate to reduce greenhouse

gas emissions To develop a greenhouse gas inventory listing national

sources and sinks


4: Trading and planning in a multinational environment

Topic List

Trade

Institutions

International financial markets

Global financial stability

Multinationals strategy

Risk

The growth of international trade brings benefits andrisks for the corporation. The globalisation of internationalmarkets facilitates the flow of funds to emerging marketsbut may create instability.


RiskMultinationalsstrategy

Global financialstability

Internationalfinancial markets

InstitutionsTrade

International tradeWorld output of goods and services is increased ifcountries specialise in the production ofgoods/services in which they have a comparativeadvantage and trade to obtain other goods andservices.

Comparative advantage Countries specialising in what they produce, evenif they are less efficient (in absolute terms) inproduction of all types of good, is the comparativeadvantage justification of free trade, withoutprotectionism or trade barriers.

Product differentiation barriers Absolute cost barriers Economy of scale barriers The level of fixed costs Legal/patent barriers

Barriers to market entry

Tariffs or customs duties Import quotas Embargoes Hidden subsidies Import restrictions Restrictive bureaucratic procedures Currency devaluations

Protectionist measures


4: Trading and planning in a multinational environmentPage 33

European UnionThe EU combines a free trade area with a customs union (mobility of factors of production).

Mutually beneficial trade may be reduced There may be retaliation Economic growth prospects may be damaged Political ill-will may be created

Whats wrong with trade protection

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

Why protect trade?





InstitutionsTrade

World Trade Organisation andInternational Monetary Fund

Reduce existing barriers to free trade Eliminate discrimination in

international trade (in eg tariffs andsubsidies)

Prevent growth of protection bygetting member countries to consultwith others first

Act as a forum for assisting free trade,and offering a disputes settlementprocess

Establish rules and guidelines tomake world trade more predictable

WTO aims

Promote international monetary co-operation, andestablish code of conduct for international payments

Provide financial support to countries with temporarybalance of payments deficits

Provide for orderly growth of international liquidity

IMF aims

World Bank (IBRD)supplements private finance and lends money on a commercialbasis for capital projects, usually direct to governments orgovernment agencies.

BISBank for International Settlements: the banker for central banks.Promotes co-operation between central banks Provides facilities for international co-operation





InstitutionsTrade


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

Arguments against EMU

Economic policy stability Facilitation of trade Lower interest rates Preservation of the Citys position

Arguments for EMU

To stabilise exchange rates between membercountries

To promote economic convergence in Europe To develop European Economic and Monetary

Union (EMU)

European Monetary System (EMS)Purposes

Globalisation of financial markets has contributed tofinancial instability, despite facilitating the transfer offunds to emerging markets.





InstitutionsTrade

The global debt crisis arose as governments in lessdeveloped countries (LDCs) took on levels of debtthat were above their ability to finance.

Deflationary policies damage profitability Devaluation of currency Reduction in imports by developing countries Increased reliance on host countries for

funding

Negative impacts on multinational firms

Restructure or rescheduled debt Economic reforms to improve balance of trade Lending governments write off some of the debts Convert some debt into equity

Resolving the global debt crisis





InstitutionsTrade


Market seeking

Raw material seeking

Production efficiencyseeking

Knowledge seeking

Political safety seeking

Economies of scale

Managerial andmarketing expertise

Technology

Financial economies

Differentiated products

Strategic reasons for FDI

Joint ventures industrial co-operation(contractual) or joint-equity

Licensing agreements Management contracts Subsidiary Branches

Ways to establish an interest abroad

Management contracts: a firm agrees to sellmanagement skills sometimes used in combinationwith licensing. Can serve as a means of obtainingfunds from subsidiaries, where other remittancerestrictions apply.

Many multinationals use a combination of methodsfor servicing international markets.





InstitutionsTrade

Multinationals financial planning

Blocked funds

Control systems

Multinational companies need to develop a financial planningframework to ensure that the strategic objectives andcompetitive advantages are realised. Such a financial planningframework will include ways of raising capital and risks relatedto overseas operations and the repatriation of profits.

A company raising funds from localequity markets must comply with thelisting requirements of the local exchange.

Multinationals can counter exchangecontrols by management charges orroyalties.

Large and complex companies may beorganised as a heterarchy, an organicstructure with significant local control.

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

Finance for overseas investment depends on:





InstitutionsTrade


Government stability Political and business ethics Economic stability/inflation Degree of international

indebtedness Financial infrastructure

Level of import restrictions Remittance restrictions Assets seized Special taxes and regulations

on overseas investors, orinvestment incentives

Factors in assessing 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

Dealing with political risk

Litigation riskscan generally be reduced by keeping abreastof changes, acting as a good corporate citizenand lobbying.

Cultural risksshould be taken into account when decidingwhere to sell abroad, and how much tocentralise activities.

Environmentally sensitive

Environmentally insensitive

Adaptation necessary

Fashion clothes Convenience foods

Standardisation possible

Industrial and agricultural products World market products, eg jeans





InstitutionsTrade

Agency issues Solutions to agency problems inmultinationalsAgency relationships exist between the CEOs of

conglomerates (the principals) and the strategicbusiness unit (SBU) managers that report to theseCEOs (agents).

Multiple mechanisms may be needed, working inunison. Eg: Board of directors: separate ratification and

monitoring of managerial decisions frominitiation to implementation.

Executive incentive systems can reduceagency costs and align the interests ofmanagers and shareholders by making topexecutives pay contingent on the value theycreate for the shareholders.

The interests of the individual SBU managers maybe incongruent not only with the interests of theCEOs, but also with those of the other SBUmanagers.

Each SBU manager may try to make sure his orher unit gets access to critical resources andachieves the best performance at the expense ofthe performance of other SBUs and the wholeorganisation.


5: DCF

Topic List

NPVs

Internal rate of return

In this chapter, we discuss the evaluation of projects usingthe Net Present Value (NPV) method and the Internal Rateof Return.

The NPV method is extended to include inflation andspecific price variation, taxation and the assessment offiscal risk and multi-period capital rationing.

We also look at the potential internal rate of return toassess a project's return margin and its vulnerability tocompetitive action.


Internalrate of return

NPVs

Net present value (NPV)The sum of the discounted cash flows less theinitial investment.

Decision criterionInvest in a project if its net present value is positiveie when NPV > 0Do not invest in a project if its net present value iszero or negative, ie when NPV 0

Real and nominal discount factorsWhat nominal rate (i) should be used for discountingcash flows, if the real rate is r and the rate of inflation h?

The net effect of inflationon the NPV of a projectwill depend on threeinflation rates: the ratesfor revenues, costs, andthe discount factor.

Corporate taxes Value added taxes

Other local taxes Capex tax

allowances

Tax effects on NPV

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

(the Fisher equation,given in exam)


Capital rationingCapital rationing problem exists when there are insufficient funds to finance all available profitableprojects.

5: DCF Page 43

Case IFractional investment allowed: rank thealternatives according to the ratio of NPV to initialinvestment or the benefit cost ratio.

Case IIFractional investment not allowed: a moresystematic approach may be needed to find the NPV-maximising combination of entire projects subject tothe investment constraint. This is provided by themathematical technique of integer programming.

The Monte Carlo method

Project Value at Risk

amounts to adopting a particular probabilitydistribution for the uncertain (random) variables thataffect the NPV and then using simulations togenerate values of the random variables.

is the minimum amount by which the value of aninvestment or portfolio will fall over a given period oftime at a given level of probability.

The multi-period capital rationing problem can beformulated as an integer programming problem.


Internalrate of return

NPVs

IRRThe discount rate at which NPV equals zero.

The IRR calculation also produces the breakeven costof capital and allows calculation of the margin of safety.

If the cash flows change signs then the IRR may notbe unique: this is the multiple IRR problem.

With mutually exclusive projects, the decisiondepends not on the IRR but on the cost of capitalbeing used. Decision criteria using IRR

A project will be selected as long as the IRRis not less than the cost of capital.


5: DCFPage 45

Modified IRR (MIRR)

Calculate the present value of the return phase(the phase of the project with cash inflows).

Calculate the present value of the investmentphase (the phase with cash outflows).

Calculate MIRR using the following formula:

This formula is given in the exam.

MIRR is the IRR which would result without theassumption that project proceeds are reinvested atthe IRR rate.

Re-investment rateThe NPV method assumes that cash flows can bereinvested at the cost of capital over the life of theproject.

Selection of investments based on the higher IRRassumes that cash flows can be reinvested at theIRR over the life of the project.The IRR assumption is unlikely to be valid and sothe NPV method is likely to be superior. The betterreinvestment rate assumption will be the cost ofcapital used for the NPV method.

Decision criterionIf MIRR is greater than the required rate of return:ACCEPTIf MIRR is lower than the required rate of return:REJECT

1

2

31n

(1+ re) 1MIRR =PVRPV1


Notes


6: Application of option pricing theory in investment decisions

Topic List

Options concepts

Real options

Option valuation techniques can be applied to capitalbudgeting exercises in which a project is coupled with aput or call option. For example, the firm may have theoption to abandon a project during its life. This amountsto a put option on the remaining cash flows associatedwith the project. Ignoring the value of these real options(as in standard discounted cash flow techniques) canlead to incorrect investment evaluation decisions.


Realoptions

Optionsconcepts

OptionsAn option is a contract that gives one party the option toenter into a transaction either at a specific time in the futureor within a specific future period at a price that is agreedwhen the contract is issued.

The buyer of a call option acquires the right, but not theobligation, to buy the underlying at a fixed price.

The buyer of a put option acquires the right, but not theobligation, to sell the underlying shares at a fixed price.

In the money option: intrinsic value is +veAt the money option: intrinsic value is zero

Out of the money option: intrinsic value is ve

The higher the exercise price, the lowerthe probability that the call will be in themoney.

As the current price of the underlyingasset goes up, the higher theprobability that the call will be in themoney.

Both a call and put will increase inprice as the underlying asset becomesmore volatile.

Both calls and puts will benefit fromincreased time to expiration.

The higher the interest rate, the lowerthe present value of the exercise price.

Determinants of option values


Realoptions

Optionsconcepts

6: Application of option pricing theory in investment decisionsPage 49

Real optionsStrategic options known as real options arisingfrom a project can increase the project value. They areignored in standard DCF analysis, which computes asingle present value.

Option to delay

Option to expand

When a firm has exclusive rights to a project or product for aspecific period, it can delay taking this project or product untila later date. For a project not selected today on NPV or IRRgrounds, the rights to the project can still have value.

is when firms invest in projects allowing further investmentslater, or entry into new markets, possibly making the NPV +ve.The initial investment may be seen as the premium to acquirethe option to expand.

Option to abandon

Option to redeployis when company can use its productive assets foractivities other than the original one. The switch willhappen if the PV of cash flows from the newactivity will exceed costs of switching.

Black-Scholes valuationIn applying Black-Scholes valuation techniques toreal options, simulation methods are typically usedto overcome the problem of estimating volatility.

is if the firm has the option to cease a projectduring its life. Abandonment is effectively theexercising of a put option. The option to abandon isa special case of an option to redeploy.


Realoptions

Optionsconcepts

Exercise price (Pe) Price of underlying asset (Pa) Volatility of underlying asset (s) Time to expiration (t) Interest rate (r) Intrinsic and time value

Determinants of option values

Real options are highly examinable.

Black-Scholes formulae

These formulae are given in the exam.

Put option

rt2e1a )eN(dP)N(dPC

=

ts

)t0.5s(rPP

Ind

2

e

a

1

++

=

tsdd 12 =

rtea ePPP

C +=


7a: Impact of financing and APV method

Topic List

Sources of finance

Duration

Credit risk

Modigliani & Miller

Other theories

APV approach

The cost of capital is the rate of return required by investorsin order to supply their funds to the company. It is also therate of return a company must earn in a project in order tomaintain its market value. There are two forms of capital to afirm, equity and debt, and each supplier of capital requires areturn which is determined by the risks each type of investorfaces.

The overall cost of capital to the firm is the weightedaverage of the cost of equity and the cost of debt.


Sources of finance

Sources offinance

Creditrisk

Othertheories

Duration APVapproach

Modigliani& Miller

Equity Venture capital

Business angels

Short-term/long-term

debt

Leasefinance

Hybrids

Assetsecuritisation

Islamicfinance


7a: Impact of financing and APV methodPage 53

Islamic financetransaction

Similar to Features

Murabaha Trade credit/loan Pre-arranged mark up for convenience of later payment, no interest

Musharaka Venture capital Profit share per contract, no dividends, losses per capital contribution,both parties participate

Mudaraba Equity Profit share per contract, no dividends, losses borne by capitalprovider, organisation runs business

Ijara Leasing Whatever the other features, lessor remains asset owner and incursrisks of ownership

Sukuk Bonds Underlying tangible asset in which holder shares may be asset-based(sale/leaseback) or asset-backed (securitisation)

Salam Forward contract Commodity sold for future delivery, cash received at discount fromfinancial institution, payments received in advance

Istisna Phased payments Project funding, initial payment and then instalments from businessundertaking the project


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller

Cost of equity

CAPM

Cost of irredeemable debt

WACC

Cost of redeemable debtIRR calculation, including amount payable onredemption

ke =

g = br

d0 (1 + g)

P0kd =

i(1 T)P0

g is growth rate of dividendsb is proportion of profits retainedr is rate of return on investments

e de de d d e

V VWACC = k k 1 T

V V V V

E(ri) = Rf + i(E(rm) Rf)



Beta factors of portfolios Difficulties in determining excess return Difficulties in determining risk-free rate Errors in statistical analysis used to calculate

betas Difficulties in forecasting companies with low

P/E ratios Assumption that costs are zero Assumption that investment market is efficient Assumption that portfolios are well-diversified

Limitations of CAPM

Portfolio of all stockmarket securities

Beta factor 1

Portfolio of risk-freesecurities

Beta factor 0

Investors portfolio Beta factor weightedaverage of individualbeta factors


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller

Geared betasmay be used to obtain an appropriate requiredreturn when an investment has differing businessand finance risks from the existing business.

Difficult to identify firms with identical operatingcharacteristics

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

Weaknesses in the formula

Exam formula

where

a = asset (or ungeared) beta

e = equity (or geared) beta

d = 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

a e dVe

(Ve + Vd(1 T))Vd(1 T)

(Ve + Vd(1 T))= +


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller


Duration (Macaulay duration)The weighted average length of time to the receiptof a bonds benefits (coupon and redemption value).The weights are the present values of the benefitsinvolved.

Calculating duration

Longer-dated bonds have longer durations Lower-coupon bonds will have longer

durations Lower yields will give longer durations

Properties of duration

Modified durationModified duration =

Modified duration shares the same properties asMacaulay duration.

1

2

3

Multiply PV of cash flows for each time periodby the time period and add together.

Add the PV of cash flows in each periodtogether.

Divide the result of step 1 by the result of step 2.

yieldredemptiongross 1durationMacaulay

+


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller

Credit migration

Credit risk (or default risk)is the risk for a lender that theborrower may default on interestpayments and/or repayment ofprincipal.

Credit risk for an individual loan orbond is measured by estimating: Probability of default

typically, using information onborrower and assigning a creditrating (eg Standard & Poors,Moodys, Fitch)

Recovery rate the fraction offace value of an obligationrecoverable once the borrowerhas defaulted

is the change in the credit rating after a bond is issued.

Standard & Poors MoodysAAA Aaa Highest quality, lowest default risk

AA Aa High quality

A A Upper medium grade quality

BBB Baa Medium grade quality

BB Ba Lower medium grade quality

B B Speculative

CCC Caa Poor quality (high default risk)

CC Ca Highly speculative

C C Lowest grade quality



Credit rating of company Maturity of debt Risk-free rate at appropriate maturity Corporate tax rate

Determinants of cost of debt capital Option pricing models to assess default risk

is the premium required by an investor in acorporate bond to compensate for the credit risk ofthe bond.Yield on corporate bond = risk free rate + creditspread

Credit spread

The equity of a company can be seen as a calloption on the assets of the company with an exerciseprice equal to the outstanding debt.

Expected losses are a put option on the assets ofthe firm with an exercise price equal to the value ofthe outstanding debt.

From the Black-Scholes formula, the probability ofdefault depends on three factors: The debt/asset ratio The volatility of the company assets The maturity of debtCost of debt capital = (1 tax rate)(risk free rate

credit spread)


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller

External credit enhancement

Internal credit enhancement Excess spreadOver-collateralisation

Letters of creditSurety bonds

Cash collateral accounts


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller


MM theory (no tax)The use of debt would only transfer morerisk to the shareholders, therefore will notreduce the WACC.

MM theory (with tax)Debt actually saves tax (due to tax reliefon interest payments) therefore firmsshould only use debt finance.

where ke = cost of equity in a geared companyke = cost of equity in an ungeared companyVd, Ve = market values of debt and equitykd = pre-tax cost of debt

This formula is given in the exam.

MM and cost of equity

e

dd

ie

iee V

V)kT)(k(1kk +=

i

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

Limitations of MM theory


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller

Static trade-off theoryA firm in a static position will adjust their gearing levelsto achieve a target level of gearing.

Agency theoryThe optimal capital structure will occur where thebenefits of the debt received by the shareholdersmatches the costs of debt imposed on theshareholders.

Problems with financial distress costs

Higher cost of capital Loss of sales Downsizing High staff turnover

Indirect financialdistress

Legal and admincosts associated withbankruptcy

Direct financialdistress



is, unlike the MM models, based on the ideaof information asymmetry: investors have alower level of information about the companythan its directors do. As a result, shareholdersuse directors' actions as a signal to indicatewhat directors believe about the companywith their superior information.

Pecking order theory 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 marketablesecurities first, before either taking on more debt orincreasing its target payout rate.

Internal finance is at the top, and equity is at thebottom, of the pecking order. A single optimal debt-equity ratio does not exist: a result similar to theMM model with no taxes.


Sources offinance

Creditrisk

Othertheories


Modigliani& Miller

Adjusted present value (APV) approachThe adjusted present value (APV) method ofvaluation is based on the Modigliani Miller modelwith taxation.

We assume that the primary benefit of borrowing isthe tax benefit and that the most significant cost ofborrowing is the added risk of bankruptcy.

Steps in applying APV 1

3

2

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 thedebt used to finance the project (use kd)

Subtract the cost of issuing new finance

i


7b:Valuation and free cash flows

Topic List

Yield curve and bond values

Free cash flows

Equity valuation

This chapter mainly focuses on the use of free cashflows and their use for valuation puposes.

It also briefly considers using the yield curve for bondvalues and recaps equity valuation methods from PaperF9 financial management.


The yield curve can be used to estimate bond value by splitting, say a four year bond into four separatebonds. Each bond can then be discounted by using the rates from the yield curve.

The total of the discounted cash flows represents the issue price.

An IRR style calculation can be used to calculate the yield to maturity.

In general:

Equityvaluation

Free cash flows

Yield curve andbond values

n1

valueRedemptionn1

Coupon21

Coupon1

CouponPrice)()()()( nn21 riririri +

++

+++

++

=

Using the yield curve


Equityvaluation

Free cash flows


7b: Valuation and free cash flowsPage 67

Free cash flow (FCF)Free Cash Flow = Earnings before Interest(FCF) 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

Forecasting FCFConstant growth

where FCF0 is the free cash flow at beginning n is the number of years

Differing growth rates

n0 g)(1FCFFCF +=

Forecast each element of FCF separately usingappropriate rate.


Equityvaluation

Free cash flows


Forecasting dividend capacity

Direct method of calculating FCFE Indirect method

The dividend capacity of a firm is measured by itsfree cash flow to equity (FCFE).

Net income (EBIT net interest tax paid)

Add depreciation

Less total net investment

Add net debt issued

Add net equity issued

Free cash flow

Less (Net interest + net debt paid)

Add Tax benefit from debt(net interest tax rate)



Firm valuation using FCF Terminal values and company valuationValue of the firm is the sum of the discounted freecash flows over the appropriate time horizon.

Value of the firm is the present value over theforecast period + terminal value of cash flowsbeyond the forecast period.

Assuming constant growth, use the Gordon model:

gkg)(1FCF

PV 00 +

=

where g = growth ratek = cost of capital

Calculate value of equity (present value ofFCFE discounted at the cost of equity).

Calculate value of debt.

Value = value of equity + value of debt

1

23

Firm valuation using FCFE


Equityvaluation

Free cash flows


Possible bases of valuation

Range of valuesMax Value the cashflows or earnings under

new ownership.Value the dividends under the existingmanagement.

Min Value the assets.

Historic basis

(unlikely to be realistic)

Replacementbasis

(asset used on ongoing

basis)

Realisablebasis

(asset sold/business

broken up)

Uses of net asset valuation method As measure of security in a share valuation As measure of comparison in scheme of

merger As floor value in business that is up for sale

Need for professional valuation Realisation of assets Contingent liabilities Market for assets

Problems in valuation



Price-earnings ratioP/E ratio =

Market value = EPS P/E ratioEPS

valueMarket

Have to decide suitable P/E ratio.Factors to consider: Industry Status Marketability Shareholders Asset backing and liquidity Nature of assets Gearing

Earnings yield valuation modelMarket value =

yield EarningsEarningsMay be affected by

one-off transactionsWhich P/E ratio to use?

Adjust downwards ifvaluing an unquoted

company

Shows the current profitability

of the company

Shows the markets view ofthe growth prospects/risk of

a company


Equityvaluation

Free cash flows


Dividend valuation model

Discounted cash flow methodValue investment using expected after-tax cash flowsof investment and appropriate cost of capitalWhere D0 is dividend in current year

g is dividend growth rate

Where P0 is price at time 0D is dividend (constant)ke is cost of equity

gkD

Pe

00 )g1( +=

ekD

P0 = Based on expected future income Can be used to value minority stake Growth rate difficult to estimate Dividend policy may change Companies that dont pay dividends dont have

zero values

Features


8: International investment decisions

Topic List

NPV and international projects

Exchange controls

Exchange rate risks

Capital structure

Companies that undertake overseas projects are subjectto exchange rate risks as well as other risks such asexchange controls, taxation and political action.

Capital budgeting methods for multinational companiescan incorporate these additional complexities in thedecision-making process.


NPVs for international projects

Capitalstructure

Exchangerate risks

Exchangecontrols

NPV andinternational projects

Purchasing power parity

International Fisher effect

Absolute purchasing parity theory: prices of products in differentcountries will be the same when expressed in the same currency.Alternative purchasing power parity relationship: changes inexchange rates are due to differences in the expected inflation ratesbetween countries.

Alternative methods for calculatingthe NPV from a overseas project:

Convert project cash flows intosterling and discount at sterlingdiscount rate to calculate NPVin sterling terms.

Discount cash flows in hostcountry's currency from projectat adjusted discount rate forthat currency and then convertresulting NPV at spot exchangerate.This equation is given in the exam.

In the absence of trade or capital flows restrictions, real interest ratesin different countries will be expected to be the same. Differences ininterest rates reflect differences in inflation rates.

b

c

b

c

h1

h1

i1

i1

+

+

+

+=


8: International investment decisionsPage 75

Effect of exchange rates on NPVWhen there is a devaluation of sterling relative to aforeign currency, the sterling value of cash flowsincreases and NPV increases. The oppositehappens when the domestic currency appreciates.

Impact of transaction costsTransaction costs are incurred when companiesinvest abroad due to currency conversion or otheradministrative expenses. These should also betaken into account.

Effect on exportsWhen a multinational company sets up a subsidiaryin another country in which it already exports, therelevant cash flows (and NPV) for evaluation of theproject should account for loss of export earnings inthe particular country.


Capitalstructure

Exchangerate risks

Exchangecontrols


SubsidiesThe benefit from concessionary loans should be included in the NPV calculation as the difference between therepayment when borrowing under market conditions and the repayment under the concessionary loan.

Low tax on foreign investment or sales incomeearned by resident companies

Low withholding tax on dividends paid to theparent

Stable government and currency

Adequate financial services support facilities

Tax haven characteristics

Host country Corporate taxes Investment allowances Withholding taxes

Home country Double taxation relief Foreign tax credits

Taxes in international context


Capitalstructure

Exchangerate risks

Exchangecontrols



Exchange controls Strategies

For an overseas project, we include only theproportion of cash flows that are expected to berepatriated in the NPV calculation.

Types

Rationing supply of foreign exchange.Payments abroad in foreign currency arerestricted, preventing firms from buying as muchas they want from abroad.

Restricting types of transaction for whichpayments abroad are allowed, eg suspending orbanning payment of dividends to foreignshareholders, such as parent companies inmultinationals: blocked funds problem.

Multinational company strategies to overcomeexchange controls:

Transfer pricing, where the parent companysells goods or services to the subsidiary andobtains payment.

Royalty payments adjustments, when a parentcompany grants a subsidiary the right to makegoods protected by patents.

Loans by the parent company to the subsidiary:setting interest rate at appropriate level.

Management charges levied by the parentcompany for costs incurred in the managementof international operations.


Capitalstructure

Exchangerate risks

Exchangecontrols


Translation exposureis the risk that the organisation will make exchangelosses when the accounting results of its foreignbranches or subsidiaries are translated.

Translation losses can arise from restating the bookvalue of a foreign subsidiarys assets at theexchange rate on the statement of financial positiondate only important if changes arise from loss ofeconomic value.

Economic exposureis the risk that the present value of a companysfuture cash flows might be reduced by adverseexchange rate movements.

Economic exposure: Can be longer-term (continuous currency

depreciation)

Can arise even without trade overseas (effects ofpound strengthening)

Transaction exposureis the risk of adverse exchange rate movementsbetween the date the price is agreed and the datecash is received/paid, arising during normalinternational trade.


Capitalstructure

Exchangerate risks

Exchangecontrols



Finance costs Taxation systems Restrictions on dividend remittances Flexibility in repayments Reduction in systematic risk Access to foreign capital Agency costs

Choice of financeOverseas subsidiariesParent company needs to consider a number ofissues when setting up an overseas subsidiary:

Amount of equity capital Whether parent owns 100% of equity Profit retention by subsidiary Amount of subsidiarys debt Amount of subsidiarys working capital Whether subsidiary should obtain local listing


Capitalstructure

Exchangerate risks

Exchangecontrols


Availability. Domestic financial markets, exceptlarger countries and the Euro zone, generallylack the depth and liquidity to accommodatelarge or long-maturity debt issues.

Lower cost of borrowing. In Eurobondmarkets interest rates are normally lower thanborrowing rates in national markets.

Lower issue costs. Cost of debt issuance isnormally lower than the cost of debt issue indomestic markets.

Advantages of international borrowingInternational borrowing options(1) Borrow in the same currency as the inflows from

the project

(2) Borrow in a currency other than the currency ofthe inflows, with a hedge in place

(3) Borrow in a currency other than the currency ofthe inflows, without hedging the currency risk

Option (3) exposes the company to exchangerate risk which can substantially change theprofitability of a project.


9: Acquisitions and mergers vs growth

Topic List

Acquisitions and mergers

Shareholder value issues

Firms may decide to increase the scale of theiroperations through a strategy of internal organic growthby investing money to purchase or create assets andproduct lines internally.

Alternatively, companies may decide to grow by buyingother companies in the market, thus acquiring ready-made tangible and intangible assets and product lines.


Shareholdervalue issues

Acquisitionsand mergers

Operating economies

Managementof acquisition

Diversification Asset backing Earningsquality

Finance/liquidity

Internal expansioncosts

Tax Defensivemerger

Economicefficiency

Mergers and acquisitions

Cost of acquisition Form of purchase consideration Reaction of predators shareholders Accounting implications Reaction of targets shareholders Future policy (eg dividends, staff)

Factors in a takeover


9: Acquisitions and mergers vs growthPage 83

SupplierAim: control ofsupply chain

Firm

Customer/distributorAim: control of

distribution

Two firms operate indifferent industries

Aim: diversification

BACKWARD MERGER

FORWARD MERGER

CONGLOMERATE MERGER

VERTICAL MERGER

Two merging firmsproduce similar products

in the same industryAim: increase market

power

HORIZONTAL MERGER




Takeover strategy AcquireGrowth prospects limited

Potential to sell other products to existingcustomers

Operating at maximum capacity

Under-utilising management

Greater control over supplies or customers

Lacking key clients in targeted sector

Improve statement of financial position

Increase market share

Widen capability

Younger company with higher growth rate

Company with complementary product range

Company making similar products operating below capacity

Company needing better management

Company giving access to customer/supplier

Company with right customer profile

Company enhancing EPS

Important competitor

Key talents and/or technology




9: Acquisitions and mergers vs growthPage 85

SynergyRevenue synergy exists when the acquisition willresult in higher revenues, higher return on equity ora longer period of growth for the acquiring company.

Revenue synergies arise from:(a) Increased market power(b) Marketing synergies(c) Strategic synergies

Cost synergy results from economies of scale. Asscale increases, marginal cost falls and this will bemanifested in greater operating margins for thecombined entity.

Diversification Use of cash slack

Tax benefits Debt capacity

Sources of financial synergy




Failures to enhance shareholder valueWhy do many acquisitions fail to enhance shareholder value?

Agency theory: takeovers may be motivated by self-interestedacquirer 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.

Hubris hypothesis: bidding company bids too much becausemanagers of acquiring firms suffer from hubris, excessive pride andarrogance.

Market irrationality argument: whena companys shares seem overvalued,management may exchange them foran acquiree firm: merger. The lack ofsynergies or better management maylead to a failing merger.

Preemptive theory: several firms maycompete for opportunity to merge withtarget to achieve cost savings. Winningfirm could improve market position andgain market share. It can be rational forthe first firm to pre-empt a merger withits own takeover attempt.

Window dressing: where companiesare acquired to present a better short-term financial picture.


10: Valuation for acquisitions and mergers

Topic List

Valuation issues

Type I

Type II

Type III

High-growth start-ups

Intangible assets

There are different methods for predicting earningsgrowth for a company, using external and internalmeasures. An acquisition potentially affects the risk ofthe acquiring company and its cost of capital.

First, we consider the overvaluation problem: theproblem that when a company acquires anothercompany, it often pays more than the companys currentmarket value.


Valuationissues

Intangibleassets

High-growthstart-ups

Type IIIType IIType I

The overvaluation problemis paying more than the current market value, toacquire a company.

During an acquisition, there is typically a fall inthe price of the bidder and an increase in theprice of the target.

The overvaluation problem may arise asmiscalculation of potential synergies oroverestimation of ability of acquiring firm'smanagement to improve performance.

Both errors will lead to a higher price thancurrent market value.

Estimating earnings growthGordon constant growth model:

PV =

Three ways to estimate g:

Historical estimates: extrapolate past values Rely on analysts forecasts Use the companys return on equity and

retention rate of earnings (g = ROE retentionrate)

g)(kg(1FCF0 )+


10: Valuation for acquisitions and mergersPage 89

Acquisitions and acquirers risk

Business risk of combined entityThe risk associated with the unique circumstancesof the combined company. Affected by the betas ofthe individual entities (target and predator) and thebeta of the resulting synergy.

Asset betaThe weighted average of the betas of the target,predator and synergy of the combined entity.

Geared equity betaCalculate value of debt (net of tax). Divide byvalue of equity.

Multiply the above by difference between betaof combined entity and beta of debt.

Add the above to the beta of the combinedentity.

1

2

3

Acquisition Affectsfinancial risk?

Affectsbusiness risk?

Type 1 N N

Type 2 Y N

Type 3 Y Y


Intangibleassets

Valuationissues



Type I valuationsMethods to value company:(1) Book value-plus models(2) Market-relative models(3) Cash flow models, including EVATM, MVA

Market-relative models (P/E ratio) P/E ratio =

so market value per share = EPS P/E ratioEPS

valueMarket

Total Asset ValueLess Long-term and short-term payablesEquals Company's Net Asset Value

Book value-plus modelsUse the statement of financial position as startingpoint.

Book value of net assets is also 'equity shareholders'funds': the owners' stake in the company.

Decide suitable P/E ratio and multiply by EPS: anearnings-based valuation.EPS could be historical EPS or prospective futureEPS. For a given EPS, a higher P/E ratio will resultin a higher price.

High P/E ratio may indicate: Optimistic expectations Security of earnings Status



Q Ratio is the market value of company assets (MV)divided by replacement cost of the assets (RC).

Points to note RC of capital is difficult to estimate, so is proxied

by the book value of capital. The equity Q ie Qeis approximated as:

Qe =

If Q 1, management has increased the value ofcontributed capital.

capitalEquity equity of value MarketQ =

Equity version of Q:

Qe = debt Total RCdebt of value MarketMV

RCMV


Calculate WACC from cost of equity (K ) and costof debt (K ).

WACC =

where

T is the tax rate

is the value of the debt

is the value of equity

Discount free cash flow at WACC to obtain value offirm.

Calculate equity value.

Equity Value = Value of the firm Value of debt

Intangibleassets

Valuationissues



Calculate Free Cash Flow.

FCF = EARNINGS BEFORE INTEREST AND TAXES (EBIT)

Less: TAX ON EBIT

Plus: NON-CASH CHARGES

Less: CAPITAL EXPENDITURES

Less: NET WORKING CAPITAL INCREASES

Plus: SALVAGE VALUES RECEIVED

Plus: NET WORKING CAPITAL DECREASES

Forecast FCF and Terminal Value.

Free cash flow model1

4

3

2

5

eV++

+

d

dd

ed

ee V

VKT)(1

)V(VV

K

e

d

dV

eV



EVA approachEVA = NOPAT WACC Capital Employed

Or, EVA = (ROIC WACC) Capital Employedwhere NOPAT = Net Operating Profits After Taxes

ROIC= Return on Invested CapitalWACC = Weighted average cost of capital

Value of firm = Value of invested capital + sum of discounted EVA

(Subtract value of debt from value of company to getvalue of equity.)

Market value added approachshows how much management has added to thevalue of capital contributed by the capital providers.

MVA = Market Value of Debt + Market Value ofEquity Book Value of Equity

MVA related to EVA: MVA is simply PV of futureEVAs of the company.

If the market value and book value of debt are thesame, MVA measures the difference between themarket value of common stock and equity capital ofthe firm.


Intangibleassets

Valuationissues



Type II valuations: APVAcquisition is valued by discounting Free CashFlows by ungeared cost of equity, then adding PVof tax shield.

APV calculation steps

APV = Initial Investment + Value of acquired companyif all-equity financed + PV of Debt Tax ShieldsIf APV is +ve, acquisition should be undertaken.

Calculate FCF (as previously).

Forecast FCFs and Terminal Value.

Ungeared beta of firm is calculated from geared beta:

1

7

6

5

4

3

2

Discount free cash flow at ungeared cost ofequity to obtain NPV of ungeared firm or project.

Calculate interest tax shields.

Discount interest tax shields at pre-tax cost ofdebt to obtain PV of interest tax shields.

APV = NPV OF UNGEARED FIRM OR PROJECT

Plus: PV OF INTEREST TAX SHIELDSPlus: EXCESS CASH AND MARKETABLE

SECURITIESLess: MARKET VALUE OF CONTINGENT

LIABILITIES= MARKET VALUE OF FIRM

Less: MARKET VALUE OF DEBT= MARKET VALUE OF EQUITYE

DT)(11

GU

+=


Intangibleassets

Valuationissues




Type III iterative valuations1

87

65

4

32

A problem with WACCIf WACC weights are not consistent withthe values derived, the valuation isinternally inconsistent.Then, we use an iterative procedure: Go back and re-compute the beta

using a revised set of weights closer tothe weights derived from the valuation.

The process is repeated until assumedweights and weights calculated areapproximately equal.

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 andacquired company, using CAPM.

Estimate asset beta for each company.

Calculate asset beta for combined entity.

Calculate geared beta of the combined firm.

Calculate WACC for combined entity.

Use WACC derived in step 8 to discount cashflows of combined entity post-acquisition.

Value of equity: difference between thevalue of the firm and the value of debt.9



Intangibleassets

Valuationissues


Valuation of high-growth start-ups

Steps in valuation

Valuation methods

Discounted Cash FlowsWith constant growth model:

V =

Since FCF = Revenue Costs = R C, value of company:

V = g r

C R

g r

FCF

Typical characteristics of start-ups: few revenues,untested products, unknown product demand,high development/ infrastructure costs.

Identify drivers (eg market potential, resourcesof the business, management team)Period of projection needs to be long-termForecasting growthGrowth in earnings (g) = b ROICFor most high growth start-ups, b = 1 and soledeterminant of growth is the return on investedcapital (ROIC), estimated from industryprojections or evaluation of management,marketing strengths, and investment. Probabilistic valuation methods can be used.

Asset-based method not appropriate: most investment of astart-up is in people, marketing and /or intellectual rights thatare treated as expenses rather than capital.Market-based methods also present problems: difficult tofind comparable companies; usually no earnings to calculateP/E ratios (but price-to-revenue ratios may help).


Intangibleassets

Valuationissues




Intangible assetsDiffer from tangible assets as they do not havephysical substance.

Goodwill Brands Patents

Customer loyalty Research and

development

Examples of intangible assets

Measuring intangible assetsMarket-to-book value measures intangible assetsas the difference between book value of tangibleassets and market value of the firm.

Tobins q =

Used to compare intangible assets of firms in sameindustry serving the same markets and with similartangible non-current assets.

Calculated intangible values (CIV) calculates anexcess return on tangible assets, which is used todetermine the proportion of return attributable tointangible assets.

assets of cost tReplacemen

firmof tioncapitalisaMarket


Intangibleassets

Valuationissues



Levs knowledge earnings method separatesearnings deemed to come from intangible assets,which are then capitalised.

Relief from royalties Premium profits Capitalisation of earnings Comparison with market transactions

Methods of valuing intangible assets

Valuing product patents as options.

Identify value of underlying asset (basedon 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 thedelay, the lower the value of cash flows).

1

2

3

5

4


11: Regulatory framework and processes

Topic List

Global issues

UK and EU regulation

Defensive tactics

The agency problem can have a significant impact onmergers and acquisitions. Takeover regulation is a keydevice in protecting the interests of all stakeholders.

Different models of regulation have been used in the UKand in continental Europe. EU level regulation seeks tocreate convergence in takeover regulation.


Defensivetactics

UK and EUregulation

Globalissues

Agency problemThe agency problem and the issues arising fromthe separation of ownership and control havepotential impact on mergers and acquisitions.

Potential conflicts of interest Protection of minority shareholders. Transfers

of control may turn existing majority shareholdersof the target into minority shareholders.

Target company management measures to prevent the takeover, which could run againststakeholder interests.

Takeover regulationTakeover regulation can: Protect the interests of minority shareholders

and other stakeholders Ensure a well-functioning market for corporate

control

Two models of regulation UK/US/Commonwealth countries: market-based

model case law-based, promotes protection ofshareholder rights especially

Continental Europe: 'block-holder' or stakeholdersystem codified or civil law-based, seeking toprotect a broader group of stakeholders: creditors,employees, national interest


Defensivetactics

UK and EUregulation

Globalissues

11: Regulatory framework and processesPage 101

UK takeover regulationMergers and acquisitions in the UK subject to:

City Code Companies Act Financial Services and Markets Act 2000 Criminal Justice Act 1993 (insider dealing provisions)

City CodeThe City Code on Takeovers and Mergers:

Originally voluntary code for takeovers/mergers ofUK companies now has statutory basis

Administered by the Takeover Panel

Similar treatment for all shareholders Sufficient time and information for

informed decision Directors must act in interests of whole

company Avoid false markets in shares Offer only made if it can be fully

implemented Offeree company not distracted for

excessive time by offer for it

City Code Principles


Defensivetactics

UK and EUregulation

Globalissues

Competition and Markets AuthorityThe Competition and Markets Authority (CMA) can accept orreject proposed merger, or lay down certain conditions, ifthere would be a substantial lessening of competition.

Substantial lessening of competition tests: Turnover test (70m min. for investigation by CMA) Share of supply test (25%)

European UnionMergers fall within jurisdiction of the EU (which will evaluateit, like the CMA in UK) where, following the merger:

(a) Worldwide turnover of more than 5bn per annum(b) EU turnover of more than 250m per annum

EU Takeovers DirectiveEffective 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 Principle of board neutrality Break-through rule: bidder able to set

aside multiple voting rights (but countriescan opt out of this)


11: Regulatory framework and processesPage 103

% Consequence of share stake levelsAny 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.

30% City Code definition of effective control. Takeover offer becomes compulsory.

50%+ CA 2006 definition of control (At this level, holder can pass ordinary resolutions.)Point at which full offer can be declared unconditional with regard to acceptances.

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 torequire minority to sell out.


Defensivetactics

UK and EUregulation

Globalissues

Defensive tactic ExplanationGolden parachutes Compensation payments made to eliminated top-management of target

firm.

Poison pill Attempt to make firm unattractive to takeover, eg by giving existingshareholders right to buy shares cheaply.

White knights and white squires Inviting a firm that would rescue the target from the unwanted bidder. Awhite squire does not take control of the target.

Crown jewels Selling firms valuable assets or arranging sale and leaseback, to makefirm less attractive as target.

Pacman defence Mounting a counter-bid for the attacker.Litigation or regulatory defence Inviting investigation by regulatory authorities or Courts.


12: Financing mergers and acquisitions

Topic List

Financing methods

Effects of offer

Questions on the subjects discussed in this chapter maybe regularly set in the compulsory section of this paper.Questions could involve calculations.

A bidding firm might finance an acquisition either by cashor by a share offer or a combination of the two. Weconsider how a financial offer can be evaluated in termsof the impact on the acquiring company and criteria foracceptance or rejection.


Effectsof offer

Financingmethods

Methods of financing mergers Funding cash offersMethods 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 Debt issue but, issuing bonds will alert th

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