ACCA P4 Key Point Notes December 2010

ACCA P4 Advanced Financial Management Key Point Notes December 2010
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ACCA
P4
Advanced Financial Management
Key Point Notes

December 2010
These notes are not intended to cover the whole syllabus, but target key examinable areas.
Prepared By:
Sunil Bhandari
Tutor Contact Details

Mobile: 00(+)44 7833 438771
E-mail:
[email protected]
Copyright to Sunil Bhandari
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Use of these Key Point Notes

These notes have been prepared exclusively for use as a
revision aide. They cover the major topics in the current
syllabus as well as showing the way in which these have
been tested in all of the past papers. In addition, the notes
now accrue for the expected change in style of the P4 exam
as outlined in Shish Malde’s article. I have also encapsulated
my knowledge gained from marking the P4 June 2010 exam.
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Contents
Chapter Chapter Name
Number
Preliminaries
Chapter One Financial Objectives-Review of F9 Knowledge
Chapter Two Cost of Capital
Chapter Three Risk Adjusted WACC

Chapter Four Capital Structure and Raising Finance
Chapter Five Dividend Policy
Chapter Six Advanced Investment Appraisal I
Chapter Seven Advanced Investment Appraisal II
Chapter Eight Valuations of Options & Value at Risk
Chapter Nine Risk Management
Chapter Ten Foreign Currency Risk Management

Chapter Eleven Interest Rate Risk Management
Chapter Twelve Business Valuation & Mergers & Acquisitions
Chapter Thirteen Company Performance Analysis

Chapter Fourteen Corporate Reconstruction & Reorganisation
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Exam Formulae and Tables
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Please note that FOREX Modified BSOP will NOT be examined

in December 2010 as it has been removed from the June
2011 formulae sheet.
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My Summary
• Strong Link To F9
• Core Topics will make up most of the paper
• Questions will be Scenario Based and Longer
• More Analytical Skills needed less Technical Difficulty
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Chapter One
Financial Objectives-
Review of F9 Knowledge
1 Primary Financial Objective
1.1 For profit making business “Maximise Shareholder(S/H)

Wealth”
1.2 To Measure S/H wealth
Value of Equity (Ve) =Number of issued Equity/Ordinary

Shares X Current Market Price (Po)
1.3 To find Po:
 Given in the Question if it is a listed company(see

below)
 Compute Using:-
• Dividend Valuation Model(DVM)

• Earnings Based Models(PE)
1.4 Check the question very carefully for the size of the
company is it:-
 Listed
 Private Company
Make your comments relevant to the size and

nature of the company stated within the
question.
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2 Indicators
2.1 Financial indicators pointing towards maximising S/H

wealth include:-
 Earning per share(EPS)

 Dividend per share(DPS)
 Return on Capital Employed(ROCE)
 Return on Shareholder Capital(ROSC)
 Profit after tax
 Revenue
2.2 Non-Financial Indicators include:
 Market Share
 Customer Satisfaction
 Quality Measures
The above are all Key Performance Indicators (KPI’s)

that need to be measured and reviewed on a regular
basis by the board of directors. (Board)
3. External Factor Affecting Ve & Po
3.1 The Board cannot control all aspects that effect

Ve and/or Po. One of the major factors is macroeconomic
variables.
3.2 Economic Variables -what are they and how may

directional changes effect the share price?
3.2.1 Interest Rates- If they fall:-
 Stimulate demand and revenue

 Lower the cost of debt and improve profits
 Investors switch to share market for better returns
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3.2.2 Inflation Rates- If it rises:-
 Costs rise causing a drop in profits

 Cause interest rates to rise.
 Devalues the home currency
3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-
 Reduce cash receipts for exporters

 Lowers the cost for importers
 Discourage exporting
3.2.4 Gross Domestic Product- If it falls:-
 Reduce demand and revenue

 Cause interest rates to fall to stimulate demand
3.2.5 General Taxation –If it rises:-
 Damage company profits

 Not encourage investment by companies
 More savings from tax effect of tax allowable
depreciation.
Important to relate your comments to the effect upon Po

& Ve .
3.3 Agency Problem
3.3.1 S/H are the owners of the company and expect

their directors (agents) to take decisions to maximise
S/H wealth. The agency problem occurs when directors
take decisions that DO NOT lead to maximising S/H
wealth.
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3.3.2 Examples of decisions that ‘may’ damage S/H wealth:
 Directors pay
 Taking high risk business decisions
 Non-payment of dividends
 Using debt finance (against the wishes of the
S/H)
3.3.3 Solutions to this problem include:
 Company Law
 Corporate Governance (eg UK Combined Code)
 Share Options (ESOPS)
3.3.4 ESOPS
This provides a way of rewarding Directors by

granting them options to buy shares in their company
at a fixed price. They can buy the shares in future
(normally 1 year) at the fixed price which usually is
today’s price.Hence, directors are encouraged to take
decisions to maximise future share prices. This
benefits both the directors and the shareholders.
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4 The Three Key Decisions
4.1 To maximize S/H wealth the board must take
 Investment
 Finance
 Dividend
4.2 Investment
4.2.1 Allocate cash for:-
 Organic Growth (Projects)

 Acquisitions
4.2.2 Must always consider how investments

impact upon:-
 Company Liquidity
 Future Profits and Asset values
 Business Risk Profile i.e. effect upon
variability of the cash flows and profits.
4.3 Finance
4.3.1 To finance investments the board have to

decide the best balance of equity and debt.
4.3.2 They will consider:-
 Cash available within the company

 Access to new sources of finance
 Impact on KPI’s like gearing
ratio(Debt:Equity)
 Cost of Finance (WACC)
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4.4 Dividends
4.4.1 The Board needs to establish a dividend policy –

see Chapter 5
4.5 The three decisions are interlinked.
Example: New projects need new finance but must

generate cash to service the finance providers
including paying dividends to the shareholders.
5 Objectives of Not-For-Profit- Organisations (NFP)
5.1 These include:
 government funded functions(“Public Sector”)

 charities
 trade unions
5.2 With no shareholders it is important to ascertain.
a) who are the main stakeholders?

b) what are there objectives?
5.3 It is widely recognised that NFP entities should

demonstrate the principles of “Value for money”(VFM)
The indicators are:-
1) Economy - lowest cost of input resources

2) Efficiency - ratio of input to output measures
3) Effectiveness - how outputs are measured.
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5.4 For example, in a government funded school measures

could be:-
Economy - cost of teachers

- cost of admin
Efficiency - cost/pupil
- Number of pupils/teacher
Effectiveness - pass rates

- number of pupils moving to higher
education
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Chapter Two
Cost of Capital
1 Weighted Average Cost of Capital (WACC)
1.1 This is the formula given on your formula sheet.
1.2 The Symbols:-
 Ke= Cost Of Equity
 Kd(1-t) = Post Tax Cost of Debt
 Kd= Yield to maturity on debt or Pre Tax Cost of Debt
 Ve=Market value of the Equity Capital.
 Vd= Market Value of the Debt Capital
 t= Corporation tax rate
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1.3 Some past P4 answers used the following symbols:-
WACC= Were + Wdrd(1-t)
 We= Ve or (1-Wd)
Ve+Vd
 W d = Vd or (1-We)
Ve+Vd
 re=Ke=Cost Of Equity
 rd(1-t)=Kd(1-t)=Cost of Debt
Therefore, it’s the same Formula!!
2 Cost of Equity (Ke, re)
2.1 Formulae are given in the exam as:-
a)
This can be simply presented as:-
Ke or re =Rf +βe(Rm-Rf)
b)
This you have to rearrange to:-
re=Do(1+g) +g
Po
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c)
This latter formula applies under M&M assumptions with tax.

(see later)
2.2 Lets clear up the additional symbols to those listed under

2.1 above:-
Rf=Risk Free Return

Rm= Return on the Market Portfolio
βe=Systematic Risk being faced by the
shareholders.
Do=The dividend per share (DPS) today or last paid.
g = Constant annual growth rate in dividends.
Po =Share price currently
Kei= Cost of equity assuming all equity position.
(Rm-Rf)= Equity Risk Premium.
2.3 Remember from F9 if you are going to we
Ke= DO(1+g) +g
PO
You need to find g
There are two ways:-
i) Historic Estimate - example
Year End Dividend per share

$
2007 0.24
2008 0.27
2009 0.29
2010 0.32
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g= 3√(0.32/0.24) -1
g=10%
ii) Gordon Growth Model
g=bre
b= the proportion of profits retained by the

business.
re= the accounting rate of return (ARR)
Example
A company has an ARR of 12% and pays out 30% of

its profits as a dividend.
g=0.70 x 0.12=0.084
2.4 At P4 level, the Gordon Growth Model can be extended

such that if re is the cost of equity, a LONGTERM
growth rate is computed.
Example
If Ke=11%
g= 0.70 x 0.11= 0.077
2.5 If using CAPM, the βe must reflect the company’s

systematic business and financial risk. Skills taught at
F9 are needed at P4.
 Degear βe’s to find βa

 Regear βa’s to find βe
We can remove the financial risk element via
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βa = Asset Beta, measure of systematic business risk

βd= Debt Beta (Often nil)
Example
βe is 1.95 Vd:Ve 1:4
t= 30% βd=NIL
Find βa
βa = 4 x 1.95
4+1(1-0.30)
= 4 x 1.95
4.7
= 1.66
If the company operates on a divisional basis and 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.
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Example
ABC is made up of two divisions
Division Asset βeta Proportion of the

Business
Food 0.75 40%
Clothes 1.80 60%
The company gearing level is 32%.
Tax =25%
βa=(0.75 x 40%)+(1.80 x 60%)
= 1.38
1.38 = 68 x βe
68+32(1-0.25)
1.38= 68 x βe
92
βe =1.87
3 Post Tax Cost of Debt (Kd(1-t) or rd(1-t))
3.1 Kd or rd is the yield or minimum return for the debt

holder – pre tax cost of debt.
Kd(1-t) or rd(1-t) is the post tax cost of debt for the

company.
3.2 To find the cost of debt we need to look at the type of

debt finance – skills taught at F9.
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3.3 Bank Loans
Kd(1-t)=Interest % x (1-t)
Example
A company has a 11% Bank Loan .Tax =30%
Kd(1-t)=11 x (1-0.30)=7.7%
3.4 Traded Bonds-Irredeemable
Kd(1-t)=Ints x (1-t)
Po
Remember Po is the market value per block of $100.
Example
9% Bonds trading at $89 t=30%
Kd(1-t)= 9 x (1-0.30) = 7.1%

89
3.5 Traded Bonds-Redeemable
Kd(1-t) is an IRR computation based upon
Time $
To Po (X) Take two guesses
T1-Tn Ints X(1-t) X like 10% and 1%
Tn Capital X and do an IRR
Repayment
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3.6 The main method used in the P4 exam is:-
Kd(1-t)=(Yield on similar Government debt + Credit Risk

Premium) x (1-t)
Example
Table of credit spreads for industrial company bonds in Basis

Points (BP=0.01%).
Rating 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
AAA 5 10 15 22 27 30 55
AA 15 25 30 37 44 50 65
A 40 50 57 65 71 75 90
BBB 65 80 88 95 126 149 175
BB 210 235 240 250 265 275 290
B+ 375 402 415 425 425 440 450
The current return on 5-year treasury bonds is 2.8%. F plc

has equivalent bonds in issue but has an A rating.
calculate the expected yield on F’s bonds

(i)
find F’s cost of debt associated with these bonds if
(ii)
the rate of corporation tax is 30%
(i) Yield =2.8+0.65 =3.45%

(ii) Kd(1-t)= 3.45% x (1-0.30)
= 2.42%
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3.7 MARKET VALUE OF TRADED BONDS
As can be seen above the market value of debt (Po) is

given per block of $100 we need this to find Vd .This
may have to be computed using the Dividend Valuation
Model (DVM).
i.e Po=Present Value of all future cash flows discounted

at the yield to maturity for the relevant debt.
Example
$20 m 7% Bond will be redeemed in 3 years at par

($100). Yield to maturity is 5.25%.
NB: Don’t forget that discount factor tables also show

formulae at the top of each table.
On the PV Table the formula is
(1+r)-n = 1
(1+r)n
Hence the Po=
$7 + $7 + $7+$100
2
1.0525 1.0525 1.05253
6.65 + 6.32 + 91.77
= $104.97
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4 Use of WACC
4.1 The WACC is the nominal cost of capital to be used in

advanced project appraisal involving DCF methods.
i.e. NPV
IRR
MIRR
4.2 The nominal cost of capital has the symbol “i” at P4 and
can be found via:-
4.3 The WACC is only useable providing:-
 The project under consideration is a core activity of the

company.
 The project finance will not significantly change the

current gearing ratio of the entity.
4.4 If the new project is a NON CORE Activity but the project
will have no significant effect upon the company’s
gearing ratio then the nominal cost of capital to use is
the RISK ADJUSTED WACC.
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Chapter Three
Risk Adjusted WACC

1 When do we use this?
As stated in Chapter Two above if the:-
a) Project is a non-core one

b) Will have no effect upon the company’s gearing ratio
2 Approach
a) Find an equity βeta for the industry relating to the

project.
b) Degear βe to find the asset βeta.
c) Re-gear βa to find the project equity βeta . Use either:-
i. The company’s existing gearing level or
ii. The specified gearing level post project
d) Use the answer to (c) above known as the project βe in

CAPM to find the project Ke
e) Find the relevant Kd(1-t)
f) Use WACC Formula, project Ke, Kd(1-t) and gearing

level stated in (c) i) or ii) above to find the Risk
Adjusted WACC-a nominal cost of capital.
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3 What to do if WACC or Risk Adjusted WACC can’t be used.
This can happen if:-
i. Project is core or non-core.
ii. Project Finance will significantly change the

company’s gearing ratio.
iii. Finance may include subsidised loans-lower interest

rate than market rate.
Solution lies in Adjusted Present Value (APV)-covered

later in the notes.
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Chapter Four
Capital Structure and

Raising Finance
1 Introduction
How should the company decide the mix of

equity and debt capital?
2 Practical Issues
If the company uses Debt capital funding it should

consider:-
Credit Rating of the company

Rate of interest it will pay
Market conditions- access to Debt capital
Forecast Cash Flows-to service and repay the debt.
Level of Tangible Assets on which secure the loans.
Interest will lead to tax savings i.e Tax Shield
Constraints on the level of debt from
a) Articles Of Association
b) Loan Agreements.
 Effect upon the company gearing ratio
Debt/Equity+Debt OR Debt/Equity
 Will the debt providers exercise influence over the

company?
 The chance of bankruptcy.
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3 Theories of Optimal Capital Structure
3.1 Common Ground-both major views accept two facts:-
a) Yield<Ke
b) Gearing causes Ke to rise
3.2 Traditional View
% Ke
Cost
Of
capital
WACC
Kd
0 X Gearing
Key Points:-
1) Ke rises due to financial risk caused by gearing.

2) Kd is initially uneffected by gearing but rises at “high”
gearing levels due to the perception of the possibility of
bankruptcy.
3) WACC-trade off of Ke and Kd. Point X is the optimum
gearing level where WACC is lowest.
4) Once point X is reached via trial and error it must be
maintained.
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3.3 MM and Tax
% Ke
Cost of
Capital
WACC
Kd
0 Gearing
Key points:-
1) Assumption behind the model:-
 All debt is risk free

 Only corporation tax exists
 Debt is issued to replace Equity
 All types of debt carry one yield, the risk free
rate
 Full distribution of profits
 Perfect Capital Market
2) MM concluded companies should gear up to the

maximum levels.
3.4 Specific Equations can be used under MM+ Tax theory.
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Vd=Vu+VDT
WACC=Keu{1-T x Vd}
(Ve+Vd)
Only the latter is given on the formulae sheet.
4 Pecking Order Theory
In this approach, there is no search for an optimal capital

structure through a theorised process. Instead it is argued
that firms will raise new funds as follows:-
 Internally-generated funds
 Debt
 New issue of equity
Firms simply use all their internally –generated funds first

then move down the pecking order to debt and the finally to
issuing new equity. Firms follow a line of least resistance that
establishes the capital structure.
Internally –generated funds-i.e. retained earnings.
 Already have funds.

 Do not have to spend any time persuading outside
investors of the merits of the project.
 No issue costs.
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Debt
 The degree of questioning and publicity associated with

debt is usually significantly less than that associated
with a share issue.
 Moderate issue costs.
New issue of equity
 Perception by stock markets that it is possible sign of

problems. Extensive questioning and publicity
associated with a share issue.
 Expensive issue costs.
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Chapter Five
Dividend Policy
1 Introduction
To maximise S/H wealth the Board should establish a

dividend policy-the payment pattern to the equity investors.
2 Theories
Several theories have been put forward to assist:-
2.1 Residual – If spare cash exists at the end of the year pay
dividend.
2.2 Pattern – Be consistent with dividend payments. Either
a) Pay the same dividend per share (DPS) each year.

b) Maintain the payout ratio (DPS/EPS)
c) Maintain the same year-on-year growth rate in
dividends. The latter links into the Po via the
dividend valuation model (DVM)
2.3 Irrelevancy (M&M)
In a perfect capital market providing the directors can

invest in projects with a positive NPV no dividends
are required. The Ve will rise and the S/H can sell shares
to create the cash the need(Manufacture Dividends).
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3 Practical Considerations
There are many to consider:
 Availability of cash
 What dividends do S/H want (clientele effect)?
 Signalling effect –payment of dividends indicates a
healthy company
 Retaining cash is a key source of finance.
 Dividend growth should be greater than inflation
 Tax impact upon S/H
 Effect the dividend will have on dividend
cover(EPS/DPS)
 Number of investment opportunities will restrict
dividend payments.
 Risk-paying now is safer than promising to pay next
year
 Is the dividend within the company law regulations?
4 Alternatives to Cash Dividends
4.1 Scrip Dividends
4.1.1 The S/H will receive extra shares instead of cash on a

pro rata basis.
4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.
4.1.3 The effect will:-
a) Increase the issued equity capital

b) Dilute EPS and Po values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue
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4.2 Share Buy Back
4.2.1 If the board has “one off” period of excess cash, they
could consider a share buy back.
i.e. Buy back shares at Po and cancel them.
4.2.2 Considerations:-
a) Allowable under company law.

b) Increase gearing as Ve may fall.
c) Tax implications for the S/H(CGT)
d) Reduced number of shares will cut supply for
trading purposes.
e) Less dividend pressure on the board in future.
f) Criticism-is this the best use of company cash.
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Chapter Six
Advanced Investment
Appraisal I
1 NET PRESENT VALUE OF FREE CASH FLOWS (FCF)
1.1 Free Cash Flows (FCF)
 The cash is available after expenditure and

reinvestment into the business.
 Computed two ways:-
1) Incremental cash flow approach
Revenue – Costs – Tax -Capex + Scrap Value - Asset

Replacement Spending – Working Capital Injection + Tax
saved on Tax Allowable Depreciation.
2) Adjusting Accounting Profit
Net operating profit (before X

interest and tax)
Plus Depreciation X
Less Taxation (X)
Operating cash flow X
Less Investment:
Replacement non-current (X)
asset investment(RAI)
Incremental non-current (X)

asset investment(IAI)
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Incremental working capital (X)

investment(IWCI)
Free cash flow for the X used in NPV comps
company
Debt Interest (X)
Debt Repayments (X)
Debt Issues X
FCF to equity X used to value equity in
certain business valuation
models.
1.2 Skills Learned at F9
Remember, Shish has clearly stated in his article that you

must remember the skills taught to you at F9.They are:
Relevant Cash Flows
Inflation
Taxation
Working Capital
Financial Maths
1.3 Relevant Cash Flows
 Incremental –caused by the project
 Future –still to occur
 Exclude:-
1) Sunk Costs
2) Finance Charges
3) Dividends
4) Non-Cash flows
5) Non-incremental fixed overheads
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1.4 Inflation (Symbol h)
Two acceptable approaches based upon matching the

cash flow to the cost of capital.
“Include”
• Cash Flows must be given in nominal terms or must

be converted into nominal terms using
Nominal CFn=Real CFn X (1+h)n
• Cost of capital must be nominal (symbol i) which

will:-
a) Given in question
b) WACC or Risk Adjusted WACC Formula /Method
c) Fisher Formula
(1+i) = (1+r) (1+h)
“Exclude”
• Cash flows are given in real terms or can be

converted into real terms.
Real CFn= Money x CFn

(1+h)n
• Cost of Capital has to be in real terms (r) which will

be given or to rearrange the Fisher Formula
(1+r)= (1+i)
(1+h)
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The “exclude” method is used when it makes practical sense

to do so. For example, the cash flow is a long annuity or
perpetuity.
1.5 Taxation
This is a relevant cash flow to be included in the FCF

schedule. Two acceptable approaches:-
• “One Line” tax flows

• “Two Line” tax flows
“One Line” tax Flow
This was in Shish’s sample question. The FCF schedule

shows only one line for tax.
A tax working is required:-
$’000
Incremental Revenue XXX Netted are

operating
Cash flows
Incremental Costs (XXX)
Tax Allowable Dep’n (XXX)
Taxable Profit XXX
Above x Tax Rate = Tax Cash Flow
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“Two Line” tax Flows
After chatting with Shish, he said that this method is

perfectly acceptable as it was used in many past F9
questions.
Here:-
• Tax is computed on Operating Cash Flows.
• Tax saved on tax allowable depreciation is shown on a

separate line.
Both “One Line” and “Two Line” will give the same yearly
FCF’S.
Finally,
READ THE QUESTION CAREFULLY RE TIMIMG OF TAX

DUE.
1.6 Working Capital
 Think as it is a project bank account.
 Invest, Adjust, Close!!
eg
$’000 T0 T1 T2 T3
WC needed - 100 170 300
Relevant (100) (70) (130) 300
Cash Flows
These go into the NPV

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1.7 Financial Maths
A quick reminder
a) 5 year discount Factor at 12%
From tables, 0.567
b) 8 year annuity factor at 7%
From tables, 5.971
c) Perpetuity Factor at 11.2%
1
= 8.928
0.112
d) Annuity Factor starting at time 4 stopping at time 9 at

8%
AF4-9 = AF1-9 – AF1-3

= 6.247-2.577=3.67
e) The present value of a cash flow starting at T5 at $200

then growing in perpetuity at 2% at 12% cost of capital.
1 x DF3
r-g
1 X .712
0.12-0.02
= 7.12
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2 Layouts
Two options depending upon the nature and style of the

FCF’S
Format A (Assuming One Line Tax)
Time
$’000 T0 T1 T2 T3 T4 T5
Revenue - X X X X
Materials - (X) (X) (X) (X)
Labour - (X) (X) (X) (X)
VOH - (X) (X) (X) (X)
Incremental - (X) (X) (X) (X)
FOH
Operating - X X X X
CF
Tax(w1) - - (X) (X) (X) (X)
Capex & (X) - - - X

Scrap
W Capital (X) (X) (X) (X) X
FCF (X) X X X X (X)
i% 1.0 X X X X X
PV (X) X X X X X
NPV $ XXX
Format B
Time $’000 % PV$’000

T0 (X) 1.0 (X)
T1-T30 X X X
T2-T31 (X) X X
T32 X X X
NPV $XXX
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Chapter Seven
Advanced Investment
Appraisal II
1 IRR
1.1 Internal Rate of Return is the cost of capital that gives

an NPV of NIL
1.2 Example
NPV @ 10% = $30K

NPV @ 20% = ($160K)
IRR=10 + ( 30 ) x (20-10) =11.6%

30-(-160)
1.3 IRR has weaknesses:-
a) Cannot be used to compare mutually exclusive projects.
b) Multiple IRR’s exist
when the cash flow pattern is not standard

ie Standard Pattern -,+,+,+,+
Non-Standard Pattern -, +, +, +,-
1.4 MIRR is a measure that gives an NPV of nil but will lead
to a project decision rule consistent with NPV.
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2 Computing MIRR
2.1 Class Illustration
Time $’000
T0 (1000)
T1 400 Return phase
T2 600 of the project
T3 300
Cost of Capital=10%
2.2 Using The Formula
NPV had been computed at 10%.
Time $ 10% PV
T0 (1000) 1.0 (1000)
T1 400 0.909 363.6 *
T2 600 0.826 495.6
T3 300 0.751 225.3
84.5
* PV of Return Phase=$1084.50
Formula given
PVR=PV of Return Phase Cash Flows

PVI=PV of Investment Cash flows
re=Cost of Capital
n= Year of the final cash flow
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MIRR= (1084.50)1/3 (1.10)-1

1000
=13%
Alternative Method:
a) Terminal value of Return Phase cash flows.
Time $’000
T1 400 X 1.102= 484
T2 600 X 1.10 = 660
T3 300 X 1.0 = 300
1444
Therefore, we now have a revised set of cash flows
T0 (1000)
T3 1444
MIRR is the discount rate that causes an NPV of nil.
MIRR = r
1444 - 1000=NIL
(1+r)3
Therefore, 3√1444 -1 =13%

1000
Both NPV rule and MIRR rule indicate project is worthwhile.
2.4 Problems with MIRR
 Both NPV and MIRR assume cash flows from a project

are reinvested at re.This may not be the case.
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 MIRR may itself have to be “modified” to accrue of

variable reinvestment rates.
 Defining the “Investment Phase”. Per Q1 Dec 08 two

definitions were possible giving slightly different
answers.
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3 Foreign Investment Appraisal
3.1Predicting future spot rates via formulae provided:-
S1=F0=Future Spot Rate

S0=Spot Rate Today
hc=Inflation Rate abroad
hb=Inflation Rate home
ic=Interest Rate abroad
ib=Interest Rate Home
3.2 Double Taxation-the golden rule is you must pay the

higher of the two rates
3.3 Format-one line tax layout is best here to accrue for

double tax.
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3.4 Suggested Layout – FCF
Foreign Currency T0 T1 T2 T3 T4
Revenue - X X X X
Costs - (X) (X) (X) (X)
T.A.D(not a C.F) - (X) (X) (X) (X)
Foreign Profit - X X X X
Foreign Tax - (X) (X) (X) (X)
Add:
TAD(above) - X X X X
CAPEX & Scrap (X) - - - X
W.C. (X) (X) (X) (X) X
Foreign FCF (X) X X X X

Spot Rates X X X X X
Home Currency (X) X X X X
Cash Flows
Additional Home
Tax (X) (X) (X) (X)
FCF (X) X X X X
4 Adjusted Present Value (APV)
4.1.1 APV is a NPV method to be used when:-
 Project is core or non-core activity

 Specific debt finance is being use on a project.
 Subsidised interest exists on the project debt finance.
4.1.2 APV is still the change in shareholder wealth arising

from the project.
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4.2 Method
 Establish the βasset for the project.

 Using the βasset in CAPM find Keu (all equity Kei)
 Discount the relevant project cash flows using Keu to
find the base case NPV
 Establish the yield on the debt
 Find PV of the issue costs (possibly post tax) using
yield as a discount rate.
 Find PV of the tax savings on the interest paid on the
loan finance raised using the yield as a discount rate
4.3 Subsidised Loans
4.3.1 If any part of the loan Finance is at a subsidised rate,

then the APV must include an extra benefit.
4.3.2 PV of the post tax subsidy discounted at the pretax cost

of debt.
APV
$m
Base case NPV X

PV of issue costs (X)
PV of tax savings on interest X
PV of net of tax subsidised interest X
APV X
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5 Capital Rationing
5.1 When there is a lack of sufficient cash to invest in all

projects with a positive NPV
5.2 Cash can be restricted due
a. “Hard” Reasons –external constraint eg Credit Crunch.

b. “Soft” Reasons –internal restrictions eg Capex Budget
Single Period-Divisible Projects
5.3 Compute the Profitability Index (PI) for each project.
PI= NPV
Cash outlay in critical period
5.4 Rank the projects based upon the PI
Example
ABC inc has $30m to spend today and has the following
projects available:-
Project Spend-Today NPV

$m $m
A 22 67
B 17 25
C 40 65
D 18 36
What are the PI’s?
a. 67/22=3.05
b. 25/17=1.47
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c. 65/40=1.63
d. 26/18=2.00
Multi-period-Divisible Projects
5.5 This is when cash is restricted in more than one period.

You must understand that the aim will be to maximise the
wealth of the shareholders but stay within the cash limits
each year. Also, some projects can “cross fertilise” – meaning
that they generate positive cash flows which can fund those
with deficits. Deposit accounts can be used to carry cash
forward into future periods.
5.6 A optimum solution can be found using linear

programming (divisible projects) and integer programming
(non divisible projects).
6 Dealing with Risk within Investment Appraisal
6.1 Sensitivity Analysis
6.1.1 Remember from ACCA F9 that this is defined as change

one variable within the project and cause the NPV to go from
positive to nil.
6.1.2 A “quick” way to compute the sensitivity margin%:-
For any Cash Flow
NPV x 100
PV Of Cash Flow
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For Cost Of Capital
IRR – Cost of Capital x 100

Cost of Capital
Example
Time $’000 10% PV $’000

T0 Capex (1000) 1.0 (1000)
T1-T5 400 3.791 1516
Revenue
T1-T5 Cost (20) 3.791 (76)
T5 Scrap 200 0.621 124
NPV 564
What are the sensitivity margin % for
 Revenue
 Capex
Revenue = 564 = 37%

1516
CAPEX = 564 =56%

1000
6.2 Simulation
“The assessment of the volatility (or standard deviation)

of the net present value of a project entails the
simulation of the financial model using estimates of the
distributions of the key input parameters and an
assessment of the correlations between variables. Some
of these variables are normally distributed but some
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(such as decommissioning cost) are assumed to have

limit values and a most likely value. Given the shape of
the input distributions, simulation employs random
numbers to select specimen value for each variable in
order to estimate a ‘trial value’ for the project NPV. This
is repeated a large number of times until a distribution of
net present values emerge. By the central limit theorem
the resulting distribution will approximate normality and
from which project volatility can be estimated.
In its simplest form, Monte Carlo simulation assumes

that the input variables are uncorrelated. However, more
sophisticated modelling can incorporate estimates of the
correlation between variables. Other refinements such as
the Latin Hypercube technique can be reduce the
likelihood of spurious results occurring through chance in
the random number generation process. The output from
a simulation will give the expected net present value for
the project and a range of other statistics including the
standard deviation of the output distribution. In addition,
the model can rank order the significance of each
variable in determining the project net present value.”
(These are the words of Shish)
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Chapter Eight
Valuation of Options
+Value at Risk
1 Valuation of Options
1.1 An option gives the holder the right, but not the
obligation to buy or sell a share at a fixed price on a
specified future date.
Details and terminology: -
(a) Put – right to sell.
(b) Call – right to buy.
(c) Exercise price / strike price – price at which shares

can be bought or sold.
(d) Expiry Date – date on which the option can be

exercised (European type option).
Our aim is to find the value of the options on the

open market.
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1.2 Components of Option Value
Intrinsic value and time value
There are 5 main components to the value of an option
(a) Intrinsic value, the difference between
(i) The current price of the asset(Pa)
(ii) The exercise price of the option(Pe)
(b) The time value of the premium, reflecting the

uncertainty surrounding the intrinsic value between
now and the exercise date. Relevant factors:
(i) Variability in the daily value of the asset

(currency, interest etc)(s)
(ii) Time until expiry of the option (a later expiry

date having greater risk)(t)
(iii) Interest rates (since cash flows occur at two

different times)(r)
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The Black Scholes Option Pricing Model
1.1 The above five factors have been built into the Black-
Scholes formula to find the value at time 0 of a
European call option. (c).
All three formulae are given in the tables but you must
know what the symbols stand for.
Symbols:
Pa=share price
Pe=exercise price option
r =annual (continuously compounded) risk free rate of

return
t =time to expiry of option in years
s =share price volatility, the standard deviation of the

rate of return on shares
e =the exponential constant 2.7183

In =natural logarithm On Your calculator!!
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d1 & d2= Compute to two decimal places.
N(d1)& N(d2)=the cumulative value from the normal

distribution tables for the value d1 or d2.Read the
bottom of the tables very carefully.
Example
The current share price of B plc shares=$100

The exercise price =$95
The risk free rate of interest = 10%pa =0.1
The standard deviation of =50% =0.5
return on the shares
The time to expiry =3 months=0.25
1) e-rt
rt =0.1 x 0.25 = 0.025
e-0.025 =0.975
2) N (d1) & N (d2)
d1= In(100/95)+(0.10+0.5 x 0.52 )0.25

0.5 x √0.25
d1 = 0.0513 + 0.05625 =0.43

0.25
d2 =0.43-0.25=0.18
N (d1) = 0.50+0.1664=0.6664
N (d2) = 0.50+0.0714=0.5714
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3) C
C = (100 x .6664) - (95 x 57.14 x .975)
= $ 13.71
1.3 Put-call parity
Black Scholes’ model will only calculate the value of a

call option. The value of a call option, a put option, the
exercise price and the share price are related (where
the put and call have the same strike and exercise
date):
Find the value of the put option
Example
p = 13.71-100 + (95 x .975)
= $6.34
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2 The Delta Hedge
Delta hedging is used by options traders who have

written options and wish to calculate how many shares
they need to hold to hedge their position. If the delta is
0.7 they will need to hold 0.7 shares for every option
written.
The delta also measures how many shares one option
will ‘cover’ if used to hedge a holding of shares.
3 Black and Scholes applied to Investment Appraisal.
3.1 Real options on projects
 Delay/Defer the project

 Switch /redeploy resources
 Expand/contract the project
 Option to abandon.
3.2 Use the normal BSOP equations but:-
Pa= PV of future Cash Flows
Pe= Given or CAPEX
R= Risk Free Rate
t= time to expiry (in years)
s= standard deviation
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4. Value at Risk (VaR)
4.1 VaR is a measure of how the market value of asset or a

portfolio of assets is likely to decrease over certain time, the
holding period (usually 1 to 10 days), under normal
conditions.
4.2 Used by Investment banks to measure the market risk of

their portfolios.
4.3 Confidence levels are normally set at 95% or 99%.
Example
A bank has estimated the expected value of its portfolio in 2

week time will be $50m.with standard deviation of $4.85m.
At 95%,what is VaR?
45% 50%
$50m
s=$4.85m
$ 50m-(1.65 X $4.85m) =$42m
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There is a 5% chance that the portfolio will fall below

$42m.
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Chapter Nine
Risk Management
1 Introduction
1.1 I expect Shish may well write an article on this topic as

guidance. I would guess that it will cover how he
expects students to deal with this topic at P4 level. This
chapter has been written in anticipation of that article.
1.2 Risk Management is a substantial part of ACCA P1. A lot

of that knowledge will be required here but with some
emphasis on particular areas.
2 Summary of P1
2.1 Sources and impacts of common business risks
 market
 credit
 liquidity
 technological
 legal
 health and safety
 reputation
 business probity
 derivatives
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2.2 Approach to risk management
 Identify
 Assess
 Measure
 Avoid
 Accept
 Hedge/Reduce Effect
3 P4-Main Risk Categories
3.1 At this level there are four major areas of risk:-
 Business Risk
 Financial Risk (Chapter 4)
 Foreign Currency Risk (Chapter 10)
 Interest Rate Risk (Chapter 11)
4 Business Risk
4.1 Defined as being the cause of variations in:
 Company profits
 Returns to a shareholder
It is related to:
i. Nature of business activity

ii. Level of operational gearing –amount of fixed costs that
make up the operational cost base.
4.2 Total business risk is measured using the standard

deviation σi. Hand in hand goes expected return Ri.
4.3 Business risk can be managed or reduced initially using

“Portfolio Theory”.
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5 Portfolio Theory(PT)
5.1 PT can be used by
 Directors-combine business activities logically

 Shareholders- create a logical share portfolio
5.2 PT relies upon the basic concept that if shares or

business activities that are combined are LESS THAN
PERFECTLY CORRELATED, risk can be reduced
5.3 The correlation coefficient is a key value and its range is:
-1 0 +1
Perfect No Correlation Perfect

Negative Positive
Correlation Correlation
5.3 When two “investments” are combined PT Formulae

exist to:-
Sp= Risk of the portfolio
Return from = (Ra x Wa) + (Rb x Wb)

the portfolio(Rp)
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6 Extend PT-more investments
6.1 The above only assumes that two investments are

combined. Naturally the more the investments are added
the lower Sp should go.
6.2 Sp does not reach nil
Market Portfolio
Sp
Unsystematic
Risk
Systematic Risk
20
No of investments
6.3 PT removes one part of Sp –unsystematic risk. This is the

specific risk caused by factors relating to the company or
industry.
6.4 The risk remaining is systematic risk-that caused by

general economic and political factors. This can be
measured via Beta factor.
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7 CAPM
7.1 Once the “market portfolio” fully diversified position has

been reached ,the company and shareholders should use
CAPM.
Risk =βe
Return= RF + (Rm-RF)βe
OR
RF + (ERP)βe
7.2 Remember from Chapter Two Cost Of Capital how a βe

can be analysed.
8 WHY DO DIRECTORS LIKE TO HAVE A DIVERSIFIED

BUSINESS?
Several Reasons:
 Stabilise profits
 Lead to move predictable cash flows
 “Larger” or safer business
 Conglomerate theory-some directors feel they can run
any type of business (Virgin, Tata)
 Foreign acquisitions will reduce economic risk.
 Risk of the investment failing a more of a problem for
the shareholder than the director
 May be the only expansion option.
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Chapter Ten
Foreign Currency Risk

Management
1. Translation Exposure
1.1 Risk caused by change in the value of a Forex asset or

liability over the long term.
1.2 Example: ABC plc has a US subsidiary worth $10m.
2009 - at $1.50 £6.67m
2010 - at $1.75 £5.71m
Loss to equity (£0.96m)
Funded by a $10m loan.
2009 - at $1.50 £6.67m
2010 - at $1.75 £5.71m
Gain to equity £0.96m
1.3 Not a cash risk, only due to financial reporting!!!!
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2 Transaction Exposure
2.1 Change in the value of the spot rate over the short term
causing a cash gain or loss.
2.2 Must hedge!!
3 SPOT Rates
3.1 Rate of exchange at a point in time.
(Bid) (Offer)
$1.5000 - $1.5555 / £
Reciprocal and
cross over!!!!! £0.6429 - £0.6667 / $
(Bid) (Offer)
3.2 Picking the correct rate-Quick Method
 If the SPOT Rates are FX/Home Currency
 We are RECEIVING FX then
 Use the right hand rate
4 Internal Hedges
4.1 Invoice in home currency
 All transactions in home currency
 Transfer risk to the other party
 Monopoly power-over our customers or suppliers

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4.2 Foreign currency bank account
 Held in the main currencies ($, Euro)
 Pool all transactions in same FX
4.3 Leading and Lagging
 Watcher / predictor of spot rate changes in short

term(say 3 months)
 Leading – accelerate exchange(early)
 Lagging – delay the exchange(late as possible)
 Used a lot by Importers who have to sell their home

currency
4.4 Netting
 “Basic” is to match all FX transactions that occur on

the same.
Class Illustration
Today 30 Sep
€200K = Expected Receipt

(€ 120K)=Expected Payment
€80K)
 Multigroup netting-used in group planning and

currency risk management. All future FX transactions
are converted into one common currency through one
company.
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5 External Hedges
5.1 Forward Market(Lock into a Fixed Rate)
“Fix the rate today that will apply on a set future date”
Technique: -
1. Net the future transactions in same FX and same

date. Ascertain if “buying” or “selling” the £.
2. Forward contract, X months, at Forward Rate

“may” have to computed as :-
SPOT + Discount (- Premium)
3. Exchange FX at the forward rate on the future

date.
5.2 Money Market Hedge(Rate used is Today’s Spot Rate)
“The exchange will take place today at the known spot

rate”.
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Technique
Home Abroad
Today’s Spot
Today £ Answer FX
X ÷ 1 + ints foreign
1+ints home
Future Date
£ Answer FX
FX
5.3 Futures(Lock into a rate that will approximately equal

Today’s Spot Rate)
The hedge is ‘effectively’ like a spread bet. If the

company will make a transaction loss by the spot rate
rising, then the hedge is to ‘effectively bet’ that this
event will occur on the Futures Market. Hence the loss
on the Spot Market is offset by the profit on the Futures
Market.
If a gain is made on the Spot Market then a loss will be

made on the Futures Market.
Hence it is trying to lock the rate at approx today’s Spot

Rate.
Technique: -
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1. Draw the timeline showing all rates. Best if rates

are presented as value of the currency of the
contracts.
2. Setup – Today
• Ascertain the downside(d/s) risk

• ‘Bet’ on the d/s risk via the futures market.
• No. of contracts =
Net FX Transaction
Futures Rate
Standard Contract Size (in currency of the

contract)
• Work out tick / contract value

• Deposit the returnable margin
3. Close out – future date

£
(a)Transaction – at spot XXX
(b) Futures Profit / Loss

(No of contracts x Tick value x Tick Movement) @ SPOT XXX
XXX
NB: Loss on transaction, gain on the future or gain

on transaction loss on the futures.
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5.4 Options
“Right to buy (call) or sell (put) FX at a fixed rate over a

set period (American) or on a set date (European)”.
Technique: -
1. Timeline-As for futures
2. Set up today
• Ascertain if we need a put or a call option

• Pick a strike rate from: -
1. Cheapest premium or
2. Nearest to spot or
3. Best possible rate
• No. of contracts
Transaction ≈ Number
Strike Rate
Standard Contract Size
• Summary
Number of contracts x size x rate.
• Compute the premium and convert at spot
3. Close out – Future date
• All situations cost = premium paid
• No receipt or payment in FX – options lapse
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• Compare spot with strike rate – choose the best

rate for the business
6. Pros & Cons
Pros Cons
Forward Market
• Fixed Rate, certainty • Inflexible/contract
• Easy • Lose out on the upside
• Cheap • Must ensure FX receipts
• Tailored arrive
MMH
• Convert today • Complicated
• Cheap • May not apply for FX
• Tailored receipt
• Flexible
Futures
• Effectively fix rate • Complicated
• No cost • Small loss
• Small gain • Need cash for margin
• No tailoring
Options
• Best hedge – cover • Complicated
d/s risk only • No tailoring
• Flexibility • Expensive
• Lots of choice
7. SWAPS
7.1 In forex swap, the parties agree to swap equivalent

amounts of currency for a period and then re-swap them
at the end of the period at an agreed swap rate.
 The swap rate and amount of currency is agreed

between the parties in advance. Thus it is called a
‘fixed rate/fixed rate’ swap.
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The main objectives of a forex swap are:
 To hedge against forex risk, possibly for a longer period

than is possible on the forward market.
 Access to capital markets, in which it may be impossible

to borrow directly.
 Forex swaps are especially useful when dealing with

countries that have exchange controls and /or volatile
exchange rates.
7.2 Example- Say the bridge will require an initial

investment of 100m pesos and is will be sold for 200m
pesos in one year’s time.
The currency spot rate is 20 pesos/£, and the

government has offered a forex swap at 20 pesos/£. A
plc cannot borrow pesos directly and there is no forward
market available.
The estimated spot rate in one year is 40 pesos/£.The

current UK borrowing rate is 10%.
Determine whether A plc should do nothing or hedge its

exposure using the forex swap.
Solution
£m 0 1
Without swap
Buy 100m pesos @20 (5.0)
Sell 200m pesos @40 5.0
Interest on sterling loan (5 (0.5)
x 10%)
(5.0) 4.5
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£m 0 1
With forex swap
Buy 100m pesos @20 (5.0)
Swap 100m pesos back 5.0
@20
Sell 100m pesos @40 2.5
Interest on sterling loan (5 (0.5)
x 10%)
(5.0) 7.0
A plc should use a forex swap.
(Key idea: The forex swap is used to hedge foreign exchange

risk. We can see that in this basic exercise that the swap
amount of 100m pesos is protected from any depreciation, as
it is swapped at both the start and end of the year at the
swap rate of 20, whilst in the spot market pesos have
depreciated from a rate of 20 to 40 pesos per pound.)
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Chapter Eleven
Interest Rate Risk

Management
Interest Rate Risk

1 ISSUE
There are two issues / type of F9 questions:-
 Term Structure of Interest rates

 Risk Management.
2 Term Structure of Interest Rates
2.1 Interest rates on the market generally follow this

relationship:
Return on LIBOR Lenders

Gov’t Bonds < (Interbank < Rates
(RF) Rate)
2.2 Hence if the RF was to change it has a direct impact on

all other rates.
2.3 To “predict” the change in the RF, we use the “Theory of

the Yield Curve”
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The standard of the

yield curve
Years until maturity
The curve is upward due to:-
a) Liquidity Preference Theory- the longer there is to

maturity the greater the return wanted by the lender.
b) Expectations theory-the yield reflects the expectation of

higher future inflation rates
2.4 Some research has indicated it may not be a curve but a

kinked function.
5 years
Years to
Maturity
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2.5 If inflation expectations are in “reverse” ie deflation, it is

feasible to get a reverse yield curve.
No of years of maturity
3 Risk Management
3.1 Normally, this occurs when a company has produced a

short term budget and believe that in the near future
they will run up a cash deficit (possibly a surplus). They
want to hedge against interest change that could damage
their profits.
3.2 For example
1 Jan 31 Mar 31 May
Now (Deficit) Return to

Pay o/d interest surplus
for 2 months
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3.3 To hedge this risk a company has two basic choices:-
 Lock the Rate

 Ceiling/ cap the rate
4 Lock the Rate
4.1 Forward Rate Agreements
Companies can lock the future interest rate by

purchasing a FRA from the markets. There is no fee
payable but the market likes to deal with minimum loan
size of $1m.
On the day the company pays the interest to the loan

provider a settlement/cash transaction takes place
between the company and the seller of the FRA.
4.2 Futures
 The aim here is to lock the interest rate to a value

approximately the same as the current value of
interest.
 The Futures market is similar to “spread betting”-

taking a bet that the interest rate will change from
current position.
 The hedge is complicated due to:
i. Standard contract sizes
ii. 3 month contract lengths
iii. Margins/deposits
iv. Tick sizes of 0.01%
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5 CEILING/CAPPED RATE
5.1 IRG
All aspects are the same as a FRA except
1) Rate is capped /maximum is created

2) Fee is payable up front.
5.2 Options
All the aspects same as a Futures hedge except
1) Create a ceiling by buying a put option

2) Pay a Fee
3) No margins/deposits
6 SWAPS
6.1 Longterm method of hedging where companies “swap”

their interest commitments but no their loans.
6.2 Class Illustration
Company A wishes to raise $10m and to pay interest at

a floating rate, as it would like to be able to take
advantage of any fall in interest rates. It can borrow for
one year at a fixed rate of 10% or at a floating rate of
1% above LIBOR.
Company B also wishes to raise $10m.They would prefer

to issue fixed rate debt because they want certainty
about their future interest payments, but can only
borrow for one year at 13% fixed or LIBOR+2%floating
as it has a lower credit rating than company A.
Calculate the effective swap rate for each company –
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assume savings are split equally.
6.3 Exam Technique
(1) Table of Interest Rates.
Company Fixed Float Want

A 10% LIBOR +1% FLOAT
B 13% LIBOR +2% FIXED
(2) Interest Difference.
%
A (Fixed)+B (Float)
10+LIBOR+2 =LIBOR +12
A(Float)+B (Fixed)
LIBOR+1+13 =LIBOR+14
Difference 2%
(3) SWAP Diagram
LIBOR + 2
A B
12(w1)
10 LIBOR+2
Net = LIBOR Net Rate=12

Rate
(w1) B-(0.5 x 2) = 12
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Chapter Twelve
Business Valuation &

Acquisitions
1 Valuation Methods
1.1 The aim is to find a range of values for a

company. The answer can be presented:-
a) Ve
b) Po
1.2 Net Asset Valuation
1.2.1 Business is worth just the value of it’s Net Assets.
To establish the net assets:-
Total Assets-(Total Liabilities +Preference Shares)
1.2.2 The Net Asset value equals the Ve and can be based
on:-
a) Book Values
b) Net Realisable Value(NRV)
c) Replacement cost
1.2.3 Useful For:-

a) “Seller “ to set minimum value of the company
(NRV)
b) Companies with lots of tangible high value
assets.Eg: Property Investment company
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1.2.3 Major Weaknesses are:-
a) Not include non-tangible assets

b) Excludes what all assets generate future:-
i. Dividends
ii. Profits
iii. Cash Flows
1.2.4 Dividend Valuation Model
1.3.1 The company is worth the present value of it’s future

dividends discounted at the cost of equity
1.3.2 Ve = Total Do(1+g)

(Ke-g)
OR
Po = Do(1+g)
(Ke-g)
1.3.3 Take Care:-
 Growth may not be constant forever

 Where to we get “g” from?
 CAPM may be needed to find Ke
 Often better for valuing a small shareholding
1.3.4 Finding g
a) Past Growth model
eg:
Year DPS
2006 $0.45
2007 $0.49
2008 $0.52
2009 $0.54
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g= 3√ (0.54)-1
(0.45)
g=0.063
b) Gordon Growth Model
g=bre
where b=Profit retention ratio

re= ARR or Cost of equity
eg A company has a retained profit ratio of 0.45.It has

an ARR of 12% and re of 14%.
Short term g=0.45 X 0.12=0.054

Long term g=0.45 X 0.14=0.063
1.4 Price –Earnings Model
1.4.1 A business is worth a multiple of it’s profits.
1.4.2 Ve=Sustainable PAT X Suitable P/E
Po=Sustainable EPS X Suitable P/E
1.4.3 Sustainable PAT-have to adjust the latest reported

reports for non-reoccurring items (post tax)
1.4.4 Suitable P/E:-
a) Take a proxy Company P/E

b) Adjust to suit the company we are valuing.
c) Simple rules
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i. Ltd Co’s – deduct 30%off proxy Co P/E

ii. Non-listed PLC’s-deduct 10% to
proxy Co P/E
1.4.5 Concerns are:-
 Finding a proxy Co P/E

 Adjustments are arbitrary
 Sustainable profits needs forecasting
adjustments.
1.5 Present value of Free Cash Flows
1.5.1 A business is worth the discounted value of the

future cash flows.
1.5.2 Establish:-
a) Future Cash flows and timescales

b) Cost of capital (WACC or Risk adjusted WACC)
1.5.3 Weaknesses are:-
 It relies on estimates of both cash flows and discount

rates.
 What time period should we evaluate in detail and

then how do you value the company’s worth beyond
this period i.e. the realisable value at the end of the
planning period.
 The NPV method does not evaluate further options

that may occur.
 It assumes that the discount rate and tax rates are

constant through the period.
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1.5.4 Example
A company has FCF for equity currently at $400m. It

has a re of 8.5% and returns 30% of its profits. If
growth is expected in perpetuity what is the Ve?
g =b X re =0.30 X 0.085 = 0.0255
Ve= FCF0(1+g)
(re-g)
= $400m (1.0255) = $6,894m

(0.085-0.0255)
1.5.5 Another Example
A company has projected its FCF to equity at:-
T1 $420m
T2 $490m
T3 $510m
From T4 onwards growth will be at 3 %pa.re=7.92%.

Find Ve
Time
$m T1 T2 T3 T4-F.Ever
FCF 420 490 510 510(1.03)
1/1.0792 1/1.07922 1/1.07923 16.171*
PV 389 421 406 8,495
Ve=$9,711m
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* 1 X 1 = 16.171
3
(0.0792-0.03) (1.0792)
1.6 Intellectual Capital(IC)
1.6.1 There are several methods of valuing IC and /or other

non-tangible assets.
1.6.2 Simple estimate
Ve under DVM or P/E Book value of Net

Or PV of CF’s method - Assets
1.6.3 Computed Intangible value (CIV)- to compute this

an industry /proxy return on total assets % must be
given in the question.
Approach:-
$ ‘000
1) Last reported profit before tax X

Less: Industry of Proxy x Co’s total (X)
Return on assets assets
Value Spread X
2) Take value spread X
Tax @X% (X)
Post tax value spread X
3) Assume post tax value spread will stay constant

From time 1 to perpetuity.
Value of IC=Post tax value Spread x 1/r
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r =Cost of Capital
4) Value of Equity is
Value of IC + Book value of the Assets
Option Valuation Method
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Business Valuation-Option Pricing Theory Question
Sparks PLC is a company in the electronics industry and is

looking to expand through acquisition. A target company,
EBMS Plc, has been identified and the directors of Sparks Plc
are looking to value the entire equity capital to EBMS.
From discussions with the director of EBMS, the assets of

EBMS have been valued at £1,450 m which the directors of
EBMS consider to be their fair value in use in the business.
The volatility of the asset value has been agreed at 10% per
annum.
EBMS currently has 4% debentures in issue with a book

value of £900m which are redeemable in 3 years’ time at a
premium of 25% over par. Interest is payable annually.
Short dated Government bonds are currently yielding on

average 4.25% and LIBOR is 0.75% above this. EBMS
currently has a BBB credit rating and the following data on
credit risk premiums (in basis points) has been obtained from
commercial rating sources:
1 year 75
2 year 95
3 year 120
5 year 135
The directors of Sparks plc always try to obtain as many

different valuations as possible when evaluating a potential
acquisition and wish to use option pricing theory in addition
to the more usual methods.
Required
Using the Black Scholes option pricing model, derive a value

for the total equity of EBMS.
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Answer
The approach to answering this question is as per Bob Ryan’s

article in November’s Student Accountant. The basic process
is to recognise that the equity represents a call option to
purchase the company from the debenture holders in three
years’ time.
Firstly, calculate the exercise price. This is the redemption

value of the debt BUT including the interest element also.
This requires calculating the fair value of the debt and then
converting it to a zero coupon bond with the same fair value
and time to maturity to obtain a redemption value
incorporating interest as well.
Required yield=risk free rate + credit premium = 4.25+1.20

=5.45%
Fair value calculation:
Year C. Flow DCF (5.45%) PV

1 £4 0.9483 £3.79
2 £4 0.8993 £3.60
3 £4 0.8528 £3.41
4 £125 0.8528 £106.60
Fair Value per £100 £ 117.40
For a 3 year zero coupon bond to have the same fair value,
the redemption premium would need to be:
Premium in 3 years =117.40 * (1+5.45%) 3 = £137.66
Therefore, theoretical exercise price=137.66/100*£900m=

£1,238.94m
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The variables can now be assigned:
Exercise Price 1,238.94

Asset Value 1,450.00
Risk Free Rate 0.0425
Time to maturity 3
Volatility 1
Calculate Black Scholes figures
D1 = 1.73
D2 = 1.56
N (D1) = 0.95818
N (D2) = 0.94062
Calculating the main formula gives an option value of

£363.5m.
This can be broken down into:
Intrinsic value £ 211.06m (1,450-1,238.94)

Time value £ 152.44m
Therefore, the equity value is £ 363.5m which is £152.44 m

more than the current net assets value of the business.
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2 Post Acquisition Analysis
2.1 The main aim of an acquisition is to add value i.e 2+2

=”5”
2.2 To establish post acquisition value there are several

methods to consider.
a) Pre –Acquisition of A X
Pre –Acquisition of A X
A+B X
P.V of Synergies X
XX
b) Pre –Acquisition PAT of A X

Pre –Acquisition PAT of A X
Combined PAT X
* P/E Ratio of A X
XX
c) Combine the FCF’S of each company and discount

at A’S WACC
2.3 Maximum A would be willing to pay for B is:-
Combined Valve A+B XX

Less: Pre Acquisition (XX)
Value of A XX
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3 Factors to consider in Mergers and Takeovers
3.1 Assets of shares-most companies buy the victim

company’s shares rather than transferring their
assets. Both are feasible.
3.2 Synergies-concept of “2+2=5”.Many sources exist:
a) Economies of scale from horizontal combinations

reduces costs and increase profits.
b) Buying suppliers can reduce profit charged on

purchases i.e. cut out the middle man.
c) Improve badly managed /inefficient businesses.
d) Diversify to stabilise profits and cash flows.
e) Access companies that generate cash

(Cash Cow)
f) Use the managerial talent of the victim in a

more productive way.
g) Market power may allow consumer price

increases and more profits.
3.3 Finance-to fund the takeover the predator company

Could use:-
a) Cash
b) Shares
c) Loan Stock
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Cash offers
Advantages:
 When the bidder gas sufficient cash the takeover can

be achieved quickly and at low cost.
 Target company shareholders have certainty about the

bid’s value i.e. there is les risk compared to accepting
shares in the bidding company.
 Increased liquidity to target company shareholders,

i.e. accepting cash in takeover, is a good way of
realising an investment.
 The acceptable consideration is likely to be less than

share exchange as there is less risk to target company
shareholders. This reduces the overall cost of the bid
to the bidding company.
Disadvantages:
 With the larger acquisitions the bidder must often

borrow in the capital markets or issue new shares in
order to raise the cash.
 Target company shareholders liable to CGT.
 Target company shareholders do not participate in new

group.
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Loan Stock
Advantages:
 Low cost when interest rates low.
 Interest payments tax deductible
 Less dilution of EPS than in a share for share

exchange.
Disadvantages:
 Increases gearing hence shareholders’ risk.
Share Exchange
Advantages:
 Shareholders of the acquired company will be

shareholders in the post acquisition company.
 Can finance very large acquisitions.
Disadvantages:
 Price risk- there is a risk that the market price of the

bidding company’s shares will fall during the bidding
process, which may result in the bid failing.
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3.4 Regulation of Takeovers
City Code on Takeovers
 Self-regulatory system of the stock exchange
 Applies only to plcs.
 No legal authority but SE can apply a range of

sanctions.
Main points of the code
 All shareholders of both the bidding and target

company must be informed as soon as firm offer is
made.
 Offers cannot be withdrawn without SE consent
 Shareholders must be given sufficient information to

make an informed judgement.
 If more than 30% of voting shares acquired, offer

must be made for all remaining shares.
 Offers must be open for at least 21 days.
 Offer is conditional on gaining 50 o the voting rights of

a target company.
Competition Commission
Under the Fair Trading Act of 1973, the Office of Fair

Trading (OFT) may refer a bid to the Commission if the
OFT thinks that a merger might be against the public
interest.
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The Commission can they investigate whether or not the

bid results in a reduction in competition in the market. If
it is felt that a takeover would reduce competition, then
they can recommend to the Secretary of State that the
bid be blocked.
3.5 Defences-The victim company could defend a

take-over in several ways:-
a) Appeal to the Competition Commission indicating

the takeover is anticompetitive.
b)Find an alternative/Friendly buyer (White Knight)
c) Appeal to the shareholders and manage a defence

showing that the takeover will not benefit them.
d)Super majority-set up in the Articles requiring a

high proportion of S/H to agree on takeovers.
e) Poison pill strategy –creation of “tripwires” invoked

on a takeover causing the acquirer to spend more
money.
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Chapter Thirteen
Company Performmance
Analysis
Ratios
1. Ratios-You must Learn!!!!
1.1 Investor
EPS = PAT less Preference Dividends

No of ordinary shares in issue
P/E = Po
EPS
Dividend Cover= EPS

DPS
Payout Ratio = DPS

EPS
Dividend Yield = DPS

Po
Total Shareholder = Dividend for + Capital Gain

Return(TSR) the year for the year
Share Price at start of the
year
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1.2 Gearing
Capital Gearing= Debt or Debt X 100

Equity Debt+Equity
NB Preference shares are generally treated as debt.
Interest Cover = Operating Profit

Interest
1.3 Profitability
ROCE = Operating Profit X 100

Equity +Debt
ROE = PAT X 100

Equity
Margin = Operating Profit X 100

Turnover
1.4 Liquidity
Current Ratio= C.Assets

C.Liabilities
Quick/Acid Test = (C.Assets-Inventory)

Ratio C.Liabilities
Inventory Days= Inventory x 365

COS or purchases
Receivables Days= Trade Receivables x 365

Sales
Payables Days = Trade Payables x 365

COS or Purchases
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2 Cash Flow Statement
In addition to the liquidity ratios above, you need to be

able to prepare a cash flow statement to assess liquidity
position
Suggested layout:
$’000
Operating Profit xxx
Add: Depreciation xxx
Change in Inventory xxx

Change in Receivables xxx
Change in payables xxx
Cash from operations xxx
Sale of NCA xxx

Issue of Shares xxx
New Loans xxx
Tax paid (xxx)

Interest paid (xxx)
Dividends paid (xxx)
Purchase of NCA (xxx)
Loans repaid (xxx)
Share buyback (xxx)
Cash generated this year xxx

Balance b/f xxx
Cash Balance C/F $xxx
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3 Economic Value Added
a. EVA = Net operating profit after tax (NOPAT) –

imputed interest charge
EVA shows whether a company is making sufficient

profit to cover its cost of capital. It is a similar
approach to residual income.
b. NOPAT is calculated by taking the operating profit

from published accounts, adding back interest and
taking off the tax paid. It is sometimes referred to
as cash earnings before interest but after tax.
c. The imputed interest charge is calculated as the

capital employed multiplied by the WACC. This
represents the return on capital required to keep the
investors happy.
d. A positive EVA indicates that a company is adding

value for its shareholders. Therefore, if managers’
remuneration is linked to EVA, the interests of
managers and shareholders should be aligned.
e. Disadvantages of EVA include:
• Calculations can be complicated and involve many

adjustments to accounting information
• EVA is a historic measure
• EVA cannot be used to directly compare companies

as it requires an adjustment for their relative sizes
• The calculation relies on CAPM for the WACC,

which itself is subject to many restrictive
assumptions
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f. Example
The directors of Old Nick plc wish to establish whether

they have increased shareholder value in the year to
September 20X2. They use the EVA model.
Profit and loss account for year ended 30 September

20X2
£m
Turnover 150
PBT 50
Tax 18
PAT 32
Dividends 10
Retained earnings 22
Additional information:
(a) Included in cost of sales and expenses is £10 million

of economic depreciation. This is the same as the
depreciation used for tax purposes.
(b) Non-cash expenses amounted to £15 million.
(c) The capital employed on the balance sheet was

£108 million.
(d) The pre-tax cost of debt is 10%.
(e) The cost of equity is 15%.
(f) Old Nick plc has an effective tax rate of 35%.
(g) The interest expense in 20X2 was £5 million.
(h) The gearing ratio is 50:50 debt to equity by market

value.
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Required
Calculate the EVA in the year to September 20X2 and

the value of the equity.
g. Solution
• WACC = (50% X 15%) + (50% X 10% X 0.65)
= 10.75%
• NOPAT:-
£m
PAT 32
Add: Non – cash Expenses 15
47
Add: Post tax ints 3.25
(5m X 0.65)
£50.25
EVA = £50.25m – (10.75% X £108m)
= £38.64m
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Chapter Fourteen
Corporate Reconstruction
and Reorganisation
1 Causes of Corporate Failure
Corporate failure when a company cannot achieve a

satisfactory return on capital over the longer term:
 If unchecked, the situation is likely to lead to an ability

of the company to pay its obligations as they become
due.
 The company may still have an excess of assets over
liabilities, but if it is unable to convert those assets into
cash it will be insolvent.
 The issue is more problematic in sectors, or economies,
where profitability is not an issue. For example, in the
former Soviet Bloc, the economy simply does not
identify poorly performing companies
 For not-for-profit organisations, the issue is usually one
of funding, and failures indicated by the inability to raise
sufficient funds to carry out activities effectively.
 Although stated in financial terms, the reasons behind
such failure are rarely financial, but seem to have more
to do with a firm’s ability to adapt to changes in its
environment.
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2 Predicting Corporate Failure
2.1 Altman Z-Score Model
The Z score model was first developed by Altman in

1968 based on research in the USA into bankrupt
manufacturing companies:
 Z scores are an attempt to anticipate strategic and

financial failures by examining company financial
statements.
 The Z score is generated by calculating five ratios,
which are then multiplied by a predetermined weighting
factor and added together to produce the Z score.
 The five ratios, which ,once combined ,were considered
to be the best predictors of failure, are:
Ratio Included to measure

X1 Working capital to total Liquidity
assets
X2 Retained earnings to Gearing
total assets
X3 Earnings before Productivity of the
interest and tax to company’s assets.
total assets
X4 Market value of The extent to which
equity(including the equity can decline
preference shares)to before the liabilities
total liabilities exceed the assets and
the company becomes
insolvent
X5 Sales to total assets The ability of the
company’s assets to
generate revenue.
Z score=1.2 X1 +1.4X2 +3.3X3 +0.6X4 +1.0X5

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2.2 Assessing the risk of failure
 The accuracy of prediction of the model.

 The Z score model was found to be an accurate
predictor of failure for up to two years prior to
bankruptcy, but that the accuracy decreases over
longer periods.
 What level of Z score indicates different levels of
likelihood of failure? It was found that:
Z score<1.81 indicates that the Company is in danger

and possibly heading towards bankruptcy.
Z score of 3 or above indicates financially sound.
Companies with scores between 1.81 and 2.99 need

further investigation
2.3 Limitations of corporate failure prediction models
There are number of limitations of the Z score and

other similar failure prediction models:
 The score estimated is a snapshot-it gives an indication

of the situation at a given point in time but does not
determine whether the situation is improving or
deteriorating.
 Further analysis is needed to fully understand the
situation.
 Scores are only good predictors in the short term.
 Some scoring systems tend to rate companies low-that
is they are likely to classify distressed firms as actually
failing.
 The Z score was estimated based on manufacturing
companies. Care needs to be taken when applying it to
other types of companies.
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3 Other signs of Corporate Failure
Information in the published accounts, for example:
 very large increases in intangible fixed assets

 a worsening cash and cash equivalents position shown
by the cash flow statement
 very large contingent liabilities
 important post balance sheet events
 Information in the chairman’s report and the director’s
report (include warnings, evasions, changes in the
composition of the board since last year.
 Information in the press (about the industry and the
company or its competitors).
 Information about environmental or external matter.
You should have a good idea as to the type of
environmental or competitive factors that affect firms.
4 Financial Reconstructions
4.1 Options open to failing companies
 a company Voluntary Arrangement (CVA)

 an administration order
4.2 General principles in devising a scheme
In most cases the company is ailing:
 Losses have been incurred with the result that capital

and long term abilities are out of line with the current
value of the company’s assets and their earning
potential.
 New capital is normally desperately required to
regenerate the business, but this will not be forthcoming
without a restructuring of the existing capital and
liabilities.
________________________________________________________________________
 Sunil Bhandari
136
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The general procedure to follow would be:
 Write off fictitious assets and the debit balance on profit

and loss account. Revalue assets to determine their
current value to the business.
 Determine whether the company can continue to trade
without further finance or, if further finance is required,
determine the amount required ,in what form(shares,
loan stock) and from which persons it is obtainable
(typically existing shareholders and financial
institutions).
 Given the size of the write off required and the amount
of further finance require, determine a reasonable
manner in spreading the write off(the capital loss)
between the various parties that have financed the
company(shareholders and creditors).
 Agree the scheme with the various parties involved.
________________________________________________________________________
 Sunil Bhandari
137
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________________________________________________________________________
 Sunil Bhandari
138

ACCA P4 Key Point Notes December 2010

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What are the main topics covered in the notes?

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What options are available for failing companies?

What options are available for failing companies?

ACCA P4 Advanced Financial Management Key Point Notes December 2010

Key Point Notes

Tutor Contact Details

Copyright to Sunil Bhandari

Use of these Key Point Notes

Chapter Three Risk Adjusted WACC

Chapter Five Dividend Policy

Chapter Six Advanced Investment Appraisal I

Chapter Seven Advanced Investment Appraisal II

Chapter Eight Valuations of Options & Value at Risk

Chapter Nine Risk Management

Chapter Ten Foreign Currency Risk Management

Chapter Twelve Business Valuation & Mergers & Acquisitions

Chapter Thirteen Company Performance Analysis

Exam Formulae and Tables

Please note that FOREX Modified BSOP will NOT be examined

1.1 For profit making business “Maximise Shareholder(S/H)

1.2 To Measure S/H wealth

Value of Equity (Ve) =Number of issued Equity/Ordinary

1.3 To find Po:

 Given in the Question if it is a listed company(see

• Dividend Valuation Model(DVM)

Make your comments relevant to the size and

2.1 Financial indicators pointing towards maximising S/H

 Earning per share(EPS)

2.2 Non-Financial Indicators include:

The above are all Key Performance Indicators (KPI’s)

3. External Factor Affecting Ve & Po

3.1 The Board cannot control all aspects that effect

3.2 Economic Variables -what are they and how may

3.2.1 Interest Rates- If they fall:-

 Stimulate demand and revenue

3.2.2 Inflation Rates- If it rises:-

 Costs rise causing a drop in profits

3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-

 Reduce cash receipts for exporters

3.2.4 Gross Domestic Product- If it falls:-

 Reduce demand and revenue

3.2.5 General Taxation –If it rises:-

 Damage company profits

Important to relate your comments to the effect upon Po

3.3 Agency Problem

3.3.1 S/H are the owners of the company and expect

3.3.2 Examples of decisions that ‘may’ damage S/H wealth:

3.3.3 Solutions to this problem include:

This provides a way of rewarding Directors by

4 The Three Key Decisions

4.1 To maximize S/H wealth the board must take

4.2.1 Allocate cash for:-

 Organic Growth (Projects)

4.2.2 Must always consider how investments

4.3.1 To finance investments the board have to

4.3.2 They will consider:-

 Cash available within the company

4.4.1 The Board needs to establish a dividend policy –