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1338371173 acca-p4-key-point-notes-december-2010

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1338371173 acca-p4-key-point-notes-december-2010

  1. 1. ACCA P4 Advanced Financial Management Key Point Notes December 2010 ------------------------------------------------------------------------------------------------------------ ACCA P4 Advanced Financial Management Key Point Notes December 2010 These notes are not intended to cover the whole syllabus, but target key examinable areas. Prepared By: Sunil Bhandari Tutor Contact Details Mobile: 00(+)44 7833 438771 E-mail: Sunil@IntelligentAccountancyTutorsLtd.co.ukCopyright to Sunil Bhandari ________________________________________________________________________  Sunil Bhandari 1
  2. 2. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 2
  3. 3. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Use of these Key Point NotesThese notes have been prepared exclusively for use as arevision aide. They cover the major topics in the currentsyllabus as well as showing the way in which these havebeen tested in all of the past papers. In addition, the notesnow accrue for the expected change in style of the P4 examas outlined in Shish Malde’s article. I have also encapsulatedmy knowledge gained from marking the P4 June 2010 exam.________________________________________________________________________ Sunil Bhandari 3
  4. 4. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Contents Chapter Chapter Name Number Preliminaries Chapter One Financial Objectives-Review of F9 Knowledge Chapter Two Cost of Capital Chapter Three Risk Adjusted WACC Chapter Four Capital Structure and Raising Finance Chapter Five Dividend Policy Chapter Six Advanced Investment Appraisal I Chapter Seven Advanced Investment Appraisal II Chapter Eight Valuations of Options & Value at Risk Chapter Nine Risk Management Chapter Ten Foreign Currency Risk Management Chapter Eleven Interest Rate Risk Management Chapter Twelve Business Valuation & Mergers & Acquisitions Chapter Thirteen Company Performance Analysis Chapter Fourteen Corporate Reconstruction & Reorganisation________________________________________________________________________ Sunil Bhandari 4
  5. 5. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Exam Formulae and Tables________________________________________________________________________ Sunil Bhandari 5
  6. 6. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 6
  7. 7. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Please note that FOREX Modified BSOP will NOT be examinedin December 2010 as it has been removed from the June2011 formulae sheet.________________________________________________________________________ Sunil Bhandari 7
  8. 8. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 8
  9. 9. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 9
  10. 10. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 10
  11. 11. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 11
  12. 12. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 12
  13. 13. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 13
  14. 14. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 14
  15. 15. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 15
  16. 16. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 16
  17. 17. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 17
  18. 18. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 18
  19. 19. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 19
  20. 20. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 20
  21. 21. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 21
  22. 22. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 22
  23. 23. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 23
  24. 24. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ My Summary • Strong Link To F9 • Core Topics will make up most of the paper • Questions will be Scenario Based and Longer • More Analytical Skills needed less Technical Difficulty________________________________________________________________________ Sunil Bhandari 24
  25. 25. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter OneFinancial Objectives-Review of F9 Knowledge1 Primary Financial Objective1.1 For profit making business “Maximise Shareholder(S/H) Wealth”1.2 To Measure S/H wealth Value of Equity (Ve) =Number of issued Equity/Ordinary Shares X Current Market Price (Po)1.3 To find Po:  Given in the Question if it is a listed company(see below)  Compute Using:- • Dividend Valuation Model(DVM) • Earnings Based Models(PE)1.4 Check the question very carefully for the size of the company is it:-  Listed  Private Company Make your comments relevant to the size and nature of the company stated within the question.________________________________________________________________________ Sunil Bhandari 25
  26. 26. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------2 Indicators2.1 Financial indicators pointing towards maximising S/H wealth include:-  Earning per share(EPS)  Dividend per share(DPS)  Return on Capital Employed(ROCE)  Return on Shareholder Capital(ROSC)  Profit after tax  Revenue2.2 Non-Financial Indicators include:  Market Share  Customer Satisfaction  Quality Measures The above are all Key Performance Indicators (KPI’s) that need to be measured and reviewed on a regular basis by the board of directors. (Board)3. External Factor Affecting Ve & Po3.1 The Board cannot control all aspects that effect Ve and/or Po. One of the major factors is macroeconomic variables.3.2 Economic Variables -what are they and how may directional changes effect the share price?3.2.1 Interest Rates- If they fall:-  Stimulate demand and revenue  Lower the cost of debt and improve profits  Investors switch to share market for better returns________________________________________________________________________ Sunil Bhandari 26
  27. 27. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3.2.2 Inflation Rates- If it rises:-  Costs rise causing a drop in profits  Cause interest rates to rise.  Devalues the home currency3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-  Reduce cash receipts for exporters  Lowers the cost for importers  Discourage exporting3.2.4 Gross Domestic Product- If it falls:-  Reduce demand and revenue  Cause interest rates to fall to stimulate demand3.2.5 General Taxation –If it rises:-  Damage company profits  Not encourage investment by companies  More savings from tax effect of tax allowable depreciation. Important to relate your comments to the effect upon Po & Ve .3.3 Agency Problem3.3.1 S/H are the owners of the company and expecttheir directors (agents) to take decisions to maximiseS/H wealth. The agency problem occurs when directorstake decisions that DO NOT lead to maximising S/Hwealth.________________________________________________________________________ Sunil Bhandari 27
  28. 28. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3.3.2 Examples of decisions that ‘may’ damage S/H wealth:  Directors pay  Taking high risk business decisions  Non-payment of dividends  Using debt finance (against the wishes of the S/H)3.3.3 Solutions to this problem include:  Company Law  Corporate Governance (eg UK Combined Code)  Share Options (ESOPS) 3.3.4 ESOPS This provides a way of rewarding Directors by granting them options to buy shares in their company at a fixed price. They can buy the shares in future (normally 1 year) at the fixed price which usually is today’s price.Hence, directors are encouraged to take decisions to maximise future share prices. This benefits both the directors and the shareholders.________________________________________________________________________ Sunil Bhandari 28
  29. 29. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------4 The Three Key Decisions 4.1 To maximize S/H wealth the board must take  Investment  Finance  Dividend 4.2 Investment 4.2.1 Allocate cash for:-  Organic Growth (Projects)  Acquisitions 4.2.2 Must always consider how investments impact upon:-  Company Liquidity  Future Profits and Asset values  Business Risk Profile i.e. effect upon variability of the cash flows and profits. 4.3 Finance 4.3.1 To finance investments the board have to decide the best balance of equity and debt. 4.3.2 They will consider:-  Cash available within the company  Access to new sources of finance  Impact on KPI’s like gearing ratio(Debt:Equity)  Cost of Finance (WACC)________________________________________________________________________ Sunil Bhandari 29
  30. 30. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ 4.4 Dividends 4.4.1 The Board needs to establish a dividend policy – see Chapter 5 4.5 The three decisions are interlinked. Example: New projects need new finance but must generate cash to service the finance providers including paying dividends to the shareholders.5 Objectives of Not-For-Profit- Organisations (NFP)5.1 These include:  government funded functions(“Public Sector”)  charities  trade unions5.2 With no shareholders it is important to ascertain. a) who are the main stakeholders? b) what are there objectives?5.3 It is widely recognised that NFP entities should demonstrate the principles of “Value for money”(VFM) The indicators are:- 1) Economy - lowest cost of input resources 2) Efficiency - ratio of input to output measures 3) Effectiveness - how outputs are measured.________________________________________________________________________ Sunil Bhandari 30
  31. 31. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ 5.4 For example, in a government funded school measures could be:- Economy - cost of teachers - cost of admin Efficiency - cost/pupil - Number of pupils/teacher Effectiveness - pass rates - number of pupils moving to higher education________________________________________________________________________ Sunil Bhandari 31
  32. 32. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 32
  33. 33. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter TwoCost of Capital1 Weighted Average Cost of Capital (WACC)1.1 This is the formula given on your formula sheet.1.2 The Symbols:-  Ke= Cost Of Equity  Kd(1-t) = Post Tax Cost of Debt  Kd= Yield to maturity on debt or Pre Tax Cost of Debt  Ve=Market value of the Equity Capital.  Vd= Market Value of the Debt Capital  t= Corporation tax rate________________________________________________________________________ Sunil Bhandari 33
  34. 34. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------1.3 Some past P4 answers used the following symbols:- WACC= Were + Wdrd(1-t)  We= Ve or (1-Wd) Ve+Vd  W d = Vd or (1-We) Ve+Vd  re=Ke=Cost Of Equity  rd(1-t)=Kd(1-t)=Cost of Debt Therefore, it’s the same Formula!!2 Cost of Equity (Ke, re)2.1 Formulae are given in the exam as:- a) This can be simply presented as:- Ke or re =Rf +βe(Rm-Rf) b) This you have to rearrange to:- re=Do(1+g) +g Po________________________________________________________________________ Sunil Bhandari 34
  35. 35. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ c)This latter formula applies under M&M assumptions with tax.(see later)2.2 Lets clear up the additional symbols to those listed under 2.1 above:- Rf=Risk Free Return Rm= Return on the Market Portfolio βe=Systematic Risk being faced by the shareholders. Do=The dividend per share (DPS) today or last paid. g = Constant annual growth rate in dividends. Po =Share price currently Kei= Cost of equity assuming all equity position. (Rm-Rf)= Equity Risk Premium.2.3 Remember from F9 if you are going to we Ke= DO(1+g) +g PO You need to find g There are two ways:- i) Historic Estimate - example Year End Dividend per share $ 2007 0.24 2008 0.27 2009 0.29 2010 0.32________________________________________________________________________ Sunil Bhandari 35
  36. 36. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ g= 3√(0.32/0.24) -1 g=10% ii) Gordon Growth Model g=bre b= the proportion of profits retained by the business. re= the accounting rate of return (ARR) Example A company has an ARR of 12% and pays out 30% of its profits as a dividend. g=0.70 x 0.12=0.0842.4 At P4 level, the Gordon Growth Model can be extended such that if re is the cost of equity, a LONGTERM growth rate is computed. Example If Ke=11% g= 0.70 x 0.11= 0.0772.5 If using CAPM, the βe must reflect the company’s systematic business and financial risk. Skills taught at F9 are needed at P4.  Degear βe’s to find βa  Regear βa’s to find βe We can remove the financial risk element via________________________________________________________________________ Sunil Bhandari 36
  37. 37. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ βa = Asset Beta, measure of systematic business risk βd= Debt Beta (Often nil) Example βe is 1.95 Vd:Ve 1:4 t= 30% βd=NIL Find βa βa = 4 x 1.95 4+1(1-0.30) = 4 x 1.95 4.7 = 1.66 If the company operates on a divisional basis and eachdivision is in a different business area. Then:- 1) Find βa’s of each industry field that the company operates in. 2) Combine using the weighted average method. 3) Gear up to the company’s gearing level.________________________________________________________________________ Sunil Bhandari 37
  38. 38. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ExampleABC is made up of two divisions Division Asset βeta Proportion of the Business Food 0.75 40% Clothes 1.80 60%The company gearing level is 32%.Tax =25%βa=(0.75 x 40%)+(1.80 x 60%) = 1.381.38 = 68 x βe 68+32(1-0.25)1.38= 68 x βe 92βe =1.873 Post Tax Cost of Debt (Kd(1-t) or rd(1-t))3.1 Kd or rd is the yield or minimum return for the debt holder – pre tax cost of debt. Kd(1-t) or rd(1-t) is the post tax cost of debt for the company.3.2 To find the cost of debt we need to look at the type of debt finance – skills taught at F9.________________________________________________________________________ Sunil Bhandari 38
  39. 39. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3.3 Bank Loans Kd(1-t)=Interest % x (1-t) Example A company has a 11% Bank Loan .Tax =30% Kd(1-t)=11 x (1-0.30)=7.7%3.4 Traded Bonds-Irredeemable Kd(1-t)=Ints x (1-t) Po Remember Po is the market value per block of $100. Example 9% Bonds trading at $89 t=30% Kd(1-t)= 9 x (1-0.30) = 7.1% 893.5 Traded Bonds-Redeemable Kd(1-t) is an IRR computation based upon Time $To Po (X) Take two guessesT1-Tn Ints X(1-t) X like 10% and 1%Tn Capital X and do an IRRRepayment________________________________________________________________________ Sunil Bhandari 39
  40. 40. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3.6 The main method used in the P4 exam is:- Kd(1-t)=(Yield on similar Government debt + Credit Risk Premium) x (1-t) ExampleTable of credit spreads for industrial company bonds in BasisPoints (BP=0.01%).Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yrAAA 5 10 15 22 27 30 55AA 15 25 30 37 44 50 65A 40 50 57 65 71 75 90BBB 65 80 88 95 126 149 175BB 210 235 240 250 265 275 290B+ 375 402 415 425 425 440 450The current return on 5-year treasury bonds is 2.8%. F plchas equivalent bonds in issue but has an A rating. calculate the expected yield on F’s bonds(i) find F’s cost of debt associated with these bonds if(ii) the rate of corporation tax is 30%(i) Yield =2.8+0.65 =3.45%(ii) Kd(1-t)= 3.45% x (1-0.30) = 2.42%________________________________________________________________________ Sunil Bhandari 40
  41. 41. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3.7 MARKET VALUE OF TRADED BONDS As can be seen above the market value of debt (Po) is given per block of $100 we need this to find Vd .This may have to be computed using the Dividend Valuation Model (DVM). i.e Po=Present Value of all future cash flows discounted at the yield to maturity for the relevant debt. Example $20 m 7% Bond will be redeemed in 3 years at par ($100). Yield to maturity is 5.25%. NB: Don’t forget that discount factor tables also show formulae at the top of each table. On the PV Table the formula is (1+r)-n = 1 (1+r)n Hence the Po= $7 + $7 + $7+$100 2 1.0525 1.0525 1.05253 6.65 + 6.32 + 91.77 = $104.97________________________________________________________________________ Sunil Bhandari 41
  42. 42. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------4 Use of WACC4.1 The WACC is the nominal cost of capital to be used in advanced project appraisal involving DCF methods. i.e. NPV IRR MIRR4.2 The nominal cost of capital has the symbol “i” at P4 andcan be found via:-4.3 The WACC is only useable providing:-  The project under consideration is a core activity of the company.  The project finance will not significantly change the current gearing ratio of the entity. 4.4 If the new project is a NON CORE Activity but the project will have no significant effect upon the company’s gearing ratio then the nominal cost of capital to use is the RISK ADJUSTED WACC.________________________________________________________________________ Sunil Bhandari 42
  43. 43. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter ThreeRisk Adjusted WACC1 When do we use this? As stated in Chapter Two above if the:- a) Project is a non-core one b) Will have no effect upon the company’s gearing ratio2 Approach a) Find an equity βeta for the industry relating to the project. b) Degear βe to find the asset βeta. c) Re-gear βa to find the project equity βeta . Use either:- i. The company’s existing gearing level or ii. The specified gearing level post project d) Use the answer to (c) above known as the project βe in CAPM to find the project Ke e) Find the relevant Kd(1-t) f) Use WACC Formula, project Ke, Kd(1-t) and gearing level stated in (c) i) or ii) above to find the Risk Adjusted WACC-a nominal cost of capital.________________________________________________________________________ Sunil Bhandari 43
  44. 44. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3 What to do if WACC or Risk Adjusted WACC can’t be used. This can happen if:- i. Project is core or non-core. ii. Project Finance will significantly change the company’s gearing ratio. iii. Finance may include subsidised loans-lower interest rate than market rate. Solution lies in Adjusted Present Value (APV)-covered later in the notes.________________________________________________________________________ Sunil Bhandari 44
  45. 45. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter FourCapital Structure andRaising Finance1 Introduction How should the company decide the mix of equity and debt capital?2 Practical Issues If the company uses Debt capital funding it should consider:- Credit Rating of the company Rate of interest it will pay Market conditions- access to Debt capital Forecast Cash Flows-to service and repay the debt. Level of Tangible Assets on which secure the loans. Interest will lead to tax savings i.e Tax Shield Constraints on the level of debt from a) Articles Of Association b) Loan Agreements.  Effect upon the company gearing ratio Debt/Equity+Debt OR Debt/Equity  Will the debt providers exercise influence over the company?  The chance of bankruptcy.________________________________________________________________________ Sunil Bhandari 45
  46. 46. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3 Theories of Optimal Capital Structure3.1 Common Ground-both major views accept two facts:- a) Yield<Ke b) Gearing causes Ke to rise3.2 Traditional View % Ke Cost Of capital WACC Kd 0 X GearingKey Points:- 1) Ke rises due to financial risk caused by gearing. 2) Kd is initially uneffected by gearing but rises at “high” gearing levels due to the perception of the possibility of bankruptcy. 3) WACC-trade off of Ke and Kd. Point X is the optimum gearing level where WACC is lowest. 4) Once point X is reached via trial and error it must be maintained.________________________________________________________________________ Sunil Bhandari 46
  47. 47. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ 3.3 MM and Tax % Ke Cost of Capital WACC Kd 0 Gearing Key points:- 1) Assumption behind the model:-  All debt is risk free  Only corporation tax exists  Debt is issued to replace Equity  All types of debt carry one yield, the risk free rate  Full distribution of profits  Perfect Capital Market 2) MM concluded companies should gear up to the maximum levels.3.4 Specific Equations can be used under MM+ Tax theory.________________________________________________________________________ Sunil Bhandari 47
  48. 48. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ Vd=Vu+VDT WACC=Keu{1-T x Vd} (Ve+Vd) Only the latter is given on the formulae sheet.4 Pecking Order TheoryIn this approach, there is no search for an optimal capitalstructure through a theorised process. Instead it is arguedthat firms will raise new funds as follows:-  Internally-generated funds  Debt  New issue of equityFirms simply use all their internally –generated funds firstthen move down the pecking order to debt and the finally toissuing new equity. Firms follow a line of least resistance thatestablishes the capital structure.Internally –generated funds-i.e. retained earnings.  Already have funds.  Do not have to spend any time persuading outside investors of the merits of the project.  No issue costs.________________________________________________________________________ Sunil Bhandari 48
  49. 49. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Debt  The degree of questioning and publicity associated with debt is usually significantly less than that associated with a share issue.  Moderate issue costs.New issue of equity  Perception by stock markets that it is possible sign of problems. Extensive questioning and publicity associated with a share issue.  Expensive issue costs.________________________________________________________________________ Sunil Bhandari 49
  50. 50. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 50
  51. 51. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter FiveDividend Policy1 IntroductionTo maximise S/H wealth the Board should establish adividend policy-the payment pattern to the equity investors.2 TheoriesSeveral theories have been put forward to assist:-2.1 Residual – If spare cash exists at the end of the year pay dividend.2.2 Pattern – Be consistent with dividend payments. Either a) Pay the same dividend per share (DPS) each year. b) Maintain the payout ratio (DPS/EPS) c) Maintain the same year-on-year growth rate in dividends. The latter links into the Po via the dividend valuation model (DVM)2.3 Irrelevancy (M&M) In a perfect capital market providing the directors can invest in projects with a positive NPV no dividends are required. The Ve will rise and the S/H can sell shares to create the cash the need(Manufacture Dividends).________________________________________________________________________ Sunil Bhandari 51
  52. 52. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3 Practical Considerations There are many to consider:  Availability of cash  What dividends do S/H want (clientele effect)?  Signalling effect –payment of dividends indicates a healthy company  Retaining cash is a key source of finance.  Dividend growth should be greater than inflation  Tax impact upon S/H  Effect the dividend will have on dividend cover(EPS/DPS)  Number of investment opportunities will restrict dividend payments.  Risk-paying now is safer than promising to pay next year  Is the dividend within the company law regulations?4 Alternatives to Cash Dividends4.1 Scrip Dividends4.1.1 The S/H will receive extra shares instead of cash on a pro rata basis.4.1.2 This will allow the S/H to sell extra shares for cash and the gain will be subject to CGT.4.1.3 The effect will:- a) Increase the issued equity capital b) Dilute EPS and Po values c) Create pressure for the board to pay more total dividends in the future as more shares are in issue________________________________________________________________________ Sunil Bhandari 52
  53. 53. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------4.2 Share Buy Back4.2.1 If the board has “one off” period of excess cash, they could consider a share buy back. i.e. Buy back shares at Po and cancel them.4.2.2 Considerations:- a) Allowable under company law. b) Increase gearing as Ve may fall. c) Tax implications for the S/H(CGT) d) Reduced number of shares will cut supply for trading purposes. e) Less dividend pressure on the board in future. f) Criticism-is this the best use of company cash.________________________________________________________________________ Sunil Bhandari 53
  54. 54. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 54
  55. 55. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter SixAdvanced InvestmentAppraisal I1 NET PRESENT VALUE OF FREE CASH FLOWS (FCF)1.1 Free Cash Flows (FCF)  The cash is available after expenditure and reinvestment into the business.  Computed two ways:- 1) Incremental cash flow approach Revenue – Costs – Tax -Capex + Scrap Value - Asset Replacement Spending – Working Capital Injection + Tax saved on Tax Allowable Depreciation. 2) Adjusting Accounting ProfitNet operating profit (before Xinterest and tax)Plus Depreciation XLess Taxation (X)Operating cash flow XLess Investment:Replacement non-current (X)asset investment(RAI)Incremental non-current (X)asset investment(IAI)________________________________________________________________________ Sunil Bhandari 55
  56. 56. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Incremental working capital (X)investment(IWCI)Free cash flow for the X used in NPV compscompanyDebt Interest (X)Debt Repayments (X)Debt Issues XFCF to equity X used to value equity in certain business valuation models.1.2 Skills Learned at F9 Remember, Shish has clearly stated in his article that you must remember the skills taught to you at F9.They are: Relevant Cash Flows Inflation Taxation Working Capital Financial Maths1.3 Relevant Cash Flows  Incremental –caused by the project  Future –still to occur  Exclude:- 1) Sunk Costs 2) Finance Charges 3) Dividends 4) Non-Cash flows 5) Non-incremental fixed overheads________________________________________________________________________ Sunil Bhandari 56
  57. 57. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------1.4 Inflation (Symbol h) Two acceptable approaches based upon matching the cash flow to the cost of capital. “Include” • Cash Flows must be given in nominal terms or must be converted into nominal terms using Nominal CFn=Real CFn X (1+h)n • Cost of capital must be nominal (symbol i) which will:- a) Given in question b) WACC or Risk Adjusted WACC Formula /Method c) Fisher Formula (1+i) = (1+r) (1+h) “Exclude” • Cash flows are given in real terms or can be converted into real terms. Real CFn= Money x CFn (1+h)n • Cost of Capital has to be in real terms (r) which will be given or to rearrange the Fisher Formula (1+r)= (1+i) (1+h)________________________________________________________________________ Sunil Bhandari 57
  58. 58. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------The “exclude” method is used when it makes practical senseto do so. For example, the cash flow is a long annuity orperpetuity.1.5 Taxation This is a relevant cash flow to be included in the FCF schedule. Two acceptable approaches:- • “One Line” tax flows • “Two Line” tax flows “One Line” tax Flow This was in Shish’s sample question. The FCF schedule shows only one line for tax. A tax working is required:- $’000 Incremental Revenue XXX Netted are operating Cash flows Incremental Costs (XXX) Tax Allowable Dep’n (XXX) Taxable Profit XXX Above x Tax Rate = Tax Cash Flow________________________________________________________________________ Sunil Bhandari 58
  59. 59. ACCA P4 Advanced Financial Management Key Point Notes December 2010 ------------------------------------------------------------------------------------------------------------ “Two Line” tax Flows After chatting with Shish, he said that this method is perfectly acceptable as it was used in many past F9 questions. Here:- • Tax is computed on Operating Cash Flows. • Tax saved on tax allowable depreciation is shown on a separate line. Both “One Line” and “Two Line” will give the same yearly FCF’S. Finally, READ THE QUESTION CAREFULLY RE TIMIMG OF TAX DUE.1.6 Working Capital  Think as it is a project bank account.  Invest, Adjust, Close!! eg $’000 T0 T1 T2 T3 WC needed - 100 170 300 Relevant (100) (70) (130) 300 Cash Flows These go into the NPV ________________________________________________________________________  Sunil Bhandari 59
  60. 60. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------1.7 Financial Maths A quick reminder a) 5 year discount Factor at 12% From tables, 0.567 b) 8 year annuity factor at 7% From tables, 5.971 c) Perpetuity Factor at 11.2% 1 = 8.928 0.112 d) Annuity Factor starting at time 4 stopping at time 9 at 8% AF4-9 = AF1-9 – AF1-3 = 6.247-2.577=3.67 e) The present value of a cash flow starting at T5 at $200 then growing in perpetuity at 2% at 12% cost of capital. 1 x DF3 r-g 1 X .712 0.12-0.02 = 7.12________________________________________________________________________ Sunil Bhandari 60
  61. 61. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------2 Layouts Two options depending upon the nature and style of the FCF’S Format A (Assuming One Line Tax) Time $’000 T0 T1 T2 T3 T4 T5 Revenue - X X X X Materials - (X) (X) (X) (X) Labour - (X) (X) (X) (X) VOH - (X) (X) (X) (X)Incremental - (X) (X) (X) (X) FOH Operating - X X X X CF Tax(w1) - - (X) (X) (X) (X) Capex & (X) - - - X Scrap W Capital (X) (X) (X) (X) X FCF (X) X X X X (X) i% 1.0 X X X X X PV (X) X X X X X NPV $ XXX Format B Time $’000 % PV$’000 T0 (X) 1.0 (X) T1-T30 X X X T2-T31 (X) X X T32 X X X NPV $XXX________________________________________________________________________ Sunil Bhandari 61
  62. 62. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 62
  63. 63. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter SevenAdvanced InvestmentAppraisal II1 IRR1.1 Internal Rate of Return is the cost of capital that gives an NPV of NIL1.2 Example NPV @ 10% = $30K NPV @ 20% = ($160K) IRR=10 + ( 30 ) x (20-10) =11.6% 30-(-160)1.3 IRR has weaknesses:- a) Cannot be used to compare mutually exclusive projects. b) Multiple IRR’s exist when the cash flow pattern is not standard ie Standard Pattern -,+,+,+,+ Non-Standard Pattern -, +, +, +,-1.4 MIRR is a measure that gives an NPV of nil but will lead to a project decision rule consistent with NPV.________________________________________________________________________ Sunil Bhandari 63
  64. 64. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------2 Computing MIRR2.1 Class Illustration Time $’000 T0 (1000) T1 400 Return phase T2 600 of the project T3 300Cost of Capital=10%2.2 Using The Formula NPV had been computed at 10%. Time $ 10% PV T0 (1000) 1.0 (1000) T1 400 0.909 363.6 * T2 600 0.826 495.6 T3 300 0.751 225.3 84.5* PV of Return Phase=$1084.50Formula givenPVR=PV of Return Phase Cash FlowsPVI=PV of Investment Cash flowsre=Cost of Capitaln= Year of the final cash flow________________________________________________________________________ Sunil Bhandari 64
  65. 65. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------MIRR= (1084.50)1/3 (1.10)-1 1000 =13%Alternative Method: a) Terminal value of Return Phase cash flows.Time $’000T1 400 X 1.102= 484T2 600 X 1.10 = 660T3 300 X 1.0 = 300 1444Therefore, we now have a revised set of cash flows T0 (1000) T3 1444MIRR is the discount rate that causes an NPV of nil.MIRR = r1444 - 1000=NIL(1+r)3Therefore, 3√1444 -1 =13% 1000Both NPV rule and MIRR rule indicate project is worthwhile.2.4 Problems with MIRR  Both NPV and MIRR assume cash flows from a project are reinvested at re.This may not be the case.________________________________________________________________________ Sunil Bhandari 65
  66. 66. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------  MIRR may itself have to be “modified” to accrue of variable reinvestment rates.  Defining the “Investment Phase”. Per Q1 Dec 08 two definitions were possible giving slightly different answers.________________________________________________________________________ Sunil Bhandari 66
  67. 67. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 67
  68. 68. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 68
  69. 69. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3 Foreign Investment Appraisal3.1Predicting future spot rates via formulae provided:- S1=F0=Future Spot Rate S0=Spot Rate Today hc=Inflation Rate abroad hb=Inflation Rate home ic=Interest Rate abroad ib=Interest Rate Home 3.2 Double Taxation-the golden rule is you must pay the higher of the two rates3.3 Format-one line tax layout is best here to accrue for double tax.________________________________________________________________________ Sunil Bhandari 69
  70. 70. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------3.4 Suggested Layout – FCFForeign Currency T0 T1 T2 T3 T4 Revenue - X X X X Costs - (X) (X) (X) (X)T.A.D(not a C.F) - (X) (X) (X) (X) Foreign Profit - X X X X Foreign Tax - (X) (X) (X) (X) Add: TAD(above) - X X X X CAPEX & Scrap (X) - - - X W.C. (X) (X) (X) (X) X Foreign FCF (X) X X X X Spot Rates X X X X XHome Currency (X) X X X X Cash FlowsAdditional Home Tax (X) (X) (X) (X) FCF (X) X X X X4 Adjusted Present Value (APV)4.1.1 APV is a NPV method to be used when:-  Project is core or non-core activity  Specific debt finance is being use on a project.  Subsidised interest exists on the project debt finance.4.1.2 APV is still the change in shareholder wealth arising from the project.________________________________________________________________________ Sunil Bhandari 70
  71. 71. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------4.2 Method  Establish the βasset for the project.  Using the βasset in CAPM find Keu (all equity Kei)  Discount the relevant project cash flows using Keu to find the base case NPV  Establish the yield on the debt  Find PV of the issue costs (possibly post tax) using yield as a discount rate.  Find PV of the tax savings on the interest paid on the loan finance raised using the yield as a discount rate4.3 Subsidised Loans4.3.1 If any part of the loan Finance is at a subsidised rate, then the APV must include an extra benefit.4.3.2 PV of the post tax subsidy discounted at the pretax cost of debt.APV $mBase case NPV XPV of issue costs (X)PV of tax savings on interest XPV of net of tax subsidised interest X APV X________________________________________________________________________ Sunil Bhandari 71
  72. 72. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------5 Capital Rationing5.1 When there is a lack of sufficient cash to invest in all projects with a positive NPV5.2 Cash can be restricted due a. “Hard” Reasons –external constraint eg Credit Crunch. b. “Soft” Reasons –internal restrictions eg Capex Budget Single Period-Divisible Projects5.3 Compute the Profitability Index (PI) for each project. PI= NPV Cash outlay in critical period5.4 Rank the projects based upon the PIExampleABC inc has $30m to spend today and has the followingprojects available:- Project Spend-Today NPV $m $m A 22 67 B 17 25 C 40 65 D 18 36What are the PI’s? a. 67/22=3.05 b. 25/17=1.47________________________________________________________________________ Sunil Bhandari 72
  73. 73. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ c. 65/40=1.63 d. 26/18=2.00Multi-period-Divisible Projects5.5 This is when cash is restricted in more than one period.You must understand that the aim will be to maximise thewealth of the shareholders but stay within the cash limitseach year. Also, some projects can “cross fertilise” – meaningthat they generate positive cash flows which can fund thosewith deficits. Deposit accounts can be used to carry cashforward into future periods.5.6 A optimum solution can be found using linearprogramming (divisible projects) and integer programming(non divisible projects).6 Dealing with Risk within Investment Appraisal6.1 Sensitivity Analysis6.1.1 Remember from ACCA F9 that this is defined as changeone variable within the project and cause the NPV to go frompositive to nil.6.1.2 A “quick” way to compute the sensitivity margin%:- For any Cash Flow NPV x 100 PV Of Cash Flow________________________________________________________________________ Sunil Bhandari 73
  74. 74. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------For Cost Of Capital IRR – Cost of Capital x 100 Cost of CapitalExampleTime $’000 10% PV $’000T0 Capex (1000) 1.0 (1000)T1-T5 400 3.791 1516RevenueT1-T5 Cost (20) 3.791 (76)T5 Scrap 200 0.621 124 NPV 564What are the sensitivity margin % for  Revenue  CapexRevenue = 564 = 37% 1516CAPEX = 564 =56% 10006.2 Simulation “The assessment of the volatility (or standard deviation) of the net present value of a project entails the simulation of the financial model using estimates of the distributions of the key input parameters and an assessment of the correlations between variables. Some of these variables are normally distributed but some________________________________________________________________________ Sunil Bhandari 74
  75. 75. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ (such as decommissioning cost) are assumed to have limit values and a most likely value. Given the shape of the input distributions, simulation employs random numbers to select specimen value for each variable in order to estimate a ‘trial value’ for the project NPV. This is repeated a large number of times until a distribution of net present values emerge. By the central limit theorem the resulting distribution will approximate normality and from which project volatility can be estimated. In its simplest form, Monte Carlo simulation assumes that the input variables are uncorrelated. However, more sophisticated modelling can incorporate estimates of the correlation between variables. Other refinements such as the Latin Hypercube technique can be reduce the likelihood of spurious results occurring through chance in the random number generation process. The output from a simulation will give the expected net present value for the project and a range of other statistics including the standard deviation of the output distribution. In addition, the model can rank order the significance of each variable in determining the project net present value.” (These are the words of Shish)________________________________________________________________________ Sunil Bhandari 75
  76. 76. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 76
  77. 77. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter EightValuation of Options+Value at Risk1 Valuation of Options1.1 An option gives the holder the right, but not the obligation to buy or sell a share at a fixed price on a specified future date. Details and terminology: - (a) Put – right to sell. (b) Call – right to buy. (c) Exercise price / strike price – price at which shares can be bought or sold. (d) Expiry Date – date on which the option can be exercised (European type option). Our aim is to find the value of the options on the open market.________________________________________________________________________ Sunil Bhandari 77
  78. 78. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------1.2 Components of Option ValueIntrinsic value and time valueThere are 5 main components to the value of an option (a) Intrinsic value, the difference between (i) The current price of the asset(Pa) (ii) The exercise price of the option(Pe) (b) The time value of the premium, reflecting the uncertainty surrounding the intrinsic value between now and the exercise date. Relevant factors: (i) Variability in the daily value of the asset (currency, interest etc)(s) (ii) Time until expiry of the option (a later expiry date having greater risk)(t) (iii) Interest rates (since cash flows occur at two different times)(r)________________________________________________________________________ Sunil Bhandari 78
  79. 79. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------The Black Scholes Option Pricing Model1.1 The above five factors have been built into the Black- Scholes formula to find the value at time 0 of a European call option. (c). All three formulae are given in the tables but you must know what the symbols stand for. Symbols: Pa=share price Pe=exercise price option r =annual (continuously compounded) risk free rate of return t =time to expiry of option in years s =share price volatility, the standard deviation of the rate of return on shares e =the exponential constant 2.7183 In =natural logarithm On Your calculator!!________________________________________________________________________ Sunil Bhandari 79
  80. 80. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ d1 & d2= Compute to two decimal places. N(d1)& N(d2)=the cumulative value from the normal distribution tables for the value d1 or d2.Read the bottom of the tables very carefully. Example The current share price of B plc shares=$100 The exercise price =$95 The risk free rate of interest = 10%pa =0.1 The standard deviation of =50% =0.5 return on the shares The time to expiry =3 months=0.25 1) e-rt rt =0.1 x 0.25 = 0.025 e-0.025 =0.975 2) N (d1) & N (d2) d1= In(100/95)+(0.10+0.5 x 0.52 )0.25 0.5 x √0.25 d1 = 0.0513 + 0.05625 =0.43 0.25 d2 =0.43-0.25=0.18 N (d1) = 0.50+0.1664=0.6664 N (d2) = 0.50+0.0714=0.5714________________________________________________________________________ Sunil Bhandari 80
  81. 81. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ 3) C C = (100 x .6664) - (95 x 57.14 x .975) = $ 13.71 1.3 Put-call parity Black Scholes’ model will only calculate the value of a call option. The value of a call option, a put option, the exercise price and the share price are related (where the put and call have the same strike and exercise date): Find the value of the put option Example p = 13.71-100 + (95 x .975) = $6.34________________________________________________________________________ Sunil Bhandari 81
  82. 82. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------2 The Delta Hedge Delta hedging is used by options traders who have written options and wish to calculate how many shares they need to hold to hedge their position. If the delta is 0.7 they will need to hold 0.7 shares for every option written. The delta also measures how many shares one option will ‘cover’ if used to hedge a holding of shares.3 Black and Scholes applied to Investment Appraisal.3.1 Real options on projects  Delay/Defer the project  Switch /redeploy resources  Expand/contract the project  Option to abandon.3.2 Use the normal BSOP equations but:- Pa= PV of future Cash Flows Pe= Given or CAPEX R= Risk Free Rate t= time to expiry (in years) s= standard deviation________________________________________________________________________ Sunil Bhandari 82
  83. 83. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------4. Value at Risk (VaR)4.1 VaR is a measure of how the market value of asset or aportfolio of assets is likely to decrease over certain time, theholding period (usually 1 to 10 days), under normalconditions.4.2 Used by Investment banks to measure the market risk oftheir portfolios.4.3 Confidence levels are normally set at 95% or 99%.ExampleA bank has estimated the expected value of its portfolio in 2week time will be $50m.with standard deviation of $4.85m.At 95%,what is VaR? 45% 50% $50m s=$4.85m $ 50m-(1.65 X $4.85m) =$42m________________________________________________________________________ Sunil Bhandari 83
  84. 84. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ There is a 5% chance that the portfolio will fall below $42m.________________________________________________________________________ Sunil Bhandari 84
  85. 85. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter NineRisk Management1 Introduction1.1 I expect Shish may well write an article on this topic as guidance. I would guess that it will cover how he expects students to deal with this topic at P4 level. This chapter has been written in anticipation of that article.1.2 Risk Management is a substantial part of ACCA P1. A lot of that knowledge will be required here but with some emphasis on particular areas.2 Summary of P12.1 Sources and impacts of common business risks  market  credit  liquidity  technological  legal  health and safety  reputation  business probity  derivatives________________________________________________________________________ Sunil Bhandari 85
  86. 86. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------2.2 Approach to risk management  Identify  Assess  Measure  Avoid  Accept  Hedge/Reduce Effect3 P4-Main Risk Categories3.1 At this level there are four major areas of risk:-  Business Risk  Financial Risk (Chapter 4)  Foreign Currency Risk (Chapter 10)  Interest Rate Risk (Chapter 11)4 Business Risk4.1 Defined as being the cause of variations in:  Company profits  Returns to a shareholder It is related to: i. Nature of business activity ii. Level of operational gearing –amount of fixed costs that make up the operational cost base.4.2 Total business risk is measured using the standard deviation σi. Hand in hand goes expected return Ri.4.3 Business risk can be managed or reduced initially using “Portfolio Theory”.________________________________________________________________________ Sunil Bhandari 86
  87. 87. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------5 Portfolio Theory(PT)5.1 PT can be used by  Directors-combine business activities logically  Shareholders- create a logical share portfolio5.2 PT relies upon the basic concept that if shares or business activities that are combined are LESS THAN PERFECTLY CORRELATED, risk can be reduced5.3 The correlation coefficient is a key value and its range is: -1 0 +1 Perfect No Correlation Perfect Negative Positive Correlation Correlation5.3 When two “investments” are combined PT Formulae exist to:- Sp= Risk of the portfolio Return from = (Ra x Wa) + (Rb x Wb) the portfolio(Rp)________________________________________________________________________ Sunil Bhandari 87
  88. 88. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ 6 Extend PT-more investments6.1 The above only assumes that two investments are combined. Naturally the more the investments are added the lower Sp should go.6.2 Sp does not reach nil Market Portfolio Sp Unsystematic Risk Systematic Risk 20 No of investments6.3 PT removes one part of Sp –unsystematic risk. This is the specific risk caused by factors relating to the company or industry.6.4 The risk remaining is systematic risk-that caused by general economic and political factors. This can be measured via Beta factor.________________________________________________________________________ Sunil Bhandari 88
  89. 89. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------7 CAPM7.1 Once the “market portfolio” fully diversified position has been reached ,the company and shareholders should use CAPM. Risk =βe Return= RF + (Rm-RF)βe OR RF + (ERP)βe7.2 Remember from Chapter Two Cost Of Capital how a βe can be analysed.8 WHY DO DIRECTORS LIKE TO HAVE A DIVERSIFIED BUSINESS? Several Reasons:  Stabilise profits  Lead to move predictable cash flows  “Larger” or safer business  Conglomerate theory-some directors feel they can run any type of business (Virgin, Tata)  Foreign acquisitions will reduce economic risk.  Risk of the investment failing a more of a problem for the shareholder than the director  May be the only expansion option.________________________________________________________________________ Sunil Bhandari 89
  90. 90. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------________________________________________________________________________ Sunil Bhandari 90
  91. 91. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------Chapter TenForeign Currency RiskManagement1. Translation Exposure1.1 Risk caused by change in the value of a Forex asset or liability over the long term.1.2 Example: ABC plc has a US subsidiary worth $10m. 2009 - at $1.50 £6.67m 2010 - at $1.75 £5.71m Loss to equity (£0.96m) Funded by a $10m loan. 2009 - at $1.50 £6.67m 2010 - at $1.75 £5.71m Gain to equity £0.96m1.3 Not a cash risk, only due to financial reporting!!!!________________________________________________________________________ Sunil Bhandari 91
  92. 92. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------2 Transaction Exposure2.1 Change in the value of the spot rate over the short term causing a cash gain or loss.2.2 Must hedge!!3 SPOT Rates3.1 Rate of exchange at a point in time. (Bid) (Offer) $1.5000 - $1.5555 / £ Reciprocal and cross over!!!!! £0.6429 - £0.6667 / $ (Bid) (Offer)3.2 Picking the correct rate-Quick Method  If the SPOT Rates are FX/Home Currency  We are RECEIVING FX then  Use the right hand rate4 Internal Hedges4.1 Invoice in home currency  All transactions in home currency  Transfer risk to the other party  Monopoly power-over our customers or suppliers________________________________________________________________________ Sunil Bhandari 92
  93. 93. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------4.2 Foreign currency bank account  Held in the main currencies ($, Euro)  Pool all transactions in same FX4.3 Leading and Lagging  Watcher / predictor of spot rate changes in short term(say 3 months)  Leading – accelerate exchange(early)  Lagging – delay the exchange(late as possible)  Used a lot by Importers who have to sell their home currency4.4 Netting  “Basic” is to match all FX transactions that occur on the same. Class Illustration Today 30 Sep €200K = Expected Receipt (€ 120K)=Expected Payment €80K)  Multigroup netting-used in group planning and currency risk management. All future FX transactions are converted into one common currency through one company.________________________________________________________________________ Sunil Bhandari 93
  94. 94. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------5 External Hedges5.1 Forward Market(Lock into a Fixed Rate) “Fix the rate today that will apply on a set future date” Technique: - 1. Net the future transactions in same FX and same date. Ascertain if “buying” or “selling” the £. 2. Forward contract, X months, at Forward Rate “may” have to computed as :- SPOT + Discount (- Premium) 3. Exchange FX at the forward rate on the future date.5.2 Money Market Hedge(Rate used is Today’s Spot Rate) “The exchange will take place today at the known spot rate”.________________________________________________________________________ Sunil Bhandari 94
  95. 95. ACCA P4 Advanced Financial Management Key Point Notes December 2010 ------------------------------------------------------------------------------------------------------------ Technique Home Abroad Today’s Spot Today £ Answer FX X ÷ 1 + ints foreign 1+ints homeFuture Date £ Answer FX FX 5.3 Futures(Lock into a rate that will approximately equal Today’s Spot Rate) The hedge is ‘effectively’ like a spread bet. If the company will make a transaction loss by the spot rate rising, then the hedge is to ‘effectively bet’ that this event will occur on the Futures Market. Hence the loss on the Spot Market is offset by the profit on the Futures Market. If a gain is made on the Spot Market then a loss will be made on the Futures Market. Hence it is trying to lock the rate at approx today’s Spot Rate. Technique: - ________________________________________________________________________  Sunil Bhandari 95
  96. 96. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ 1. Draw the timeline showing all rates. Best if rates are presented as value of the currency of the contracts. 2. Setup – Today • Ascertain the downside(d/s) risk • ‘Bet’ on the d/s risk via the futures market. • No. of contracts = Net FX Transaction Futures Rate Standard Contract Size (in currency of the contract) • Work out tick / contract value • Deposit the returnable margin 3. Close out – future date £ (a)Transaction – at spot XXX (b) Futures Profit / Loss (No of contracts x Tick value x Tick Movement) @ SPOT XXX XXX NB: Loss on transaction, gain on the future or gain on transaction loss on the futures.________________________________________________________________________ Sunil Bhandari 96
  97. 97. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------5.4 Options “Right to buy (call) or sell (put) FX at a fixed rate over a set period (American) or on a set date (European)”. Technique: - 1. Timeline-As for futures 2. Set up today • Ascertain if we need a put or a call option • Pick a strike rate from: - 1. Cheapest premium or 2. Nearest to spot or 3. Best possible rate • No. of contracts Transaction ≈ Number Strike Rate Standard Contract Size • Summary Number of contracts x size x rate. • Compute the premium and convert at spot 3. Close out – Future date • All situations cost = premium paid • No receipt or payment in FX – options lapse________________________________________________________________________ Sunil Bhandari 97
  98. 98. ACCA P4 Advanced Financial Management Key Point Notes December 2010------------------------------------------------------------------------------------------------------------ • Compare spot with strike rate – choose the best rate for the business6. Pros & Cons Pros Cons Forward Market• Fixed Rate, certainty • Inflexible/contract• Easy • Lose out on the upside• Cheap • Must ensure FX receipts• Tailored arrive MMH• Convert today • Complicated• Cheap • May not apply for FX• Tailored receipt• Flexible Futures• Effectively fix rate • Complicated• No cost • Small loss• Small gain • Need cash for margin • No tailoring Options• Best hedge – cover • Complicated d/s risk only • No tailoring• Flexibility • Expensive• Lots of choice7. SWAPS7.1 In forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-swap them at the end of the period at an agreed swap rate.  The swap rate and amount of currency is agreed between the parties in advance. Thus it is called a ‘fixed rate/fixed rate’ swap.________________________________________________________________________ Sunil Bhandari 98

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