From June 2014:

Modules 3 & 4

How Module 3 has been tested on the exam:

Bond/Pfd Share Refinancing

• Refinancing could be done to eliminate restrictive covenants, but more likely to

refinance debt at lower interest rates

• The refinancing analysis is a variation of the NPV calculation

• Decision rule: Go ahead if PV of replacing current debt/pfd shares with new bond > than

PV of current cash outflows associated with existing financing

Steps to refinancing

1. Net investment required to refinance old issue

– Call Premium

– Net flotation costs – Cost of flotation less PV tax shield of deduction floatation costs

– Net additional interest expenses/dividends during bond overlap period

2. Calculate incremental after tax interest savings/dividend savings* from refinancing.

– Savings are calculated on the overlapping period of two bonds/shares.

3. Calculate PV of after tax interest savings/dividend savings* from refinancing.

4. Calculate NPV of refinancing [ PV of after tax interest savings/dividend savings* - net investment needed ] or Step 3 – Step 1.

* Preferred share dividends are not tax deductible

What discount rate do you use?

• All cash flows are discounted using after tax cost of new debt / quarterly cost

of new pfd share issue.

– Current market opportunity cost of company.

To determine appropriate effective rate:

1. Convert stated rate to the effective annual rate

2. Apply tax rate

3. Convert after tax annual rate to required semi annual or quarterly period

using the following:

For effective annual to effective semi annual = (1+r)1/2 -1

For effective annual to effective quarterly = (1+r)1/4 - 1

Step 1. Calculate net investment required to refi old issue

Step 2. Calculate incremental after tax savings from refi

Step 3. Calculate PV of after tax interest savings from refinancing.

Step 4. Calculate NPV of refinancing

Preferred share refinancing: Reading 3.6 minicase 3-2

Reading 3.10 : Rights Offerings

Rights On Period: Ex Right Period:

Announcement date to Ex date Ex date to Expiration

Ron= (Pon-E) ÷ (N+1) Rex= (Pex-E) ÷ N

Rights offerings

• Offer shares directly to current shareholders. Current shareholders have the

right to subscribe to additional shares at a specified price.

• Four important dates:

– announcement date: date when company announces the rights offering.

– record date: date the company distributes to its current shareholders of

record one right A shareholder becomes a shareholder of record three

business days after purchasing shares.

– ex-rights date: two business days before the record date. On this date

shares no longer receive rights.

– expiration date: when the rights expire.

From Dec 2011 Exam:

Answer:

Rights On Period: Ex Right Period:

Announcement date to Ex date Ex date to Expiration

Ron= (Pon-E) ÷ (N+1) Rex= (Pex-E) ÷ N

Module 4: Capital Structure and Dividend Policy

For both exams in 2012, there was a qualitative long

answer on dividend policy. Last year, the exam went back

to focusing on capital structure decisions.

Need to know info for the Exam

Reading 4.5 : Selecting the optimal capital structure

Leverage-indifference EBIT level

• Defined as EBIT level at which return on assets = interest cost of

debt.

• Used when comparing share financing with debt financing, and preferred share financing with common share financing.

• When comparing debt financing with preferred share financing,

Equation 4-18 will not have an answer since it is assumed debt

interest and preferred share dividend yield are the same in both

scenarios.

• In this case, compare after tax interest cost on debt with dividend

yield on preferred shares.

Page 6

7.5 8.519108

.40 .404.4 2.0

Other factors influencing capital structure

• Financial flexibility

• Control

• Asset growth

• Level of cash flows

Modifying MM

• Proposition I:

Reading 4.6 : Dividend Policy: Theoretical

Foundation

Traditional bird-in-hand

Perfect-market view

Tax differential effects

Signalling hypothesis

Expectations view

Clientele effect

June 2012 Q5

March 2012 Q4 f-h

Reading 4.6-2 : Dividend Policy in Practice

Constant dividend payout ratio policy

Residual dividend payout ratio policy

Constant dollar dividend policy

Two most important features of dividend policy

1. Stability

2. Industry norms

Dec 2011 exam Q5

Modules 7-9

Need to know info for the Exam

**Question 6 March 2013 Exam

June 2012 exam Question 2f

***Zero coupon bond has

duration = maturity

Yield to maturity is used as discount rate

Step 1. Have to determine dw

dw

Step 2. Calculate impact on portfolio of 1% increase in interest rates

If all interest rates increase by 1%, we estimate that the portfolio’s value will decline by $172.24

Gap analysis

• More commonly associated with banks as a way to measure interest rate risk.

Gap analysis identifies the difference between a firm’s interest rate sensitive

assets and its interest rate sensitive liabilities.

Gap = rate sensitive assets – rate sensitive liabilities Equation 7-7

Positive gap – rate sensitive assets > rate sensitive liabilities �company benefits if interest rates rise

Negative gap – rate sensitive assets < rate sensitive liabilities �company loses if interest rates rise

• We can estimate the decrease in net interest income by multiplying expected

change in interest rates by the gap

• From Minicase 7-10:

Change in net interest income = .01 x -200 = -2 million

Value at Risk (VaR)

• VaR is an estimate of the minimum loss to be occurred with a given probability level over a certain time period.

• If a $1 Billion investment portfolio has a VaR of $200 million at a one week, 99% confidence interval, it means that there is a 1% chance that the portfolio will drop more than $200 million in any given week.

VaR = portfolio value x standard deviation x z statistic

At 90% confidence level z = 1.28

At 95% confidence level z = 1.645

At 97.5% confidence level z = 1.96

At 99% confidence level z = 2.33

From March 2013 exam:

Module 8: Futures, Forwards, and Swaps

When hedging against interest rate risk, you are using derivatives on BA

futures.

Differences between futures and forwards

• Futures are traded on an exchange so prices are publicly available. Forwards

are private, negotiated agreements.

• The exchanges in which the futures are traded determine the specifics of the

futures contract. Forward contracts can be entirely tailored to the needs of a

hedger (provided the counterparty agrees to the terms).

• Traders in the futures market are subject to margin requirements to reduce

the risk of the respective clearing house. Participants in the forward market

can only rely on the credit worthiness of the counterparty.

The basics of hedging with futures and forwards

• Direct hedge – Asset underlying a futures/forward contract is the same as the

asset being hedged.

• Cross hedge – The asset underlying a futures/forward contract is different

from the asset being hedged.

Module 9: Options

Call options

• Gives the holder the right, but not the obligation, to buy the underlying asset

at a specified price on or before a specified date from the option writer.

• From a hedging perspective, a party would hold a call option if exposed to

the risk of rising prices/rates.

• A party writing a call option is speculating that the underlying asset won’t

increase in price (i.e either stay flat or decrease) � earn the premium

income.

• A call option writer faces potentially unlimited risk (how high does the asset

price rise?)

• For a hedging strategy, you do not want to write a call because of the

potentially unlimited risk.

Put options

• Gives the holder the right, but not the obligation, to sell the underlying asset

at a specified price on or before a specified date from the option writer.

• From a hedging perspective, a party would hold a put option if exposed to

the risk of falling prices/rates.

• A party writing a put option is speculating that the underlying asset won’t

decrease in price (i.e either stay flat or increase) � earn the premium

income.

• A put option writer faces potentially unlimited risk (can a stock price go to

zero?).

• For a hedging strategy, you do not want to write a put because of the

potentially unlimited risk.

Differences between options and futures/forwards

• The biggest difference between options & futures/forwards is that the

decision to exercise the option rests solely with the holder.

Reading 9.2: Option Pricing

Relationship between premium and exercise price

Steps in using Black-Scholes

We need five numbers in calculating Black-Scholes: Exercise price (E),

Maturity of option in years (T), Price of underlying asset (S), risk free rate (r),

and standard deviation of underlying asset (Ϭ) :

Step 1. Determine d1 first, then d2

Step 2. Determine N(d1) & N(d2) with equation 9-6

Step 3. Calculate option premium with equation 9-4

Inputs Black-Scholes: S = $27, E = $25, r = .03, Ϭ = .10, T =

(15+31+30+31+20) / 365 = .3479

Step 1: Determine d1 & d2

Step 2: Determine N(d1)) & (N)d2 with equation 9-6 & Appendix A

Equation 9-5

Step 3: Calculate call option premium with Equation 9-4

Question 6 2013:

Put-call parity

• Defines relationship between European call & put options with the same

exercise price and expiration date.

• The value of a put option is a function of the value of the call option.

Using Black-Scholes for valuing a Put option:

You could use equation 9-10 to use the Black-Scholes formula, but it is easier to use put-call parity (equation 9-9) since the put has the same expiry date and exercise price as the call.

Determining the continuously compounded rate and effective annual rate pg 13-14

March 2013:

Dec 2011:

Hedge ratio 8-6

From Mach 2014:

From June 2013 exam

Spot rate to buy Canadian dollars US$1.008369

Interest rate parity Equation 8-5