CPA

CERTIFIED PUBLIC ACCOUNTANTS

PART III
SECTION 5

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ADVANCED FINANCIAL MANAGEMENT

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STUDY TEXT
 ADVANCED FINANCIAL MANAGEMENT

PAPER NO. 15 ADVANCED FINANCIAL MANAGEMENT

GENERAL OBJECTIVES
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable
him/her to apply advanced financial management techniques in an organization

15.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:
Evaluate capital investment decisions under uncertain economic conditions
Design an optimal capital structure for an organization
Predict corporate failure
Apply derivatives in financial risk management
Apply financial management skills in the public sector

CONTENT

15.1 Nature and purpose of financial management

- Introduction to financial management
- Stakeholders theory
- Conflicting stakeholders interest and corporate governance

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- Corporate social responsibility (CSR) and financial management

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- Ethical issues in financial management

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15.2 The investment Decision

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- Investment decision under capital rationing: multiperiod

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- Investment decision under inflation

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- Investment decision under uncertainty/risk

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- Nature and measurement of risk and uncertainty
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- Techniques of handling risk: sensitivity analysis; scenario analysis; simulation analysis;
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decision theory models; certainty equivalent; risk adjusted discount rates; utility curves
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- Special cases in investment decision: projects with unequal lives; replacement analysis;
abandonment decision
- Real options in investment decisions: types of real options; evaluation of a capital project
using real options
- Common capital budgeting pitfalls
- Bond refinancing/refunding

15.3 Portfolio theory and analysis

- Portfolio theory and risk reduction
- Risk return trade off, mean-Variance Analysis
- Capital efficient portfolios
- Capital asset pricing models (CAPM)
- Arbitrage pricing model (APT) and other multifactor models
- Beta estimation
- Portfolio performance measurement: Treynors measure, Sharpes measure and Jensens
measure

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 ADVANCED FINANCIAL MANAGEMENT

15.4 The financing decision

- Introduction to financing decision
- Nature and significance of financing decision
- Cost of capital and significance : specific cost of capital, weighted average cost of capital
(WACC), Marginal cost of capital (MCC), MCC-IOS/MCC-IRR schedules
- Capital structure theories: Traditional theories; Net Income (NI) Approach, Net Operating
Income (NOI)
- Fanco Modigliani & Merton Miller (MM) propositions: MM without taxes, MM with
corporate taxes, MM with corporate capital structure theories
- Special topics in financing: EBIT_EPS analysis, financial and operating leverage, financial
and operating leverage combined, geared and ungeared betas, lease versus purchase
- Impact of financing on investment decisions-adjusted present value
- Financial distress: signs of financial distress, forms of financial distress, predicting
organization failure, Solution to financial distress

15.5 Corporate valuation

- Application of valuation model
- Use of free cash flows in valuation
- Use of relative measures: economic value added (EVA)
- Use of enterprise value

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15.6 Mergers and acquisitions

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- Nature of mergers and acquisitions

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- Reasons for mergers and acquisitions

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- Acquisition and mergers versus organic growth

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- Valuation of acquisition and mergers

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- Financing acquisitions and mergers

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- Takeover and defense tactics
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- Regulatory framework for mergers and acquisition .s
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- Valuation and analysis of corporate restructuring, leveraged buy outs (LBO) divestitures,
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strategic alliances, liquidation and recapitalization

- Mergers and acquisition in the global context

15.7 Derivatives in financial risk management

- Introduction to financial risk management
- Types of risks: operational risks, political risks, economic risks, fiscal risks, regulatory risks:
currency risks, and interest rate risks
- Foreign currency risk management: Types of forex risks, hedging currency risks, forward rate
agreement, interest rate futures, interest rate swaps, interest rate options
- Derivatives in risk management: meaning and purpose of derivatives; types of derivatives;
forwards, options, futures and swaps
- Valuations of derivatives: options;- Black Scholes options pricing models Greeks
(definitions)

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 ADVANCED FINANCIAL MANAGEMENT

15.8 International financial management

- International investments
- International financial institutions
- Dividend policy for multinationals
- Availability and timing of remittances
- Transfer pricing: Impact on taxes and dividends

15.9 Emerging issues and trends

CONTENT PAGE

Topic 1: Nature and purpose of financial management..5

Topic 2: The investment Decision....22

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Topic 3: Portfolio theory and analysis..70

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Topic 4: The financing decision..120

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Topic 5: Corporate valuation195

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Topic 6: Mergers and acquisitions223

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Topic 7: Derivatives in financial risk management..274
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Topic 8: International financial management...315
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Revised on: November 2016

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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 1

NATURE AND PURPOSE OF FINANCIAL MANAGEMENT

INTRODUCTION TO FINANCIAL MANAGEMENT

Meaning of Financial Management

Financial Management means planning, organizing, directing and controlling the financial activities
such as procurement and utilization of funds of the enterprise. It means applying general
management principles to financial resources of the enterprise.

Scope/Elements

1. Investment decisions includes investment in fixed assets (called as capital budgeting).

Investment in current assets are also a part of investment decisions called as working capital
decisions.

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2. Financial decisions - They relate to the raising of finance from various resources which will

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depend upon decision on type of source, period of financing, cost of financing and the returns

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thereby.

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3. Dividend decision - The finance manager has to take decision with regards to the net profit

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distribution. Net profits are generally divided into two:

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a. Dividend for shareholders- Dividend and the rate of it has to be decided.

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b. Retained profits- Amount of retained profits has to be finalized which will depend

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upon expansion and diversification plans of the enterprise.
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Objectives of Financial Management

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The financial management is generally concerned with procurement, allocation and control of
financial resources of a concern. The objectives can be-

1. To ensure regular and adequate supply of funds to the concern.

2. To ensure adequate returns to the shareholders which will depend upon the earning capacity,
market price of the share, expectations of the shareholders
3. To ensure optimum funds utilization. Once the funds are procured, they should be utilized in
maximum possible way at least cost.
4. To ensure safety on investment, i.e, funds should be invested in safe ventures so that adequate
rate of return can be achieved.
5. To plan a sound capital structure-There should be sound and fair composition of capital so
that a balance is maintained between debt and equity capital.

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 ADVANCED FINANCIAL MANAGEMENT

Functions of Financial Management

1. Estimation of capital requirements: A finance manager has to make estimation with

regards to capital requirements of the company. This will depend upon expected costs and
profits and future programmes and policies of a concern. Estimations have to be made in an
adequate manner which increases earning capacity of enterprise.
2. Determination of capital composition: Once the estimation have been made, the capital
structure have to be decided. This involves short- term and long- term debt equity analysis.
This will depend upon the proportion of equity capital a company is possessing and additional
funds which have to be raised from outside parties.
3. Choice of sources of funds: For additional funds to be procured, a company has many
choices like-
a. Issue of shares and debentures
b. Loans to be taken from banks and financial institutions
c. Public deposits to be drawn like in form of bonds.

Choice of factor will depend on relative merits and demerits of each source and period of
financing.

4. Investment of funds: The finance manager has to decide to allocate funds into profitable

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ventures so that there is safety on investment and regular returns is possible.

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5. Disposal of surplus: The net profits decision have to be made by the finance manager. This

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can be done in two ways:

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a. Dividend declaration - It includes identifying the rate of dividends and other benefits

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like bonus.

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b. Retained profits - The volume has to be decided which will depend upon expansional,

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innovational, diversification plans of the company.

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6. Management of cash: Finance manager has to make decisions with regards to cash
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management. Cash is required for many purposes like payment of wages and salaries,
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payment of electricity and water bills, payment to creditors, meeting current liabilities,
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maintainance of enough stock, purchase of raw materials, etc.

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7. Financial controls: The finance manager has not only to plan, procure and utilize the funds
but he also has to exercise control over finances. This can be done through many techniques
like ratio analysis, financial forecasting, cost and profit control, etc.

STAKEHOLDERS THEORY

Stakeholder theory states that a company owes a responsibility to a wider group of stakeholders,
other than just shareholders. A stakeholder is defined as any person/group which can affect/be
affected by the actions of a business. It includes employees, customers, suppliers, creditors and even
the wider community and competitors.
Edward Freeman, the original proposer of the stakeholder theory, recognised it as an important
element of Corporate Social Responsibility (CSR), a concept which recognises the responsibilities of
corporations in the world today, whether they are economic, legal, ethical or even philanthropic.
Nowadays, some of the worlds largest corporations claim to have CSR at the centre of their
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 ADVANCED FINANCIAL MANAGEMENT

corporate strategy. Whilst there are many genuine cases of companies with a conscience, many
others exploit CSR as a good means of PR to improve their image and reputation but ultimately fail
to put their words into action.
Within an organisation there are a number of internal parties involved in corporate governance.
These parties can be referred to as internal stakeholders.

A useful definition of a stakeholder, for use at this point, is 'any person or group that can affect or be
affected by the policies or activities of an organization.

The basis for stakeholder theory is that companies are so large and their impact on society so
pervasive that they should discharge accountability
accountability to many more sectors of society than solely their
shareholders demonstrated in the diagram below;

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Stakeholder theory may be the necessary outcome of agency theory given that there is a business
case in considering the needs of stakeholders through improved
improved customer perception, employee
motivation, supplier stability, shareholder conscience investment.
Each internal stakeholder has:
An operational role within the company
A role in the corporate governance of the company
A number of interests in the company
c (referred to as the stakeholder 'claim'
'claim').

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 ADVANCED FINANCIAL MANAGEMENT

Operational role Corporate Main interests in the

governance role company
Responsible for the Control company in - pay
actions of the corporation. best interest of the - performance linked
stakeholders bonus
- share options
- status
- reputation
- power
Company Stakeholder Advise board on
secretary corporate governance
matters
- pay

Sub-board Directors -Identify and evaluate - Job stability

management risks faced by a - career progression
company. - status
-enforce controls. - working conditions
-monitor success. - performance linked
-reports concerns. bonus

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Employees Carry out orders of - Comply with internal

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management. controls

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-Report breaches

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Employee Protect employee interests Highlight and take - Power

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representatives action against breaches

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e.g trade in governance - Status

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unions requirements e.g.

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protection of whistle .s
blowers.
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 ADVANCED FINANCIAL MANAGEMENT

External corporate governance stakeholders

A company has many external stakeholders involved in corporate governance.
Each stakeholder has:
a role to play in influencing the operation of the company
its own interests and claims in the company.

External party Main role Interests and claims in company

Auditors Independent review of companys - Fees

reported financial position. - Reputation
- Quality of relationship
- Compliance with audit requirements
Regulators Implementing and monitoring - Compliance with regulations
regulations - Effectiveness of regulations.
Government Implementing and maintaining laws with - Compliance with laws
which all companies must comply - Payment of taxes
- Levels of employment
- Levels of imports/exports
Stock exchange Implementing and maintaining rules and - Compliance with rules and
rules and regulations for companies regulations

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listed on the exchange - fees

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Small investors Limited power with use of vote - Maximisation of shareholder value

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Institutional Through considered use of their votes - Value of shares and dividend

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investors can (and should) beneficially influence payments

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corporate policy - Security of funds invested

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- Timeless of information received

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from company

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- Shareholder rights are observed.
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CONFLICTING STAKEHOLDERS INTERESTS AND CORPORATE GOVERNANCE

Agency theory
Agency theory is part of the bigger topic of corporate governance.
It involves the problem of directors controlling a company whilst shareholders own the company. In
the past, a problem was identified whereby the directors might not act in the shareholders (or other
stakeholders) best interests. Agency theory considers this problem and what could be done to
prevent it.

A number of key terms and concepts are essential to understanding agency theory.
An agent is employed by a principal to carry out a task on their behalf.
Agency refers to the relationship between a principal and their agent.
Agency costs are incurred by principals in monitoring agency behaviour because of a lack of
trust in the good faith of agents.

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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 2
THE INVESTMENT DECISION

INTRODUCTION

Introduction

An investment decision revolves around spending capital on assets that will yield the highest return
for the company over a desired time period. In other words, the decision is about what to buy so that
the company will gain the most value.

To do so, the company needs to find a balance between its short-term and long-term goals. In the
very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't
investing in things that will help it grow in the future. On the other end of the spectrum is a purely
long-term view. A company that invests all of its money will maximize its long-term growth
prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon.
Companies thus need to find the right mix between long-term and short-term investment.

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The investment decision also concerns what specific investments to make. Since there is no

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guarantee of a return for most investments, the finance department must determine an expected

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return. This return is not guaranteed, but is the average return on an investment if it were to be made

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many times.

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The investments must meet three main criteria:

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1. It must maximize the value of the firm, after considering the amount of risk the company is
comfortable with (risk aversion).
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2. It must be financed appropriately
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3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to
shareholder in order to maximize shareholder value.

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 ADVANCED FINANCIAL MANAGEMENT

INVESTMENT DECISIONS UNDER CAPITAL RATIONING

Capital rationing is the strategy of picking up the most profitable projects to invest the available
funds. Hard capital rationing and soft capital rationing are two different types of capital rationing
practices applied during capital restrictions faced by a company in its capital budgeting process. In
the efficient capital markets, a companys aim is to maximize the shareholders wealth and its value
by investing in all profitable projects. However, in real life, a company may realize that the internal
and the external funds available for new investments may be limited.

Definition of Hard and Soft Capital Rationing

There are two situations which may lead to capital rationing, namely hard and soft capital
rationing. Hard capital rationing or external rationing occurs when the company faces problems in
raising funds in the external equity markets. This can lead to the shortage of capital to finance the
new projects in the company.

On the other hand, soft capital rationing or internal rationing is caused due to the internal policies
of the company. The company may voluntarily have certain restrictions that limit the amount of
funds available for investments in projects. However, these restrictions can be modified in the

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future; hence, the term soft is used for it.

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Benefits and Disadvantages of Capital Rationing

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Reasons for Hard Capital Rationing

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Hard capital rationing is an external form of capital rationing. The company finds itself in a position

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where it is not able to generate external funds to finance its investments. w
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There could be several reasons for this scenario:

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Start-up Firms: Generally, young start-up firms are not able to raise the funds from equity
markets. This may happen despite the high projected returns or the lucrative future of the
company.
Poor Management / Track Record: The external funds can also be affected by the bad track
record of the company or the poor management team. The lenders can consider such
companies as a risky asset and may shy away from investing in projects of these companies.
Lenders Restrictions: Quite often, medium sized and large sized companies rely on
institutional investors and banks for most of their debt requirements. There may be
restrictions and debt covenants placed by these lenders which affect the companys fund-
raising strategy.
Industry Specific Factors: There could be a general downfall in the entire industry affecting
the fund raising abilities of a company.

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 ADVANCED FINANCIAL MANAGEMENT

Reasons for Soft Capital Rationing

Soft capital rationing, on the other hand, is a company-led capital restriction due to the following
reasons:

Promoters Decision: The promoters of the company may decide to limit raising more
capital too soon for the fear of losing control of the companys operations. They may prefer
to raise funds slowly and over a longer period to ensure their control of the company.
Moreover, this could also help in getting a better valuation while raising capital in the future.
An increase in Opportunity Cost of Capital: Too much leverage in the capital structure
makes the company a riskier investment. This leads to increase in the opportunity cost of
capital. The companies aim to keep their solvency and liquidity ratios under control by
limiting the amount of debt raised.
Future Scenarios: The companies follow soft rationing to be ready for the opportunities
available in the future, such as a project with a better rate of return or a decline in the cost of
capital. There is prudence in conserving some capital for such future scenarios.

SINGLE PERIOD CAPITAL RATIONING

It is a situation where the company has limited amounts of funds in one investment period only.
After that period, the company can access funds from various sources, e.g. issuing shares, borrowing

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from banks or issuing bonds.

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Illustration

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ABC Ltd.is considering investing in the following independent projects

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Project PV of cash flow Initial cost NPV P.I

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1 230,000 200,000 30,000 1.15
2 141,250 125,000 16,250 1.13
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3 194,250 175,000 19,250 1.11
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4 162,000 150,000 12,000 1.08

The company has set a capital limit of sh.300000.

Required:
Advice the management on the projects to undertake

Solution
If there was no capital rationing then all the 4 projects would be accepted coz they have positive
NPV. However with capital rationing, the projects have to be compared using PI index. With
sh.300,000, we could have invested in three options. Invest in project 1; invest in projects 2 and 3;
invest in projects 2 and 4. We will select the option that gives us the highest weighted average
profitability index.

A major assumption made in analysis is that the PI index of all projects is excess of one and the
unused funds PI is equal to one.

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 ADVANCED FINANCIAL MANAGEMENT

Weighted average PI:

For option 1: 1.15(200/300) + 1.0(100/300) = 1.1
For option 2: 1.13(125/300) + 1.11(175/300) = 1.118
For option 3: 1.13(125/300) + 1.08(150/300) + 1(25/300) = 1.094
Decision: Invest in project 2 and 3 since these results in the highest weighted average PI.

MULTI-PERIOD CAPITAL RATIONING

It occurs where the company has limited amounts of funds for a longer duration of time. The capital
constraints extend beyond one investment period.
If we assume that its possible to undertake fractional projects then the problem can be formulated
using linear programming. If the projects are indivisible, however, then integer programming should
be used.

Under the multi-period capital rationing, situation the NPV or PI criterion alone cannot give optimal
Solution therefore a mathematical optimization model must be used to generate an optimal Solution
subject to a specified constraint.
There are a number of mathematical optimization models;

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1) Linear programming (LP) model for divisible model.

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2) Integer programming (IP) model for non-divisible model

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3) Goal programming (GP) model for project with several goals.

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4) Dynamic programming (DP) model for variables that is uncertain.

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Illustration

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A company is considering investing into projects whose cash flows are as shown below:
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Year Cash flows Sh. m
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0 (10) (20)
1 (20) (10)
2 - (30)
3 60 100
The companys cost of capital is 10%. The amounts available for investment are restricted to sh.
20m, 25m and 20m in years 0, 1 and 2 respectively. None of the projects can, be delayed or deferred
however they are divisible.

Required:
a) Formulate a LP model to solve for the optimal soln.
b) Solve the problem using the graphical method.

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 This is a SAMPLE (Few pages extracted from the complete notes: Note page
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[email protected]

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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 3

PORTFOLIO THEORY AND ANALYSIS

RISK AND RETURN

When considering a prospective investment the financial manager, or any rational investor, will be
concerned not only with the volume and timing of its expected future cash flows but also with their
riskiness, by which in finance we mean their tendency to vary from some expected or mean value.
The greater the range or spread of possible returns from an investment, the greater its risk. Thus both
the return and the risk dimension of investment decisions must be evaluated.

Risk and return are intimately related and we shall spend some time exploring this fundamental
relationship (or in technical terms the correlation), between risk and return. We will see how the
notion of return cannot be considered in isolation from risk - the two variables are inseparable. We
will also examine risk and return in the context of modern portfolio theory and see how risk can be
reduced by diversification.

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For the financial manager the goal of investment decisions is to maximise shareholder wealth, and

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making sound investment decisions that enhance shareholder wealth lies at the very heart of the

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financial manager's job. Wealth-enhancing investment decisions (corporate or personal) cannot be

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made without an understanding of the interplay between investment returns and investment risk. The

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risk-return relationship is central to investment decision making, whether evaluating a single

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investment or choosing between alternative investments

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Potential investors, for example, will assess the risk-return relationship or trade-off in deciding
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whether to invest in company securities such as shares or bonds. Investors will evaluate whether, in
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their view, the securities provide a return commensurate with their level of risk.
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The risk return relationship

Every financial decision contains an element of risk and an element of return. The relationship
between risk and return exists in the form of a risk-return trade-off, by which we mean that it is only
possible to earn higher returns by accepting higher risk. If an investor wishes to earn higher returns
then the investor must appreciate that this will only be achieved by accepting a commensurate
increase in risk. Risk and return arc positively correlated, an increase in one is accompanied by an
increase in the other.

The implication for the financial manager in evaluating a prospective investment project is that an-
effective decision about the: project's value to the firm cannot be made simply by focusing on its
expected level of returns: the project's expected feral of risk must also be simultaneously considered.
This risk-return trade-off is central to investment decision-making.

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Risk diversification

It is unlikely that the financial manager or corporate treasurer will be involved with investing the
entire firm's capital resources in only a single project or asset, this would be very risky. As the old
adage goes, all the firm's eggs would be in one basket. More probable resources will be invested in a
collection or portfolio of investment projects as totals will be reduced through diversification.

This means risk will be spread and therefore not all the firm's investment eggs will be in the one
basket. From the shareholder's perspective, the firm itself can be viewed as a portfolio of assets or
investment projects managed by a professional team - the firms managers.

Holding a group of diversified assets (that is, assets that do not move in the same direction at the
same time) in a portfolio reduces overall risk and risk reduction through diversification is a key
aspect of the corporate treasury risk management role.

Thus the financial manager's concern is not just with the relative timing of investment returns but
also with their relative risks, (that is, the potential variability of their future returns) and how
together these will impact on the firm's market value and shareholder wealth.

Shareholder wealth maximisation means maximising the value of the share price while risk and

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return are two key determinants of share price. We will begin our study of risk and return by first

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considering return; it is the easier of the two to understand.

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Return

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An investment's return can be actual or expected and is measured in terms of cash-flows, positive or
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negative. Measuring actual return is usually a retrospective and comparatively easier exercise than
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measuring expected return. In calculating actual return the relevant data is historic and is known
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with certainty: determining expected return is altogether a more problematic exercise as we are
dealing with the future and the future is uncertain.

An investment's expected return - usually denoted E(r) or f (referred to as 'r bar')-is the

Investment's most likely return and is measured in terms of the future cash flows, positive and
negative, it is expected to generate. It represents the investor's best estimate of the investment's
future returns.

As a general rule the rate of return (actual or expected) on any investment over a defined period of
time can be calculated simply as:

100 = %

A refinement to the above would be to allow for changes in the value of the investment over the
period, such as the capital gain on a share.

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 ADVANCED FINANCIAL MANAGEMENT

( )+

For example, if you bought a security such as a share for shs.10.00 which one year later was valued
at shs.11.00 and it paid you a shs.0.50 dividend during the year, your return would be:
( . . . . ) . . . .
100 = %= 100 = 15%
. . . .

If you invested in a security such as a bond, the income is the cash you receive in the form of
interest plus any principal repayments and/or changes in the market price of the bond. The above is
an example of actual or realized returns where the relevant variables (cash income, beginning value
and ending value) are known. They are calculated after the event, are thus sometimes referred to as
ex post returns.

In contrast, when faced with making an investment decision the relevant variables are not known
with certainty, and consequently they have to be estimated. In making investment decisions for the
firm, the financial manager will need to make estimates of the returns (cash flows) expected from an
investment.

e
The expected return is determined ex ante, (before the event) that is before the investment is made,

pl
am
and is calculated by the same method as before only this time expected values are substituted in the

-S
formula for the actual values.

e
o.k
( )+

.c

ya
ken
ea
For example, you know that your share is currently valued at shs.11.00. If you expect its most likely
om
value to be shs.12.00 one year from now and expect it to pay you a dividend of shs.0.75 during the .s
w
w

year, your expected return E(r) would be:

w

( . . . . ) . .
E(r) = 100 = %
. .

. .
= 100 = 15.9%
. .

Clearly, in one year's time the actual return from this investment may be very different )in the
expected return. However, at the present point in time, the expected return is our best guess of the
shares future return.

The determination of return, actual or expected, in general can be expressed mathematically as:

r1 =

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 ADVANCED FINANCIAL MANAGEMENT

Where;

rt = actual or expected rate of return during period t

vt = value of asset at time tn

Vt -1 = value of asset at time t-1

CF = cash flow from investment over the period t-1 to t

Frequently in finance we will be measuring returns over the period of a year, so rt often represent the
annual rate of return. Where an investment is held for a period greater or less than a year it is best to
convert the return to an annual return, as this makes reviewing and comparing investment
performance easier.

For example, if you bought a share six months ago for shs.100 and sold it today for shs 106, and in
the meantime received a dividend of shs.3 your- return over the six- month holding period (known
as the holding period return)would be calculated as:

Holding period return = (shs.106 shs.100 + shs.3)/shs.100 = 9%

e
pl
To convert this to an annual rate of return we can divide the six-month holding period return by 0.5,

am
thus the annualized return is: 9/0.5 = 18%. For any investment we convert its holding period return

-S
to an annual return by dividing the holding period by the number of holding periods, expressed in

e
.k
o
terms of years, thus:

.c
ya
en
Annual return - holding period return/number of holding periods (in years)

k
ea
om
18% = 9%/0.5
.s
w
We have previously defined expected return as the most likely future return. When considering a
w
w

potential investment an investor is likely to determine a range of possible future returns for the
investment before deciding on the most likely return.

Returning to our previous share example, if you wish to estimate the share's future return, you may
intuitively consider a number of possible future values.

For example assume there is a 25 per cent share of the future return remaining at 15 per cent, a 50
percent chance of it increasing to 16 per cent and a 25 percent chance that it might be 17 percent.
You could then compile a probability distribution of future returns as follows:

Probability (p) Return (r) (p) (r)

0.25 15% 3.75
0.50 16% 8.00
0.25 17% 4.25
E(r) = 16.00%

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you the topics covered in the notes.

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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 4

THE FINANCING DECISION

INTRODUCTION

The financing decisions are decisions regarding the methods that are used to raise funds which
would be used for making acquisitions. The financing decisions are decisions concerning
the liabilities and stockholders' equity side of the firm's balance sheet, such as a decision to issue
bonds.
The financing decisions involve various factors. They are determining the proper amount of funds to
employ in a firm, selecting projects and capital expenditure analysis, raising funds on the most
favorable terms possible and finally managing working capital such as inventory and accounts
receivable. The goals of corporate finance can be achieved only when the corporate investment is
financed appropriately. The financing mix will make an impact the valuation.

e
pl
The company should therefore identify an optimal mix of financing i.e. the one which results in

am
-S
maximum value.

e
The sources of finance are usually comprised of a combination of debt and equity financing. A

o.k
project that is financed through debt results in a liability and obligation. When the projects are

.c
ya
financed through equity, it is less risky with respect to cash flow commitments. The cost of equity is

ken
always higher than the cost of the debt. The equity financing may result in an increased hurdle rate

ea
om
which will offset any reduction in the cash flow risk. The management of the company must match
.s
the financing mix to the asset that is being financed.
w
w
w

One of the theories as to how the firms make their financing decisions is the Pecking Order
Theory. Under this theory the firms should avoid external financing if they have an availability
of internal financing option. They also avoid equity financing if they have an option of debt
financing at lower interest rates. Another theory which helps firms in financial decision is the Trade-
off theory where firms are assumed to trade-off the tax benefits of debt with the bankruptcy costs of
debt when making their decisions.

NATURE AND SIGNIFICANCE OF THE FINANCING DECISION

The nature of financial decisions varies from one firm to the other. It may also be different for the
same firm over a period of time. The reason is that the nature of financial decisions is influenced by
the prevailing microeconomic and macroeconomic conditions. These factors are explained below;-

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 ADVANCED FINANCIAL MANAGEMENT

Microeconomic Factors
Microeconomic factors are related to the internal conditions of the firm. Important among these
conditions are:
1. Nature and size of the enterprise;
2. Level of risk and stability in earnings;
3. Liquidity position;
4. Asset structure and pattern of ownership;
5. Attitude of the management.

Nature and size of the enterprise;

If a firm is engaged in manufacturing operations or in the provision of public utility services, its
investment in fixed assets is large and hence the capital structure has a large share of long-term
capital. The share of long-term capital in the capital structure is also large in firms producing capital
goods. On the other hand, in trading concerns, a greater part of the investment is found in current
assets. With a greater ratio of current assets, the ratio of current liabilities rises. Similarly, companies
that is larger in size need a large capital. Small firms may obtain their fixed assets on lease, but large
firms would need to construct their own building and assemble their own plant. Small firms have

e
pl
am
lower goodwill in the capital market and so their financing decisions are different from that of large

-S
firms. It is because of the lack of sufficient goodwill in the capital market that small firms are largely

e
dependent on internal finances and this is one of the reasons that their dividend decisions are

.k
o
.c
different from that of large firms.

ya
ken
Level of risk and stability in earnings;

ea
om
Risk is another important factor influencing financial decisions. The greater the risk, the higher the
.s
discount factor. Thus, risk influences the long-term investment decision or capital budgeting
w
w
w

decision. Again, if risk is higher or income is not stable, the finance manager tries to impress on the
shareholders for more retention of earnings rather than adopting a liberal dividend policy. But with
stable income or lower risk, the financial decision will be just the reverse. In such cases, the fixed-
cost capital, such as preference shares and debentures, may be preferred and also the firm may adopt
a liberal dividend policy.

Liquidity position
The third factor influencing financial decisions is the liquidity position. Since dividend is normally
paid out of cash, firms with a sound liquidity position adopt a liberal dividend policy. But if, in such
cases, the working capital requirements are very large or the firm has to meet significant past
obligations, it will have to follow a conservative dividend policy. Any tilt towards illiquidity will
alter the nature of financing and dividend decisions.

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 ADVANCED FINANCIAL MANAGEMENT

Asset structure and pattern of ownership

Again, in a closely-held company where the ownership lies in a few hands, the management does
not find it difficult to persuade the owners to accept a conservative dividend policy in the interests of
the firm. But in cases where there are many shareholders, their wishes matter considerably.

Attitude of the management

Last but not least is the managements attitude. A conservative finance manager will attach greater
importance to liquidity rather than to the profitability. On the other hand an aggressive finance
manager will stress on the latter, and financial decisions will be taken accordingly. For example, a
conservative finance manager attempts to tread a beaten path, preferring to avoid fixed obligations
for raising additional capital even if debt financing is advantageous. The preference is to maintain a
large volume of current assets. However, an aggressive finance manager is ready to bear the risk
involved in debt financing or that involved in maintaining lower current assets. However, a prudent
finance manager would prefer a compromise between risk and return or between profitability and
liquidity.

Macroeconomic Factors
Macroeconomic factors are the environmental factors that are beyond the control of the firms

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pl
am
management. They relate primarily to:

-S
1. The state of the economy;

e
2. Governmental policy.

.k
o
.c
ya
The state of the economy

ken
The state of the economy changes from time to time and the financial decisions of a firm conform to

ea
om
these changes. When the economy is growing or proceeding towards recovery, the finance manager
.s
should be eager to avail investment opportunities. But when the economy is facing a slump, the
w
w
w

finance manager should proceed with care. For example, in such a situation it would not be
advisable to go for an expansion programme. Similarly, when the economy is experiencing an
uptrend, the finance manager can opt for trading on equity as larger profits are assured. But in times
of a downtrend, the stress should be on internal financing. Again, during an uptrend, higher
dividends can be declared, but during a downtrend conservation of cash is necessary and therefore a
strict dividend policy should be followed.

The state of economy is also denoted by the structure of capital and money markets. If the capital
market is well developed having a multitude of financial institutions and venturesome investors, the
finance manager will find it easy to select the proportion-mix of capital structure and, accordingly,
financing decisions will be broader. He can manage with a comparatively lower amount of cash as
he can get funds whenever he desires. The dividend policy too is broad in such cases as the
shareholders are not necessarily interested in regular and large dividends. But if the investors are not
venturesome, they will wish for large dividends and the finance manager will have to adopt a liberal
dividend policy, and will not be able to opt for trading on equity to any great extent. Similarly, if the
financial institutions provide concessional assistance for priority projects, the investment decisions
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 ADVANCED FINANCIAL MANAGEMENT

will be influenced in favour of such projects. Moreover, if the financial institutions stress on a
particular debt-equity ratio, the financing decisions will be so influenced.

Governmental policy
Apart from the state of economy, governmental policy is no less significant in influencing corporate
financial decisions. State intervention or state regulation is found in almost all countries. Thus
corporate investment decisions are governed by the nature and extent of state regulations.

SIGNIFICANCE OF THE FINANCING DECISION

There are two fundamental types of financial decisions that the finance team needs to make in a
business i.e investment and financing. The two decisions boil down to how to spend money and how
to borrow money. The overall goal of financial decisions is to maximize shareholder value, so every
decision must be put in that context.

Investment
An investment decision revolves around spending capital on assets that will yield the highest return

e
pl
am
for the company over a desired time period. In other words, the decision is about what to buy so that

-S
the company will gain the most value.

e
To do so, the company needs to find a balance between its short-term and long-term goals. In the

o.k
.c
very short-term, a company needs money to pay its bills, but keeping all of its cash means that it isn't

ya
investing in things that will help it grow in the future. On the other end of the spectrum is a purely

ken
long-term view. A company that invests all of its money will maximize its long-term growth

ea
om
prospects, but if it doesn't hold enough cash, it can't pay its bills and will go out of business soon.
.s
Companies thus need to find the right mix between long-term and short-term investment.
w
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The investment decision also concerns what specific investments to make. Since there is no
guarantee of a return for most investments, the finance department must determine an expected
return. This return is not guaranteed, but is the average return on an investment if it were to be made
many times.

The investments must meet three main criteria:

1. It must maximize the value of the firm, after considering the amount of risk the company is
comfortable with (risk aversion).
2. It must be financed appropriately (we will talk more about this shortly).
3. If there is no investment opportunity that fills (1) and (2), the cash must be returned to
shareholder in order to maximize shareholder value.

Financing
All functions of a company need to be paid for one way or another. It is up to the finance department
to figure out how to pay for them through the process of financing.

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you the topics covered in the notes.

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or
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To get the complete notes either in softcopy form or in

Hardcopy (printed & Binded) form, contact us:

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Call/text/whatsApp 0707 737 890

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-S
e
o.k
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ya
en
[email protected]

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[email protected]
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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 5

CORPORATE VALUATION

INTRODUCTION
Several valuation methods are available, depending on a companys industry, its characteristics (for
example, whether it is a start-up or a mature company), and the analysts preference and expertise.
In this chapter, we focus on the mainstream valuation methods. These methods are classified into
two categories, based on two dimensions. The first dimension distinguishes between direct (or
absolute) valuation methods and indirect (or relative) valuation methods

As their name indicates, direct valuation methods provide a direct estimate of a companys
fundamental value. In the case of public companies, the analyst can then compare the companys
fundamental value obtained from that valuation analysis to the companys market value. The
company appears fairly valued if its market value is equal to its fundamental value, undervalued if
its market value is lower than its fundamental value, and overvalued if its market value is higher

e
than its fundamental value.

pl
am
-S
In contrast, relative valuation methods do not provide a direct estimate of a companys

e
.k
fundamental value: They do not indicate whether a company is fairly priced; they indicate only

o
.c
whether it is fairly priced relative to some benchmark or peer group. Because valuing a company

ya
en
using an indirect valuation method requires identifying a group of comparable companies, this

k
ea
approach to valuation is also called the comparable approach.
om
These two approaches to valuation are broken down as follows;- .s
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Present Value of Cash Flows (PVCF) /direct valuation methods

i) Present value of dividends (DDM)
ii) Present value of free cash flow to equity (FCFE)
iii) Present value of free operating cash flow to the firm (FCFF)

Relative Valuation Techniques

i) Price/earnings ratio (P/E)
ii) Price/cash flow ratio (P/CF)
iii) Price/book value ratio (P/ BV)
iv) Price/sales ratio (PIS)

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 ADVANCED FINANCIAL MANAGEMENT

APPLICATION OF VALUATION MODELS

ABSOLUTE VALUE MODELS/ DISCOUNTED CASH FLOW VALUATION

TECHNIQUES

The discounted cash flow techniques are based on the basic valuation model which asserts that the
value of an asset is the present value of its expected cash flows and can be expressed as follows:

Vj =
( )

Where Vj Value of stock j

n Life of the asset
CFt Cash flow in period t
k The discount rate that is equal to the investors required rate of return for asset j, which
is determined by the uncertainty (risk) of the assets cash flows

Under the discounted cash flow techniques we have the following techniques:

e
pl
i. The dividend discount model-DDM ( Present value of dividends)

am
ii. Present value of operating free cash flows (Pv OFCE)

-S
iii. Present value of free cash flow to equity ( Pv FCFE)

e
.k
o
.c
ya
i) The dividend discount model(DDM)

en
According to this model, the value of a share is the present value of all future dividends.

k
ea
This is given by:
om
.s
w
w

Vj =
w

( )

+ ++
( ) ( ) ( )

Where Vj is the value of a common stock/share

Dn Dividend during period t
k Required rate of return on stock j
n number of periods
This formula assumes that a share is held indefinitely. However, this is not usually the case since
securities could be held for a period (year), several years (multiple periods) or for an infinite period
of time.

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 ADVANCED FINANCIAL MANAGEMENT

a) Single period model (One year holding period)

In a single period model, an investors intention is to purchase a share now, hold it for one year and
sell it off at the end of one year. The investor therefore would be expected to receive an amount of
dividend as well as the selling price after one year.
To calculate the value of the share, we must estimate the dividends to be received during this
period, the expected sale price at the end of the holding period as well as the investorsrequired
rate of return.

The Present value of the share will be expressed as:

Vj = ( )
+( )

Where
D1 = Amount of dividend expected to be received at the end of one year.
S1 = Selling price expected to be realised on sale of the share at the end of one year.
k=Rate of return required by the investor

e
pl
am
-S
Illustration

e
An investor expects to invest in a company and to get shs 1.50 as dividends from a share next year

o.k
and hopes to sale off the share at 30 shillings after holding it for 1 year. His required rate of return is

.c
ya
20%

ken
i) What is the present value of the share

ea
om
ii) How much should he be willing to buy a share of this company
.s
w
w

.
w

Value of share =
( )
+( )
=( +(
. ) . )

.
=( +(
. ) . )

= 1.25 + 25 = Shs. 26.25

The value he should be willing to pay the share should be shs. 26.25 or less
Shs. 26.25 is the intrinsic value of the share. The investor would buy this share only if its current
market price is lower than or equal to this value.

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 ADVANCED FINANCIAL MANAGEMENT

b) Multiple period model ( Multiple-year Holding period)

An investor may hold a share for a certain number of years and sell it off at the end of his holding
period. In this case, he would receive annual dividends each year and the sale price of the share at
the end of the holding period. The present value of the share will be expressed as:

Vj = + + +
( ) ( ) ( ) ( )

Where
D1, D2, D3,Dn = Annual dividends to be received each year.
Sn = Sale price at the end of the holding period
k = Investors required rate of return.
n = Holding period in years.

Illustration
An investor intends to invest in XYZ Company and expects to get sh. 3.5, sh.4 and sh. 4.5 as
dividends from a share during the next three years and hopes to sale it off at sh. 75 at the end of the
third year. His required rate of return is 25%

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pl
am
Required;-

-S
What is the present value of the share of XYZ company.

e
.k
o
.c
ya
. .
Value of the share = +( +(

en
( . ) . ) . )

k
ea
om
= 2.8 + 2.56 + 40.70 = sh.46.06 .s
w
w
w

However, to use the dividend discount model, an investor has to forecast the future dividends as well
as the selling price of the share at the end of his holding period. This is a major limitation since it is
not possible to forecast these variables accurately. For this reason, the model is practically
infeasible.
In the case of most equity shares, the dividend per share grows because of the growth in earnings of
a company. It also follows that dividends grow and are not constant over time. The growth rate
pattern of equity dividends have to be estimated.

To overcome this major limitation, assumptions about growth rate patterns can be made and
incorporated into the valuation models. The assumptions include:
1. Dividends grow at a constant rate in future, i.e the constant growth rate assumption.
2. Dividends grow at varying rates in future, i.e multiple growth assumption.

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you the topics covered in the notes.

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To get the complete notes either in softcopy form or in

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Call/text/whatsApp 0707 737 890

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en
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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 6

MERGERS AND ACQUISITIONS

DEFINITION OF TERMS

Acquiring Effective Control

This means the acquisition of shares in the offeree which together with shares if any, already held by
the offeror or by any other person that is deemed to be associated or a company or by any other
company that is deemed by virtue of being a related company to the offeror or by persons acting in
concert with the offeror carry the right to exercise or control the exercise of not less than twenty-five
percent of the votes attached to the ordinary shares of the offeree provided that such person already
holding twenty five percent or more but less than fifty percent of the voting shares may acquire no
more than five percent of the shares of a listed company in any one year.

Acting in concert

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pl
This refers to persons who pursuant to a formal or informal agreement or understanding actively co-

am
operate through the acquisition by any of them of shares having voting rights in a public listed

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company to obtain or consolidate control of that company.

e
.k
o
.c
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Competing take-over offer

en
This means an offer made by a person with respect to the offerees voting shares in response to an

k
ea
offer that has already been made and such other person shall be deemed to be the competing offeror.
om
.s
w
w

Counter offer
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Its a take-over offer made by an offeree to an offeror;

Effective control
This is where a person or a company makes an offer for the acquisition of effective control of an
offeree which holds shares which together with shares, if any, already held by such person or an
associate person or a company or by any other company that is deemed by virtue of being a related
company or by persons acting in concert with such person carry the right to exercise or control the
exercise of not less than twenty five percent of the votes attached to the ordinary shares of an offeree
which shall be deemed to be a take-over and the provisions of these Regulations shall apply except
where that person or associate person or related company or persons acting in concert with the
person, already hold shares carrying more than ninety percent voting rights in the offeree;

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 ADVANCED FINANCIAL MANAGEMENT

Merger
This refers to an arrangement whereby the assets of two or more companies become vested in or
under the control of one company;

Offeror
In relation to a take-over scheme or a take-over offer means any person who acquires or agrees to
acquire effective control in the offeree either directly or with any associated person or related
company or any person acting in concert with the offeror but does not include a person who holds
shares carrying more than ninety percent voting rights in the offeree

Offeree
In relation to a take-over scheme or a take-over offer means a listed company on a securities
exchange with shares to which the scheme or offer relates;

Offer period
This refers to the means the period commencing from the date the offeror sends an offerors
statement until -
(a) The first closing date of the take-over offer; or

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pl
am
(b) The date when the take-over offer becomes or is declared unconditional as to acceptances,

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lapses or is withdrawn.

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o.k
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Press notice

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This means to announce or publish information on the take-over through the print or `electronic

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ea
media;

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Related company
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This refers to a company which is -

(a) The holding company of another company;
(b) A subsidiary of another company; or
(c) A subsidiary of the holding company of another company; and for purposes of ascertaining the
relation, that first mentioned company and the other company shall be deemed to be related to
each other;

Reverse take-over offer

This means a situation where an offeror makes a take-over offer for the voting shares of an offeree
by means of an exchange of shares such that if the take-over offer is accepted, the shareholders of
the offeree would control the offeror;

Take-over offer
This means a general offer to acquire all voting shares in the offeree company and includes a take-
over scheme;

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 ADVANCED FINANCIAL MANAGEMENT

Take-over scheme
This means a scheme involving the making of offers for acquisition by or on behalf of a person of
(a) all voting shares in the offeree;

(a) such shares in any company which results in an offeror acquiring effective control in an
offeree;
(b) any shareholding of twenty five percent or more in a subsidiary of a listed company that has
contributed fifty percent or more to the average annual turnover in the latest three financial
years of the listed company preceding the acquisition; or
(c) any acquisition deemed by the Authority to constitute a take-over scheme.

Ultimate offeror

This includes a person -

(a) in accordance with whose directions and instructions the proposed offeror or any person
acting in concert with the proposed offeror is accustomed to act; or
(b) having an interest in the proposed take-over offer pursuant to an agreement, arrangement or

e
understanding with the proposed offeror.

pl
am
-S
e
.k
NATURE OF MERGERS AND ACQUISITION

o
.c
ya
en
Definition of merger

k
ea
When we use the term "merger", we are referring to the joining of two companies where one new
om
company will continue to exist. .s
w
The term "acquisition" refers to the purchase of assets by one company from another company. In an
w
w

acquisition, both companies may continue to exist.

However, throughout this topic we will loosely refer to mergers and acquisitions (M & A) as a business
transaction where one company acquires another company. The acquiring company (also referred to as
the predator company) will remain in business and the acquired company (which we will sometimes call
the Target Company) will be integrated into the acquiring company and thus, the acquired company
ceases to exist after the merger.

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 ADVANCED FINANCIAL MANAGEMENT

TYPES OF MERGERS

Mergers can be categorized as follows:

Horizontal: Two firms are merged across similar products or services. Horizontal mergers are often used
as a way for a company to increase its market share by merging with a competing company. For example,
the merger between Total and ELF will allow both companies a larger share of the oil and gas market.

Vertical: Two firms are merged along the value-chain, such as a manufacturer merging with a supplier.
Vertical mergers are often used as a way to gain a competitive advantage within the marketplace. For
example, a large manufacturer of pharmaceuticals may merge with a large distributor of pharmaceuticals,
in order to gain an advantage in distributing its products.

Conglomerate: Two firms in completely different industries merge, such as a gas pipeline company
merging with a high technology company. Conglomerates are usually used as a way to smooth out wide
fluctuations in earnings and provide more consistency in long-term growth. Typically, companies in
mature industries with poor prospects for growth will seek to diversify their businesses through mergers
and acquisitions.

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There are two types of mergers that are distinguished by how the merger is financed. Each has

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certain implications for the companies involved and for investors:

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Purchase Mergers

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As the name suggests, this kind of merger occurs when one company purchases another. The

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purchase is made with cash or through the issue of some kind of debt instrument; the sale is taxable.

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Acquiring companies often prefer this type of merger because it can provide them with a tax benefit.
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Acquired assets can be written-up to the actual purchase price, and the difference between the book
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value and the purchase price of the assets can depreciate annually, reducing taxes payable by the
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acquiring company. We will discuss this further in part four of this tutorial.

Consolidation Mergers

With this merger, a brand new company is formed and both companies are bought and combined
under the new entity. The tax terms are the same as those of a purchase merger.

REASONS FOR MERGERS AND ACQUISITIONS

a. Synergy
Every merger has its own unique reasons why the combining of two companies is a good business
decision. The underlying principle behind mergers and acquisitions ( M& A ) is simple: 2 + 2 = 5. The
value of Company A is Sh. 2 billion and the value of Company B is Sh. 2 billion, but when we merge the

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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 7

DERIVATIVES IN FINANCIAL RISK MANAGEMENT

INTRODUCTION
Risk can be defined as the chance of loss or an unfavorable outcome associated with an action.
Uncertainty does not know what will happen in the future. The greater the uncertainty, the greater
the risk. For an individual farm manager, risk management involves optimizing expected returns
subject to the risks involved and risk tolerance.

Risk is what makes it possible to make a profit. If there was no risk, there would be no return to the
ability to successfully manage it. For each decision there is a risk-return trade-off. Anytime there is a
possibility of loss (risk), there should also be an opportunity for profit. Growers must decide
between different alternatives with various levels of risk. Those alternatives with minimum risk may
generate little profit. Those alternatives with high risk may generate the greatest possible return but

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may carry more risk than the producer will wish to bear. The preferred and optimal choice must

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balance potential for profit and the risk of loss.

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Financial risk encompasses those risks that threaten the financial health of the business and has four

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basic components:

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1) The cost and availability of capital;

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2) The ability to meet cash flow needs in a timely manner;

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4) The ability to absorb short-term financial shocks.
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TYPES OF RISKS

1. Interest rate risk

Firms are exposed to interest rate risk in two ways:

1. The cost of existing borrowings (or the yield on deposits) may be linked to interest rates in
the economy. This risk exposure can be eliminated by using fixed rate products.
2. Cash flow forecasts may indicate the need for future borrowings/deposits. Interest rates may
change before these are needed and thus affect the ultimate cost/yield

2. Foreign exchange risk

Firms may be exposed to three types of foreign exchange risk:

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 ADVANCED FINANCIAL MANAGEMENT

Transaction risk
1. The risk of an exchange rate changing between the transaction date and the subsequent
settlement date on an individual transaction. i.e. it is the gain or loss arising on conversion.
2. Associated with exports/imports.

Economic risk
1. Includes the longer-term effects of changes in exchange rates on the market value of a
company (PV of future cash flows).
2. Looks at how changes in exchange rates affect competitiveness, directly or indirectly.

Translation risk
1. How changes in exchange rates affect the translated value of foreign assets and liabilities (e.g.
foreign subsidiaries).

3. Political risk
Political risk is the risk that a company will suffer a loss as a result of the actions taken by the
government or people of a country. It arises from the potential conflict between corporate goals and
the national aspirations of the host country.

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This is obviously a particular problem for companies operating internationally, as they face political

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risk in several countries at the same time.

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likely problems concern changes to the rules on the remittance of cash out of the host country to the

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holding company. Typical issues include the following:

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Exchange control regulations, which are generally more restrictive in less developed countries for
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example:
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1. Rationing the supply of foreign currencies which restricts residents from buying goods abroad
2. Banning the payment of dividends to foreign shareholders such as holding companies in
multinationals, who will then have the problem of blocked funds.
Import quotas to limit the quantity of goods that subsidiaries can buy from its holding company to
sell in its domestic market.
Import tariffs could make imports (from the holding company) more expensive than domestically
produced goods.
Insist on a minimum shareholding, i.e. that some equity in the company is offered to resident
investors.
Company structure may be dictated by the host government - requiring, for example, all
investments to be in the form of joint ventures with host country companies.
Super-taxes imposed on foreign firms, set higher than those imposed on local businesses with the
aim of giving local firms an advantage. They may even be deliberately set at such a high level as to
prevent the business from being profitable.
Restricted access to local borrowings by restricting or even barring foreign-owned enterprises
from the cheapest forms of finance from local banks and development funds. Some countries ration
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 ADVANCED FINANCIAL MANAGEMENT

all access for foreign investments to local sources of funds, to force the company to import foreign
currency into the country.
Expropriating assets whereby the host country government seizes foreign property in the national
interest. It is recognized in international law as the right of sovereign states provided that prompt
consideration at fair market value in a convertible currency is given. Problems arise over the
exact meaning of the terms prompt and fair, the choice of currency, and the action available to a
company not happy with the compensation offered.

4. Regulatory risk
Regulatory risk is the potential for laws related to a given industry, country, or type of security to
change and affect:
1. how the business as a whole can operate
2. the viability of planned or ongoing investments.

Regulations might apply to:

1. businesses generally (for example, competition laws and anti-monopoly regulations)
2. specific industries (for example, catering and health and safety regulations, publishing and
copyright laws).

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5. Fiscal risk

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Fiscal risk from a corporate perspective is the risk that the government will have an increased need

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to raise revenues and will increase taxes, or alter taxation policy accordingly. Changes in taxation

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will affect the present value of investment projects and thereby the value of the company.

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The primary requirement of a fiscal risk management strategy is an awareness of the huge impact tax
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can make to the viability of a project. Tax should be factored in to the calculations for all significant
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investment appraisal projects.

It is important not only to ensure that the tax rules being applied are up-to-date, but that any
potential changes in the tax rules are also considered. Investment projects may be intended to run for
many years and future changes (particularly those intended to close 'loopholes' in the taxation
system) could wipe out the expected benefits from the project.

Many larger firms will maintain a full time taxation team within the finance function to deal with the
tax implications of investment plans. Smaller companies are more likely to employ external tax
experts. In either case, a relevant tax expert should always be involved in the analysis of the project
and its sensitivity to the taxation assumptions should be carefully modeled.

vi) Operational risk

Operational risk is "the risk of a change in value caused by the fact that actual losses, incurred for
inadequate or failed internal processes, people and systems, or from external events (including legal
risk), differ from the expected losses".
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 ADVANCED FINANCIAL MANAGEMENT

It can also include other classes of risk, such as fraud, security, privacy protection, legal risks,
physical (e.g. infrastructure shutdown) or environmental risks.
Operational risk is a broad discipline, close to good management and quality management.

In similar fashion, operational risks affect client satisfaction, reputation and shareholder value, all
while increasing business volatility.

Contrary to other risks (e.g. credit risk, market riskand insurance risk) operational risks are usually
not willingly incurred nor are they revenue driven. Moreover, they are not diversifiable and cannot
be laid off; meaning that, as long as people, systems and processes remain imperfect, operational
risk cannot be fully eliminated.

Operational risk is, nonetheless, manageable as to keep losses within some level of risk tolerance
(i.e. the amount of risk one is prepared to accept in pursuit of his objectives), determined by
balancing the costs of improvement against the expected benefits.

FOREIGN CURRENCY RISK MANAGEMENT

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Many firms are exposed to foreign exchange risk - i.e. their wealth is affected by movements in

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exchange rates - and will seek to manage their risk exposure. This page looks at the different types

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of foreign exchange risk and introduces methods for hedging that risk.

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TYPES OF FOREX RISKS w
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1. Transaction risk
This is the risk of an exchange rate changing between the transaction date and the subsequent
settlement date, i.e. it is the gain or loss arising on conversion.
This type of risk is primarily associated with imports and exports. If a company exports goods on
credit then it has a figure for debtors in its accounts. The amount it will finally receive depends on
the foreign exchange movement from the transaction date to the settlement date.
As transaction risk has a potential impact on the cash flows of a company, most companies choose
to hedge against such exposure. Measuring and monitoring transaction risk is normally an important
component of treasury risk management.

The degree of exposure is dependent on:

(a) The size of the transaction, is it material?
(b) The hedge period, the time period before the expected cash flows occurs.

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 ADVANCED FINANCIAL MANAGEMENT

TOPIC 8

INTERNATIONAL FINANCIAL MANAGEMENT

INTRODUCTION
International financial management, also known as international finance, is the management of
finance in an international business environment; that is, trading and making money through the
exchange of foreign currency.

Compared to national financial markets international markets have a different shape and analytics.
Proper management of international finances can help the organization in achieving same efficiency
and effectiveness in all markets, hence without IFM sustaining in the market can be difficult.

Companies are motivated to invest capital in abroad for the following reasons
Efficiently produce products in foreign markets than that domestically.
Obtain the essential raw materials needed for production.

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Broaden markets and diversify

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Earn higher returns

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foreign investment

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INTERNATIONAL INVESTMENTS

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International investing is a type of investment that involves purchasing securities that originate in
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other countries. This type of investment is popular because it can provide diversification and
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opportunities for superior growth. There are many different ways to invest internationally including
through mutual funds, exchange traded funds (ETFs) and American depository receipts.
International investing is a procedure that many investors choose to get involved in by investing
money outside of their domestic market. For example, instead of holding a portfolio of only
domestic stocks and bonds, an investor could purchase some stocks from a foreign country or buy
shares of a mutual fund that specializes in international investment.

Types of international investments

There are several ways that you could choose to invest internationally. Mutual funds and exchange
traded funds are one of the most common methods.

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 ADVANCED FINANCIAL MANAGEMENT

Exchange-Traded Funds (ETFs);-These investments offer a wide variety of international flavors.

You can buy ETFs that track most of the major foreign indexes, and they allow investors to obtain a
return based on a specific foreign market without having too great of an exposure. Also, because
they trade and work like any other ETF, they aren't expensive to trade and are relatively liquid.

International Funds;-International stock funds are comparable to international ETFs as they also
provide for diversification but have same drawbacks and benefits that are associated with regular
funds and ETFs. In these international funds, a hired professional portfolio manager is in charge and
decides what to place in the portfolio.

Foreign Securities;-many brokerage firms will offer investors the ability to buy investments from
different countries directly from the brokerage's international trading desk.

Benefits of international investments

There are a few benefits that can be realized by investing internationally that may not come with
traditional investments. By investing internationally;
Potential for higher rates of growth abroad.

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Potential to lower overall risk in your portfolio.

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It has to be noted that there are some risks associated with international investing. One of the most

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prominent risks is the risk of changes in the exchange rate. If you invest in a foreign bond, for

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example, by the time you get your principal back, the exchange rate could have moved against you

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and your investment may not be as profitable as you had hoped. Many foreign companies also do

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not put out as much information for investors, so making an educated decision can be difficult.
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INTERNATIONAL FINANCIAL INSTITUTIONS

International financial institutions (IFIs) are financial institutions that have been established (or
chartered) by more than one country, and hence are subjects of international law. Their owners or
shareholders are generally national governments, although other international institutions and other
organizations occasionally figure as shareholders. The most prominent IFIs are creations of multiple
nations, although some bilateral financial institutions (created by two countries) exist and are
technically IFIs. Many of these are multilateral development banks (MDB).

Types
o Multilateral development bank
o Bretton Woods institutions
o Regional development banks
o Bilateral development banks and agencies
o Other regional financial institutions
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