ACCA P4 Advanced Financial Management

Tuition Study Note

For exams in June 2015

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© Lesco Group Limited, April 2016
All rights reserved. No part of this publication may be reproduced,
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 Content
Chapter1 Financial Crisis & Corporate Governance ..................................4

Sessoin1: Why financial crisis ..............................................................4

Session2 Corporate governance ............................................................6

Chapter 2 Accounting Equation: Assets=liability +Equity .....................9

Session1 Assets ...................................................................................10

Session1.1 Domestic investment appraisal ................................10

Session1.2 International investment appraisal ..........................63

Session1.3 Business Valuation...................................................70

Session1.4 Risk Management ..................................................109

Session2 Liability + Equity ..............................................................180

Session2.1 Financing decision ....................................................181

Session 2.2 Dividend Policy Decision ........................................203

Chapter 3 How to grow and save your business? ...................................205

Session3.1 International Trade....................................................206

Session3.3 Business Reorganization and Reconstruction ..........213

Chapter4 Other current issues .................................................................223

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 Chapter1 Financial Crisis & Corporate Governance

Sessoin1: Why financial crisis

In order to boost the economy, in 2007 government in USA slashed interest rate
to make borrowing cheaper and of course another effect of this is that when
deposit money into the bank investors would get lower return because of the
low interest rate.

As a result of this investors looked for other investment opportunities and

focused on Prime mortgage market. What this means is that people want to
borrow money from bank to buy a house and then bank lends them money to
purchase it. Then bank sells the right to receive future cash inflow, ie, interest to
some investors by creating collateralized debt obligation(CDO) and dividing
CDOs into different categories and requires credit rating agency like Standard
&Poor’s to rate the mortgage like AAA, BB etc.

Then this can be sold to different investors with different needs, eg, pension
funds like safe investment so would like to buy higher credit rating mortgage.
Hedge funds like investment with higher return so would like to buy a slightly
low credit rating mortgage.

To make the top tranches safer banks would buy insurance on these mortgages
called “credit default SWAP” and hence insurance companies like AIG which gets
future money from investors gets very wealthy.

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This went well and investors loved to do so because they thought they were risk
free, ie, if home owners default on payment investors would not suffer a loss
because they believed that house prices would increase all the time and
investors would get their homes even though home owners default on
payments.

As more and more people in the Prime market (wealthy people) have borrowed
money to buy a house, Bank still got lots of money into the system(because of
the low interest rate so they can borrow from US federal reserve at a very low
cost) and there were not too many mortgages available any more whilst the
demand by investors regarding mortgages are very high so they decide to turn
to Subprime market(low income people).

Same process continues as the above one and eventually there were more and
more home owners defaulted on payment and bank gets the house then supply
is greater than demand hence prices for houses dropped down significantly.
Insurance company needed to pay large amount of credit default SWAP and
they don't have enough money to do so and so many of them collapsed like AIG.
As CDOs are worth less and more risky so many investors like pension funds
wouldn't buy them any more so many of investment banks like Lehman Brothers
and American banks have gone bankruptcy.

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 Session2 Corporate governance

In the p4 exam it’s highly unlikely your examiner will test you about the detail
rules regarding corporate governance.

You should know:

 Best practices(UK CG code)

 International corporate governance issues

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Session2.1 Best practices

 There should be separation of executive directors and non-executive

directors to the board and they should be balanced.

 There should be separation between chairman and CEO.

 Executive directors include like CEO, CFO and other managers who are
involved in day to day operation of business, ie, they should go to work on
time daily.

 Non-executive directors are not involved in the day to day running of the
business. They are here to oversee the performance of executive directors.

They are allocated to different sensible areas within company to form into
committees like, remuneration committee; nomination committee; audit
and risk committee.

The reason why they are called sensible areas is because EDs in these areas
are not independent to do the job, ie, they would like to pay them more even
though company is in trouble. They would like to employ someone who will
not challenge them during the work.

Of course their roles would be:

People role: Employ right EDs to the board
Risk role: Ensure risks are properly identified and addressed
Strategy role: Challenge strategy made by EDs to make sure it doesn't do
harm to co.
Scrutiny role: Oversee performance of EDs

The idea behind NEDs is they should be independent, ie, they are outsiders
of company and you can think about them to be consultant to company. So
when employing NEDs to company of course they shouldn't be close family
relationship members with EDs and they shouldn't have major business
transactions with company etc.

 Talking about sensible areas such as remuneration committee they need to

ensure the remuneration package is performance related and fair.

 Audit committee should ensure internal and external auditors are doing their
work properly, ie, they should be independent and competent.

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 Nomination committee should ensure directors in the board are competent
and have different skills, ie, being diversified.
 International corporate governance issues
In this exam you need to know briefly about different countries corporate
governance structure and its implication to managers within company as well.

Germany companies often have 2 tier board system including supervisory

board and management board. In the supervisory board there would be lots of
representatives from the company like employees, major shareholders, banks
etc. So when manager’s work in Germany companies they need to makes sure
any decisions must be communicated to supervisory board and agreed by them
before implementation.

Japanese companies mainly have 3 boards:

Policy boards deal with long term strategy.
Functional boards deal with day to day running of business.
Symbolic boards only have symbolic function.
And companies in Japanese would focus on collaboration so mangers in Japan
should seek to establish long-term consensual business relationships with
banks, suppliers and customers. In many companies they will focused primarily
on long-term objectives such as market share rather than short-term profit
maximization.

USA companies are following Sarbanes Oxley Act so mangers working in USA
companies should ensure they follow the rules otherwise it will have to pay a
large amount of penalties.

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 Chapter 2 Accounting Equation:
Assets=liability +Equity

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 Session1 Assets

Session1.1 Domestic investment appraisal

The idea behind this is to use techniques to evaluate whether the investment
proposal is worthwhile.

Techniques would be classified between:

Non-discounting techniques Discounting techniques
Payback period Net present value(NPV)

Other decisions
Asset replacement
Capital rationing
Lease or buy decision

Free cash flow

Risks &Uncertainty
Sensitivity analysis
Monte Carlo simulation

Value at risk

Option pricing model

Real option
Black-Scholes
option pricing
model
Accounting rate of return(ARR/ROCE/ROI) Adjusted present value
Internal rate of return(IRR)
Discounted payback period
Duration/ Macaulay Duration method
Modified internal rate of return(MIRR)

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Payback period
It means how long that company can recover its initial investment.

Decision criteria: if it’s less than target payback period then project would be
accepted.

GOGO Ltd
1, GOGO Ltd spent $1,000 to purchase a machine A and expects to generate
into future cash flow of $200 per annum.
Target payback period for machine A is 3 years.

2, GOGO Ltd spent $100,000 to purchase a machine B and expects to generate

into future cash flow as follows:
Years Cash flow($000)
1 50,000
2 40,000
3 30,000
4 25,000
5 20,000
Target payback period for machine A is 3.5 years.

Required:
Calculate the payback period for machine A and B.

Answer:
Machine A:
$1,000
$200 = 5years (reject project)

Machine B:
Years Cash flow($000) Cumulative cash flow
0 (100,000)
1 50,000 (50,000)
2 40,000 (10,000)
3 30,000 20,000
4 25,000
5 20,000

Payback period= 2years+ 10,000 =2.33years (accept project)

30,000

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Comment on payback period

Advantages:
1, it’s easy to calculate and understand.
2, when company has limited cash resources and want to speed up the return.
3, it uses cash flow not profit and hence reduce manipulation.

Disadvantages:
1, it doesn’t give a return but just to indicate when the initial investment would
be recovered.
2, it ignores time value of money.
3, it doesn’t consider cash flows beyond payback point.
4, any target payback period set it subjective.

Tutor tips: Because payback period:

It ignores time value of money- So discounted payback has been developed.

It doesn’t consider cash flows beyond payback point. - So duration has been
developed.

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Accounting rate of return (ARR)
This means we invested money into project and how much profit we can get as
a percentage of investment.

Decision criteria: If this is greater than target accounting rate of return then
we should accept this project.

Calculation:
ARR (ROCE/ROI) = AAP (Annual Average profit) X100
AI (Average Investment)

AAP:
Total cash profit(Sales-Expenses) X
-Total depreciation(Cost-RV) (X)
Total profit X
No of years X
AAP X

AI= initial investment + residual value

2

Initial investment=fixed capital +working capital

Residual value = fixed capital residual value + working capital recovered

LALA ltd
LALA ltd is considering investing in a project which generates Sales of $500 and
incurs expense of $250.

The initial investment in the project is to be $100 and at the end of 5th year it can
be scrapped for $10.

LALA ltd would need to spend $20 buying inventory and plans to incur $10
receivable from customers as well as $5 payable to suppliers.

At the end of 5th year 80% of working capital would be recovered by LALA ltd.

Required:
Calculate ARR of this project for LALA ltd.

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Answer:

ARR (ROCE/ROI) = AAP (Annual Average profit) X100

AI (Average Investment)

AAP:
Total cash profit(Sales-Expenses) 500-250 250
-Total depreciation(Cost-RV) 100-10 (90)
Total profit 160
No of years 5
AAP 32

AI= initial investment + residual value

2
fixed capital +working capital + fixed capital residual value + working capital
recovered
=100+ (20+10-5) +10 + 80% (20+10-5)
=155/2=77.5

So ARR= 32 = 41.3%
77.5

Comment on ARR

Advantages:
1, it’s easy to calculate and understand.
2, it’s widely used by company to evaluate projects.
3, it can be calculated from available accounting data.

Disadvantages:
1, it doesn’t consider time value of money.
2, it’s based on subjective accounting profit and easy to subject to manipulation.
3, it’s easy to be manipulated because it can be expressed in different ways.

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Net present value (NPV)

Basic NPV theory

This method considers time value of money.

Time value of money means as time goes by the value of money goes down.

Decision rule:
If NPV>0 then accept the project
If NPV<0 then reject the project

Pro forma:

Yeas 0 1 2
1. Net trading revenue
2. Tax payable
3. Tax allowances
4. Capital expenditure
5. Residual value
Working capital

Net cash flow

Discount factor
Present value

Comment on NPV

Advantages:
1. Project with a positive NPV will increase company value and hence maximize
shareholders wealth.

2. It considers time value of money and hence opportunity cost of capital.

3. It is based on cash flow not profit and hence less subject to manipulation.

4. It is an absolute measure of return and it can reflect the size of a project.

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Disadvantages:
1. Determination of future cash flow would be difficult and subjective.

2. Determination of discount rate would be difficult.

Tax allowances:

Year Capital allowance Tax relief (30%) Timing

0 (1,000)
1 1,000X25%= 250 75 2
2 250X75%= 188 56 3
3 188X75%= 141 42 4
3 Balancing =allowance 371 111 4
1,000-50= 950

Tax Exhaustion

Year 1 2
PBT 3 8
Tax paid (25%)
PAT
Capital allowance is 4 in year 1 and 2.

Required: calculate PAT.

Answer:

Year 1 2
PBT 3 8
Tax paid (25%) 0 (0.75) (W)
PAT 3 7.25

W:
Tax paid in year2:
Way1:
Tax paid based on PBT: 8X25% = (2)
Tax allowance: (1+4) X 25% =1.25
(0.75)

Way2:
Tax paid: (8-5) X25%=0.75

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Other NPV Decisions

1, Asset Replacement

Think about you owned a car which helps you walk less. You bought it in 2000
and now decides to replace this car and after you replace this car which still
helps you walk less which has the same effect as before and so one of the
assumptions that asset replacement would consider is that this happens
throughout the lifecycle of the business and assumes revenue generated from
the replacement of assets is the same.

Another assumption is that the operating efficiency of machines will be similar

with differing machines or with machines of differing ages.

So how can we calculate the costs associated with the asset replacement?
1, calculate NPV of each asset
2, calculate EAC for each asset (=NPV/annuity)
3, compare and rank the asset with a lower EAC.

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Example: EAC Company:

EAC Company is considering the replacement of an asset with the following two
machines:
Machine
A B
$000s $000s
INVESTMENT COST 60 30
Life 3 years 2 years
Running costs 10 p.a. Yr 1: 20
Yr 2: 15
Residual value 5 nil

Required:
Determine which machine should be bought using a NPV analysis at a cost of
Capital of 10%.

Answer:
Year CF DF@10% Discounted CF
A B A B
0 (60) (30) 1 (60) (30)
1 (10) (20) 0.909 (9) (18)
2 (10) (15) 0.826 (8) (12)
3 (10)+5 - 0.751 (4) -
1,NPV (81) (60)
2,Annuity factor 2.487 1.736
3,EAC 32.57 34.56
4,Ranking 1 2

Comment of EAC:
Main criticism would be:
It assumes revenue of each asset are the same.
It ignores technological change.

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2. Capital rationing

General issues:
It means a limit on the level of funding available to a business, there are two

Types:
1, hard capital rationing
2, soft capital rationing

*hard capital rationing means the limit is externally imposed by banks.

Due to:
Wider economic factors (e.g. a credit crunch)
Company specific factors
(a) Lack of asset security
(b) No track record
(c) Poor management team.

2, Soft capital rationing means the limit is internally imposed by senior

management.
Issue: Contrary to the rational aim of a business which is to maximize
shareholders’ wealth (i.e. to take all projects with a positive NPV)

Reasons:
1. Lack of management skill
2. Wish to concentrate on relatively few projects
3. Unwillingness to take on external funds
4. Only a willingness to concentrate on strongly profitable projects.

Mutually exclusive project means you can’t do both of them.

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Single period or multi period capital rationing:

1, Single period capital rationing

Divisible projects

It means funds are limited at a time.

If the project is divisible then we can use profitability index. Example would be
looking at APC we have a study project including basic, super and gold study
packages and if we have limited funds right now and we can only make good use
of our funds given those packages which would generate into a higher NPV.

Example:
Funds are just $200.
Project 1 would include the following items:
Items Initial investment NPV
A 100 25
B 200 35
C 80 21
D 75 10

Required:
Which items should we invest in order to maximize the return to company?

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Answer:

PI & ranking
Items Initial investment NPV Profitability index(PI)(NPV/II) ranking

A 100 25 0.25 2
B 200 35 0.175 3
C 80 21 0.265 1
D 75 10 0.133 4

Production schedule:
Items Funds NPV
200
C (80) 21
120
A (100) 25
20
B (20) 20
200 X 35 =3.5
0 Total NPV 49.5
Indivisible projects

Example:

Funds are just $200.

Project 1 would include the following items:
Items Initial investment NPV
A 100 25
B 200 35
C 80 21
D 75 10

Item A and C are mutually exclusive.

Required:
Which items should we invest in order to maximize the return to company?

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Answer:

PI & ranking
Items Initial investment NPV Ranking based on NPV only

A 100 25 2
B 200 35 1
C 80 21 3
D 75 10 4

Items Funds NPV

200
B (200) Total:35
0

Items Funds NPV

200
A (100) 25
100
D (75) 10
25
35

2, Multi period capital rationing

It means funds are limited not just at a time.

Steps: Mnemonics: DD computer

1: define objective
2: define constraints
Indivisible projects: either 0 or 1
Divisible projects: 0<X<1
3: slot into computer and let it do this.

Example:
Projects A B C
Funds required:
Year 0 30 - 40
Year 1 - 20 50
Year 2 40 50 60
NPV 50 70 80

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Funds available:
Year 0: 65
Year 1: 60
Year 2: 100

Required:
Layout steps involved in determining optimal mix of projects in order to
maximize NPV of the business.

-if projects are indivisible

-if projects are divisible.

Answer: DDD computer

1: define objective
Z=50A+70B+80C

2: define constraints
If projects are indivisible: if projects are divisible:
A, B and C would be 0 or 1. 0<A, B, C<1
30A+40C <=65
20B+50C<=60
40A+50B+60C<=100

3: slot into computer and let it do this.

3. Lease or buy decision

A specific decision that compares two specific financing options, the use of a
finance ease or buying outright financing via a bank loan.

Key concerns:

1. Discount rate = post tax cost of borrowing

The rate is given by the rate on the bank loan in the question, if it is pre-tax then
the rate must be adjusted for tax. If the loan rate was 10% pre-tax and
corporation tax is 30% then the post -tax rate would be 7%. (10% x (1 – 0.3)

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 Free Cash flows

Bank loan Finance lease

1, Cost of investment 1. Lease rental
2, WDA tax relief on investment 2. Tax relief on rental
3, Residual value

Banana Ltd

Banana plc is considering how to finance a new project that has been accepted
by its investment appraisal process.

For the four year life of the project the company can either arrange a bank loan
at an interest rate of 15% before corporation tax relief. The loan is for $100,000
and would be taken out immediately prior to the year end. The residual value of
the equipment is $10,000 at the end of the fourth year.

An alternative would be to lease the asset over four years at a rental of $30,000
per annum payable in advance.

Tax is payable at 33% one year in arrears. Capital allowances are available at
25% on the written down value of the asset.

Required:
Should the company lease or buy the equipment?

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Answer:

Buy:
Year 0 1 2 3 4 5
CAPEX (100)
Tax relief(W) 8.3 6.3 4.7 10.6
RV 10
Net CF (100) - 8.3 6.3 14.7 10.6
DF (15%X(1-33%) 1 0.909 0.826 0.751 0.683 0.621
PV (100) - 6.856 4.731 10.040 6.583
NPV= (71,800)

Lease:
Year CF AF @(15%X(1-33%)=10%

0-3 Rental (30,000) 3.487 (104,610)

expense
2-5 Tax relief 9,900 2.881 28,530
(76,100)

Decision: lease the asset

Free cash flow

Free cash flow to firm is cash flow from operations+ interest expense -cash flow
from investing activities.

Free cash flow to equity is free cash flow-interest expense (net of tax)-net debt
borrowing.

Once we have calculated the free cash flow to equity we can then establish the
dividend cover based on free cash flow to equity. We have learnt how to
calculate dividend cover where we take PAT/Dividend paid. But before PAT is
profit and it’s subject to manipulation by management so we can use a cash flow
approach to do this.

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There are 2 ways to calculate free cash flow to equity:

Direct method:
PAT x
Adjustment for non cash item x
Adjustment for changes in working capital x
-cash flow from investing activities x
Adjustment for net debt borrowing x
Free cash flow to equity x

Indirect method:
Free cash flow x
-Interest paid (net of tax)-because in free cash flow we have subtracted the whole taxes x
Adjustment for net debt borrowing x
Free cash flow to equity x

Free cash flow needs to be assessed not in a single period because sometimes
company would spend money into expanding the business in the current year so
the current year’s free cash flow would be low but it does benefit the company
for the long term.

Example Human Ltd

The following statement of profit or loss relates to Human Ltd.

$m
Sales 90
Cost of sales (30)
Gross profit 60
Operating expense (20)
PBIT 40
Interest (10)
PBT 30
Tax@20% (6)
PAT 24

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During the year loan repayments are expected to amount to $20 million.
Issue of new debt is $69m.

Deprecation charge is $30 million and capital expenditure is $10 million.

Human ltd bought $3 inventory during the year.

Human Ltd ha 100m shares in issue and DPS is $0.03.

Required:
1, calculate free cash flow to firm
2, calculate free cash flow to equity
3, calculate dividend cover using free cash flow to equity method.

Answer:

1, FCF to firm:

PBIT 40
Tax at 20% on PBIT (8)
32
Depreciation 30
Working capital (3)
Capital expenditure (10)
FCF to firm 49

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2, FCF to equity:

Indirect method:
FCF to firm 49
-interest net of tax (10 x (1-20%)) (8)
Adjustment to net debt borrowing 49
(69-20)
FCFTE 90

Direct method:
PAT 24
Adjustment to non cash item 30
Depreciation
Adjustment to working capital (3)
CAPEX (10)
Adjustment to net debt borrowing 49
(69-20)
FCFTE 90

3, dividend cover: = FCFTE

Dividend value
= 90
100mX0.03
=30times

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1, Risks & Uncertainty

2, Sensitivity analysis

This means by what extent something changes then NPV becomes 0.

There are 3 types of sensitivity analysis which can be asked in the exam:

For:
Selling price,
Variable cost,
Fixed cost,
Units to sell,
Initial investment,
Scrap value.
We use: Sensitivity margin= NPV X100
PV of variable

For:
Number of years we use discounted payback period methods.

For:
Cost of capital we use internal rate of return (IRR).

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Example Sisi
The following NPV analysis of SISI ltd would be as follows:

Years 0 1 2
Sales revenue 100 100
Variable Costs (5) (5)
Fixed costs (5) (5)
CAPEX (100)
Scrap value 10
Net cash flow (100) 90 100
Discount factor (10%) 1 0.909 0.826
Discounted cash flow (100) 82 83
NPV=65

Required:
Provide a sensitivity analysis of the above variables including:
1, sales revenue;
2, variable costs;
3, fixed costs;
4, units to sell;
5, capital expenditure;
6, scrap value;
7, cost of capital;
8, number of years.

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Answer:

Sensitivity margin for:

1, sales revenue= NPV = 65 X100= 37%

PV of sales revenue 100X0.909+100X0.826

It means if sale revenue drops by 37% (or 37%X100=37) then NPV=0.

2, variable costs= NPV = 65 X100= 749%

PV of variable costs 5X0.909+5X0.826

It means if variable costs increase by 749 % (or 749%X5=37.5) then NPV=0.

3, fixed costs= NPV = 65 X100= 749%

PV of fixed costs 5X0.909+5X0.826

It means if fixed costs increase by 749% (or 749%X5=37.5) then NPV=0.

4, units to sell= NPV = 65 X100= 39%

PV of contribution (100-5) X0.909 + (100-5) X0.826

It means if units to sell decreases by 39% (or 39%X (100-5) =37) then NPV=0.

5, capital expenditure= NPV = 65 X100= 65%

PV of CAPEX 100X1
It means if capital expenditure increase by 65% (or 65%X100=65) then
NPV=0.

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6, scrap value= NPV = 65 X100= 79%
PV of scrap value 10X0.826

It means if scrap value decreases by 79% (or 79%X10=7.9) then NPV=0.

7, cost of capital: (IRR approach)

1,
Net cash flow (100) 90 100
Discount factor (10%) 1 0.909 0.826
Discounted cash flow (100) 82 83
NPV=65

2,
Net cash flow (100) 90 100
Discount factor (20%) 1 0.833 0.694
Discounted cash flow (100) 75 69
NPV=44

IRR=L+ NPV L X (H-L)

NPV L – NPV H

=10%+65 X (20%-10%)
65-44
=41%

So when cost of capital increases to 41% or increases by 31 % (changes from

10% to 41%) then the NPV=0.

8, number of years (discounted cash flow method)

Years 0 1 2
Discounted cash flow (100) 82 83
Cumulative cash flow (18) 65

So
Number of years=1+18 = 1.22 years
83
So when project life becomes 1.22years then the NPV=0(breakeven).

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3, Monte Carlo simulation

Sensitivity analysis we have looked at just analyze the single variable change
would have an impact on the NPV which haven’t included all of other variables.

E.g., in the real life variable costs increase by 5% then company might want to
increase its selling price of 5% in order to compensate for the losses then it
would have a further impact on the NPV.

So using Monte Carlo Simulation which would help us identify all of the variables
and set up the relationship among them and usually this would be done by a
computer ERP system.

In the exam you are required to know the steps involved in the Monte Carlo
Simulation and comment about it.

Steps:
1. Specify all major variables
2. Specify the relationship between those variables
3. using a probability distribution, simulate each environment.

Comment:

Advantage:
It includes all foreseeable outcomes.

Disadvantages
It’s difficult in formulating the probability distribution and the model becoming
very complex.

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4, Value at risk

It means that although we have established the NPV of this project is to be 100
but maybe we haven’t got 100% confidence that we can get these full 100 but
instead we are confident to get 180 of it. So there would be a value of 20 at risk
that we can’t get.

So that value at risk is a value we are going to lose.

Z can be found in normal distribution table:

If it’s 99% confidence then Z=2.33
If it’s 95% confidence then Z=1.65

Standard deviation graph:

Probability

Value
mean

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 Something we are going to lose [Value at risk(VAR)]:

In one period:

VAR (1 period) = XZ

More than one period:

VAR (multi period) =VAR (1 period) X T

T would stand for how many times that 1 period would become multi period.
Eg, if one period=1year and multi period=5years then T=5.
If one period is 3months and multi period =1year then T=4.

 Something we can get at least:

Mean-VAR

 If we are given , the mean and actual result then we can calculate Z
and from distribution table we can find the % that we can get the actual
result.

What is ?
This is a measure of how data would be different from the average figure
(mean).

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Example: Apple Ltd

Apple ltd has estimated an annual standard deviation of $800,000 on one of its
other projects, based on a normal distribution of returns. The average annual
return on this project is $2,200,000.

Required:
Estimate the project’s Value at Risk (VAR) at a 99% confidence level for one
year and over the project’s life of five years.

Answer:

In one period:

VAR (1 period) = XZ =$800,000 X2.33=$1,864,000.

This means we would have a 1% of chance to lose $1,864,000 in 1 year.

In turn we have a 99% chance to get $2,200,000-$1,864,000=$336,000.and

this is the X value.

5 years

VAR (multi period) =VAR (1 period) X T =$1,864,000X 5 =$4,168,000.

This means we would have a 1% of chance to lose $4,168,000 over a 5 year

period.

In turn we have a 99% chance to get $2,200,000X5 -$4,168,000

=$6,832,000.and this is the X value.

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Apple ltd (continued):

Apple ltd has estimated an annual standard deviation of $800,000 on one of its
other projects, based on a normal distribution of returns. The average annual
return on this project is $2,200,000.

Required:
Calculate the percentage that Apple Ltd can guarantee to get at least $336,000.

Answer:

= 336,000 -2,200,000

800,000
=2.33

From the normal distribution table this gives us 0.4901 and due to its “mirror
effect” then we take 0.4901+0.5=99% so this means there would be 99% of
chance we can get 336,000 and 1% of chance we will lose 336,000
-2,200,000=$1,864,000.

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Option pricing model

Real options &Black-Scholes Option Pricing Model in investment decision making

When appraising the project the traditional NPV method doesn’t consider future
uncertainty relating to the project, i.e., a rise in material price leading to rise in
production costs to company would make company delay its projects to a
certain date later and if this is the case then we need to calculate that value
management would make as well, i.e., by delaying projects would save
company money and hence increase the overall value in the project as well.

1, Real Options

Types of options: (Real Options)

Option to delay To start a project later when it’s in at appropriate time
Option to expand To expand its business buying more NCAs or investment in overseas
Option to abandon To sell off something at the end of its life
Option to redeploy To abandon something in order to improve it

The first two options would be call options: a right to buy in the future, i.e.,
spending money.

The last two options would be put options: a right to sell in the future, i.e., to
withdraw something.

Project value= traditional value (NPV) + option value*

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*option value
This means an uncertainty taken into account by management into appraising a
project such as the options outline above.

Factors affecting option value

Call option value Put option value

Market price
Exercise price
Time to expiry
Volatility
Interest rate

Of course using Black Scholes Option pricing model can give you that option
value.

Black Scholes Option pricing is a European style option meaning it can be

exercised only ON the expiry date.

American option can be exercised before the expiry date.

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The calculation is to use Black-Scholes Option Pricing Model and your P4
examiner tends to focus on “option to delay” which has been tested in DEC2007
and June2011.

Formulae: (this has been given in your formulae sheet):

c= call option value

Pa= future cash flow resulting from the investment
Pe =cost incurred relating to the investment
e= 2.7183 (exponential constant which is developed by scientist)
r= risk free rate (not cost of capital)
t= time remaining before costs incurred (ie, the investment begins in 2years
time so t=2 not 24months because it’s expressed in years.)

2, Black Scholes Option Pricing model

Characteristics of Black Scholes Option Pricing model:

 Transaction costs and taxes are zero;

 The share pays no dividends;

 The option has European exercise terms;

 The short-term (risk-free) interest rate is known and constant.

 The standard deviation of returns must be estimated and be constant over

the life of the option;

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Q MMC (June2011 Q4) (call option)

Mesmer Magic Co (MMC) is considering whether to undertake the development

of a new computer game based on an adventure film due to be released in 22
months. It is expected that the game will be available to buy two months after
the film’s release, by which time it will be possible to judge the popularity of the
film with a high degree of certainty. However, at present, there is considerable
uncertainty about whether the film, and therefore the game, is likely to be
successful. Although MMC would pay for the exclusive rights to develop and sell
the game now, the directors are of the opinion that they should delay the
decision to produce and market the game until the film has been released and
the game is available for sale.

MMC has forecast the following end of year cash flows for the four-year sales
period of the game.

Year 1 2 3 4
Cash flow 25 18 10 5

MMC will spend $7 million at the start of each of the next two years to develop
the game, the gaming platform, and to pay for the exclusive rights to develop
and sell the game. Following this, the company will require $35 million for
production, distribution and marketing costs at the start of the four-year sales
period of the game.

It can be assumed that all the costs and revenues include inflation. The relevant
cost of capital for this project is 11% and the risk free rate is 3·5%. MMC has
estimated the likely volatility of the cash flows at a standard deviation of 30%.

Required:
(a) Estimate the financial impact of the directors’ decision to delay the
production and marketing of the game.

The Black-Scholes Option Pricing model may be used, where appropriate. All
relevant calculations should be shown.
(12 marks)

(b) Briefly discuss the implications of the answer obtained in part (a) above.
(5 marks)
(17 marks)

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Answer:

(b)
 It allows uncertainty to be considered when appraising a project.
 I.e., if the film is so successful then company would continue its investment.
 Based on the traditional NPV calculation it is a negative figure which is
unacceptable from shareholders perspective but when the option value is
calculated and integrated then it would be attractive because it’s positive.
 This calculation has lots of assumption and hence limitations come when
doing the calculation, e.g.:
1. Transaction costs and taxes are zero;
2. The share pays no dividends;
3. The option has European exercise terms;
4. The short-term (risk-free) interest rate is known and constant.
5. The standard deviation of returns must be estimated and be constant over
the life of the option;

 Company would have other options not just to delay, ie, when investing
money into the game platform maybe lots of programmers can be used
potentially for other future game centers as well and hence option to
redeploy can be considered.

 Or if the project is successful and so lots of advertisement expenses would

go into the company and hence company can further expand its businesses,
ie, option to expand by taking follow-on projects involving games based on
film sequels

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Q Dilute Ltd

Assume that Dilute ltd is considering taking a 20-year project which requires an
initial investment of $ 250 million in a real estate partnership to develop time
share properties with a UK real estate developer, and where the present value of
expected cash flows is $ 254 million. While the net present value of $ 4 million
is small, assume that dilute ltd has the option to abandon this project anytime
by selling its share back to the developer in the next 5 years for $ 150 million.
A simulation of the cash flows on this time share investment yields a variance in
the present value of the cash flows from being in the partnership of 0.09. The 5
year risk-free rate is 7%.

Required:
Calculate the total NPV of the project, including the option to abandon.

Answer:

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 Adjusted Present Value (APV)

We have looked at NPV calculation and we use WACC (weighted average cost of
capital) to discount cash flow.

WACC has incorporated debt and equity element and one of the arguments for
this is future sales, costs incurred have nothing to do with financing but instead
they are something to do with operations.

So that’s why we developed APV to separate business option from financing.

APV is used when you are appraising a project where its financial risk is
changed.

This means we use cost of equity (ungeared) to discount the basic cash flow
including revenue & expenses because they are something to do with business
not finance.

We can then establish present value of finance effect including issue cost, tax
saving on interest and subsidy as well and for these items we use risk free
rate/cost of debt to discount because APV doesn’t specify which discount rate
we should choose and you can argue that e.g., for tax saving on interest we
have no idea when tax rate may change and as a result we can use Rf or Kd to
discount the cash flow. Here notice you can either use Rf or Kd to discount cash
flow and whichever you use your examiner would give you a mark in the
exam(although your answer may be different from examiner’s and that’s totally
acceptable).

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 Calculation:

APV= Base case NPV + PV of Finance Effect

 Issue costs
 Tax savings on interest
 Subsidy
Only include relevant cash flow from operations

Discount factor would only include BR (Keu)

But when Co is geared(2approach to separate (Keu))

M&M preposition Beta

2 cost of equity Keg=Keu+(Keu-Kd)D(1-T) Geared Ungeared
E

3 WACC WACC(g)=WACC(ungeared)(1-Dt ) 1, ungeared βa= βe [ E ]

(Keu) D+E E+D(1-T)

2,CAPM Keu=rf+βa(Rm-Rf) Keu=rf+βa(Rm-Rf)

PV of finance effect calculation:

Issue costs:
1, % X amounts raised (not amounts required)
2, net off with tax saving
3, discount them

Tax saved on interest:

1, interest expense
2, multiply by tax rate
3, discount it

Subsidy:
1, PV of tax shield on interest
2, PV of subsidy (amounts saved net of tax because save interest=save
expense so increase in tax)

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Base Case NPV Example1:

Company A is an equity finance company with Ke=10%.

Company B is considering a project that would cost $100,000 to be financed

50% by equity (ke= 21.6%) and 50% by debt (kd (pre-tax) =12%).

Required:
Calculate Keu for company A and company B.

Answer:

Company A: Keu=10%

Company B:
Keg=Keu + (Keu-Kd)D(1-T)
E

21.6% =Keu + (Keu-12%) X 50 X (1-30%)

50
Keu=17.6%

Base Case NPV Example2:

Company has the following market value of finance:

Value of debt is $6m.

Value of equity is $11.8m.
Company’s current WACC is 19.7%.
Tax rate is 30%.

Required:
Calculate Keu for company.

Answer:
WACC (g) =WACC (ungeared) (1- Dt )

(Keu) D+E

19.7% =WACC (ungeared) X 1- 6X30%

6+11.8
WACC (ungeared) (Keu) =21.9%

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Base Case NPV Example3:

Company diversifies its business by entering into the mining industry.

The company’s equity beta is 0.85, and its financial gearing is 60% equity, 40%
debt by market value.

The average equity beta in the mining industry is 1.2, and average gearing 50%
equity, 50% debt by market value.

Tax rate is 30%.

The risk free rate is 5.5% per annum and the market return 12% per annum.

Required:
Calculate Keu.

Answer:
1, βa= βe [ E ] βa=1.2 x 50
ungeared E+D(1-T) 50+50 X (1-30%)
=0.71
2,CAPM Keu=rf+βa(Rm-Rf) Keu=5.5%+0.71X12%
=10%

Base Case NPV Example4:

Company has an equity beta of 0.85 and asset beta of 0.5.

Rf =5%
Rm=10%

Required:
Calculate Keu.

Answer:
Keu= Rf+βa(Rm-Rf)
=5%+0.5x(10%-5%)
=0.075

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Example: (JOJO Ltd) (issue cost)

CAPEX required: $20m

How to raise $20m: from a 1 for 3 rights issue at a price of £2 per share.

Right issue cost: 5%.

Rf: 10%.

Required:
Calculate issue cost to be incorporated into APV calculation where:
1, issue cost is not a tax allowable expense
2, issue cost is a tax allowable expense and tax is paid 1 year in arrears while tax
rate is 30%.

Answer:
1,
Amounts raised – issue costs = amounts required

100% 5% 95%
20m

20/0.95
=21.05 21.05-20=1.05
21.05X5%

DF @ yr 0= 1.05X1=1.05

APV= base case NPV - 1.05

2, DF@10% PV
Issue cost = 1.05 (1) yr0 1 (1.05)
Tax saved: 30%X1.05 =0.315 yr1 0.909 0.32
(0.73)

APV= base case NPV - 0.73

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Example: TT Ltd (tax saving on interest)

CAPEX required: $10m.

How to raise $10m: use a 5 year bank loan (year1-5) and interest expense is
10%.

Tax is paid 1 year in arrears at 30%.

Rf =10%.

Required:
Calculate tax saving on interest to be incorporated into APV calculation.

Answer:

1, interest 10%X$10m=$1m.
2, tax saved: 30% X$1m= $0.3m
3, discount it:
1 year in arrears based on year 1-5

$0.3X AF (YR2-6) @10%

$0.3XAF1-6 XDF (yr 1-5)@10%
=0.3X 1/0.1 X (1-1/1.1^5)X0.909
=0.3X3.791X0.909
=1.03

So APV=base case NPV + 1.03

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Example: SS ltd

CAPEX required=$20m

Company would normally borrow at 8%

Government has offered a loan at 6% (which is lower than market rate)

Risk free rate=5%

Project is for 5years

Tax rate is at 30% paid in the current year.

Required:
Calculate subsidy to be incorporated into APV calculation.

Answer:

1, PV of tax shield on interest

$20m X6%X30% XAF@5%(1-5yr) = 1.56
4.33

2, PV of subsidy
Subsidy %= 8%-6% =2%
Total subsidy p.a.= 2% X$20m=0.4

PV of subsidy (net off tax) 0.4X(1-30%)XAF@5% 5yrs =1.21

APV=base case NPV +1.56+1.21

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Comment of APV:

1, Difficult to choose an appropriate discount rate for side effect, ie, tax shield.

2, when establish the discount rate for base case NPV, ie, Keu, the beta factor is
based on M&M assumptions.

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 Internal rate of return (IRR)

This is a point at which NPV=0.

It means that any cost of capital which is more than this then company will lose
money.

It also means if any cost of capital=IRR then company would make no profit or
loss out of it so IRR is the maximum cost of capital company would suffer.

But IRR doesn’t consider the size of the project because it uses relative
measure.

IRR has got an assumption that cash flow would be reinvested at IRR but this is
too optimistic because maybe the project is very profitable once and you get
money from this project trying to invest in another profitable project? Well may
be yes and maybe no. Also most business when they got surplus funds they
would invest they in short term security and normally this would yield a lower
return than IRR.

Decision criteria:

IRR>cost of capital -accept the project

Calculation:

IRR= L + NPVL X (H-L)

NPVL-NPVH

Example Insider Ltd:

Insider Ltd has got net cash flows of project over 3 years to be $10m, $20m and
$30m. The cost of capital of Insider Ltd is 10%.

Required:
Calculate the internal rate of return (IRR) for the project.

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Answer:
Years Net cash flow DF@10% PV
1 10 0.909 9
2 20 0.826 17
3 30 0.751 23
49

Years Net cash flow DF@20% PV

1 10 0.833 8
2 20 0.694 14
3 30 0.579 17
39

IRR= L + NPVL X (H-L)

NPVL-NPVH
=10% + 49 X (20%-10%)
49-39
=59%

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 Modified internal rate of return (MIRR)

Because IRR is too optimistic so that’s why MIRR is developed and MIRR has got
an assumption to reinvest its cash flow based on cost of capital rather than IRR.

Calculation (given in the exam):

Way1: use growth method:

g=(Do )^1/n -1
Dn

Where Do=terminal value

Dn=initial investment

Way2: formulae (particularly useful when you are asked to calculate NPV and
then use NPV to slot into this formulae)

Example: MM ltd

MM Ltd is going to invest in a project with initial investment of $10m and a

further investment at the end of 1st year of $5m (present value is
$5m/1.08=4.6).

Cash flow expected from this project is as follows:

Year Cash DF@8% PV Compound Terminal
flow factor@8% value
1 6 0.925 6 1.08^4 8
2 5 0.856 4 1.08^3 6
3 4 0.793 3 1.08^2 5
4 3 0.734 2 1.08^1 3
5 5 0.679 3 1.08^0 5
18 27

Required:
Calculate MIRR.

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Answer:
WAY1：
Year CF DF
0+1 10X1+5X0.925 14.6
1-5 27 So 0.54 (14.6)
0
So from PV table DF should be @ 13%.

Way2: growth method

g=(Do )^1/n -1 = ( 27 )^1/5 -1 =13%

Dn 14.6

Way3:
Use formulae in the exam:

=( 18 )^1/5 (1+8%) -1
14.6
=13%

Comment about MIRR

 It gives the same result when using NPV and MIRR

 Does not assume that the CFs are reinvested at the IRR

 Eliminates the possibility of multiple IRRs

 Relative measure, easier for non-financial managers

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 Duration

This is the time taken to recover the approximately 50% of initial investment (if
discounted using IRR) or approximately 50% of present value of the project (if
discounted using cost of capital).

We’ve looked at payback period but it doesn’t consider the time value of money.

Then we developed discounted payback period but still this doesn’t consider the
cash flow beyond the pay back point.

In order to fix this problem we develop DURATION which stands for the average
time it takes to recover the initial investment considering the whole life of
projects.

Calculation:

Duration= PV x YRS

PV

We can develop present value by choosing either IRR or Cost of capital as

discount factor.

Example: Duration ltd

Duration ltd has the following project:

Years Cash flow
0 Initial investment (35)
1 Cash inflow 10
2 Cash inflow 20
3 Cash inflow 30
4 Cash inflow 40
5 Cash inflow 50

Required:

1 calculate the duration of project using IRR of 56% as a discount rate.

2 calculate the duration of project using cost of capital of 30% as a discount rate.

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Answer:

1, using IRR as a discount rate

Years Cash flow DF @ PV PVxYRs

56%(IRR)
1 Cash inflow 10 0.641 6 6
2 Cash inflow 20 0.411 8 16
3 Cash inflow 30 0.263 8 24
4 Cash inflow 40 0.169 7 28
5 Cash inflow 50 0.108 6 30
35 104

So duration=104/35=2.97years.

2, using cost of capital of 30% as a discount rate

Years Cash flow DF @ PV PVxYRs

30%(COC)
1 Cash inflow 10 0.769 8 8
2 Cash inflow 20 0.592 12 24
3 Cash inflow 30 0.455 14 42
4 Cash inflow 40 0.350 14 56
5 Cash inflow 50 0.269 13 65
61 195

So duration = 195/61=3.19years.

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 Macaulay Duration

This measures the time taken to recover approximately 50% of the initial
investment in the bond.

The method would be the same as the above while for the bond we are going to
discount cash flow using IRR.

Calculation:

Duration= PV x YRS

PV

1, we establish cash flow using coupon rate.

2, we discount cash flow using yield to maturity (IRR).

Example: Ma Ltd

Ma Ltd has a 5 year bond with a coupon rate of 10% at par value and market
value of $80.

At the end of 5th year Ma ltd would get 10% over the par value of bond.

The gross yield to maturity (IRR) is 16%.

Required:
Calculate Macaulay duration for this bond.

Answer:
Years Cash flow PV@16% PV x YRs
1 10 8.6 8.6
2 10 7.4 14.8
3 10 6.4 19.2
4 10 5.5 22
5 110 52.3 261.5
80 326.1

Macaulay duration=326.1 =4.07years.

80
It takes an average of 4.07 years to recover the initial investment in
bond.
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Bond price:

E.g., 5% coupon rate on 1000 par value.

If MV is 1200 so current yield is 50 =4%
1200

If MV is 800 so current yield is 50 =6%

800

Since par value is only1000 and for the option 1 you would need to pay the extra
of 200 to the company so actually you spent money out and so the gross return
you can get would reduce of course you can buy the bond with a higher coupon
rate in the market.

Since par value is only1000 and for the option 2 you have paid less 200 to the
company so actually you spent money out and so the gross return you can get
would increase of course you can buy the bond with a lower coupon rate in the
market.

Macaulay duration in detail:

This is also a measure of interest rate risk, i.e., as interest rate increases by 1%
then bond price would fall by 4.07% from the above calculation.

But is this correct? Well maybe no because the figure we just calculated is the
straight line figure but the actual figure would be in the slope line.

So we need to account for the error between actual and prediction value.

So that’s why we introduce “Convexity”.

The prediction value is always lower than the actual one so we need to plus that
convexity amount to arrive at the actual value.

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Modified Duration

An alternative way to calculate the interest impacting on the bond price would
be using “Modified Duration”.

Formulae:

Modified duration= Macaulay duration

1+yield to maturity(gross redemption yield)

Example:

Macaulay duration is 4.07, the gross redemption yield is 3%.

Calculate the modified duration.

Answer:

Modified duration= Macaulay duration =4.07 =3.95

1+yield to maturity 1+3%

This means when interest rate increases by 1% the bond price would fall by
3.95% or if interest rate decreases by 1% the bond price would increase by
3.95%.

Comment

 If there’s higher duration this means bond would be more risky than the one
with lower duration.

 Maturity period increases then duration increases.

 Coupon payment increases then duration decreases.

 As interest rate increases the market value of bond decreases and so

duration would decrease as well.

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Past exam question about Macaulay Duration: (June2011 Q3)

GNT Co is considering an investment in one of two corporate bonds. Both bonds

have a par value of $1,000 and pay coupon interest on an annual basis. The
market price of the first bond is $1,079·68. Its coupon rate is 6% and it is due
to be redeemed at par in five years. The second bond is about to be issued with
a coupon rate of 4% and will also be redeemable at par in five years. Both bonds
are expected to have the same gross redemption yields (yields to maturity).

GNT Co considers duration of the bond to be a key factor when making decisions
on which bond to invest.

Required:

(a) Estimate the Macaulay duration of the two bonds GNT Co is considering for
investment.
(9 marks)
(b) Discuss how useful duration is as a measure of the sensitivity of a bond price
to changes in interest rates.
(8 marks)
(17 marks)

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(b)

 Bonds which pay higher coupons effectively mature ‘sooner’ compared to

bonds which pay lower coupons.

 Therefore these bonds are less sensitive to interest rate changes and will
have a lower duration.

 Duration assumes there’s a linear relationship between bond price and the
yield to maturity.

 As yield to maturity (YTM) increases the bond price decreases.

 It also assumes an e.g., 5% increase in YTM would result in 5% decreases in

bond price.

 But this is different from the actual price.

 So therefore we need to calculate “convexity” between the two and modify

the prediction value.

 Duration is only useful in assessing small changes in interest rates.

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Session1.2 International investment appraisal

When appraising an overseas project using NPV this is very similar to what we
have done in the domestic NPV calculation.

We have 5 steps which would be applied in the international investment

appraisal as well.

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Pro forma:

Years 0($) 1($) 2($) 3($) 4($)

Sales revenue x x x x
Variable costs (x) (x) (x) (x)
Fixed costs (x) (x) (x) (x)
Taxable profit x x x x
Tax (x) (x) (x)
Tax saving on CA x x x
CAPEX (x)
Residual value x
Working capital (x) (x) (x) (x) x
Net cash flow($) (x) x x x x
Exchange rate(W)
Net cash flow(£) (x) x x x x
Additional tax
Net cash flow(£) (x) x x x x
Discount factor() 1
Present value (x) x x x x
NPV x

The difference between international and domestic NPV calculation is in the

international investment appraisal we include:

1. Retranslating overseas cash flow into home currency.

2. Additional tax we need to pay for.

Retranslation

When retranslating overseas cash flow into home currency we need to use
exchange rate.

So for the year0 (current year) we use the spot rate given by examiner.

But for year1, 2, 3 etc. which exchange rate we should use?

Well, we need to predict those using:

Inflation rate (purchasing power parity theory)*

Interest rate (interest rate parity theory)*

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*theories

1, PPPT (purchasing power parity theory)

What is it?
It means two currencies should have the same purchasing power, ie, buying
things at the same price in different countries.

If we buy an iPhone in US at $90 then in the UK suppose the current spot rate is
$2/ £ so in the UK we should purchase the iPhone for £45.

In one year’s time the price of the IPhone becomes $94.5 because of the 5%
inflation in US and £47.7 in UK because of the 6% inflation in UK.

In order to make the purchasing power equal(parity) then the exchange rate
would become $1.981/£. (94.5)
47.7

How to apply?

Example:

Spot rate is £1:$2 ($2/£)

Inflation:
UK USA
1 10% 15%
2 8% 10%
3 12% 8%
4 11% 11%

Required:
Estimate the foreign exchange rate for year 1-4.

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Answer:

St=So X (1+I1)
(1+I2)

Year
1 2X (1+15%) =2.09
(1+10%)
2 2.09 X(1+10%)=2.13
(1+8%)
3 2.13X (1+8%) =2.05
(1+12%)
4 2.05X(1+11%)=2.05
(1+11%)

2, interest rate parity theory (IRPT)

What is it?

It means two currencies should have the same amount. Wherever you’re going
to deposit money that would make no difference.

But in the real life different banks in different world offers different interest rate.

So if the current spot rate between $ and £ is $2/ £ which means if I put $50 in
US bank then it should be equal to £25 in the UK bank.

But if USA bank interest rate is 5% whilst in the UK bank it’s 6% then the money
would become:

US: $50 x (1+5%) =$52.5

UK: £25 X (1+6%) =£26.5

So in order to make two amounts interest rate equal to each other then the
exchange rate would become $1.981/£. ($52.5)
£26.5

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 How to apply?

Example:

Spot rate is £1:$2 ($2/£)

Interest rate:
UK USA
1 10% 15%
2 8% 10%
3 12% 8%
4 11% 11%

Required:
Estimate the foreign exchange rate for year 1-4.

Answer:

St=So X (1+Int1)
(1+Int2)

Year
1 2X (1+15%) =2.09
(1+10%)
2 2.09 X(1+10%)=2.13
(1+8%)
3 2.13X (1+8%) =2.05
(1+12%)
4 2.05X(1+11%)=2.05
(1+11%)

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Summary international fisher effect (1+m)=(1+r)(1+i)

It means after taking into account the inflation as well as interest rate (included
in m) the real rate of return of two currencies would be the same.

Illustration:

Interest rate Inflation rate

USA UK USA UK
6.08% 4.04% 4% 2%

Required:
What is the real rate of return for $ and £.

Answer:
R($) = 1+m =1+6.08% -1 =2%
1+I 1+4%

R(£) = 1+m =1+4.04% -1 =2%

1+I 1+2%

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 Additional tax
The objective of the company is to maximize shareholders wealth so after
investing money into overseas starting a project those NPV should be remitted
back to the parent company because most of the shareholders would be based
in there.

The question is should be pay additional tax?

Well, this is relating to double tax treaties.

The simple idea being if overseas tax rate is 20% but the home tax rate is 30%
then when remitting dividend to the home country we need to pay additional
10% of tax.

The reason why double tax treaties exist is because if country A has a lower tax
rate than country B then most companies in country B would invest in country A
in order to enjoy a lower tax rate and hence create benefits when competing
with local competitors in country A. so usually country A&B would sign a double
tax agreement to project the local market.

The next question is where do we apply the additional tax rate?

Example:

Years 0($) 1($) 2($) 3($) 4($)

Taxable profit 10 20 30 40

UK US
Tax rate 30% 20%
Tax rate 20% 30%
Tax rate 30% 30%

Required:
What is the additional tax we need to pay?
1.
Years 0($) 1($) 2($) 3($) 4($) 5($)
Taxable profit 10 20 30 40

Additional (1) (2) (3) (4)

tax@10%
2, no additional tax
3, no additional tax

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