Bcu msc cg week 10 corporate finance & inv 120812

ASPECTS OF FINANCIAL RISK :
CORPORATE FINANCE
& INVESTMENT
MSC ACCOUNTANCY & FINANCE :
CORPORATE GOVERNANCE
& OPERATIONS RISK ANALYSIS AND CONTROL
Stephen Ong
BSc(Hons) Econs (LSE),
MBA International
Business(Bradford)
Visiting Fellow, Birmingham City University
Visiting Professor, Shenzhen University

• Discussion : Auditor
Independence
1
• Cost of Capital : Equity and Gearing
• Investment Appraisal
• Dividend policy
• Foreign exchange
2
• Case Presentation: IBM3
Today’s Overview

1. Open Discussion
• Rocco R. Vanasco, (1996),"Auditor
independence: an international
perspective", Managerial Auditing Journal,
Vol. 11 No.: 9 pp. 4- 48

Working Capital Cycle
Working Capital
Stocks
Debtors
Bank/Cash
Less Creditors
Purchase stock buy in goods & services
Spendresourcesonlabourand
costs,turnintofinishedgoods
Sell goods to customers on credit
DebtorspaythecashCreditors
arepaid

REVIEW : THE STAFFORD &
SKEGNESS RAILWAY EXAMPLE

2. COST OF CAPITAL:
EQUITY
&
LEVERAGE AND GEARING

The Finance Function in a large organisation

Cash – the lifeblood of the business

Main elements in strategic planning

Factors influencing the value of the firm

Financial markets, institutions,
suppliers and users

Shareholder value analysis
framework

Risk-averse investor’s utility
function

Variability of project returns

Simulated probability distributions

How risk is assumed to
increase over time

Risk premiums for activities of varying risk

Shares and Long Term Capital
Funding
INTERNAL
• RETAINED PROFITS
• Possible Cause of Conflict
• Internal generation is the
cheapest form of finance.
• Shareholders will probably
expect to receive a dividend,
reducing the amount
available for retention.
• Some shareholders may
prefer retention which should
lead to an increase in capital
value.
EXTERNAL:
• Shares sold to
investors
• Debt and Debt
Instruments
• Leasing, Hire
Purchase, contract
hire
• Grants, subsidies
etc.

ORDINARY SHARES
• The Owners.
• The Major ‘Risk Takers’
• Carry Voting rights.
• Authorised and Issued Capital.
• Nominal or Par value, Balance sheet value and
Market value.
• Various issue methods, eg public or rights issue
could be at a ‘premium’
• Revenue return in the form of Dividends, not at
a fixed rate.
• Shareholders will also probably expect an
increase in share value.

PREFERENCE SHARES
Which may be:
• Straight Preference Shares.
• Cumulative Preference Shares.
• Redeemable Preference Shares.
• Cumulative and Redeemable.
• AND THERE IS ALSO LOAN CAPITAL

Loan Capital
• Usually in the form of Debentures.
• Return is in the form of Interest.
• Interest, unlike dividends is tax deductible
• Do not carry voting rights
• May be convertible

ORDINARY SHARES & Rights Issue
• May be ‘sold’ by way of a Public Issue
OR
• A Rights Issue ~ which has the advantages of:
– Costing considerably less than a public Issue
– Rewarding Shareholder Loyalty
– Less likely to change ‘Power Blocks’
– Potentially, S/Holders can maintain % holding
– S/holders can exercise, sell, do both or ignore the
Issue.
‘Rights’ have a value!
There again so do shares and Debentures!
What Factors Influence Value?

Calculating Free Cash Flow (FCF)

Capital structure & Return :
How gearing affects the ROE

The ‘traditional’ view of
capital structure

Leverage and Gearing
The relationship between equity (ordinary shares) and fixed
return finance (preference shares and debt). Consider the
following hypothetical situation:-
Company U Company L Company H
Ord Shares £1.00 Nom. 1,000,000 900,000 100,000
10% Debt - 100,000 900,000
Total Finance = Net Assets 1,000,000 1,000,000 1,000,000
The 3 companies appear to be of a ‘similar size’, but each is
financed differently.

Comparisons
Company U is ungeared or unlevered. It is
composed entirely of equity shares. All profits will
go towards maximising shareholder wealth.
Company H is Highly geared or levered. There is a
high level of debt in relation to the amount of
equity.
Company L is low geared. Debt is small in relation
to the level of equity funding.
There are 3 main implications to gearing which are:

Corporate Control
1. Control ! So, (in theory at least) It would
require:
Company U ~500,001 shares to control £1
Million assets
Company L ~450,001 shares to control £1
Million assets
Company H ~ 50,001 shares to control £1
Million assets
For a relatively small share input tremendous
control can be exerted

Tax deduction
2. Tax deductibility of Debt.
Interest, unlike dividends, is a charge against profits, not an
appropriation of profits. So if we take an example of two
companies, one which is geared and has 100,000 10% debt in issue
and one which is not geared. Assume a Corporate Tax Rate of (say)
40%
Geared Ungeared
EBIT. 50,000 50,000
Interest 10,000 -
Profit after Interest 40,000 50,000 (10,000 diff)
Tax @ 40% 16,000 20,000
Profit after tax 24,000 30,000 (6,000 diff)
The net after tax cost of debt is 10% - tax shield 40% = 6%

Fixed charges coverage
3. Coverage of fixed charges and the
associated risks implications that exist when such
charges have been paid off.
• The debt holders have a prior claim to the equity
shareholders against any profits the organisation
makes. Interest is an operating cost or expense.
• From the investors viewpoint the 3 companies
have different risk profiles. Consider a
situation where each of the three companies
make the same level of profit over 3 years:
£100,000 in year 1,
£120,000 in year 2
and £ 80,000 in year 3.

Fixed Charges Example : Year 1, profit is
100,000 (10% on net assets) Ignore Tax!
E L H
Profit before Interest 100,000 100,000 100,000
Less debt interest - 10,000 90,000
Profit after Interest 100,000 90,000 10,000
Earnings per share £0.10 £0.10 £0.10
All three companies have an EPS of £0.10 even though
L & H are paying debt interest.
Suppose now there is an increase in
profits of 20%, to £120,000

£120,000 (12% on net assets) Ignore Tax!
U L H
Debt Interest - 10,000 90,000
Profit after interest 120,000 110,000 30,000
EPS £0.12 £0.122 £0.30
% increase from year 1 +20% +22% +200%!
Once the fixed charges are covered in the high geared
company there is only a ‘small base’ of equity shares
and returns are high.
However in year 3 assume profits before interest
fall to £80,000.

£80,000 (8% on net assets) Ignore Tax!
U L H
Debt Interest - 10,000 90,000
Profit after Interest 80,000 70,000 (10,000)
EPS £0.08 £0.077
% movement on year 1 -20% -24%
% movement on year 2 -33% -37%
Company H DOOM! Goodnight Vienna !

Fixed Charges Example :
Implications
• Fixed charges must be covered! If interest levels
are substantial so is the risk of default. This place
a high risk on the debt holders and a high risk on
the equity shareholders.
• The extreme level of gearing in the Company
H example is unlikely because:
– There is a very high risk to the equity shareholders.
Such a high level of risk would demand a very high
return.
– There is a very high risk to the Debt holders, they
too would require a high return. Also of course if
they see that it is the majority of their finance
which is generating profits they will want the
majority of those profits.

But ~ Capital structure is important
• Assume Gardener Plc has 500,000 ordinary shares of £0.50
nominal, no debt and generates net earnings of £75,000.
The market price of one share is £1.00 so the market
capitalisation or value of Gardener Plc is £500,000
• The required return and therefore the cost of capital is
• Earnings x 100 = 75,000 x 100 = 15%
• Market value 500,000
• £100,000 6% (net after tax shield effect) debt is
introduced.
• Gardner now has an ‘extra’ £100,000 to use to generate
earnings.
• It is reasonable to assume it will generate a net return of
15% on those ‘extra’ resources. SO.....

Gardener plc
Total value of all financing:
Ordinary shares 500,000
Debt 100,000
600,000
Generating 15% net = 90,000
Less net debt interest 6,000
Profit after interest 84,000
• However the risk profile of Gardener Plc has changed. The
company now has to cover the fixed interest charges.
• From the debt holders viewpoint their risk is relatively low and
will accept a net return of 6%.
• The ordinary shareholders however may require a higher return
than the base 15% to compensate them for the extra risk.
• Assume their required return moves to 16%.
Then:

Gardener plc : Value of shares
• A total return of 84,000 will need to represent a return of
16% so the capital value will be 84,0000 = £ 525,000
0.16
• The market value of 1 share will be £525,000 = £1.05
500,000 No. of
shares
• This means:
Nominal Price Value Proportion K Weight
o/s 500,000 £.05 525,000 84 16 13.44
Debt 100,000 16 6 0.96
625,000 100 14.40
The overall cost of capital has fallen from 15% to 14.40%!
• The value of the company and ordinary shares has risen.
An Increase in excess of the ‘extra’ £100,000 (of debt)
which was put in.

Harrington plc
• Harrington PLC has 1,000,000 ordinary shares of
£1.00 nominal in issue. The current market price of
one share is £1.50 and Harrington’s earnings are
£255,000. The company issues £200,000 5% (net
after tax) debt. Following the debt issue the share
price increases to £1.59.
1 What is Harrington’s cost of capital prior to the
debt issue?
2 What is the shareholders required return after the
debt issue?
3 What is Harrington’s WACC after the debt issue.?

Harrington plc : Cost of capital & shareholder return
• Earnings 255,000 x 100 = 17%
Market Value 1,500,000
• Cost of capital = 17%. Harrington generates 17% on
finance available.
• Original earnings 255,000
amounts generated on debt finance
200,000 x 17% 34,000
289,000
less net debt interest 200,000 @ 5% 10,000
available for Ordinary S/H 279,000
Total value of all ordinary shares moves to 1,000,000 @
1.59 = 1,590,000
(new) Earnings 279,000 x 100 = 17.54%
M. Value 1,590,000

Harrington plc : WACC
3 WACC after debt issue.
Value Proportion K Weight
Ord shares 1,590 88.82 17.54 15.57
Debt 200 11.18 5.00 .56
WACC is in the region of 16.13
Cost of capital is reduced,
Value of firm increased.

This would lead us to assume that if
we graphed Ko against leverage........
O Gearing 100%
Ko
Cost
of
capital
Optimum Capital
Structure

Gearing and the cost of capital
However, Modigliani and Miller hold a somewhat different
view of gearing and the cost of capital!
• They contend that the potential increase in share values is
unrealistic and that consequently the share is
overvalued.
• So, by a process called arbitrage people will capitalise on
this apparent over value and sell the shares. Eventually the
price of the shares will fall to equate with an ungeared firm
or organisation. This is very much an oversimplification!
• However they contend that because of this, although the
initial introduction of debt will reduce cost of
capital because of the tax deductibility of
interest, Ko will then remain constant regardless of the
level of gearing. (and by default the value of the shares and
company)

Whereas M & M consider...
0% Gearing 100%
Cost of
Capital
Ko

And Perhaps Reality is
Optimum
Capital
Structure
Range
0% Gearing 100
Cost of
Capital
Ko

INVESTMENT APPRAISAL
Investment in long-term assets or projects
is an element of long-term strategic
planning. The Investment decision has a
progression of 4 elements:
1. Perception
2. Formulation (of alternatives)
3. Evaluation (of alternatives)
4. Choice or Selection

Lampard proposal: NPV–IRR graph

What is involved
• EDMONDS ENGINEERING Plc is a company manufacturing
components for consumer goods. It expects to grow over
the next few years following the decision by a major
appliance manufacturer to place a long term contract with
Edmonds. This will require an investment in new plant and
machinery.
• The newly appointed Operations Director is concerned at
the firm’s lack of formal appraisal procedures. At previous
firms where he has worked he has come
across, Payback, Accounting rate of return, DCF and yield.
He is not sure which method to adopt.
– A. Discuss the merits and advantages of each of
the four methods.
– B. Recommend and justify which technique
should be adopted by Edmonds

Mariner PLC HAS A PROJECT IN MIND
• Project 1
Outlay 100,000
Expected annual net profit (loss)
Year 1 29,000
2 (1,000)
3 2,000
Estimated residual value 7,000
• The company has an estimated weighted average cost
of capital of 10% and uses the straight line method of
depreciation when calculating net profit.
• Appraise the project

PROJECT I
The average annual profit is
(29,000 + (1,000) + 2,000 )/3 = £ 10,000 pa.
So the Accounting Rate of Return is:
10,000/100,000 x 100 = 10%
BUT
How Reliable is the data?
Profit will be after allowing for depreciation
which is a ‘non-cash’ item

SO:
• Annual depreciation must be:
(100,000 – 7,000)/3 = 31,000 pa
• So the CASH FLOWS generated must be:
29,000 + 31,000 = 60,000
(1,000) + 31,000 = 30,000
2,000 + 31,000 = 33,000
&
• Residual or scrap value 7,000
• SO the Pay back is 2.30 years

And the D C Fs
• Outlay (100,000)
Cash flows 10%
1 60,000 .91 54,600
2 30,000 .83 24,900
3 33,000 .75 24,750
3 7,000 .75 5,250
• Discounted Cash Flow 109,500
• +ve Net Present Value 9,500
• The Project is viable
• The Discount Factor is the Cost of Capital, K.

And if we wish to establish Yield
• Outlay (100,000)
Cash flows at 18%
1 60,000 .85 51,000
2 30,000 .72 21,600
3 33,000 .61 20,130
3 7,000 .61 4,270
• Discounted Cash Flow 97,000
• -ve Net Present Value (3,000)
• So actual return or yield is above 10% but
below 18%

Project 1 : Yield
• SO the actual rate of return or yield, is greater than
10% but less than 18%
10 18 range = 8
|-----------------|------|
9,500 0 -3,000 range = 12,500
• 9,500/12,500 x 100 = 76% along the scale
• 8 x 76% = 6.08
• Yield = 10 + 6.08 = 16.08%

Project 2
Payback ~ 2.36 years
N.P.V. ~ £7,040
Yield ~ 17%
Accounting Rate of Return ~ 11.1%
Project 1 is preferable because it generates
the greatest Net Present Value.
So if this is the case why bother with
alternative methods? These can have a role
to play in......

Why alternatives?
• Providing added criteria if two or
more projects have a similar NPV
• Acting as a ‘sifting mechanism’
during formulation of
alternatives.
• Acting as a ‘hurdle rate’ or
‘benchmark’

Project 2
(annual Dep’n=60,000-6,000/3 18,000)
(60,000)
36,000 .91 32,760
16,000 .83 13,280
22,000 .75 16,500
06,000 .75 4,500
67,040
NPV 7,040
(60,000)
36,000 .85 30,600
16,000 .72 11,520
22,000 .61 13,420
06,000 .61 3,660
59,200
NPV @ 18% -ve 800
Yield 7,040/7840 x 100 = 89.8%
8 x 89.8% = 7.18
Yield is 10 + 7.18 = 17.18%

But What About such things as
• Taxation
• Risk
• Taxation ~ if a project makes profits it will
have to pay tax on those profits. The
taxation will reduce the gross cash flows.
• However, Corporate taxation is paid 9
months after the year end, ie. in the year
following the year in which the profit was
made. So for example:

Example : Taxation
Viceroy Plc is appraising a project. This is considered to
give rise to the following 3 year life cash flows:
Year 1 £ 65,000 Tax on the profit generated £ 12,000
SO the actual cash flows to be discounted at the cost of
capital would be: NCF
Year 1 + 65,000
Year 2 80,000 - Year 1 Tax 12,000 + 68,000
Year 3 95,000 – Year 2 Tax 14,250 + 80,750
Year 4 Tax Year 3 profits -ve 16,000

RISK & Investment Appraisal
Measures or approaches to allow for risk
include:
a. Risk adjusted discount rate. The cost
of capital is calculated. A ‘risk
premium’ is added to WACC and used
to discount the project.
b. Certainty equivalents. Assuming the
base figures to be the most
conservative. The lowest level of
sales units and highest level of
production costs.

c. Sensitivity analysis. Determination of
how sensitive a project is to changes in
circumstances. Consider the case of
Project X. The cost of capital is
calculated to be 8%
Project X Outlay
7,000
Net Cash flows 8% factor DCF
Year 1 4,000 .926 3,704
Year 2 4,500 .857 3,856 7,560
+ve Net present Value 560
• Now if we delve deeper into the underlying
information we are able to determine:
Outlay (7000)
Inflows Outflows NCF k=8%
Year 1 6,000 2,000 4,000 .926 3,704
Year 2 7,000 2,500 4,500 .857 3,856
+ve NPV 560

We can now establish
1 The PV of the inflows 6,000 .926 5,556
7,000 .857 5,999
11,555
2 The PV of the outflows 2,000 .926 1,852
2,500 .857 2,143
3,995
3 So now we can look at such things as ~ How
sensitive is the project to a change in capital
cost?
Project NPV 560 x 100 = 8%
Capital cost 7,000
Capital costs could rise by 8% before the project
is jeopardised

4 The sensitivity of the project to changes in in
operating costs:
Project NPV 560 x 100 = 14%
Operating costs 3,995
Operating costs could rise by 14% before
project is jeopardised. The project does not
seem to be particularly sensitive to changes
in costs.
5 The sensitivity of the project to changes in
revenues:
Project NPV 560 x 100 = 4.8%
Revenues 11,555
The project is far more sensitive to changes in
revenues than costs.

Combinations of risk : Example
If costs rise by say 6% what is the latitude
on revenues?
Project NPV
560 cost rise 3,995 x 6%
240 Relating to revenues
320 320 x 100 = 2.8%
11,555
So what would the latitude on revenues
be if costs rose by 7%

Application of Probabilities
Probability ~ the likelihood of something
happening. So the probable outcomes of
flipping a coin are:
Heads
or Tails
There is a 50/50 chance of either, a 50% chance
of heads or tails. We can express this as:
Probability
Heads .50
Tails .50
1.00 certainty, it will be one or
the other

Unless of course you are a pedantic purist when you
may argue for example that:
Probability
Heads .49995
landing and remaining on edge .00010
Tails .49995
1.00000
We can apply this to the investment decision. For
example the sales forecast(s) relating to 2 future
projects are as follows:
A B
Not less than £ 240,000 300,000
Realistically 350,000 380,000
Not more than 410,000 450,000

Then probabilities could be assigned~
A 000’s Prob B 000’s Prob
240 .20 48.00 300 .12 36.00
350 .75 262.50 380 .80 304.00
410 .15 1.50 450 .05 22.50
1.00 E = 312.00 1.00 E = 362.50
By applying such techniques as standard deviation we
can obtain an insight into the relative riskiness of
each project. By the same token we could discount a
project or projects and assign probabilities to the
achievement of the net present value that has been
calculated.
For example:

Example : Probability
Two mutually exclusive courses of action have been
appraised and show net present values (£000’s) of:
Project Alpha Project Beta
750 760
Analysts, economists, market researchers et al have
reviewed all the underlying figures and assumption
and concluded the following in relation to the two
projects:
Prob Prob
NPV being 750 .65 760 .55
NPV being 800 .24 820 .20
NPV being 680 .11 660 .25
Which Project do you consider to be preferable?

Example : Probability
Prob Prob
NPV 750 .65 487.50 760 .55 418.00 NPV
800 .24 192.00 820 .20 164.00 NPV 680
.11 74.80 660 .25 165.00
753.30 747.00
• Project Alpha gives rise to the greatest expected
net present value and is preferable to beta.
(other aspects eg std deviation should also be
taken into consideration.
• This approach is often presented in a Decision
Tree format to give a clear indication of different
courses of action

Exercise : Swift plc (1)
Swift Plc has just successfully relocated to larger
and more up to date premises. The Board are
now considering the best course of action to
take in respect of the old factory site. three
courses of action have been suggested.
1. Sell the entire site as it stands to a property
development company for £3 million.
2. Wait for a year. At this time analysts have
predicted that there will be a 55% probability it
could be sold for £3.8 million, a 35% probability
it could be sold for £3.1 million and a 10%
probability that it would be sold for £2.5
million.

Exercise : Swift plc (2)
3. Undertake some basic reclamation alteration and
improvement works. This would cost £650,000, but
having undertaken it, analysts predict a 60% probability
that it could be sold for £4.7 million, a 30% probability
that it could be sold for £3.5 million and a 10%
probability that it could command a value of £3.0
million.
• Note that all costs and revenues are given in present
values and should not be discounted
• You are required: To draw a decision tree covering the
above courses of action and also to prepare a report for
management giving your recommended course of action
based on the decision tree, bringing to management’s
attention any other points of factors that you consider
they should bear in mind.

A simple capital budgeting system

Investment Appraisal :
Capital Budgeting EXAMPLE
• GUY has had a hot tip! It requires an
investment or outlay of now of £850.
• Cash Flows of £400 pa will arise at
annual intervals for three years starting
one year hence.
• So: The pay back is 2 years 3 months
• Is this a worthwhile Investment ?

Example
• He pays out £850 and collects £1,200
• His average (accounting rate of) return
is
–400/850 x 100 = 47%
–£400 = average annual profit
• UNFORTUNATELY:
• Guy is ‘broke’ but, he can borrow the
money at 8% pa
• Is he still onto a ‘good thing’?

Example : WELL~ 8% seems to
be the Key
Assume a base of 100.00
8% 8.00
108.00
8% 8.64
116.64
8% 9.33
125.97
100/108 = .9259
100/116.64 = .8573
100/125.97 = .7938
2.577

Example : Discount factors
.9259, .8573 & .7938 are PV or
discount factors, 2.577 is a three
year annuity factor for 8%
£
So: Paid out 850.00
Cash Inflows:
8% factor DCF
Year 1 400 @ .9259 370.36
Year 2 400 @ .8573 342.92
Year 3 400 @ .7938 317.52
Discounted Cash Flows 1,030.80
+ve Net Present Value 180.80
(400 @ 2.577 = 1,030.80)

And to prove it is no ‘fix’:-
Summarised Bank account over three Years:
Now o/d = (850.00)
Bank charges interest of 8% (68.00)
(918.00)
But we receive a cash flow of 400.00
(518.00)
Year 2 Bank charges 8% (41.40)
(559.40)
We receive a cash flow of 400.00
At the end of year 2 (159.40)

So in Year 3 it all comes together:
We start year 3 with (159.40)
The Bank Charges us 8% (12.80)
(172.20)
And we receive our last cash inflow 400.00
And we finish with 227.80
And the clever bit…………………

£ 227.80 is what we will have in 3 years time:
The Present Value or PV of this amount now is
227.80 @ .7938 = 180.80
We have increased our present value by 180.80

Dividends & Dividend Policy
• Paid out of Earnings, but retained
earnings are probably the most
important source for finance. Thus
an area of conflict. Dividend Policy
will need to address Goal
Congruence.
• Corporate needs will need to
balanced against shareholder and
stakeholder expectations.

The impact of a permanent
dividend cut

• Consider this situation. Matador has I million
ordinary shares of £1.00 nominal in issue.
Matador has announced that it has made
profits of £300,000. The company has
previously ‘paid out’ all profits made as
dividends.
• Current market value cd is £2.30 (reflecting the
expectation that a dividend of £.30 per share
will be paid.)
• An opportunity to invest £300,000 (the total
potential dividend) arises which will generate
£45,000pa. What would happen if the potential
dividend was used to finance the investment ?
Example : Matador

Currently:
Shareholder wealth is share value 2.00
and the (‘potential)dividend’ 0.30
in total 2.30
0.30/2.00 implies Ke of 15% the same as the return on
the project
The £300,000 is used to finance the project. Therefore in
future the (extra) £45,000 generated could be used to
pay dividends ~ 45,000/1,000,000 = (increase in
div) £ 0.045
but the ‘base’ dividend is 0.300
so total future dividends = 0.345

This will be 1 year on so:
• Present value of future dividends at 15% K will
be 0.345 x 0.870 = £0.30 ~ £2.00+0.30 = £2.30
• PV of future Dividends = 0.345 /.15 = 2.30
The dividend foregone has effectively been
replaced by a capital gain.
• Simplified because of such factors as
Divergences of rates of return, communications
to the market, taxation, transaction costs,
shareholder expectations.
• So: Are Dividends Irrelevant?

M & M Theory of Dividends
• Essentially dividends are irrelevant and
shareholders will form a clientele as to
whether they want dividends or capital
growth.
• Perhaps what is more important than
dividend policy is the likely outcome of
a change (however perceived) of policy.
• So what must be born in mind when
making the dividend decision?

Other Factors.
Dividends:
• Express confidence.
• There is a risk reduction cash today not hopes for the
future, they act as a resolution of uncertainty.
• Policy of comparable enterprises
• What are shareholder expectations?
• What is the legal position?
Capital Gains:
• Offer a Tax exempted level.
• Will involve sale of the investment with associated
transaction costs.
• May appeal to certain shareholders

Consider the possibility/suitability
and implications of:
• Profit patterns and trends.
• Other possibilities include:
–Shareholder benefits
–Share repurchase and dealing
schemes
–Stock dividends

We must be mindful towards
maintaining (and enhancing):
• The share price
• Reputation
• Credibility
• Shareholder confidence
• Shareholder Loyalty

Factors influencing
Exchange Rates
1.Currency supply & demand
2.Interest rate
parity/Expectations theory
3.Purchasing power parity
4.The Fischer effect (interest
rates & expected inflation)

Evolution to Floating
Exchange Rates
• The Smithsonian Agreement (1971)
–8% devaluation of the dollar
–revaluation of other currencies
–widening of exchange rate flexibility
• The Jamaica Agreement (1976)
–provided greater exchange rate
flexibility
–eliminated the use of par values

Exchange Rate Arrangements
• Under the Jamaica Agreement
countries selected and maintained
their own exchange rate
arrangements
• The IMF monitors the exchange
rate policies of countries to see if
they are acting openly and
responsibly

Exchange Rate Arrangements
Exchange Rate Arrangements and Anchors

Three Choices:
Hard Peg, Soft Peg, or Floating
• The IMF classifies currencies into three categories
• Hard peg
– 12.2% of total
– value is locked into something and does not change
– dollarization
– currency boards
• Soft peg
– 45.7% of total
– more flexible than hard peg
• Floating
– 42.1% of total
– floating or freely floating

The Euro
• The European Monetary System (EMS) (1992)
– established to create exchange rate stability within
the European Community
• European Monetary Union (EMU)
– outlined the criteria for euro applicants (17/27)
•the U.K., Sweden, and Denmark
opted not to adopt the euro
• The European Central Bank (ECB)
– sets monetary policy for the adopters of the euro

Determining Exchange Rates
• Currency in a floating rate
world
–demand for a country’s currency
is a function of the demand for
that country’s goods and
services and financial assets

The Equilibrium Exchange Rate and How it
Moves

• Currency in a fixed rate or managed
floating rate world
–Role of central banks
• reserve assets
• intervening in the market
• attitudes toward intervention
–The Bank for International Settlements (BIS)
• the central banks’ bank
• coordinates central bank intervention

Black Markets
• A black market closely
approximates a price based on
supply and demand for a
currency instead of a
government controlled price

Foreign Exchange
Convertibility and Controls
• Hard currencies
– U.S. dollar, euro, British pound, Japanese yen
• Soft currencies
– developing countries
• Countries can control convertibility through
– licenses
– multiple exchange rate systems
– advance import deposits
– quantity controls

Exchange Rates and
Purchasing Power Parity
• Purchasing power parity (PPP)
–a change in relative inflation
between two countries must cause a
change in exchange rates to keep the
prices of goods in the countries fairly
similar
• The Big Mac Index

Exchange Rates and Interest Rates
• The Fisher Effect
–links inflation and interest rates
• The International Fisher Effect (IFE)
–links interest rates and exchange rates
• Other Factors in Exchange Rate
Determination
–Confidence (speculation)
–information(speculation)
– trade flows

Interlocking theories in
international economics

Fundamental and Technical
Forecasting
• Forecasting exchange rates
– Fundamental forecasting
•uses trends in economic variables to
predict future rates
– Technical forecasting
•uses past trends in exchange rates to
spot future trends
– Biases can skew forecasts
– Timing, direction, and magnitude of exchange rate
movements are important to consider

Fundamental Factors
to Monitor
• Monitor
–The institutional setting
–Fundamental analyses
–Confidence factors
–Events
–Technical analyses

Business Implications of Exchange
Rate Changes
• Marketing Decisions
– when the value of a country’s currency rises, exporting
becomes more difficult as the product becomes more
expensive in foreign markets
• Production Decisions
– might locate production in a weak currency country because
the initial investment is cheap and it will make a good base
for exports
• Financial Decisions
– currency rates influence sourcing, cross-border remittance
of funds, and the reporting of financial results

Foreign Exchange Risk Management
• Types of foreign exchange exposure
– Translation
• exposed accounts either gain or lose value in dollars
when the exchange rate changes
– Transaction
• when a transaction is denominated in a foreign currency
and the settlement results in a cash flow gain or loss
– Economic or operating
• the potential for change in expected cash flows that
arises from the pricing of products, the sourcing and cost
of inputs, and the location of investments

Foreign Exchange Risk Management
• Exposure Management Strategy
– Defining and measuring exposure
– Creating a reporting system
– Adopt a policy assigning responsibility for
minimizing or hedging exposure
– Formulating hedging strategies
•Operational
–leads and lags strategy
•Financial
–forward contracts and currency options

Devising a foreign exchange management
strategy (based on McRae, 1996)

Foreign Exchange : Implications
• Rates of Exchange may be quoted in two ways,
EG:
– £stg = 1.60 Frankmarks is the same as:
– Frankmark = £stg 0.625
• In reality two rates are quoted, the rate at
which the bank or dealer will buy or sell the
currency, for example:
– £stg = $ 1.5690 ~ 1.570 which is also of course
$ = £ .6374 ~ .6369
SO:

Foreign Exchange Example
• If we have £100 we can buy (100 @ 1.569) $156.90
(The same as 100/.6374)
• And we can sell $156.90 (156.9 @ .6369) £ 99.93
(the same as 156.9 / 1.57)
• The bank makes a commission on buying and selling.
• However ~ ‘we’ may contract to supply a foreign customer or give
an order to a foreign supplier. When the ‘deal is struck’ we know
what the rate of exchange is. When the time comes to collect or
pay the rate of exchange may be different. We have ‘Exposure
Risk’
• We can adopt an aggressive or defensive (risk taking or risk
averse) approach. Do we want a safe and predictable outcome, or
do we want to try to ‘make a profit’ out of currency dealings.

Managing Exposure Risk
• We can buy currency on the ‘Spot’ or we can
take out a Forward Contract for example:
– Spot £ = $1.5
Three Months forward £ = $1.55 in which case
the $ is at a forward discount and the £ at a
forward premium.
• Conversely
Spot $ = £0.667 (£=1.50) Forward
$ = £0.680 (£=1.47) The £ is at a forward discount

Influences on exchange rates
• include, inter alia:-
– Supply and demand
– Rates of Inflation
– Interest Rates
– Balance of Payments
– Speculation
– Government policies and actions etc.
• Using a forward contract will eliminate any
‘exposure risk’ We can plan with certainty.
• Should Treasury Department be a cost centre or a
profit centre. Should it aim to make profits out of
currency rate movements and fluctuations.

FX Example : What’s the outcome?
• What do you think of the Treasurer’
actions (Dominator example)
£ stg
• Actual Outcome July $6 mil @ 1.442 4,160,888
September $6 mil @ 1.508 spot 3,978,780
8,139,668
• If Forward taken in March $12 Mil @ 1.485 8,080,808
• Sell forward in July $12 mil @1.442 8,321,775
• Sell spot in September $12 mill @ 1.508 7,957,560
• Has he made a profit? Incurred a loss? Acted in a
reckless manner? What were the reasons for his
courses of action? Was he authorised to take such
actions and so on.

FX Example
• Spot Rate March £1 = $1.500 $1 = £0.6666
$12 m will buy £ 8 m
• March 3 months forward £1= $1.485 $ 1 = £0.6700
$12m would buy £8,080,808
• The forward contract is assuming the $ is at a forward
premium and the £ at a forward discount. The $ will
strengthen and the £ weaken. You will get more £ for
your $ and fewer $ for your £. You are buying £ with $
and would benefit compared to March Spot.
• June 3 months forward £1 = $1.442 $ 1 = £0.6935
The forward contract is assuming the £ will continue to
weaken against the $ and the $ will continue to
strengthen against the £.
• However 3 months after June

FX Example
• The September spot is £1 = 1.5080 $1 = £0.66
• Contrary to the situation assumed in the July 3 month
forward contract the £ has rallied and strengthened
against the $. The $ has weakened against the £.
Dominator is selling dollars and can buy fewer £.
• The possibility of invoicing overseas customers in £ and
passing the exposure risk to the customer should be
considered.
• Also if Dominator had an American subsidiary or division
payment could be made to them.
• The situation(s) outlined would be reversed if Dominator
was required to pay an American supplier in $.

Source: Buckley and Casson (1981).
Exporting vs. FDI

Classification of firms by extent
of operating exposure

The Future: The Dollar, The
Euro, The Yen, The Yuan
• Europe
– the euro should take market
share away from the dollar
as the prime reserve asset
assuming the problems in
PIIGS, ie Greece and other
countries are controlled ???
• Asia
– China is moving forward to
establish the yuan as a
major world currency ???
• Latin America
– emerging market currencies
should strengthen as
commodity prices recover
???

Core Readings
• CIMA - Performance Strategy: Study Text (2013)
BPP Learning Media Ltd. Part C : 9-12
• Pike, Neale & Linsley (2012) Corporate Finance
and Investment 7th edition, Pearson Education

Next Week’s Ideas for Discussion
• Bartram, S (2008) What lies beneath:
foreign exchange rate exposure, hedging
and cash flows. Journal of Banking and
Finance, 32 (8). pp. 1508-1521.

Casestudy 5 : Gertsner’s Pay
Package at IBM
Read and prepare the
Casestudy on Gertsner’s
Pay Package at IBM
(Monks & Minow (2011))
for discussion next class.
Identify the corporate
governance issues faced.
You are required to:
–Map out the stakeholder
power/interest issues.
–Evaluate the executive
compensation & incentives
scheme and model of
executive succession
planning.
–Propose a more equitable
scheme and model to
satisfy all stakeholders.

Bcu msc cg week 10 corporate finance & inv 120812

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