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Advanced Financial Management (AFM) – Technical Articles

An outline of the aim of Advanced Financial Management, its structure and how the
syllabus is tested

Advanced Financial Management is one of the four options exams in Strategic Professional
in the ACCA Qualification. This article highlights the overall aims of, and main capabilities
required, for the exam and it recommends the study approach that candidates should adopt
(and the bad habits to avoid) when preparing for the Advanced Financial Management exam
to increase their chances of success.

Aim and capabilities

The aim of Advanced Financial Management is to enable candidates to demonstrate

application of relevant knowledge, techniques and skills, and to exercise professional
judgment, in recommending or taking decisions relating to the financial management of a
business. The overarching aim of such recommendations and decisions is to add value to a
business, paying due regard to the impact on the reputation of the business; and to ethical,
environmental and stakeholder concerns.

The exercise of professional judgment in making sound decisions requires the need for
careful weighing up of evidence that is often partial and incomplete. The right decision must
often be made without the help of a simple algorithm, and in the face of an array of criteria –
some technical and some ethical – which may be in conflict and not entirely clear cut. As
such, candidates are required to display analytical and evaluative skills, skills of judgment
where alternatives are considered, and discuss the limitations of techniques used. Presentation
skills are also important, and answers should be clear and well structured.

Analytical techniques and discussion should be applied in relation to the context of the
scenario in the question and related to the real world where applicable. It is not sufficient to
apply techniques or to conduct discussions without considering whether or not these apply to
the question asked. It is also important that candidates are up-to-date in their knowledge and
understanding of the current global economic and financial environment.

The principles underpinning Advanced Financial Management are introduced and developed
in Financial Management. In Financial Management, the following essential areas are
introduced and developed: financial environment; investment appraisal; cost of capital;
alternative ideas of, and impact of changes to, the capital structure; sources of finance;
dividend policy; working capital management; risk management and business valuation.

Advanced Financial Management explores these same areas, but at a more advanced level,
and considers problems and issues (many derived from real situations) relevant to the
highest-level financial management of an organisation.

New areas specific to Advanced Financial Management include responsibility towards

stakeholders, acquisitions and mergers, corporate reconstruction and re-organisation, the
international business environment and multinational organisations, and emerging issues.

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Finance managers need more than a battery of theories and techniques to succeed – they also
need a deep understanding of the context in which they work. As a consequence, candidates
will be expected to demonstrate up-to-date understanding of the international macroeconomic
environment and the operation of those international institutions that govern both trade and
the operation of the financial markets. This is especially important in the current global
economic climate of uncertainty.

To be successful at this level, candidates must be able to demonstrate an integrated

understanding of the subject. Therefore, it is essential that candidates are able to draw upon
the knowledge, techniques and skills gained in Financial Management, and apply these to
Advanced Financial Management. Also, knowledge gained from the other ACCA exams will
be useful in helping candidates demonstrate an integrated approach.

Advanced Financial Management syllabus

The relational diagram, Syllabus and Study Guide give a comprehensive detail of the
Advanced Financial Management syllabus. The intention is to test the entire range of the
Advanced Financial Management syllabus topic areas. It is important that candidates have a
sound knowledge of all the parts of the Syllabus and Study Guide and are able to apply the
knowledge to a variety of different business situations. It is also important that candidates
bring forward their knowledge of Financial Management and understand how the Advanced
Financial Management syllabus develops these areas.

All the questions in the exam may require candidates to draw on knowledge and techniques
from different parts of the syllabus. It is unlikely that questions will relate to only one part of
the syllabus.

On the other hand, it is likely that exams will continue to contain questions which are
substantive and analytically complex. The scenarios in questions are likely to be detailed and
require in-depth analysis, evaluation and discussion. Candidates’ ability to relate their
answers to the actual question scenario is vitally important.

In the main, the Syllabus and Study Guide areas are clarified, with sections being added as
necessary.

Please refer to the relational diagram, Syllabus and Study Guide for the further detail on topic
areas.

Structure and layout of the Advanced Financial Management exam

Section A contains one compulsory 50-mark question. This question is scenario-based, and
the requirements come from different areas of the syllabus. The question normally requires
candidates to perform complex computations, evaluate and analyse information, discuss and
assess various options, and make judgments, possibly based on explained and justified
assumptions. The question is substantive and analytically complex. It requires candidates to
structure at least part of the answer in a formal context for which four professional marks are
allocated.

These professional marks are awarded on the basis of the clarity and structure of the answer.
They may also be awarded for answers that are presented in the required format. So, for

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example, if a report is required, in order to gain the professional marks, the answer should be
in a report format and consist of a title, an introduction, other features as appropriate, a
conclusion, and make appropriate use of appendices.

Section B consists of two compulsory 25-mark questions. Although these questions and the
requirements are not as substantive as the 50-mark question in Section A, it is nevertheless
possible for the requirements of the questions to come from different parts of the syllabus.

Questions in Section B may require candidates to perform computations, interpret and

analyse information, discuss and assess various options, make judgments and explain
assumptions, and provide reasoned recommendations, to varying degrees. Questions will be a
mix of computations and discursive requirements. It is also possible for candidates to be
provided with incomplete or incorrect data and information, for which they need to provide
further computations and amendments, and then provide analysis and assessments.
Additionally, it is also possible that candidates are provided with numerical data and
information, which they need to analyse and provide recommendations. Section B questions
will be scenario-based as well.

Given that candidates are asked to consider information-intensive scenario-based questions in

both sections, it is imperative that they effectively plan their answers before the start writing.

Recommendations when preparing for and doing the advanced financial

management exam: forming good habits

The Advanced Financial Management exam is challenging. Adopting these recommendations

and good habits will give you a good chance of being successful in the examination.

Develop a sound knowledge of the entire Advanced Financial Management syllabus.

Augment studying the manuals with wider reading of the financial press, finance textbooks,
articles in Student Accountant and financial journals.

You should expect and be prepared for questions from a range of syllabus areas and more
than one area may be tested in a single question. Be prepared for questions that require you to
consider a number of areas of the syllabus within one question.

Use your exam time effectively. The questions may contain a substantial amount of
information that you will need to sort out and apply properly and you should plan your
answer before beginning to write it.

In your exams, good time management techniques and habits are essential in ensuring
success. Make sure that you are able to answer all parts of each question and manage your
time effectively so that you make a reasonable attempt at each part of each question. Good
time management skills are essential.

Often parts of a requirement may ask for more than one aspect. Make sure that you can
answer, and do answer, everything each part of each requirement is asking for.

Make sure you answer the requirements correctly. For example, if the question asks you to
explain, it is not enough just to list. If the question asks you to assess, it is not enough just to
explain.

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For the written parts of any question, remember it is generally a mark for each relevant point.
Repeating a point does not get you any extra marks and it wastes time. Avoid repetition.

Your answer must relate to the scenario in question. Context is very important for higher-
level exams. General answers will gain fewer or even no marks.

The presentation of your answers is critical. It is very important to pay regard to neatness,
organisation and structure of your answers. Professional exams are extremely time-pressured
but giving your answers a structure will help you organise your thoughts and work more
effectively. Make sure that your answers are legible because markers cannot award marks for
something that they cannot read.

Work through the past exam questions under exam conditions and to time. Doing past
questions will help you build efficiency in answering questions and help you build
knowledge of how to make your answer relevant to the scenario in the question.

Three things to avoid: do not form bad habits

Don’t use past exam questions to try to pick topic areas from the syllabus or rely on certain
areas coming up, for two reasons: first, you may get it wrong; second, the topic you picked is
part of a question but the rest of the question relates to a topic you decided not to study.
Trying to question/topic spot is not recommended.

Don’t disregard what you learnt in Financial Management and other exams. You will
probably need the knowledge (and techniques) from the other stages.

Don’t use incomplete sentences when making a point. Marks are awarded for complete points
made in full sentences. However, you can use bullet points and numbered paragraphs, and
headings when appropriate, to structure an answer to a question. But points made should be
in complete sentences.

In the future

The Syllabus and Study Guide will continue to be reviewed, updated and changed
periodically, and major changes will be explained in articles in Student Accountant.

In summary, applying correct techniques and knowledge to differing and complex scenarios,
adopting an integrative approach, demonstrating sound evaluative skills, displaying good
presentation skills, and making considered judgments and decisions, are the factors that will
lead to success in the Advanced Financial Management exam.

Written by a member of the Advanced Financial Management examining team

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Stepping up from Financial Management to

Advanced Financial Management

The Advanced Financial Management exam at Strategic Professional follows on from the
Financial Management exam at Applied Skills. As throughout the ACCA syllabus, the
underlying exam covers the main technical areas that all accountants are required to master,
whereas the Strategic Professional exam builds on that knowledge and explores advanced
skills and techniques.

In particular Advanced Financial Management expects candidates to have more depth of

knowledge, better analytical skills, and to be able to exercise greater professional judgement
than at Financial Management. Hence, instead of being asked to value a bond, a potential
Financial Management question, candidates will need to be able to recognise the need to
calculate a bond value given the scenario. For instance, candidates may be required to
evaluate the potential gain to the shareholders of a target company, of various offers from a
predator company. If one of these offers includes bonds then the value of the bonds will need
to be calculated, unless of course it is given in the question.

Another key distinction between Financial Management and Advanced Financial

Management is that in general the scenarios that candidates will be faced with will refer to
larger, more complex and more international organisations. A calculative example of this is
the need to be able to appraise projects carried out overseas whereas a discursive example is
the need to be able to discuss the role of key international organisations such as the
International Monetary Fund.

What is the key knowledge I need to bring forward from financial

management and how must I develop my knowledge for advanced financial
management?

In this section I will consider each of the key topics within Financial Management and give
some thoughts on what remains crucial and how it is developed further in Advanced
Financial Management. Given the constraints of this article please do not consider this list to
be exhaustive.

The financial management functions

This topic comprises knowledge that must be retained and developed as it will often help
candidates generate relevant points in discursive questions. Candidates should remember that
the overarching aim of their recommendations and decisions should be to add value to a
business. In particular candidates should recognise the responsibility financial managers have
to all stakeholders when they take decisions. Hence, decisions should be taken with due
regard to ethical, environmental and stakeholder concerns and, hence, the potential impact on
the reputation of the business. Additionally, the strategic impact of Financial Management
decisions and modern developments in Financial Management become important in
Advanced Financial Management.

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The financial management environment

This topic also comprises knowledge that must be retained and developed. Financial
managers must understand the environment in which they work if they are to take suitable
decisions. At Advanced Financial Management an up-to-date understanding of the
macroeconomic environment and the operation of those financial institutions that govern
trade and the operation of the global financial markets is essential.

Working capital management

At Advanced Financial Management it is unlikely that there will be questions regarding the
detail of how each element of working capital could be managed. However, candidates
should remember the key questions regarding how much should be invested in working
capital (the profitability/liquidity trade off) and how the working capital investment could be
funded. Equally the ability to calculate the relevant working capital ratios and the operating
cycle and discuss their significance should be retained.

Investment appraisal

This topic remains core. Out of the investment appraisal methods learnt at Financial
Management the discounted cash flow methods and in particular Net Present Value are the
most important. Key new techniques in Advanced Financial Management include Modified
Internal Rate of Return, the Adjusted Present Value approach and the ability to calculate the
NPV for an overseas project. Additionally, students should also be able to understand the use
of Value at Risk and how Linear Programming can be used to solve a multi-period capital
rationing problem. However actually solving the Linear Programming problem is beyond the
syllabus.

Business finance – including the cost of capital

With regard to Business Finance the knowledge developed at Financial Management needs
to be retained and developed. However as previously mentioned the focus in Advanced
Financial Management will be on larger, more complex and more international businesses.
Hence, a past exam question asked students to consider the ability of a company to pay its
desired dividend given that the profits were being earned in a number of different countries
with different tax rates and that transfer prices were being charged between some of those
divisions. Additionally, students need to understand and discuss how an acquisition could be
financed.

With regard to the Cost of Capital the key knowledge to be brought forward is the Capital
Asset Pricing Model including de-gearing and re-gearing, and the calculation of a Weighted
Average Cost of Capital. The detailed calculations for calculating the cost of debt are rarely
used in Advanced Financial Management. Instead candidates need to be able to calculate a
cost of debt using credit spreads expressed in basis points. Advanced Financial Management
also requires candidates to be able to use the Miller and Modigliani Proposition 2 (with tax)
formula to de-gear and re-gear a cost of equity. De-gearing and re-gearing in order to
calculate a suitable cost of equity for the given scenario is an area which has been much
examined in Advanced Financial Management. Hence, it is an area well worth mastering.

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Business valuations

While everything from Financial Management remains examinable, the key valuation
methods to remember are the free cash flow and price earnings methods. Furthermore, the
ability to forecast growth using past growth or Gordon’s growth approximation remains
important as growth is a key driver of value. This knowledge is then used in Advanced
Financial Management when considering mergers and acquisitions and corporate
reconstructions. Additionally, candidates should be able to value intangible assets, although
as yet this has not been examined to any great extent.

With regard to mergers and acquisitions candidates at Advanced Financial Management

should be able to distinguish between the different acquisition types and carry out appropriate
valuations and evaluate bids being made for a company from the point of view of the various
interested parties. Equally candidates need to be able to discuss the rationale for such
transactions and the actions a company could take to defend itself against a takeover bid.

With regard to corporate reconstructions candidates at Advanced Financial Management need

to be able to understand and discuss the potential causes of financial distress and failure and
how the risk of failure can be evaluated. The basic process that is likely to be used in any
reconstruction should be understood as this will help candidates better understand the
scenario of a question and what they are required to do in the question. Candidates should
understand the various types of business reorganisation, such as demergers, and discuss and
evaluate a potential Management Buy-Out. Demergers have arisen in a couple of recent
exams, and there is a common misconception that demerged companies are still controlled by
the same senior management which is simply not the case.

Risk management

In Financial Management the focus is on foreign exchange risk and interest rate risk. While
these remain important in Advanced Financial Management candidates should learn to think
about risk more broadly and be able to identify a great variety of risks from a scenario and
suggest ways in which they could be managed and mitigated.

With regard to foreign exchange risk candidates must remember what they learnt at Financial
Management. A past exam question in Advanced Financial Management required candidates
to consider the various types of foreign exchange risk that exist which is very much a
Financial Management topic. Additionally, a key skill that candidates must bring forward
from Financial Management, or relearn, is the ability to successfully convert from one
currency to another as candidates without this skill will always struggle to score well on a
calculative foreign exchange risk question. Having been briefly introduced to futures, options
and swaps at Financial Management candidates for Advanced Financial Management need to
learn how to carry out the necessary calculations for these instruments. This is a tricky, but
commonly examined area.

The situation with interest rate risk is similar. As well as remembering their knowledge from
Financial Management candidates for Advanced Financial Management must also learn the
detailed calculations required for futures, options, collars and swaps.

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The Black-Scholes option pricing model

The Black-Scholes option pricing model is a key new skill that has to be mastered for
Advanced Financial Management. Candidates must ensure that they can use the formula to
confidently and accurately value an option. Furthermore, candidates must understand the
various determinants of option value and the various sensitivities such as delta and the other
‘Greeks’. Indeed, candidates also need to be able to use delta to set up suitable hedging
strategies. The use of the Black-Scholes option pricing model to value real options also needs
to be understood.

The Black-Scholes option pricing model can arise in a multitude of questions. A question
could require the valuation of a financial or real option followed by related discussion and
analysis. Equally a project could have an embedded real option which needs to be valued in
addition to carrying out the usual project appraisal. Additionally, candidates should be able to
discuss other uses of the model such as how it can be used to value the equity of a company.

How to study advanced financial management

Initially candidates for Advanced Financial Management must ensure that they remember or
revise the key knowledge from Financial Management as well as studying the new topics and
techniques required for Advanced Financial Management. While doing this candidate must
make sure that they become confident with all the formulae given in the formula sheet
provided. Any formula provided is likely to be of importance, but candidates very often seem
unable or unsure how to use them. Equally candidates must make sure that they can use their
calculator quickly and confidently and get correct answers to their calculations. It is not
uncommon for students to show a formula with all the correct inputs but calculate an
incorrect answer.

Candidates should not spend excessive amounts of time studying the necessary topics as you
will pass Advanced Financial Management by applying your knowledge to the questions set,
not by rote learning. Hence, as soon as possible candidates should be working past exam
questions as this is how the application skills are learnt. Initially this is difficult as many
questions (especially those in Section A) will require knowledge from a number of topic
areas. However, candidates must persevere as it is by doing questions that they will pass the
exam.

Initially when working questions candidates may find that they need to refer to their notes or
textbooks or even have a very brief look at the answer to get them moving in the right
direction. However, candidates must learn to tackle the question themselves and must avoid
becoming expert at ‘auditing’ the examiners answer. I have never seen an exam question
where candidates are given the answer and asked to check it!

When working questions candidates should train themselves to use rounding in their
calculations as this saves time. A candidate who answers all the questions but whose answers
are more rounded than the printed answers is much more likely to pass than a candidate who
provides more detailed answers to only a few questions. Equally using rounding keeps the
numbers small and, hence, silly calculation errors are less likely to arise. Furthermore,
candidates should learn to give some sort of brief explanation of their calculations where
necessary. All too often markers are faced with large calculations which have inevitably
strayed from the model answer and, hence, are incorrect. If there is no explanation as to what

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the candidate was trying to do or thought the answer was showing it is very hard for credit to
be given. If there is a bit of explanation then, so long as sound financial management
techniques have been used, credit can be given to such answers.

With regard to the discursive elements of questions candidates must train themselves to write
brief concise points in short sentences. Candidates should aim to make as many different
points as the marks available. Equally there will always be more credit given to points which
relate to the scenario and which truly add value. Indeed, a list of points not related to the
scenario is unlikely to earn enough marks to pass. There is no point repeating the same point
or explaining it in huge depth. Showing you have breadth of knowledge is crucial.

Within the exam there will be four professional marks available. Typically, the Section A
question requires you to draft a report. Candidates must make sure that they learn how to earn
these marks as they could easily make the difference between a pass and a fail. Assuming a
report is required then candidates should:

• Show the bulk of the necessary calculations in an appendix. Very often you need to do
the calculations before writing the report. Hence, the examiner is quite happy that the
appendix comes first as he understands the constraints of the answer booklet you are
provided with.
• Start the report on a new page as this looks professional and means that you will have
some spare space in your appendix should you suddenly decide you need an
additional calculation.
• Show a brief but good report rubric showing who the report is to and from, the date
and the subject.
• Start with a brief introduction. Keep it short as your marker knows what the report is
about!
• Structure your answer. Use sub-headings which indicate which requirement you are
currently dealing with and keep your sentences and paragraphs short and easy to read.
Don’t let yourself ramble.
• Leave blank lines between your paragraphs as it looks, and is, much more
professional and is easier for your marker to read.
• Finish with a brief conclusion.
• Keep your writing as neat as possible.

As your skills develop you should aim to start working questions to time. If you always give
yourself the luxury of additional time before the exam you will not be able to complete the
exam in the time required.

By working questions in this way candidates will not only learn how to apply their
knowledge but will also learn the nature of their examiner and what he is looking for. Indeed,
students must learn to read the questions carefully. Especially when a question is dealing with
a tricky area the scenario and requirement often provides a significant amount of information
as to how the question should be answered. I would also recommend that candidates read a
couple of past examiner’s reports and the examiner’s approach article in the examiner’s
guidance section of the Advanced Financial Management pages on the ACCA website. By
doing this you will learn more about what the examiner is looking for and what he likes and
does not like.

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At the same time as learning the necessary topics and working questions candidates should be
reading around the subject using the financial press and the technical articles shown on the
Advanced Financial Management pages on the ACCA website. Taking an interest in the
subject can pay real dividends in the exam as a candidate who has been reading about real
world mergers and acquisitions is in a far better position to understand the scenario set in in a
mergers and acquisitions question and will also be far more able to come up with ideas
relevant to the scenario.

As the exam approaches candidates should avoid question spotting. The examiner is keen that
candidates do not pass when they have only mastered a few selected topics and sets the paper
accordingly.

Finally, prior to going into the exam candidates should decide their exam technique. How
much time should they spend reading the question and planning their answer? What order
will they attempt the questions in? I believe exam technique is very individual and candidates
should decide what will suit them best given their nature and based on their past experience. I
would however advise against leaving the Section A question until last as achieving a
reasonable mark in this question is so fundamental to achieving a pass.

What to do in the Advanced Financial Management exam

In the Advanced Financial Management exam students should:

• Avoid panic – I often think that candidates who fail, when they have the knowledge
to pass, do so because they end up in a panic. While it may be hard to avoid, knowing
your exam technique and sticking to it can help avoid panic. Additionally, remember
that while the exam is designed to test you and the scenario may be very different to
anything you have tackled before the solution must use the tools that you have learnt.
• Read and think carefully about a question before starting it – Too often
candidates seem to waste valuable time making a false start on one or more questions.
• Don’t give up – In calculation questions there are always easy marks available and if
you give up you will miss out on them. For instance, in a Net Present Value question
make sure you get the marks for discounting the net cash flows and adding them up
and making the basic conclusion as to whether or not the project seems acceptable. If
necessary make assumptions. If you need to calculate a Weighted Average Cost of
Capital but cannot see how to calculate the cost of equity you should simply assume a
sensible number. While you will have lost some marks, you can at least continue with
the question. In discursive questions even if the situation is something you have never
thought about before try to think what you could say that would be useful or would
add value.
• Maintain good structure – Keep your answers as neat as possible and keep your
sentences and paragraphs short and meaningful.
• Timings – Make sure you allocate sufficient time to each question. As soon as you do
not have a fair attempt at three questions your chances of passing start declining
rapidly.
• Rounding – Use rounding to keep your calculations simple and save time. Equally
save time by not writing out formulae unless you really need to – you win the mark by
using the formulae!
• Professional marks – Make sure you get as many of them as possible.

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Conclusion

Unfortunately, Advanced Financial Management earned the reputation of being a very hard
paper to pass. While it remains a testing paper, a candidate who prepares well and tackles the
exam in a sensible fashion should be able to pass. Candidates should try and be confident and
treat the exam as their chance to show off the knowledge and skills they have acquired.

William Parrott, freelance tutor and senior FM tutor at MAT Uganda

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Advanced Financial Management

– examiner approach
An outline of the aim of Advanced Financial Management, its structure and how the
syllabus is tested

Advanced Financial Management is one of the four options exams in Strategic Professional
in the ACCA Qualification. This article highlights the overall aims of, and main capabilities
required, for the exam and it recommends the study approach that candidates should adopt
(and the bad habits to avoid) when preparing for the Advanced Financial Management exam
to increase their chances of success.

Aim and capabilities

The aim of Advanced Financial Management is to enable candidates to demonstrate

application of relevant knowledge, techniques and skills, and to exercise professional
judgment, in recommending or taking decisions relating to the financial management of a
business. The overarching aim of such recommendations and decisions is to add value to a
business, paying due regard to the impact on the reputation of the business; and to ethical,
environmental and stakeholder concerns.

The exercise of professional judgment in making sound decisions requires the need for
careful weighing up of evidence that is often partial and incomplete. The right decision must
often be made without the help of a simple algorithm, and in the face of an array of criteria –
some technical and some ethical – which may be in conflict and not entirely clear cut. As
such, candidates are required to display analytical and evaluative skills, skills of judgment
where alternatives are considered, and discuss the limitations of techniques used. Presentation
skills are also important, and answers should be clear and well structured.

Analytical techniques and discussion should be applied in relation to the context of the
scenario in the question and related to the real world where applicable. It is not sufficient to
apply techniques or to conduct discussions without considering whether or not these apply to
the question asked. It is also important that candidates are up to date in their knowledge and
understanding of the current global economic and financial environment.

The principles underpinning Advanced Financial Management are introduced and developed
in Financial Management. In Financial Management, the following essential areas are
introduced and developed: financial environment; investment appraisal; cost of capital;
alternative ideas of, and impact of changes to, the capital structure; sources of finance;
dividend policy; working capital management; risk management and business valuation.

Advanced Financial Management explores these same areas, but at a more advanced level,
and considers problems and issues (many derived from real situations) relevant to the
highest-level financial management of an organisation.

New areas specific to Advanced Financial Management include responsibility towards

stakeholders, acquisitions and mergers, corporate reconstruction and re-organisation, the
international business environment and multinational organisations, and emerging issues.

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Finance managers need more than a battery of theories and techniques to succeed – they also
need a deep understanding of the context in which they work. As a consequence, candidates
will be expected to demonstrate up-to-date understanding of the international macroeconomic
environment and the operation of those international institutions that govern both trade and
the operation of the financial markets. This is especially important in the current global
economic climate of uncertainty.

To be successful at this level, candidates must be able to demonstrate an integrated

understanding of the subject. Therefore, it is essential that candidates are able to draw upon
the knowledge, techniques and skills gained in Financial Management, and apply these to
Advanced Financial Management. Also, knowledge gained from the other ACCA exams will
be useful in helping candidates demonstrate an integrated approach.

Advanced Financial Management syllabus

The relational diagram, Syllabus and Study Guide give a comprehensive detail of the
Advanced Financial Management syllabus. The intention is to test the entire range of the
Advanced Financial Management syllabus topic areas. It is important that candidates have a
sound knowledge of all the parts of the Syllabus and Study Guide and are able to apply the
knowledge to a variety of different business situations. It is also important that candidates
bring forward their knowledge of Financial Management and understand how the Advanced
Financial Management syllabus develops these areas.

All the questions in the exam may require candidates to draw on knowledge and techniques
from different parts of the syllabus. It is unlikely that questions will relate to only one part of
the syllabus.

On the other hand, it is likely that exams will continue to contain questions which are
substantive and analytically complex. The scenarios in questions are likely to be detailed and
require in-depth analysis, evaluation and discussion. Candidates’ ability to relate their
answers to the actual question scenario is vitally important.

In the main, the Syllabus and Study Guide areas are clarified, with sections being added as
necessary.

Please refer to the relational diagram, Syllabus and Study Guide for the further detail on topic
areas.

Structure and layout of the Advanced Financial Management exam

Section A contains one compulsory 50-mark question. This question is scenario-based and
the requirements come from different areas of the syllabus. The question normally requires
candidates to perform complex computations, evaluate and analyse information, discuss and
assess various options, and make judgments, possibly based on explained and justified
assumptions. The question is substantive and analytically complex. It requires candidates to
structure at least part of the answer in a formal context for which four professional marks are
allocated.

These professional marks are awarded on the basis of the clarity and structure of the answer.
They may also be awarded for answers that are presented in the required format. So, for

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example, if a report is required, in order to gain the professional marks, the answer should be
in a report format and consist of a title, an introduction, other features as appropriate, a
conclusion, and make appropriate use of appendices.

Section B consists of two compulsory 25-mark questions. Although these questions and the
requirements are not as substantive as the 50-mark question in Section A, it is nevertheless
possible for the requirements of the questions to come from different parts of the syllabus.

Questions in Section B may require candidates to perform computations, interpret and

analyse information, discuss and assess various options, make judgments and explain
assumptions, and provide reasoned recommendations, to varying degrees. Questions will be a
mix of computations and discursive requirements. It is also possible for candidates to be
provided with incomplete or incorrect data and information, for which they need to provide
further computations and amendments, and then provide analysis and assessments.
Additionally, it is also possible that candidates are provided with numerical data and
information, which they need to analyse and provide recommendations. Section B questions
will be scenario-based as well.

Given that candidates are asked to consider information-intensive scenario-based questions in

both sections, it is imperative that they effectively plan their answers before the start writing.

Recommendations when preparing for and doing the advanced financial

management exam: forming good habits

The Advanced Financial Management exam is challenging. Adopting these recommendations

and good habits will give you a good chance of being successful in the examination.

Develop a sound knowledge of the entire Advanced Financial Management syllabus.

Augment studying the manuals with wider reading of the financial press, finance textbooks,
articles in Student Accountant and financial journals.

You should expect and be prepared for questions from a range of syllabus areas and more
than one area may be tested in a single question. Be prepared for questions that require you to
consider a number of areas of the syllabus within one question.

Use your exam time effectively. The questions may contain a substantial amount of
information that you will need to sort out and apply properly and you should plan your
answer before beginning to write it.

In your exams, good time management techniques and habits are essential in ensuring
success. Make sure that you are able to answer all parts of each question and manage your
time effectively so that you make a reasonable attempt at each part of each question. Good
time management skills are essential.

Often parts of a requirement may ask for more than one aspect. Make sure that you can
answer, and do answer, everything each part of each requirement is asking for.

Make sure you answer the requirements correctly. For example, if the question asks you to
explain, it is not enough just to list. If the question asks you to assess, it is not enough just to
explain.

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For the written parts of any question, remember it is generally a mark for each relevant point.
Repeating a point does not get you any extra marks and it wastes time. Avoid repetition.

Your answer must relate to the scenario in question. Context is very important for higher-
level exams. General answers will gain fewer or even no marks.

The presentation of your answers is critical. It is very important to pay regard to neatness,
organisation and structure of your answers. Professional exams are extremely time-pressured
but giving your answers a structure will help you organise your thoughts and work more
effectively. Make sure that your answers are legible because markers cannot award marks for
something that they cannot read.

Work through the past exam questions under exam conditions and to time. Doing past
questions will help you build efficiency in answering questions and help you build
knowledge of how to make your answer relevant to the scenario in the question.

Three things to avoid: do not form bad habits

Don’t use past exam questions to try to pick topic areas from the syllabus or rely on certain
areas coming up, for two reasons: first, you may get it wrong; second, the topic you picked is
part of a question but the rest of the question relates to a topic you decided not to study.
Trying to question/topic spot is not recommended.

Don’t disregard what you learnt in Financial Management and other exams. You will
probably need the knowledge (and techniques) from the other stages.

Don’t use incomplete sentences when making a point. Marks are awarded for complete points
made in full sentences. However, you can use bullet points and numbered paragraphs, and
headings when appropriate, to structure an answer to a question. But points made should be
in complete sentences.

In the future

The Syllabus and Study Guide will continue to be reviewed, updated and changed
periodically, and major changes will be explained in articles in Student Accountant.

In summary, applying correct techniques and knowledge to differing and complex scenarios,
adopting an integrative approach, demonstrating sound evaluative skills, displaying good
presentation skills, and making considered judgments and decisions, are the factors that will
lead to success in the Advanced Financial Management exam.

Written by a member of the Advanced Financial Management examining team

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Scoring professional marks

This article explains what professional marks are, how they are awarded in the Strategic
Professional exams and to remind potential candidates how best to achieve these additional,
and often crucial, marks.

Professional marks were introduced to the ACCA Qualification to allow candidates to

demonstrate – and the ACCA examining team to assess – particular professional
communication skills and high-level capabilities that employers expect ACCA members to
possess.

Where and how many professional marks are available?

Apart from the Strategic Business Leader exam, in which 20 marks are available for
demonstrating professional skills, all other Strategic Professional exams include four
professional marks at each session. As shown by the specimen exams, these four marks are
available as follows:

• Strategic Business Reporting: two marks in the 'accounting and ethical implications
question' in Section A and two marks in the 'analysis questions' in Section B
• Strategic Professional – Options: in Question 1, the 'case study question' in Section A.

Professional marks are awarded for capabilities and skills which are in addition to – and
separate from – the technical intellectual levels, which include synthesis and evaluation as the
basis of Level 3 intellectual level capabilities – and as specified in the ACCA Strategic
Professional study guides.

They are awarded for the overall quality of answers and for using or adopting effective
professional communication skills as required by the examining team. These are determined
by a number of factors, as decided by the relevant examining team. They can include the
relevance of advice given, the clarity of information and explanations provided, presenting
logical conclusions and recommendations where appropriate, quality of discussion, showing
sensitivity to the intended target audience and using the appropriate tone and, for the format,
structure and presentation of the answer or communication required. Professional marks can
also be awarded for introducing an answer clearly by ‘setting the scene’ – laying out key
objectives in the context of the specific requirements and for the use of judgment in
addressing the key objective of the communication.

A typical requirement relating to professional marks would be as follows, from the Advanced
Financial Management (AFM) specimen exam:

Professional marks will be awarded in part (d) for the presentation, structure, logical flow
and clarity of the memorandum. (4 marks)

Such requirements have been regularly examined in Strategic Professional exams since
December 2007 and have included the need to do the following or similar:

• prepare meeting notes

• draft a discussion paper

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• report to a board of directors

• prepare a memorandum
• present briefing notes
• write a letter to a client

Candidates can earn a majority of the marks available for the technical content of the
requirements, particularly if their answer contains enough relevant points, but the major
discriminator in answering the case study question is the professional mark component.

It is the latter that many technically well-prepared and knowledgeable candidates fail to
adequately address, and which can lead to failure for the exam overall. As there are 1.8
minutes per mark for the Strategic Business Reporting and Strategic Professional – Options
exams, professional marks should attract at least seven minutes of work or thought in an
exam and, therefore, should be given sufficient attention when answering such a question.

It is vitally important to remember that, statistically, a significant proportion of candidates

score between 45% and 55% in any exam, as a consequence of the ‘bell-shaped’ curve of the
normal distribution of marks derived from a representative cohort of candidates. This means
that marks lost or missed for any available professional marks can make a considerable
difference to the marginal candidates’ chances of success, particularly when up to 4% of the
marks in any one exam may be at stake for demonstrating these professional skills. And
following the aforementioned 1.8 minutes per mark rule, you should aim to use the required
exam time to gain these marks. Hence, the need for careful consideration.

Some tips for acquiring professional marks, depending on what is being asked
for

• Think and plan your answer before you start writing.

• Establish who you are or what your role is in the requirement, along with who
your audience is and what you are trying to achieve. For example, are you an audit
manager, a management expert employed by the company or an independent financial
consultant and who are you trying to influence or persuade, and for what reason?
• Consider the type of communication you are required to give and be clear whether
you are writing in the first (‘I’ or ‘we’) or third person (‘it’ or ‘the company’). For
example, a letter is best written in the first person and a report usually in the third
person.
• Adopt a format or structure that is most appropriate for the type of communication
required – is there a need for an introduction, conclusions or recommendations?
• Decide in which order you should present information, to improve the logical flow
and strength of your arguments.
• Group similar points together and decide whether you want to introduce key points
first, or keep some until last, for maximum impact and to improve persuasiveness.
• Use headings and include spaces between your paragraphs to enhance your
presentation marks and create a more professional looking answer.
• Use bullet points only when appropriate.
• Where relevant, try and refer to your audience throughout the answer, particularly in a
letter in which the tone of your answer is personal. For example: ‘If you were to claim
this relief, you would have to …’.

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Professional marks are, therefore, about showing the ability to communicate effectively by
formulating advice or supporting a course of action and demonstrating alternative standpoints
using the case scenario and through effective argument and counterargument. It may be that
the examining team wants the candidate to generate ideas or link or adapt theories or
methods. Professional marks may require a candidate to arrive at a solution or gain a new
insight by exercising professional judgment and adopting an ethical stance in providing
advice.

Such professional skills require the candidate to analyse and present information in the
context of the views and perceptions of the person that they are supposed to represent, such
as a CEO, and may include anticipating reactions from the intended audience.

To earn professional marks, it may often be necessary to draw together the main themes of an
answer and select or prioritise the main points of an argument to arrive at a valid and properly
supported overall conclusion. Sometimes you may be required to put forward some
recommendations, which must be supported by the details included in the main body of the
answer given or drawn from information in the case scenario.

Summary

In summary, professional marks are for doing the following:

• understanding the intended purpose of a communication

• identifying its intended users and their needs
• preparing and using the appropriate type of document in an answer
• using a logical and appropriate answer structure or format
• judging the tone to use, depending on the nature of background information and
objectives to be met
• assessing where and how much detail is required, as appropriate
• adopting clear, concise, and precise methods of presentation, both in verbal and
numerical contexts.

Not all the above will be assessed in each exam, but they do indicate the kind of capabilities
that candidates might be required to demonstrate. The relevant question requirements will
clearly indicate where professional marks are allocated in each exam and how these marks
will be awarded.

As already stated, in total, four marks will be available for professional capabilities in
Question 1 in each of the Strategic Professional – Options exams and split between a Section
A question and a Section B question in Strategic Business Reporting. The professional marks
may be available for just one part of the requirements or the entire requirements.

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How to answer an interest rate risk

management question
Questions on risk management feature regularly in the Advanced Financial Management
exam. Performance information from recent exams suggests students tend to do less well on
interest rate risk management questions than questions about foreign exchange risk
management. This article will therefore explain the significance of the information you’ll be
given in interest rate risk management questions and show you what you’ll be asked to do.

The scenario is adapted from Wardegul Co, Question 4 in the September/December 2017
sample questions which ACCA has published.

Scenario

Assume Wardegul Co has a newly acquired subsidiary in Euria, where the local currency is
the dinar (D). The subsidiary expects to receive D27,000,000 and wants to invest this
D27,000,000. Assume it is now 1 October 2017 and the subsidiary expects to receive the
money on 31 January 2018. It wishes the money to be invested for five months until 30 June
2018.

Currently the central bank base rate in Euria is 4·2%, but Wardegul Co’s treasury team has
seen predictions that the central bank base rate could increase by up to 1·1% or fall by up to
0·6% between now and 31 January 2018. The treasury team believes that Wardegul Co can
invest funds at the central bank base rate less 30 basis points.

The treasury team normally hedge interest rate exposure by using whichever of the following
products is most appropriate:

• Forward rate agreements (FRAs)

• Interest rate futures
• Options on interest rate futures

Treasury function guidelines emphasise the importance of mitigating the impact of adverse
movements in interest rates. However, they also allow staff to take into consideration upside
risks associated with interest rate exposure when deciding which instrument to use.

A local bank in Euria, with which Wardegul Co has not dealt before, has offered the
following FRA rates:

• 4–9: 5·02%
• 5–10: 5·10%

The treasury team has also obtained the following information about exchange traded Dinar
futures and options:

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Three-month D futures, D500,000 contract size

Prices are quoted in basis points at 100 – annual % yield

December 2017 94.84

March 2018 94.78
June 2018 94.66

Options on three-month D futures, D500,000 contract size, option premiums are in

annual %

Call Put
December March June December March June
0.417 0.545 0.678 94.25 0.071 0.094 0.155
0.078 0.098 0.160 95.25 0.393 0.529 0.664

It can be assumed that futures and options contracts are settled at the end of each month.
Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on
monthly time intervals. It can also be assumed that there is no basis risk and there are no
margin requirements.

Requirements
Recommend a hedging strategy for the D27,000,000 investment, based on the hedging
choices which treasury staff are considering, if interest rates increase by 1·1% or decrease by
0·6%. Support your answer with appropriate calculations and discussion. (18 marks)

Approaching the question

Read the requirements carefully

You should read the requirements first before reading the scenario in detail. Knowing what
your answer has to cover, and therefore what the key data will be, will help you analyse the
scenario.

Breaking down the requirements for Wardegul Co:

Recommend a You’ll have to make a clear recommendation

hedging strategy based on your calculations. Anyone reading the
recommendation should be able to see:

• How much would be received under each

instrument

• The effective annual interest rate for each

instrument

so that they can compare the results of the

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hedging choices with the interest rate currently

available.
Based on the hedging You need to consider all the hedging
choices which treasury instruments for which data is given, including
staff are considering both the options.
If interest rates You should assess, for all the hedging
increase by 1·1% or instruments, what will happen if interest rates
decrease by 0·6% rise or fall.
Support your answer You should make some comment on any
with appropriate calculation you carry out in the Advanced
calculations and Financial Management exam. However,
discussion mentioning discussion in the question
requirements here indicates that a number of
marks will be available for comments (four
marks maximum per the marking scheme).
Therefore, a single sentence comment won’t be
enough.

Identify the important data in the scenario

For interest rate hedging questions, you need to identify the information that will affect the
calculations for each instrument. Let’s have another look at the scenario, with the important
data highlighted and referenced to explanations below.

Assume Wardegul Co has a newly-acquired subsidiary in Euria, where the local currency is
the dinar (D). The subsidiary expects to receive D27,000,000 and wants to invest this
D27,000,000.

Forward rate Futures Options

agreements
Wants to invest this Possibilities are: Buy now (go long), Buy call option
D27,000,000 sell later

• Pay money to bank if

base rate exceeds FRA
rate

• Receive money from

bank if FRA rate is
greater than base rate

Assume it is now 1 October 2017 and the subsidiary expects to receive the money on 31
January 2018.

Forward rate Futures Options

agreements
It is now 1 Oct 2017 A period of four Choose futures dated Choose options dated
and the subsidiary months, so look for a after January – March after January – March
expects to receive the 4–x agreement is closest date is closest date

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Forward rate Futures Options

agreements
money on 31 Jan
2018

It wishes the money to be invested for five months until 30 June 2018.

Forward rate Futures Options

agreements
The money Four months Contracts are Contracts are
to be to start of for three for three
invested for investment + months, so months, so
five months five months to adjust adjust
until 30 June end of contracts contracts
2018 investment = calculation, so calculation,
nine months, that five- so that five-
so select 4–9 month period month period
agreement is covered is covered
Calculate Calculate Calculate
investment investment investment
return for five return for five return for five
months months months
Calculate
transaction
with bank for
five months
Adjust Adjust Adjust
effective effective effective
annual annual annual
interest rate interest rate interest rate
calculation for calculation calculation
interest being for interest for interest
received for being being
five months received for received for
five months five months

Currently the central bank base rate in Euria is 4·2%,

Forward rate Futures Options

agreements
Currently the Affects Affects Affects
central bank calculation of: calculations calculations
base rate in of: of:
Euria is • Future
currently interest rates • Future • Future
4.2% interest rates interest rates

• Basis • Basis

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but Wardegul Co’s treasury team has seen predictions that the central bank base rate could
increase by up to 1·1% or fall by up to 0·6% between now and 31 January 2018.

Forward rate Futures Options

agreements
The central Affects future Affects future Affects future
bank base interest rates interest rates interest rates
rate could and hence: and hence: and hence:
increase by
up to 1.1% or • Actual • Actual • Actual
fall by up to investment investment investment
0.6% return return return

• Transaction • Calculation • Calculation

with bank of expected of expected
futures price futures price
and hence and hence
result on whether
futures options are
market exercised or
not

• Calculation
of gain if
options are
exercised

The treasury team believes that Wardegul Co can invest funds at the central bank base
rate less 30 basis points.

Forward rate Futures Options

agreements
Wardegul Co can Affects actual Affects actual Affects actual
invest funds at the investment return: investment return: investment return:
central bank base
rate less 30 basis • If rate rises to 5.3%, • If rate rises to 5.3%, • If rate rises to 5.3%,
points investment return will investment return investment return
be 5.0% will be 5.0% will be 5.0%

• If rate falls to 3.6%, • If rate falls to 3.6%, • If rate falls to 3.6%,

investment return will investment return will investment return will
be 3.3% be 3.3% be 3.3%

The treasury team normally hedges interest rate exposure by using whichever of the
following products is most appropriate:

• Forward rate agreements (FRAs)

• Interest rate futures
• Options on interest rate futures

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Treasury function guidelines emphasise the importance of mitigating the impact of adverse
movements in interest rates. However, they also allow staff to take into consideration upside
risks associated with interest rate exposure when deciding which instrument to use.

A local bank in Euria, with which Wardegul Co has not dealt before, has offered the
following FRA rates:

• 4–9: 5·02%
• 5–10: 5·10%

The treasury team has also obtained the following information about exchange traded Dinar
futures and options:

Three-month D futures, D500,000 contract size

Forward rate Futures Options

agreements
Three-month Affects calculations
D500,000 futures of:

• Number of futures
contracts

• Result on futures
contracts

Prices are quoted in basis points at 100 – annual % yield

December 2017 94.84

March 2018 94.78
June 2018 94.66

Options on three-month futures, D500,000 contract size, option premiums are in annual %

Forward rate Futures Options

agreements
Options on three- Affects calculation
month futures, is of:
D500,000 contract
size • Number of options
contracts

• Gain if options are

exercised

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Forward rate Futures Options

agreements

• Option premium

Call Put
December March June December March June
0.417 0.545 0.678 94.25 0.071 0.094 0.155
0.078 0.098 0.160 95.25 0.393 0.529 0.664

It can be assumed that futures and options contracts are settled at the end of each month.
Basis can be assumed to diminish to zero at contract maturity at a constant rate, based on
monthly time intervals. It can also be assumed that there is no basis risk and there are no
margin requirements.

Forward Futures Options

rate
agreements
Basis can be Use in basis Use in basis
assumed to calculation: calculation:
diminish to
zero at • Period • Period
contract between between
maturity at a investment investment
constant date (31 date (31
rate, based January) and January) and
on monthly contract contract
time maturity date maturity date
intervals (31 March) (31 March)
(two months) (two months)

• Period • Period
between between
today’s date today’s date
(1 October) (1 October)
and contract and contract
date (31 date (31
March) (six March) (six
months) months)

Let’s now review the answer:

Forward rate agreement

FRA 5.02% (4 – 9) since the investment will take place in four months’ time for a period of
five months.

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If interest rates increase by 1.1% to 5.3%

D
Actual investment return 5.0% × 5/12 × D27,000,000 562,500
Payment to bank (5.3% – 5.02%) × 5/12 × D27,000,000 (31,500)
Net receipt 531,000
Effective annual interest rate 531,000/27,000,000 × 12/5 4.72%
D
Actual investment return 3.3% × 5/12 × D27,000,000 371,250
Receipt from bank (5.02% – 3.6%) × 5/12 × 159,750
D27,000,000
Net receipt 531,000
Effective annual interest rate as above 4.72%
531,000/27,000,000 × 12/5
Comment

The two calculations should give the same effective annual interest rate.

Futures

Buy futures now (go long in the futures market), as the hedge is against a fall in interest
rates.

Use March contracts, as investment will be made on 31 January.

Number of contracts = D27,000,000 ÷ D500,000 × 5 months ÷ 3 months = 90 contracts

Basis

Current price (1 October) – futures price = basis

(100 – 4.20) – 94.78 = 1.02

Unexpired basis on 31 January = 2/6 × 1.02 = 0.34

If interest rates increase by 1.1% to 5.3%

D
Actual investment return 5.0% × 5/12 × D27,000,000 562,500
Expected futures price: 100 – 5.3 – 0.34 = 94.36
Loss on the futures market: (0.9436 – 0.9478) × (47,250)
D500,000 × 3/12 × 90
Net return 515,250
Effective annual interest rate 515,250/27,000,000 × 12/5 4.58%

If interest rates fall by 0.6% to 3.6%

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D
Actual investment return 3.3% × 5/12 × D27,000,000 371,250
Expected futures price: 100 – 3.6 – 0.34 = 96.06
Profit on the futures market: (0.9606 – 0.9478) × 144,000
D500,000 × 3 /12 × 90
Net receipt 515,250
Effective annual interest rate 515,250/27,000,000 × 12/5 4.58%
Comment

The two calculations should give the same effective annual interest rate.

As we are buying futures now, then selling futures later:

• we make a PROFIT if the expected futures price is GREATER than the current futures
price

• we make a LOSS if the expected futures price is LESS than the current futures price

Options

Buy call options as need to hedge against a fall in interest rates.

Use March contracts, as investment will be made on 31 January.

Number of contracts = D27,000,000 ÷ D500,000 × 5 months ÷ 3 months = 90 contracts

Basis

Current price (1 October) – futures price = basis

(100 – 4.20) – 94.78 = 1.02

Unexpired basis on 31 January = 2/6 × 1.02 = 0.34

If interest rates increase by 1.1% to 5.3%

Exercise price 94.25 95.25

Expected futures price: 94.36 94.36
100 – 5.3 – 0.34 = 94.36
Exercise? Yes No
Gain in basis points 11 0
D D

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Actual investment return 562,500 562,500

5.0% × 5/12 ×
D27,000,000
Gain from options 0.0011 12,375 0
× D500,000 × 3/12 × 90
Premium
0.00545 × D500,000 × (61,313)
3/12 × 90
0.00098 × D500,000 × (11,025)
3/12 × 90
Net return 513,562 551,475
Effective interest rate
513,562/27,000,000 × 4.56%
12/5
551,475/27,000,000 × 4.90%
12/5
Exercise price 94.25 95.25
Expected futures price: 96.06 96.06
100 – 3.6 – 0.34 =
96.06
Exercise? Yes Yes
Gain in basis points 181 81
Actual investment 371,250 371,250
return 3.3% × 5/12 ×
D27,000,000
Gain from options
0.0181 × D500,000 × 203,625
3/12 × 90
0.0081 × D500,000 × 91,125
3/12 × 90
Premium

0.00545 × D500,000 × (61,313)

3/12 × 90
0.00098 × D500,000 × (11,025)
3/12 × 90
Net return 513,562 451,350
Effective interest rate
513,562/27,000,000 × 4.56%
12/5
451,350/27,000,000 × 4.01%
12/5

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Comment

If one of the options is exercised for both interest rates, as the 94.25 is here, the calculations
should give the same result.

As these are CALL options, options to buy, choose the LOWER price and so:

• If the exercise price is LOWER than the expected futures price, EXERCISE

• If the exercise price is HIGHER than the expected futures price, DO NOT EXERCISE

Discussion
The forward rate agreement gives the highest guaranteed return. If Wardegul Co wishes to
have a certain cash flow and is primarily concerned with protecting itself against a fall in
interest rates it will most likely choose the forward rate agreement. The 95.25 option gives a
better rate if interest rates rise, but a significantly lower rate if interest rates fall, so if
Wardegul Co is at all risk averse it will choose the forward rate agreement.

This assumes that the bank with Wardegul Co deals with is reliable and there is no risk of
default. If Wardegul Co believes that the current economic uncertainty may result in a risk
that the bank will default, the choice will be between the futures and the options, as these are
guaranteed by the exchange. Again the 95.25 option may be ruled out because it gives a much
worse result if interest rates fall to 3.6%. The futures give a marginally better result than the
94.25 option in both scenarios, but the difference is small. If Wardegul Co feels there is a
possibility that interest rates will be higher than 5.41%, the point at which the 94.25 option
would not be exercised, it may choose this option rather than the future.

Comment
Identifying which of the possible strategies gives the highest value is only the start of the
discussion and you need to consider other factors that may influence the decision to obtain
four marks:

• The level of risk aversion that Wardegul Co has. The treasury team appears to be weighing
limiting downside against the possibility of taking advantage of upside.

• Other risk considerations are also important. There may be counterparty risk, as FRAs are
over-the-counter instruments.

• The decision may depend upon what is believed about future interest rates. Here, as rates
are volatile, you should consider whether the decision would change depending on what
interest rates are expected.

The discussion should be in full sentences and use information relevant to the scenario. A
bullet point list or generic statements relating to hedging are unlikely to be awarded many
marks.

Conclusion

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This article has demonstrated how to use the data given in the question to calculate the impact
of interest rate hedging. Hopefully it will help you tackle interest rate risk management
questions in a structured way, which should mean that you score well.

Written by a member of the examining team for Advanced Financial Management

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Reverse takeovers
Reverse takeovers is a topic that is examinable in Advanced Financial Management. This
article aims to provide an explanation of reverse takeovers and to discuss the potential
benefits and drawbacks associated with reverse takeovers (RTO).

Reverse takeovers – an explanation

An RTO involves a smaller quoted company taking over a larger unquoted company by a
share-for-share exchange. In order to acquire the larger unquoted company, a large number of
shares in the quoted company will have to be issued to the shareholders of the larger
unquoted company. Hence, after the takeover the current shareholders in the larger unquoted
company will hold the majority of the shares in the quoted company and will therefore have
control of the quoted company.

On completion of an RTO, it is usual for the quoted company to be managed by the senior
management team from the previously unquoted company and to take the name of the
previously unquoted company.

Through the RTO, the previously unquoted company has effectively achieved a listing on the
stock exchange. Eddie Stobart, a road haulage company based in the UK, achieved a listing in
this way in 2007 by combining with Westbury, a property and logistics company.

It is worth noting that in the USA, the term 'reverse merger' is often used as opposed to the
term reverse takeover.

As ever, there are many variations on the basic idea. For instance, an RTO may involve a
quoted company, which is actively trading, or a shell company, which is not actively trading.

RTOs have often been deemed to be the poor man’s initial public offering (IPO) perhaps due
to US studies showing that companies achieving a listing through a reverse merger generally
have lower survival rates and underperform compared to companies who have achieved their
listing through a traditional IPO.

However, studies in the UK have shown that this is not necessarily the case. Indeed, during
the period 1995 to 2012, RTOs seem to have survival rates similar to those for IPOs. The best
results seem to arise with RTOs, which involve a quoted company that is actively trading, as
the takeover is then able to benefit from synergy gains. Equally, small RTOs seem to perform
better than larger ones.

Reverse takeovers – the potential benefits

As previously stated, an RTO is effectively a way that a currently unquoted company can
achieve a listing. Hence, just as with an IPO, the company obtains the benefits of the public
trading of its securities. These benefits include:

Easier access to capital markets

As a listed company, more finance is likely to be available and the cost of that finance is
likely to be lower than if the company was still unquoted.

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Higher company valuation

As the shares in the company will be listed, potential investors will deem the shares to be less
risky as the company will have to abide by the relevant rules and regulations. Additionally,
they will know that the shares are liquid and that whenever they wish to sell there will be a
willing buyer. As a result of this, investors are likely to attribute a higher value to the shares.

Enhanced ability to carry out further takeovers

Once the shares in a company are listed, the company is able to acquire other companies
through further share-for-share exchanges.

Enhanced ability to use share-based incentive plans

Once the shares of a company are listed, share based incentive plans can be used as a key tool
to attract and retain good quality employees.

In addition to the above, an RTO has a number of other potential benefits when compared to
a normal IPO. These include the following:

Speed
An IPO can often take between one and two years to complete whereas an RTO can be
completed in as little as 30 days. Furthermore, the work required to complete an IPO can
mean that the managers of a company have less time to run the company, which may prove
detrimental to the growth prospects of the company. The variability of market conditions can
also make the speed of an RTO attractive, as in the time taken to prepare for an IPO, the
market may deteriorate such that the IPO is not finally worth completing. Furthermore,
particular circumstances in a market may make RTOs attractive. For instance, in China the
IPO process is notoriously slow and there is usually a significant queue of companies waiting
to carry out an IPO. An RTO allows a company to jump this queue.

Cost
Just as an IPO is a time-consuming process, it is also an expensive one due to the volume of
work required by investment banks, sponsors, accountants and other advisers. An RTO will
usually, but not always, cost less.

Availability
In a market downturn it is not easy to convince investors to support an IPO, whereas this does
not seem to be the case with RTOs. Studies have shown that the volume of RTO transactions
is far more resilient to market downturns. During the market correction that followed the
bursting of the dotcom bubble, the number of RTOs actually increased while the number of
IPOs fell very significantly.

Similarly, the fall in the number of RTOs was less than the fall in the number of IPOs
following the more recent financial crisis. This is probably because, with an RTO, the deal is
fundamentally between the shareholders of the quoted and unquoted companies involved and,
hence, market sentiment has much less import.

Furthermore, while an RTO is often accompanied by a concurrent secondary offering to raise

new finance, the amount of new finance being raised in both $ and % terms is usually less
than that which is raised during an IPO. Hence, even in a downturn, investors are often more
willing to support an RTO rather than an IPO.

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Existing analyst coverage

A listed company subject to an RTO is likely to have existing analyst coverage and, after the
RTO, this analyst coverage usually continues. However, companies that use an IPO may
struggle to get significant analyst coverage especially if they are smaller. Without reasonable
analyst coverage, potential investors may not have much awareness of the company and,
hence, are unlikely to want to invest in the company.

Reverse takeovers – the potential drawbacks

RTOs do, however, have a number of potential drawbacks when compared to an IPO and any
company considering an RTO should be aware of these.

Lack of expertise
A company achieving a listing through an RTO may find that it does not have the expertise to
understand and deal with all the regulations and procedures that listed companies must
comply with. The long process of listing through an IPO can be viewed as a valuable training
period and any company that has been through the process is in a better position to deal with
the requirements of the exchange than a company catapulted onto the market through an
RTO. Hence, any company considering an RTO must consider the need to hire and/or retain
staff from the existing listed company who are able to keep the company compliant with all
the relevant regulations.

Reputation
As previously discussed, an RTO has often been viewed as a poor man’s IPO. Hence,
companies that achieve their listing in this way may be viewed less favourably by investors
than companies that have completed an IPO. To some extent, the reasons for this lie in the
recent past.

In 2011 and 2012, there were a number of accounting scandals involving Chinese firms that
gained access to the US markets through RTOs. Indeed, over 100 companies were suspended
or delisted as a result. A public bulletin issued by the US Securities and Exchange
Commission in June 2011 warned investors by stating that ‘many companies either fail or
struggle to remain viable following a reverse merger’ and that there have been ‘instances of
fraud and other abuses involving reverse merger companies’.

Since that time, the regulations and standards that apply to reverse mergers / RTOs on the US
stock exchanges and other exchanges around the word have been tightened up in order to
prevent similar problems arising in the future.

Risk
As a result of the lower level of scrutiny that is applied to an RTO compared to an IPO,
investors must be aware of the higher level of risk that is attached to companies achieving a
listing in this way. In particular, the unquoted company carrying out an RTO must ensure that
there is a thorough investigation of the listed company which they are taking over so that all
potential problems and liabilities are revealed.

Regulation
Although RTOs can generally be completed more quickly than an IPO as there is less
regulation and scrutiny involved, it must be recognised that there are still a significant
amount of regulatory hurdles to overcome. It should be understood that RTOs are, to some

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extent, combinations of acquisitions and IPOs and, as such, are potentially complex and
difficult deals to manage. By way of example, two regulatory issues that may arise are now
discussed:

• Suspension
The Financial Conduct Authority’s (FCA) standard view is that when an RTO is
announced or leaked, there will generally be insufficient information publicly
available on the proposed transaction. In particular, information on the unquoted
company contemplating the takeover could well be limited compared to the
information that is available on listed companies. As a result of this, the listed
company will not be able to accurately assess its financial position and inform the
market. Hence, the FCA will often consider that a suspension of trading in the shares
is appropriate. This standard view can be rebutted, but there is significant work
required to achieve this. However, this work is essential as the listed company will not
want to contemplate a scenario where its listing is suspended and is quite likely to
walk away from the proposed transaction were this to occur.
• Mandatory offer
If, individually or with their closely connected persons or friends, any shareholder in
the unquoted company carrying out an RTO will on completion of the transaction
hold shares that carry 30% or more of the voting rights of the listed company, then
that shareholder will be required to make a general cash offer for the remaining shares
in the listed company under the mandatory bid rule. This would obviously undermine
the reason for doing the RTO in the first place. While the takeover panel will usually
consent to a waiver of this requirement as long as certain conditions are satisfied, it is
another regulatory obstacle which must be navigated around carefully.

Share price decrease

Many listed companies which could make potential RTO targets are in that position because
of past problems. Hence, they may have shareholders who are keen to exit from the company
as soon as a suitable opportunity arises and, hence, they may ‘dump’ their shares shortly after
the RTO has completed. To safeguard against the risk of a ‘dump’ occurring, the shareholders
may need to guarantee that they will not sell their shares until a certain period of time has
elapsed since the deal is completed. This is called a lock-up and/or a lock-up period.

Cost
While a reverse takeover is usually cheaper than an IPO, there are still significant direct and
indirect costs involved and, hence, the total cost can easily be far more than was originally
anticipated. A number of these costs are now considered:

• Regulatory costs
As mentioned previously, an RTO is a complex transaction and to ensure that the
regulatory hurdles are successfully overcome will incur significant cost.
• Acquisition cost
As a result of an RTO being seen as an easier and quicker option than an IPO,
especially in the Chinese market, the value of potential listed company targets are
often at a significant premium to their true value. Furthermore, the pressure to find a
target has resulted in some unusual combinations such as a mobile computer game
developer getting listed through the acquisition of a shoe company! It is hard to
imagine there were any synergy gains available here and, indeed, resolving cultural

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and other issues that may well have arisen would have further added to the indirect
cost of achieving the listing.
• Investor relations
Although an RTO may benefit from existing analyst coverage, RTO transactions only
really introduce liquidity to a previously private company if there is real investor
interest in the company. In many cases, in order to generate this interest, a
comprehensive investor relations and investor marketing programme will be required.
This is another potential indirect cost of an RTO.

Conclusion

As with anything that seems too good to be true, it must be recognised that an RTO is not
without significant complication and cost. Just as there is no such thing as a free lunch, there
is also no easy way to achieve a listing.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

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Currency swaps
A currency swap is an agreement in which two parties exchange the principal amount of a
loan and the interest in one currency for the principal and interest in another currency.

At the inception of the swap, the equivalent principal amounts are exchanged at the spot rate.

During the length of the swap each party pays the interest on the swapped principal loan
amount.

At the end of the swap the principal amounts are swapped back at either the prevailing spot
rate, or at a pre-agreed rate such as the rate of the original exchange of principals. Using the
original rate would remove transaction risk on the swap.

Currency swaps are used to obtain foreign currency loans at a better interest rate than a
company could obtain by borrowing directly in a foreign market or as a method of hedging
transaction risk on foreign currency loans which it has already taken out.

We will consider how a fixed for fixed currency swap works by looking at an example.

An American company may be able to borrow in the United States at a rate of 6%, but
requires a loan in rand for an investment in South Africa, where the relevant borrowing rate is
9%. At the same time, a South African company wishes to finance a project in the United
States, where its direct borrowing rate is 11%, compared to a borrowing rate of 8% in South
Africa.

Each party can benefit from the other's interest rate through a fixed-for-fixed currency swap.
In this case, the American company can borrow U.S. dollars for 6%, and then it can lend the
funds to the South African company at 6%. The South African company can borrow South
African rand at 8%, then lend the funds to the U.S. company for the same amount.

Currency swaps can also involve exchanging two variable rate loans, or fixed rate borrowing
for variable rate borrowing. Let’s consider a case where a company exchanges fixed rate
borrowing for variable rate borrowing.

Barrow Co, a company based in the USA, wants to borrow €500m over five years to finance
an investment in the Eurozone.

Today’s spot exchange rate between the Euro and US $ is €1·1200 = $1.

Barrow Co’s bank can arrange a currency swap with Greening Co. The swap would be for the
principal amount of €500m, with a swap of principal immediately and in five years’ time,
with both these exchanges being at today’s spot rate.

Barrow Co’s bank would charge an annual fee of 0.4% in € for arranging the swap.

The benefit of the swap will be split equally between the two parties.

The relevant borrowing rates for each party are as follows:

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Barrow Co Greening Co
USA 3.6% 4.5%
Eurozone EURIBOR + 1.5% EURIBOR + 0.8%

We will see what the gain on the swap for each party will be.

Barrow Co Greening Co Benefit

USA 3.6% 4.5% 0.9%
Eurozone EURIBOR + 1.5% EURIBOR + 0.8% 0.7%
Gain on swap 0.8% 0.8% 1.6%
Bank fee (0.2%) (0.2%) (0.4%)
Final gain 0.6% 0.6% 1.2%

Using this gain to work out the overall result for each company, we can provide an
illustration of how the swap could work as follows:

Barrow Co Greening Co
Barrow Co borrows 3.6%
Greening Co borrows EURIBOR + 0.8%
Swap
Greening Co receives (EURIBOR)
Barrow Co pays EURIBOR
Barrow Co receives (2.9%)
Greening Co pays 2.9%
Net result EURIBOR + 0.7% 3.7%
Bank fee 0.2% 0.2%
Overall result EURIBOR + 0.9% 3.9%

The overall result shows each party paying 0.6% less than they would have paid in they had
borrowed directly in the foreign markets.

Barrow Co’s original principal amount of €500m would be exchanged at the inception of the
swap for $446,428,517. The principal would be swapped back five years later, at the end of
the agreement, at the original spot rate.

Written by a member of the examining team for Advanced Financial Management

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Patterns of behaviour
Are all financial decisions rational? The assumption that they are underpins theories of
economic behaviour and stock market models, such as the efficient market hypothesis.

Why then do stock market booms and busts occur if investors are acting rationally? Rational
behaviour surely implies no shocks, with stock markets showing steady movements in share
prices, but not sudden spurts. However, unexpected and significant news could still result in
sudden shocks.

Also, why are some mergers and acquisitions considered to be poor deals? If a listed
company is being acquired, surely the acquisition price should be based on the market value
of its shares, if the markets are valuing it fairly. Why then is there uncertainty about the true
value of many acquired companies? Why also do many acquisitions run into difficulties?

If proper due diligence has been done and decisions are made rationally, surely the directors
of the acquiring company will only go ahead if the combination stands a very good chance of
success.

Behavioural finance attempts to explain how decision makers take financial decisions in real
life, and why their decisions might not appear to be rational every time and, hence, have
unpredictable consequences. Behavioural finance has been described as ‘the influence of
psychology on the behaviour of financial practitioners’ (Sewell, 2005). Behavioural finance
seeks to examine the following assumptions of rational decision making by investors and
financial managers:

1. Financial decision makers seek to maximise their utility and do so by trying to

maximise portfolio or company value.
2. They take financial decisions based on analysis of relevant information.
3. The analysis of financial information that they undertake is rational, objective and risk
neutral.

Let’s look at how behavioural factors may influence decision making and, therefore, stock
markets’ and companies’ financial strategies.

Investors

Maximisation of utility
Rational decision making by investors implies that their decisions about their investment
portfolios will aim to maximise their long-term wealth and, hence, their utility. However,
behavioural factors may influence investors to take decisions that are not the best ones for
achieving maximum value from their portfolios. Investors may have preferences for
particular stocks on non-financial grounds – for example, companies that they consider are
acting with social responsibility. They may also avoid ’sin stocks’ – companies operating in
sectors that they regard as unethical.

Investor utility may also be linked to the process of decision making. Some investors hold on
to shares with prices that have fallen over time and are unlikely to recover. They may do this

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because it will cause them psychological hurt to admit, even only to themselves, that their
decision to invest was wrong. This is known as cognitive dissonance.

Analysis of relevant information

Behavioural finance next looks at the basis that investors use to take decisions. It suggests
that decisions may not be based on an assessment of relevant financial information, but on
other grounds. Investors may use information that is not relevant but is readily available,
possibly to simplify the decision-making process (known as anchoring). For example,
investors may buy shares that in the past have had high values, on the grounds that these
represent their true potential values, even though rational analysis suggests that the prices of
these shares will remain low in the future

Investors may also believe that the probability of a future outcome will be influenced by how
often the same outcome has occurred in the past. A non-financial example of this idea would
be the situation when a coin is flipped eight times, comes up as tails every time and it is said
that heads is more likely the ninth time as, by the ‘law of averages’, heads must come up
soon.

If the value of a company’s shares has risen for some time, investors will be using similar
logic to the coin example if they sell those shares on the grounds that the shares have gained
in value for ‘long enough’ and their price must therefore soon start to fall, even if rational
analysis suggest that the rise in price will continue. This is known as the gambler’s fallacy.

Another deviation from rational analysis is the herd instinct, where investors buy or sell
shares in a company or sector because many other investors have already done so.
Explanations for investors following a herd instinct include social conformity, the desire not
to act differently from others. Following a herd instinct may also be due to individual
investors lacking the confidence to make their own judgements, believing that a large group
of other investors cannot be wrong. If many investors follow a herd instinct to buy shares in a
certain sector, for example the IT sector, this can result in significant price rises for shares in
that sector and lead to a stock market bubble.

Investors may not therefore base their decisions on rational analysis, but there is also
evidence to suggest that stock market ‘professionals’ often don’t do so either. Studies have
shown that there are traders in stock markets who do not base their decisions on fundamental
analysis of company performance and prospects. They are known as noise traders.

Characteristics associated with noise traders include making poorly timed decisions and
following trends. Chartism, using analysis of past share prices as a basis for predicting the
future, is an example of noise trading.

Fund managers may also be subject to behavioural influences. Fund managers who wish to
give the impression that they are actively managing their investment portfolios, may
periodically reposition their portfolios into new sectors, even though the old sectors continue
to have good prospects. Some fund managers also ignore companies with low market
capitalisation, with the result that their shares are not purchased and their value remains low
(known as small capitalisation discount).

Rational, objective and risk-neutral analysis

Investors may base their decision on an analysis of available information, but behavioural

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finance has highlighted that this analysis can be subjective. One aspect is confirmation bias,
taking an approach or paying attention to evidence that confirms investors’ current beliefs
about their investments and ignoring evidence that casts doubt on their beliefs. In the dotcom
boom, some investors used a variety of methods to value high-tech companies at a large
premium but ignored models such as cash flow valuation models that indicated the worth of
those companies was much lower.

Another aspect of investor bias is attitudes towards risks. Rational theory suggests that risk-
neutral investors will adopt a long-term approach based on expected values. However,
behavioural finance has highlighted various attitudes towards the risks of making profits or
losses. Some investors may be attracted by a company that offers the possibility of making
very high returns, even if the possibility is not very great (again, the dotcom boom provides
evidence of this).

Other investors may have regret aversion, avoiding investments that have the risk of making
losses, even though expected value analysis suggests that, in the long-term, they will make
significant capital gains. Investors with regret aversion may also prefer to invest in companies
that look likely to make stable, but low, profits, rather than companies that may make higher
profits in some years but possibly losses in others.

There is also evidence that many investors pay most attention to the last set of financial
results and other recent information about a company and take less notice of data that has
been available for a while. Explanations for this have included recent information being more
readily accessible and more immediate in investors’ minds than older information. A
consequence of this may be over-reaction when companies release information, with share
prices rising or falling quickly after information is released and then going back in the
opposite direction to an equilibrium value over time.

Behavioural finance also suggests that there may be a momentum effect in stock markets. A
period of rising share prices may result in a general feeling of optimism that price rises will
continue and an increased willingness to invest in companies that show prospects for growth.
If a momentum effect exists, then it is likely to lengthen periods of stock market boom or
bust.

Finance managers

Behavioural finance studies have also looked at decision making by managers of companies.
They have identified factors that affect investment decisions of all types, but particularly
focused on mergers and acquisitions, since many do not appear to fulfil the expectations of
the acquiring company.

Maximisation of utility
Companies can be regarded as maximising their utility by long-term maximisation of their
shareholders’ wealth. However, it is not just behavioural finance that casts doubt on whether
company managers are seeking this objective for their shareholders. Agency theory also
highlights that managers may have different objectives from shareholders, such as
maximising their own short-term rewards and expanding the company by acquisition or other
means in order to enhance their own reputation.

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However, behavioural finance has highlighted that managers’ objectives may not be
explainable rationally. Studies have looked at contested takeovers, where different companies
bidding against each other has forced the acquisition price up to a level that was significantly
greater than many outside the companies involved thought was reasonable. One theory for
this is that once managers enter into competition, it makes acquiring a company that others
have sought to buy as well, a source of satisfaction in itself. The acquirer’s managers are
unwilling to let someone else have what they have been trying to acquire (known as loss
aversion bias).

Analysis of relevant information

There is also evidence that when managers choose to bid for another company, the factor is
sometimes not a rational assessment of the target’s potential, but their belief in their own
abilities. Some managers of acquiring companies seem to believe that, however poor the
outlook for the target seems, their own considerable management skills will improve its
prospects after the merger takes place. A symptom of this belief could be managers arguing
that the target should be valued not using its own price-earnings ratio, but using the (higher)
price-earnings ratio of the acquirer.

Once an acquisition or any other strategy has been implemented, what influences managers
may be the need to show that they have made the right decisions. Managers may feel that a
failing strategy would damage their reputation, and possibly their future prospects. Therefore,
they may decide to commit more funds trying to ensure that the strategy is successful, rather
than admitting defeat and taking steps to mitigate losses (known as entrapment).

Rational, objective and risk-neutral analysis

Managers may also be subjective when they analyse information. Also, they may have
confirmation bias, paying attention to information that suggests that an acquisition will
enhance value and ignoring evidence that indicates that the target will not be a good buy.
They may also seek information that provides a simple yardstick for their own decision
making, however flawed that information may be. The value put on the target company by its
own directors may be subject to considerable bias, but the acquirer’s directors may regard it
as a good indication of what the target’s fair value is.

Limitations of behavioural finance

Critics of the behavioural finance approach have argued that even if individuals make
irrational decisions when left by themselves, participating in finance markets helps discipline
them to act rationally by giving them opportunities to learn from their experiences. The
consequences of irrational decisions are short-term anomalies. In the longer-term general
theories, such as the efficient market hypothesis, will apply.

Conclusion

Behavioural finance has identified a number of factors that may take individuals away from a
process of taking decisions to maximise economic utility on the basis of rational analysis of
all the information supplied. If these factors apply in practice, they can lead to movements
from what would be considered a fair price for an individual company’s shares, and the
market as a whole to a period where share prices are collectively very high or low. For an
acquisition, it can lead to a purchase price that differs significantly from what appears to be a
rational valuation.

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If you’re asked in the Advanced Financial Management exam to consider behavioural factors
that may influence the decisions of investors or managers, you’ll need to read the question
scenario very carefully. Look out for information about how investors or managers may be
taking decisions, or factors in the situation that may trigger biases that the decision makers
have.

You may not be able to come to a firm conclusion about what decision makers will do and
why, but you should be looking to discuss various possibilities. Bringing real life into your
answer has to mean questioning the assumption that all financial decisions are taken
rationally, and at least admitting that behavioural factors may influence decision makers.

Written by a member of the examining team for Advanced Financial Management

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Patterns of behaviour

Are all financial decisions rational? The assumption that they are underpins theories of
economic behaviour and stock market models, such as the efficient market hypothesis.

Why then do stock market booms and busts occur if investors are acting rationally? Rational
behaviour surely implies no shocks, with stock markets showing steady movements in share
prices, but not sudden spurts. However, unexpected and significant news could still result in
sudden shocks.

Also, why are some mergers and acquisitions considered to be poor deals? If a listed
company is being acquired, surely the acquisition price should be based on the market value
of its shares, if the markets are valuing it fairly. Why then is there uncertainty about the true
value of many acquired companies? Why also do many acquisitions run into difficulties?

If proper due diligence has been done and decisions are made rationally, surely the directors
of the acquiring company will only go ahead if the combination stands a very good chance of
success.

Behavioural finance attempts to explain how decision makers take financial decisions in real
life, and why their decisions might not appear to be rational every time and, hence, have
unpredictable consequences. Behavioural finance has been described as ‘the influence of
psychology on the behaviour of financial practitioners’ (Sewell, 2005). Behavioural finance
seeks to examine the following assumptions of rational decision making by investors and
financial managers:

1. Financial decision makers seek to maximise their utility and do so by trying to

maximise portfolio or company value.
2. They take financial decisions based on analysis of relevant information.
3. The analysis of financial information that they undertake is rational, objective and risk
neutral.

Let’s look at how behavioural factors may influence decision making and, therefore, stock
markets’ and companies’ financial strategies.

Investors

Maximisation of utility
Rational decision making by investors implies that their decisions about their investment
portfolios will aim to maximise their long-term wealth and, hence, their utility. However,
behavioural factors may influence investors to take decisions that are not the best ones for
achieving maximum value from their portfolios. Investors may have preferences for
particular stocks on non-financial grounds – for example, companies that they consider are
acting with social responsibility. They may also avoid ’sin stocks’ – companies operating in
sectors that they regard as unethical.

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Investor utility may also be linked to the process of decision making. Some investors hold on
to shares with prices that have fallen over time and are unlikely to recover. They may do this
because it will cause them psychological hurt to admit, even only to themselves, that their
decision to invest was wrong. This is known as cognitive dissonance.

Analysis of relevant information

Behavioural finance next looks at the basis that investors use to take decisions. It suggests
that decisions may not be based on an assessment of relevant financial information, but on
other grounds. Investors may use information that is not relevant but is readily available,
possibly to simplify the decision-making process (known as anchoring). For example,
investors may buy shares that in the past have had high values, on the grounds that these
represent their true potential values, even though rational analysis suggests that the prices of
these shares will remain low in the future

Investors may also believe that the probability of a future outcome will be influenced by how
often the same outcome has occurred in the past. A non-financial example of this idea would
be the situation when a coin is flipped eight times, comes up as tails every time and it is said
that heads is more likely the ninth time as, by the ‘law of averages’, heads must come up
soon.

If the value of a company’s shares has risen for some time, investors will be using similar
logic to the coin example if they sell those shares on the grounds that the shares have gained
in value for ‘long enough’ and their price must therefore soon start to fall, even if rational
analysis suggest that the rise in price will continue. This is known as the gambler’s fallacy.

Another deviation from rational analysis is the herd instinct, where investors buy or sell
shares in a company or sector because many other investors have already done so.
Explanations for investors following a herd instinct include social conformity, the desire not
to act differently from others. Following a herd instinct may also be due to individual
investors lacking the confidence to make their own judgements, believing that a large group
of other investors cannot be wrong. If many investors follow a herd instinct to buy shares in a
certain sector, for example the IT sector, this can result in significant price rises for shares in
that sector and lead to a stock market bubble.

Investors may not therefore base their decisions on rational analysis, but there is also
evidence to suggest that stock market ‘professionals’ often don’t do so either. Studies have
shown that there are traders in stock markets who do not base their decisions on fundamental
analysis of company performance and prospects. They are known as noise traders.

Characteristics associated with noise traders include making poorly timed decisions and
following trends. Chartism, using analysis of past share prices as a basis for predicting the
future, is an example of noise trading.

Fund managers may also be subject to behavioural influences. Fund managers who wish to
give the impression that they are actively managing their investment portfolios, may
periodically reposition their portfolios into new sectors, even though the old sectors continue
to have good prospects. Some fund managers also ignore companies with low market
capitalisation, with the result that their shares are not purchased and their value remains low
(known as small capitalisation discount).

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Rational, objective and risk-neutral analysis

Investors may base their decision on an analysis of available information, but behavioural
finance has highlighted that this analysis can be subjective. One aspect is confirmation bias,
taking an approach or paying attention to evidence that confirms investors’ current beliefs
about their investments and ignoring evidence that casts doubt on their beliefs. In the dotcom
boom, some investors used a variety of methods to value high-tech companies at a large
premium but ignored models such as cash flow valuation models that indicated the worth of
those companies was much lower.

Another aspect of investor bias is attitudes towards risks. Rational theory suggests that risk-
neutral investors will adopt a long-term approach based on expected values. However,
behavioural finance has highlighted various attitudes towards the risks of making profits or
losses. Some investors may be attracted by a company that offers the possibility of making
very high returns, even if the possibility is not very great (again, the dotcom boom provides
evidence of this).

Other investors may have regret aversion, avoiding investments that have the risk of making
losses, even though expected value analysis suggests that, in the long-term, they will make
significant capital gains. Investors with regret aversion may also prefer to invest in companies
that look likely to make stable, but low, profits, rather than companies that may make higher
profits in some years but possibly losses in others.

There is also evidence that many investors pay most attention to the last set of financial
results and other recent information about a company and take less notice of data that has
been available for a while. Explanations for this have included recent information being more
readily accessible and more immediate in investors’ minds than older information. A
consequence of this may be over-reaction when companies release information, with share
prices rising or falling quickly after information is released and then going back in the
opposite direction to an equilibrium value over time.

Behavioural finance also suggests that there may be a momentum effect in stock markets. A
period of rising share prices may result in a general feeling of optimism that price rises will
continue and an increased willingness to invest in companies that show prospects for growth.
If a momentum effect exists, then it is likely to lengthen periods of stock market boom or
bust.

Finance managers

Behavioural finance studies have also looked at decision making by managers of companies.
They have identified factors that affect investment decisions of all types, but particularly
focused on mergers and acquisitions, since many do not appear to fulfil the expectations of
the acquiring company.

Maximisation of utility
Companies can be regarded as maximising their utility by long-term maximisation of their
shareholders’ wealth. However, it is not just behavioural finance that casts doubt on whether
company managers are seeking this objective for their shareholders. Agency theory also
highlights that managers may have different objectives from shareholders, such as
maximising their own short-term rewards and expanding the company by acquisition or other
means in order to enhance their own reputation.

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However, behavioural finance has highlighted that managers’ objectives may not be
explainable rationally. Studies have looked at contested takeovers, where different companies
bidding against each other has forced the acquisition price up to a level that was significantly
greater than many outside the companies involved thought was reasonable. One theory for
this is that once managers enter into competition, it makes acquiring a company that others
have sought to buy as well, a source of satisfaction in itself. The acquirer’s managers are
unwilling to let someone else have what they have been trying to acquire (known as loss
aversion bias).

Analysis of relevant information

There is also evidence that when managers choose to bid for another company, the factor is
sometimes not a rational assessment of the target’s potential, but their belief in their own
abilities. Some managers of acquiring companies seem to believe that, however poor the
outlook for the target seems, their own considerable management skills will improve its
prospects after the merger takes place. A symptom of this belief could be managers arguing
that the target should be valued not using its own price-earnings ratio but using the (higher)
price-earnings ratio of the acquirer.

Once an acquisition or any other strategy has been implemented, what influences managers
may be the need to show that they have made the right decisions. Managers may feel that a
failing strategy would damage their reputation, and possibly their future prospects. Therefore,
they may decide to commit more funds trying to ensure that the strategy is successful, rather
than admitting defeat and taking steps to mitigate losses (known as entrapment).

Rational, objective and risk-neutral analysis

Managers may also be subjective when they analyse information. Also, they may have
confirmation bias, paying attention to information that suggests that an acquisition will
enhance value and ignoring evidence that indicates that the target will not be a good buy.
They may also seek information that provides a simple yardstick for their own decision
making, however flawed that information may be. The value put on the target company by its
own directors may be subject to considerable bias, but the acquirer’s directors may regard it
as a good indication of what the target’s fair value is.

Limitations of behavioural finance

Critics of the behavioural finance approach have argued that even if individuals make
irrational decisions when left by themselves, participating in finance markets helps discipline
them to act rationally by giving them opportunities to learn from their experiences. The
consequences of irrational decisions are short-term anomalies. In the longer-term general
theories, such as the efficient market hypothesis, will apply.

Conclusion

Behavioural finance has identified a number of factors that may take individuals away from a
process of taking decisions to maximise economic utility on the basis of rational analysis of
all the information supplied. If these factors apply in practice, they can lead to movements
from what would be considered a fair price for an individual company’s shares, and the
market as a whole to a period where share prices are collectively very high or low. For an
acquisition, it can lead to a purchase price that differs significantly from what appears to be a
rational valuation.

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If you’re asked in the Advanced Financial Management exam to consider behavioural factors
that may influence the decisions of investors or managers, you’ll need to read the question
scenario very carefully. Look out for information about how investors or managers may be
taking decisions, or factors in the situation that may trigger biases that the decision makers
have.

You may not be able to come to a firm conclusion about what decision makers will do and
why, but you should be looking to discuss various possibilities. Bringing real life into your
answer has to mean questioning the assumption that all financial decisions are taken
rationally, and at least admitting that behavioural factors may influence decision makers.

Written by a member of the examining team for Advanced Financial Management

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Using real options when making financial

strategy decisions

While the use of real options in investment appraisal is increasingly accepted, the
practicalities of using option pricing techniques and ideas in making actual financial strategy
decisions is less well understood.

This article will initially consider how an individual traditional project could be reassessed
using option valuation. It will then consider how option valuation could assist when assessing
a portfolio of projects and will conclude with a brief discussion regarding inter-dependent
projects.

A traditional project and option valuation

Let us imagine that a company is proposing a major expansion project. The operational
management team have forecast the cash flows relevant to the project in line with the
standard assumptions and policies set down by the financial management. The financial
management have then discounted these cash flows at a cost of capital of 11% and this has
resulted in an NPV of just $5m. For the sake of simplicity tax, inflation and other real world
complications have been ignored.

NPV calculation – overall:

Those executives who are keen proponents of this expansion are disappointed by the low
NPV and fear that the project is unlikely to win approval when competing for funds against
other projects. They consider that the project is being undervalued and, hence, a meeting with
the financial management team is arranged. At this meeting the financial management team
query the large net cash outflow that is forecast to occur at the end of year two. As a result of
this, it becomes apparent that the project comprises an initial investment of $600m which will
produce net cash inflows of $110m for the following 10 years, followed by a further
investment of $300m after two years which will increase the net cash inflows by $48m to

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$158m per year for the remaining eight years. Further discussion reveals that the additional
investment after two years is discretionary and does not necessarily need to be made.

Hence, the project could be viewed as an initial expansion costing $600m – phase 1 –
followed by an option to expand further after two years – phase 2.

If separate NPV calculations are carried out for each of these phases. The results below are
obtained.

NPV calculation – phase 1:

NPV calculation – phase 2:

The total NPV is fundamentally unchanged as $47.8m – $43m = $4.8m, which is about the
same as the $5m calculated initially. To the extent there is a difference, this can be attributed
to rounding. This analysis alone provides some insight as, given that there is no obligation for
the company to carry out phase two, the overall NPV must be at least $47.8m which far
exceeds the initial NPV calculated of $5m.

It is worth noting that the discretionary spend at the end of year two has also been discounted
at the 11% cost of capital. Although this is the approach commonly taken it could be more
accurate to discount such discretionary expenditure at the risk-free rate. This is because
discretionary expenditure has much less operational risk than the net cash inflows that it is
hoped will arise from such expenditure. If a risk-free rate of 5% is used the present value of
the $300m expenditure at the end of year two would be $272.1m. This is $28.5m (272.1 –
243.6) more than the present value if the cost of capital is used. Hence, the original overall
NPV and the NPV of phase two should perhaps be reduced by this $28.5m. This approach

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would be consistent with the treatment of the exercise price in the Black Scholes Option
Pricing model.

Although phase two does not currently seem worthwhile the option to carry out this phase
can only add value as an option can never have a negative value. If the cash flows expected
from phase two were to become favourable, the company will have the ability to carry out
phase two and reap the benefit. Hence, the overall NPV will be $47.8m plus the value of the
option to carry out phase two.

In order to value the option to carry out phase two we must first attribute figures to the inputs
required for the Black Scholes option pricing (BSOP) formula:

• Pe = the investment required after two years to carry out phase two = $300m
• Pa = the PV of the net cash inflows currently forecast to arise from phase two =
$200.6m (this must exclude the Pe)
• t = the time until phase two will begin = 2 years
• s = the volatility – assumed to be 0.4 (standard deviation)
• r = the risk-free rate – assumed to be 5%

The Pe and Pa figures can be seen in the calculation of the NPV for phase two and, as we
know, the company has the option to expand into phase two after two years. The s and r will
both be given within any exam question and, hence, suitable figures have been assumed.

Using these inputs, the option value can now be calculated.

Option value:

d1 = (ln(200.6/300) + (0.05 + 0.5 x 0.42) x 2) / (0.4 x √2) = (– 0.402 + 0.260) / 0.566 = –

0.251 ≈ – 0.25

d2 = – 0.251 – 0.566 = – 0.817 ≈ - 0.82

N(d1) = 0.5 – 0.0987 = 0.4013

N(d2) = 0.5 – 0.2939 = 0.2061

Call option value = (200.6 x 0.4013) – (300 x 0.2061 x e(-0.05 x 2)) = 80.5 – 55.9 = $24.6m

Hence, the total NPV for the project with the option to expand = $47.8m + $24.6m = $72.4m.
As a result of the financial management taking the time to better understand the project and
the real options within it a project which seemed fairly marginal, has been shown to be
attractive and is far more likely to win approval.

The attractiveness of the project arises because phase one of the project is itself attractive and
the company can potentially benefit if the phase two expansion finally becomes worthwhile.

As discussed in the previous real options article, there are significant problems associated
with using BSOP to value real options and, hence, the option value of $24.6m calculated
should be treated as indicative only and should be used with care.

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A portfolio of projects and option valuation

As soon as executives launch a strategy conditions change in the environment within which
they are operating and indeed their knowledge of that environment is updated. Hence,
managers must actively manage and respond accordingly. Traditional NPV analysis is
probably too static a tool to reflect this active management. This is because it tends to assume
a company will follow a previously agreed plan and does not account so well for how events
may unfold. Instead managers should perhaps view the projects they could undertake to
achieve their goals as a portfolio of real options which they could potentially exercise over
time.

Imagine a company is faced with six independent projects as follows:

Given this basic NPV analysis projects U and V would be accepted and a total NPV of $8m
would be generated for the company.

Let us now imagine that projects U and X have to be carried out immediately or not at all. In
other words, there is no option to delay these projects. Hence, project U would be accepted to
generate an NPV of $5m and project X would be rejected. A useful analogy here is that of
fruit growing in a garden. Projects U and X represent fruits which have to be picked now.
Project U represents the perfectly ripe fruit which can be sold or eaten, while project X
represents the rotten fruit which must be picked but then discarded.

The remaining projects can be delayed and represent fruits which do not have to be picked
immediately and which have the potential to develop into perfectly ripe fruit. Given the
volatility of the cash flows from these projects and the period by which they could be delayed
option values can be calculated for these projects. This data and the resulting option values
are presented below:

These option values have been calculated using an assumed risk-free rate of 5%.

These option values total to a value of $30.5m. If the NPV of project U, which has already
been accepted, is added to this a total value of $35.5m is created. This value is significantly
higher than the original NPV of $8m which could have been generated by accepting projects
U and V. However, careful management is necessary if as much value as possible is to be
generated.

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We will now consider each of projects V, W, Y and Z separately:

Project V:
This project looks most promising. It has a positive NPV if exercised now but its value as an
option is significantly higher. Hence, exercising now would appear sub-optimal as with
further nurturing a higher value could be generated. To continue the fruit analogy this project
represents a fruit which could be picked now and eaten or sold but which, with careful
cultivation, could become a larger and better fruit. However, just as ripening fruit can be
eaten by pests, there is potential for project value to be lost – through the actions of
competitors for instance. Hence, the company may decide to exercise the option early to
realise the existing positive NPV.

Project W:
This project is not at all promising. It has a negative NPV if exercised now and, as it has a
low volatility and there is a relatively short time until a decision has to be made regarding this
project, it has a low option value. Hence, this project will probably never be worth exercising.
This project could be thought of as the small, late developing fruit which is unlikely to ripen
before the season ends.

Project Y:
Despite currently having a negative NPV this project has a high value as an option. This is
due to the fact that it will not expire for three years and has a relatively high volatility when
compared to the other projects. Hence, this project will probably be worth exercising at some
later date. This project represents the unripe fruit which cannot be picked now, but which is
expected to mature into a perfectly ripe fruit in the future.

Project Z:
This project is similar to project Y but is much less promising. It currently has the same
negative NPV as project Y but as it has a lower volatility and a shorter time until it expires it
has a lower value as an option when compared to project Y. This project seems unlikely to be
worth exercising but there is still a reasonable chance that it could move ‘into the money’
and, hence, may become worth exercising in the future. As with project Y this project is also
an unripe fruit which cannot be picked now. However, its chances of maturing into a
perfectly ripe fruit seem much less.

How does the use of option valuation analysis help when compared to a
traditional NPV analysis?

As previously stated traditional NPV analysis would lead to the acceptance of projects U and
V, resulting in an NPV of $8m, and the rejection of the other four projects. However, option
valuation analysis results in the acceptance of project U generating an NPV of $5m, the
rejection of project X and options to carry out the four other projects in the future the total
value of which has been estimated as $30.5m.

Further the analysis encourages active management:

Project V has been identified as worthy of careful management to ensure it is carried out at
the optimal time to maximise the value created but at the same time ensuring that the existing
positive NPV is not destroyed.

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Of the remaining projects Project W has been identified as the project deserving least
attention while with careful nurturing project Y and even project Z could finally create value
for the company.

It is crucial to recognise that projects, just like fruit, do require nurturing. This is because as
the time approaches when the project must be carried out or abandoned, the option value will
always tend to decline assuming all other variables remain constant. This is because the time
to maturity falls and the present value of the exercise price, the investment to be made to
carry out the project, is rising.

Hence, without nurturing all the option values will move to zero over time. For this not to
happen there must be good luck or active management. Good luck could add value to a
project because, for instance, sudden growth in the economy could mean the returns from a
project become higher than originally forecast. Active management could involve taking
action to reduce the costs or increase the revenues associated with a project. Equally action
could be taken to reduce the initial investment required in the project.

Using the option valuation approach has helped identify those projects most likely to benefit
from such nurturing and, hence, is useful as a company follows and develops its financial
strategy.

Inter-dependent projects

So far this article has looked at how our understanding of a single project and a portfolio of
independent projects could be enhanced by the use of option valuation. Let us now consider
briefly interdependent projects.

Just as you and I are faced with a myriad of options when buying a new car, the car
manufacturer also has many options.

For instance, a car manufacturer may have a project to launch a new saloon model. From this
saloon model, an estate model could then be launched, and from this a 4x4 version of the
estate model could be launched. This is a strategy followed by Skoda with their Octavia and
Superb ranges. In effect the company has the initial project (the launch of the saloon),
followed by a call option on the launch of the estate, which itself has a call option on the
launch of the 4x4 estate. Hence, the company has a call on a call! This is known as a nest of
options or nested options.

Another car manufacturer may also have a project to launch a new saloon model. From this
saloon, an estate model could be launched and a sports utility vehicle (SUV) model could
also be launched. This is a strategy followed by BMW with their 3 series and 5 series ranges.
In effect the company has the initial project (the launch of the saloon), followed by a call
option on the launch of the estate and a call option on the launch of the SUV model (the
BMW X3 and X5). While these options are not nested they are obviously still very much
related.

Understanding how these options inter-relate is obviously useful to a company as they

develop their strategy. Once again good luck and active management play their part. For
instance, a few bad winters is likely to enhance future sales of SUV’s and 4x4 estates. This in

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turn enhances the value of the call options to manufacture these models and, hence, the value
of the original product launch.

Active management could involve the development of a new more fuel efficient 4x4 system.
Any such increase in fuel efficiency is also likely to enhance the sales of 4x4 equipped
SUV’s and estates and enhance the value of the call options to manufacture these models and,
hence, the value of the original product launch. Conversely, extra sales of 4x4 equipped
models may reduce sales of other models.

Obviously the initial product launch should be marketed in such a way as to maximise its
success. Active management should also ensure that this initial product launch should ensure
consumers’ perception of the new model is developed in such a way that the chances of
success of the follow-on models is optimised.

Our knowledge of the determinants of option values can also be useful. For instance, if sales
of SUV’s are high in a more volatile market such as China this adds value to the option to
develop the SUV variant of the model in the future, and, hence, enhances the value of the
initial project to launch the saloon.

Conclusion

This article has demonstrated how option valuation techniques can help understand the
potential value of projects and how financial strategy decisions can be made using this
knowledge in order to maximise the results arising from projects and, hence, maximise
company value.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

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Investment appraisal and real options

Real options’ valuation methodology adds to the conventional net present value (NPV)
estimations by taking account of real-life flexibility and choice. This is the first of two
articles which considers how real options can be incorporated into investment appraisal
decisions. This article discusses real options and then considers the types of real options
calculations which may be encountered in Advanced Financial Management, through three
examples. The article then considers the limitations of the application of real options in
practice and how some of these may be mitigated.

The second article considers a more complex scenario and examines how the results
produced from using real options with NPV valuations can be used by managers when
making strategic decisions.

Net present value (NPV) and real options

The conventional NPV method assumes that a project commences immediately and proceeds
until it finishes, as originally predicted. Therefore, it assumes that a decision has to be made
on a now or never basis, and once made, it cannot be changed. It does not recognise that most
investment appraisal decisions are flexible and give managers a choice of what actions to
undertake.

The real options method estimates a value for this flexibility and choice, which is present
when managers are making a decision on whether or not to undertake a project. Real options
build on net present value in situations where uncertainty exists and, for example: (i) when
the decision does not have to be made on a now or never basis, but can be delayed, (ii) when
a decision can be changed once it has been made, or (iii) when there are opportunities to
exploit in the future contingent on an initial project being undertaken. Therefore, where an
organisation has some flexibility in the decision that has been, or is going to be made, an
option exists for the organisation to alter its decision at a future date and this choice has a
value.

With conventional NPV, risks and uncertainties related to the project are accounted for in the
cost of capital, through attaching probabilities to discrete outcomes and/or conducting
sensitivity analysis or stress tests. Options, on the other hand, view risks and uncertainties as
opportunities, where upside outcomes can be exploited, but the organisation has the option to
disregard any downside impact.

Real options methodology takes into account the time available before a decision has to be
made and the risks and uncertainties attached to a project. It uses these factors to estimate an
additional value that can be attributable to the project.

Estimating the value of real options

Although there are numerous types of real options, in Advanced Financial Management,
candidates are only expected to explain and compute an estimate of the value attributable to
three types of real options:

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(i) The option to delay a decision to a future date (which is a type of call option)
(ii) The option to abandon a project once it has commenced if circumstances no longer justify
the continuation of the project (which is a type of put option), and
(iii) The option to exploit follow-on opportunities which may arise from taking on an initial
project (which is a type of call option).

In addition to this, candidates are expected to be able to explain (but not compute the value
of) redeployment or switching options, where assets used in projects can be switched to other
projects and activities.

For the Advanced Financial Management exam purposes, it can be assumed that real options
are European-style options, which can be exercised at a particular time in the future and their
value will be estimated using the Black-Scholes Option Pricing (BSOP) model and the put-
call parity to estimate the option values. However, assuming that the option is a European-
style option and using the BSOP model may not provide the best estimate of the option’s
value (see the section on limitations and assumptions below).

Five variables are used in calculating the value of real options using the BSOP model as
follows:

1. The underlying asset value (Pa), which is the present value of future cash flows
arising from the project.
2. The exercise price (Pe), which is the amount paid when the call option is exercised, or
amount received if the put option is exercised.
3. The risk-free (r), which is normally given or taken from the return offered by a short-
dated government bill. Although this is normally the discrete annualised rate and the
BSOP model uses the continuously compounded rate, for Advanced Financial
Management purposes the continuous and discrete rates can be assumed to be the
same when estimating the value of real options.
4. The volatility (s), which is the risk attached to the project or underlying asset,
measured by the standard deviation.
5. The time (t), which is the time, in years, that is left before the opportunity to exercise
ends.

The following three examples demonstrate how the BSOP model can be used to estimate the
value of each of the three types of options.

Example 1: Delaying the decision to undertake a project

A company is considering bidding for the exclusive rights to undertake a project, which will
initially cost $35m.

The company has forecast the following end of year cash flows for the four-year project.

Year 1 2 3 4
Cash 20 15 10 5
flows
($m)

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The relevant cost of capital for this project is 11% and the risk-free rate is 4.5%. The likely
volatility (standard deviation) of the cash flows is estimated to be 50%.

Solution:
NPV without any option to delay the decision

Year Today 1 2 3 4
Cash flows ($) -35m 20m 15m 10m 5m
PV (11%) ($) -35m 18.0m 12.2m 7.3m 3.3m

NPV = $5.8m

Supposing the company does not have to make the decision right now but can wait for two
years before it needs to make the decision.

NPV with the option to delay the decision for two years

Year 3 4 5 6
Cash flows 20m 15m 10m 5m
($)
PV (11%) 14.6m 9.9m
5.9m 2.7m
($)

Variables to be used in the BSOP model

Asset value (Pa) = $14.6m + $9.9m + $5.9m + $2.7m = $33.1m
Exercise price (Pe) = $35m
Exercise date (t) = Two years
Risk free rate (r) = 4.5%
Volatility (s) = 50%

Using the BSOP model

d1 0.40
d2 -0.31
N(d1) 0.6554
N(d2) 0.3783
Call value $9.6m

Based on the facts that the company can delay its decision by two years and a high volatility,
it can bid as much as $9.6m instead of $5.8m for the exclusive rights to undertake the project.
The increase in value reflects the time before the decision has to be made and the volatility of
the cash flows.

Example 2: Exploiting a follow-on project

A company is considering a project with a small positive NPV of $3m but there is a
possibility of further expansion using the technologies developed for the initial project. The
expansion would involve undertaking a second project in four years’ time. Currently, the

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present values of the cash flows of the second project are estimated to be $90m and its
estimated cost in four years is expected to be $140m. The standard deviation of the project’s
cash flows is likely to be 40% and the risk-free rate of return is currently 5%.

Solution:
The variables to be used in the BSOP model for the second (follow-on) project are as follows:

Asset Value (Pa) = $90m

Exercise price (Pe) = $140m
Exercise date (t) = Four years
Risk free rate (r) = 5%
Volatility (s) = 40%

Using the BSOP model

d1 0.10
d2 -0.70
N(d1) 0.5398
N(d2) 0.242
Call value $20.8m

The overall value to the company is $23.8m, when both the projects are considered together.
At present the cost of $140m seems substantial compared to the present value of the cash
flows arising from the second project. Conventional NPV would probably return a negative
NPV for the second project and therefore the company would most likely not undertake the
first project either. However, there are four years to go before a decision on whether or not to
undertake the second project needs to be made. A lot could happen to the cash flows given
the high volatility rate, in that time. The company can use the value of $23.8m to decide
whether or not to invest in the first project or whether it should invest its funds in other
activities. It could even consider the possibility that it may be able to sell the combined rights
to both projects for $23.8m.

Example 3: The option to abandon a project

Duck Co is considering a five-year project with an initial cost of $37,500,000 and has
estimated the present values of the project’s cash flows as follows:

Year 1 2 3 4 5
Present values 1,496.9 4,938.8 9,946.5 7,064.2
13,602.9
($ 000s)

Swan Co has approached Duck Co and offered to buy the entire project for $28m at the start
of year three. The risk-free rate of return is 4%. Duck Co’s finance director is of the opinion
that there are many uncertainties surrounding the project and has assessed that the cash flows
can vary by a standard deviation of as much as 35% because of these uncertainties.

Solution:
Swan Co’s offer can be considered to be a real option for Duck Co. Since it is an offer to sell
the project as an abandonment option, a put option value is calculated based on the finance

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director’s assessment of the standard deviation and using the Black-Scholes option pricing
(BSOP) model, together with the put-call parity formula.

Although Duck Co will not actually obtain any immediate cash flow from Swan Co’s offer,
the real option computation below, indicates that the project is worth pursuing because the
volatility may result in increases in future cash flows.

Without the real option

Year 1 2 3 4 5
Present values 1,496.9 4,938.8 9,946.5 7,064.2 13,602.9
($ 000s)

Present value of cash flows approx. = $37,049,300

Cost of initial investment = $37,500,000
NPV of project = $37,049,300 – $37,500,000 = $(450,700)

With the real option

The asset value of the real option is the sum of the PV of cash flows foregone in years three,
four and five, if the option is exercised ($9.9m + $7.1m + $13.6m = $30.6m)

Asset value (Pa) $30.6m

Exercise Price (Pe) $28m
Risk-free rate (r) 4%
Time to exercise (t) Two years
Volatility (s) 35%

d1 0.59
d2 0.09
N(d1) 0.7224
N(d2) 0.5359
Call Value 8.25

Put Value $3.50m

Net present value of the project with the put option is approximately $3.05m ($3.50m –
$0.45m).

If Swan Co’s offer is not considered, then the project gives a marginal negative net present
value, although the results of any sensitivity analysis need to be considered as well. It could
be recommended that, if only these results are taken into consideration, the company should
not proceed with the project. However, after taking account of Swan Co’s offer and the
finance director’s assessment, the net present value of the project is positive. This would
suggest that Duck Co should undertake the project.

Limitations and assumptions

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Many of the limitations and assumptions discussed below stem from the fact that a model
developed for financial products is used to assess flexibility and choice embedded within
physical, long-term investments.

European-style options or American-style options

The BSOP model is a simplification of the binomial model and it assumes that the real option
is a European-style option, which can only be exercised on the date that the option expires.
An American-style option can be exercised at any time up to the expiry date. Most options,
real or financial, would, in reality, be American-style options.

In many cases the value of a European-style option and an equivalent American-style option
would be largely the same, because unless the underlying asset on which the option is based
is due to receive some income before the option expires, there is no benefit in exercising the
option early. An option prior to expiry will have a time-value attached to it and this means
that the value of an option prior to expiry will be greater than any intrinsic value the option
may have, if it were exercised.

However, if the underlying asset on which the option is based is due to receive some income
before the option’s expiry; say for example, a dividend payment for an equity share, then an
early exercise for an option on that share may be beneficial. With real options, a similar
situation may occur when the possible actions of competitors may make an exercise of an
option before expiry the better decision. In these situations, the American-style option will
have a value greater than the equivalent European-style option.

Because of these reasons, the BSOP model will either underestimate the value of an option or
give a value close to its true value. Nevertheless, estimating and adding the value of real
options embedded within a project, to a net present value computation will give a more
accurate assessment of the true value of the project and reduce the propensity of organisations
to under-invest.

Estimating volatility

The BSOP model assumes that the volatility or risk of the underlying asset can be determined
accurately and readily. Whereas for traded financial assets this would most probably be the
case, as there is likely to be sufficient historical data available to assess the underlying asset’s
volatility, this is probably not going to be the case for real options. Real options would
probably be available on large, one-off projects, for which there would be little or no
historical data available.

Volatility in such situations would need to be estimated using simulations, such as the Monte-
Carlo simulation model, with the need to ensure that the model is developed accurately and
the data input used to generate the simulations reasonably reflects what is likely to happen in
practice.

Other limitations of real options

The BSOP model requires further assumptions to be made involving the variables used in the
model, the primary ones being:

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(a) The BSOP model assumes that the underlying project or asset is traded within a situation
of perfect markets where information on the asset is available freely and is reflected in the
asset value correctly. Further it assumes that a market exists to trade the underlying project or
asset without restrictions (that is, that the market is frictionless)
(b) The BSOP model assumes that interest rates and the underlying asset volatility remain
constant until the expiry time ends. Further, it assumes that the time to expiry can be
estimated accurately
(c) The BSOP model assumes that the project and the asset’s cash flows follow a lognormal
distribution, similar to equity markets on which the model is based
(d) The BSOP model does not take account of behavioural anomalies which may be
displayed by managers when making decisions, such as over- or under-optimism
(e) The BSOP model assumes that any contractual obligations involving future commitments
made between parties, which are then used in constructing the option, will be binding and
will be fulfilled. For example, in example three above, it is assumed that Swan Co will fulfil
its commitment to purchase the project from Duck Co in two years’ time for $28m and there
is therefore no risk of non-fulfilment of that commitment.

In any given situation, one or more of these assumptions may not apply. The BSOP model
therefore does not provide a ‘correct’ value, but instead it provides an indicative value which
can be attached to the flexibility of a choice of possible future actions that may be embedded
within a project.

Conclusion

This article discussed how real options thinking can add to investment appraisal decisions
and in particular NPV estimations by considering the value which can be attached to
flexibility which may be embedded within a project because of the choice managers may
have when making investment decisions. It then worked through computations of three real
options situations, using the BSOP model. The article then considered the limitations of, and
assumptions made when, applying the BSOP model to real options computations. The value
computed can therefore be considered indicative rather than conclusive or correct.

The second article will consider how managers can use real options to make strategic
investment appraisal decisions.

Written by a member of the Advanced Financial Management examining team

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Securitisation and tranching

Securitisation became a topical issue during the credit crunch, and still remains a relevant
issue for financial management and Advanced Financial Management students

Please note:
This is an updated version of the 'Toxic Assets' technical article

Securitisation through Collateralised Debt Obligations (CDOs)

One common use of securitisation occurs when banks lend through mortgages, credit cards,
car loans or other forms of credit, they invariably move to ‘lay off’ their risk by a process of
securitisation. Such loans are an asset on the statement of financial position, representing
cash flow to the bank in future years through interest payments and eventual repayment of the
principal sum involved. By securitising the loans, the bank removes the risk attached to its
future cash receipts and converts the loan back into cash, which it can lend again, and so on,
in an expanding cycle of credit formation.

Securitisation is achieved by transferring the lending to specifically created companies called

‘special purpose vehicles’ (SPVs). In the case of conventional mortgages, the SPV effectively
purchases a bank’s mortgage book for cash, which is raised through the issue of bonds
backed by the income stream flowing from the mortgage holder. In the case of sub-prime
mortgages, the high levels of risk called for a different type of securitisation, achieved by the
creation of derivative-style instruments known as ‘collateralised debt obligations’ or CDOs.

Securitisation may be also appropriate for an organisation which wants to enhance its credit
rating by using low-risk cash flows, such as rental income from commercial property, which
will be diverted into a "ring-fenced" SPV.

CDOs are a way of repackaging the risk of a large number of risky assets such as sub-prime
mortgages. Unlike a bond issue, where the risk is spread thinly between all the bond holders,
CDOs concentrate the risk into investment layers or ‘tranches’, so that some investors take
proportionately more of the risk for a bigger return and others take little or no risk for a much
lower return.

Each tranche of CDOs is securitised and ‘priced’ on issue to give the appropriate yield to the
investors. The investment grade tranche of CDOs will be the most highly priced, giving a low
yield but with low risk attached. At the other end, the ‘equity’ tranche carries the bulk of the
risk – it will be very lowly priced but with a high potential, but very risky, yield. There is
more detail on this in the next section.

CDOs are, therefore, a mechanism whereby losses are transferred to investors with the
highest appetite for risk (such as hedge funds), leaving the bulk of CDOs’ investors (mainly
other banks) with a low risk source of cash flow.

The structure of CDOs

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An example of a possible structure for a CDO is as follows. For a pool of mortgages taken
over by the SPV, three tranches of CDOs are created:

• Tranche 1 (highest risk) known as the ‘equity’ tranche and normally comprising
about 10% of the value of the mortgages in the pool. Throughout the CDOs’ life, the
equity tranche will absorb any losses brought about by default on the part of mortgage
holders, up to the point that the principal underpinning the tranche is exhausted. At
this point the investment is worthless.
• Tranche 2 (intermediate risk or ‘mezzanine’ tranche) consists of around 10% of the
principal and will absorb any losses not absorbed by the equity tranche until the point
at which its principal is also exhausted.
• Tranche 3 (AAA or ‘senior’ tranche) consists of the balance of the pool value and
will absorb any residual losses.

The proportion of the principal held in each tranche is known as the CDO ‘structure’, and if
there is perceived to be little risk of default then the percentage of value in the mortgage pool
forming the equity and mezzanine tranches will be quite small. However, if the risk is high
then CDOs will be created with a greater proportion of the principal in the equity and
mezzanine tranches and a relatively smaller proportion in the senior tranche.

When cash flows are received from borrowers in the form of interest payments and loan
repayments, these payments are paid to tranche 3 first until their obligation is fulfilled, then
tranche 2, and anything left over is paid to the equity tranche. Any defaults hit tranche 1 first,
then tranche 2 and so on. The repayments represent a ‘waterfall’ of cash with the investors
holding the tranches like buckets. The senior tranches get filled first, the mezzanine holders
get filled next and anything left falls into the equity pools at the bottom.

Example

A bank has made a number of mortgage loans to customers with a current total value of $350
million. The mortgages have an average term to maturity of ten years. The net income from
the loans is 7% per year. The bank will use 85% of the mortgage pool as collateral for a
securitisation with the following structure:

• 75% of the collateral value to support a tranche of A-rated loan notes offering
investors 6% per year.
• 15% of the collateral value to support a tranche of B-rated loan notes offering
investors 11% per year.
• 10% of the collateral value to support a tranche of subordinated certificates which are
unrated.

The estimated cash flows for this arrangement would be as follows:

Cash inflows

Inflows from mortgages $350m x 7% = $24.5m

Cash outflows

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A-rated loan notes

$350m x 85% x 75% x 6% = $13.4m

B-rated loan notes

$350m x 85% x 15% x 11% = $4.9m

Total outflows = $13.4m + $4.9m = $18.3m

The difference between the inflows and the outflows is returned to the high-risk unrated
certificates.

Difference in cash flows = $24.5m – $18.3m = $6.2m

The subordinated certificates have a value of $350m x 85% x 10% = $29.75m.

The return on this high-risk investment is $6.2m/$29.75m = 20.8%

However, this return is at risk should there be a reduction in the income from the mortgages
resulting from customers defaulting on their mortgages. Because of this level of risk, the
equity tranche may be unattractive to investors for some securitisation arrangements.

Note that all of the income from the mortgages is used to pay the tranche holders, not just
85% representing the securitised amount. The reason why the securitisation is performed is to
get money in quickly. In order to sell the various tranches, there needs to be an incentive; for
this to be present for all tranches not all of the available pool of mortgages is securitised, but
all of the income from the pool is distributed. The bank, in theory, loses out from this
approach by distributing 100% of the income instead of keeping 15%, but has achieved the
objective of getting the initial funds from the tranche holders as quickly as possible.

Written by a member of the examining team for Advanced Financial Management

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Exchange traded foreign exchange

derivatives

The aim of this article is to consider both foreign exchange futures and options using real
market data. The basics, which have been well examined in the recent past, will be quickly
revisited. The article will then consider areas which, in reality, are of significant importance
but which, to date, have not been examined to any great extent.

Foreign exchange futures – the basics

Scenario

Imagine it is 10 July. A UK company has a US$6.65m invoice to pay on 26 August. They are
concerned that exchange rate fluctuations could increase the £ cost and, hence, seek to
effectively fix the £ cost using exchange traded futures. The current spot rate is $/£1.71110.

Research shows that £/$ futures, where the contract size is denominated in £, are available on
the CME Europe exchange at the following prices:

September expiry – 1.71035

December expiry – 1.70865

The contract size is £100,000 and the futures are quoted in US$ per £1.

Note:
CME Europe is a London based derivatives exchange. It is a wholly owned subsidiary of
CME Group, which is one of the world’s leading and most diverse derivatives marketplace,
handling (on average) three billion contracts worth about $1 quadrillion annually!

Setting up the hedge

1. Date? – September:
The first futures to mature after the expected payment date (transaction date) are
chosen. As the expected transaction date is 26 August, the September futures which
mature at the end of September will be chosen.
2. Buy/Sell? – Sell:
As the contract size is denominated in £ and the UK company will be selling £ to buy
$ they should sell the futures.
3. How many contracts? – 39
As the amount to be hedged is in $ it needs to be converted into £ as the contact size is
denominated in £. This conversion will be done using the chosen futures price. Hence,
the number of contracts required is: ($6.65m ÷ 1.71035)/£100,000 ≈ 39.

Summary

The company will sell 39 September futures at $/£1.71035.

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Outcome on 26 August:
On 26 August the following was true:
Spot rate – $/£ 1.65770
September futures price – $/£1.65750

Actual cost:
$6.65m/1.65770 = £4,011,582

Gain/loss on futures:
As the exchange rate has moved adversely for the UK company a gain should be expected on
the futures hedge.

$/£
Sell – on 10 July 1.71035
Buy back – on 26 August (1.65750)
Gain 0.05285

This gain is in terms of $ per £ hedged. Hence, the total gain is:
0.05285 x 39 contracts x £100,000 = $206,115

Alternatively, the contract specification for the futures states that the tick size is 0.00001$ and
that the tick value is $1. Hence, the total gain could be calculated in the following way:

0.05285/0.00001 = 5,285 ticks

5,285 ticks x $1 x 39 contracts = $206,115

This gain is converted at the spot rate to give a £ gain of:

$206,115/1.65770 = £124,338

Total cost:
£4,011,582 – £124,338 = £3,887,244

This total cost is the actual cost less the gain on the futures. It is close to the receipt of
£3,886,389 that the company was originally expecting given the spot rate on 10 July when
the hedge was set up. ($6.65m/1.71110). This shows how the hedge has protected the
company against an adverse exchange rate move.

Summary

All of the above is essential basic knowledge. As the exam is set at a particular point in time
you are unlikely to be given the futures price and spot rate on the future transaction date.
Hence, an effective rate would need to be calculated using basis. Alternatively, the future
spot rate can be assumed to equal the forward rate and then an estimate of the futures price on
the transaction date can be calculated using basis. The calculations can then be completed as
above.

The ability to do this would normally earn four marks in an exam. Equally, another one or
two marks could be earned for reasonable advice such as the fact that a futures hedge

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effectively fixes the amount to be paid and that margins will be payable during the lifetime of
the hedge. It is some of these areas that we will now explore further.

Foreign exchange futures – other issues

Initial margin

When a futures hedge is set up the market is concerned that the party opening a position by
buying or selling futures will not be able to cover any losses that may arise. Hence, the
market demands that a deposit is placed into a margin account with the broker being used –
this deposit is called the ‘initial margin’.

These funds still belong to the party setting up the hedge but are controlled by the broker and
can be used if a loss arises. Indeed, the party setting up the hedge will earn interest on the
amount held in their account with their broker. The broker in turn keeps a margin account
with the exchange so that the exchange is holding sufficient deposits for all the positions held
by brokers’ clients.

In the scenario above the CME contract specification for the £/$ futures states that an initial
margin of $1,375 per contract is required.

Hence, when setting up the hedge on 10 July the company would have to pay an initial
margin of $1,375 x 39 contracts = $53,625 into their margin account. At the current spot rate
the £ cost of this would be $53,625/1.71110 = £31,339.

Marking to market

In the scenario given above, the gain was worked out in total on the transaction date. In
reality, the gain or loss is calculated on a daily basis and credited or debited to the margin
account as appropriate. This process is called ‘marking to market’.

Hence, having set up the hedge on 10 July a gain or loss will be calculated based on the
futures settlement price of $/£1.70925 on 11 July. This can be calculated in the same way as
the total gain was calculated:

$/£
Sell – on 10 July 1.71035
Settlement price – 11 July (1.70925)
Gain 0.00110

Gain in ticks – 0.00110/0.00001 = 110

Total gain – 110 ticks x $1 x 39 contracts = $4,290
This gain would be credited to the margin account taking the balance on this account to
$53,625 + $4,290 = $57,915.

At the end of the next trading day (Monday 14 July), a similar calculation would be
performed:

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$/£
Settlement price – 11 July 1.70925
Settlement price – 14 July (1.70805)
Gain 0.00120

Gain in ticks – 0.00120/0.00001 = 120

Total gain – 120 ticks x $1 x 39 contracts = $4,680.
This gain would also be credited to the margin account taking the balance on this account to
$57,915 + $4,680 = $62,595.

Similarly, at the end of the next trading day (15 July), the calculation would be performed
again:

$/£
Settlement price – 14 July 1.70805
Settlement price – 15 July (1.71350)
Loss 0.00545

Loss in ticks – 0.00545/0.00001 = 545

Total loss – 545 ticks x $1 x 39 contracts = $21,255.
This loss would be debited to the margin account, reducing the balance on this account to
$62,595 – $21,255 = $41,340.

This process would continue at the end of each trading day until the company chose to close
out their position by buying back 39 September futures.

Maintenance margin, variation margin and margin calls

Having set up the hedge and paid the initial margin into their margin account with their
broker, the company may be required to pay in extra amounts to maintain a suitably large
deposit to protect the market from losses the company may incur. The balance on the margin
account must not fall below what is called the ‘maintenance margin’. In our scenario, the
CME contract specification for the £/$ futures states that a maintenance margin of $1,250 per
contract is required. Given that the company is using 39 contracts, this means that the balance
on the margin account must not fall below 39 x $1,250 = $48,750.

As you can see, this does not present a problem on 11 July or 14 July as gains have been
made and the balance on the margin account has risen. However, on 15 July a significant loss
is made and the balance on the margin account has been reduced to $41,340, which is below
the required minimum level of $48,750.

Hence, the company must pay an extra $7,410 ($48,750 – $41,340) into their margin account
in order to maintain the hedge. This would have to be paid for at the spot rate prevailing at
the time of payment unless the company has sufficient $ available to fund it. When these
extra funds are demanded it is called a ‘margin call’. The necessary payment is called a
‘variation margin’.

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If the company fails to make this payment, then the company no longer has sufficient deposit
to maintain the hedge and action will be taken to start closing down the hedge. In this
scenario, if the company failed to pay the variation margin the balance on the margin account
would remain at $41,340 and given the maintenance margin of $1,250 this is only sufficient
to support a hedge of $41,340/$1,250 ≈ 33 contracts. As 39 futures contracts were initially
sold, six contracts would be automatically bought back so that the markets exposure to the
losses the company could make is reduced to just 33 contracts. Equally, the company will
now only have a hedge based on 33 contracts and, given the underlying transaction’s need for
39 contracts, will now be underhedged.

Conversely, a company can draw funds from their margin account so long as the balance on
the account remains at, or above, the maintenance margin level, which, in this case, is the
$48,750 calculated.

Foreign exchange options – the basics

Scenario

Imagine that today is the 30 July. A UK company has a €4.4m receipt expected on 26 August.
The current spot rate is £/€0.7915. They are concerned that adverse exchange rate
fluctuations could reduce the £ receipt but are keen to benefit if favourable exchange rate
fluctuations were to increase the £ receipt. Hence, they have decided to use €/£ exchange
traded options to hedge their position.

Research shows that €/£ options are available on the CME Europe exchange.

The contract size is €125,000 and the futures are quoted in £ per €1. The options are
American options and, hence, can be exercised at any time up to their maturity date.

Setting up the hedge

1. Date? – September:
The available options mature at the end of March, June, September and December.
The choice is made in the same way as relevant futures contracts are chosen.
2. Calls/Puts? – Puts:
As the contract size is denominated in € and the UK company will be selling € to buy
£, they should take the options to sell € for £ – put options.
3. Which exercise price? – €/£ 0.79250
An extract from the available exercise prices showed the following:

Exercise price Put premiums

£/€1 £/€1
0.79000 0.00465
0.79250 0.00585

As the company is selling €, it wants the maximum net £ receipt for each € sold. The
maximum net receipt is the exercise price minus the premium cost.

This is calculated below:

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Exercise Put
price premiums Net receipt
£/€1 £/€1 £/€1
0.79000 0.00465 0.7900 – 0.00465 = 0.78535
0.79250 0.00585 0.79250 – 0.00585 = 0.78665

Hence, the company will choose the 0.79250 exercise price as it gives the maximum net
receipt. Alternatively, the outcome for all available exercise prices could be calculated.

In the exam, either both rates could be fully evaluated to show which is the better outcome
for the organisation or one exercise price could be evaluated, but with a justification for
choosing that exercise price over the other.

4. How many? – 35
This is calculated in a similar way to the calculation of the number of futures. Hence, the
number of options required is:
€4.4m/€0.125m ≈ 35

Summary

The company will buy 35 September put options with an exercise price of 0.79250 £/€

Premium to pay – £/€0.00585 x 35 contracts x €125,000 = £25,594

Outcome on 26 August:
On 26 August the following was true:
Spot rate – £/€ 0.79650

As there has been a favourable exchange rate move, the option will be allowed to lapse, the
funds will be converted at the spot rate and the company will benefit from the favourable
exchange rate move.

Hence, €4.4m x 0.79650 = £3,504,600 will be received. The net receipt after deducting the
premium paid of £25,594 will be £3,479,006.

Note:
Strictly a finance charge should be added to the premium cost as it is paid when the hedge is
set up. However, the amount is rarely significant and, hence, it will be ignored in this article.

If we assume an adverse exchange rate move had occurred and the spot rate had moved to £/€
0.78000, then the options could be exercised and the receipt arising would have been:

Receipt €4,400,000
Exercise option:
Pay – 35 x 125,000 (€4,375,000)
Receive –
4.375m x 0.79250 £3,467,188
Underhedged amount €25,000

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Buy £ at spot (£/€ 0.78) (€25,000) £19,500

0 £3,486,688
Deduct premium cost (£25,594)
Net receipt – see Note 1 £3,461,094

Notes:
1. This net receipt is effectively the minimum receipt as if the spot rate on 26 August is
anything less than the exercise price of £/€ 0.79250, the options can be exercised and
approximately £3,461,094 will be received. Small changes to this net receipt may occur as
the €25,000 underhedged will be converted at the spot rate prevailing on the 26 August
transaction date. Alternatively, the underhedged amount could be hedged on the forward
market. This has not been considered here as the underhedged amount is relatively small.

2. For simplicity it has been assumed that the options have been exercised. However, as the
transaction date is prior to the maturity date of the options the company would in reality sell
the options back to the market and thereby benefit from both the intrinsic and time value of
the option. By exercising they only benefit from the intrinsic value. Hence, the fact that
American options can be exercised at any time up to their maturity date gives them no real
benefit over European options, which can only be exercised on the maturity date, so long as
the options are tradable in active markets. The exception perhaps is traded equity options
where exercising prior to maturity may give the rights to upcoming dividends.

Summary

Much of the above is also essential basic knowledge. You are unlikely to be given the spot
rate on the transaction date. However, the future spot rate can be assumed to equal the
forward rate which is likely to be given in the exam. The ability to do this may earn up to six
marks in the exam. Equally, another one or two marks could be earned for reasonable advice.

Foreign exchange options – other terminology

This article will now focus on other terminology associated with foreign exchange options
and options and risk management generally. All too often students neglect these as they focus
their efforts on learning the basic computations required. However, knowledge of them would
help students understand the computations better and is essential knowledge if entering into a
discussion regarding options.

Long and short positions

A ‘long position’ is one held if you believe the value of the underlying asset will rise. For
instance, if you own shares in a company you have a long position as you presumably believe
the shares will rise in value in the future. You are said to be long in that company.

A ‘short position’ is one held if you believe the value of the underlying asset will fall. For
instance, if you buy options to sell a company’s shares, you have a short position as you
would gain if the value of the shares fell. You are said to be short in that company.

Underlying position

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In our example above where a UK company was expecting a receipt in €, the company will
gain if the € gains in value – hence the company is long in €. Equally the company would
gain if the £ falls in value – hence, the company is short in £. This is their ‘underlying
position’.

To create an effective hedge, the company must create the opposite position. This has been
achieved as, within the hedge, put options were purchased. Each of these options gives the
company the right to sell €125,000 at the exercise price and buying these options means that
the company will gain if the € falls in value. Hence, they are short in €.

Therefore, the position taken in the hedge is opposite to the underlying position and, in this
way, the risk associated with the underlying position is largely eliminated. However, the
premium payable can make this strategy expensive.

It is easy to become confused with option terminology. For instance, you may have learnt that
the buyer of an option is in a long position and the seller of an option is in a short position.
This seems at variance with what has been stated above, where buying the put options makes
the company short in €. However, an option buyer is said to be long because they believe that
the value of the option itself will rise. The value of put options for € will rise if the € falls in
value. Hence, by buying the €/£ put options the company is taking a short position in € but is
long the option.

Hedge ratio

The hedge ratio is the ratio between the change in an option’s theoretical value and the
change in the price of the underlying asset. The hedge ratio equals N(d1), which is known as
delta. Students should be familiar with N(d1) from their studies of the Black-Scholes option
pricing model. What students may not be aware of is that a variant of the Black-Scholes
model (the Grabbe variant – which is no longer examinable) can be used to value currency
options and, hence, N(d1) or the hedge ratio can also be calculated for currency options.

Hence, if we were to assume that the hedge ratio or N(d1) for the €/£ exchange traded options
used in the example was 0.95 this would mean that any change in the relative values of the
underlying currencies would only cause a change in the option value equivalent to 95% of the
change in the value of the underlying currencies. Hence, a 0.01€ per £ change in the spot
market would only cause a 0.0095 € per £ change in the option value.

This information can be used to provide a better estimate of the number of options the
company should use to hedge their position, such that any loss in the spot market is more
exactly matched by the gain on the options:

Number of options required = amount to hedge/(contract size x hedge ratio)

In our example above, the result would be:

€4.4m/(€0.125m x 0.95) ≈ 37 options

Conclusion

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This article has revisited some of the basic calculations required for foreign exchange futures
and options questions using real market data and has additionally considered some other key
issues and terminology in order to further build knowledge and confidence in this area.

William Parrott, freelance tutor and senior FM tutor, MAT Uganda

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Conditional probability

Management decision making in both financial and performance management involves

making choices based upon what may happen in the future. Such future events can be
predicted but decision makers can rarely be 100% certain that these future events will
actually occur or will occur in the way in which they are forecast.

There are a variety of ways of dealing with such uncertainty in forecast outcomes. In this
article, we shall look at how to consider all of the possible outcomes that may arise, together
with their associated chances of occurring. This is referred to as a situation where we are
evaluating risk, since there is past information or experience which can provide statistical
evidence in order to assist in determining the possibility of each event occurring.

Expected values, decision trees and combined probabilities

A commonly used way of evaluating decisions is via the use of expected values.

An expected value summarises all the different possible outcomes by weighting the possible
outcomes by their probabilities and then summing the result.

Problems where one or more decisions have to be taken can become more complex and may
require the use of a decision tree, with expected values being used to evaluate each of the
decisions.

A decision tree is a diagrammatic representation of a problem, where the decision maker

needs to consider the logical sequence of events.

Since one event may depend upon another, we may get situations where event one has a
certain probability of occurring and event two, which depends on event one occurring, has
another probability of occurring. In such circumstances, we have a situation of combined
probabilities

For example, if event one has a 0.6 chance of occurring and subsequent event two a 0.75
chance of occurring, then overall the probability of both events occurring is:

0.6 x 0.75 = 0.45

ie a 45% chance of occurring.

We shall look at such concepts in the following example, which demonstrates how techniques
acquired from the Applied Skills exams can be used in the Strategic Professional exams.

Scenario

Brisport Master Motor Co (Brisport) designs, manufactures and sells a range of components
for the motor car industry. The design team has recently designed a new component for
inclusion into hybrid cars. The component greatly enhances the battery ‘road time’ and
therefore reduces the frequency with which the battery has to be recharged.

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The company can either sell the design now, for its initial market value of $400,000, or
attempt to develop the design into a marketable product, which can be supplied to the motor
industry. This development would have an initial outlay of $300,000 now and the component
would take one year to be developed. In such a fast-moving market, the component is likely
to have a market life as a saleable product of just five years after development.

If the company decides to develop the component, the chances of succeeding in developing
the design into the marketable product are 80%. If the attempt to develop fails, the design can
only be sold, in one year’s time, for half of its earlier market value.

If the attempt to develop the design succeeds the company has a choice of either selling both
the design and the rights to sell the developed component, or marketing the component
themselves.

Selling the design would yield $300,000 in one year’s time and $160,000 in royalty payments
for each of the five years thereafter (years 2 to 6).

If the component is marketed by Brisport then there is a 75% probability that the product will
be popular and will generate cash inflows of $440,000 per annum but there is a 25%
probability that it will be unpopular and it will generate cash outflows of $55,000 per annum.
Both cash flow figures are also for each of years 2 to 6.

Brisport uses a weighted average cost of capital of 7% to discount its future cash flows.

The management of Brisport Master Motor Co seeks your advice as to their best course of
action.

Solution

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There are two decisions which need to be taken by the company:

1. sell the design or develop it

2. if it is developed, then whether to sell the design and the rights to sell the developed
component, or market it themselves

In order to evaluate decision 1, decision 2 needs to be evaluated first. In other words, the
values we use in decision 1 need to be determined by the decision we take in decision 2.

Decision 2

The net present value ($000s) on the 75% path is

1,686 – 300 = 1,386.

Taken together with the net present value ($000s) on the 25% path of

(211) – 300 = (511)

there is an expected net present value of choosing to market the component of ($000s):

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[0.75 x 1,386] + [0.25 x (511)]

= 1,040 – 128
= 912

This is a higher value than the option of selling the design and the rights to sell the developed
component for a net present value of $594,000 ($894,000 – $300,000). Therefore, if the
development goes ahead, it will be more beneficial to market the product.

Of course, we still need to evaluate decision 1, whether to develop at all. The ‘success’ of the
expected present value of $912,000 in decision 2 has an 80% chance of arising, but there is a
20% chance of the development not succeeding and recouping just half of the initial market
value, that being $187,000 in present value terms, resulting in the company being worse off
by $113,000 in present value terms after taking the development costs into account.

Hence, the expected net present value of the development option of decision 1 can be
calculated ($000s):

= [0.80 x 912] + [0.20 x (113)]

= 730 – 23
= 707

Since this is higher than the option to sell the design at time 0, $400,000, on an expected
value basis, the component should be developed and marketed.

Attitude to risk

The expected value approach assumes risk neutrality, but not all management decision
makers are risk neutral. A risk averse management would, in this scenario, be concerned with
the 20% probability of being $113,000 worse off in present value terms should the
development decision go on to fail.

Furthermore, having taken the decision (at node 2) that marketing the component is preferred
to selling both the design and developed component there is a further risk of losses, since
there is a 25% chance of the component being unpopular leaving the company worse off by
$511,000 in present value terms.

Combined with the 80% probability of the development being successful, there is an overall
20% chance of this $511,000 loss. This 20% is known as a conditional probability since it
depends upon the 80% (0.80) success rate firstly and then depends on the 25% (0.25)
unpopularity chance.

Hence,

0.80 x 0.25 = 0.20 ie 20%

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For completeness, there is of course a 75% chance of the component being popular if
marketed, and hence the overall combined probability of a successful development together
with a marketing campaign which results in popularity is:

0.80 x 0.75 = 0.60

ie 60%

Summary

Outcome Probability Net present value ($000s)

Development succeeds and component is popular 60% 1,386
Development succeeds but component is
20% (511)
unpopular
Development fails 20% (113)

Therefore, be aware that expected values can lead to a false sense of security. The expected
NPV of $707,000 is an average. In other words, it is the average NPV if the decision is
repeated over and over again. But is that useful in this situation? This is a one-off
development of a product and therefore only one of the outcomes listed in the table above
will actually occur. (This is analogous to tossing a coin once. We know that the outcome will
either be a head or a tail, not the expected value of ‘half a head’ or ‘half a tail’). As can be
seen above, there is a 40% chance that the NPV will be negative, and that is maybe a risk that
the company is not prepared to take.

Furthermore, be aware that the analysis largely depends upon the values of the probabilities
prescribed. Often these are subjective estimates made by the decision makers and it would
only take relatively small changes in these to alter one of the decisions.

For example, in decision 2, if the probability of successful marketing falls to 55%, then the
expected NPV of ‘marketing’ falls to:

[0.55 x 1,386] + [0.45 x (511)]

= 762 – 230
= 532

This is now a lower value than the option of selling the design and the rights to sell the
developed component for a net present value of $594,000.

Such sensitivity analysis can be performed on other variables within the model.

Of course, decision models such as this are only as good as the information used. In reality
there would probably be a much wider range of possible outcomes than the discrete outcomes
described above. In other words, the problems in examination questions are a simpler version
of what is usually found in reality, but nonetheless are very useful techniques of which you
should be aware.

Written by a member of the Advanced Financial Management examining team

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Business valuations

Business valuation is ‘an art not a science’. These are the words used by many ACCA
financial management tutors (including myself) when introducing this topic to students
preparing for Advanced Financial Management. The words imply that when trying to value
the equity capital of a business, there is range of possible correct answers, all of which can be
justified as being the most appropriate. To a certain extent this is true but, as I like to put it,
‘there are different degrees of correctness’.

Questions on Business Valuations are included in every Financial Management exam. The
questions have typically tested the ‘basic’ equity valuation methods of:

• net assets
• dividend valuation model (or dividend growth model)
• earnings model using P/E ratio or earnings yield

The Advanced Financial Management syllabus builds on those methods tested at the lower
level paper. The concept is the same – to find the value of equity. However, the techniques
and methods are more sophisticated. As I stated above, ‘there are different degrees of
correctness’.

The primary purpose of this article is to demonstrate how to tackle an Advanced Financial
Management business valuation question. The detailed understanding of this topic will be
gained from your studies, whichever mode you choose to use. My aim is to show you how to
successfully apply this knowledge under exam conditions.

Equity valuation – categorising the methods

As stated above, there are more methods and models that can be used to find an equity share
price in Advanced Financial Management. The official textbooks explain these in detail and
choose different ways of categorising them within their material. I prefer to take a simple
view of equity valuation by allocating the methods into two main categories:

• Pre-acquisition
• Post-acquisition

Under the first category, the question will be asking the students to ascertain an equity value
for a company. The entity may be a private company and, hence, no stock market price exists
or that even if the company is listed, the market price may not be appropriate for the relevant
situation. The valuation methods appropriate here are:

• net assets
• dividend valuation model (or dividend growth model)
• earnings model using P/E ratio or earnings yield
• net assets + calculated intangible value (CIV)
• free cash flows (FCF)

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Past questions have, in my view, clearly indicated which method should be used to arrive at
the share price. However, it is fair to say that the free cash flow model has been tested more
than any other method.

Post-acquisition valuation requires a different mindset and series of methods. Here, students
will need to ascertain the value of the combined companies after acquisition. More
importantly, past exam requirements have requested students to ascertain the percentage gain
or loss to both groups of shareholders – those of both the buying and selling companies.

The post-acquisition valuation methods are:

• bootstrapping – applying the price earnings ratio of the buyer to the combined
expected earnings of the two entities
• combining the pre-acquisition values of the two companies and appending these with
the fair value of the synergies
• free cash flows (FCF) – present value of the combined companies FCF using the
relevant discount rate.

As I have stated above, your preparation should include ample time to study and understand
the equity valuation methods above, allowing you to apply your knowledge successfully in
the exam room.

Below is a worked sample question illustrating how I would tackle a 25-mark exam style
question, based broadly on previous exam content.

Borgonni and Venitra

Borgonni Co is a very successful entity. The company has consistently followed a business
strategy of aggressive acquisitions, looking to buy companies that it believes were poorly
managed and hence undervalued. Borgonni can be described as a modern-day conglomerate
and its business interests stretch far and wide.

Its board of directors has chosen the takeover targets with care. Always looking for
companies with potential, but which were poorly managed and having a below par market
value, Borgonni has maintained its price earnings (P/E) ratio on the stock market at 12.2.

Borgonni’s 20X3 figures show a profit after tax of $886m and it has 375m shares in issue.

Venitra Pvt is a well-established owner-managed business. In financial terms it has a rather

chequered history with its up and downs corresponding directly with the state of the global
economy. Over the past five years, its profits have fallen each year with the 20X3 values
standing at:

$m
Revenue 1,500
Operating profit 480
Interest (137)
Profit before tax 343
Taxation @ 25% (86)

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$m
Profit after tax 257

Number of shares in issue 150m

EPS $1.72

However, with economists predicting an upturn in the Western economies, Venitra’s

management team feel that revenue will increase by 6% per annum up to and including 20X7.
The company’s operating profit margin is not expected to change for the foreseeable future.

Operating profits are shown after deducting non-cash expenses (including tax allowable
depreciation) of $125m. This is expected to increase in line with sales. However, the
company has recently spent $210m on purchase of non-current assets. Venitra’s management
believes this value will have to increase by 10% per annum until 20X7 to enable the company
to remain competitive. Venitra has estimated its overall cost of capital to be approximately
12%, but this assumes it will maintain its debt to equity ratio at 40:60.

Some of Venitra’s major shareholders are not so confident about the future and would like to
sell the business as a going concern. The minimum price they would consider would be the
fair value of the shares, plus a 10% premium. Venitra’s CFO believes the best way to find the
fair value of the shares is to discount the forecasted free cash flows of the firm, assuming that
beyond 20X7 these will grow at a rate of 3% per annum indefinitely.

Requirement
(a) As at 1 January 20X4, prepare a schedule of Venitra’s forecast free cash flows for the
firm. Ascertain the fair value of the Venitra’s equity on a per share basis.
(10 marks)

(b) Borgonni intends to make an offer to Venitra based upon a share for share swap.
Borgonni will exchange one of its shares for every two Venitra shares. Assuming that
Borgonni can maintain its earnings rating at 12.2, calculate the percentage gain in equity
value that will earned by both groups of shareholders?
(8 marks)

(c) What factors should the Venitra shareholders consider before deciding whether to accept
or reject the offer made by Borgonni?
(7 marks)
(25 marks)

Solution


At this stage, you can choose one of two ways to follow my approach to answering this
question. My solution to each part along with the relevant explanation is shown below.

(a) Venitra – Forecast Free Cash Flows and Value of Equity

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Notes and explanations:

1. As we are preparing a valuation as at 1 January 20X4, I have set up columns for each
future period. I need to prepare a detailed forecast for the first four years only. After
20X7, the FCF of the firm will increase at the rate of 3% per annum. I have started
with a 20X3 column just as a reference point.
2. Revenue has been increased by 6% per annum using the 20X3 sales as a base point.
3. The operating margin in 20X3 was 32% (480/1,500). This will be maintained for the
foreseeable future.
4. One key factor is to ignore the interest payment. FCF for the firm must EXCLUDE
interest. This is because the cost of capital used to discount these flows is the
company WACC. The WACC takes into account the interest element and its tax
benefit.
5. Income tax on company profits is charged at 25%. In this case, it is to be paid in the
same year as the profits are earned.
6. The operating profit is after deducting non-cash expenses, which are allowable for
taxation. These include tax allowable depreciation. In this question, these expenses
will increase in line with sales and they have to be added back after the tax charge has
been computed.
7. Venitra needs to set aside cash each year to maintain its non-current asset (NCA)
base. The amount of capital expenditure will increase by 10% per annum for the next
four years.
Please note that in some past questions, it has been assumed that the non-cash
expenses equal the required investment in NCAs. Hence, the add back and deduction
will cancel out.
8. The forecast FCF for the firm is a simple totalling up process for the first four years.
After 20X7, the FCF are expected to grow at a rate of 3% per annum indefinitely.
Therefore, the 20X8 value is calculated as $305m x 1.03.
9. As stated in point 4, the relevant discount rate to apply to the FCF of the firm is
Venitra’s WACC. This has been estimated as 12%. The first four discount factors
have been copied from the discount tables provided at the end of the exam paper. The
discount factor for 20X8 and beyond must take into account both a 3% per annum
growth rate as well as a cost of capital of 12%. The financial mathematics for a
delayed perpetuity with an annual growth rate is (1/(0.12 – 0.03) x 0.636).

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10. The value of the entity is the total of the present value of the forecast FCF. However,
this amount represents a combination of the debt and equity together. Venitra’s equity
is equal to 60% of the value of the firm.
11. The question requirement is to ascertain the equity value per share. Therefore,
$1,866m /150m = $12.44. This is the fair value of one share of Venitra.
12. Finally, I have computed the P/E ratio for Venitra. Although this was not specifically
asked for, this value will be needed for part (b).

(b) Percentage gain in equity value – both groups of shareholders

The first stage is to compute the current market price per share for Borgonni:

$m
20X3 – Earnings 886
x
P/E ratio 12.2
Value of equity $10,809m
No of issued shares 375m
Value per share (Po) $28.82

Borgonni expects to maintain its P/E ratio after acquiring Venitra. Therefore, the post-
acquisition value of the two entities combined together can be ascertained by applying
Borgonni’s P/E ratio to the sum of the latest earnings of each company. As the P/E ratio of
Borgonni (12.2) exceeds that of Venitra (7.23) this is known as ‘bootstrapping’.

$m

Borgonni – 20X3 PAT 886

Venitra – 20X3 PAT 257
1,143
P/E ratio – Borgonni 12.2
Post-acquisition value $13,945m

The purchase is to be funded via a share for share exchange. Borgonni will issue one new
share in its company in return for every two shares in Venitra.

Borgonni issued share capital 375m

Additional shares issued (150m/2) 75m
New total issued share capital 450m

The new equity value for a Borgonni share is now $13,945m/450m = $30.99.

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However, although many candidates may stop at this point (believing they have reached
Utopia!) the requirement has not been addressed. The question asks candidates to ascertain
the gain that will be made on the equity value to each group of shareholders. Looking at each
in turn:

Borgonni shareholders’ gain (($30.99 – $28.82)/$28.82) x 100 = 7.53%

To compute the gain for the Venitra shareholders, the candidate must first compute the post-
acquisition value of a Venitra share. Venitra shareholders gave up two shares in their
company to receive one new Borgonni share. Therefore, the equivalent post-acquisition value
of a Venitra share will be $30.99/2 = $15.50.

The fair value of a Venitra share, per part (a), was $12.44. Therefore, the Venitra
shareholders gain 24.60%.

(c) Factors to consider – for the Venitra shareholders

There is no one correct answer to this part. As long as the candidate produces a reasonable
number of valid points, they will earn decent marks.

My answer would read as follows:

• Venitra shareholders wanted a gain of at least 10% on the fair value of the shares.
Based upon the figures, they are gaining nearly 25%, which is likely to encourage
them to accept the offer.
• The share for share exchange may be beneficial for tax planning. Any capital gain
earned on the sale of the shares will be rolled over until the gain is realised in cash.
• Venitra may decide to reject this bid believing that Borgonni will make a more
lucrative offer in the future.
• The fair value of the Venitra shares has been based upon forecasts and estimates.
Some sensitivity analysis needs to be carried out to ensure the value is robust.
• There is no guarantee that Borgonni can maintain its P/E ratio at 12.2. There may well
be an element of dilution given the much lower P/E of Venitra. Hence, the post-
acquisition value is then uncertain.
• Not all Venitra shareholders want to sell the company. The constitution of the
company may allow the takeover to be blocked unless a certain percentage majority
of the shareholders agree.
• Venitra shareholders may also feel that as the economic conditions are improving,
their business prospects and value will get better. They may reject Borgonni’s
approach and stay as an independent company.

As you can see, business valuation questions require you to have a disciplined approach and
to demonstrate that you have studied and understand this key area of the syllabus. Although
equity valuations are an ‘art not a science’, you have to produce an answer that is pleasing to
the eyes of the examining and marking team.

Sunil Bhandari, freelance tutor

www.SunilBhandari.com

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International project appraisal

International project appraisal is an integral part of the Advanced Financial Management
syllabus.

The purpose of this series of articles is to assist your preparation for the exam by
demonstrating how to attempt exam questions on this area of the syllabus. Coupled with a
comprehensive mode of study and revision, you should be ready for whatever the exam may
contain. International project appraisal will be a large component of your studies, and I will
demonstrate a systematic method of answering a question on this topic for each section of the
exam.

In this article, I will demonstrate how to answer a ‘Section B’ style 25-mark question.

Penn Co

Penn Co is successful company based in a European country where the local currency is the
dollar and inflation has been stable at 5% pa. Income tax is charged on company profits at the
rate of 25% and is payable in the same year as the profits are earned.

The company is listed on several major stock exchanges as it has operations all over the
globe. Its market capitalisation is $655m. The company has bonds with varying maturities
trading at $145m.

The treasury department of the company regularly computes the company’s nominal cost of
capital and this has been fairly stable at 10%. However, when Penn Co have carried out
projects in developing markets it has used a nominal risk-adjusted rate of 12%.

Penn Co’s primary business is construction and laying of train tracks and tramlines. Their
main consumers are governments due to Penn Co’s position as the market leader. Penn Co
has a record of completing long and complex contracts within schedule, as well as conducting
its business in an ethical manner.

The CEO of Penn Co recently attended a trade delegation to Africa where he met the prime
minister of the fast-developing country called Zanadia. The prime minister and his political
team provided Penn’s CEO with an outline of a contract that the Zanadian government would
like to award to Penn Co.

Tramline project

Zanadia is situated on the African West coast, with the local currency being the dinar.
Although being relatively small when compared to its neighbours, its economy has grown at
over 15% pa for the past five years, but this has led to an inflation rate currently running at
30% pa. The democratically elected government has taken full credit for this economic
prosperity.

The prime minister is adamant that the performance of the country is a result of trade links he
created with European-based multinational corporations (MNCs). He believes that by
encouraging investment from these entities in his country, the MNCs will generate substantial

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returns with minimal risk, as many of the projects are government contracts.

There has been varied success when European MNCs have invested in Zanadia, with political
interference, particularly from the prime minister, being blamed for below par returns.
Rumours have been rife that the prime minister has been ordering his government to make ad
hoc requests for payments to be made at various times during the contracted period. The
government themselves have stated that, on a very rare basis, penalty charges have been
levied when companies have not been keeping to schedule.

The Zanadian government’s latest project is to create an environmentally friendly electric

tramline network to connect all areas of Enat, which is Zanadian’s capital city. The project
will ultimately take 20 years to complete. However, the initial contract will be to lay the
tramline to connect Enat to the national airport located 23 kilometres away. Providing this is
completed to the satisfaction of the Zanadian government, they will extend the contract to
allow initial supplier connect the rest of the city.

Following the recent meeting between the prime minister and the CEO of Penn Co, the prime
minister has authorised his government officials to release financial projections to Penn Co to
allow it to assess the financial viability of the contract.

Financial details

The government will pay a fixed price of dinar 5000m for the initial contact to lay the
tramline between Enat and the national airport. This will be paid in stages:

Time period %
6 months 10
12 months 20
18 months 40
24 months 30

Machinery needs to be purchased in Zanadia at a cost of dinar 1000m at the start of the
project. The other costs will be locally incurred labour costs, which are estimated to be 30%
of the revenue. All values are given in nominal terms. The government has already purchased
sufficient materials from a low-cost provider based in the US for the initial 23 kilometres of
the tramline. They only require Penn Co to lay and test the tramline.

The government taxes company profits at 40% and this is to be paid in the year in which the
profit is earned. The government has no provision to offset tax allowable depreciation (TAD).

The current spot rate Dinar/$ 150 – 175 and this is expected to change in the future based
upon the relative inflation rates.

After two years, the prime minister will personally review the work carried out by Penn Co
and he expects to extend the contract to complete Enhat’s city tramline. The exact terms of
this contract extension will be subject to negotiation but the returns are expected to be
substantial.

Requirement

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(a) Prepare a financial assessment of the project covering the initial two-year period assuming
Penn Co appraises projects by discounting nominal $m cash flows at the appropriate cost of
capital. State clearly any assumptions that you make. (11 marks)
(b) Explain the main risks and issues faced by Penn Co if it chooses to undertake this project.
(14 marks)

(25 marks)

The key to a good Advanced Financial Management answer is to have a clear plan when
answering the question. Knowing where to start and how to progress through in a smooth and
efficient way is vital.

Time allocation

The 25-mark question needs to be completed in 45 minutes, allowing 1.8 minutes per mark.
A split of 20 minutes for part (a) and 25 minutes for part (b) is a good starting point in terms
of allocation, but with students often finding the numerical elements challenging, allowing a
minimum of 20 minutes for part (b) will give flexibility.

Understand the requirements

What are you been asked to do? Read the requirements and understand the key words. Match
them to your Advanced Financial Management knowledge.

In this case:
(a) Compute a net present value in $m. ‘Nominal’ cash flows means adjusted for relevant
inflation. ‘Appropriate’ cost of capital – my initial thoughts are either the company’s
weighted average cost of capital (WACC) or a risk adjusted WACC. I need to list out any
assumptions I make.
(b) ‘Risks and issues’ – I assume I will be able to derive most of these from the main body of
the question coupled with the relevant Advanced Financial Management knowledge areas.

Which part to attempt first?

From experience, most candidates attempt the question in the order it is set. There are no
instructions that says you have to do this. Decide which order you feel most comfortable
with, but ensure you make a valid attempt at both parts of the question.

As for me, I would attempt Part (b) first. I feel I am more likely to be in control of my time
this way. However, I will show my answer in the order the question was set.

The read through

I understand the requirements. Now, I need to digest the details of the question. My approach
is a simple one.

Part (a) – Answer

To address this requirement I need to show a disciplined approach. Let me break this down

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into stages and explain my thought process for each step.

(1) Dinar cash flows

Now 6 months 12 months 18 months 24 months

Description
Dinar (m) Dinar (m) Dinar (m) Dinar (m) Dinar (m)
Revenue 500 1,000 2,000 1,500
Variable cost (150) (300) (600) (450)
(30%) _______ _______ _______ _______
Taxable cash
350 700 1,400 1,050
flows
Taxation
(140) (280) (560) (420)
@ 40%
Initial investment (1,000)
______ _______ _______ _______ ______
Project cash flows (1,000) 210 420 840 630

The points to notes here:

• Columnar layout corresponding with the timing of the cash flows specified in the
question.
• Cash flows are in nominal dinars; they have already been adjusted for Zanadian
inflation.
• Revenue is dinar 5000m allocated per the percentages specified in the question. I see
no reason to show a working for this.
• Variable cost is just 30% of the revenue figures as indicated on the schedule.
• Sub-totalled to show the taxable ‘profits’. As there is no TAD in this question, these
are equal to the operating cash flows.
• Taxation is a relevant cash flow. On the read through stage, I noted that there was no
time delay in the payment of the tax to the Zanadian government.
• Initial investment is a simply copy and paste.
• The total project cash flows show that Penn Co will need to initially buy dinars (sell
$s) to make the investment. Subsequently, Penn Co will be receiving dinars that it will
convert into $s. Care needs to be taken when choosing/calculating the spot rates.

(2) Spot rates and conversion to $m

Project cash flows (1,000) 210 420 840 630

Spot rate (W1) Dinar/$ 150 196 217 243 269
Free cash flows ($m) (6.67) 1.07 1.94 3.46 2.34

The question stated that the current spot rate was dinar 150 – 175/$. As Penn Co needs to sell
$s initially, the bid rate of dinar 150/$ will apply. As all other cash flows are receipts in

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dinars, a working is needed to compute the projected offer spot rates via the purchasing
power parity theory (PPPT) formula.

Dinar/$
Now 175
6 months (175 + 217) / 2 196
12 months 175 x 1.30 / 1.05 217
18 months (217 + 268) / 2 243
24 months 217 x 1.30 / 1.05 269

The PPPT formula is used to calculate the annual spot rates. The intervening half-year rates
are average values.

Finally, many students fail to convert the foreign cash flows into the home currency correctly.
Based on my experience, I have seen many answers where confusion has reigned supreme, as
students are not sure whether to divide or multiply. In this case the project cash flows are in
dinars and our spot rates are dinar/$. We divide the dinar cash flows to convert to $m.

(3) Final answer

Now 6 months 12 months 18 months 24 months

Description
Dinar (m) Dinar (m) Dinar (m) Dinar (m) Dinar (m)
Revenue 500 1,000 2,000 1,500
Variable cost (150) (300) (600) (450)
_______ ______ _______ _______ _______
Taxable
350 700 1,400 1,050
cash flows
Taxation
(140) (280) (560) (420)
@ 40%
Initial (1,000)
investment ______ ______ _______ _______ _______
Project
(1,000) 210 420 840 630
cash flows
Spot rate
150 196 217 243 269
(W1) Dinar/$
Free cash
(6.67) 1.07 1.94 3.46 2.34
flows ($m)
Cost of
1.000 0.945 0.893 0.844 0.797
capital
______ ______ _______ ______ ______
(12%)
Present (6.67) 1.01 1.73 2.92 1.87
values ($m) ______ ______ _______ _______ ______
Net present
+$0.86m
value ($m)

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Discounting at the risk adjusted WACC of 12% (see assumptions below) should be the easy
part. The discount factors for 12 and 24 months can be taken from the tables provided at the
back of the exam. Those same tables provide the formula to use to calculate the six-month
and 18-month discount factors remembering that r = 0.12 and n = 0.5 and 1.5 respectively.

(4) Assumptions
The requirement invites the students to state any assumptions. Here is a sample of some that
could be made:

• The nominal risk adjusted cost of capital of 12% is the appropriate discount rate given
that the project is based in a developing country.
• There is no additional taxation to pay in Penn Co’s home country on the remitted
dinar cash flows.
• Inflation rates in both countries will remain constant at their respective rates for the
next two years.
• The PPPT formula provides a materially accurate assessment of the projected spot
rates.
• There is no residual value for the machinery after two years, as it will continue in use
after this initial period.

Part (b) – Answer

As stated above, students could choose to ‘front load’ the answer to this requirement. My
thought process here is to derive as many relevant points from the information in the scenario
that relate to ‘risks and issues’ and expand on these. The examiner is looking for students to
apply their knowledge to the details given in the question. It is these points that will ensure
you achieve a sound pass mark for this requirement.

In addition, I will include the relevant factual points that can be found in any of the Advanced
Financial Management approved textbooks. They will certainly earn some marks.

Risks and issues facing Penn Co

• Sensitivity analysis – irrespective of the final NPV, the values used to arrive at this
number are subject to estimation errors. The ones of particular concern are the cost of
capital and predicted spot rates. Penn Co should carry out sensitivity analysis to
identify how any changes to these variables affect the NPV.
• Recent history – although many MNCs have invested in Zanadia, this has not always
led to success. Penn Co needs to investigate and ascertain a little more detail as to
why this has been the case. Blame could lie with both parties to the contract.
• Ad hoc Payments – Penn Co needs to obtain some clarity on this matter. These
charges would reduce the NPV of the project and may even change the decision that
the company takes. The terms of the contract need to be carefully reviewed to ensure
that Penn Co is aware of what the Zanadian government expects.
• Supplier – Penn Co has a reputation for manufacturing as well as laying tramlines. In
this case, they will be installing lines purchased from another supplier. There may
well be quality and specification issues.

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• Prime minister – the prime minister has a lot of influence over this contract. He will
‘personally’ review the work carried out by Penn Co before deciding to extend the
contract. The criteria on which his decision will be made are not specified and may
well be highly judgmental.
• 20-year contract – this is a long project and the risks associated with time are very
high. The returns are said to be substantial but again not quantified.
• Other issues – there are a number of other issues Penn Co should accrue for:
– The company would need to be aware of local customs and work practices.
– The legal and regulatory issues would need to be quantified.
– If managers would be recruited in Zanadia or sent from Penn Co’s home country.
– The project will not damage Penn Co’s business and ethical reputation.

International project appraisal questions are challenging, but far from impossible. Students
need to follow a disciplined approach. The format is very similar to when preparing a
standard ‘home country based’ NPV which candidates have practised many times as it is part
of both Financial Management and Advanced Financial Management.

For projects based abroad it is about starting with the relevant nominal foreign currency cash
flows. The key differences are the computation of the spot rates and conversion of foreign
currency cash flows to domestic currency values. Discounting at risk-adjusted rates should
not be unexpected given the change in risk levels when investing abroad.

There are certain skills that we have not seen tested above such as royalties, transfer pricing
and double taxation. These will be part of my next article when we return to Penn Co and
look at another international project it is considering as an investment opportunity.

Sunil Bhandari, freelance tutor

www.SunilBhandari.com

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International project appraisal - part 2

The first part of this article highlighted the importance of international project appraisal
within the Advanced Financial Management syllabus. There was also a demonstration as to
how to tackle a Section B, 25-mark question using material from your studies.

It is just as important to prepare for a Section A 50-mark test on international project

appraisal. There will be a large section of text containing far more information than a Section
B type question. However, this is compensated by a greater mark allocation and, hence, more
time to produce an acceptable answer. As shown in the previous article, students need to
adopt a methodical approach to ensure they are rewarded with high marks.

Let us now return to Penn Co and consider another international investment opportunity.

Penn Co

Penn Co is a successful company based in the European country, Ayjai. The local currency is
the dollar ($), inflation has been stable at 2.75% pa and income tax is charged on profits, in
the year in which they are earned, at a rate of 25% pa. The company is listed on several major
stock exchanges as it has operations all over the globe. Its market capitalisation is $655m.
The company has bonds with varying maturities trading at $145m.

Penn’s nominal cost of capital has been stable at 10%. However, Penn Co uses a nominal
risk-adjusted rate of 12% when carrying out projects in developing markets.

Penn Co’s main operation is constructing and laying of train tracks and tramlines. Due to its
position as the market leader, its primary consumers are governments. Penn Co is renowned
for its ethical business style, and ability to complete long and complex contracts within
schedule.

Penn Co sets up wholly owned subsidiary companies in each country where it has business
interests, including in Nuruk.

Nuruk

Nuruk is a fully-fledged member of the euro zone and shares a border with Ayjai. Its
currency is the euro (€). Nuruk is a well-developed country and, unlike most of the euro zone,
its economy is growing at a healthy rate.

The primary reason for Nuruk’s current economic state is its low level of taxation. Income
tax is charged at 20% pa and can be paid up to one year after profits are earned. In addition,
the Nurukian government reacted to the global recession with a substantial fiscal expenditure
plan, leading to the enhancement of the national railway network.

Since 2009, the government have invested in replacing and upgrading the state-owned
national railway network to allow the lines to run the new 'SuperFast2 (SPF2)' trains. The

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government committed to a 10-year plan to ensure SPF2 trains could operate on lines
nationwide.

Penn Co, via its Nurukian subsidiary, has benefited from the government investment in the
railway network. The subsidiary was granted preferred supplier status by the government in
2009. It has been the primary, but not the exclusive, business partner to the government. To
date, Penn Co have supplied the entire specialist train track required to run the SPF2 and have
consulted and advised the various construction companies, contracted by the government, on
the laying and testing process. Currently, all stakeholders are content with the progress made.

Final Phase

The final phase of the project will take five years to complete. The track is to be laid on a
national heritage site, the Linus mountain range, by which there are many small villages.

The government has been scrutinised by both the villagers and environmental protest groups,
concerned that the new line would cause substantial ecological damage. In 2010, the
government pushed back the start date to 1 January 2014 in order to hold a public enquiry
and hear the concerns of the stakeholders. They decided that environmental considerations
should be prioritised when laying the SPF2 rail line and it should be considered a 'special
case'. The government accepted these findings and decided that Penn Co would be the most
suited company to carry out the upgrades due to its ethical approach.

Penn Co is required to supply, fit and test the line via its subsidiary. The government will
closely monitor the project due to the outcome of the enquiry and, in addition, has allocated
extra resources to this phase, as it understands the task of laying the new rail-line will be
onerous.

Penn Co wishes to consider the financial and other implications of the project before making
a final decision. The subsidiary will need to buy specialist machinery at the commencement
of the project for €1,000m. The company can claim tax allowable depreciation (TAD) on
only €250m of this investment, claimed on a straight-line basis over the life of the project.

Penn Co’s treasury department believes at this financial investment will not alter the
company’s gearing level nor will the project affect its business risk profile. However, the
necessary amount of funds to purchase specialist machinery will have to be raised in Ayjain
dollars via the financial markets.

One key stipulation of the public enquiry was to specify how many metres of line could be
laid in each calendar year:

Year ending 31 December Metres

2014 5,700
2015 6,500
2016 10,900
2017 8,100
2018 6,300

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The government will pay Penn Co, €55,000 per metre at the end of 2014, increasing by 3%
pa. Material and local labour costs are expected to be €23,000 per metre at the end of 2014,
with expected increases at a rate of 5% pa thereafter. Fixed operating costs will increase by
€40m at the end of 2014 and this amount will rise by 6% pa.

Penn Co has a standard policy that all its foreign subsidiaries must make a fixed annual
royalty payment of $15,000 per metre back to the holding company at the end of each
respective year. This is a fair arm’s length value to cover the investment made by Penn Co to
develop the train track technology.

Working capital funds will be needed from 1 January 2014. The initial amount can be
estimated to be 10% of the revenue earned at the end of year 2014. Each year, this will need
to be adjusted by €10 for each €100 change in annual sales revenue. Working capital will be
recovered in full on 31 December 2018. On the same day, the Nurukian government has
guaranteed to purchase from Penn Co the specialist machinery for a nominal value of €500m.

Economic forecasters believe that the mid-point spot exchange rate on 1 January 2014 will be
€0.7810/$. The Ayjain Central Bank expects the dollar to devalue at a rate of 5% pa. The
current risk-free rate is 4.5% pa. The estimated standard deviation of the future free cash
flows is 30%.

A bilateral tax treaty exists between the countries of Ayjai and Nuruk – hence, taxable profits
earned in Nuruk will be liable to the differential income tax rate on company profits that
applies between the two countries. The Ayjain government expects this to be paid in the same
year as the taxable profits are earned.

Offer from Elders Inc

Elders Inc is the largest construction company based in Nuruk. Since 2009, it has laid and
tested a substantial amount of the new SPF2 train line in Nuruk. It has worked closely with
Penn Co as it supplied this train track.

The board of directors (BoD) were bemused that the Nurukian government did not offer them
the SPF2 contract for the final phase. They believe that they have gone through the learning
curve and could do the work on an efficient basis.

The BoD decided to approach Penn Co with an offer of $1,200m to purchase the contract
from them in two years’ time (31 December 2015). Penn Co’s lawyers have advised them
that the Nurukian government has not expressly precluded Penn Co from exiting the contract
early but advise Penn Co to consider their ethical stance should they decide to do so.

Alternative Sources of Finance

The chief financial officer (CFO) of Penn Co has concerns about the substantial initial
investment required to start the project, relative to Penn Co’s market value. The company’s
financial advisers agree with the CFO and are suggesting two alternative methods of raising
the funds.

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• €1,000m five-year 6.25% syndicated bank loan – Penn Co’s advisers believe that a
number of Nurukian banks would be willing to participate in such a transaction. They
also believe that they may be able to persuade the Nuruk government to provide a
subsidised interest rate of 4% pa on an element of this loan.
• To raise the required funds using Islamic finance in the form of sukuk bonds. The
advisers feel that the project’s characteristics are within the Sharia law regulations and
this would give Penn Co access to low cost finance.

Requirement
Prepare a report to the Board of Directors (BoD) of Penn Co that:

a) Provides a financial assessment of the final phase of the Nuruk train line project as at 1
January 2014. All cash flows are to be presented in nominal terms and the project’s dollar
free cash flows are to be discounted at the appropriate nominal cost of capital. Ignore the
offer from Elders Inc and the alternative finance options. (22 marks)

b) A discussion of the assumptions made in arriving at the financial assessment.

(5 marks)

c) An assessment of the offer made by Elders Inc to purchase the contract from Penn Co in
two years’ time. This should include an estimate of the financial value of the real option. (9
marks)

d) A discussion of the two alternative finance options specifically addressing:

(i) If Penn Co raised the funds from the banks based in Nuruk, how this would affect the
financial assessment of the project.

No further calculations are required.

(4 marks)

(ii) The key differences that Penn Co should be aware of between raising money via the
Islamic finance option as opposed to traditional forms of debt capital. (6 marks)

Professional marks awarded for format, structure and presentation of the report.
(4 marks)

(50 Marks)

Students will not be surprised to see a scenario-based question 1 containing a vast amount of
information. Several areas of the syllabus will be tested, including international project
appraisal. Before focusing on the primary topic, I wish to demonstrate my step-by-step
approach to answering question 1.

Understand the Requirements and Allocate Your Time

This question represents 50% of the exam – therefore, the answer should be completed in 90
minutes. However, the requirements of the question should be understood. ‘Topic
recognition’ as I call it entails identifying which part of the syllabus is being targeted by each

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requirement. Simultaneously, I will allocate my time based upon the standard approach of 1.8
minutes per mark.

a) Keywords ‘financial assessment’, ‘project’s dollar nominal cash flows’ and ‘discounted’
would trigger my thoughts. I have to prepare a schedule of free cash flows and compute the
net present value (NPV). 22 marks would indicate a time allotment of 40 minutes. However,
there are four professional marks for structure and presentation, which I can spread across the
requirements. Revised time allocation – 45 minutes.

b) ‘Assumptions’ relating to the financial assessment – lots of scope to score marks here
within nine minutes.

c) ‘Real option’ takes my thought process directly to the Black-Scholes Option Pricing model
(BSOP). I have to compute the value of this PUT option and add the relevant discussion
points. Allocate 17 minutes.

d) The topic under scrutiny here appears to be two different forms of debt finance. However,
the requirements need to be interpreted very carefully.

(i) How raising loan finance will affect the project appraisal. My initial thoughts are to
explain the Adjusted Present Value (APV) appraisal method. (8 minutes)

(ii) Islamic finance – I need to apply my knowledge of Islamic finance (sukuk bonds) to
answer this final requirement. (11 minutes)

Answer Format

The question has clearly stated that the answer should be presented in a report format. The
best way to do this is have appendices showing the computational elements, followed by the
discussion parts in the main body of the headed report. In this case, I would layout my
answer:

• Appendix 1 – NPV and relevant workings

• Appendix 2 – Real option valuation using BSOP model
• Headed report – With four subheadings matching the requirements.

From reading the examiner’s report published after each exam, there appear to be a worrying
number of candidates who don’t format their answer as requested, and then missing out on
the ‘easy-to-earn’ marks.

The Read Through

I understand the requirements. Now, I need to digest the details of the question. My approach
is a simple one.

Let me now return and concentrate on preparing an answer on the international project
appraisal aspects of this question.

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Appendix 1 – NPV and Workings

Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Time 6

Description
€m €m €m €m €m €m €m
Revenue 313.50 368.23 636.01 486.81 389.99
(W1) _____ _____ _____ _____ _____ _____ _____

Variable cost
131.10 156.98 276.40 215.67 176.13
(W2)
Incremental
40.00 42.40 44.94 47.64 50.50
fixed costs
Royalty
63.44 68.72 109.48 77.29 57.11
(W3)
50.00 50.00 50.00 50.00 50.00
TAD (250/5)
_____ _____ _____ _____ _____
284.54 318.10 480.82 390.60 333.73
Total costs
_____ _____ _____ _____ _____ _____ _____

Taxable cash
28.96 50.13 155.19 96.21 56.25
flows
Taxation
(5.79) (10.03) (31.04) (19.24) (11.25)
@ 20%
Add:
50.00 50.00 50.00 50.00 50.00
TAD

Initial
(1000.00)
investment
Scrap
500.00
proceeds

Working (31.35) (5.47) (26.78) 14.92 9.68 39.00

capital ______ _____ ______ _____ ______ ______ ______
€m (1031.35) 73.49 67.56 210.08 124.86 626.01 (11.25)
Spot rate
0.7810 0.7420 0.7049 0.6696 0.6361 0.6043 0.5741
(W4) €/$

$m $m $m $m $m $m $m
Remitted
(1320.55) 99.05 95.84 313.74 196.28 1035.89 (19.60)
amounts
Royalty
85.50 97.50 163.50 121.50 94.50
income (W3)
Taxation
(21.38) (24.38) (40.88) (30.38) (23.63)
on royalty

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Income
@ 25%
Additional
tax on €
Taxable
profits (1.95) (3.56) (11.59) (7.56) (4.65)
(W5) _______ _____ _____ ______ _____ ______ ______
Free cash
(1320.55) 161.22 165.41 424.78 279.84 1102.11 (19.60)
flows

Cost of
1.000 0.909 0.826 0.751 0.683 0.621 0.564
capital (10%)
________ ______ ______ ______ ______ ______ ______
Present (1320.55) 146.55 136.63 319.01 191.13 684.41 (11.05)
values ($m) ________ ______ ______ ______ ______ ______ ______

Net present
value ($m) +146.13

My explanations and workings are as follows:

• Columnar layout corresponding with the timing of the cash flows specified in the
question. Even though the project will finish in Year 5, there will be some taxation to
pay one year later.
• Revenue needs to be supported with a working:

(W1) Revenue Time 1 Time 2 Time 3 Time 4 Time 5

Metres 5,700 6,500 10,900 8,100 6,300
55,000 56,650 58,350 60,100 61,903
Price (€)
______ ______ ______ _____ ______
313.50 368.23 636.01 486.81 389.99
€m
______ ______ ______ _____ ______

I have noted that €55,000 is the nominal price at the end of Year 1 and then it increases by
3% pa. So many past questions have asked students to adopt this approach for converting real
cash flows into nominal values.

• When computing the variable cost, my working incorporates the 5% pa increase in the
unit cost from Year 2 onwards.

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(W2) Variable cost Time 1 Time 2 Time 3 Time 4 Time 5

Unit cost 23,000 24,150 25,358 26,625 27,957
______ ______ ______ _____ ______
Metres x unit cost 131.10 156.98 276.40 215.67 176.13
(€m) ______ ______ ______ _____ ______

• Incremental fixed costs can be directly entered on to the schedule of cash flows
accruing for the 6% pa increase from Year 2.
• Royalty – this needs some care. I have incorporated this twice on the schedule of cash
flows. The royalty will be income earned in dollars for Penn Co in Ayjai. However, it
will be an operational cost for the Nurukian subsidiary, and the dollar values need to
be converted, at the predicted spot rate, into euros.

(W3) Royalty Time 1 Time 2 Time 3 Time 4 Time 5

Metres x $15,000
$85.50 $97.50 $163.50 $121.50 $94.50
($m)
Spot rate €0.7420 €0.7049 €0.6696 €0.6361 €0.6043
(€/$) – (W4) ______ ______ ______ ______ ______
63.44 68.72 109.48 77.29 57.11
€m
______ ______ ______ _____ ______

The predicted spot rate is a mid-point number (an average of the bid and offer rates) and is
the value of one dollar in euros. The dollar is predicted to devalue by 5% pa.

Time Time Time Time Time Time Time

(W4) Spot rates
0 1 2 3 4 5 6
Spot
rate €0.7810 €0.7049 €0.6696 €0.6361 €0.6043 €0.5741
(€/$) €0.7420

• TAD is not a cash flow. It is an allowable expense so I can compute the taxable profit
and the relevant taxation cash flow. The TAD is then added back.
• Taxation is computed at the rate of 20% of the taxable profit. However, it will be paid
one year after the profit was earned.
• Initial investment and scrap proceeds are just a copy and paste.
• Working capital – my ‘thought process’ is to assume the project needs to have a
unique bank account. It needs a cash investment on 1 January 2014 of €31.35m (10%
x €313.50m). At end of the first year an incremental adjustment is needed that can be
computed as 10% x (€368.23m – €313.50m). Similar adjustments are made at the end
of T2, T3 and T4. At the end of the project, I assume this bank account is closed and
whatever is left is withdrawn.

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• The euro cash flows are converted into dollars at the predicted spot rates. As I stated
in my last article, some students make errors at this point. In this case, I have to divide
the euro cash flows by the spot rate (euro per dollar) to find the dollar amounts.
• As mentioned above, the dollar value of the royalty appears twice on the schedule.
Penn Co will receive the royalties, and these will be subject to taxation in Ayjai.
• The bi-lateral tax agreement mentioned in the question leads to an additional cash
flow. The working clarifies the position.

(W5) Additional taxation Time 1 Time 2 Time 3 Time 4 Time 5

€m €m €m €m €m
Taxable profit 28.96 50.13 155.19 96.21 56.25
(25–20)% x
(1.45) (2.51) (7.76) (4.81) (2.81)
Taxable Profit
€0.7420 €0.7049 €0.6696 €0.6361 €0.6043
Spot Rate (€/$) – W4
______ ______ ______ ______ ______
(1.95) (3.56) (11.59) (7.56) (4.65)
$m
______ ______ ______ ______ ______

• As the project will not alter Penn Co’s business and financial risk, the appropriate cost
of capital is 10%, the company’s WACC.

Extract from the Report

Let me turn my attention to the report. I will show you an extract from this so as you can get
a feel as to what you need to produce in the exam.

To: BoD of Penn Co

From: xxxxxx
Subject: Nurukian Train Line Project
Date: xx-xx-xx

-------------------------------------------------------------------------------

Financial assessment
I have prepared a forecast of the nominal free cash flows for the Nurukian train line project in
Appendix (1). After discounting these at the Penn Co’s current cost of capital (10%), the
project increases shareholder wealth by just under $150m. Based on this value, the company
should accept this project.

All forecasts are subject to estimation errors. This should be taken into account when the
BoD arrives at its final decision.

Assumptions
There are a number of assumptions that have been made when computing the NPV. Some of
these are considered below:

• Inflation – specific inflation rates have been incorporated into the appraisal and are
expected to remain constant for the five-year period.

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• Taxation – the current tax rates and allowances used to arrive at the taxation cash
flows may vary over the life of the project.
• Scrap proceeds – the Nuruk government have guaranteed to purchase the machinery
for a value of €500m. This may be subject to the condition of the machine as there
will be wear and tear.
• Exchange rates – future spot rates are affected by many factors and, hence, the values
used in the assessment may be incorrect.
• Finance – the project requires €1,000m ($1280m) initial finance. It has been assumed
that this will be raised in the Ayjain financial markets. This is a large value relative to
the company’s current entity value. The project may be too big for Penn Co to
undertake.

Sensitivity analysis should be carried out to identify how changes in key variables affect the
NPV.

Appendix (2) and Remaining Part of the Report

The primary objective of this second article was to show how to deal with international
project appraisal within Section A of Advanced Financial Management. This has now been
achieved. Appendix (2) and the remaining elements of this report are on other key areas of
the Advanced Financial Management syllabus. Although, these are just as important, they are
not the focus of these series of articles. My intention was to provide you with a logical way of
attacking questions on international project appraisal only.

International project appraisal is an important element within the Advanced Financial

Management syllabus. Students preparing to attempt this exam should ensure they study this
topic very carefully. Know your subject well.

As I have demonstrated in this series of articles, a question on this area can appear in either
section of the exam. As long as you take a disciplined approach and apply the knowledge you
gave gained from your studies, you can earn a mark worthy of a pass.

Sunil Bhandari, freelance tutor

www.SunilBhandari.com

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Aspects of Islamic finance

This article aims to continue to develop the understanding of Islamic finance and follows the
first article on this subject, 'Islamic finance – theory and practical use of sukuk bonds'. The
first article focused on Sukuk finance and case studies where Sukuk finance was utilised.
This article is more general and considers different aspects, issues and developments of
Islamic finance. It also extends the explanations provided in the appendix to the first article.

Questions are likely to focus on the application of Islamic finance as an additional source of
finance, and assessing its benefits and drawbacks, in different business scenarios and
situations.

Overview

Islamic virtues and tenets specify the need for ethical behaviour and fair treatment. Within a
business context, this means that organisations should maintain high ethical standards in all
business dealings. Specifically, business and enterprise should be conducted with honesty and
integrity, maintaining truthfulness and morality in all dealings. In particular, such business
and enterprise should not capitalise on the misfortune of others or take unfair advantage. For
example, higher prices should not be charged to an individual because they lack knowledge
and information about the fair price of a product that they are purchasing. Profit creation
should be the result of business activity that benefits society at large.

Within this context, the Islamic finance framework is based on certain prohibitions. In
particular, money (and money substitute products such as gold and silver) should not be
viewed as commodities, but rather as means of exchange. Therefore, interest (or riba) cannot
be paid or received on loans. Furthermore, although it is fully acceptable to engage in
profitable business activities, such business should be ethical. In particular dealing in alcohol,
pork-related products, armaments, gambling and other socially detrimental activities is not
acceptable. Engaging in activities involving speculation is also not allowed, limiting the use
of derivative instruments and money markets, which are based on interest.

Operationalising Islamic finance

Organisations need access to short-term and long-term sources of finance. The basic,
fundamental function of banks is to provide a channel that enables the flow of financial
resources from investors to borrowers, and thereby provides a source of finance for
organisations. Investors invest their excess funds to earn interest, and borrowers use the funds
in business activity to generate profits, some of which are then used to pay interest on the
borrowings. Among other sources of finance that involve the payment and receipt of interest
are corporate and government bonds.

The question that could be asked is how could finance flow between investors and borrowers
without involving interest. The answer provided by Islamic finance, in its basic form, is
through profit-sharing arrangements or partnerships. The article on Islamic finance published
in February 2013 explained it as follows:

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In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead
channelled into an underlying investment activity, which will earn profit. The depositor is
rewarded by a share in that profit, after a management fee is deducted by the bank.

Islamic finance institutions (IFIs), including banks, could raise finance via Mudaraba and
Musharaka equity-type contracts through multi-partnership contracts (see below). Here,
investors (known as rub-ul-mal) would invest funds with the IFI (known as the mudareb or
investment manager). The funds are then pooled and used in profit-making projects while
also keeping within Sharia rules. Therefore, the IFI would effectively become the rub-ul-mal
and the corporation that uses the funds for investment purposes becomes the mudareb. In
each case, the emphasis is on partnerships, and the profits earned are shared between the
corporation, the bank and the investors. It is possible that all three parties share the losses as
well, if the business venture is not successful.

However, with corporations requiring different modes of finance and IFIs keen on providing
these, different types of Islamic financial products have been developed. The challenge for
IFIs is to ensure that the products comply with Sharia rulings, as well as normal financial
regulations and law.

Common Islamic financial products

IFIs offer two broad categories of financial products: equity-based and fixed income-based.
The appendix to the February 2013 article on Islamic finance explained many of these
financial products and it is recommended that this article is read in conjunction with the first
article for further detail.

Equity-based financial products

Equity-based financial products consist of Mudaraba and Musharaka contracts. With these
contracts, the investor or IFI (rub-ul-mal) and the investment manager or corporation
(mudareb) share the profits from the business venture, in which the funds are invested, in a
pre-arranged agreement. The key differences between the two contracts are two-fold.

With a Mudaraba contract:

• all losses are borne solely by the investor (IFI), although provisions can be set up to
carry forward these losses against future profits, and
• the mudareb, as the expert in the business venture takes the sole responsibility for
running the business.

With a Musharaka contract:

• losses are shared between the two parties in proportion to their monetary investment
or investment-in-kind, and
• both parties would participate in managing and running the venture jointly.

Diminishing Musharaka contracts are a recent innovation where not only are the profits
shared between rub-ul-mal and the mudareb, but the mudareb would pay greater amounts to
the rub-ul-mal. In this way the mudareb owns greater and greater proportion of the asset, until
eventually the ownership of the asset is passed to the mudareb entirely.

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Fixed-income based financial products

With Murabaha contracts, the IFI purchases the asset and then sells it to the business or
individual at cost plus a fair profit. The business or individual pays for the asset in pre-agreed
instalments and over a pre-agreed time period.

Ijara contracts are similar to short-term leases where the IFI purchases an asset for the
business or individual to use. The lease payments, the lease period and payment terms are
agreed at the start of the contract. The lessor is responsible for the maintenance and insurance
of the asset. Provisions can be made to allow the lessee to purchase the asset for a nominal
fee at the end of the contract.

Sukuk bonds were covered in some detail in the February 2013 article on Islamic finance and
it is recommended that you study that article in detail. Sukuk bonds have been based on
underlying securitised Islamic contracts such as Ijara and Mudaraba, as well on individual or
groups of physical assets. Some Sukuk bonds have been based on securitised Murabaha
contracts, but there is some debate on whether these comply with Sharia rulings, as they may
be viewed as debt on debt and therefore attracting riba. Some Sharia rulings have allowed
minor proportions of Murabaha and Istisna contracts within the securitised asset portfolio,
used as the underlying asset portfolio.

Salam contracts are similar to forward contracts, where a commodity (or service) is sold
today for future delivery. Cash is received immediately from the IFI and the quantity, quality,
and the future date and time of delivery are determined immediately. The sale will probably
be at a discount so that the IFI can make a profit. In turn, the IFI would probably sell the
contract to another buyer for immediate cash and profit, in a parallel Salam arrangement.
Salam contracts are prohibited for commodities such as gold, silver and other money-type
assets.

Istisna contracts are often used for long-term, large construction projects of property and
machinery. Here, the IFI funds the construction project for a client that is delivered on
completion to the IFI’s client. The client pays an initial deposit, followed by instalments, to
the IFI, the amount and frequency of which are determined at the start of the contract.

Sharia boards

Sharia Boards (SBs) ensure that all products and services offered by IFIs are compliant with
the principles of Sharia rules. They review and oversee all new product offerings made by the
IFI and make judgments on an individual case-by-case basis, regarding their acceptability
with Sharia rulings. Additionally, SBs often oversee Sharia compliant training programmes
for an IFI’s employees and participate in the preparation and approval of the IFI’s annual
reports.

SBs are normally made up of a mixture of Islamic scholars and finance experts to ensure that
fair and reasonable judgments are made. Where necessary, the finance experts can explain the
products to the Islamic scholars. The Islamic scholars often sit on several SBs of a number of
different IFIs. SBs are in-turn supervised by the International Association of Islamic Bankers
(IAIB).

SBs face several challenges when making judgments. Sharia law can be open to different
interpretations, leading to different outcomes on the acceptability of the same products by

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different SBs and Islamic scholars. Furthermore, precedents set by SBs are not binding, and
changes in SB’s personnel over time may shift the balance of the SB’s collective opinions
and judgments on the acceptability of existing and new products.

SBs need considerable resources to operate effectively, especially where Sukuk finance is
concerned. IFIs need to ensure that their SB members are well informed about the
developments and trends in global financial markets.

Benefits, drawbacks and challenges

Benefits
Corporations, individuals and IFIs engaged in raising and issuing funding based on Islamic
finance virtues may be viewed as belonging in stakeholder-type partnerships that are engaged
in deriving benefits from ethical, fair business activity. The result of these partnerships is one
of mutual interest, trust and co-operation. The ethical stance and fair dealing of Islamic
finance virtues means that partnerships, business activity and profit creation comes from
benefiting the community as a whole.

Since the virtues of Islamic finance and enterprise prohibit speculation and short-term
opportunism, it encourages all parties to take a longer-term view of success from the
partnership. It focuses all the parties’ attention on creating a successful outcome to the
venture. This should result in a more stable financial environment. Indeed, literature in this
area suggests that had banks and other financial institutions conducted their business activity
based on Islamic finance principles, the negative impact of the banking and sovereign debt
financial crises would have been much reduced.

IFIs or conventional financial institutions with products based on Islamic finance principles
gain access to Muslim funds across the world and provide finance for organisations and
individuals who need them. As the February 2013 article stated, it is estimated that Islamic
financial assets have exceeded $1,600bn worldwide. As the world emerges from the global
financial crisis and business activity increases, this should increase. Furthermore, access to
Islamic finance is not restricted to Muslim communities only. The wider business community
could have access to new sources of finance. This may be particularly attractive to
corporations focused on ethical investments that Islamic finance virtues stipulate.

Drawbacks and challenges

Because of the prohibitions of riba and on speculation, IFIs may be slower to react to market
demand and changes. They may lack sufficient flexibility in their product offering when
compared to conventional financial institutions and may be less able to take advantage of
short-term opportunities.

Moral hazard and principal-agent issues may be more pronounced between IFIs and
organisations and individuals to whom they lend funds. This is because Islamic finance
virtues stipulate close relationships from partnership-like arrangements. However,
information asymmetry between the IFI and the borrower of funds will always exist.
Therefore, costs related to increased level of due diligence and negotiating are probably
higher for IFIs.

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Costs related to developing new financial products may also be higher for IFIs because not
only will the products have to comply with normal financial laws and regulations but also
with Sharia rules. As stated above, the resources required by SBs can be considerable.

Added to this, because these financial products need to go through stages of compliance and
layers of complications before they are approved, the approval process can take time. The
pace of innovation of new Islamic financial products may be considerably slower than that of
conventional products. This may make the IFI less able to compete with conventional
financial institutions and may make it restrict its activities to smaller, niche markets.

Some Islamic financial products may not be compatible with international financial
regulation – for example, a diminishing Musharaka contract may not be an acceptable
mortgage instrument in law, although it could be constructed as such. The need to ensure that
such products comply with regulations may increase legal and insurance costs.

The interpretation of Sharia rulings may allow certain Islamic finance products to be
acceptable in some markets, but not in others. This has led to some Islamic scholars, who are
experts in Sharia and finance, to criticise a number of product offerings. For example, some
Murabaha contracts have been criticised because their repayments have been based on
prevailing interest rates rather than on economic or profit conditions within which the asset
will be used. Some Sukuk bonds have faced similar criticisms in that their repayments have
been based on prevailing interest rates, they have been credit-rated and their redemption
value is based on a nominal value rather than on a market value, and thereby, perhaps,
making them too close to conventional bonds and their repayments too similar to riba. On the
other hand, the opposite argument could be that in order to make Islamic financial products
competitive in all markets, their valuations need to be comparable. Therefore, benchmarking
them using conventional means is necessary.

So far the discussion on drawbacks and challenges has focused on IFIs, as providers of
Islamic finance. It is also important to consider the drawbacks and challenges that
corporations may face when using Islamic finance.

From the above discussion, the costs related to developing and gaining approval for Islamic
financial products is likely to be passed down to customers and possibly make these products
more expensive. In addition to this, access to new products and flexibility within existing
products may be limited, due to the more complicated approval process that is necessary.
These more expensive and less flexible sources of finance may make the corporation using
them less competitive when compared to rivals who have access to cheaper, more flexible
sources of finance.

The partnership nature of Islamic finance contracts may also cause agency type issues within
corporations. These may be more prevalent in joint venture type situations or where the
diverse range of stakeholders may make it more difficult for corporations to determine and
act upon the importance of various stakeholder groups. For example, in the case of a
Musharaka contract, where the IFI and the organisation are both involved in the management
of a project, dealing with other stakeholder groups may be more challenging.

Before the financial crisis, trading in asset backed and securitised Sukuk products, issued by
corporations, has been limited (a notable exception was Sukuk products denominated in

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Malaysian ringgits). Furthermore, since the financial crisis, issuance in new Sukuk products
has reduced somewhat.

Using Islamic finance may also increase the cost of capital for a corporation. For example, it
may be more difficult to demonstrate that repayments for Mudaraba, Musharaka and Sukuk
contracts are like debt, and therefore they may not attract a tax-shield. However, an
equivalent organisation which raises the same finance using conventional debt finance may
be able to lower its cost of capital due to tax-shields and therefore increase the value of its
investment.

Conclusion

The increasing global interest in and use of Islamic finance means that this is an important
source of finance which organisations need to consider. Its many attributes that are common
to ethical investment and finance would make it an attractive source of finance particularly to
organisations that place importance on ethical issues. The innovations in Islamic financial
products by IFIs, such as Sukuk and diminishing Musharaka, have meant new and innovative
Islamic finance products are being developed and are coming into the market. This is likely to
continue as the impact of the financial crisis recedes.

However, IFIs face a number of challenges such as agency-related issues, increased costs,
lack of flexibility, difficulties with complying with Sharia rulings, and also normal
regulations and law. The IFIs (and the wider Islamic finance regulatory bodies) need to put
into place mechanisms and strategies that will help to overcome these challenges, and thereby
ensure that Islamic finance-based products compete and compare with conventional riba-
based financial products.

Written by a member of the Advanced Financial Management examining team

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Islamic finance

This article looks at Islamic finance as a growing and important source of finance,
including the success and failure of the use.

The growth and popularity of the use of Islamic finance has been exceptional since the
Central Bank of Bahrain issued the first sovereign sukuk bonds in 2001. It is estimated that
by the end of 2012 Islamic financial assets will have exceeded $1,600bn, which is around 1–
2% of global financial assets worldwide.

A successful Advanced Financial Management student must: ‘Demonstrate an understanding

of the role of, and developments in, Islamic financing as a growing source of finance for
organisations; explaining the rationale for its use and identifying its benefits and
deficiencies.’

This article is focused on Islamic finance as a growing and important source of finance. In
particular, it looks at the success and failure of the use of sukuk bonds to finance the purchase
of assets. However, for the purpose of reference, the attached appendix explains the basic
principles of Islamic finance.

Sukuk finance

What is sukuk finance? The official definition provided by the Accounting and Auditing
Organization for Islamic Financial Institutions (AAOIFI), the Bahrain-based Islamic financial
standard setter, is ‘certificates of equal value representing undivided shares in the ownership
of tangible assets, usufructs and services or (in the ownership of) the assets of particular
projects or special investment activity.’

Sukuk is about the finance provider having ownership of real assets and earning a return
sourced from those assets. This contrasts with conventional bonds where the investor has a
debt instrument earning the return predominately via the payment of interest (riba). Riba or
excess is not allowed under Sharia law.

There has been considerable debate as to whether sukuk instruments are akin to conventional
debt or equity finance. This is because there are two types of sukuk:

• Asset based – raising finance where the principal is covered by the capital value of the
asset but the returns and repayments to sukuk holders are not directly financed by
these assets.
• Asset backed – raising finance where the principal is covered by the capital value of
the asset but the returns and repayments to sukuk holders are directly financed by
these assets.

There are fundamental differences between these. The diagrams set out below explain the
mechanics of how each sukuk operates.

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Asset-based sukuk

Sukuk Al-ijarah: financing acquisition of asserts or raising capital through sale and lease
back.

1. Sukuk holders subscribe by paying an issue price to a special purpose vehicle (SPV)
company.
2. In return, the SPV issues certificates indicating the percentage they own in the SPV.
3. The SPV uses the funds raised and purchases the asset from the obligor (seller).
4. In return, legal ownership is passed to the SPV.
5. The SPV then, acting as a lessor, leases the asset back to the obligor under an Ijarah
agreement.
6. The obligor or lessee pays rentals to the SPV, as the SPV is the owner and lessor of
the asset.
7. The SPV then make periodic distributions (rental and capital) to the sukuk holders.

Asset-backed sukuk

Sukuk: Securitisation of Leasing Portfolio

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1. Sukuk holders subscribe by paying an issue price to a SPV company.

2. In return, the SPV issues certificates indicating the percentage they own in the SPV.
3. The SPV will then purchase a portfolio of assets, which are already generating an
income stream.
4. In return, the SPV obtains the title deeds to the leasing portfolio.
5. The leased assets will be earning positive returns, which are now paid to the SPV
company.
6. The SPV then makes periodic distributions (rental and capital) to the sukuk holders.
7. With an asset-based sukuk, ownership of the asset lies with the sukuk holders via the
SPV. Hence, they would have to maintain and insure the asset. The payment of rentals
provides the return and the final redemption of the sukuk is at a pre-agreed value. As
the obligor is the lessee, the sukuk holders have recourse to him if default occurs. This
makes this type of sukuk more akin to debt or bonds.

Asset-backed sukuk certainly have the attributes of equity finance – the asset is owned by the
SPV. All of the risks and rewards of ownership passes to the SPV. Hence, should the returns
fail to arise the sukuk holders suffer the losses. In addition, redemption for the sukuk holders
is at open market value, which could be nil.

Sukuk finance case studies

For Emirates airline, the use of sukuk finance has been a huge success. The company issued
its first sukuk (Islamic Bond), with a seven-year term, in 2005, which was listed on the
Luxembourg Stock Exchange. The $550m was repaid in full in June 2012.

‘The repayment of our first ever sukuk bond is part of Emirates’ varied financing strategy and
reflects our robust financial position,’ said Sheikh Ahmed bin Saeed Al Maktoum, chairman
of the Emirates Group and chief executive of Emirates airline.

Emirates’ initial injection of equity finance at the time of its creation 24 years ago has been
supplemented by a variety of financing options, including leasing, EU/US export credits,
commercial asset-backed debt, Islamic financing, conventional bonds, as well as sukuk.

Tim Clark, Emirates’ president, recently stated that the airline had traditionally used
European debt to finance purchase of its fast-growing Boeing and Airbus fleet. The French
banks were particularly forthcoming with finance solutions.

However, since the global debt crisis in 2008, the traditional debt markets have taken a risk
averse position – even with a business-like Emirates, which has an unbroken profit-making
record.

Clark outlined that obtaining funding for new planes using sukuk could be tricky because
Islamic finance, in addition to forbidding payment of interest, prohibits pure monetary
speculation and requires deals to involve concrete assets. It would be harder to win a seal of
approval from Islamic finance scholars for a sukuk that was based on assets, which the airline
did not yet own.

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For new aircraft, it is not impossible, but it is much more complicated as the cash would have
to go from investors through a special purpose vehicle to the manufacturer before a lease-
back arrangement is put in place. Hence, using existing assets to obtain sukuk finance is far
easier.

Emirates currently has two aircraft-based sukuk instruments that have been issued globally
and is backed by existing aircraft: a $500m issue from GE Capital in November 2009, and a
$100m deal for Nomura in July 2010.

Emirates is not the only success story when it comes to the use of sukuk finance. Dubai
shopping mall developer Majid Al Futtaim decided against issuing a conventional bond
because of pricing concerns. It mandated its banks to set up a separate sukuk programme.
Turkish Airlines has followed suit and will finance the purchase of its expanding fleet with
Islamic bonds.

The sukuk market has been relatively resilient during the instability in global financial
markets, which has made it more difficult for even highly rated companies around the world
to issue conventional bonds. That is partly because Islamic investors in the Gulf remain cash-
rich, partly due to the limited supply of sukuk, and partly since sukuk investors tend to hold
the bonds until maturity. If these bonds are not being sold on to other investors, there is little
or no chance of the bond value fluctuating.

Recent events have shown the same is not true for conventional bonds. The influence of the
credit rating agencies with their regular reassessment of government and corporate credit
ratings has caused downward movement in prices. As one commentator recently stated:
‘Equities are the only game in town – bonds carry more risk.’

However, the story of Dubai World, the sovereign investment fund of the Dubai royal family,
gives the other side of the story when it comes to the use of Islamic finance. On 25 November
2009, the financial world was shocked when Dubai World requested a restructuring of $26bn
in debts. The main concern was the delay in the repayment of the $4bn sukuk, or Islamic
bond, of Dubai World’s developer Nakheel, which was especially known for construction of
the Dubai Palm Islands.

The Nakheel sukuk was quite a complicated instrument. It was broadly based on the
aforementioned Ijarah structure. In theory, the SPV has legal ownership over the asset in this
sale and leaseback arrangement. However, in this case the SPV only had a long leasehold
interest for a period of 50 years. The issue is that leasehold right is not seen as a real right or
property right under UAE law as applicable in Dubai. What may have seemed secure was
not.

Nevertheless, the Nakheel sukuk was backed by a few additional guarantees that should have
provided sukuk investors with some recourse. As such, these guarantees gave investors the
confidence to invest in the sukuk. A guarantee from the state-owned parent company, which
implicitly provides a government guarantee for the sukuk (despite the fact that the prospectus
clearly stated otherwise), had reassured investors. This misplaced assumption misled
investors in their risk–return decision on the investment.

The issue, however, did not end there; the complications worsened when the parent company
that acted as guarantor found itself in a situation that made it no better placed than Nakheel to

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repay the sukuk. Dubai World is also just a holding company for a number of other
companies beside Nakheel. However, all of Dubai World’s subsidiaries have their own
creditors and their own debts to service, and the important thing for Nakheel sukuk-holders is
that the creditors of Dubai World, through the guarantee, are subordinated to the creditors of
the subsidiaries of Dubai World.

A public statement on 30 November 2009 by the Dubai Finance Department director-general,

that the Dubai World debts are ‘not guaranteed by the government’, appears to correctly
reflect the legal position, as the Dubai government was not required by the lenders, and nor
did it provide, any contractual guarantees in respect of the Dubai World debt.

As history tells us, Nakheel did not default on its Islamic bond. The well reported $10bn
bailout, including providing $4.1bn to assist Nakheel directly from Dubai’s rich neighbours
Abu Dhabi, calmed the markets. But this was only part of the solution. Nakheel also issued
new sukuk bonds to some of its creditors in lieu of amounts due to them. This was a key part
of the company's restructuring.

In a prospectus attached to the new sukuk, Nakheel revealed that it wrote down the value of
its property and project portfolio by almost Dh74bn (US$20.14bn) in 2009 as its fortunes
flagged. The company also said it changed tactics in response to the financial crisis, forging
ahead with a selection of its projects and putting others on hold.

Conclusion

The global debt crisis sent shockwaves through the financial markets and, at the time of
writing this article, the western banks remain reluctant to loan cash to the business
community. Islamic finance, and in particular sukuk, has to some extent filled the gap left by
the traditional debt markets.

The Sharia principle on which it is based is fundamentally important and should ensure it is a
safe and sensible finance option for both the company needing the finance as well as the
sukuk holder. Clearly, companies like Emirates have shown the way on how to make sukuk
one part of their finance portfolio.

However, the Nakheel story paints a different picture. A complicated Ijarah structure and a
lack of legal clarity as to ownership of the underlying asset have clouded the water. If the
Abu Dhabi bailout failed to materialize, then the story may have been significantly different.

Sunil Bhandari is a freelance tutor (www.SunilBhandari.com)

Appendix – The basic principles of Islamic finance

The Islamic economic model has developed over time based on the rulings of Sharia on
commercial and financial transactions. The Islamic finance framework is based on:

• equity, such that all parties involved in a transaction can make informed decisions
without being misled or cheated

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• pursuing personal economic gain but without entering into those transactions that are
forbidden (for example, transactions involving alcohol, pork-related products,
armaments, gambling and other socially detrimental activities). Also, speculation is
also prohibited (so options and futures are ruled out)
• the strict prohibition of interest (riba = excess).

As stated above, earning interest (riba) is not allowed.

In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead
channelled into an underlying investment activity, which will earn profit. The depositor is
rewarded by a share in that profit, after a management fee is deducted by the bank.

A typical illustration would be how an Islamic bank may purchase a property from a seller
and resell it to a buyer at a profit. The buyer will be allowed to pay in instalments. Compare
this to a typical mortgage where the bank lends money to the buyer and charges interest.

Hence, returns are made from cash returns from a productive source – for example, profits
from selling assets or allowing the use of an asset (rent).

In Islamic banking there are broadly two categories of financing techniques:

• ‘fixed Income’ modes of finance – murabaha, ijara, sukuk

• equity modes of finance – mudaraba, musharaka.

Fixed income modes

(a) Murabaha
Murabaha is a form of trade credit or loan. The key distinction between a murabaha and a
loan is that, with a murabaha, the bank will take actual constructive or physical ownership of
the asset. The asset is then sold to the ‘borrower’ or ‘buyer’ for a profit, but they are allowed
to pay the bank over a set number of instalments.

The period of the repayments could be extended, but no penalties or additional mark-up may
be added by the bank. Early payment discounts are not within the contract.

(b) Ijara
Ijara is the equivalent of lease finance. It is defined as when the use of the underlying asset or
service is transferred for consideration. Under this concept, the bank makes available to the
customer the use of assets or equipment such as plant or motor vehicles for a fixed period and
price. Some of the specifications of an Ijara contact include:

• the use of the leased asset must be specified in the contract

• the lessor (the bank) is responsible for the major maintenance of the underlying assets
(ownership costs)
• the lessee is held for maintaining the asset in proper order.

(c) Sukuk

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Companies often issue bonds to enable them to raise debt finance. The bond holder receives
interest and this is paid before dividends.

This is prohibited under Islamic law. Instead, Islamic bonds (or sukuk) are linked to an
underlying asset, such that a sukuk holder is a partial owner in the underlying assets and
profit is linked to the performance of the underlying asset. So, for example, a sukuk holder
will participate in the ownership of the company issuing the sukuk and has a right to profits
(but will equally bear their share of any losses).

Equity modes

(a) Mudaraba
Mudaraba is a special kind of partnership where one partner gives money to another for
investing it in a commercial enterprise. The investment comes from the first partner (who is
called ‘rab ul mal’), while the management and work is an exclusive responsibility of the
other (who is called ‘mudarib’).

The Mudaraba (profit sharing) is a contract, with one party providing 100% of the capital and
the other party providing its specialist knowledge to invest the capital and manage the
investment project. Profits generated are shared between the parties according to a pre-agreed
ratio. In a Mudaraba only the lender of the money has to take losses.

This arrangement is therefore most closely aligned with equity finance.

(b) Musharaka
Musharaka is a relationship between two or more parties that contribute capital to a business
and divide the net profit and loss pro rata. It is most closely aligned with the concept of
venture capital. All providers of capital are entitled to participate in management but are not
required to do so. The profit is distributed among the partners in pre-agreed ratios, while the
loss is borne by each partner strictly in proportion to their respective capital.

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Determining interest rate forwards and

their application to swap valuation
The previous article on bonds (see 'Related links') considered the relationship between bond
prices, the yield curve and the yield to maturity. It demonstrated how bonds can be valued
and how a yield curve may be derived using bonds of the same risk class but of different
maturities. It also showed how individual company yield curves maybe estimated.

This article follows on from that and will show how interest rate forwards may be determined
from the spot yield curve. It will then briefly discuss what they mean, before proceeding to
show how they may be used in determining the value of an interest rate swap. The second
article addresses the learning required in the E1 and E3 areas of the Advanced Financial
Management Syllabus and Study Guide.

Determination of interest rate forwards

Supposing that a bank assesses and quotes the following rates to a company, based on the
annual spot yield curve for that company’s risk class:

One-year: 3.50%
Two-year: 4.60%
Three-year: 5.40%
Four-year: 6.10%
Five-year: 6.30%

This indicates that the company would have to: pay interest at 3.50% if it wants to borrow a
sum of money for one year; pay interest at 4.60% per year if it wants to borrow a sum of
money for two years; pay interest at 5.40% per year if it wants borrow a sum of money for
three years; and so on.

Alternatively, for a two-year loan, the company could opt to borrow a sum of money for only
one year, at an interest rate of 3.50%, and then again for another year, commencing in one
year’s time, instead of borrowing the money for a total of two years.

Although the company would be uncertain about the interest rate in one year’s time, it could
request a forward rate from the bank that is fixed today – for example, through a 12v24
forward rate agreement (FRA). The question then arises: how may the value of the 12v24
FRA be determined?

A forward rate commencing in one year for a borrowed sum lasting a year can be calculated
as follows:

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In summary:

Supposing the company wants to borrow a sum of money for three years on the basis of the
above rates:
i. it could pay annual interest at a rate of 5.40% in each of the three years, or
ii. it could pay interest at a rate 3.50% in the first year, 5.71% in the second year and 7.02%
in the third year, or
iii. it could pay annual interest at a rate of 4.60% in each of the first two years and 7.02% in
the third year.

Using interest rate forwards to value a simple interest rate swap contract

Supposing the above company has $100m borrowings in the form of variable interest rate
loans repayable in five years and pays interest based on the above yield curve. It expects
interest rates to increase in the future and is therefore keen to fix its interest rate payments.

The bank offers to swap the variable interest rate payments for a fixed rate, such that the
company pays a fixed rate of interest to the bank in exchange for receiving a variable rate of

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return from the bank based on the above yield rates less 50 basis points. The variable rate
receipts from the bank will then be used to pay the interest on the loan.

The fixed equivalent rate of interest the company will pay the bank for the swap can be
calculated as follows:

The current expected amounts of interest the company expects to receive from the bank,
based on year 1 spot rate and years 2, 3, 4 and 5 forward rates are:

Year 1 0.0300 x $100m = $3.00m

Year 2 0.0521 x $100m = $5.21m
Year 3 0.0652 x $100m = $6.52m
Year 4 0.0773 x $100m = $7.73m
Year 5 0.0660 x $100m = $6.60m

Note: The rates used to calculate the annual amounts are reduced by 50 basis points or 0.5%.

At the start of the swap, the net present value of the swap receipts based on the variable rates
from the bank will be the same as the costs based on the fixed amount paid to the bank.

Let’s say R is the fixed amount of interest the company will pay the bank, then

Removing the brackets, the above expands to:

2.90m – 0.966R + 4.76m – 0.914R + 5.57m – 0.854R +
6.10m – 0.789R + 4.86m – 0.737R= 0

Simplifying this, adding all the $ flows together and R-flows together, gives:
24.19m – 4.26R = 0
$5.68m = R

In percentage = $5.68m/$100m = 5.68%

In practice the receipts and payments of the swap would be netted off such that the company
will expect to pay $2.68m ($5.68m – $3.00m) to the bank in year one, and expect to receive
$0.84m ($6.52m – $5.68m) from the bank in year three, and so on for the other years. The
present values of these n et annual flows, discounted at the yield curve rates, will be zero. The
fixed rate of 5.68% is lower than the five-year spot rate of 6.30% because some of the
receipts and payments related to the swap contract occur in earlier years when the spot yield
curve rate is lower.

Although at the commencement of the contract, the present value of the swap is zero, as
interest rates fluctuate, the value of the swap will change. For example, if interest rates
increase and the company pays interest at a fixed rate, then the swap’s value to the company

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will increase. The value of the swap contract will also change as the swap approaches
maturity, and the number of receipts and payments reduce.

Conclusion

The previous article and this article considered the relationship between bonds, interest rates,
spot and forward yield curves, culminating with how the forwards rates can be used to
determine the equivalent fixed rate of a simple swap contract. The examples used were
simplified into annual cash flows and rates, and students undertaking Advanced Financial
Management should be able to demonstrate their knowledge and understanding of these areas
to this extent.

In practice, valuation of bonds and related products is more complicated because of factors
such as: cash flows occurring more frequently than once a year, early redemption of products,
change in product values, and so on. However, these aspects are beyond the scope of the
Advanced Financial Management syllabus.

Written by a member of the Advanced Financial Management examining team

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Bond valuation and bond yields

Bonds and their variants such as loan notes, debentures and loan stock, are IOUs issued by
governments and corporations as a means of raising finance. They are often referred to as
fixed income or fixed interest securities, to distinguish them from equities, in that they often
(but not always) make known returns for the investors (the bond holders) at regular intervals.
These interest payments, paid as bond coupons, are fixed, unlike dividends paid on equities,
which can be variable. Most corporate bonds are redeemable after a specified period of time.
Thus, a ‘plain vanilla’ bond will make regular interest payments to the investors and pay the
capital to buy back the bond on the redemption date when it reaches maturity.

This article, the first of two related articles, will consider how bonds are valued and the
relationship between the bond value or price, the yield to maturity and the spot yield curve. It
addresses, in part, the learning required in Sections B3a and B3e of the the Advanced
Financial Management Syllabus and Study Guide.

Bond value or price

Example 1
How much would an investor pay to purchase a bond today, which is redeemable in four
years for its nominal value or face value of $100 and pays an annual coupon of 5% on the
nominal value? The required rate of return (or yield) for a bond in this risk class is 4%.

As with any asset valuation, the investor would be willing to pay, at the most, the present
value of the future income stream discounted at the required rate of return (or yield). Thus,
the value of the bond can be determined as follows:

If the required rate of return (or yield) was 6%, then using the same calculation method, the
price of the bond would be $96.53. And where the required rate of return (or yield) is equal to
the coupon – 5% in this case – the current price of the bond will be equal to the nominal
value of $100.

Thus, there is an inverse relationship between the yield of a bond and its price or value. The
higher rate of return (or yield) required, the lower the price of the bond, and vice versa.
However, it should be noted that this relationship is not linear, but convex to the origin.

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The plain vanilla bond with annual coupon payments in the above example is the simpler
type of bond. In addition to the plain vanilla bond, candidates – as part of their Advanced
Financial Management studies and exam – are required to have knowledge of, and be able to
deal with, more complicated bonds such as: bonds with coupon payments occurring more
frequently than once a year; convertible bonds and bonds with warrants which contain option
features; and more complicated payment features such as repayment mortgage or annuity
type payment structures.

Yield to maturity (YTM) (also known as the [Gross] Redemption Yield (GRY))
If the current price of a bond is given, together with details of coupons and redemption date,
then this information can be used to compute the required rate of return or yield to maturity
of the bond.

Example 2
A bond paying a coupon of 7% is redeemable in five years at nominal value ($100) and is
currently trading at $106.62. Estimate its yield (required rate of return).

The internal rate of return approach can be used to obtain r. Since the current price is higher
than $100, r must be lower than 7%.

Initially, try 5% as r:

$7 x 4.3295 [5%, five - year annuity] + $100 x 0.7835 [PV 5%, five - year] = $30.31 +
$78.35 = $108.66

Try 6% as r:
$7 x 4.2124 [6%, five - year annuity] + $100 x 0.7473 [PV 6%, five - year] =
$29.49 + $74.73 = $104.22

Yield = 5% + (108.66 – 106.62 / 108.66 – 104.22) x 1% = 5.46%

The 5.46% is the yield to maturity (YTM) (or redemption yield) of the bond. The YTM is the
rate of return at which the sum of the present values of all future income streams of the bond
(interest coupons and redemption amount) is equal to the current bond price. It is the average
annual rate of return the bond investors expect to receive from the bond till its redemption.
YTMs for bonds are normally quoted in the financial press, based on the closing price of the

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bond. For example, a yield often quoted in the financial press is the bid yield. The bid yield is
the YTM for the current bid price (the price at which bonds can be purchased) of a bond.

Term structure of interest rates and the yield curve

The yield to maturity is calculated implicitly based on the current market price, the term to
maturity of the bond and amount (and frequency) of coupon payments. However, if a
corporate bond is being issued for the first time, its price and/or coupon payments need to be
determined based on the required yield. The required yield is based on the term structure of
interest rates and this needs to be discussed before considering how the price of a bond may
be determined.

It is incorrect to assume that bonds of the same risk class, which are redeemed on different
dates, would have the same required rate of return or yield. In fact, it is evident that the
markets demand different annual returns or yields on bonds with differing lengths of time
before their redemption (or maturity), even where the bonds are of the same risk class. This is
known as the term structure of interest rates and is represented by the spot yield curve or
simply the yield curve.

For example, a company may find that if it wants to issue a one - year bond, it may need to
pay interest at 3% for the year, if it wants to issue a two - year bond, the markets may demand
an annual interest rate of 3. 5%, and for a three-year bond the annual yield required may be
4.2%. Hence, the company would need to pay interest at 3% for one year; 3.5% each year, for
two years, if it wants to borrow funds for two years; and 4.2% each year, for three years, if it
wants to borrow funds for three years. In this case, the term structure of interest rates is
represented by an upward sloping yield curve.

The normal expectation would be of an upward sloping yield curve on the basis that bonds
with a longer period of maturity would require a higher interest rate as compensation for risk.
Note here that the bonds considered may be of the same risk class but the longer time period
to maturity still adds to higher uncertainty.

However, it is entirely normal for yield curves to be of many different shapes dependent on
the perceptions of the markets on how interest rates may change in the future. Three main
theories have been advanced to explain the term structure of interest rates or the yield curve:
expectations hypothesis, liquidity-preference hypothesis and market-segmentation
hypothesis. Although it is beyond the remit of this article to explain these theories, many
textbooks on investments and financial management cover these in detail.

Valuing bonds based on the yield curve

Annual spot yield curves are often published by the financial press or by central banks (for
example, the Bank of England regularly publishes UK government bond yield curves on its
website). The spot yield curve can be used to estimate the price or value of a bond.

Example 3
A company wants to issue a bond that is redeemable in four years for its nominal value or
face value of $100, and wants to pay an annual coupon of 5% on the nominal value. Estimate
the price at which the bond should be issued.

The annual spot yield curve for a bond of this risk class is as follows:
One-year 3.5%

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Two-year 4.0%
Three-year 4.7%
Four-year 5.5%

The four-year bond pays the following stream of income:

Year 1 2 3 4
Payments $5 $5 $5 $105

This can be simplified into four separate bonds with the following payment structure:

Year 1 2 3 4
Bond 1 $5
Bond 2 $5
Bond 3 $5
Bond 4 $105

Each annual payment is a single payment in that particular year, much like a zero-coupon
bond, and its present value can be determined by discounting each cash flow by the relevant
yield curve rate, as follows:

The sum of these flows is the price at which the bond can be issued, $98.57.

The yield to maturity of the bond is estimated at 5.41% using the same methodology as
example 2.

Some important points can be noted from the above calculation; firstly, the 5.41% is lower
than 5.5% because some of the ret urns from the bond come in earlier years, when the interest
rates on the yield curve are lower, but the largest proportion comes in Year 4. Secondly, the
yield to maturity is a weighted average of the term structure of interest rates. Thirdly, the
yield to maturity is calculated after the price of the bond has been calculated or observed in
the markets, but theoretically it is term structure of interest rates that determines the price or
value of the bond.

Mathematically:

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In this article it is assumed that coupons are paid annually, but it is common practice to pay
coupons more frequently than once a year. In these circumstances, the coupon payments need
to be reduced and the time period frequency needs to be increased.

Estimating the yield curve

There are different methods used to estimate a spot yield curve, and the iterative process
based on bootstrapping coupon paying bonds is perhaps the simplest to understand. The
following example demonstrates how the process works.

Example 4
A government has three bonds in issue that all have a face or nominal value of $100 and are
redeemable in one year, two years and three years respectively. Since the bonds are all
government bonds, let’s assume that they are of the same risk class. Let’s also assume that
coupons are payable on an annual basis. Bond A, which is redeemable in a year’s time, has a
coupon rate of 7% and is trading at $103. Bond B, which is redeemable in two years, has a
coupon rate of 6% and is trading a t $102. Bond C, which is redeemable in three years, has a
coupon rate of 5% and is trading at $98.

To determine the yield curve, each bond’s cash flows are discounted in turn to determine the
annual spot rates for the three years, as follows:

The annual spot yield curve is therefore:

Year
1 3.88%
2 4.96%
3 5.80%

Discussion of other methods of estimating the spot yield curve, such as using multiple
regression techniques and observation of spot rates of zero coupon bonds, is beyond the
scope of the Advanced Financial Management syllabus.

As stated in the previous section, often the financial press and central banks will publish
estimated spot yield curves based on government issued bonds. Yield curves for individual
corporate bonds can be estimated from these by adding the relevant spread to the bonds. For
example, the following table of spreads (in basis points) is given for the retail sector.

Rating 1 year 2 year 3 year

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AAA 14 25 38
AA 29 41 55
A 46 60 76

Example 5
Mason Retail Co has a credit rating of AA, then its individual yield curve – based on the
government bond yield curve and the spread table above – may be estimated as:

Year 1 Year 2 Year 3

4.17% 5.37% 6.35%

These would be the rates of return an investor buying bonds issued by Mason Retail Co
would expect, and therefore Mason Retail Co would use these rates as discount rates to
estimate the price or value of coupons when it issues new bonds. And Mason Retail Co’s
existing bonds’ market price would reflect its individual yield curve.

Conclusion
This article considered the relationship between bond prices, the yield curve and the yield to
maturity. It demonstrated how bonds can be valued and how a yield curve may be derived
using bonds of the same risk class but of different maturities. Finally, it showed how
individual company yield curves may be estimated.

A following article will discuss how forward interest rates are determined from the spot yield
curve and how they may be useful in determining the value of an interest rate swap. It will
address the learning required in Sections E1 and E3 of the Advanced Financial
Management Syllabus and Study Guide.

Written by the Advanced Financial Management examining team

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Risk management

The management of risk is a key area within a number of ACCA exams, and exam
questions related to this area are common. It is vital that students are able to apply risk
management techniques, such as using derivative instruments to hedge against risk, and
offer advice and recommendations as required by the scenario in the question. It is also
equally important that students understand why corporations manage risk in theory
and in practice, because risk management costs money but does it actually add more
value to a corporation? This article explores the circumstances where the management
of risk may lead to an increase in the value of a corporation.

Risk, in this context, refers to the volatility of returns (both positive and negative) that can be
quantified through statistical measures such as probabilities, standard deviations and
correlations between different returns. Its management is about decisions made to change the
volatility of returns a corporation is exposed to, for example changing a company’s exposure
to floating interest rates by swapping them to fixed rates for a fee. Since business is about
generating higher returns by undertaking risky projects, important management decisions
revolve around which projects to undertake, how they should be financed and whether the
volatility of a project’s returns (its risk) should be managed.

The volatility of returns of a project should be managed if it results in increasing the value to
a corporation. Given that the market value of a corporation is the net present value (NPV) of
its future cash flows discounted by the return required by its investors, then higher market
value can either be generated by increasing the future cash flows or by reducing investors’
required rate of return (or both). A risk management strategy that increases the NPV at a
lower comparative cost would benefit the corporation.

The return required by investors is the sum of the risk-free rate and a premium for the risk
they undertake. If investors hold well-diversified portfolios of investments then they are only
exposed to systematic risk as their exposure to firm-specific risk has been diversified away.
Therefore, the risk premium of their required return is based on the capital asset pricing
model (CAPM). Research suggests companies with diverse equity holdings do not increase
value by diversifying company specific risk, as their equity holders have already achieved
this level of risk diversification. Moreover, risk management activity designed to transfer
systematic risk would not provide additional benefits to a corporation because, in perfect
markets, the benefits achieved from risk management activity would at least equal the costs
of undertaking such activity. Therefore, in a situation of perfect markets, it may be argued
that risk management activity is at best neutral or at worst detrimental because costs would
either equal or be more than the benefits accrued.

Such an argument would not apply to smaller companies which have concentrated, non-
diversified equity holdings. In this case the equity holders, because they are exposed to both
specific and systematic risk, would benefit from risk diversification by the company.
Therefore, whereas larger companies may not create value from risk management activity,
smaller companies can and should undertake risk management. However, empirical research
studies have found that risk management is undertaken mostly by larger companies with
diverse equity holdings and not by the smaller companies. The accepted reason for this is that

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the costs related to risk management are large and mostly fixed. Small companies simply
cannot afford these costs nor can they benefit from the economies of scale that large
companies can.

In addition to the ability of larger companies to undertake risk management, market

imperfections may provide the motivation for them to do so. Market imperfections that exist
in the real world, as opposed to the perfect world conditions assumed by finance or economic
theory, may provide opportunities to reduce volatility in cash flows and thereby reduce the
costs imposed on a corporation. The following discussion considers the circumstances which
may result in providing such opportunities.

Taxation

Risk management may help in reducing the amount of tax that a corporation pays by reducing
the volatility of the corporation’s earnings. Where a corporation faces taxation schedules that
are progressive (that is the corporation pays proportionally higher amounts of tax as its profits
increase), by reducing the variability of that corporation’s earnings and thereby staying in the
same low tax bracket will reduce the tax payable.

According to academics, corporations could often find themselves in situations where they
face progressive tax functions, for example, when they have previous losses which are not
written off or, in the case of multinational corporations, due to the taxation treaties which
exist between different countries. The amount of taxation that can be saved depends upon the
corporation’s individual circumstances.

Insolvency and financial distress

A corporation may find itself in a situation of being insolvent when it cannot meet its
financial obligations as they fall due. Financial distress is a situation that is less severe than
insolvency in that a corporation can operate on a day-to-day basis, but it finds that these
operations are difficult to conduct because the parties dealing with it are concerned that it
may become insolvent in the future. When facing financial distress, a corporation will incur
additional costs, both direct and indirect, due to the situation it is facing.

The main indirect costs of financial distress relate to the higher costs of contracting with the
corporation’s stakeholders, such as customers, employees and suppliers. For example,
customers may demand better warranty schemes or may be reluctant to buy a product due to
concerns about the corporation’s ability to fulfil its warranty; employees may demand higher
salaries; senior management may ask for golden hellos before agreeing to work for the
corporation; and suppliers may be unwilling to offer favourable credit terms.

Academics exploring this area postulate that because stakeholders are subject to the
corporation’s full risk, as opposed to only systematic risk, which is faced by the corporation’s
equity holders, the stakeholders would demand greater compensation for their participation.
Where an organisation actively manages its risk and prevents (or reduces the possibility of)
situations of financial distress, it will find it easier to contract with its stakeholders and at a
lower cost. Hence, the more volatile the cash flows of a corporation, the more likely the need
to manage its risk in order to reduce the costs related to financial distress.

External funding and agency costs

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Another consequence of financial distress is the impact this may have on the corporation’s
ability to undertake profitable future investment. Financial distress may make the cost of
external debt and equity funding so expensive that a corporation and its management may be
forced reject profitable projects. Academics refer to this as the under-investment problem.

Equity holders in effect hold a call option on a corporation’s assets and debt holders can be
considered to have written the option. In cases of low financial distress the company may be
considered to be similar to an at-the-money option for its equity holders, and, therefore, they
would be more willing to undertake risky projects as they would benefit from any increase in
profitability, but the impact of any loss is limited. In the case of substantial financial distress,
the option could be considered to be well out-of-money. In this situation there is little (or no)
benefit to equity holders of undertaking new projects, as the benefits of these will pass to the
debt holders initially. However, debt holders would be reluctant to lend to a severely
distressed company in any case.

Therefore, when raising debt capital, a corporation that is subject to low levels of financial
distress would face higher agency costs, with lenders imposing higher borrowing costs and
more restrictive covenants. Whereas debt holders get a fixed return on their investment, any
additional benefit due to higher profits would go to the equity holders. This would make the
debt holders reluctant to allow the corporation to undertake risky projects or to lend more
finance to the corporation because they would not gain any benefit from the risky projects.

A corporation that faces high levels of financial distress would find it difficult to raise equity
capital in order to undertake new investments. If corporations try to raise equity finance for
relatively less risky projects then the profits earned from such projects would initially go to
the debt holders and the equity holders will gain only residual profits. Therefore, equity
holders would put pressure on the corporation and its management to reject good, low risk
projects, which may have been acceptable to the bondholders.

Therefore, risk management in reducing financial distress by reducing the volatility of the
corporation’s cash inflows may help the management to obtain an optimal mix of debt and
equity, and to undertake profitable projects.

Capital structure and information asymmetry

Risk management can help a corporation obtain an optimal capital structure of debt and
equity to maximise its value. Since risk management stabilises the variability of cash inflows,
this would enable a corporation to take more debt finance in its capital structure. Stable cash
flows indicate less risk and therefore debt holders would become more willing to lend to the
corporation. Since debt is cheaper to finance than equity because of lower required rates of
return and the tax shield, taking on more debt should increase the value of the corporation.
Risk management can help achieve this.

Academics have observed that managers would prefer to use internally generated funds rather
than going to the external markets for funds because it is cheaper and less intrusive on the
corporation. They suggest that borrowing money from the external markets, whether equity
or debt, would involve parties who do not have the complete information about the
corporation. This information asymmetry would make the external sources of funds more
expensive. If risk management stabilises the cash flows that the corporation receives from
year to year, then this would enable managers to plan when the necessary internal funds will

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become available for future investments with greater accuracy. They will then be able to
align their investment policies with the availability of funding.

Manager behaviour towards risk management

In his seminal paper, Rene Stulz suggests that managers, whose performance reward structure
includes large equity stakes in a corporation, are more likely to reduce the corporation’s risk,
as opposed to managers whose performance reward structure is based primarily on equity
options. Managers who hold concentrated equity stakes in a corporation face increased levels
of risk when compared to other equity holders. As discussed previously, investors hold well-
diversified portfolios and face exposure to systematic risk only. But managers with
concentrated equity stakes would face both systematic and unsystematic risk. Therefore, they
have a greater propensity to reduce the unsystematic risk.

However, if investors do not reward corporations that are reducing unsystematic risk, because
they have diversified this risk away themselves. And if a corporation’s managers use the
corporation’s resources to reduce unsystematic risk, thereby reducing the corporation’s value.
Then it is worth exploring under what circumstances would equity investors allow managers
to act to reduce unsystematic risk and whether such actions could actually result in the value
of the corporation increasing.

Stulz argues that encouraging managers to hold concentrated equity positions but allowing
them to reduce unsystematic risk at the same time, may enable them to act in the best
interests of the corporation and the result may be an increase in the corporate value. He
explains that managers, who do not have to worry about risks that are not under their control
(because they have hedged them away), would be able to focus their time, expertise and
experience on the strategies and operations that they can control. This focus may result in the
increase in the value of the corporation, although the impact of this increase in value is not
easily measurable or directly attributable to risk management activity.

As an aside, one could pose the question, why don’t managers, who are rewarded by equity,
diversify the risk of concentrated equity investments themselves? They could sell equity in
their own corporation and replace it by buying equity in other corporations. In this way they
do not have to hold concentrated equity positions and then would be like the normal equity
holders facing only systematic risk. A research study on wealth management, which looked at
concentrated equity positions and risk management, found that senior managers are reluctant
to reduce their concentrated equity positions because any attempt to sell the equity would
send negative signals to the markets, and cause their corporation’s value to decrease
unnecessarily.

Contrary to the behaviour of managers who hold concentrated equity stakes, managers who
own equity options, which will be converted into equity at a future date, will actively seek to
increase the risk of a corporation rather than reduce it. Managers who hold equity options are
interested in maximising the future price of the equity. Therefore, in order to maximise future
profits and the price of the equity, they will be more inclined to undertake risky projects (and
less inclined to manage risk). Equity options, as a form of reward, have been often criticised
because they do not necessarily make managers behave in the best interests of the corporation
or its equity investors, but encourage them to act in an overly risky manner.

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A number of empirical studies looking at manager behaviour support the above discussion
(see for example Tufano’s study published in 1996 in the Journal of Finance).

Testing the impact of risk management

In addition to the above, empirical research studies have looked at the risk management
policies and actions pursued by corporations and their impact on corporate value. Although
the studies have provided varying results when studying each area of market imperfections
and their impact, the overarching conclusion from these studies is that: corporations manage
their risks in the belief that this would create or increase corporate value, although a direct
link between risk management and a corresponding increase in corporate value has not been
established.

Hence the belief held among managers is that the management of risk does create value, and
certainly corporations and their senior managers seem to believe and act in a manner that it
does. However, the jury is still out on whether risk management actually does lead to
increased corporate value. There seem to be strong theoretical reasons for managing risk, but
empirical research has not proven the impact of risk management activity on corporate value.

Written by a member of the examining team for Advanced Financial Management

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Passing Strategic Professional exams

This article looks at what you can do to improve your chances of passing ACCA’s
Strategic Professional exams.

Strategic Professional exams are a step up from the Applied Skills level and candidates
require a different approach to these exams in order to pass and move on towards becoming
an ACCA member.

A useful resource is the articles about stepping up from the Applied Skills underlying papers.
These are full of useful guidance and are highly recommended reading if you are taking one
of these exams.

At Strategic Professional, candidates are expected to have a good level of technical

knowledge across the full range of topic areas in the Study Guide. While technical knowledge
is essential, on its own it will not be enough to obtain a pass mark.

What is important is an understanding of the skills the examining team are testing. What they
are looking for is the application of the detailed knowledge and, how it is used in context.

Strategic Professional exams are at the higher end of learning skills, and require such skills as
analysis, evaluation, assessment, decision making, critical analysis and discussion. Repetition
of textbook material or model answers to a different question is highly unlikely to be awarded
many marks. For the Strategic Business Leader exam, the integrated case study, you will be
required to demonstrate the professional skills that employers deem as most in demand in the
accountancy sector, such as analysis, scepticism, evaluation, commercial acumen, and
communication.

There are a number of things you can do, once you have completed your learning phase, to
give yourself the best chance of passing your Strategic Professional exams and we will look
at these in turn.

Timed question practice

To allow yourself the best chance of passing the exam on the day, you should practice
answering questions to the time that you would have available in the exam. ACCA’s
approved content providers have question and answer banks with plenty of exam standard
and style questions for you to practice with.

Once you have answered the question to time, it is important to look at your answer against
the published answer – are you making the same kind of points or do your calculations follow
the correct approach?

Don’t be disheartened if your answer does not appear to be the same as the published answer.
These are usually comprehensive answers for learning purposes and are not intended to be
representative of what can be achieved in the time available. If you are able to understand
where you went wrong, this is good learning for future questions. Also remember that
calculation mistakes are only penalised once under the own figure rule so if you make a
mistake at the start of a calculation you are still able to pick up the remaining marks.

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Read the question requirements

Although many candidates may want to read the scenario first, it is beneficial to read the
question requirements before the scenario. This will ensure that when you read the scenario,
it is with a clear idea of what you are looking for.

Read the question very carefully – what is the requirement? This is absolutely crucial in the
exam. A significant number of students produce an answer to a different question than the
one which has been asked. In an exam situation, to ensure that you do not misunderstand the
question you should adopt the following approach. Read the question once and then read it
again, trying to be as objective in your reading as possible and do not make the question
appear to be the one that you wanted to be asked.

Read the question scenario and plan your answer

Now that you are clear on the question requirements, you can read the question scenario,
identifying key points which relate to the question requirements.

Then make a quick plan of what you are going to write taking into account the mark
allocation. Then, before actually starting your answer, check that the plan and the question
match up. It is almost impossible to misinterpret the question when taking this approach.

Your answer plan will have identified key areas that you wish to address in your answer. It is
a valuable skill to be able to prioritise the problems/issues within the scenario and to show the
marker that you are able to think strategically. It will help you focus on key strategic issues in
the scenario and mean you are likely to score higher marks.

Time management

Your approach to planning your time in the exam is crucial for completing the exam and to
ensure best use of the time available.

If you do not manage your time well, the penalty can be quite severe. It is often seen that
there are candidates who reach 46% with one or two requirements still to be answered, only
to find that there is nothing left to mark. If you manage your time badly your chances of
passing are reduced – it is much tougher to get 50 marks if you only answer 90, 80, or 75
marks of the 100 available.

Explaining points in appropriate detail

When answering business scenarios candidates need the following skills:

• To identify key issues/defects from the question scenario

• The ability to use analysis to make inferences from the question and to delve deeper
into the problems.
• To identify things noticeable by their absence. That is, things the organisation should
be doing but is not doing at present.

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It is the ability to add value to the scenario in this way that scores marks in the exam –
repetition of information from the scenario or long introductions or descriptions score very
little, if any, marks.

A common mistake is that candidates will write a lot about a single point on which they are
very knowledgeable with the following point being a single short sentence. The balance of
time and content should be about the same for each point made. Once the marker is satisfied
that you have made the point, you will score the mark.

Once you have made the point, extra marks can be obtained from explaining the
consequences from this point and what needs to be done about it.

You can add these points into your answer through the use of phrases such as:

• this indicates…
• the impact of this is…
• to address this problem management need to…

Additionally, markers can only give marks for what has actually been written and so it is
important to ensure the significance of the point and its main consequence has been fully
explained. Even if you believe it is really obvious, include an explanation of any
consequences in your answer. You cannot be awarded a mark for something that you haven’t
included in the answer.

You may have reached this stage of your studies without needing to do some of the above
tips. However, as stated earlier, the Strategic Professional exams are a step up from the lower
level and different skills are needed here and these methods will significantly improve your
chances of passing your exams.

Good luck with your Strategic Professional exams and your journey towards ACCA
membership.

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