Advance Financial Management

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1 ACCA P4 Advance Financial Management Revision Notes (March/June 2017) Page 1 of 138

2 Contents Topic Page No Advanced Investment Appraisal Investment Appraisal 03 Modified Internal Rate of Return 09 Project Duration 11 Weighted Average Cost of Capital 13 Risk Adjusted WACC 34 Adjusted Present Value 40 International Investment and Financing Decision 47 Acquisition and Merger M & A Theoretical aspects 53 Valuation Techniques 64 Reverse Take Over s 74 Corporate reconstruction and Reorganization Types of Reconstruction 78 Business Re-Organization 80 Risk Management Foreign Currency Risk Management 84 Interest Risk Management 93 Option Pricing Theory 102 Other Topics Value at Risk 104 Greeks 105 Bond duration 106 Securitization and Trenching 108 Delta Hedging 108 Dark Pool Trading 110 Credit default Swaps 110 Real Option 113 Multinational Enterprise 119 Behavioral Finance 129 Islamic Finance 131 Page 2 of 138

3 Investment Appraisal Decision making Short term (Single period effect) Long term (Having multi period effects) Investment Appraisal:- A detailed evaluation of projects/investments to assess the viability, its effects on shareholders wealth is called investment appraisal, What is Appraisal:- Any expenditure in the expectation of future benefits. There are two types of investment: Capital expenditure: Capital expenditure is expenditure which results in the acquisition of non-current assets or an improvement in their earning capacity. It is not charged as an expense in the income statement; the expenditure appears as a non-current asset in the balance sheet. Revenue expenditure: Charged to the income statement and is expenditure which is incurred. (i) (ii) For the purpose of the trade of the business this includes expenditure classified as selling and distribution, administration expenses and finance charges. To maintain the existing earning capacity of non-current asset. Relevant Cash flows in Investment Appraisal Relevant cash flows are those cash flows which are: Directly related with the project. Incremental Future cash flows Any cash flows or cost incurred in the past, or any committed cost which will be incurred regardless of whether the investment is undertaken or not is a non-relevant cash flows e.g. sunk cost, Allocated/General fixed overheads etc. The other cash flows, which should be considered as Relevant Cash flows are as follow: Opportunity Cost: Tax: Residual value: Infra-structure Costs: Marketing Costs: Page 3 of 138

4 Human resource costs: Finance Related Cash flows: Relevant Benefits of Investment: Relevant benefits from investments include not only increased cash flows but also savings and relationships with customer and employees. These might consist of benefits of several types; Savings because assets used currently will no longer be used. The savings should include savings in staff costs, or savings in other operating costs, such as consumable materials. Extra savings or benefits because of the improvements or enhancement that the investment might bring. These include more sales revenue, greater contribution, more efficient systems operation and savings in staff time. Possibly someone off revenue benefits from the sales of assets that are currently in use, but which will no longer be required. Greater customer satisfaction, arising from a more prompt service (e.g. because of a computerized sales and delivery service). Improved staff morale from working with high quality assets. Better decision marking may result from better information system. Investment Appraisal Techniques i. Payback period method,(non-discounted) ii. Net present value method (NPV), (Discounted) iii. Internal rate of return method (IRR), (Discounted) iv. Discounted payback period method, (Discounted) v. Modified internal rate of return (MIRR),(Discounted) vi. Duration,(Discounted) vii. Adjusted present value (APV),(Discounted) Payback period method: Definition:- The time period, in which initial investment is recovered, known as payback period. The number of years for the cash out lay to be matched by cash inflows. Formula:- For constant (Even) cash flows: Payback period = Initial investment Annual inflows For Uneven cash flows: Draw a cumulative cash flow column, then calculate project payback period. Answer should be compared with the target payback period of the business. Page 4 of 138

5 Decision rule:- Feasibility Decision: If payback period is less than target payback period then ACCEPT the project. If payback period is more than target payback period then REJECT the project. Comparison Decision: Project with minimum payback period should be preferred. Advantages of payback period:- It is simple to calculate and easy to understand, as it does not involve complex calculations. Payback period method can also be use as a basic screening device at the first stage for short list projects. It considers cash flows rather than accounting profits, that s why chances of manipulation are very low. Payback period method indirectly avoids risk as it gives favor to those investments which have short payback periods. This method helps the company to grow, minimize risk and maximize liquidity. In the situation of capital rationing, it can be used to identify the projects which generate additional cash for investment quickly. It does not consider the time value of money. Disadvantages of payback period:- It does not consider the whole life of money. It might be possible that it will favor the projects, giving high cash inflows in the starting years only and giving very low cash inflows in the remaining years. There is no specific criteria or rule which can justify that company s target payback period is measured accurately that why it is difficult to measure target payback period. It may lead to excessive investment in short term projects. It does not consider the risk and uncertainty in the projects. Uncertainty of cash inflows can deteriorate the results. It does not focus on shareholders wealth maximization. Life expectancy of a project is ignored. Projects with same payback period may have different cash flows. Page 5 of 138

6 Formula to calculate NPV:- NPV=PV of cash inflows - PV of cash outflows. Decision Rule:- If NPV of the project is positive, accept the project If NPV of the project is negative, reject the project. NET PRESENT VALUE (NPV): Advantages of Net Present Value: Net Present Value method takes into account the time value of money and this is giving a better picture of the projects viability. It considers the whole life of the project because all cash flows relating to the project life is incorporated in its calculations. It gives an indication about the increase or decrease in the wealth of shareholders. Its decisions rule is consistent with the objective of maximization of shareholders wealth. It focuses on cash flows rather than accounting profit, so it takes into account the relevancy and irrelevancy of cash flows. Change in cost of capital can be incorporated in it. It can also be used for projects with nonconventional cash flows. It gives a better ranking of mutually exclusive projects. It assumes that cash flows are reinvested at the company s cost of capital. NPV is technically more superior method to IRR because of its less rigid assumptions. Disadvantages of Net Present Value: It involves complex calculations as compared to other techniques. Resultantly, it is difficult to calculate and difficult to understand. Managers feel it difficult to explain the calculations of Net Present Value method. It does not take into account the risk and uncertainty of estimates and scarcity of resources. Cost of capital used in NPV calculation is difficult to calculate and gets subjective when we incorporate risk and uncertainty within companies cost of capital. Changing technology may render the product obsolete before the natural end of the project life. It fails to relate the return of the project to the size of the cash outlay. Internal Rate of Return (IRR) Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero. It s the maximum cost of capital that should be acceptable for evaluating investment projects. As any increased in the cost above IRR will result in negative NPV. IIIIII = rr aa + NNNNNN aa NNNNNN aa (rr bb rr aa ) rr aa = LLLLLLLLLL dddddddddddddddd rrrrrrrr cchoooooooooo Page 6 of 138

7 rr bb = HHHHHHheeee dddddddddddddddd rrrrrrrr cchoooooooooo NN aa = NNNNNN aaaa rr aa NN bb = NNNNNN aaaa rr bb Year Cash flows (400) (600) Dis. 10% Present Values (400) (545) NPV 214 Year Cash flows (400) (600) Dis. 20% Present Values (400) (500) NPV 25 IIIIII = (20 10) = 19% 19% is the maximum cost of capital that should be acceptable as it s the rate where NPV of the project will be zero. Decision Rule:- Feasibility Decision: If IRR of the project > Benchmark Cost of Capital, Accept the project because the project is adding value to the owners wealth resulting in positive NPV. If IRR of the project < Benchmark Cost of Capital, Reject the project because the project is destroying value in shape of negative NPV. Comparison Decision: Project with higher IRR shall be preferred. Advantages of IRR: IRR takes into account the time value of money and thus giving a better picture of the projects viability. It considers the timing and life of the project. It can be calculated by assuming any discount rate in its calculation. IRR is easier to understand as compared to NPV. Risk can be incorporated into decision making by adjusting the company s target discount rate. Page 7 of 138

8 PROBLEMS WITH IRR IRR assumes that all the cash flows are reinvested in the project at calculated IRR which may be invalid in case of high IRR. IRR produces multiple answers in case of non-conventional cash flows. IRR is not helpful in choosing the best answer in case of mutually exclusive projects. IRR is a relative measure therefore it does not consider the size of the project. Page 8 of 138

9 Modified Internal Rate of Return Modified internal rate of return (MIRR) provides the same result as IRR but it assumes that positive cash flows are reinvested at the firm's cost of capital. For example, suppose that a project has an NPV of +$300,000 when discounted at a cost of capital of 8%, and the IRR of the project is 14%. In calculating the IRR, an assumption would be that all cash flows from the project are reinvested as soon as they are received to earn a return of 14% even though the company s cost of capital is 8%. MIRR would be calculated on the assumption that project cash flows are reinvested, when received, to earn a return equal to 8% per year. MIRR is more realistic because it s based on the cost of capital as the reinvestment rate. MIRR 1st FORMULA MMMMMMMM = PPPP RR PPPP II 1 nn (1 + rr ee) 1 Year Cash flows (400) (600) Dis. 10% Present Values (400) (545) NPV 214 MIRR = [(1159/ 945) ^ (1/6)] ( ) 1 = 13.8% MIRR 2ND FORMULA TTTTTTTTTTTTTTTTTT CCCCCCh FFFFFFFF OOOOOOOOOOOO = 1 + MMMMMMMM)nn n is the number of years of the project. We can arrange this formula and find a solution for this project as follows: nn TTTTTTTTTTTTTTTT CCCCCCh FFFFFFFF MMMMMMMM = 1 OOOOOOOOOOOO Year Cash flows Inflating Factor (1.1)^4 (1.1)^3 (1.1)^2 (1.1)^1 Terminal Values Page 9 of 138

10 MIRR = [(2056/945) ^ (1/6)] 1 = 13.8% WHY USE MIRR INSTEAD OF IRR MIRR assumes reinvestment of cash flows at cost of capital which is more realistic in case of having a very high IRR. In case of non-conventional cash flows MIRR produces a single answer. It is easier to calculate than IRR. MIRR decision is in line with NPV decision so there are lesser chances of conflict. Advantages of MIRR: Tells whether an investment increases firm s value. Considers all cash flows of a project. Considers time value of money into account. Addresses the reinvestment rate issue i.e. it does not make the assumption that the company s reinvestment rate is equal to whatever the project IRR happens to be. Provides rankings which are consistent with the NPV rule (which is not always the case with IRR). Provides a % rate of return for project evaluation. It is claimed that nonfinancial managers prefer a % result to a monetary NPV amount, since a % helps measure the headroom when negotiating with suppliers of funds. Considers the riskiness of future cash flows (through the use of cost of capital as a decision rule)... Relatively quicker to calculate. Don t produce multiple answers. Disadvantages of MIRR/ Reservations with MIRR: Requires an estimate of the cost of capital in order to make a decision. May not give the value maximizing decision when used to compare mutually exclusive projects. May not give the value maximizing decision when used to choose projects when there is capital rationing. In what are claimed to be the very exceptional circumstances where the reinvestment rate exceeds the company s cost of capital, the MIRR will underestimate the project s true rate of return. The determination of the life of a project can have a significant effect on the actual MIRR, if the difference between the project s IRR and the company s cost of capital is large. Like IRR, the MIRR is biased towards projects with short payback periods and large initial cash inflows. The extent to which this method is being used in industry is unclear and only time will tell whether it eventually becomes popular Page 10 of 138

11 Capital Investment Project Duration It is the weighted average time required to obtain cash flows from investment. Another way of saying this is that the duration of the project is the time required to cover one half of the value of investment returns. Steps to calculate duration Find discounted cash flows of return phase Find total present value of return phase by adding all discounted cash flows calculated above Find proportion of all present values by dividing each present value with total Find weighted average years by multiplying relevant years to above proportion Add all weighted years as duration Duration can be used in capital investment appraisal to assess the payback on the project. Unlike payback and discounted payback, however, it takes into consideration the total expected returns from the entire project (at their projected value), not just returns up to the payback time. Decision Rule: Duration of the project < Target life of the project = Accept the project Duration of the project > Target life of the project = Reject the project If duration of the project is short relative to the life of the project- for example, if the duration is less than half the expected total life of the project-this means the most of the returns from the project will be recovered in the early years. If duration of the project is large portion of the total life of the project for example if duration is 75% or more of the total life of the project this means the most of the returns from the project will be recovered in later years. It could therefore be argued that duration is the best available method of assessing the time for an investment to provide its return on capital invested. To calculate duration for a project, the negative cash flows at the beginning of the project are ignored. Duration is calculated using cash flows from the year that the cash flows start to turn positive. However, if there are any negative cash flows in any year after the cash flow turn positive, such as in the final year of the project, these negative cash flows are included in the calculation of duration (as negative cash flows). Advantages Duration captures both the time value of money and the whole of the cash flows of a project. It is also a measure which can be used across projects to indicate when the bulk of the project value will be captured. This measure captures both the full value and time value of the project it is recommended as a superior measure to either payback or discounted payback when comparing the time taken by different projects to recover the investment involved. Page 11 of 138

12 Disadvantages Its disadvantage is that it is more difficult to conceptualize than payback and may not be employed for that reason. It is not an industry preferred Method. Example Duration D.F.10% P.V of return phase Proportion of present value Weighted years Duration(=sum of weighted years) 3.55 Duration of 3.55 reflects the investment will recover half of its return in almost three and a half years over a 6 years life of the project. Example 2 Year Discounted cash flow(recovery)( $m) Present value of recovery phase Proportion of cash flow recovered Weighted years Project duration(years Page 12 of 138

13 Weighted Average Cost of Capital (WACC) The weighted average cost of capital (WACC) is the rate that a company is expected to pay on average to all its providers of capital to finance its assets. WACC commonly include cost of Equity, Preference and Debt sources Cost of equity, cost of debt and the weighted average cost of capital (WACC) For each company there is a cost of equity. This is the return required by its shareholders, in the form of dividends or share price growth. There is a cost for each item of debt finance. This is the yield required by the lender or bond investor. When there are preference shares, there is also a cost of preference share capital, which is the dividend yield, required by the shareholders. The cost of capital for a company is the return that is must make on its investment so that it can afford to pay its investors the returns that they require. The cost of capital for investors and the cost of capital for companies should theoretically by the same. However, they are different because of the differing tax positions of investors and companies. The cost of capital for investors is measured as a pre-tax cost of capital. This is a return ignoring taxation. The cost of capital for companies recognizes the interest costs are allowable expenses for tax purpose, and the cost of debt capital to a company should allow for the tax relief that companies receive on interest payments, reducing their tax payments. The cost of debt capital for companies is measured as an after-tax cost. Comparing the cost of equity and the cost of debt For investors and for companies, the cost of their equity is always higher than the cost of their debt capital. This is because equity investment in a company is always more risky than investment in the debt capital of the same company. In addition, from a company's perspective, the cost of debt is also reduced by the tax relief on interest payments. This makes debt finance even lower than the cost of equity. The effect of more debt capital, and higher financial gearing, on the WACC is considered in more detail later. Cost of Equity: It can be calculated using one for the following method. Dividend Valuation Model Gordon Growth Model Capital Asset Pricing Model Cost of equity: the dividend valuation model method If it is assumed that future annual dividends are expected to remain constant into the foreseeable future, the cost of equity can be calculated as follows: KK EE = dd MMMM Page 13 of 138

14 Where: K E is the cost of equity D= the expected future annual dividend MV is the share price ex dividend. The ex-dividend share price is a price that excludes any dividend that has been declared and is payable in the near future. Example: A company's shares are currently valued at $11.70 and the company is expected to pay an annual dividend of $1.40 per share for the foreseeable future. The cost of equity in the company can therefore be estimated as: (1.40 / 11.70) = or 11.97%, say 12% Cost of Equity: Cost of equity: the dividend growth model method If it is assumed that the annual dividend will grow at a constant percentage rate into the foreseeable future, the cost of equity can be calculated as follows: KK gg = Where: dd (1 + gg) +gg MMMM K E is the cost of equity d = the annual dividend for the year that has just ended g is the annual growth rate in dividends, expressed as a proportion (8% = 0.08, etc.) MV is the share price ex dividend d (1 + g) is therefore the expected dividend next year. Example: A company's share price is $ The company has just paid an annual dividend of $1.40 per share, and the dividend is expected to grow by 3% into the foreseeable future. The cost of equity in the company can be estimated as follows: 1.40 (1.03) KK gg= Page 14 of 138

15 Two methods to calculate growth 1. Historic Estimate Example Year End g= 3 (0.32/0.24) -1 g=10% Dividend per share $ Gordon's growth approximation Gordon's growth approximation is a method of estimating what the future rate of growth might be. It is based on the assumption that a company pays dividends out of profits (earnings). Growth in future profits, and so future growth in dividends is achieved by reinvesting some of the current profits. The reinvested profits earn additional earnings which can then be used to pay higher dividends. The same principle might be applied to reinvestment of free cash flows rather than reinvestment of profits. However, the concept is the same: dividend growth is achieved by reinvesting some of the returns that could otherwise be paid as current year dividends. Gordon's growth approximation is an estimate of future dividend growth, expressed by the formula: g = b r e Where: g = the annual rate of dividend growth b = the proportion of earnings (or free cash flow) reinvested for growth, and r e = the rate of return on those reinvested earnings (a rate of return on equity since The reinvested earnings represent equity profits). Always use Ke as ROE because over the longer term it will sustain and attainable. Example: A company reported profits after interest and tax of $6 million and paid dividends of $4 million. This ratio of dividend payments to earnings is fairly typical of the company's dividend policy. The company's cost of equity is 12%. The proportion of profits reinvested for growth is 0.33 (2/6). An estimate of the future growth rate in annual dividends, using Gordon's growth Approximation is: 0.33x0.12 = 0.04 or 4.0%. Page 15 of 138

16 Example: Gordon's growth approximation can also be applied to free cash flows, as the following example shows: A company has a cost of equity of 10%. The company's cash flows for the financial year just ended are as follows: $ million Net cash inflow from operating activities 84 Interest payments less interest receipts (17) Taxation paid (23) 44 Capital expenditure (21) Financing cash flows: repayment of debt (16) Increase in cash for the year 7 Free cash flow to equity will be defined as the net cash inflow from operating activities less net interest payments and less payment of tax, but before reinvestment. Here, the free cash flow to equity (FCFE) is $44 million. B= CAPEX/free cash flow before reinvestment The rate of reinvestment is assumed to be the total amount of capital expenditure in the year (net of disposal proceeds), which is $21 million. We can estimate the rate of reinvestment of cash flows that could otherwise be paid as dividends as: 21/44 = An estimate of the future growth rate in annual dividends, using Gordon's growth approximation, is: x 0.10 = , say 4.8%. Cost of equity: CAPM method Another approach to calculating the cost of equity in a company is to use the CAPM and the equity beta for the company's shares. K E = R RF + β (RM - R RF ) Where: KE = the cost of equity in the company RF = the risk-free rate of return Return on govt stock, treasury yield, gilt edged security RM = the return on the market portfolio of securities that are not risk-free Rm = dividend yield of market portfolio * (1 + GDP growth) + GDP growth β = the beta factor for the company's equity. The CAPM method of estimating the cost of equity is an alternative to a dividend-based estimate using the dividend growth model. The two methods will normally produce differing estimates. Page 16 of 138

17 Example: A company's shares have a current market value of $ The most recent annual dividend has just been paid. This was $2.00 per share. Required: Calculate the cost of equity in this company in each of the following circumstances: (a) The annual dividend is expected to remain $2.00 into the foreseeable future. (b) The annual dividend is expected to grow by 2% each year into the foreseeable future (c) The CAPM is used, the equity beta is 1.20, the risk-free cost of capital is 5% and the expected market return is 9%. Answer: (aa). CCCCCCCC oooo eeeeeeeeeeee = 2.00 = % (bb) (1.02) CCCCCCCC oooo eeeeeeeeeeee = = oooo 10.16% (cc). CCCCCCCC oooo eeeeeeeeeeee = 5% (9 5)% = 9.8% CAPITAL ASSET PRICING MODEL The capital asset pricing model (CAPM) is used to calculate the required rate of return (ke). It assumes investor s hold a diversified portfolio so it s require return based only on systematic risk. Systematic risk is how market factors effect that investment. Market factors are:- Macroeconomic variables Political factors The measure is relative to the benchmark of the market portfolio which has a βeta factor of 1. TOTAL RISK Unsystematic risk Company specific factors Can be eliminated by Systematic risk General economic factors cannot be eliminated Diversification By holding a portfolio, the unsystematic risk is diversified away but the systematic risk is not and will be present in all portfolios. If we were to enlarge our portfolio to include approximately 25 shares we would expect the unsystematic risk to be reduced to close to zero, the implication being that we may eliminate the Unsystematic portion of overall risk by spreading investment over a sufficiently diversified portfolio. Page 17 of 138

18 Advantages of CAPM; It generates a theoretically derived relationship between required return and systematic risk, which has been subject to frequent empirical research and testing. It explicitly takes into account company s level of systematic risk relative to stock market as a whole. Clearly superior to wacc in providing discount rate for investment appraisal. Criticisms of CAPM 1. CAPM is a single period model. This means that the values calculated are only valid for a finite period of time and will need to be recalculated or updated at regular intervals. 2. CAPM assumes no transaction costs associated with trading securities. 3. Any beta value calculated will be based on historic data which may be not appropriate currently. This is particularly so if the company has changed the capital structure of the business or the type of business it is trading in. 4. The market return may change considerably over short periods of time. 5. CAPM assumes an efficient investment market where it is possible to diversify away risk. This is not necessarily the case, meaning that some unsystematic risk may remain. 6. Additionally, the idea that all unsystematic risk is diversified away will not hold true if stocks change in terms of volatility. As stocks change over time it is very likely that the portfolio becomes less than optimal. 7. CAPM assumes all stocks relate to going concerns, this may not be the case. Debt capital Cost of variable rate debt (floating rate debt) Cost of irredeemable fixed rate debt (perpetual bonds) Cost of redeemable fixed rate debt (redeemable fixed rate bonds) Cost of preference shares The yield curve (term structure of interest rates) The yield curve and non-risk-free debt: spreads Cost of debt capital Each item of debt finance for a company has a different cost. This is because debt capital has differing risk, according to whether the debt is secured, whether it is senior or subordinated debt, and the amount of time remaining to maturity. (i) Cost of variable rate debt (floating rate debt) a. Kd=Interest % x (1-t) (ii) Bank Loans a. Kd=Interest % x (1-t) Example A company has a 11% Bank Loan.Tax =30% b. Kd(1-t)=11 x (1-0.30)=7.7% (iii) Cost of irredeemable fixed rate debt (perpetual bonds) The cost of irredeemable fixed rate bonds, which might be described as perpetual bonds, is calculated as follows: Page 18 of 138

19 Pre-tax cost KK DD = ii MMMM = KK DD = Post-tax cost ii (1 tt) MMMM Where: K D is the cost of the debt capital I is the annual interest payable on each $100 (nominal value) of the bonds. T is the rate of tax on company profits. MV is the market value of $100 nominal value of bonds, excluding any interest currently payable. For example, suppose that the coupon rate of interest on some irredeemable bonds is 6% and the market value of the bonds is The tax rate is 25%. (a) The pre-tax cost of the debt is 6/ = or 5.8%. (b) The after-tax cost of the bonds is 6 (1-0.25)/ = or 4.3%. (iv) Cost of redeemable fixed rate debt (redeemable fixed rate bonds) The cost of redeemable bonds is their redemption yield. This is calculated as the rate of return that equates the present value of the future cash flows payable on the bond (to maturity) with the current market value of the bond. In other words, it is the IRR of the cash flows on the bond to maturity, assuming that the current market price is a cash outflow. A problem arises with calculating the pre-tax and the after-tax cost of redeemable bonds, because the redemption of the principal at maturity is not an allowable expense for tax purposes. The post-tax cost of redeemable debt could therefore be calculated in a way Method: Calculate the post-tax cost of debt as the IRR of the future cash flows, allowing for tax relief on the interest payments and the absence of tax relief on the principal repayment. Example: The current market value of a company s 7% loan stock is Annual interest has just been paid. The bonds will be redeemed at par after four years. The rate of taxation on company profits is 30%. Required: Calculate the after-tax cost of the bonds for the company Page 19 of 138

20 Cost of redeemable fixed rate debt (redeemable fixed rate bonds) Continued Answer: Method Year Cash Flow Try 6% Try 5% Discount Factor PV Discount Factor PV 0 Market value (96.25) (96.25) (96.25) 1 Interest Interest Interest Interest Redemption NPV Using interpolation, the before-tax cost of the debt is: % + XX XX( 6 5) % = 5.98%, ssssss 6.0% ( ) (v) Cost of preference shares For irredeemable preference shares, the cost of capital is calculated in the same way as the cost of equity, assuming a constant annual dividend. Kp = preference dividend/ Mv of preference share The yield curve (term structure of interest rates) The yield is the income return on an investment, such as the interest or dividends received from holding a particular security. Whereas a yield curve on a graph in which the yield of fixed-interest debt is plotted against the length of time they have to run to maturity. The cost of new debt can be estimated by reference to a yield curve. The cost of fixed-rate debt is commonly referred to as the Interest yield'. Page 20 of 138

21 The interest yield on debt capital varies with the remaining term to maturity of the debt. As a general rule, the interest yield on debt increases with the remaining term to maturity. For example, it should normally be expected that the interest yield on a fixed-rate bond with one year to maturity/redemption will be lower than the yield on a similar bond with ten years remaining to redemption. Interest rates are normally higher for longer maturities to compensate the lender for tying up his funds for a longer time. When interest rates are expected to fall in the future, interest yields might vary inversely with the remaining time to maturity. For example, the yield on a oneyear bond might be higher than the yield on a ten-year bond when rates are expected to fall in the next few months. When interest rates are expected to rise in the future, the opposite might happen, and yields on longer-dated bonds might be much higher than on shorter-dated bonds as investors will get higher yields when interest rates rise. Yield curves are widely used in the financial services industry. Two points that should be noted about a yield curve are that: Yields are gross yields, ignoring taxation (pre-tax yields). A yield curve is constructed for 'risk-free' debt securities, such as government bonds. A yield curve therefore shows 'risk-free yields'. As the name implies, risk-free debt is debt where the investor has no credit risk whatsoever, because it is certain that the borrower will repay the debt at maturity. Debt securities issued in their domestic currency by the government should always be risk-free: yield curves are therefore constructed for government bonds. The yield curve and non-risk-free debt: spreads The interest yield on other debt, such as corporate bonds and loans, is higher than the yield on risk-free debt with the same maturity. For example, the interest rate on a sterling bond of ABC Company with twoyears to maturity will be higher than the interest yield on a two-year UK government bond. The higher yield is to compensate investors in corporate bonds for the fact that the debt is not risk-free. The company might default. 'Spread' is the difference between the risk-free rate of return (the yield curve) and the cost of debt for the same maturity that is not risk-free. For example, if the risk-free return on five-year government bonds is 5.4% and the spread for a company's five-year bonds is 80 basis points, the yield on the company bonds is: Yield curve + Spread =5.40%+ 0.80% = 6.20%. KD (1-t) = (Yield on similar Government debt + Credit Risk Premium) x (1-t) The size of spreads The size of the spread allows for the additional risk in the debt that is not risk-free. The spread is therefore higher for debt that has a higher risk for investors or lenders. Many large companies are given a credit rating by a credit rating agency, such as Moody's, Standard & Poor's and Fitch. (Strictly, the Page 21 of 138

22 company's debt is given a credit rating, but it is common to speak of companies having a credit rating rather than the debt having a credit rating.) The top credit rating is a 'triple-a' credit rating. Spreads are lowest for the top Credit ratings, and higher for lower credit ratings. Credit Ratings Each credit rating agency uses its own credit rating system. The most well-known are the rating systems of Standard & Poor's and Moody's. Their ratings for bonds are set out in the table below. Standard & Moody's credit Poor's credit ratings ratings Investment grade AAA Highest rating Aaa AA Still high quality debt Aa A A BBB Baa Sub-Investment grade (*junk*) BB Major uncertainties Ba about the ability of the borrower to pay interest and repay principal on time B B CCC Caa CC Ca C C D In default D Standard & Poor's credit ratings are also modified by + and '-' signs. A + sign indicates a better credit rating and a'-' indicates a lower credit rating. Credit ratings are therefore AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB, BBB-, BB+, BB, BB- and so on. The lowest investment grade credit rating is BBB-. Moody's credit ratings are modified in a similar way, but using the numbers 1, 2 and 3. Credit ratings are therefore Aaa, Aal, Aa2, Aa3, Al, A2, A3, Baal, Baa2, Baa3, Bal, Ba2, Ba3 and so on. The lowest investment grade rating is Baa3. Sub-investment grade debt, also called 'junk bonds', is a speculative investment for the lender or bondholder, and yields required by investors are normally much higher than on investment grade debt. Page 22 of 138

23 Spreads and credit ratings: Spreads very according to: The risk characteristics of the industry The time remaining to maturity for the debt, and The credit rating. Example: Yield spreads on US bonds for companies in the construction industry are as follows: Spreads: Years to maturity Rating: AAA / Aaa AA+ / Aa AA / Aa AA / Aa A+ / A A / A A- / A This table would show, for example, that if a company wants to issue seven year bonds, and the credit rating for the bonds is expected to be AA, the company will expect to pay a yield on the bonds that is 52 basis points above the risk-free rate. If the yield curve shows the risk-free rate on US government bonds (Treasuries ) to be 6.6%, the yield on the company s bonds will be 6.6% % = 7.12%. Method of calculating the WACC The WACC is a weighted average of the (after-tax) cost of all the sources of capital for the company. It is calculated as follows: Example: A company has 8 million shares each with a value of $7.90, whose cost is 8.4%. It has 6% bonds with a market value of $50 million and an after-tax cost of 3.6%. It has a bank loan of $10 million whose after-tax cost is 4.1%. It also has 2 million 8% preference shares of $1 whose market price is $1.33 per share and whose cost is 6%. Calculate the WACC Market Value of Equity = 7.90 x 8 million shares = $63.2 million Market Value of debt = $50 m Market Value of Bank Loan = $ 10m Market Value of Preference Shares = $1.33 x 2 million preference shares = $ 2.66 million Page 23 of 138

24 WACC = (63.2/125.86) 8.4% + (50/125.86)3.6% + (10/125.86)4.1% + (2.66/125.86) 6% WACC= WACC = 6.09% 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. 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. Advantages of WACC Simple and Easy: The biggest advantage of using WACC as a hurdle rate to evaluate the new projects is its simplicity. The calculation does not involve too much of complication Single Hurdle Rate for All Projects: One single hurdle rate for all projects saves a lot of time of the managers in an evaluation of the new projects. If the projects are of same risk profile and there is no change in the proposed capital structure, the current WACC can be applied and effectively used. Disadvantages of WACC Difficulty in Maintaining the Capital Structure: The impractical assumptions of No Change in Capital Structure has rare possibilities of prevailing all the time. It suggests the same capital structure for new projects. The impractical assumptions of No Change in Risk Profile of New Projects again has its inbuilt drawbacks. Difficulty in Acquiring Current Market Cost of Capital: The WACC used for evaluation of new projects require consideration of present day cost of capital and knowing such costs is difficult. The WACC considers mainly equity, debt and preferred. The interest cost of debt keeps changing in the market depending on the economic changes WACC and market value For a company with constant annual 'cash profits', there is an important connection between WACC and market value. (Note: 'Cash profits' are cash flows generated from operations, before deducting interest costs.) If we assume that annual cash profits are a constant amount in perpetuity, the total value of a company, equity plus debt capital, is calculated as follows: TTTTTTTTTT mmmmmmmmmmmm vvvvvvvvvv oooo tthee cccccccccccccc = AAAAAAAAAAAA cccccch pppppppppppppp WWWWWWWW From this formula, the following conclusions can be made: The lower the WACC, the higher the total value of the company will be (equity + debt capital), for any given amount of annual profits. Similarly, the higher the WACC, the lower the total value of the company. For example, if annual cash profits are $12 million, the total market value of the company would be: $100 million if the WACC is 12% ($12 million/0.12) $120 million if the WACC is 10% ($12 million/0.10) Page 24 of 138

25 $200 million if the WACC is 6% ($12 million/0.06). The aim should therefore be to achieve a level of financial gearing that minimizes the WACC, in order to maximize the value of the company. Important questions in financial management are: How does the WACC change with changes in gearing? For each company, is there an 'ideal' level of gearing that minimizes the WACC? Cost of capital and gearing: The traditional view of gearing and WACC The Modigliani-Miller propositions: ignoring corporate taxation The Modigliani-Miller propositions: allowing for corporate taxation Cost of capital and gearing For a given level of annual cash profits before interest and tax, the value of a company (equity + debt) is maximized at the level of gearing where WACC is lowest. This should also be the level of gearing that optimizes the wealth of equity shareholders. The question is therefore: How does a change in gearing affect the WACC, and is there a level of gearing Where the WACC is minimized? The most important analysis of gearing and the cost of capital, for the purpose of your examination, is the analysis provided by Modigliani and Miller that allows for tax relief on debt interest. However, the traditional view of WACC and gearing, and Modigliani and Miller's propositions ignoring tax relief on debt are also described briefly. The traditional view of gearing and WACC The traditional view of gearing is that there is an optimum level of gearing for a company. This is the level of gearing at which the WACC is minimized. Optimum gearing % = minimum WACC Page 25 of 138

26 The traditional view of gearing and WACC - Continued As gearing increases, the cost of equity rises. However, as gearing increases, there is a greater proportion of debt capital in the capital structure, and the cost of debt is cheaper than the cost of equity. Up to a certain level of gearing, the effect of having more debt capital has a bigger effect on the WACC than the rising cost of equity, so that the WACC falls as gearing increases. However, when gearing rises still further, the increase in the cost of equity has a greater effect than the larger proportion of cheap debt capital, and the WACC starts to rise. The traditional view of gearing is therefore that an optimum level of gearing exists, where WACC is minimized and the value of the company is maximized. The Modigliani-Miller propositions: ignoring corporate taxation The traditional view of gearing and WACC was challenged by Modigliani and Miller in the 1950s. Initially, their arguments were based on the assumption that corporate taxation, and the tax relief on interest, could be ignored. You do not need to know Modigliani and Miller's arguments, only the conclusions they reached. They argued that if corporate taxation is ignored, an increase in gearing will have the following effect: As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital structure of the firm. However, the cost of equity rises as gearing increases. As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of equity is that the WACC remains unchanged. The WACC is the same at all levels of financial gearing. The total value of the company is therefore the same at all levels of financial gearing Modigliani and Miller therefore reached the conclusion that the level of gearing is irrelevant for the value of a company. There is no optimum level of gearing that a company should be trying to achieve. Modigliani and Miller's propositions: ignoring taxation Modigliani and Miller's arguments, ignoring taxation, can be summarized as two propositions. Proposition 1. The WACC is constant at all levels of gearing. For companies with identical annual profits and identical business risk characteristics, their total market value (equity plus debt) will be the same regardless of differences in gearing between the companies. Proposition 2. The cost of equity rises as the gearing increases. The cost of equity will rise to a level such that, given no change in the cost of debt, the WACC remains unchanged. Page 26 of 138

27 Modigliani-Miller formulae: ignoring taxation There are three formulae for the Modigliani and Miller theory, ignoring corporate taxation. These are shown below. The letter Vu refers to an ungeared company (all-equity Company) and the letter Vg refers to a geared company. (1) WACC The WACC in a geared company and the WACC in an identical but ungeared (all-equity) company are the same: WACC G = WACC U This formula expresses a part of proposition 1. (2) Total value of the company (equity plus debt capital) The total value of an un-geared company is equal to the total value of an identical geared company (combined value of equity + debt capital): V G = V U This formula expresses another part of proposition 1 (3) Cost of equity The cost of equity in a geared company is higher than the cost of equity in an ungeared company, by an amount equal to: The difference between the cost of equity in the ungeared company and the cost of debt (KEU - K D ) Multiplied by the ratio of the market value of debt to the market value of equity in the geared company (D/E). KK EEEE = KK EEEE + DD EE (KK EEEE KK DD ) This formula expresses proposition 2. Example 1: An all-equity company has a market value of $150 million and a cost of equity of 10%. It borrows $50 million of debt finance, costing 6%, and uses this to buy back and cancel $50 million of equity. Tax relief on debt interest is ignored. Required: According to Modigliani and Miller, if taxation is ignored, what would be the effect of the higher gearing on (a) the WACC (b) the total market value of the company and (c) the cost of equity in the company? Answer: According to Modigliani and Miller: formulae: ignoring taxation (on the previous page) a) WACC. The WACC in the company is un-changed, at 10%. b) Total Value. The total value of the company with gearing is identical to the market value of the company when it was all equity, at $150 million. This now consists of $50 million in debt and $100 million equity ($150 million -$50 million of debt). c) Cost of equity. The cost of equity in the geared company is KK EEEE = KK EEEE + DD EE (KK EEEE KK DD ) 10% + 50 XX (10 6) % = 12.0% 100 Page 27 of 138

28 Example 2: A company has $500 million of equity capital and $100 million of debt capital, all at current market value. The cost of equity is 14% and the cost of the debt capital is 8%. The company is planning to raise $100 million by issuing new shares. It will use the money to redeem all the debt capital. Required According to Modigliani and Miller, if the company issues new equity and redeems all its debt capital, what will be the cost of equity of the company after the debt has been redeemed? Assume that there is no corporate taxation. Answer: In the previous example, the Modigliani-Miller formulae were used to calculate a cost of equity in a geared company, given the cost of equity in the company when it is un-geared (all-equity). This example works the other way, from the cost of equity in a geared company to a cost of equity in an un-geared company. The same formulae can be used. Example 2: Continued Using the known values for the geared company, we can calculate the cost of equity in the un-geared company after the debt has been redeemed. K EG = K EU + D/E [K EU K D ] 14.0 = KEU + 100/500 [K EU 8.0] 1.2 KEU = KEU = 13.0% (15.6 / 1.2) The Modigliani-Miler view: allowing for corporate taxation Modigliani and Miller revised their arguments to allow for the fact that there is tax relief on interest. You do not need to know the arguments they used to reach their conclusions, but you must know what their conclusions were. You should also know and be able to apply the formulae described below. (The formula for the cost of equity is given in the formula sheet in your examination, so you do not need to learn it) Modigliani and Miller argued that allowing for corporate taxation and tax relief on interest, an increase in gearing will have the following effect: As the level of gearing increases, there is a greater proportion of cheaper debt capital in the capital structure of the firm. However, the cost of equity rises as gearing increases. As gearing increases, the net effect of the greater proportion of cheaper debt and the higher cost of equity is that the WACC becomes lower. Increases in gearing result in a reduction in the WACC. The WACC is therefore at its lowest at the highest practicable level of gearing. (There are practical limitations on gearing that stop it from reaching very high levels. For example, lenders will not provide more debt capital except at a much higher cost, due to the high credit risk). Page 28 of 138

29 The total value of the company is therefore higher for a geared company than for an identical allequity company/the value of a company will rise, for a given level of annual cash profits before interest, as its gearing increases. Modigliani and Miller therefore reached the conclusion that because of tax relief on interest, there is an optimum level of gearing that a company should be trying to achieve. A company should be trying to make its gearing as high as possible, to the maximum practicable level, in order to maximize its value. Modigliani and Miller's propositions: allowing for taxation Modigliani and Miller's arguments, allowing taxation, can be summarized as two propositions. Proposition 1. The WACC falls continually as the level of gearing increases. In theory, the lowest cost of capital is where gearing is 100% and the company is financed entirely by debt. (Modigliani and Miller recognized, however, that 'financial distress' factors have an effect at high levels of gearing, increasing the cost of debt and the WACC.) For companies with identical annual profits and identical business risk characteristics, their total market value (equity plus debt) will be higher for a company with higher gearing. Proposition 2. The cost of equity rises as the gearing increases. There is a positive correlation between the cost of equity and gearing (as measured by the debt/equity ratio). Modigliani-Miller formulae: allowing for taxation There are three formulae for the Modigliani and Miller theory, allowing for corporate taxation. These are shown below. The letter V refers to an ungeared company (all-equity Company) and the letter V refers to a geared company. (1) WACC using weighted average formula (2) Value of a company The total value of a geared company (equity + debt) is equal to the total value of an identical ungeared company plus the value of the 'tax shield'. This is the market value of the debt in the geared company multiplied by the rate of taxation (Dt). V G =V V +Dt Where: VG = value of geared company Vu = value of an identical but ungeared (all-equity) company D = market value of the debt in the geared company t = the rate of taxation on company profits. This formula expresses another part of proposition 1. Modigliani-Miller formulae: allowing for taxation (3) Cost of equity The cost of equity in a geared company is higher than the cost of equity in an ungeared company, by a factor equal to: The difference between the cost of equity in the ungeared company and the cost of debt, (KEU- KD) Multiplied by the ratio (1 tt) XX DD EE Page 29 of 138

30 KK EEEE = KK EEEE + (1 TT)(KK EEEE KK DD ) DD EE This formula expresses proposition 2. It is given to you in your examination, in a formula sheet. Although you do not need to learn the formula, you should become familiar with it, and know how to use it Example: 1 An all-equity company has a market value of $60 million and a cost of equity of 8%. It borrows $20 million of debt finance, costing 5%, and uses this to buy back and cancel $20 million of equity. The rate of taxation on company profits is 25%. According to Modigliani and Miller: (a) Market value The market value of the company after the increase in its gearing will be: V G = V U + Dt VG = $60 million + (20 million X 0.25) = $75 million. The market value of the debt capital is $20 million; therefore the market value of the equity in the geared company is $55 million ($75 million - $20 million). (b) WACC of the geared company The WACC of the company after the increase in its gearing is calculated as follows: DDDD WWWWWWWW GG = WWWWWWWW UU 1 (DD + EE) WWWWWWWW GG = 8% 1 ($2 mmmmmmmmmmmmmm XX 25%) = 8% ( = 7.38%) ($65 mmmmmmmmmmmmmm) Example: 1 - Continued (c) Cost of equity in the geared company KK EEEE = KK EEEE + (1 tt)(kk EEEE KK DD ) DD EE (1 0.25)(8 5)20 KK EEEE = 8% = 8% + 1% = 9% 45 Change in gearing, the WACC and capital investment appraisal Modigliani and Miller with taxation: from one level of gearing to another When a company is considering a major new capital investment project (where the business risk is similar to the risk with the company's other business operations), the method of financing the investment might alter the company's gearing. For example, if a project is financed entirely by new debt capital, its gearing level will increase. A change in gearing will alter the cost of equity (Modigliani and Miller proposition 2). Page 30 of 138

31 There might be a change in the cost of debt, where the gearing level rises to such a high level that 'financial distress' concerns make debt capital more expensive. However, at lower levels of gearing it is assumed that the cost of debt is unaffected by changes in the gearing level. There will be a reduction in the WACC (Modigliani and Miller proposition 1). If the project is evaluated using the WACC to estimate the NPV, the new WACC should be used for the NPV evaluation. This means that when a new capital project will result in a change in gearing, it is necessary to calculate a new WACC before going on to the NPV calculations. The Modigliani and Miller formulae can be used to do this. The explanation that follows concentrates on the formula for the cost of equity, because this is the formula that you will be given in the examination. The method The approach should be as follows: Step 1. Start with the company at its original level of gearing. You should be given the value of the company (the value of its equity and the value of its debt capital) and the cost of its equity and debt capital. Step 2. Use these values to calculate the value of a comparable ungeared company, and the cost of equity in the ungeared company. Use the Modigliani and Miller formulae to do this You now have the cost of equity in a comparable ungeared company. Step 3. Use these values for the ungeared company to work out values for the company at its new level of gearing: total value, value of equity, WACC and cost of equity. Example: 1 A company has a total current value of $100 million, consisting of $80 million equity and $20 million of debt capital. The cost of equity is 10% and the pre-tax cost of the debt capital is 6%. The rate of tax on company profits is 25%. The company proposes to borrow an additional $20 million of debt capital, and use the money to buy back and cancel $20 million of its equity. Required: According to Modigliani and Miller, what will be the following values for the company at its new level of gearing? (a) Its total value, divided into a value for the equity and a value for the debt capital (b) Its WACC (c) The cost of its equity capital. This is a long example, but you should work through the solution carefully. Answer: (a) Total value of the company i. Step 1: Value of a similar all-equity company. Page 31 of 138

32 We have the current value of the geared company, which is $100 million, consisting of $80 million equity and $20 million debt capital. We can calculate the cost of a similar company that is all-equity financed. V G = V U + Dt 100 million = Vu + (20 million x 0.25) Vu = 95 million. V U = 95 million ii. Step 2: Value of the company at the new level of gearing. The company will be replacing $20 million of equity with $20 million of debt capital, so in the new gearing structure, debt capital increases. The market value of the debt will be $20 million + $20 million = $40 million. We can calculate the total cost of the company at its new gearing level, using the same MM formula. V G + V U + Dt VG = 95 million + (40 million x 0.25) = 105 million The total value of the company at the new gearing level will be $105 million. Of this, $40 million will be debt capital; therefore the value of the remaining equity will be $65 million Example: 1 - Continued (b) WACC i. Step 1: WACC of a similar all-equity company. The WACC of the company at its current level of gearing is calculated as follows: WACC = 8.9/100 = or 8.9%. We can use the MM formula for WACC to calculate what the WACC would be in a similar ungeared company. The WACC of a similar ungeared company is: 20 XX = WWWWWWWW UU xx ( ) = WACC U WACC U = (c) Cost of equity i. Step 1: Cost of equity of a similar all-equity company. A similar approach is taken for calculating the cost of equity. We start by calculating the cost of equity in a similar all-equity company, using the MM formula for Proposition 2. We know the value of KEG and we need to calculate a value for KEU. Page 32 of 138

33 In the original geared company, the value of equity is $80 million and the value of debt capital is $20 million. The cost of equity in a similar all-equity company is calculated as follows: KK EEEE = KK EEEE + (1 tt)(kk EEEE KK DD ) DD EE 10 = KK EEEE + [(1 0.25)(KK EEEE 6 ) ] 10 = KK EEEE KK EEEE K EU = Example: 1 - Continued ii. Step 2: Cost of equity of the company at the new level of gearing. Having calculated the cost of equity in a similar all-equity company, we can now calculate the cost of equity in the company at its new level of gearing. Debt capital is $40 million and equity is $65 million. (The value of equity and debt capital at the new level of gearing were calculated in (a) KK EEEE = KK EEEE + (1 tt)(kk EEEE KK DD ) DD EE KK EEEE = (1 0.25)( )40/65 KK EEEE = = , ssssss 10.9% Relevance for capital investment appraisal The Modigliani and Miler formulae can be used to re-calculate the cost of equity and the WACC in a company where the level of gearing changes, provided there is no change in the overall business risk and the company is therefore similar in all respects except for its gearing. When a company plans a new capital investment that will alter its gearing, without affecting its business risk profile, the MM formulae can be used to calculate the cost of equity and WACC at the new level of gearing. The new WACC can then be used as the discount rate for calculating the NPV of the proposed project. Page 33 of 138

34 Risk Adjusted WACC & APV A company s shareholders bear two types of systematic risk: Systematic business risk a) Aries out of the risky nature of the areas of business in which the company out of the risky nature of the company is engaged Systematic financial risk b) Arises out of the business capital structure In the Balance Sheet Assets = Liabilities (equity + debt) However, there is a second pair of balancing values in the Balance Sheet. Not only does the value of the assets equal the value of the liabilities, but also: The risk of the assets = the risk of the liabilities In fact, this relationship can be stated more logically the risk of the liabilities reflects the risky nature of the assets that those liabilities financing. As a result we can say Risk of the Assets = Risk of the Liabilities β Equity Debt Asset = ΒEquity + ΒDebt However, it is not simply a case that the β asset equals the sum of the β equity and the β debt. What also need to be taken into account is the proportions of equity and debt: EE βasset = βequity + EE EE+DD βdebt X EE + DD Finally, we need to take into account tax relief on interest payments, (as it will affect the financial risk exposure of shareholders). This now gives rise to a very important equation for the exam: EE βasset = β Equity EE + DD (1 TTTT) + DD (1 TTTT) βdebt X EE + DD (1 TTTT) Where: β Equity s known as the equity Beta. It measures the systematic business risk and the systematic financial risk of the company s shares. β Asset is known as the asset beta. It measures the systematic business risk only. βdebt is known as the bet beta. It measures the systematic risk of the company s debt securities. Example # 1: B plc has a gearing ratio (D: E) of 1: 2 and its shares have a beta value (βequity) of The corporation tax rate is 30%, debt is assumed to be risk free. Page 34 of 138

35 Solution: βasset = 1. 45X (1 0.3) = Four Implications This analysis gives rise to four important implications: A company s equity beta will always be greater than is asset beta. This is because the equity beta measures both business and financial risk, while the asset beta measures business risk only. β e > β a The one exception to this is where the company is all equity financed, and so only has systematic business risk, and has no financial risk. In those circumstances its equity beta and its asset beta will be the same. Then β e = β a Companies in the same area of business, (i.e. they have the same business risk), will have the same asset beta. Companies in the same area of business will not have the same equity beta, unless they also happen to have the same gearing ratios. (Means financial risk same). If the company operates on a divisional basis and each division 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. Example ABC is made up of two divisions Division Asset βeta Proportion of the Business Food % Clothes % The company gearing level is 32%. Tax =25% βa= (0.75 x 40%)+(1.80 x 60%) = = 68 x βe 68+32(1-0.25) 1.38= 68 x βe 92 βe=1.87 Page 35 of 138

36 DETERMINATION OF DISCOUNT RATE FOR APPRAISAL OF PROJECT Undertaking the project will alter the capital structure of the company No If the company is an a single area of business Yes Regardless of whether the project has the same or different systematic business risk. Use APV method If the Co. is in several areas of business The project is in the same area of business The project is in a different area of business to the Co. For a project in a particular area of business Company s existing WACC is suitable Company s existing WACC is not suitable Use risk-adjusted WACC STEPS FOR THE DETERMINATION RISK ADJUSTMENT WACC 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.: Example # 1: SKANS is an education services provider with a debt: equity ratio of 1:3. It wishes to diversify into the professional publications of ACCA & CA students, using an NPV analysis. The company does not intend to change its capital structure. Suppose that BPP is a typical professional book publisher. It has an equity beta of 1.25 and a debt: equity ratio of 1: 2. Because BPP is in the same area of business as the project, it is known as the pure-play company. If R f = 6%, R m = 14% and T c = 30% - and it is assumed that the debt is risk free. Page 36 of 138

37 Required: Calculate risk adjusted WACC for the project. Solution Stage One - The asset beta of BPP the pure-play comparison company is calculated and then used as an estimate of the asset beta of SKANS publishing project. Using EE βasset = βequity X EE + DD (1 TT) 2 βasset BPP = 1. 25X (1 0.30) = Thus βasset = = βasset Project This asset beta reflects the systematic business risk of publishing books. Stage Two - Having estimated an asset beta for the publishing project, we can now estimate an equity beta for the project; to reflect both the systematic business risk of professional publication and the systematic financial risk of SKANS capital structure. EE βasset = βequity X EE + DD (1 TTTT) = βequity Project X (1 0.30) = βequity Project X = βequity Project = Example # 1: Continued Stage Three: - Using CAPM calculate Ke Ke Publication Project = Rf + [Rm - Rf] βequity Ke Publication Project = 6% + [14% - 6%] X = 15.14% Therefore the cost of equity capital for the project is 15.14% Stage # Five: - Using the following formula EE Risk Adjusted = KeProject X EE + DD + KKdddddd = EE EE + DD WACC for the project - Here Ke project = Calculated in Step # 3 Company s existing capital structure Kd AT = Company s cost of debt (after tax) Stage Six: Finally, the risk-adjusted WACC for SKANS publication project can now be calculated, by using the project s Ke and SKANS Kd and capital structure. If a cost of debt capital is needed but no cost of debt is given, we can make use of the fact that the question allows use to assume the debt beta is zero. In these circumstances; K d = Rf And KdAT = R f X (1 TC) Therefore, KdAt = 6 X (1 0.30) = 4.2% Page 37 of 138

38 Hence the publication project s risk-adjusted WACC can now be calculated. Ko Publication Project Ke Publication X EE VV + Kd AT DD VV Where the value for E, D, V and Kd relate to the onion project s parent company Carrot plc. Ko Publication Project = 15.14%X % X 1 4 = 12.4% Therefore SKANS proposed professional publication project should be evaluated using 12.4% as the NPV discount rate = 0.88 Example: Fruit and Veg plc both strawberries and potatoes; by both turnover and profit, 70% of the company s business is strawberries and 30% is involved with producing potatoes. The company s equity beta is 1.64 and its debt: equity ratio is 2:5. Strawberry plc is a competitor company which specializes in strawberry production. Its equity beta is 1.25 and its debt: equity ratio is 1:3. The risk free interest rate is 7% and the market return is 15%. The corporate tax rate is 30%. Corporate debt can be assumed to be risk free. Required: Fruit and Veg plc wish to evaluate a potato investment (which will not change the company s existing capitals structure) and so need a suitable discount rate to apply to their NPV analysis. The approach to be taken here is as follows. 1. The asset beta of Strawberry plc can be Identified 3 βasset = X (1 0.3) = The asset beta of Fruit and Vet plc can also be identified. 5 βasset = X (1 0.3) = Fruit and Veg s asset beta measures the systematic business risk of the company. If fact it represents a weighted average of the risk of both the strawberry business and the potato business, as follows: β Frunit and Veg Asset = 0.70 X β Strawberry Asset β Potato Asset Therefore, using our knowledge of both Strawberry plc s asset beta and Fruit and Veg plc s asset beta, we can identify the asset beta for potato production = (0.70 X 1.013) + (0.30 X β Potato Asset ) And so: βpotato Asset = = Page 38 of 138

39 4. This is effectively the end of Stage One of the risk-adjusted WACC analysis, and the remainder of analysis follow as normal: Stage Two: = βpotato Equity X (1 0.30) = Stage Three: Ke Potato = 7% + [15% 7%] = 26.5% Stage Four: WACC Potato = 26.5% X % (1 0.30)X 2 7 = 20.3% Therefore, 20.3% would be an appropriate NPV discount rate for Fruit and Veg plc to use in order to evaluate potato projects. Page 39 of 138

40 Adjusted Present Value The APV method shows how the NPV of a project can be increased or decreased by project financing effects. When to Use Adjusted Present Value (APVs): Business Risk Unchanged Change Financial Risk Unchanged Existing WACC Risk Adjusted WACC Change APV APV ** When financial risk changes due to undertake that project always use APV The APV method described as a 'DIVIDE AND CONQUER' approach. Broadly speaking, APV consist of two different decisions which are as follows: Adjusted Present Value = Investment Side + Financing Side The decision rule for the APV method If, Adjust Present Value is positive = Accept the project If, Adjust Present Value is Negative = Reject the project Performa of Adjusted Present Value (APV): Investment Decision Base Case NPV XXX Financing Decisions Present value of issue cost Equity (X) Debt XXX Present value of Tax Shield Simple Subsidized Loan Debt capacity Adjusted Present Value X X XXX XXXX Investment Decision (Base Case NPV) The base case NPV is calculated by assuming the project is financed entirely by equity, so that the method of financing is ignored. To do this: Convert a geared beta for the industry to an asset beta (ungeared beta) for the industry, and then Use this asset beta or ungeared beta and the CAPM to establish the cost of equity in an ungeared company, and this the discount rate Page 40 of 138

41 Normal DCF techniques are used to establish the expected cash flows for the project. Having establish a cost of equity for an ungeared company, the expected project cash flows are discounted at this cost to obtain the base case NPV. Financing Decision Financing decision consists of following items: Present value of Issuance Cost Present value of Tax Shield a) Simple Loan b) Subsidized loan c) Debt Capacity As all financing cash flows are facing lower risk as compare with equity for this reason they are discounted at either the cost of debt (Kd) Note: If cost of debt is not available or cannot be calculated then risk free rate (RF) can be used for discounting the financing cash flows Grossing up: A firm will know how much finance is required for the investment. Issue costs of finance will be quoted on the top. It will therefore be necessary to gross up the funds to be raised Present value of Issuance cost: Issue costs might be an allowable expense for the tax purposes. When they are tax- allowable, the PV of issue costs must allow for the reduction in tax payments that will occur. The PV of the issue costs is therefore net of the present value of any tax relief on the costs. As always calculation involving debt must take account of the tax effects. Normally, situation is as follows: Issuance Cost Equity Issue cost Debt issue cost Not tax allowable expense Tax allowable expense Page 41 of 138

42 Issuance Cost xxx Tax Relief on issuance cost (Tax rate x Issue cost) xxx Present Value of Tax Relief (Tax relief x discount factor) xxx PV of the Issue cost xxx Present value of Tax Shield on interest payment: The Present value of the tax relief on interest payment is also known as the present value of the tax shield. The method adopted depends on the information given: Debentures: Interest payments (tax rate x interest rate) XXX Annual Tax relief (interest rate x Tax rate) XXX Annuity {Simple or deferred (if one year in delay)} XXX Present value of TAX shield XXXX EXAMPLE: A company is considering a project that would cost $100,000 and it will be financed 60% by equity and 40% by debt (pre-tax cost 4%). Tax is at 30%. Issuance cost of equity is 4% and issuance cost of debt is 2 %. Debt is raised for 5 years Issuance Cost Funds required: Equity Required: $60,000 Debt Required: $40,000 Equity Raised: 60,000/96% = 62,500 Equity Issuance Cost=62,500-60,000= 2,500 Debt Raised = 40,000/98%= 40,816 Debt issuance cost = 40,816-40,000= 816 Tax 30% = (245) Net Debt issuance cost = 571 P.V of tax shield P.V of tax savings on interest payment. Gross loan interest rate Tax rate = x 4% x 30% 490 Annuity before tax KD = P.V of tax shield = 2181 Amortizing loan: The repayment will be made up of both interest and capital Step 1: Find the amount of the repayment Annual amount = Amount of the loan / Annuity Factor Page 42 of 138

43 Step 2: Calculate the annual interest charge Subsidized or cheap loan: If a loan is taking cheap loan or subsidized loan then the interest rate is lower, so its benefit is also reduced since tax shield will also be lower: Interest saved (Loan x (Normal int. rate - Cheap int.rate)) Tax Relief Lost (interest Saved X tax rate) Net Benefit Annuity (Simple or deferred if one year in delay) Present value of the cheap loan XX (X) XXX X XXX Debt Capacity: Debt finances a project because of the associated tax shield. If a project brings about an increase in the borrowing capacity of the firm, it will increase the potential tax shield available. Note An Exam trick is to give both the amount of debt actually raised and the increase in debt capacity brought by the project. It is the theoretical debt capacity which the tax shield should be based. In simple words, tax shield will be calculated on total amount of debt capacity of the company. No matter how much company actually used the amount of debt from that debt capacity. For example, if a question told that actual debt rose is $200,000 but you are also told in the question that the investment is believed to add $500,000 to the company's debt capacity. Then present value of tax shield will be calculated on the $500,000 (this is theoretical amount). EXAMPLE: 2 A company is considering a project that would cost $100,000 and it will be financed 60% by subsidized debt (interest cost 4%) and 40% by normal debt (pre-tax cost 7%). Tax is at 30%. Normal loan issuance cost of debt is 2 %.Debt is raised for 5 years. It is assumed in this example only that there is no issuance cost on subsidized debt. Risk free rate is 5%. Issuance Cost Funds required: Subsidized debt required: $60,000 Normal Debt Required: $40,000 Subsidized debt Raised = 60,000 Normal Debt Raised = 40,000/98%= 40,816 Debt issuance cost = 816 Tax 30% = (245) Net Debt issuance Cost = 571 Tax Shield Normal Loan 40,816 7% 30% = $ 857 Annuity 5 % = Present Value of Tax shield $3710 Page 43 of 138

44 Subsidized loan 60,000 4% 30% = $720 Annuity 5 % = Present Value of Tax shield 3117 EXAMPLE: 2 Continued When Tax is payable in arrears P.V of Interest savings on subsidized loan. Gross subsidized loan interest rate saving = Normal Annuity factor = P.V of interest savings = P.V of tax loss on Interest savings. Gross subsidized loan interest rate saving tax rate = Normal Annuity factor Discount factor of 1 st year = P.V of tax loss = P.V of Interest savings on subsidized loan. 60,000 3% = 1800 Annuity (decided above) = P.V of interest savings = 7,792 P.V of tax loss on Interest savings. 60,000 3% 30% = 540 Normal Annuity factor Discount factor of 1 st year = P.V of tax loss = 2226 When Tax is payable in the same Year P.V of after tax Interest savings on subsidized loan. Gross subsidized loan interest rate saving (1-T) = Annuity (decided above) = P.V of after tax interest savings = P.V of after tax Interest savings on subsidized loan. 60,000 3% (1-0.30) =1260 Annuity (decided above) = P.V of after tax interest savings shield = 5,455 DEBT CAPACITY For example in previous example because of new project debt capacity rises to $ 120,000. Answers: Deb capacity = $120,000 Debt Raised = $ 100,000 Unutilized capacity = $ 20,000 Page 44 of 138

45 It is assumed that this remaining capacity will be utilized elsewhere in other projects. Unutilized capacity Normal interest rate tax rate 20,000 7% 30% 420 Annuity Present Value of tax shield 1818 Why we use APV method? Conceptually, the APV is relatively easy to understand. The method separates the investment decision from the financing decision by breaking the traditional DF into two parts. The first part (the investment decision) discounts cash flows at an equity rate of return/ cost of equity (Key) to calculate base case npv. The second part (the financing decision) discounts the interest tax shield to the present value at a rate of return that reflect the risk in actually achieving these tax benefits. The two parts are then summed to derive the value of the entire enterprise. The traditional discounted cash flow method where in debt free cash flows are discounted to the present at the WACC may not be appropriate in every circumstance. The WACC assumes a static debt to equity ratio presumably at an optimal capital structure. However, many companies do not expect to have static level of debt to equity, particularly in situations involving highly leveraged transactions. Under these types of situations, the Adjusted Present Value Method may be a better method. The APV separates the value of operations from value created or destroyed by how the company is financed. The APV maybe a better tool to analyze the value of entities with unique financing. As such, the APV can also be used as a management tool to break out the value created from specific managerial decisions. The APV is based upon a principle of value addition that analysts can use with valuations. Difference of WACC & APV Approach The APV method is a powerful tool. APV s approach is to analyze financial maneuvers separately and then at their value to that of the business. WACC approach is to adjust the discount rate to reflect the financial enhancement. Analyst apply the adjusted discount rate directly to the business cash flows. WACC is supposed to handle financial side effects automatically, without requiring any addition after the fact. APV is used instead of NPV for appraising the project. When the capital structure and the financial risk of the new project is different from the existing structure of the company. The benefit of APV is that it breaks the problem down into the value of project itself (if equity financed) and the value of financing (whereas as the effect of financing is taken account of and the WACC when calculating regular NPV). This makes APV flexible enough to cover many different types of real world financing arrangements such as Change in gearing level over the project life Issuance cost of equity and debt properly The proper impact of subsidized loan Page 45 of 138

46 Using debt for financing, has the tax advantage and interest payment are deductible. This tax deduction has a source of value for the firm. In the normal NPV calculation, this additional value is accounted for in the WACC. Unlike APV, the normal assumption in NPV is that all cash flows are financed using the same WACC and remain constant each year. Therefore, when dealing with changing financial risk and more complicated financial situation, APV is preferable appraisal method over NPV. Page 46 of 138

47 International Investment Appraisal There are four adjustments in international investment appraisal. 1. Exchange Rate prediction: Purchasing Power Parity S1 = So x (1+Hc)/ (1+Hb) EXAMPLE: The Current Dollar Sterling exchange rate is given $/ Expected Inflation Rates are: Year USA UK 1 5% 2% 2 3% 4% 3 4% 4% Find the expected spot rate for next three years. SOULTION: Year Calculation Future Expected Spot Year x (1.05/1.02) Year x (1.03/1.04) Year x (1.04/1.04) Taxation The level of taxation on a project s profits will depend on the relationship between the tax rates in the home and overseas country. The question will always assume a double-tax treaty project always taxed at higher rate. Page 47 of 138

48 EXAMPLE: What will be the rate of tax on a project carried out in the US by a UK company in each of the following scenarios? Scenarios UK TAX US TAX A 33% < 40% B 33% = 33% C 33% > 25% Scenario A No further UK tax to pay on the project s $ profits. Profits taxed at 40% in US. Scenario B No further UK tax to pay on the project s $ profits. Profits taxed at 33% in US. Scenario C Project s profits would be taxed at 33%. 25% in US and further 8% tax payable in the UK. 3. Inter-Company Cash flows Inter-company cash flows, such as transfer prices (intercompany transactions), royalties and management charges, can also affect the tax computations. Example: A project carried out by a US subsidiary of a UK company is due to earn revenues of $100m in the US in Year 2 with associated costs of $30m. Royalty payments of $10m will be made by US subsidiary to UK. Assume tax is paid at 25% in the US and 33%; and assume a forecast $/ spot rate of $1.50/. What are the cash flows associated with the project? Year 2 $m Revenues 100 Costs (30) Royalties (10) Page 48 of 138

49 Pre-Tax profit 60 25% US Tax (15) Remit to Parent 45* Cash Flow 30 - *45/1.50 Royalties 6.7 $10m/1.50 UK Tax (5.4)** After Tax Cash flow 31.3m UK Tax Computation: UK Tax on $ profits 33% - 25% =8% 8% UK tax on $ profits: $60m/1.50 = 40m : 40m x 0.08 = 3.2m 33% UK Tax on Royalties = 6.7m x 0.33 = 2.2m ** UK TAX PAYABLE: 5.4m 4. Remittance Remittance occurs where an overseas government places a limit on the funds the can repatriated back to the holding company. This restriction will change the cash flows that are received by the holding company. Example: A project s after US-tax $ cash flow is as follows ($m): YEAR (10) Page 49 of 138

50 In any one year, only 50% of cash flows generated can be remitted back to the parent. The blocked funds can be released back to parent in the year after the end of project Q. Identify the cash flows to be evaluated? YEAR Net Cash Flow Blocked Funds (1.5) (2) (3) Remit to Parent (Final Cash flows) Page 50 of 138

51 International Investment Appraisal PROFORMA: Year FC FC FC FC FC FC Sales/receipts x x x x payments: Variable costs (x) (x) (x) (x) Wages/materials (x) (x) (x) (x) Incremental fixed (x) (x) (x) (x) costs Untaxed royalties / (x) (x) (x) (x) mgt charges etc Tax allowable depn (x) (x) (x) (x) Taxable profits x x x x Foreign say (x) (x) (x) (x) 20% Add: Tax allowable x x x x depn Initial outlay (x) Realisable value x Working capital (x) (x) (x) (x) (x) x Net foreign CF (x) x x x x x YMT FC FC FC FC FC FC Exchange rate x x x x x x (based on PPPT) Home currency CF (x) x x x x x Domestic tax on (x) (x) (x) (x) foreign taxable - 20% = 10% Untaxed royalties / x x x x mgt charges etc Domestic tax on (x) (x) (x) (x) royalties Net home (x) x x x x x currency CF DF (say 16%) Home currency (x) x x x x x PV Home currency NPV Page 51 of 138

52 International APV INVESTMENT SIDE Same Performa as in Investment Appraisal Discount with UN gear cost of equity. Parent Co home currency cash flows Additional Tax Incremental contribution Contribution Loss Discount with parent co Cost of capital Financing Side Issuance Cost of Equity and Debt Present Value of Tax saving on Interest Subsidized Loan Debt Capacity First convert into parent co currency then discount with before Tax Kd or Rf. Page 52 of 138

53 Mergers and Acquisitions Mergers A merger is in essence the pooling of interests by two business entities which results in common ownership. Acquisitions An acquisition normally involves a larger company (a predator) acquiring smaller company (a target). Generally both referred to as mergers for PR reasons: i. It portrays a better message to the customers of the target company. ii. To appease the employees of the target company. An alternative approach is that a company may simply purchase the assets of another company rather than acquiring its business, goodwill, There are 3 main types of mergers 1. Horizontal integration. 2. Vertical integration. 3. Conglomerate integration. Types of Merger 1. Horizontal integration When two companies in the same industry, whose operations are very closely related& are combined /integrate.this is known as horizontal integration/merger. Main Benefits of horizontal integration includes economies of scale, increased market power& improved product mix. Disadvantages of such type of integration are that it can be referred to relevant competition authorities. 2. Vertical integration When two companies in the same industry, but from different stages of the production chain are merged. This is known as vertical integration. For example 1. A company combines with its supplier 2. Major players in the oil industry tend to be highly vertically integrated. Main benefits of such type of integration include increased certainty of supply or demand and just-in-time inventory systems leading to major savings in inventory holding costs. 3. Conglomerate integration When two or more companies which are completely unrelated businesses combine/merged & there is no common thread, such type of merger is known as conglomerate. The main synergy lies with the management skills and brand name. Main benefits of conglomerate integration are 1) risk reduction through diversification, 2) cost reduction (management) &3) improved revenues (brand). Page 53 of 138

54 Growth strategy The companies can grow in 2 ways i.e. either organically or by acquisition/merger. Whatever will be the growth strategy, assuming a standard profit maximizing company, the primary purpose of any growth strategy should be to increase shareholder wealth. Comparison of Organic growth & growth by acquisition 1. Organic Growth Organic growth is internally generated growth within the firm. No external growth should be considered unless the organic alternative has been dismissed as inferior. Advantages of organic growth Organic growth allows planning of strategic growth in line with stated objectives of company. It is less risky because it is done over time i.e. more understanding of business The Cost in organic growth is lower Organic Growth Avoids problems of integrating new acquired companies i.e. the integration process is often a difficult process due to cultural differences between the two companies. By organic Growth,an immediate pressure on current management resources to learn to manage the new business will be avoided Disadvantages of organic growth It requires time to enter a new product or geographical market. It increases the risk of over-supply and excessive competition. It increased the competition as more competitor are in market. Organic growth Might results in low market power as compared to acquisition strategy &by increased market power companies are able to exercise some control over the price of the product, e.g. monopoly or by collusion with other producers. Organic growth may give lesser competitive edge as compared to acquisition i.e. Acquisition results in the Acquisition of the target company's staff & highly trained staff may give a competitive edge 2. Growth by Acquisition It is the growth achieved by merger/acquisition of Target Company. Advantages of growth by acquisition It is the quickest way to enter a new product or geographical market. It reduces the risk of over-supply and excessive competition. Acquisition results in decrease competition as fewer competitor are available in market. Acquisition results in Increase market power& by increased market power companies are able to exercise some control over the price of the product, e.g. monopoly or by collusion with other producers. Acquisition results in the Acquisition of the target company's staff & highly trained staff may give a competitive edge Dis Advantages of growth by acquisition Page 54 of 138

55 As compared to Organic growth, growth by acquisition does not allow the planning of strategic growth in line with stated objectives. It is more risky than organic growth because it is not done over time & might have lesser understanding of business of target company The cost is often much higher in an acquisition due to significant acquisition premiums. It increases the problems of integrating new acquired companies i.e. the integration process is often a difficult process due to cultural differences between the two companies. An acquisition places an immediate pressure on current management resources to learn to manage the new business. The Main AIM of a company is to gain synergy benefits from Acquisition strategy but there are other motives also exist CREATING SYNERGIES The three main types of synergy to be gained from acquisitions or mergers i. Revenue Synergy ii. Cost Synergy iii. Financial Synergy The existence of synergies has been presented as one of the two main explanations that may increase shareholder`s value in an acquisition. Indeed the identification, qualification and announcement of these synergies are an essential part of the process as shareholders of the companies need to be persuaded to back the manager. TYPES OF SYNERGIES 1. Revenue Synergy Revenue synergy exists when the acquisition of the target company will result in higher revenues for the acquiring company, higher return on equity or a longer period of growth. Revenue synergies arise from: (1) Increased market power (2) Marketing synergies (3) Strategic synergies Revenue synergies are more difficult to quantify relative to financial and cost synergies. When companies merge, cost synergies are relatively easy to assess pre-deal and to implement post-deal. But revenue synergies are more difficult. It is hard to be sure how customers will react to the new market/product(in financial services mergers, massive customer defection is quite common)& whether customers will actually buy the new products & how it react to new expanded total systems capabilities & how much of the company s declared cost savings they will demand in price concessions (this is common in automotive supplier M&A where the customers have huge purchasing power over the suppliers). Nevertheless, revenue synergies must be identified and delivered. The stock markets will be content with cost synergies for the first year after the deal, but thereafter they will want to see growth. Page 55 of 138

56 Customer Relationship Management and Product Technology Management are the two core business processes that will enable the delivery of revenue. 2. Cost Synergy A cost synergy results primarily from the existence of economies of scale. As the level of operation increases, the marginal cost falls and this will be manifested in greater operating margins for the combined entity. The resulting costs from economies of scale are normally estimated to be substantial. 3. Financial Synergy A financial synergy results from financial factors e.g. tax savings There are many factors which result in financial synergy. These include: a) Diversification Diversification is the process of acquiring another firm/co. As a way of reducing risk. It cannot create wealth for two publicly traded firms, with diversified stockholders, but it could create wealth for private firms or closely held publicly traded firms. A takeover, motivated only by diversification considerations, has no effect on the combined value of the two firms involved in the takeover. The value of the combined firms will always be the sum of the values of the independent firms. In the case of private firms or closely held firms, where the owners may not be diversified personally, there might be a potential value gain from diversification. b) Cash Slack When a firm with significant excess cash acquires a firm, with great projects but insufficient capital, the combination can create value. Managers may reject profitable investment opportunities to take over a cash-poor firm with good investment opportunities, or vice versa. The additional value of combining these two firms lies in the present value of the projects that would not have been taken if they had stayed apart, but can now be taken because of the availability of cash. c) Tax Benefits The tax paid by two firms combined together may be lower than the taxes paid by them as individual firms. If one of the firms has tax deductions that it cannot use because it is losing money, while the other firm has income on which it pays significant taxes, the combining of the two firms can lead to tax benefits that can be shared by the two firms. The value of this synergy is the present value of the tax savings that accrue because of this merger. The assets of the firm being taken over can be written up to reflect new market value, in some forms of mergers, leading to higher tax savings from depreciation in future years. d) Debt Capacity: By combining the two firms, each of which has little or no capacity to carry debt, it is possible to create a firm that may have the capacity to borrow money and create value. Diversification will lead to an increase in debt capacity and an increase in the value of the firm, has to be weighed against the immediate transfer of wealth that occurs to existing bondholders in both firms from the stockholders. When two firms in different businesses merge, the combined firm will have less variable earnings, and may be able to borrow more (have a higher debt ratio) than the individual firms. Page 56 of 138

57 Why Companies went for Acquisition/Reason for Acquisition Whilst synergy is one of a key reason given for growth by acquisitions but there are many other motives do exist as well. These are: Entry to new markets and industries. To acquire the target company's staff and know-how. Arrogance factor/hubris hypothesis. Diversification. A defense mechanism to prevent being taken over. A means of improving liquidity. Improved ability to raise finance (Debt Capacity). To obtain a growth company (especially when the predator's growth is declining). Factors to be considered when choosing an appropriate target company for acquisition/reason for Acquistion a) Benefits for acquiring undervalued company The target firm should trade at a price below the estimated value of the company when acquired. This is true of companies which have assets that are not exploited. b) Diversification: The target firm should be in a business which is different from the acquiring firm s business and the correlation in earnings should be low. c) Operating synergy: The target firm should have the characteristics that create the operating synergy. Thus the target firm should be in the same business in order to create cost savings through economies of scale. Or it should be able to create a higher growth rate through increased monopoly power. d) Tax savings: The target company should have large claims to be set off against taxes and not sufficient profits. The acquisition of the target firm should provide a tax benefit to acquirer. e) Increase the debt capacity: This happens when the target firm is unable to borrow money or is forced to pay high rates. The target firm should have capital structure such that its acquisition will reduce bankruptcy risk and will result in increasing its debt capacity. f) Disposal of cash slack: This is where a cash rich company seeks a development target. The target company should have great projects but no funds. This happens when, e.g. the target company has some exclusive right to product or use of asset but no funds to start activities. g) Access to cash resources: A company with a number of cash intensive projects or products in their pipe-line, or heavy investment in R&D might seek a company that has significant cash resources or highly cash generative product lines to support their own needs. h) Control of the company: In this case the objective is to find a target firm which is badly managed and whose stock has underperformed the market. The management of an existing company is not able to fully utilize the potential of the assets of the company and the bidding company feels that it has greater expertise or better management methods. The bidding company therefore believes that the assets of the target Page 57 of 138

58 company will generate for them greater return than for their current owners. The criterion in this case is a market valuation of the company which is lower than, e.g. the value of its assets. i) Access to key technology: Some companies do not invest significantly in R&D but acquire their enabling technologies by acquisition. Pharmaceutical companies who take over smaller bio techs in order to get hold of the technology are a good examp0le of this type of strategy. Why acquisitions fail Over-optimistic assessment of economies of scale. Once a company has been bought, management moves on to identify the next target rather than ensuring that the predicted synergy is realized. Inadequate preliminary investigation combined with an inability to implement the amalgamation efficiently. Winner s curse where two or more predators bid to buy a target & the winner often had to pay an excessive premium to secure the deal. Dominance of subjective factors such as the status of the respective board of directors. Difficulty of valuation i.e. correct value of target company/firm\culture differences Loss of key personnel from target company Capital structure Integration difficulties - e.g. systems, operations Factors effecting the likely success of the bid for Acquisition (1) Level of consideration The acquirer should offer an initial bid price, keeping in mind a satisfactory premium over and above the actual market value of the acquire company. A generous offer would incline the target company to consider the offer positively. (2) Expectations of future profits In order to encourage the shareholders of Target Company to retain their shares in the combined company, a potential estimate of future earnings and synergies would be required by them. (3) Future dividend policy Shareholders of Target Company may be sensitive to the dividend policy possibly being less generous than they have been used to before the acquisition. (4) Tax position The shareholders may prefer a future capital gain on sale of shares in acquirer company to cash consideration, or instant sale of any shares they are given. (5) Changes in shares prices Shareholders will also take account of any changes in share prices that occur during the bid price. Reasons for predatory bids (Undervalued companies) The circumstances under which a predator may seek to buy a group at less than full value are usually as follows: 1. The share price is depressed. This can usually be identified by: The group's market value being below the net value of its shareholders' funds; or the group's price/earnings ratio being below, or its yield being above that for its sector In this case, however, the predator may believe that under its management the group can recover and perform much better financially than under existing management. Page 58 of 138

59 2. The group's prospects are better than the share price would indicate. A period of fluctuating profits may be about to be followed by a good recovery. A predator night recognize this before it became apparent to the stock market as a whole, and seek to capitalize on the opportunity. 3. The group occupies a strong position in one or more markets. The predator may see the acquisition of the group as a unique opportunity to purchase a major market share, and wish to do so without paying the market premium which should, in theory, attach to such a one-off situation. Types of Mergers The types of Mergers i.e. Horizontal,Vertical& Conglomerate can be sub divided into: 1. Friendly Mergers The acquirer will generally start the process by approaching target management directly. The target could approach the acquirer, although this method is much less common. If both management teams are amenable to a potential deal, then the two companies enter into merger discussions. The negotiations revolve around the consideration to be received by the target company's shareholders and the terms-of the transaction as well as other aspects, such as the post-merger management structure. Before negotiations can culminate in a formal deal, each of the parties examines the others' books and records in a process called due diligence. Once due diligence and negotiations have been completed, the companies enter into a definitive merger agreement 2. Hostile Mergers In a hostile merger, which is a merger that is opposed by the target company's management, the acquirer may decide to circumvent the target management's objections by submitting a merger proposal directly to the target company's shareholders by: a) Tender Offer b) Proxy Fight Defenses to Takeover/Merger/Acquisition A target company might use defensive measure to delay, negotiate a batter deal for shareholders, or attempt to keep the company independent. Defensive measure can be implemented either before or after a takeover attempt has begun. Strategic Defenses can be split into pre-bid and post-bid defenses. 1. Pre Offer Defense 2. Post Offer Defense 1. Pre-Offer Takeover Defense Mechanisms The defense that is used before the offer is take place. There are many types of pre-offer defenses including: 1. Poison Pills The poison pill is a legal device that makes it prohibitively costly for an acquirer to take control of a target without the prior approval of the target's board of directors. Page 59 of 138

60 There are two basic types of poison pills: a) The flip-in pill b) The flip-over pill a) Flip In Pill When the common shareholder of the target company has the right to buy its shares at a discount, the pill is known as a flip-in. The pill is triggered when a specific level of ownership is exceeded. b) Flip Over Pill In the case of a flip-over pill, the target company's common shareholders receive the right to purchase shares of the acquiring company at a significant discount from the market price, which has the effect of causing dilution to all existing acquiring company shareholders. 2. Poison Puts In the event of a takeover, poison puts allow bondholders to put the bonds to the company. In other words, if the provision is triggered by a hostile takeover attempt, then bondholders have the right to sell their bonds back to the target at a redemption price that is pre-specified in the bond agreement 3. Staggered Board of Directors Instead of electing the entire board of directors each year at the company's annual meeting, a company may arrange to stagger the terms for board members so that only a portion of the board seats are due for election each year. 4. Supermajority Voting Provisions Many target companies change their charter and bylaws to provide for a higher percentage approval by shareholders for mergers than normally is required. A typical provision might require a vote of 75 percent of the outstanding shares of the target company (as opposed to a simple 51 percent majority). 5. Golden Parachutes Golden parachutes are compensation agreements between the target company and its senior managers. These employment contracts allow the executives to receive lucrative payouts, usually several years worth of salary, if they leave the target company following a change in corporate control. Without a golden parachute, some contend that target company executives might be quicker to seek employment offers from other companies to secure their financial future. 6. Clearly defined strategy and communication Communicate the strategy effectively to ensure that it is well understood, this will reassure shareholders and tend to maintain the share price. 7. Cross shareholdings Your company buys a substantial proportion of the shares in a friendly company, and it has a substantial holding of your shares. 8. Strong dividend Policy The level of cash dividend is often held to influence share price. Page 60 of 138

61 2. Post-Offer Takeover Defense Mechanisms 1. Litigation A popular technique used by many target companies is to file a lawsuit against the acquiring company based on alleged violations of securities or antitrust laws. Lawsuits often serve as a delaying tactic to create additional time for target management to develop other responses to the unwanted offer. 2. Greenmail This technique involves an agreement allowing the target to repurchase its own shares back from the acquiring company, usually at a premium to the market price. Greenmail is usually accompanied by an agreement that the acquirer will not pursue another hostile takeover attempt of the target for a set period. 3. Leveraged Buyout(LBO) In some cases, a target company buys all of its shares and converts to a privately held company in a transaction called a leveraged buyout. In a leveraged buyout (LBO), the management team generally partners with a private equity firm that specializes in buyouts. 4. Leveraged Recapitalization A technique somewhat related to the leveraged buyout is the leveraged recapitalization. A leveraged recapitalization involves the assumption of a large amount of debt that is then used to finance share repurchases (but in contrast to a leveraged buyout, in a recapitalization, some shares remain in public hands). 5. "Crown Jewel" Defense After a hostile takeover is announced, a target may decide to sell off a subsidiary or asset to a third party. If the acquisition of this subsidiary or asset was one of the acquirer's major motivations for the proposed merger, then this strategy could cause the acquirer to abandon its takeover effort 6. "Pac-Man" Defense The target can defend itself by making a counteroffer to acquire the hostile bidder. This technique is rarely used because, in most cases, it means that a smaller company (the target) is making a bid for a larger entity. Methods of financing mergers In general a purchaser and a vendor will need to agree on three basic issues in regard to an acquisition: i. Whether shares or assets are to be purchased ii. Type of consideration iii. Financial value Type of Consideration The means of transferring the financial value of the shares or assets of the business, the consideration, can be satisfied in a combination of several alternatives: 1. Cash 2. Debt 3. Preference shares. 4. Ordinary shares. Page 61 of 138

62 5. Debt and preference share consideration that can be convertible into ordinary shares. 6. Share and loan stock used as consideration are known as 'paper issues'. 7. If a share exchange is used the target company's shares are purchased using shares of the predator. 1. Cash It is the most popular method (especially after stock market declines in early years.) For the acquirer Advantages Disadvantages When the bidder has sufficient cash the merger can be achieved quickly. Cash flow strain - usually either must borrow (increased gearing) or issue new shares in order to raise the cash. Cheaper: the consideration is likely to be less than a share exchange, as there is less risk to the shareholders. Retains control of their company. For the target shareholders Advantages Certainty about bids value Freedom to invest in a wide ranging portfolio. Disadvantages Liable to CGT Do not participate in new group. The cash to fund the purchase may have been raised by a rights issue before the takeover bid. 2. Shares It is the second most popular method. For the acquirer Advantages No cash outflow Disadvantages Dilution of control Bootstrapping - P/E ratio game can be played(discuss later) Page 62 of 138

63 For the target shareholders Advantages Postponement of CGT liability Disadvantages Uncertain value Participate in new group Choice of payment type a) Sometimes investors are given a choice in the method of payment, with the logic that different forms of payment might be attractive to different types of investor. b) Could influence the success or failure of a bid. c) Problematic for the bidder in that the cash needs and the number of shares to be issued is not known. d) Capital structure may alter in an unplanned manner. e) Ideally a bidder would like to tailor the form of the bid to that favored by major investors in the targeted company. Factors used to decide payment type Predator and its shareholders i. Control if a large number of shares are issued then control of the company may alter ii. Increases in authorized capital may be needed iii. Increases in borrowing limits may be required iv. The cost to the company will vary with debt, equity and convertible loan stocks v. There may be a dilution of earnings per share vi. The level of gearing resultant on an issue of debt to finance a cash acquisition may be unacceptable. Target company shareholders i. Share price shareholders want shares that will at least retain their value ii. Future investments some shareholders may prefer shares to maintain an investment in the company iii. Taxation Liability may be deferred if the consideration was in shares iv. Income shareholders will want a minimum income stream. Page 63 of 138

64 Business Valuation Method of Valuation Cash flow based model Net Asset method Market Relative based model Dividend Valuation model Free Cash flow to Firm FCFF Free cash flow to Equity FCFE Combine Company Value Valuation Based on APV Net asset Value P/E ratio Or Earning Yield Price/cash flow Calculated Intangible Value (CIV ) CASH-FLOW BASED METHOD DIVIDEND VALUATION MODEL The dividend valuation model (or growth model) suggests that the market value of a share is supported by the present value of future dividends Formula MV = D0(1 + g) / (Ke g) where: MV = share price g = future annual growth rate D0 = dividend at Time 0 Ke = rate of return required by the equity shareholders Three inputs have to be estimated if this approach is to be used: D0, g and Ke. D0 This is the dividend that has either just been paid or is just about to be paid: it is the current dividend. g = This is estimate by looking directly at the historical dividend growth rate and assuming this will continue in the future. OR Gordon s growth approximation : G=b x r g = b x Cost of equity where: b =( 1-dividend pay out ratio). r= Cost of equity Ke can be estimated using the capital asset pricing model: Required rate of return, Ke = Rf + β(rm Rf) Page 64 of 138

65 DIVIDEND VALUATION MODEL ( TWO METHODS) Single Growth model: MV = D0(1 + g) / ( Ke g) Multiple Growth model: Year Infinity Dividends D1 D2 D3 D3*(1+g)/Ke-g D.F at Ke D.f of last year Market Capitalisation= Mv/share number of shares ASSUMPTIONS It is assumed that current dividend payout ratio reflects the normal dividend capacity of business. It is assumed that dividend will increase with constant growth for the foreseeable future. Required return of investors (Ke) will remain constant for the foreseeable future. Dividend Growth model estimates market value according to the non-controlling shareholders. In order to get control of the company acquirer will have to pay some extra amount as control premium. FREE CASH FLOWS Scenario 1 : Single Growth Model. Market Value of Business = FCFF (1 + g) WACC g Free Cash Flow from Firm PBIT Tax Depreciation W.Cap. Change CAPEX XX (X) X (X) (X) FCFF Discount this using weighted average cost of capital. Scenario 2: Multiple Growth Model Year FCFF FCFF FCFF FCFF FCFF (1 + g) WACC g D.f of last year P.V= Market Value of Business Market Value of Equity = Market Value of Business Market Value of Debt Historic Growth Historic cost based on sales or operating profits. Page 65 of 138

66 FCFE Free Cash Flow To Equity PBIT 30% Depreciation W.Cap. Change Interest ( 1 1) CAPEX XX (X) X (X) (X) (X) FCFE Discount using cost of equity Scenario 1 Single Growth Model Market Value of Equity = FCFE (1 + g) Ke g Scenario 2 Multiple Growth Model Year FCFF FCFF FCFF FCFF FCFF (1 + g) Ke-g D.f of last year P.V= Market Value of Equity How to Calculate Growth in FCFE model Historical Growth Based on Sales or Operating profits Gordon Growth g = b x r r = Cost of Equity b = CAPEX FCFE before CAPEX Return on equity is not suitable therefore use cost of equity. Assumptions of Free Cash Flows It is assumed that level of free cash flows reflect the normal capacity of business. It is assumed that free cash flows will grow with constant growth rate for the foreseeable future. Required return of investors will remain constant. It is company policy to have consistent re-investments in CAPEX. Interest rate or Interest amount will remain constant (loan amount will be constant) It is assumed that replacement CAPEX are equivalent to the annual depreciation (only when mentioned in question). Page 66 of 138

67 Asset Based Approach The business is estimated as being worth the value of its Net Assets. Net Assets = Total Assets Total Liabilities Preference Share Value Adjustments: Monetary assets: book value Tangible assets: Replacement value( if purpose is going concern) Realizable Value( if purpose is of disposal) Book value( if above values are not available) Intangible Assets: consider if market value is available Inventory: at NRV Receivable: less any allowance for doubtful debt Liabilities: redemption value PROBLEMS & ADVANTAGES OF NET ASSETS METHOD Problems of Net Assets Method It does not consider future projects of a company. It does not consider all intangibles of a company. It cannot be used in service based industry. Replacement cost is difficult to estimate. Advantages of Net Asset Method It can be used as floor value (minimum value) in mergers and acquisitions. It is the only method used in case of liquidation. It can be used as valuation method in asset intensive firm. e.g. real estate business. CALCULATED INTANGIBLE VALUE (CIV) MODEL Step 1: Identify suitable proxy company or industry return on capital employed. Step 2 PBIT of Target Company Capital Employed of target. x Industry ROCE Excess earnings Tax After-tax Excess Earnings or value surplus XX (XX) XX (XX) XX P.V of all intangibles = Excess Earnings (1-T) WACC Total Value = Capital Employed + P.V of Intangibles Page 67 of 138

68 MARKET RELATIVE BASED APPROACH Price/Earning Method / Earnings Multiple This method relies on finding listed companies in similar businesses to the company being valued (the target company), and then looking at the relationship they show between share price and earnings. P/E ratio = Market Value of Share / Earnings per Share Market Value of Target Company = Earnings per Share of Target Company X P/E Ratio of Proxy or (Industry Average) Adjustments. Adjust earnings for one off exceptional items (After-tax). If target company is a private company then downwards adjust the calculated market value because: Public company has better image over private company Public company shares are more marketable and liquid Public company is less risky as compared to private company. ADJUSTMENTS TO BE DONE WHEN USING THE PRICE TO EARNINGS RATIO METHOD If private company has better growth prospects then upwards adjust the calculated market value. For better analysis use forecasted earnings. MV of Target co=forecasted Earnings x P/E Ratio of Industry In exam we will calculate both values (using historic earnings and forecasted earnings) and suggest that market value of the company should be in between. INCOME BASED APPROACH Earning Yield Method: Earnings yield = Earnings per share/ Market value per share. For example, if EPS was 1 per share and the market price per share was 10, then the earnings yield would be 10%. Earnings yield is the mirror image of the PRICE-EARNINGS RATIO. MARKET VALUE OF TARGET COMPANY/ SHARE = EPS OF TARGET COMPANY X 1/ EARNING YIELD (PROXY) Problems of P/E ration method Historical values used in calculations Single year data is being considered Difficult to find suitable proxy company Page 68 of 138

69 OTHER MEASURES Price to Cash Flow Ratio/ Cash flow multiple M.V of target = Free cash flow of target x price to CF ratio of proxy Price to Book Value/ Book Value Multiple M.V of target = Book value of target x price to book value of proxy Valuation Using Apv Method Same Business Risk and Different Financial Risk: Use Adjusted Present Value Investment Side Calculate free cash flows of target company and discount these free cash flows at un-geared cost of equity. FINANCING SIDE Issue costs Present value of tax shield Present value of interest savings on subsidized loan. Discount all of these using risk-free rate or cost of debt Market value of business = Investing Side + Financing Side Market value of equity = Market value of business market value of debt Benefit = Market value of equity cost of acquisition MARKET VALUE OF COMBINE BUSINESS Different Business Risk and Different Financial Risk: Market value of combined company Step 1: Un-gear βe of both acquirer and target company to calculate βa. Step 2: Calculated weighted average βa using above calculated βa weighting them according to their current market values. Step 3: Re-gear the calculated βa (w.avg) using post acquisition gearing and calculate βe. Step 4: Calculate cost of equity using CAPM and WACC using post-acquisition gearing. Step 5: Calculate combined free cash flows to the firm and using combined WACC, calculate combined market value of business. M.V of Equity = M.V of Business Total Debt Synergy Benefit = Combined M.V M.V of Acquirer. M.V of Target Synergy benefit= Maximum premium to be paid Methods of Financing Mergers Share for Share Cash Offer Bond Offer Mix Offer (Cash + Share offer, cash + bond offer) Page 69 of 138

70 Example Market value of target company $5 per share, market value of acquirer $4 per share. Acquirer has offered its 3 shares for every 2 shares of target company. Calculate %age benefits for target company. Solution: Value Offered = 3 x 4 = $12.00 Value of Target = 2 x 5 = $10.00 Gain $2.00 Gain %age = 2/10 x 100 = 20% Share for Share Exchange Gain to Target Co Value offer (Based on combine value) Value of target co Gain Gain to Acquirer Post-acquisition value Pre-acquisition value Gain Example Market value of target company is $2.50, market value of acquirer $3.00, combined market value $4.00. Acquirer has offered its 2 shares for every 3 shares of target company. Requirement: Calculate %age gain to both the acquirer and target shareholders. Solution: Target: Value of Acq. Offer =2 x 4 = $8 Value of target = 3 x 2.5= $7.50 Gain %age = 0.5/7.5 = 6.67% Acquirer: Gain %age = (4 3)/3 x 100 = 33.33% Combined Market Value o o o Earning Based (P/E will be given, synergy/year given) Based on total synergy Based on combine free cash flow and combined WACC Earning Based: Combine Earnings = Acquirer Earnings + Target Earnings + Synergy/year Combine Market Value = Combined Earning x P/E of Group Combine M.V/Share = Page 70 of 138

71 Combine M.V/ (Existing Shares of Acq. + New shares issued by acquirer) Combine Market Value Combine market value based on total synergy M.V of Acquirer + M.V of target Co + Total Synergy = Combine M.V of Equity Combine M.V/Share = Combine M.V/(Acq. Existing Shares + New Shares) Combine market value based on free cash flows Step 1: Calculate Combine M.V by discounting FCFF with combined WACC. Step 2: Combined M.V of Equity = M.V of Business Total Debt M.V (consolidated Debt) Combined M.V/Share = Combine M.V/ (Existing shares + New Shares) CASH OFFER Gain to Target Co cash offer Value of target co Gain Gain to Acquirer Post-acquisition value Pre-acquisition vale Gain Example: Market value of target co. is $4/share. Acquirer has offered $5 each for every share of target company. Calculate %age gain to the target company shareholders. Cash Offer = 5 Value of Target = 4 Gain %age = ¼ x 100 = 25% Combined Market Value Calculate combine M.V using any method given. Combine M.V/Share = Combine M.V Cash Paid Existing Shares of Acquirer Acquirer Post Acq. Value XX Pre Acq. Value (XX) Gain/ (loss) X Page 71 of 138

72 BOND OFFER Gain to Target Co Bond offer/number of shares Value of target co Gain Gain to Acquirer Post-acquisition value Pre-acquisition vale Gain Example: M.V of target co. $4/Share. Acquirer has offered $110 worth Bond for every 20 shares of target co. Calculate %age gain for target company shareholders. M.V of Bond = 110/20 = $5.5 Value of Target = $4 Gain %age = 1.5/4 x 100 = 31.50% STEPS Combine Market Value (In-order to calculate acquirers gain) Calculate combined market value using given method Combine M.V/Share = Combine M.V M.V of Bond Acquirer Existing Shares Acquirer Post Acq. Value XX Pre Acq. Value (X) Gain X MIX OFFER Example: Market value of target company $5 per share. Company has offered $107 worth bond for 25 shares of target company plus $1.50 cash for every share of target company. Requirement: Calculate %age gain to the target company. Value of Offer Shares 107/ Cash Value of target (5.00) Page 72 of 138

73 Gain 0.78 Gain percentage 15.60% Page 73 of 138

74 Reverse Takeovers An Explanation An RTO involves a smaller quoted company taking over a larger unquoted company by a share-for-share exchange. In order to acquire the larger unquoted company, a large number of shares in the quoted company will have to be issued to the shareholders of the larger unquoted company. Hence, after the takeover the current shareholders in the larger unquoted company will hold the majority of the shares in the quoted company and will therefore have control of the quoted company. On completion of an RTO, it is usual for the quoted company to be managed by the senior management team from the previously unquoted company and to take the name of the previously unquoted company. Through the RTO, the previously unquoted company has effectively achieved a listing on the stock exchange. It is worth noting that in the USA, the term 'reverse merger' is often used as opposed to the term reverse takeover. As ever, there are many variations on the basic idea. For instance, an RTO may involve a quoted company, which is actively trading, or a shell company, which is not actively trading. RTOs have often been deemed to be the poor man s initial public offering (IPO) perhaps due to US studies showing that companies achieving a listing through a reverse merger generally have lower survival rates and underperform compared to companies who have achieved their listing through a traditional IPO. REVERSE TAKEOVERS THE POTENTIAL BENEFITS As previously stated, an RTO is effectively a way that a currently unquoted company can achieve a listing. Hence, just as with an IPO, the company obtains the benefits of the public trading of its securities. These benefits include: Easier access to capital markets As a listed company, more finance is likely to be available and the cost of that finance is likely to be lower than if the company was still unquoted. Higher company valuation As the shares in the company will be listed, potential investors will deem the shares to be less risky as the company will have to abide by the relevant rules and regulations. Additionally, they will know that the shares are liquid and that whenever they wish to sell there will be a willing buyer. As a result of this, investors are likely to attribute a higher value to the shares. Enhanced ability to carry out further takeovers Once the shares in a company are listed, the company is able to acquire other companies through further share-for-share exchanges. Enhanced ability to use share based incentive plans Once the shares of a company are listed, share based incentive plans can be used as a key tool to attract and retain good quality employees. In addition to the above, an RTO has a number of other potential benefits when compared to a normal IPO. Page 74 of 138

75 These include the following: Speed An IPO can often take between one and two years to complete whereas an RTO can be completed in as little as 30 days. Furthermore, the work required to complete an IPO can mean that the managers of a company have less time to run the company, which may prove detrimental to the growth prospects of the company. The variability of market conditions can also make the speed of an RTO attractive, as in the time taken to prepare for an IPO, the market may deteriorate such that the IPO is not finally worth completing. Furthermore, particular circumstances in a market may make RTOs attractive. For instance, in China the IPO process is notoriously slow and there is usually a significant queue of companies waiting to carry out an IPO. An RTO allows a company to jump this queue. REVERSE TAKEOVERS THE POTENTIAL BENEFITS - CONTINUED Cost Just as an IPO is a time-consuming process, it is also an expensive one due to the volume of work required by investment banks, sponsors, accountants and other advisers. An RTO will usually, but not always, cost less. Availability In a market downturn it is not easy to convince investors to support an IPO, whereas this does not seem to be the case with RTOs. Studies have shown that the volume of RTO transactions is far more resilient to market downturns. During the market correction that followed the bursting of the dotcom bubble, the number of RTOs actually increased while the number of IPOs fell very significantly. Similarly, the fall in the number of RTOs was less than the fall in the number of IPOs following the more recent financial crisis. This is probably because, with an RTO, the deal is fundamentally between the shareholders of the quoted and unquoted companies involved and, hence, market sentiment has much less import. Furthermore, while an RTO is often accompanied by a concurrent secondary offering to raise new finance, the amount of new finance being raised in both $ and % terms is usually less than that which is raised during an IPO. Hence, even in a downturn, investors are often more willing to support an RTO rather than an IPO. Existing analyst coverage A listed company subject to an RTO is likely to have existing analyst coverage and, after the RTO, this analyst coverage usually continues. However, companies that use an IPO may struggle to get significant analyst coverage especially if they are smaller. Without reasonable analyst coverage, potential investors may not have much awareness of the company and, hence, are unlikely to want to invest in the company. Page 75 of 138

76 REVERSE TAKEOVERS THE POTENTIAL DRAWBACKS RTOs do, however, have a number of potential drawbacks when compared to an IPO and any company considering an RTO should be aware of these. Lack of expertise A company achieving a listing through an RTO may find that it does not have the expertise to understand and deal with all the regulations and procedures that listed companies must comply with. The long process of listing through an IPO can be viewed as a valuable training period and any company that has been through the process is in a better position to deal with the requirements of the exchange than a company catapulted onto the market through an RTO. Hence, any company considering an RTO must consider the need to hire and/or retain staff from the existing listed company who are able to keep the company compliant with all the relevant regulations. Reputation As previously discussed, an RTO has often been viewed as a poor man s IPO. Hence, companies that achieve their listing in this way may be viewed less favorably by investors than companies that have completed an IPO. Risk As a result of the lower level of scrutiny that is applied to an RTO compared to an IPO, investors must be aware of the higher level of risk that is attached to companies achieving a listing in this way. In particular, the unquoted company carrying out an RTO must ensure that there is a thorough investigation of the listed company which they are taking over so that all potential problems and liabilities are revealed. Regulation Although RTOs can generally be completed more quickly than an IPO as there is less regulation and scrutiny involved, it must be recognized that there are still a significant amount of regulatory hurdles to overcome. REVERSE TAKEOVERS THE POTENTIAL DRAWBACKS Regulation - continued It should be understood that RTOs are, to some extent, combinations of acquisitions and IPOs and, as such, are potentially complex and difficult deals to manage. By way of example, two regulatory issues that may arise are now discussed: Suspension The Financial Conduct Authority s (FCA) standard view is that when an RTO is announced or leaked, there will generally be insufficient information publicly available on the proposed transaction. In particular, information on the unquoted company contemplating the takeover could well be limited compared to the information that is available on listed companies. As a result of this, the listed company will not be able to accurately assess its financial position and inform the market. Hence, the FCA will often consider that a suspension of trading in the shares is appropriate. This standard view can be rebutted, but there is significant work required to achieve this. However, this work is essential as the listed company will not want to contemplate a scenario where its listing is suspended and is quite likely to walk away from the proposed transaction were this to occur. Mandatory offer If, individually or with their closely connected persons or friends, any shareholder in the unquoted company carrying out an RTO will on completion of the transaction hold shares that carry 30% or more of the voting rights of the listed company, then that shareholder will be required to make a general cash offer for the remaining shares in the listed company under the mandatory bid rule. This would obviously undermine the reason for doing the RTO in the first place. While the takeover panel Page 76 of 138

77 will usually consent to a waiver of this requirement as long as certain conditions are satisfied, it is another regulatory obstacle which must be navigated around carefully. Share price decrease Many listed companies which could make potential RTO targets are in that position because of past problems. Hence, they may have shareholders who are keen to exit from the company as soon as a suitable opportunity arises and, hence, they may dump their shares shortly after the RTO has completed. To safeguard against the risk of a dump occurring, the shareholders may need to guarantee that they will not sell their shares until a certain period of time has elapsed since the deal is completed. This is called a lock-up and/or a lock-up period. REVERSE TAKEOVERS THE POTENTIAL DRAWBACKS Cost While a reverse takeover is usually cheaper than an IPO, there are still significant direct and indirect costs involved and, hence, the total cost can easily be far more than was originally anticipated. A number of these costs are now considered: Regulatory costs As mentioned previously, an RTO is a complex transaction and to ensure that the regulatory hurdles are successfully overcome will incur significant cost. Acquisition cost As a result of an RTO being seen as an easier and quicker option than an IPO, especially in the Chinese market, the value of potential listed company targets are often at a significant premium to their true value. Acquisition cost - continued Furthermore, the pressure to find a target has resulted in some unusual combinations such as a mobile computer game developer getting listed through the acquisition of a shoe company! It is hard to imagine there were any synergy gains available here and, indeed, resolving cultural and other issues that may well have arisen would have further added to the indirect cost of achieving the listing. Investor relations Although an RTO may benefit from existing analyst coverage, RTO transactions only really introduce liquidity to a previously private company if there is real investor interest in the company. In many cases, in order to generate this interest, a comprehensive investor relations and investor marketing programme will be required. This is another potential indirect cost of an RTO. CONCLUSION As with anything that seems too good to be true, it must be recognized that an RTO is not without significant complication and cost. Just as there is no such thing as a free lunch, there is also no easy way to achieve a listing. Page 77 of 138

78 Corporate Restructuring TYPES OF RECONSTRUCTION Financial Reconstruction It involves changing the capital structure of the firm. It also includes Leveraged Recapitalization, Leveraged Buy-Outs and Debt for Equity swap. Portfolio Reconstruction It involves making additions to or disposals from companies businesses. It includes Divestments, Demergers, spin-offs or management buy-outs. Organizational Reconstruction It involves changing the organizational structure of the firm. Financial Restructuring Reasons: Company going towards Default Reconstruction for Value Creation Facing Downfall so restructure to improve performance No innovation in products Statutory and Legal Compliance Steps :- It is assumed that company is no longer operational. Prepare a Liquidation Statement and calculate what each party gets if the company were to go in Liquidation. Liquidation Statement Realizable value of Assets Liquidation Fees Redundancy Cost Secure Creditors Unsecured Creditors Trade Payable Overdraft Preference shares Ordinary Shares XX (xx) (xx) (xx) (xx) (xx) XX Steps: - Bond Holders/Banks are risk averse in nature therefore will not be ready to take up risk. Evaluate the effects of Restructuring Proposals on the following,( you may have to calculate in exam ) Fund Flow Forecasts (Cash Inflow & Cash Outflow) from additional resources and investments Forecasted Earning per Share Page 78 of 138

79 Market value on the basis of forecasted Cash Flows and P/E Ratios. Analyze the Restructuring Proposal and check whether the parties will be better off under the proposed scheme compare to liquidation. Increase in interest rate from existing level Offer higher nominal value to existing bondholders Offer majority shares to debt holders. Offer security to unsecured to debt holders Fixed Charge offered to existing floating charge debt holders. CONCLUSION: Come to conclusion and discuss whether it is a successful restructuring scheme or not. Leveraged Recapitalization In leveraged Recapitalization a firm replaces the majority of its equity with a package of debt securities. The high level of debt in the company discourages other companies to make take-over bids. Companies should be Relatively debt free Consistent cash flows Debt/Equity Swaps The value of the swap is determined usually at current market rates. Management may offer higher exchange values to share- and debt holders to force them participate in the swap. Leveraged buy-outs (LBOs) It refers to the takeover of a company that utilizes mainly debt to finance the buyout and company is de-listed. A small group of individuals, possibly including existing shareholders and/or management buys all the company's shares. Advantages Protection from Share price movement No hostile bids Focus on Long-term performance Minimized agency costs Disadvantages Shares don t trade publicly anymore. Bankrupt if the cash flow risk is too high. Unbundling is a process by which a large company with several different lines of business retains one or more core businesses and sells off the remaining assets, product/service lines, divisions or subsidiaries. Unbundling is a Portfolio Restructuring Strategy. It includes the following: Page 79 of 138

80 Business Re-Organization Divestment Demergers Sell - Offs Spin - Off Carve Outs Management Buy Out Unbundling Divestments Divestment is the partial or complete sale or disposal of physical and organizational assets, the shutdown of facilities and reduction in workforce in order to free funds for investment in other areas of strategic interest. Divestments are undertaken for a variety of reasons. They may take place as a Corrective action in order to reverse unsuccessful previous acquisitions. Divestments may also be take place as a response to a cyclical downturn in the activities of a particular unit or line of business. normally to reduce costs or to increase return on assets Demergers A demerger is the splitting up of corporate bodies into two or more separate bodies, to ensure share prices reflect the true value of underlying operations. A demerger is the opposite of a merger. It is the splitting up of a corporate body into two or more separate and independent bodies. Advantages of demergers The main advantage of a demerger is its greater operational efficiency and the greater opportunity to realize value. A two-division company with one loss making division and one profit making, fast growing division may be better off by splitting the two divisions. The profitable division may acquire a valuation well in excess of its contribution to the merged company. Disadvantages of demergers Economies of scale may be lost. The smaller companies which result from the demerger will have lower turnover, profits and status than the group before the demerger. Page 80 of 138

81 There may be higher overhead costs as a percentage of turnovers. The ability to raise extra finance, especially debt finance, to support new investments and expansion may be reduced. Vulnerability to takeover may be increased. Sell-offs A sell-off is the sale of part of a company to a third party, generally for cash. A sell-off is a form of divestment involving the sale of part of a company to a third party, usually another company. Generally, cash will be received in exchange. Reasons for Sell-Off As part of its strategic planning, it has decided to restructure, concentrating management effort on particular parts of the business. Control problems may be reduced if peripheral activities are sold off. It wishes to sell off a part of its business which makes losses, and so to improve the company's future reported consolidated profit performance. In order to protect the rest of the business from takeover, it may choose to sell a part of the business which is particularly attractive to a buyer. The company may be short of cash. A subsidiary with high risk in its operating cash flows could be sold. A subsidiary could be sold at a profit. Liquidations The extreme form of a sell-off is where the entire business is sold off in liquidation. In a voluntary dissolution, the shareholders might decide to close the whole business, sell off all the assets and distribute net funds raised to shareholders. Spin-offs In a spin-off, a new company is created whose shares are owned by the shareholders of the original company which is making the distribution of assets. In a spin-off, there is no change in the ownership of assets, as the shareholders own the same proportion of shares in the new company as they did in the old company. Reasons: a) The change may make a merger or takeover of some part of the business easier in the future, or may protect parts of the business from predators. b) There may be improved efficiency and more streamlined management within the new structure. c) It may be easier to see the value of the separated parts of the business now that they are no longer hidden within a conglomerate. d) The requirements of regulatory agencies might be met more easily within the new structure. Page 81 of 138

82 Carve-Out A carve-out is the creation of a new company, by detaching parts of the company and selling the shares of the new company to the public. In a carve-out, a new company is created whose shares are owned by the public with the parent company retaining a substantial fraction of the shares. Parent companies undertake carve-outs in order to raise funds in the capital markets. These funds can be used for the repayment of debt or creditors or it can be retained within the firm to fund expansion. Carved out units tend to be highly valued. Management buy-outs (MBOs) A management buy-out is the purchase of all or part of the business by its managers. The main complication with management buy-outs is obtaining the consent of all parties involved. Venture capital may be an important source of financial backing. A management buy-out is the purchase of all or part of a business from its owners by its managers. Reasons for a management Buy-out The subsidiary may be peripheral to the group's mainstream activities, and no longer fit in with the group's overall strategy. The group may wish to sell off a loss-making subsidiary, and a management team may think that it can restore the subsidiary's fortunes. The parent company may need to raise cash quickly. The best offer price might come from a small management group wanting to arrange a buy-out. When a group has taken the decision to sell a subsidiary, it will probably get better co-operation from the management and employees. The sale can be arranged more quickly than a sale to an external party. The selling organization is more likely to be able to maintain beneficial links with a segment sold to management rather than to an external party. Problems with buy-outs Managers may have little or no experience of entrepreneur skills. Difficulties in deciding on a fair price to be paid Convincing employees of the need to change working practices Inadequate cash flow to finance the maintenance and replacement of tangible fixed assets The maintenance of previous employees' pension rights Accepting the board representation requirement that many sources of funds will insist upon The loss of key employees. Maintaining continuity of relationships with suppliers and customers Advantages of MBOs to disposing company To raise cash quickly to improve liquidity. Known buyer If subsidiary is loss making then sale to management will be better financially than liquidation Page 82 of 138

83 Better publicity Advantages of MBOs to management It preserves their jobs. It offers a chance to become owner of the company It is quicker than starting a similar business from scratch They can carry out their own strategies, no longer required approval from head office. They have detail knowledge and relevant skills. Buy-ins 'Buy-in' is when a team of outside managers, as opposed to managers who are already running the business, mount a takeover bid and then run the business themselves. A management buy-in might occur when a business venture is running into trouble, and a group of outside managers see an opportunity to take over the business and restore its profitability. They may bring fresh ideas and experience. They may bring better finance for company. Page 83 of 138

84 Foreign Currency Risk Management FOREX How to Convert Currency How Currency Fluctuates Types of Foreign Risk Hedging Methods RISK MANAGEMENT EXCHANGE RATE CONVERSION Bid Offer/ask Bank Buy Bank Sell $/ $/ When dealing with converting Foreign currency, it is important to consider the following points Always consider yourself at Adverse Position In case of Receipt (Lower Receipt) In case of Payments (Higher Payment) In Currency Division In case of Receipt, Sell Currency, Exports, Gain or Income In case of Payment, Buy Currency, Import, Loss or Expense Divide with Higher Currency Rate Divide with Lower Currency Rate HOW CURRENCY FLUCTUATES Supply & Demand Export and Import Foreign Direct Investment (FDI) Foreign Currency Loans Page 84 of 138

85 PURCHASING POWER PARITY (PPP) According to PPP the exchange rate between two currencies can be explained by the difference between inflation rated in respective countries. PPP says country with HIGH inflation rate normally faces the decrease in its currencies value and a country with a LOW inflation rate has an expectation of increase in its currencies value. The businesses normally use PPP for calculation of expected spot rate against the forward rate offered by banks. Expected spot rate Future Spot rate= current spot rate ( 1+ inflation of first currency) (1 + inflation of 2 nd currency) INTEREST RATE PARITY (IRP) This concept says that the difference between 2 currencies worth can be explained by interest rate structure in the countries of these 2 currencies. According to IRP a country with a high interest rate structure normally has a currency at discount in relation to another currency whose country has a low interest rate structure & vice versa. HIGH INTEREST in country LOWER INTEREST in country LOWER will be the value of currency HIGHER will be the value of currency We can predict forward rate between two currencies by using interest rate parity concept as follows; Forward rate Forward rate= current spot rate (1+ interest of first currency) (1 + interest of 2 nd currency) FISHER EFFECT This concept tells us the relation between interest rate and inflation. It assumes that real interest rate between two economies is same and nominal interest rates are different because of inflation. Countries with relatively high rate of inflation will generally have high nominal rates of interest, partly because high interest rates are a mechanism for reducing inflation. USA 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate] UK 1+nominal (money) rate] = [1+ real rate] x [1+ inflation rate] TYPES OF FOREIGN EXCHANGE RISK TRANSLATION RISK Translation risk refers to the possibility of accounting loss that could occur because of foreign subsidiary, as a result of the conversion of the value of assets and liabilities which are denominated in foreign currency, due to movements in exchange rate. This risk is involved where a parent company has foreign subsidiaries in a depreciating currency environment. Page 85 of 138

86 TRANSLATION RISK HEDGING Arrange Maximum Borrowing in Subsidiary Co. currency. Maintain Surplus Assets in Parent Co. currency which will reduce the overall exposure of Translation risk. METHODS OF HEDGING FOREX RISK ECONOMIC RISK Long-term movement in the rate of exchange which puts the company at some competitive disadvantage is known as economic risk. E.g. if competitor currency starts depreciating or our company currency starts appreciating. It may affect a company s performance even if the company does not have any foreign currency transactions. ECONOMIC RISK HEDGING Shift manufacturing to cheaper labor areas Create innovative and differentiate units to create brand loyalty Diversify into new products and into new markets TRANSACTION RISK - INTERNAL HEDGING METHOD TRANSACTION RISK Transaction risk refers to adverse changes in the exchange rate before the transaction is finally settled. Invoice in Home Currency Suitability: Monopoly power & customer has no option. Supplier agrees to invoice in your currency. Matching Foreign Currency (Receipts and Payments) Timing and currencies should be same Netting NETTING Netting is a process in which all transaction of group companies are converted into the same currency and then credit balances are netted off against the debit balances, so that only reduced net amounts remain due to be paid or received. Step 1: Convert all transactions of group companies or in case of multilateral netting the other non-group companies in to the same currency (normally the parent Co currency. Step 2: Prepare the Transaction matrix ( Netting Table ) Page 86 of 138

87 Step 3: Companies with negative balance will pay the amounts to companies having positive balance. Receipts Read Across USA UK Europe Total Payments Net Amounts USA UK Europe Total Receipts TRANSACTION RISK - EXTERNAL HEDGING METHOD Forward Contract : A forward contract is an agreement made today between a buyer and seller to exchange a specified quantity of an underlying asset at a predetermined future date, at a price agreed upon today. Example Home Currency is British Pound, Exports receipts = $ 500,000 after six months Spot Rate = $/ Six month forward rate = $/ Expected Net Receipt if Forward Contract is taken = $500,000/1.33 = 375,940 Adjustment: 3 month forward 1.28 $/ 8 month forward 1.38 $/ 6 month forward? TRANSACTION RISK - EXTERNAL HEDGING METHOD Money Market Hedging: Foreign Currency Receipts / Exports Steps: a) Calculate present value of foreign currency using borrowing rate of foreign currency and take loan of this amount. Present Value = Foreign Currency amount (1+ borrowing rate of FCY) a) Convert that present value into home currency using spot exchange rate. b) Deposit the home currency at the deposit rate of home currency. Total receipts= Home currency ( 1 + lending rate of HCY ) Page 87 of 138

88 FOREIGN CURRENCY PAYMENTS / IMPORTS Steps: a) Calculate present value of foreign currency using lending rate of foreign currency and deposit that amount. Present Value = Foreign Currency amount (1+ lending rate of FCY) a) Convert that present value into home currency using spot exchange rate. b) Borrow the home currency at the borrowing rate of home currency. Total payment= Home currency (1 + borrowing rate of HCY ) TRANSACTION RISK - EXTERNAL HEDGING METHOD Derivatives: Future Settlement Initial amount to be paid is nil or low Drive their value from some underlying Traded in two types of market (Over the counter Market & Exchange Traded) Over-the-Counter Derivatives Exchange-Traded Derivatives Customized Contracts Standardized Contracts Any Amount Standardized Contract Size (e.g. $ 62,500) Available in any Currency Major Currencies Settlement on any date Settlement Date Mar/Jun/Sept/Dec No Initial margin requirement Initial Margin Requirement Gain or Loss settled at maturity Gain or Loss settled on daily basis using Mark to Market High Risk of Default No Risk of Default Counter Party is another Investor Counter Party is clearing house. E.G FORWARD CONTRACTS E.G FUTURE CONTACTS TRANSACTION RISK - EXTERNAL HEDGING METHOD FUTURE CONTRACT Futures are standardized contracts traded on a regulated exchange to make or take delivery of a specified quantity of a foreign currency, or a financial instrument at a specified price, with delivery or settlement at a specified future date. They are Exchange Traded derivatives contracts. Standardized contract sizes and are available in only major currencies There are four settlement dates MAR/JUNE/SEPT/DEC. Page 88 of 138

89 FUTURE CONTRACT Step 1: Identify the amount of currency to be hedged Step 2: Decide whether to buy or sell future If you want to buy currency Buy that currency future If you want to sell currency Sell that currency future Think according to the contract size currency Step 3: Identify the settlement date expiring immediately after the payment is due to be paid or received Step 4: Calculate no of contracts Transaction Amount/Contract Size If transaction currency is different from the contract size currency then using future rate convert that transaction amount currency into the same currency of contract size. Step 5: Calculate Basis Risk. BASIS = Current Spot rate Opening Future Rate Remaining Basis =( Difference/Total months)* remaining months Basis Risk It s the risk that current spot will not reduce over the time to exactly match the opening future rate. Lock in Rate= opening future rate ± Remaining Basis ( opposite to normal rule ) Convert the foreign currency into home currency using Lock in rate. OPTION CONTRACT Currency options give the buyer the right but not the obligation to buy or sell a specific amount of foreign currency at a specific exchange rate (the strike price) on or before a predetermined future date. For this protection, the buyer has to pay a premium. A currency option may be either a call option or a put option Currency option contracts limit the maximum loss to the premium paid up-front and provide the buyer with the opportunity to take advantage of favorable exchange rate movements. TYPES: CALL OPTION Right to buy at a specified rate PUT OPTION Right to sell at a specified rate OPTION BUYER OPTION HOLDER LONG POSITION OPTION SELLER OPTION WRITER SHORT POISTION American Option can be exercised at any time before maturity Page 89 of 138

90 European Option can be exercised at maturity only. OPTION CONTRACT Step 1: Identify the amount of currency to be hedged Step 2: Decide whether to buy Call or Put If you want to buy any currency in future call If you want to sell any currency in future put Think according to the contract size currency Step 3: Identify the settlement date expiring immediately after the payment is due to be paid or received Step 4: Identify the exercise price Step 5: Calculate the no of contracts = (Foreign Currency Amount/ Exercise Price) / Contract Size Step 6: Calculate the premium cost = No of contract x Contract size x Premium If premium answer is not in your home currency then using current spot rate convert it into home currency. Step 7: NOTE: It is assumed that option will be exercised. Exercise the option Over or under hedge amount Premium Net Amount CURRENCY SWAP A currency swap is an agreement in which two parties exchange the principal amount of a loan and the interest in one currency for the principal and interest in another currency. At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate. During the length of the swap each party pays the interest on the swapped principal loan amount. At the end of the swap the principal amounts are swapped back at either the prevailing spot rate, or at a pre-agreed rate such as the rate of the original exchange of principals. Using the original rate would remove transaction risk on the swap. Page 90 of 138

91 FIXED FOR FIXED SWAP An American company may be able to borrow in the United States at a rate of 6%, but requires a loan in rand for an investment in South Africa, where the relevant borrowing rate is 9%. At the same time, a South African company wishes to finance a project in the United States, where its direct borrowing rate is 11%, compared to a borrowing rate of 8% in South Africa. Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap. In this case, the American company can borrow U.S. dollars for 6%, and then it can lend the funds to the South African company at 6%. The South African company can borrow South African rand at 8%, and then lend the funds to the U.S. Company for the same amount. CROSS CURRENCY PLAIN VANILLA SWAP/FIXED FOR FLOATING SWAP Barrow Co, a company based in the USA, wants to borrow 500m over five years to finance an investment in the Eurozone. Today s spot exchange rate between the Euro and US $ is = $1. Barrow Co s bank can arrange a currency swap with Greening Co. The swap would be for the principal amount of 500m, with a swap of principal immediately and in five years time, with both these exchanges being at today s spot rate. Barrow Co s bank would charge an annual fee of 0.4% in for arranging the swap. The benefit of the swap will be split equally between the two parties. The relevant borrowing rates for each party are as follows: Barrow Co Greening Co USA 3.6% 4.5% Eurozone EURIBOR + 1.5% EURIBOR + 0.8% Barrow Co Greening Co Swap Combinations USA 3.6% 4.5% EURIBOR+6% Eurozone EURIBOR + 1.5% EURIBOR + 0.8% EURIBOR+4.4% Gain on swap 1.6% Bank fee (0.2%) (0.2%) (0.4%) Final gain 0.6% 0.6% 1.2% Barrow Co Greening Co Barrow Co borrows 3.6% Greening Co borrows EURIBOR + 0.8% Swap Greening Co receives (EURIBOR) Barrow Co pays EURIBOR Barrow Co receives (2.9%) Page 91 of 138

92 Greening Co pays 2.9% Net result EURIBOR + 0.7% 3.7% Bank fee 0.2% 0.2% Overall result EURIBOR + 0.9% 3.9% Page 92 of 138

93 Interest Rate Risk Management Interest rate risk (IRR) can be explained as the impact on an institution s financial condition if it is exposed to negative movements in interest rates. This risk can either be translated as an increase of interest payments that it has to make against borrowed funds or a reduction in income that it receives from invested funds. METHODS OF HEDGING INTEREST RATE RISK Forward rate Agreement (FRA) Interest Rate Future Options Interest Rate Swaps CAP, FLOOR & COLLAR FORWARD RATE AGREEMENT (FRA) FRA is a contract in which two parties agree on interest rate to be paid on a notional amount at a specified future time. The buyer of FRA is partly wishing to protect itself against a rise in rates while the seller is a party protecting itself against an interest rate decline. FRAs can be used to hedge transactions of any size or maturity and offer an alternative ta interest rate futures for hedging purpose. FRAs do not involve any margin requirements. Forward Rate Agreement (FRA) A co, can enter into a FRA with a bank that fixes the rate Of interest for borrowing at a certain time in the futures. If the actual interest rate proves to be Higher than the rate agreed The bank pays the co, the difference lower than the rate agreed The co, pays the bank the difference FORWARD RATE AGREEMENT It is 30 June. Lynn plc will need a 10 million 6 month fixed rate from 1 October. Lynn wants to hedge using an FRA. The relevant FRA rate is 6% on 30 June. a) State what FRA is required Page 93 of 138

94 b) What is the result of the FRA and the effective loan rate if the 6 month FRA benchmark rate has moved to 1. 5% 2. 9% Solution a) The forward rate agreement required is 3-9. b) (i) At 5% because interest rates have fallen, Lynn plc will pay the bank: FRA payment 10 million x (6% - 5%) x 6/12 (50,000) Payment on underlying loan 5% x 10 million x 6/12 (250,000) Net payment on loan (300,000) Effective interest rate on loan 6% (ii) At 9% because interest rates have risen, the bank will pay Lynn plc FRA receipt 10 million x (9% - 6%) x 6/12 150,000 Payment on underlying loan at market rate 9% x 10 million x 6/12 (450,000) Net payment on loan (300,000) Effective interest rate on loan 6% INTEREST RATE FUTURE IMPORTANT TERMS a) BUY FUTURE RIGHT TO RECEIVE INTEREST (DEPOSIT) SELL FUTURE RIGHT TO PAY INTEREST (BORROW b) PRICE OF THE CONTRACT IS DETERMINED AS (100 r) r = Libor interest rate If Libor 11% = (100-11) =89 If Libor 5% = (100-5) =95 c) TICK VALUE=CONTRACT SIZE X 0.01 % x 3/12 d) Settlement date = March, June, September & December e) Contract size= standardized normally in , f) Basis risk = Current spot rate( current Libor) opening future rate Remaining Basis =( Difference/Total months)* remaining months Closing future = Closing Spot ( closing Libor) ± Remaining Basis ( based on Trend ) Page 94 of 138

95 Basis Risk It s the risk that current spot will not reduce over the time to exactly match the opening future rate. g) No. of contracts = amount of loan /deposit x time period of loan Contract size 3 METHODS OF HEDGING INTEREST RATE RISK STEPS: Identify the borrowing or lending amount. Decide whether to buy or sell future If you want to receive interest = buy future=lender If you want to pay interest = sell future=borrower Identify the settlement date expiring immediately after the loan is taken No of Contracts = amount of loan /deposit x time period of loan Contract size 3 Basis risk = Current spot rate( current Libor) opening future rate Remaining Basis =( Difference/Total months)* remaining months Closing future = Closing Spot (closing Libor) ± Remaining Basis ( based on Trend ) Close the future contract by comparing opening future with the closing future and calculate gain or loss. Opening future rate xx Closing future rate xx Gain/Loss xx Borrow from market (Actual Interest + Spread) x months/12 x loan amount Actual Amount Borrowed = xx Gain/Loss Future = xx/(xx) Effective Cost xx Advantages of futures An important advantage of futures as a hedging instrument is the flexibility of closing a position at any time before delivery date, so that the hedge can be timed to match exactly the underlying borrowing, lending or investment transaction. In contrast, the settlement date or exercise date for FRAs and European-style interest rate options is set for an exact date when the transaction is arranged; giving the user no timing flexibility should the loan or investment date be slightly delayed or brought forward. The user of futures also has the opportunity to benefit from current market prices, should these seem particularly favorable, by closing a position before the loan or investment takes place. Disadvantages of futures Initial margins and variation margins tie up cash in deposits for the sale or purchase transaction until the futures position is closed. There can be a considerable amount of administrative work to manage futures positions efficiently. Futures are a short-term hedging method, and most contracts traded on an exchange are for the next one or two delivery dates. The range of available interest rate contracts is fairly limited and restricted to the major currencies. Page 95 of 138

96 OPTION ON INTEREST RATE FUTURE An interest rate option is an option on a notional borrowing or a deposit which guarantees a minimum or a maximum rate of interest (called strike price) for the option holder. The option is settled in cash. This product is available on payment of an upfront fee called a premium. STEPS: Identify the amount of borrowing/lending Decide whether to Buy Call or Put Option Call option=right to buy= Buy future=if you want to receive interest=lender Put option= Right to Sell= Sell future=if you want to pay interest =Borrower Identify the settlement date expiring immediately after the loan is taken Identify the best Exercise Price Select lower Put Option Exercise Price interest rate + Premium Cost Select higher Call Option Exercise Price interest rate - Premium Cost No of Contracts = Amount/Contract Size x Duration / 3 Calculate Premium Cost = ticks x tick value x number of contracts Decide whether to exercise the option or not by comparing strike price with basis adjusted closing future price. Actual Borrowing or lending in market (Closing libor + Spread) =xx Gain on option = xx/(xx) Premium Cost =x Effective Cost xx METHODS OF HEDGING INTEREST RATE RISK Interest Rate CAPS An interest rate cap is a series of borrowers option which sets the limit on maximum interest rate. A CAP fixed the interest rate to be paid on the borrowing. JAN MAR JUN 6% 6% 6% Interest Rate (Market) 8% 9% 4%* 2% (Gain) 3% (Gain) *Interest rate will be paid at 4% as Cap will not be exercised High upfront premium Cost Interest Rate FLOOR An interest rate floor is a series of Lenders options, that protects the lender against a decline in the floating interest rates. A floor guarantees that the interest rate received on a deposit will not be less than a specified level. Page 96 of 138

97 High upfront premium Cost JAN MAR JUN 6% 6% 6% Interest Rate 4% 5% 9% Interest rate will be received at 9% 2% (Gain) 1% (Gain) - (Not Exercised) An interest rate collar is a combination of a cap and a floor transacted simultaneously. BORROWER COLLAR Buy Cap Buy Put options /Lock the maximum interest cost Sell Floor Sell Call option /Lock the minimum interest cost Advantage: Reduced Premium Cost E.g. put option is bought at 95.00(5% exercise price). Whenever interest rate rises above this level it will be exercised and company will pay maximum cost of 5%. PREMIUM PAID E.g. Call option is Sold at 96.00(4% exercise price). Whenever interest rate falls below this level it will be exercised by lenders and company will have to pay minimum cost of 4%. PREMIUM RECEIVED Disadvantage: Borrower will have to pay minimum interest cost in any case Lender s Collar Sell Cap Sell Put options /Lock the maximum interest Income Buy Floor Buy Call option /Lock the minimum interest Income Advantage: Reduced Premium Cost E.g. put option is sold at 95.00(5% exercise price). Whenever interest rate rises above this level it will be exercised by borrower and Lender will receive maximum Income of 5%. PREMIUM Received E.g. Call option is bought at 96.00(4% exercise price). Whenever interest rate falls below this level it will be exercised by lenders and will receive minimum income of 4%. PREMIUM Paid Disadvantage: Lender has set limit to its maximum interest income. Page 97 of 138

98 Methods of Hedging Interest Rate Risk Interest Rate COLLAR An interest rate collar is a combination of a cap and a floor transacted simultaneously. The buyer of an interest rate cap, purchases an interest rate cap while selling a floor indexed to the same interest rate, for the same amount and covering the same period. BORROWER COLLAR Prepare collar contract by buying Put option at higher rate and selling call option at lower rate and also calculate net premium cost Compare call or put strike prices with closing future rates to calculate gain and losses 1. Actual Borrowing from Market xx 2. Gain or loss on Collar xx 3. Net premium cost xx Effective Cost X LENDER COLLAR Prepare collar contract by selling Put option at higher rate and buying call option at lower rate and also calculate net premium cost Compare call or put strike prices with closing future rates to calculate gain and losses 1. Actual Deposit from Market xx 2. Gain or loss on Collar xx 3. Net premium cost xx Effective Income X Interest Rate SWAP It s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another called plain vanilla swap. Lending bank Floating-rate payment Borrowing Firm Floating-rate receipt Floating-rate payment Swap Counterparty Page 98 of 138

99 Borrow from bank (Floating interest rate) Receive from swap agent (Floating interest rate) Pay to swap agent (Fixed interest rate) After swap cost Fixed interest cost Interest Rate SWAP It s instrument in which two parties agree to exchange interest rate cash flows based on a specified notional amount from a fixed rate to a floating rate (or vice versa) or from one floating rate to another Example Firm A has a credit rating of BBB and is about to arrange a loan' of UK10 million.. It can obtain this loan at either a fixed rate of 9.25% or a floating rate of LIBOR +1.5%. Firm A has approached a Swap dealer with the request to arrange an interest rate swap that could potentially lower its interest cost. Firm B, another client of the Swap dealer, is about to raise the same amount priced at a floating rate of LIBOR +0.5%. It shall be provided a price of 7.5% if it wishes to raise this amount on a fixed rate. Firm B has a credit rating of AA and has made it clear that it would be willing to enter into a swap agreement if two-thirds of the potential swap benefits are passed on to it. Illustrate how the Swap dealer can proceed with the arrangement, with the Swap fee being 0.10% from each party? Methods of Hedging Interest Rate Risk Interest Rate SWAP EXAMPLE: ARRANGEMENT FOR AN INTEREST RATE SWAP Make two possible swaps by combining fixed rate of Part A with floating rate of party B and then combine fixed rate of party B and floating rate of party A, select the cheaper combination. Difference between these two combinations will be savings and Firm A and B should borrow now in the chosen structure. Fixed Rate Floating rate Combination options available Total cost Firm A 9.25% B borrows at fixed, LIBOR + 1.5% A LIBOR % at floating Firm B 7.50% LIBOR + 0.5% A borrows at fixed, B LIBOR+ 9.75% at floating Savings 0.75% Page 99 of 138

100 Distribute the savings between both parties as per the arrangement provided otherwise divide equally. Deduct the swap dealer's fee from the savings to compute the Net savings. Swap Fees Net Savings Share of A (1/3) 0.25% 0.10% 0.15% Share of B (2/3) 0.50% 0.10% 0.40% Deduct the Net savings from the interest rate that each party would have paid,had it not arranged for a swap and taken loan directly in its desire exposure. This shall become the final interest cost to be borne by each parry. Preferred Price Net Savings Final Cost Firm A 9.25% 0.15% 9.10% Firm B Libor + 0.5% 0.40% LIBOR % Given that the interest rate to be paid to the bank and the final cost is now available, the interest rate for the cash flows to be exchanged between the parties shall be computed. The simplest way to compute these rates is to make the party that has borrowed a floating rate, receive the same floating rate from the other party. The equation should than be solved for the fourth variable which is the fixed rate that is to be paid to the other party by the floating rate payer. Arrange for Swap Firm A Firm B Borrow Floating (LABOR + 1.5%) Borrows Fixed (7.5%) Pays to B (9.00%) Receives from A 9.00% Receives from B LIBOR + 1.5% Pays to A (LIBOR+1.5%) Net Cost (9.00%) (LIBOR) Swap Fee (0.10%) (0.10%) Final Cost (9.10%) (LIBOR+ 0.10%) Advantages of swaps Swaps are flexible instruments for managing interest rates for longer- term funding (and investments), as a separate measure from managing the debt (or investment portfolio) itself. As a hedging instrument, swaps give management the opportunity to: manage the fixed/floating rate balance of debts or investments, and Take action in anticipation of future interest rate changes, without having to repay existing loans, take out new loans or alter an investment portfolio. Fixing the cost of debt for an extended period can improve the credit perception of a company, particularly in an environment of rising interest rates, as it reduces a company's financial risk exposures. There is an active swaps market and positions can be changed over time as required. It is also relatively easy, when necessary, to close a swaps position by termination, reversal or buyout. Page 100 of 138

101 SWAPTION An interest rate swaption is an option on a swap where one counter party (buyer) has paid a premium to the other counter party(seller) for an option to choose whether the swap will actually go into effect on some future Date. There are two types of swaption. Payer swaption: a payer swaption gives the buyer the right to be the fixed-rate payer(and floating rate receiver)in a pre-specified swap at a pre-specified date.the payer swaption is almost like a protective put in that it allows the holder to pay a set fixed rate, even if rates have increased. Receiver swaption: a receiver swaption gives the buyer the right to be the fixed rate receiver (and floating rate payer) at some future date. The receiver swaption is the reverse of the payer swaption.in this case, the holder must expect rates to fall, and the swap ensures receipt of a higher fixed rate while paying a lower floating rate. Payer swaption If market interest rates are high at the expiration of the swaption,the holder of the payer swaption will exercise the option to pay a lower rate through the swap than the holder of the swaption would pay with a regular swap purchased in the market. If interest rates are low, the holder would let the swaption expire worthless and only lose the premium paid. Receiver swaption If interest rates are high, the holder of the swaption would let it expire worthless and only lose the premium paid. If market interest rates are low, the swaption would be exercised in order to receive cash flows based on an interest rate higher than the market rate. Page 101 of 138

102 Option Pricing Call Option The right but not the obligation to buy a particular asset at an exercise price Put Option The right but not an obligation to sell a particular asset at an exercise price VALUE OF an OPTION= Intrinsic value + time Value DETERMINANTS OF CALL OPTION PRICES Increase In Value of a Call Value of a Put Pa= price of underlying Share Price Increase Decrease Pe = Exercise price Exercise Price Decrease Increase Time= t ( in years) Time to Expiry Increase Decrease S=standard deviation ( in decimal ) Volatility Increase Decrease Risk free rate = Rf ( in decimal Interest Rate Increase Decrease THE BLACK SCHOLES MODEL THE Black-Scholes model values options before the expiry date and takes account of all the determinants that effect the value of option Value of a Call Option = Pa N (d1) Pe N (d2) e ^-rt Where d1 = In(Pa/Pe) + (r + 0.5s^2) t / S T d2 = d1 S T Pa = Current Price of a underlying asset Pe = Exercise Price r= Risk Free Rate t = time until expiry of options in years s = Volatility of the share price THE BLACK SCHOLES MODEL Value of a Call Option = Pa N (d1) Pe N (d2) e ^-rt Example : The current share price of TYZ Co = $120 The exercise price = $100 The risk free interest rate = 12% Standard deviation of return on the shares = 40% Time to Expiry = 3 months Calculate the value of call option Solution: d1 = In (120/100) + ( x 0.4^2)0.25 / = 1.16 d2 = = 0.96 N (d1) = = Page 102 of 138

103 N (d2) = = THE Black-Scholes model values options before the expiry date and takes account of all the determinants that effect the value of option Value of a PUT option = c Pa + Pe x e^-rt Step 1 : Value the corresponding call option using Black Scholes Model Step 2 : Calculate the value of a put option using the above formula Assumptions and Limitations No Transaction Costs or taxes Options are European calls Investor can borrow at the risk-free rate Risk free rate and share price volatility is constant over the period No dividends before expiration AMERICAN CALL OPTIONS If no dividends are payable before the option expiry date, the American call option will be worth the same as European Call Option Calculate the Dividend adjusted share price Deduct the present value of dividends to be paid from current Share Price Pa, becomes Pa PV (dividends) in Black Scholes Model. Pa adjusted = Pa Dividend e-(rt) Page 103 of 138

104 Value At Risk Value at risk (VAR) is the minimum amount by which the value of an investment portfolio will fall over a given period of time at a given level of probability. Alternatively, it is defined as the maximum amount that it may lose at a given level of confidence Level. Example: Assume VAR is $100,000 at 5% probability, or that it is $100,000 at 95% confidence level. The first definition implies that there is a 5% chance that the loss will exceed $100,000, or that we are 95% sure that it will not exceed $100,000. VAR can be defined at any level of probability or confidence, but the most common probability levels are 1, 5 and 10%. In general the VAR will be given by: VAR = kσ N Where - k is determined by the probability level, - σ is the standard deviation and - N is the periods over which we want to calculate the VAR. Having defined the VAR, we can define the project value at risk (PVAR), PVAR - As the loss that may occur at a given level of probability over the life of the project. Example The annual cash flows from a project are expected to follow the normal distribution with a mean of $50,000 and standard deviation of $10,000. The project has a 10 year life. What is the PVAR if probability is 5%? The PVAR for a year is: PVAR = x $10,000 = $16,450 The PVAR that takes into account the entire project life is: PVAR = x $10,000 x 10 = $52,019; this is the maximum amount by which the value of the project will fall at a confidence level of 95%. So far we have used the normal distribution to calculate the VAR. The assumption that project cash flows or values follow the normal distribution may not be plausible. ADVANTAGES It s easy to understand Comparing VAR of different assets and portfolios The VAR provides an indication of the potential riskiness of a project DISADVANTAGES Value At Risk can be misleading: false sense of security VAR does not measure worst case loss The resulting VAR is only as good as the inputs and assumptions Different Value At Risk methods lead to different results Page 104 of 138

105 GREEKS GAMMA Gamma = Change in Delta Value/ Change in price of the underlying share It measures the extent to which delta changes when the share price changes. The higher the gamma value, the more difficult it is for the option writer to maintain a delta hedge because the delta value increases more for a given change in share price. Gamma values will be highest for a share which is close to expiry and is 'at the money THETA Theta is the change in an option's price (specifically its time premium) over time An option's price has two components, its intrinsic value and its time premium. When it expires, an option has no time premium. Thus the time premium of an option diminishes over time towards zero and theta measures how much value is lost over time, and therefore how much the option holder will lose through retaining their options. Theta is usually expressed as an amount lost per day. At the money options have the greatest time premium and thus the greatest theta. RHO: Rho measures the sensitivity of option prices to interest rate changes An option's rho is the amount of change in value for a 1% change in the risk-free interest rate. Rho is positive for calls and negative for puts Interest rate is the least significant influence on change in price and interest rate tends to change slowly and in small times. Long-term options have larger RHO than short-term options. The more time there is until expiration, the greater the effect of a change in interest rates. VEGA: Vega measures the sensitivity of an option's price to a change in its implied volatility Vega is the change in value of an option that results from a 1% point change in its volatility. If a dollar option has a vega of 0.4, its price will increase by 40 cents for a 1% point increase in its volatility. Vega is the same for both calls and puts. Long-term options have larger vega than short-term options. The longer the time period until the option expires, the more uncertainty there is about the expiry price. Page 105 of 138

106 SUMMARY OF GREEKS Change in With Delta Option Value Underlying Asset Value Gamma Delta Underlying Asset Value Theta Time Premium Time Rho Option Value Interest rates Duration Duration (Macaulay duration) is the weighted average time to receive a bond s benefits (annual interest and redemption value) with the weights being the present value of benefits to be received. Durations compares two bonds by giving each an overall risk weighting. Steps to Calculate Duration i. Find present value of future cash flows ii. Find total present value by adding all discounted cash flows calculated above iii. Find proportion of all present values by dividing each present value with total iv. Find weighted average years by multiplying relevant years to above proportion v. Add all weighted years as duration EXAMPLE & SOLUTION Example Magic Inc has a bond (Bond X) in issue which has a nominal value of $1,000 and is redeemable at par. Bond X is a 6% bond maturing in three years time and has a gross redemption yield (GRY) of 3.5%. The current price of the bond is $1, Required: Calculate the duration of the bond. Solution Total Cash flow Discount Factor (3.5%) Present Value X by year PROPERTIES OF DURATION The basic features of sensitivity to interest rate risk will all be mirrored in the duration calculation. Longer-dated bonds will have longer durations Lower-coupon bonds will have longer durations. The ultimate low-coupon bond is a zero-coupon bond where the duration will be the maturity. Page 106 of 138

107 Lower yields will give longer durations. In this case, the present values of flows in the future will rise if the yield falls, extending the point of balance, therefore lengthening the duration MODIFIED DURATION Modified duration measures the sensitivity of the price of a bond to a change in the interest rates. MMMMMMMMMMMMMMMM DDDDDDDDDDDDDDDDDD MMMMMMMMMMMMMMMM DDDDDDDDDDDDDDDD = 1 + GGGGGG Using the example on duration, the modified duration of the bond is 2.84/( ) = 2.74 This can be used to determine the proportionate change in bond price for a given change in yield as follows. MMMMMMMMMMMMMMMM DDDDDDDDDDDDDDDD = PP PP xx YY Where: ΔP = change in bond price ΔY = change in yield P = current market price of the bond PROPERTIES OF MODIFIED DURATION As the modified duration is derived from the Macaulay duration, it shares the same properties. Longer dated bonds will have higher modified durations that is, bonds which are due to be redeemed at a later are more price-sensitive to changes in interest rates and are therefore more risky. Lower coupon bonds will have higher modified durations Lower yields will give higher modified durations The higher the modified duration, then the greater the sensitivity of that bond to a change in the yield. THE BENEFITS AND LIMITATIONS OF DURATION Benefits It allows bonds of different maturities and coupon rates to be directly compared. If a bond portfolio is constructed based on weighted average duration, it is possible to determine portfolio values changes based on interest rate changes. Managers may be able to modify interest rate risk by changing the duration of bond portfolio. Limitations The main limitation of duration is that it assumes a linear relationship between interest rates and price that is, it assumes that for a certain percentage change in interest rates will be an equal percentage change in price. However as interest rates change the bond price is unlikely to change in a linear fashion. Convexity is another method which take into account the non-linear relation. Page 107 of 138

108 Tranching/ Securitization A tranche is a slice of a security (typically a bond or other credit-linked security) which is funded by investors who assume different risk levels within the liability structure of that security. One common use of securitization occurs when banks lend through mortgages, credit cards, car loans or other forms of credit, they invariably move to lay off their risk by a process of securitization. Such loans are an asset on the statement of financial position, representing cash flow to the bank in future years through interest payments and eventual repayment of the principal sum involved. By securitizing the loans, the bank removes the risk attached to its future cash receipts and converts the loan back into cash, which it can lend again, and so on, in an expanding cycle of credit formation. Securitization is achieved by transferring the lending to specifically created companies called special purpose vehicles (SPVs). In the case of conventional mortgages, the SPV effectively purchases a bank s mortgage book for cash, which is raised through the issue of bonds backed by the income stream flowing from the mortgage holder. In the case of sub-prime mortgages, the high levels of risk called for a different type of securitization, achieved by the creation of derivative-style instruments known as collateralized debt obligations or CDOs. Securitization may be also appropriate for an organization which wants to enhance its credit rating by using low-risk cash flows, such as rental income from commercial property, which will be diverted into a "ring-fenced" SPV. Delta In Black-Scholes model, the value of N(d1) can be used to indicate the amount of the underlying shares (or other instruments) which the writer of an option should hold in order to hedge the option position. Delta = change in call option price change in the price of the shares CC SS = dddddddddd The appropriate hedge ratio N(d1) is referred to as the delta value; hence the term delta hedge. The delta value is valid if the price changes are small. For long call options (and/or short put options), delta has a value between 0 and 1. For long put options (and/or short call options), delta has a value between 0 and -1. DELTA HEDGING CALL OPTION The significance of the delta value is illustrated by the process of delta hedging. Delta hedging allows us to determine the number of shares that we must buy to create the equivalent portfolio to an option and hedge it. Investing at risk free rate = buying share portfolio + selling call options Delta hedge is only valid for small share price movement. Delta value is likely to change during the period of hedge so continuous rebalancing is required that is why it is an expensive hedge Page 108 of 138

109 Example What is the number of call options that you would have to sell in order to hedge a holding of 200,000 shares, if the delta value (N(d1)) of options is 0.8? Assume that option contracts are for the purchase or sale of units of 1,000 shares. Answer The delta hedge can be calculated by the following formula. Number of Contracts = Number of Shares Delta of Option x size of contract = x 1000 = 250 If in this example the price of shares increased by $1, the value of the call options would increase by $800 per contract. Since however we were selling these contracts the increase in the value of our holding of shares, 200,000 x $1, would be matched by the decrease in our holding of option contracts 250 x $800. DELTA HEDGING PUT OPTION Investing at risk free rate = buying share portfolio + Buy Put options Put option delta= N(-d1) If D1 is positive then N(-d1) = Table value If D1 is negative then N(-d1) = Table value OTHER POINTS ABOUT DELTA VALUES The table below shows approximate values of delta for different types of options and the position of the exercise In the Money At the Money Out of the Money Call Approaching 1 Approx. 0.5 Approaching 0 Put Approaching -1 Approx Approaching 0 OTHER POINTS ABOUT DELTA VALUES The factors influencing delta are: The exercise price The time to expiration The risk-free rate of return The volatility in the returns on the share Page 109 of 138

110 Dark Pool Trading A dark pool network allows shares to be traded anonymously, away from public scrutiny. No information on the trade order is revealed prior to it taking place. The price and size of the order are only revealed once the trade has taken place. MAIN REASONS: It prevent the risk of other traders moving the share price up or down; It result in reduced costs because trades normally take place at the mid-price between the bid and offer; and because broker-dealers try and use their own private pools, and thereby saving exchange fees. Dark pools are an 'alternative' trading system that allows participants to trade without displaying quotes publically. The transactions are only made public after the trades have been completed. PROBLEMS WITH DARK POOL TRADING SYSTEM: Prices at which these trades are executed remain unknown until after the event. Lack of information on significant trades makes the regulated exchanges less efficient Resulting in reduced transparency as fewer trades are publicly exposed Reduce liquidity in the regulated exchanges and hinder efficient price-setting. Dark Pool Trading defeat the purpose of fair and regulated markets with large numbers of participants and threaten the healthy and transparent development of these markets. Credit Default Swaps A credit default swap is a specific type of counterparty agreement which allows the transfer of third-party credit risk from one party to the other. It is similar to insurance because in the event of a fire, the buyer of the policy will receive whatever the damaged or destroyed goods are worth in monetary terms. It provides the buyer of the contract, who often owns the underlying credit, with protection against default, a credit rating downgrade, or another negative credit event. The buyer of CDS agrees to pay a fixed spread to the seller of the CDS. The more likely the risk of default, the larger the spread. For example, If the CDS spread is 200 basis points (or 2.0%) then a party buying $10 million worth of CDS from a bank must pay the bank $200,000 per year. These payments continue until either the CDS contract expires or party defaults. CDSs are unregulated. This means that contracts can be traded or swapped from investor to investor without anyone overseeing the trades to ensure the buyer has the resources to cover the losses if the security defaults. Page 110 of 138

111 USES OF CREDIT DEFAULT SWAPS: Speculative investors bought and sold the instruments without having any direct relationship with the underlying investment. Speculators to "place their bets" about the credit quality of a particular reference entity: EXAMPLE: A hedge fund believes that a company (ABC Co) will shortly default on its debt of $20 million. The hedge fund may therefore buy $20 million worth of CDS protection for, say, 2 years, with (ABC Co) as the reference entity, at a spread of 1000 basis points (10%) per annum. If (ABC Co) does default after, say, one year, then the hedge fund will have paid $2000,000 to the bank but will then receive $20 million (assuming zero recovery rate). The bank will incur a $1.8 million loss unless it has managed to offset the position before the default. If (ABC Co) does not default, then the CDS contract will run for two years and the hedge fund will have paid out $4 million to the bank with no return. The bank makes a profit of $4 million; the hedge fund makes a loss of the same amount. What would happen if the hedge fund decided to liquidate its position after a certain period of time in an attempt to lock in its gains or losses? Say after one year the market considers ABC Co to be at greater risk of default, and the spread widens from 1000 basis points to 2,500. The hedge fund may decide to sell $20 million protection to the bank for one year at this higher rate. Over the two years, the hedge fund will pay the bank $4 million (2 x 10% x $20 million) but will receive $5 million (1 x 25% x $20 million) a net profit of $1million (as long as (ABC Co) does not default in the second year) A CDS contract can be used as a hedge or insurance policy against the default of a bond or loan. An individual or company that is exposed to a lot of credit risk can shift some of that risk by buying protection in a CDS contract. Example A pension fund owns $20 million of a 5-year bond issued by XYZ Co. In order to manage the risk of losses in the event of a default by XYZ Co, CDS of a notional amount of $20 million were bought by the pension funds to hedge the risk. Assume the CDS trades at 500 basis points (5%) which means that the pension fund will pay the bank an annual premium of $1 million. If XYZ Co does not default on the bond, the pension fund will pay a total premium of 5 x $1000,000 = $5 million to the bank and will receive the $20 million back at the end of the 5 years. Although it has lost $5 million, the pension fund has hedged away the default risk. If XYZ Co defaults on the bond after, say, 2 years, the pension fund will stop paying the premiums and the bank will refund the $20 million to compensate for the loss. The pension fund's loss is limited to the premiums it had paid to the bank (2 x $1000,000 = $2000,000) if it had not hedged the risk, it would have lost the full $20 million. THE ROLE OF CDS IN THE GLOBAL ECONOMIC CRISIS Once an obscure financial instrument for banks and bondholders, CDSs are now at the heart of the recent credit crisis. American International Group (AIG) the world's largest insurer could issue CDSs without putting up any real collateral as long as it maintained a triple-a credit rating. There was no real capital cost to Page 111 of 138

112 selling these swaps; there was no limit. Thanks to fair value accounting, AIG could book the profit from, say, a five-year credit default swap as soon as the contract was sold, based on the expected default rate. In many cases, the profits it booked never materialized. On 15 September 2007 the bubble burst when all the major credit-rating agencies downgraded AIG. At issue were the soaring losses in its CDSs. The first big write-off came in the fourth quarter of 2007, when AIG reported an $11 billion charge. It was able to raise capital once, to repair the damage. But the losses kept growing. The moment the downgrade came, AIG was forced to come up with tens of billions of additional collateral immediately. This was on top of the billions it owed to its trading partners. It didn't have the money. The world's largest insurance company was bankrupt. As soon as AIG went bankrupt, all those institutions which had hedged debt positions using AIG CDSs had to mark down the value of their assets, which at once reduced their ability to lend. The investment banks had no ability to borrow, as the collapse of the CDS market meant that no one was willing to insure their debt. The credit crunch had started in earnest Page 112 of 138

113 Real Options Real options valuation methodology adds to the conventional net present value (NPV) estimations by taking account of real life flexibility and choice. NET PRESENT VALUE (NPV) AND REAL OPTIONS The conventional NPV method assumes that a project commences immediately and proceeds until it finishes, as originally predicted. Therefore it assumes that a decision has to be made on a now or never basis, and once made, it cannot be changed. It does not recognize that most investment appraisal decisions are flexible and give managers a choice of what actions to undertake. The real options method estimates a value for this flexibility and choice, which is present when managers are making a decision on whether or not to undertake a project. Real options build on net present value in situations where uncertainty exists and, for example: (i) when the decision does not have to be made on a now or never basis, but can be delayed, (ii) when a decision can be changed once it has been made, or (iii) when there are opportunities to exploit in the future contingent on an initial project being undertaken. Therefore, where an organization has some flexibility in the decision that has been, or is going to be made, an option exists for the organization to alter its decision at a future date and this choice has a value. ESTIMATING THE VALUE OF REAL OPTIONS Although there are numerous types of real options, in the P4 paper, candidates are only expected to explain and compute an estimate of the value attributable to three types of real options: a) The option to delay a decision to a future date (which is a type of call option. b) The option to abandon a project once it has commenced if circumstances no longer justify the continuation of the project (which is a type of put option), and c) The option to exploit follow-on opportunities which may arise from taking on an initial project (which is a type of call option). it can be assumed that real options are European-style options, which can be exercised at a particular time in the future and their value will be estimated using the Black-Scholes Option Pricing (BSOP) model and the put-call parity to estimate the option values. However, assuming that the option is a Europeanstyle option and using the BSOP model may not provide the best estimate of the option s value (see the section on limitations and assumptions below). Five variables are used in calculating the value of real options using the BSOP model as follows: 1. The underlying asset value (Pa), which is the present value of future cash flows arising from the project. 2. The exercise price (Pe), which is the amount paid when the call option is exercised or amount received if the put option is exercised. 3. The risk-free (r), which is normally given or taken from the return offered by a short-dated government bill. Although this is normally the discrete annualized rate and the BSOP model uses the continuously compounded rate, for P4 purposes the continuous and discrete rates can be assumed to be the same when estimating the value of real options. 4. The volatility (s), which is the risk attached to the project or underlying asset, measured by the standard deviation. Page 113 of 138

114 5. The time (t), which is the time, in years, that is left before the opportunity to exercise ends. The following three examples demonstrate how the BSOP model can be used to estimate the value of each of the three types of options. Example 1: Delaying the decision to undertake a project A company is considering bidding for the exclusive rights to undertake a project, which will initially cost $35m. The company has forecast the following end of year cash flows for the four-year project. Year Cash flows ($m) The relevant cost of capital for this project is 11% and the risk free rate is 4.5%. The likely volatility (standard deviation) of the cash flows is estimated to be 50%. Solution: NPV without any option to delay the decision Year Today Cash flows ($) -35m 20m 15m 10m 5m PV (11%) ($) -35m 18.0m 12.2m 7.3m 3.3m NPV = $5.8m Example 1: Delaying the decision to undertake a project - Continued Supposing the company does not have to make the decision right now but can wait for two years before it needs to make the decision. NPV with the option to delay the decision for two years Year Cash flows ($) 20m 15m 10m 5m PV (11%) ($) 14.6m 9.9m 5.9m 2.7m Variables to be used in the BSOP model Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m Exercise price (Pe) = $35m Page 114 of 138

115 Exercise date (t) = Two years Risk free rate (r) = 4.5% Volatility (s) = 50% Using the BSOP model d d N(d1) N(d2) Call value $9.6m Based on the facts that the company can delay its decision by two years and a high volatility, it can bid as much as $9.6m instead of $5.8m for the exclusive rights to undertake the project. The increase in value reflects the time before the decision has to be made and the volatility of the cash flows. Example 2: Exploiting a follow-on project A company is considering a project with a small positive NPV of $3m but there is a possibility of further expansion using the technologies developed for the initial project. The expansion would involve undertaking a second project in four years time. Currently, the present values of the cash flows of the second project are estimated to be $90m and its estimated cost in four years is expected to be $140m. The standard deviation of the project s cash flows is likely to be 40% and the risk free rate of return is currently 5%. Solution: The variables to be used in the BSOP model for the second (follow-on) project are as follows: Asset Value (Pa) = $90m Exercise price (Pe) = $140m Exercise date (t) = Four years Risk free rate (r) = 5% Volatility (s) = 40% Using the BSOP model d d N(d1) Page 115 of 138

116 N(d2) Call value $20.85m The overall value to the company is $23.85m, when both the projects are considered together. At present the cost of $140m seems substantial compared to the present value of the cash flows arising from the second project. Conventional NPV would probably return a negative NPV for the second project and therefore the company would most likely not undertake the first project either. However, there are four years to go before a decision on whether or not to undertake the second project needs to be made. A lot could happen to the cash flows given the high volatility rate, in that time. The company can use the value of $23.85m to decide whether or not to invest in the first project or whether it should invest its funds in other activities. It could even consider the possibility that it may be able to sell the combined rights to both projects for $23.85m. Example 3: The option to abandon a project Duck Co is considering a five-year project with an initial cost of $37,500,000 and has estimated the present values of the project s cash flows as follows: Year Present values ($ 000s) 1, , , , ,602.9 Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start of year three. The risk free rate of return is 4%. Duck Co s finance director is of the opinion that there are many uncertainties surrounding the project and has assessed that the cash flows can vary by a standard deviation of as much as 35% because of these uncertainties. Solution: Swan Co s offer can be considered to be a real option for Duck Co. Since it is an offer to sell the project as an abandonment option, a put option value is calculated based on the finance director s assessment of the standard deviation and using the Black-Scholes option pricing (BSOP) model, together with the put-call parity formula. Although Duck Co will not actually obtain any immediate cash flow from Swan Co s offer, the real option computation below, indicates that the project is worth pursuing because the volatility may result in increases in future cash flows. Without the real option Year Present values ($ 000s) 1, , , , ,602.9 Page 116 of 138

117 Present value of cash flows approx. = $37,049,300 Cost of initial investment = $37,500,000 NPV of project = $37,049,300 $37,500,000 = $(450,700) Example 3: The option to abandon a project - Continued With the real option The asset value of the real option is the sum of the PV of cash flows foregone in years three, four and five, if the option is exercised ($9.9m + $7.1m + $13.6m = $30.6m) Asset value (Pa) $30.6m Exercise Price (Pe) $28m Risk-free rate (r) 4% Time to exercise (t) Two years Volatility (s) 35% d d N(d1) N(d2) Call Value 8.20 Put Value $3.45m Net present value of the project with the put option is approximately $3m ($3.45m $0.45m). If Swan Co s offer is not considered, then the project gives a marginal negative net present value, although the results of any sensitivity analysis need to be considered as well. It could be recommended that, if only these results are taken into consideration, the company should not proceed with the project. However, after taking account of Swan Co s offer and the finance director s assessment, the net present value of the project is positive. This would suggest that Duck Co should undertake the project. Page 117 of 138

118 LIMITATIONS AND ASSUMPTIONS EUROPEAN-STYLE OPTIONS OR AMERICAN-STYLE OPTIONS The BSOP model is a simplification of the binomial model and it assumes that the real option is a European-style option, which can only be exercised on the date that the option expires. An Americanstyle option can be exercised at any time up to the expiry date. Most options, real or financial, would, in reality, be American-style options. if the underlying asset on which the option is based is due to receive some income before the option s expiry; say for example, a dividend payment for an equity share, then an early exercise for an option on that share may be beneficial. With real options, a similar situation may occur when the possible actions of competitors may make an exercise of an option before expiry the better decision. In these situations the American-style option will have a value greater than the equivalent European-style option. Because of these reasons, the BSOP model will either underestimate the value of an option or give a value close to its true value. Nevertheless, estimating and adding the value of real options embedded within a project, to a net present value computation will give a more accurate assessment of the true value of the project and reduce the propensity of organizations to under-invest. OTHER LIMITATIONS OF REAL OPTIONS The BSOP model requires further assumptions to be made involving the variables used in the model, the primary ones being: a) The BSOP model assumes that the underlying project or asset is traded within a situation of perfect markets where information on the asset is available freely and is reflected in the asset value correctly. Further it assumes that a market exists to trade the underlying project or asset without restrictions (that is, that the market is frictionless) b) The BSOP model assumes that interest rates and the underlying asset volatility remain constant until the expiry time ends. Further, it assumes that the time to expiry can be estimated accurately c) The BSOP model assumes that the project and the asset s cash flows follow a lognormal distribution, similar to equity markets on which the model is based d) The BSOP model does not take account of behavioral anomalies which may be displayed by managers when making decisions, such as over- or under-optimism e) The BSOP model assumes that any contractual obligations involving future commitments made between parties, which are then used in constructing the option, will be binding and will be fulfilled. For example, in example three above, it is assumed that Swan Co will fulfil its commitment to purchase the project from Duck Co in two years time for $28m and there is therefore no risk of nonfulfilment of that commitment. Page 118 of 138

119 Multinational Enterprise A multinational enterprise is one which owns or controls production facilities or subsidiaries outside the country in which it is based. Multinational enterprises range from medium-sized companies having only a few facilities (or 'affiliates') abroad to giant companies having annual revenue larger than the gross national product (GNP) of some smaller countries of the world exporting. Then they create overseas sale subsidiaries and enter into licensing agreements. Finally they invest and create production facilities in overseas locations. The key element of the process of expansion is the creation of competitive advantages. Competitive advantages of multinationals 'Market seeking' firms engage in FDI either to meet local demand or as a way of exporting to markets Other than the home market. Firms in such industries as oil, mining, plantation and forestry will extract raw materials in the places where they can be found, whether for export or for further processing and sale in the host country. The labour-intensive manufacture firms normally invest in other countries because of cheap production labour. Knowledge-seeking firms choose to set up operations in countries in which they can gain access to technology or management expertise. Firms which are seeking 'political safety' will acquire or set up new operations in those countries which are thought to be unlikely to expropriate or interfere with private enterprise or impose import controls. Production economies can arise from use of large-scale plant or from the possibility of rationalising production by adopting worldwide specialisation. Multinational car manufacturers produce engines in one country, transmissions in another, bodies in another, and assemble cars in yet another country Multinationals enjoy considerable cost advantages in relation to finance. They have the advantage of access to the full range of financial instruments, such as euro currency and euro bonds, which reduces their borrowing costs. Commonly used means to establish an interest abroad include: Joint ventures Licensing agreements Management contracts Branches Subsidiaries Joint ventures The two distinct types of joint venture are industrial co-operation (contractual) and joint-equity. A contractual joint venture is for a fixed period and the duties and responsibility of the parties are defined. A joint-equity venture involves investment, is of no fixed duration and continually evolves The main advantages of joint ventures are: Page 119 of 138

120 Relatively low-cost access to new markets Easier access to local capital markets, possibly with accompanying tax incentives or grants Use of joint venture partner's existing management expertise, local knowledge, distribution network, technology, brands, patents and marketing or other skills The main disadvantages of joint ventures are Managerial freedom may be restricted by the need to take account of the views of all the joint venture partners. There may be problems in agreeing on partners' percentage ownership, transfer prices, Reinvestment decisions, nationality of key personnel, remuneration and sourcing of raw materials and components. Finding a reliable joint venture partner may take a long time. Joint ventures are difficult to value, particularly where one or more partners have made intangible contributions. Exporting and licensing Exporting may be direct selling by the firm's own export division into the overseas markets, or it may be indirect through agents, distributors, trading companies and various other such channels. Licensing involves conferring rights to make use of the licensor company's production process on producers located in the overseas market. Licensing is an alternative to FDI by which overseas producers are given rights to use the licensor s production process in return for royalty payments. Exporting may be unattractive because of tariffs, quotas or other import restrictions in overseas markets, and local production may be the only feasible option in the case of bulky products, such as cement and flat glass. The main advantages of licensing are: It can allow fairly rapid penetration of overseas markets. It does not require substantial financial resources. Political risks are reduced since the licensee is likely to be a local company. Licensing may be a possibility where direct investment is restricted or prevented by a country. For a multinational company, licensing agreements provide a way for funds to be remitted to the parent company in the form of licence fees. The main disadvantages of licensing are: The arrangement may give the licensee know-how and technology which it can use in competing with the licensor after the license agreement has expired. It may be more difficult to maintain quality standards, and lower quality might affect the standing of a brand name in international markets. It might be possible for the licensee to compete with the licensor by exporting the produce to markets outside the licensee's area. Although small cash inflows will be generated. relatively insubstantial financial resources are required, on the other hand relatively Page 120 of 138

121 Management contracts Management contracts whereby a firm agrees to sell management skills are sometimes used in combination with licensing. Such contracts can serve as a means of obtaining funds from subsidiaries, and may be a useful way of maintaining cash flows where other remittance restrictions apply. Many multinationals use a combination of various methods of servicing international markets, depending on the particular circumstances. Overseas subsidiaries The basic structure of many multinationals consists of a parent company (a holding company) with subsidiaries in several countries. The subsidiaries may be wholly owned or just partly owned, and some may be owned through other subsidiaries. There are different approaches to increasing profits that the multinational might take. At one extreme, the parent company might choose to get as much money as it can from the subsidiary, and as quickly as it can. This would involve the transfer of all or most of the subsidiary's profits to the parent company. At the other extreme, the parent company might encourage a foreign subsidiary to develop its business gradually, to achieve long-term growth in sales and profits. To encourage growth, the subsidiary would be allowed to retain a large proportion of its profits, instead of remitting the profits to the parent company. Branches Firms that want to establish a definite presence in an overseas country may choose to establish a branch rather than a subsidiary. Key elements in this choice are as follows. Taxation In many countries the remitted profits of a subsidiary will be taxed at a higher rate than those of a branch, as profits paid in the form of dividends are likely to be subject to a withholding tax Formalities As a separate entity, a subsidiary may be subject to more legal and accounting formalities than a branch. However, as a separate legal entity, a subsidiary may be able to claim more reliefs and grants than a branch. Marketing A local subsidiary may have a greater profile for sales and marketing purposes than a branch. Theory of international trade In the modern economy, production is based on a high degree of specialisation. Within a country individuals specialise, factories specialise and whole regions specialise. International trade originated on the basis of nations exchanging their products for others which they could not produce for themselves. International trade arises for a number of reasons. Different goods require different proportions of factor inputs in their production. Economic resources are unevenly distributed throughout the world. The international mobility of resources is extremely limited. Page 121 of 138

122 The law of comparative advantage The significance of the law of comparative advantage is that it provides a justification for the following beliefs Countries should specialisein what they produce, even when they are less efficient (in absolute terms) in producing every type of good. They should specialise in the goods where they have a comparative advantage (they are relatively more efficient in producing). International trade should be allowed to take place without restrictions on imports or exports ie there should be free trade. Free trade does not always exist. Some countries take action to protect domestic industries and discourage imports. Transport costs (assumed to be nil in the examples above) can be very high in international trade so that it is cheaper to produce goods in the home country rather than to import them The advantages of international trade The law of comparative advantage is perhaps the major advantage of encouraging international trade. However, there are other advantages to the countries of the world from encouraging international trade. Some countries have a surplus of raw materials to their needs, and others have a deficit. A country with a surplus (eg of oil) can take advantage of its resources to export them. International trade increases competition among suppliers in the world's markets. Greater Competition will reduce cost and increase quality of products. International trade creates larger markets for a firm's output, and so some firms can benefit from economies of scale by engaging in export activities. There may be political advantages to international trade, because the development of trading links provides a foundation for closer political links. Barriers to entry are factors which make it difficult for suppliers to enter a market Multinationals may face various entry barriers. All these barriers may be more difficult to overcome if a multinational is investing abroad because of such factors as unfamiliarity with local consumers and government favouring local firms. Strategies of expansion and diversification imply some logic in carrying on operations. It might be a better decision, although a much harder one, to cease operations or to pull out of a market completely. There are likely to be exit barriers making it difficult to pull out of a market. Product differentiation barriers An existing major supplier would be able to exploit its position as supplier of an established product that the consumer/customer can be persuaded to believe is better. A new entrant to the market would have to design a better product, or convince customers of the product's qualities, and this might involve spending substantial sums of money on R&D, advertising and sales promotion. Absolute cost barriers These exist where an existing supplier has access to cheaper raw material sources or know-how that the new entrant would not have. This gives the existing supplier an advantage because its input costs would be cheaper in absolute terms than those of a new entrant. Page 122 of 138

123 Economy of scale barriers These exist where the minimum level of production needed to achieve the greatest economies of scale is at a high level. New entrants to the market would have to be able to achieve a substantial market share before they could gain full advantage of potential scale economies, and so the existing firms would be able to produce their output more cheaply. Fixed costs The amount of fixed costs that a firm would have to sustain, regardless of its market share, could be a significant entry barrier. Legal barriers These are barriers where a supplier is fully or partially protected by law. For example, there are some legal monopolies (nationalised industries perhaps) and a company's products might be protected by patent (for example, computer hardware and software). Trade Agreements Protection include prevention of the import of cheap goods and dumping, and protection of infant or declining industries. Protectionist measures may be implemented by a government Free trade can lead to greater competition and efficiency, and achieve better economic growth worldwide. Free trade exists where there is no restriction on imports from other countries or exports to other countries. Protection can be applied in several ways, including the following. Tariffs or customs duties Tariffs or customs duties are taxes on imported goods. The effect of a tariff is to raise the price paid for the imported goods by domestic consumers, while leaving the price paid to foreign producers the same, or even lower. The difference is transferred to the government sector. An ad valorem tariff is one which is applied as a percentage of the value of goods imported. A specific tariff is a fixed tax per unit of goods. Import quotas Import quotas are restrictions on the quantity of a product that is allowed to be imported into the country. The quota has overall complicated effects. o Both domestic and foreign suppliers enjoy a higher price, while consumers buy less. o Domestic producers supply more. o There are fewer imports (in volume). o The Government collects no revenue. An embargo on imports from one particular country is a total ban, ie effectively a zero quota. Hidden export subsidies and import restrictions Page 123 of 138

124 An enormous range of government subsidies and assistance for exports and deterrents against imports have been practised, such as: For exports export credit guarantees, financial help and State assistance via the Foreign Office For imports complex import regulations and documentation, or special safety standards demanded from imported goods and so on Arguments against protection Arguments against protection are as follows. Reduced international trade Because protectionist measures taken by one country will almost inevitably provoke retaliation by others, protection will reduce the volume of international trade. This means that the following benefits of international trade will be reduced. Specialisation Greater competition, and so greater efficiency among producers The advantages of economies of scale Retaliation If one country stop import from other country that other country can also stop importing. Imports might be reduced, but so too would exports. Effect on economic growth It is generally argued that widespread protection will damage the prospects for economic growth among the countries of the world. Political consequences Although from a nation's own point of view protection may improve its position, protectionism leads to a worse outcome for all. Protection also creates political ill-will among countries of the world and so there are political disadvantages in a policy of protection. Arguments in favour of protection Imports of cheap goods Measures can be taken against imports of cheap goods that compete with higher priced domestically produced goods, and so preserve output and employment in domestic industries. Dumping Measures might be necessary to counter 'dumping' of surplus production by other countries at an uneconomically low price. Although dumping has short-term benefits for the countries receiving the cheap goods, the longer-term consequences would be a reduction in domestic output and employment. Infant industries Protectionism can protect a country's 'infant industries' that have not yet developed to the size where they can compete in international markets. Less developed countries in particular might need to protect industries against competition from advanced or developing countries. Page 124 of 138

125 Declining industries Without protection, the industries might collapse and there would be severe problems of sudden mass unemployment among workers in the industry. The EU The EU is one of several international economic associations. It dates back to 1957 (the Treaty of Rome)and now consists of 27 countries, including formerly communist Eastern European countries. The EU incorporates a common market combining different aspects. A free trade area exists when there is no restriction on the movement of goods and services between countries. A common market encompasses the idea of a customs union but has a number of additional features. In addition to free trade among member countries there is also complete mobility of the factors of production. The single European currency, the euro. The customs union The customs union of the EU establishes a free trade area between member states, and also erects common external tariffs to charge on imports from non-member countries. The EU thus promotes free trade among member states, while acting as a protectionist bloc against the rest of the world. It is accordingly consistent that the EU negotiates in General Agreement on Tariffs and Trade (GATT) talks as a single body. The single European market The elimination of these trade barriers will directly benefit multinational companies, making it easier for them to engage in business across the European Union without having to deal with differing regulations (and other trade barriers) within each country of the EU. Elimination of trade restrictions Physical barriers (e.g. customs inspection) on goods and services have been removed for most products. Technical standards (e.g. for quality and safety) should be harmonised. Governments should not discriminate between EU companies in awarding public works contracts. Telecommunications should be subject to greater competition. It should be possible to provide financial services in any country. There should be free movement of capital within the community. Professional qualifications awarded in one member state should be recognised in the others. The EU is taking a co-ordinated stand on matters related to consumer protection North American Free Trade Agreement (NAFTA) Canada, the US and Mexico formed the North American Free Trade Agreement (NAFTA) which came into force in This free trade area covering a population of 360 million and accounting for economic output of US$6,000 billion annually is almost as large as the European Economic Area (EEA), and is thus the second largest free trade area after the EEA. Page 125 of 138

126 Under NAFTA, virtually all tariff and other (non-tariff) barriers to trade and investment between the NAFTA members are to be eliminated over a 15-year period. In the case of trade with non-nafta members, each NAFTA member will continue to set its own external tariffs, subject to obligations under GATT. The NAFTA agreement covers most business sectors, with special rules applying to especially sensitive sectors, including agriculture, the automotive industry, financial services and textiles and clothing. WORLD TRADE ORGANIZATION The World Trade Organization (WTO) was formed in 1995 to continue to implement the GATT. The WTO has well over 100 members, including the entire EU. Its aims include: To reduce existing barriers to free trade To eliminate discrimination in international trade such as tariffs and subsidies To prevent the growth of protection by getting member countries to consult with others before taking any protectionist measures To act as a forum for assisting free trade, by for example administering agreements, helping countries negotiate and offering a disputes settlement process Establishing rules and guidelines to make world trade more predictable Most favoured nation: a principle in the GATT international trade agreement binding the parties to grant each other treatment which is as favourable as that offered to any other GATT member in respect of tariffs and other trading conditions. The WTO encourages free trade by applying the 'most favoured nation' principle where one country (which is a member of GATT) that offers a reduction in tariffs to another country must offer the same reduction to all other member countries of GATT. Impact on protectionist measures Although the WTO has helped reduce the level of protection, some problems still remain Special circumstances (for example economic crises, the protection of an infant industry, the rulesof the EU) have to be admitted when protection or special low tariffs between a group of countries are allowed. A country in the WTO may prefer not to offer a tariff reduction to another country because it would have to offer the same reduction to all other GATT members. In spite of much success in reducing tariffs, the WTO has had less effect in dealing with many non-tariff barriers to trade that countries may set up. Some such barriers, for example those in the guise of health and safety requirements, can be very difficult to identify. New agreements are not always accepted initially by all members. INTERNATIONAL MONETARY FUND The IMF and financial support for countries with balance of payment difficulties If a country has a balance of payments deficit on current account, it must either borrow capital or use up official reserves to offset this deficit. Since a country's official reserves will be insufficient to support a balance of payments deficit on current account for very long, it must borrow to offset the deficit. The IMF can provide financial support to member countries. Most IMF loans are repayable in three to five years. Page 126 of 138

127 Of course, to lend money, the IMF must also have funds. Funds are made available from subscriptions or quotas' of member countries. The IMF uses these subscriptions to lend foreign currencies to countries which apply to the IMF for help. IMF loan conditions The preconditions that the IMF places on its loans to debtor countries vary according to the individual situation of each country, but the general position is as follows. The IMF wants countries which borrow from the IMF to get into a position to start repaying the loans fairly quickly. To do this, the countries must take effective action to improve their balance of payments position. To make this improvement, the IMF generally believes that a country should take action to reduce the demand for goods and services in the economy (e.g. by increasing taxes and cutting government spending). With 'deflationary' measures along these lines, standards of living will fall (at least in the short term) and unemployment may rise. The IMF regards these short-term hardships to be necessary if a country is to succeed in sorting out its balance of payments and international debt problems. The existence of the IMF affects multinational companies by bringing a measure of financial stability by Ensuring that national currencies are always convertible into other foreign currencies. Stabilizing the position of countries that are having difficulties repaying international loans The strict terms attached to IMF loans can lead to economic stagnation as countries struggle to repay these loans. Deflationary policies imposed by the IMF may damage the profitability of multinationals' subsidiaries by reducing their sales in the local market. Higher interest rates are likely to be introduced to suppress domestic consumers' demand for imports. The World Bank The World Bank lends to creditworthy governments of developing nations to finance projects and policies that will stimulate economic development and alleviate poverty. The World Bank consists of two institutions, The international bank for reconstruction and development (ibrd) International Development Association (IDA). The IBRD focuses on middle-income and creditworthy poorer countries, while the IDA focuses exclusively on the world s poorest countries. Both the IBRD and the IDA aim to provide finance for projects concerned with the development of agriculture, electricity, transport (which are likely to have an impact on the poorest people) on attractive terms. IBRD loans must normally be repaid within 15 years, and IDA loans are interest free and have a maturity of up to 40 years. European Central Bank The European Central Bank (ECB) was established in 1998 and is based in Frankfurt. It is responsible for administering the monetary policy of the EU Euro zone member states and is thus one of the world's most powerful central banks. Page 127 of 138

128 The main objective of the ECB is to maintain price stability within the Eurozone (keep inflation low). Its key tasks are to define and implement monetary policy for the Euro zone member states and to conduct foreign exchange operations. The main relevance of the ECB to a multinational organisation is that by keeping inflation low, the ECB can help to create long-term financial stability. For example, low inflation should help to protect the value of the euro over the long-term. This is helpful to multinational organisations with assets and profits denominated in Euros. Bank of England The Bank of England is the central bank of the UK. In 1997 it became an independent public organisation with independence on setting monetary policy. The Bank of England performs all the functions of a central bank. The most important of these functions is the maintenance of price stability and support of British economic policies (thus promoting economic growth). Stable prices and market confidence in sterling are the two main criteria for monetary stability. The bank aims to meet inflation targets set by the Government by adjusting interest rates (determined by the Monetary Policy Committee which meets on a monthly basis). Financial stability is maintained by protecting against threats to the overall financial system. Such threats are detected through the bank's surveillance and market intelligence functions and are dealt with through domestic and international financial operations. The bank can also operate as a 'lender of last resort' that is, it will extend credit when no other Institution will. Federal Reserve System The Federal Reserve System (known as the Fed) is the central banking system of the United States. Created in 1913, its responsibilities and powers have evolved significantly over time. Its current main duties include conducting the US monetary policy, maintaining stability of the financial system and supervising and regulating banking institutions. Whilst the Board of Governors states that the Fed can make decisions without ratification by the President or any other member of government, its authority is derived from US Congress and subject to its oversight. The Fed also acts as the lender of last resort to those institutions that cannot obtain credit elsewhere and the collapse of which would have serious repercussions for the economy. The Fed sets monetary policy by influencing the Federal funds rate (the rate of interbank lending of excess reserves) using the three tools of monetary policy: (1) Open market operations the purchase and sale of US Treasury and federal agency securities. Such operations allow the Fed to increase or decrease the amount of money in the banking system. (2) Discount rate the interest rate charged to commercial banks on loans they receive from the Fed. This rate is generally set at a rate close to 100 base points above the target federal funds rate in an attempt to encourage banks to seek alternative funding before approaching the Fed. (3) Reserve requirements (required reserve ratio) the amount of funds that a depository institution must hold in reserve against specified deposit liabilities Page 128 of 138

129 Behavioral Finance Behavioral finance considers the impact of psychological factors on financial decision-making. This challenges the idea that share prices and investor returns are determined by rational economic criteria. 1. Psychological factors affecting decision making Behavioral finance examines the psychological factors that lie behind financial decision making; some of the main factors are listed below. Overconfidence Investors and managers have a tendency to overestimate their own abilities. Search for patterns, herding and cognitive dissonance Investors look for patterns which can be used to justify investment decisions. This might involve analyzing a company s past returns and using this to extrapolate future performance. It might also involve comparing peaks or troughs in the stock market to historic peaks and troughs in previous decades. This type of behavior can lead to herding, where people buy (or sell) shares because share prices are rising (or falling) and can help to explain stock market bubbles (or crashes). Herding is also based on the psychological comfort of following the crowd. A stock market bubble can emerge because investors buy shares simply because share prices have been rising in the past, this then creates a stronger rise in share prices which in turn creates a stronger demand for shares. Share prices can therefore be driven up to a level that is not justified given the future profit potential due investors following the crowd and continuing to buy shares. This is compounded by a reluctance of investors to admit that they are wrong (sometimes referred to as cognitive dissonance). Narrow framing Many investors fail to see the bigger picture, and focus too much on short-term fluctuations in share price movements. Availability bias People will often focus more on information that is prominent (available). Prominent information is often the most recent information about a company, and this may help to explain why share prices move significantly shortly after financial results are published. Conservatism Investors and managers are resistant to changing their opinion so, for example, if a company s profits are better than expected the share price may not react significantly because investors under react to this news 2. Share valuation Behavioral finance suggests that managers are over-confident in their own abilities. This helps to explain why most boards believe that the market undervalues their shares. This can lead to managers taking actions that may not be in their shareholders best interests, such as delisting from the stock market or defending against a takeover bid that they believe undervalues their company. Page 129 of 138

130 3. Acquisitions Behavioral finance can also explain why many acquisitions are over-valued, this aspect of behavioral finance is covered in chapter CAPM Behavioral finance conflicts with theories (such as the capital asset pricing model) that suggest that asset prices and investor returns are determined in a rational manner, based on the anticipated risk and future cash flows of a share. For example, narrow framing can mean that if a single share in a large portfolio performs badly in a particular week then logically this should not matter greatly to an investor who is investing in shares over say a twenty year period. However in reality it does seem to matter, so investors are showing a greater aversion to risk than the capital asset pricing model (which argues that diversified investors should only care about systematic risk) suggests they should. 5. Financial strategy Behavioral factors such as overconfidence and cognitive dissonance can also explain why managers persist with investment strategies that are unlikely to succeed. For example, in the face of economic logic managers will often delay decisions to terminate projects for behavioral reasons. Page 130 of 138

131 Islamic Finance Islamic finance is finance that is compliant with Sharia'a law. Islamic finance transactions are based on the concept of sharing risk and reward between the investor and the user of funds. The object of an Islamic finance undertaking is not simply the pursuit of profit, but that the economic benefits of the enterprise should extend to goals such as social welfare and full employment. Making profits by lending alone and the charging of interest is for bid den under Sharia'a law. The business of trading goods and investment in Sharia'a acceptable enterprises form the core of Islamic finance. Riba Riba (interest) is for bid den in Islamic finance. Riba is generally interpreted as the predetermined interest collected by a lender, which the lender receives over and above the principal amount it has lent out. The Quranic ban on riba is absolute. Riba can be viewed as unacceptable from three different perspectives, as outlined below. For the borrower Riba creates unfairness for the borrower when the enterprise makes a profit which is less than the interest payment, turning their profit in to a loss. For the lender Riba creates unfairness for the lender in high inflation environments when the returns are likely to be below the rate of inflation. For the economy Riba can result in inefficient allocation available resources in the economy and may contribute to instability of the system. In an interest-based economy, capitalis directed to the borrower with the highest credit worthiness rather than the borrower who would make the most efficient use of the capital. Islamic Finance Contracts Mudaraba Musharaka Murabaha Ijara Sukuk a partnership contract a form of equity where a partnership exists and profits and losses are shared a form of credit sale a form of lease similar to a bond Mudaraba Contract A mudaraba transaction is a partnership transaction in which only one of the partners (the rab al mal) contributes capital, and the other (the mudarib) contributes skill and expertise. The contributor of capital has no right to interfere in the day to day operations of the business. Due to the fact that one of the partners is running the business and the other is solely providing capital, the investor has to rely heavily on the mudarib, their ability to manage the business and their honesty when it comes to profit share payments. Page 131 of 138

132 Mudaraba transactions are particularly suited to private equity investments or for clients depositing money with a bank. Investing Partner (RabalMal) BusinessPartner (Mudarib) Profit & loss Capital Expertise Profit & loss BusinessPartner (Mudarib) The roles of and the returns received by the rab-al-mal and mudarib under a mudaraba contract Capital injection The investor provides capital for the project or company. Generally, an investor will not provide any capital unless a clearly defined business plan is presented to them. In this structure, the investor provides 100% of the capital. Skill and expertise The business manager's contribution to the partnership is their skill and expertise in the chosen industry or area. Profit and loss Any profits will be shared between the partners according to the ratios agreed in the original contract. Any losses are solely attributable to the investor due to the fact that they are the sole provider of all capital to the project. In the event of a loss, the business manager does not receive any compensation (mudarib share) for their efforts. The only exception to this is when the business manager has been negligent, in which case they become liable for the total loss. The investor in a mudaraba transaction is only liable to the extent of the capital they have provided. As a result, the business manager cannot commit the business for any sum which is over and above the capital provided. The mudaraba contract can usually be terminated at any time by either of the parties giving a reasonable notice. Typically, conditions governing termination are included in the contract so that any damage to the business or project is eliminated in the event that the investor would like to take their equity out of the venture. Page 132 of 138

133 The rab al mal has no right to interfere with the operations of the business, meaning this situation is similar to an equity investment on a stock exchange. Musharaka partnership contract Musharaka transactions are typically suitable for investments in business ventures or specific business projects, and need to consist of at least two parties, each of which is known as musharik. It is widely used in equity financing. Once the contract has been agreed between the partners, the process can be broken down into the following two main components. a) All partners bring a share of the capital as well as expertise to the business or project. The partners do not have to provide equal amounts of capital or equal amounts of expertise. b) Any profits will be shared between the partners according to the ratios agreed in the original contract. To the contrary, any losses that the project might incur are distributed to the partners strictly in proportion to capital contributions. Although profits can be distributed in any proportion by mutual consent, it is not permissible to fix a lump sum profit for any single partner. This transaction is similar to venture capital, for example a management buyout, where both parties contribute both capital and expertise. The venture capitalist will want board representation and therefore provides expertise and they will also want management to provide capital to demonstrate their commitment. Murabaha contract Instruments with predictable returns are typically favoured by banks and their regulators since the reliance on third-party profit calculations is eliminated. A murabaha transaction is a deferred payment sale or an instalment credit sale and is mostly used for the purchase of goods for immediate delivery on deferred payment terms. In its most basic form, this transaction involves the seller and buyer of a good, as can be seen below. Simple murabaha structure Seller 1. Dellver goods today 2. Pay for goods later Buyer As part of the contract between the buyer and the seller, the price of the goods, the mark-up, the delivery date and payment date are agreed. The sale of the goods is immediate, against future payment. The buyer has full knowledge of the price and quality of goods they buy. In addition, the buyer is also aware of the exact amount of mark-up they pay for the convenience of paying later. In the context of trading, the advantage to the buyer is that they can use the goods to generate a profit in their business and subsequently use the profit to repay the original seller. The underlying asset can vary, and can include raw materials and goods for resale. Sharia'a prescribes that certain conditions are required for a sales contract (which include murabaha contracts) to exist. The object in the contract must actually exist and be owned by the seller. Page 133 of 138

134 The object is offered for a price and both object and price are accepted (the price should be within fair market range). The object must have a value. The object in question and its exchange may not be prohibited by Sharia'a. The buyer in the contract has the right to demand that the object is of suitable quality and is not defective. A bank can provide finance to a business in a murabaha transaction as follows. The manager of the business identifies an asset that the business wants to buy. The bank agrees to buy the asset, and to resell it to the business at an agreed (fixed) price, higher than the original purchase price of the asset. The bank will pay for the asset immediately but agrees to payment from the business under a deferred payment arrangement (murabaha). The business therefore obtains the asset 'now' and pays for it later. This is similar in effect to arranging a bank loan to purchase the asset, but it is compliant with Sharia'a law. Ijara contract An ijara transaction is the Islamic equivalent of a lease where one party (lessor) allows another party (lessee) to use their asset against the payment of a rental fee. Two types of leasing transactions exist: operating and finance leases. The only distinction between the two is the presence or absence o fa purchase undertaking from the lessee to buy the asset at the end of the lease term. In a finance lease, this purchase undertaking is provided at the start of the contract. The lessor cannot stipulate that they will only lease the asset if the lessee signs a purchase undertaking. Not every asset is suitable for leasing. The asset needs to be tangible, non-perishable, valuable, identifiable and quantifiable. In an operating lease, depicted in Figure1, the lessor leases the asset to the lessee for a pre-agreed period and the lessee pays pre-agreed periodic rentals. The rental or lease payments can either be fixed for the period or floating with periodical refixing. Figure1:Operating lease At the end of the period, the lessee can either request to extend the lease or hand the asset back to the lessor. When the asset is returned to the lessor at the end of the period, they can either lease it to another counter party or sell the asset in the open market. If the lessor decides to sell the asset, they may offer it to the lessee. In a finance lease, as depicted in Figure 2, the process is the same as for an operating lease, with the exception that the lessor amortises the asset over the term of the lease and at the end of the period the asset will be sold to the lessee. Page 134 of 138

135 Figure2:Finance lease As with an operating lease, rentals can be fixed for the period or floating. As part of the lease agreement, the amount at which the lessee will purchase the asset upon expiry of the lease is specified. In both forms of ijara the lessor is the owner of the asset and incurs all risk associated with ownership. While the lessee bears the responsibility for wear and tear, day to day maintenance and damage, the lessor is responsible for major maintenance and insurance. Due to the fact that the lessee is using the asset on a daily basis, they are often in a better position to determine maintenance requirements, and are generally appointed by the lessor as an agent to ensure all maintenance is carried out. In addition, the lessee is, in some cases, similarly appointed as agent for the lessor to insure the asset. In the event of a total loss of the asset, the lessee is no longer obliged to pay the future periodic rentals. However, the lessor has full recourse to any insurance payments. Sukuk is about the finance provider having ownership of real assets and earning a return sourced from those assets. This contrasts with conventional bonds where the investor has a debt instrument earning the return predominately via the payment of interest (riba). Riba or excess is not allowed under Sharia law. There has been considerable debate as to whether sukuk instruments are akin to conventional debt or equity finance. This is because there are two types of sukuk: Asset based raising finance where the principal is covered by the capital value of the asset but the returns and repayments to sukuk holders are not directly financed by these assets. Asset backed raising finance where the principal is covered by the capital value of the asset but the returns and repayments to sukuk holders are directly financed by these assets. There are fundamental differences between these. The diagrams set out below explain the mechanics of how each sukuk operates. ASSET-BASED SUKUK Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale and lease back. 1. Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV) company. 2. In return, the SPV issues certificates indicating the percentage they own in the SPV. 3. The SPV uses the funds raised and purchases the asset from the obligor (seller). 4. In return, legal ownership is passed to the SPV. 5. The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah agreement. 6. The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of the asset. 7. The SPV then make periodic distributions (rental and capital) to the sukuk holders. Page 135 of 138

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