F3 - Financial Strategy - Summary Notes

Index
Chapter 1 - Strategic Financial Objectives 2

Chapter 2 - Strategic Financial Objectives 14

Chapter 4 - Financing - Equity Finance 29

Chapter 5 - Financing - Debt Finance 44

Chapter 6 - Financing - Capital Structure 56

Chapter 7 - Dividend Policy 70

Chapter 8 - Financial Risk 78

Chapter 9 - Currency Risk Management 87

Chapter 11 - Financial and strategic implications of mergers and acquisitions 114

Chapter 12 - Business Valuation 123

Chapter 13 - Pricing Issues and Post Transaction Issues 135

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Chapter 1 - ​Strategic Financial Objectives

1. Mission and the objectives of different entities

Mission:​ The fundamental objective(s) of an entity, expressed in general terms.

Mission statement:​ A published statement, apparently of the entity’s fundamental
objective(s). This may or may not summarise the true mission of the entity.

• The mission and objectives of an entity depend upon:

- the type of entity, and

- the requirements of the various stakeholders of the entity.

• The main objective of a profit-making entity is to maximise the wealth of

shareholders.

• The main aim of not-for-profit entities is to benefit specific groups of people.

However, as they do need funds to provide services, their secondary objective is to
raise the maximum funds and use them efficiently.

2. Definitions of different types of entity

• Profit-making entities​: many companies operate with a view to earning profit.

Their main objective is thus to satisfy their shareholders by making a profit.

• Not-for-profit entities​: the main objective of these entities is not to earn profit.
These entities have primary objectives that are usually non-financial in nature. Most
public sector entities are not-for-profit entities.

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• Incorporated entities​: an incorporated entity is one that is legally separate from its
owners. There is a greater potential for conflict of stakeholder objectives due to the
likelihood of there being several owners.

• Unincorporated entities​: an unincorporated entity is one that is not considered

separate from its owner/s, and thus the owners bear the risks associated with the
entity’s business. Sole traders and partnerships are usually unincorporated entities.

• Quoted entities​: an incorporated entity that is listed on the stock exchange. The
shareholders of the company can buy and sell its shares. A quoted company is
subject to increased scrutiny and so should set appropriate objectives relating to the
environment and staff.

• Unquoted entities​: the entity’s shares are not quoted on the stock exchange.

• Private sector entity​: an entity owned by private investors.

• Public sector entity​: an entity that is owned by the government.

• Charitable entity (charity)​: a not-for-profit entity that focuses on philanthropic

goals and social well-being, e.g. activities that serve the public interest.

• An association/union​: a group of individuals who agree on a common purpose as

their goal, e.g. trade associations and professional associations (like CIMA).

3. Profit-making entities

Objectives

The main objective of a profit-making entity is to maximise shareholder wealth.

However, due to having other key stakeholders, the entity will have additional
objectives.

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A profit-making entity will have both financial and non-financial objectives.

A company’s objectives can be grouped into:

• Primary objectives​ (the ultimate long-term objective(s), often financial)

• Secondary objectives​ (lower priority, a stepping stone to achieving the primary

objective(s))

There are 3 key decisions in financial management.

● Investment
● Financing
● Dividends

These 3 key decisions are interrelated

Financial objectives

When establishing objectives, certain factors will need to be considered:

• Shareholder attitudes

• Finance providers’ requirements

• Suppliers’ credit terms

• Exposure to risk

• Government restrictions and incentives

To achieve financial objectives, the management will set financial targets such as an
increase in profitability by a certain percentage or setting a debt:equity ratio.

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These financial targets will set the company’s direction and assist in measuring its
performance.

4. Non-financial objectives

The influence of the various parties with interest in the firm results in firms adopting
many nonfinancial objectives.

5. Assessing Value For Money (VFM)

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Other than the three integral components of VFM, economy, efficiency and
effectiveness, another component is sometimes used, equity.

Equity determines whether the services have reached all of the people that they were
intended to reach.

A value-for-money audit gives an opinion on the value for money achieved, i.e. the
outcomes reached with the resources available.

6. Performance Measurement

Profitability ratios

Profit figures in the statement of profit or loss

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GROSS PROFIT MARGIN = Gross profit / Revenue x 100

OPERATING PROFIT MARGIN = Operating Profit / Revenue x 100

NET PROFIT MARGIN = Net Profit / Revenue x 100

GROSS PROFIT = sales – cost of sales

OPERATING PROFIT = sales – profit before interest and tax

NET PROFIT = profit after deduction of interest and tax

Lending Ratios
● Gearing is the mix of debt to equity within a firm's permanent capital.

● There are particularly two useful measure

I. Capital gearing – a measure of capital structure

● Capital gearing = Debt /Equity × 100
Or = Debt/ (Debt + Equity) × 100 [​ most commonly used formula]
● Market values should be used in preference to book values for the capital
gearing ratio
Book value of equity = ordinary share capital + reserves
Market value of equity = Number of shares × Share price
II. Interest cover – a statement of profit or loss measure
● Interest cover = Profit before interest and tax/ Interest payable [​the higher
the ratio, the better​]
● EBITDA can be used for better approximation to the cash generated by
business
● Debt ratio = Total long term debt / Total assets

11. Investor ratio

● Ex-dividend market price = Cum-dividend market price – Forthcoming dividend

per share.

a. Earnings per share (EPS)

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● EPS = Earnings/ Number of ordinary shares in issue [ a measure of return ]
Where, Earnings = Profit distributable to ordinary shareholders, i.e. after interest,
tax and any preference dividend.
● Note​ -EPS is a historical figure and can be manipulated by changes in accounting
policies, mergers or acquisitions, etc.

b. P/E ratio

● P/E ratio = Current share price/EPS [ a measure of growth ]

Or, alternatively, Total market capitalization/Total earnings
● The higher the P/E ratio, the greater the market expectation of future earnings
growth. This may also be described as market potential.

c. Earning Yield

● Earnings yield = EPS/ Current share price [indication of the future earning power
of the entity]
Or, alternatively, Total earnings/Total market capitalization.

d. Dividend-payout rate

● Payout rate = Dividend per share/ EPS

Or, alternatively, Total dividend/Total earnings
● Note when analyzing financial statements from an investor’s point of view it is
important to identify the objectives of the investor. Does the investor require high
capital growth and high risk, or a lower risk, fixed dividend payment and low
capital growth?

e. Dividend yield

● Dividend yield = Dividend per share / Current share price

Or, alternatively, Total dividend/Total market capitalization
● However, the capital gain from a share may well be far more significant than the
dividend.

f. Dividend cover

● Dividend cover = Earnings per share / Dividend per share

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 Or, alternatively, Total earnings/Total dividend

g. Earnings growth and dividend growth

● High growth rates in earnings and dividends are usually viewed positively.
For example - if earnings per share have grown from $0.28 to $0.33 over a 4 year
period, the implied compound annual growth rate is: [​4​√ (0.33/0.28) – 1] × 100% =
4.19% per year

7. Sensitivity analysis

Changes in economic and business variables will affect financial forecasts and
possibly impact the entity’s ability to achieve its financial objectives. Businesses need
to forecast these changes so that they recognise and respond to changes in a timely
manner.

Economic variables:

• Increased interest rates will lead to reduced spending by customers, a decrease in

the value of assets, foreign funds being invested in the country’s banks (which could
then be loaned to the entities), reduction in inflation and a rise in exchange rates.

• Fluctuations in inflation can weaken a country’s competitive position, cause

planning and production difficulties for businesses, redistribute wealth and income,
destabilise markets and distort consumer behaviour.

Consequences of an increase in interest rate

● Spending falls
● Asset values fall
● Foreign funds are attracted into the country
● The exchange rate rises
● Inflation falls

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The effects of inflation

● Distorts consumer behavior

● Redistributes income
● Affects wage bargainers
● Undermines business confidence
● Weakens the country’s competitive position
● Redistributes wealth

8. Interest rate parity theory

The interest rate parity theory shows that the forward rate of exchange can be found
by adjusting the spot rate of exchange to reflect the differential in interest rates
between the two countries.

Note In order to assess the likelihood of an entity achieving a given objective, you
should revise the financial statements to reflect the expected change and then
recalculate the necessary ratios

9. The use of published accounts for ratio analysis

For an external stakeholder published Accounts are the most readily available source
of information to assess the performance of an entity

Limitations of published accounts figures for ratio analysis

● Published accounts are historic records, not forward looking

● Not inclusion of cash flow statement will not give the entity’s true cash position
● Contained only financial information

Possible question to consider

1. Change in Mission/Vision statements due to change in ecosystem

2. What financial & non financial objectives should we consider of our main
stakeholders (key players) e.g government, Not for profits etc

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 3. Application of value for money concept in to our company
4. Impact of economic variables in different situations e.g. supplier negotiation,
mergers & acquisitions, price negotiation
5. Carry out a financial ratio analysis & analyse the financial health of the
company

Chapter 2 - ​Strategic Financial Objectives

1. Financial and Non- Financial Reporting

​ Financial Reporting :

● The objective of financial reporting is to 'provide information about the

reporting entity that is useful to existing and potential investors, lenders and
other creditors in making decisions about providing resources to the entity'.

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 ● Financial statements provide historical financial information, but they do not
provide a full picture of how the entity is performing.

Non Financial Reporting:

● This is looking beyond just financial statements. It involves disclosure of

economic, environmental and social performance indicators.
● The GRI guidelines and <IR> framework provide guidelines and basis to carry
out non-financial reporting effectively

Limitations of financial statements

Capitalism relies on the efficient allocation of capital to deliver returns to investors over
the short, medium and long term. Resilient capitalism needs financial stability and
sustainability in order to succeed.
Unfortunately, this type of corporate reporting no longer reflects the needs of users

1. The Global reporting Initiative (GRI)

Economic, environmental and social factors disclosed alongside the standard

financial statements enable investors and other stakeholders to make a much better
assessment of the organisation.
G4​ - the fourth version of the GRI guidelines issued in May 2013 - provides universal
guidelines for reporting on sustainability performance.
It heavily focuses on issues that are material to the organisation
It requires companies to indicate and explain omissions of standard or material
disclosures

Principles that define reporting content

● Stakeholder Inclusiveness - identify its stakeholders and how the
company acted on their expectations
● Sustainability Context - present the entity’s performance in the wider
context of sustainability.
● Materiality - Materiality is the threshold at which Aspects become
sufficiently important that they should be reported.
● Completeness - Coverage of all the material topics and indicators

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 Principles that define Report Quality
● Balance
● Comparability
● Accuracy
● Timeliness
● Clarity
● Reliability

General Standard Disclosures

• Strategy and Analysis - strategic view of the entity’s sustainability
• Organizational Profile - overview of organisational characteristics
• Identified Material Aspects and Boundaries - overview of the process that the
entity has followed to define the Report Content, the identified material
Aspects and boundaries
• Stakeholder Engagement - entity’s stakeholder engagement during the
reporting period.
• Report Profile - overview of the basic information like reporting period, date
of previous report.
• Governance - overview of the highest governance body
• Ethics and Integrity - the entity's values, principles, standards and norms

Specific Standard Disclosures

• Disclosures on Management Approach
• Indicators

Disclosures on Management Approach (DMA)

Shows how the economic, environmental and social impacts related to
material Aspects are managed.

Indicators:

Economical- h​ ow the company ​ i​ mpacts on the economic conditions of its

stakeholders and on economic systems.

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 Ex: Revenues/Costs, Wage rates in comparison to competitors, extent of
investment in infrastructure

Environmental- ​how the company impacts on living and non-living natural

systems.
Ex: Fuel consumption, emission of greenhouse gases, environmental impact of
the products, steps taken to reduce pollution, recycling processes.

Social- ​how the entity impacts the social systems it operates within. It is
further divided into 4 categories
1. Labor Practices and Decent Work
Ex: Staff turnover, benefits provided to staff, training provided, diversity
and equality among workforce
2. Human Rights
Ex: Right to exercise freedom of association, number of human rights
reviews that the operations were subjected to.
3. Society
Ex: Local community engagement, violation of laws of the land.
4. Product Responsibility
Ex: Breach of health and safety of customers, products sold that are
banned in other countries/markets, issues regarding customer privacy

Non-Disclosure
● Identify the information that has been omitted.
● Explain the reasons why the information has been omitted.

Process of preparing a Report

Step 1: Identification
- Consider the GRI Aspects list and other topics of interest
- Identify where the impacts occur: within or outside of the organisation
- List the Aspects and other topics considered relevant, and their
Boundaries

Step 2: Prioritization
- Identify the material Aspects by combining the assessments

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 - Define and document thresholds (criteria) that render an Aspect
material

Step 3: Validation
- Approve the list of identified material Aspects with the relevant internal
senior decision- maker
- Prepare systems and processes to gather the information needed to be
disclosed
- Translate the identified material Aspects into Standard Disclosures –
DMA and Indicators – to report against.

Step 4: Review
- Review the Aspects that were material in the previous reporting period
- Use the result of the review to Identify for the next reporting cycle

2. Integrated Reporting (<IR>)

Objective:
To create a more holistic and balanced view of the company being reported
upon, bringing together material aspects such as strategy, governance,
performance and prospects in a way that reflects the commercial, social and
environmental context within which it operates.

<IR> enables an organisation to communicate in a clear, articulate way how it

is drawing on all the resources and relationships it utilizes to create and
preserve value in the short, medium and long term, helping investors to
manage risks and allocate resources most efficiently.

● Sustainability reporting is an intrinsic element of integrated reporting

Fundamental Concepts
➢ Value creation for the organisation and for others
➢ The capitals
➢ The Value creation process

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The Capitals
1. Financial capital:​ The pool of funds that is:
– available to an organization for use in the production of goods
– obtained through financing, such as debt, equity, or generated through
operations or investments.

2. Manufactured capital​: Manufactured physical objects that are available to an

organisation including buildings, equipment, infrastructure (such as roads,
ports, etc.)

3. Intellectual capital:​ Organisational, knowledge-based intangibles including:

– intellectual property. Ex: patents, copyrights, software, rights and licences
– 'organizational capital' such as tacit knowledge, systems, procedures and
protocols

4. Human capital: ​ People’s competencies, capabilities and experience, and their

motivations to innovate, including their:
– alignment with and support for an organization’s governance framework
and ethical values
– ability to understand, develop and implement an organization’s strategy
– loyalties and motivations for improving, including their ability to lead, manage
and collaborate

5. Social and relationship capital:​ The institutions and the relationships within
and between communities, groups of stakeholders and other networks, and
the ability to share information to enhance individual and collective well-being.

6. Natural capital: ​All renewable and non-renewable environmental resources

and processes that provide goods or services that support the past, current or
future prosperity of an organisation. It includes:
– air, water, land, minerals and forests
– biodiversity and ecosystem health

Presentation of the extra information

The information is included as the company's Management Commentary and is often
part of the report containing the financial Statements.

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Management commentary is a narrative report that provides a context within which
to interpret the financial position, financial performance and cash flows of an entity.
Management are able to explain their objectives and strategies for achieving those
objectives.

Framework for presentation of Management Commentary (MC)

(a) it should provide management’s perspective of the entity’s performance, position
and progress;
(b) it should supplement and complement information presented in the financial
statements;
(c) it should have an orientation to the future;
(d) it should possess the qualitative characteristics of relevance and faithful
representation as described in the IASB's Conceptual Framework for Financial
Reporting.

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 3. United Nations Sustainable Development goals (UN SDGs)

Long term benefits of adopting the principles:

• Improved reputation with customers for being socially responsible
• A healthier and more skilled workforce
• Greater growth opportunities in developing countries as their economy
strengthens, giving the population more disposable income
• Continued supply of raw materials from a sustainable source, helping to
secure the long term future of the business
• Reduced risks of regulatory breaches and bad publicity

→ Integrated reporting provides a framework to help senior management focus on

SDGs and build them into the organisation’s long term strategy.

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→ All the goals and guidelines are not applicable to every company. The company
must focus on adopting all those applicable to them

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F3 - Chapter 3
Development of Financial Startegy
1. Introduction

The purpose of this chapter is to introduce the framework within which financial
managers operate, and to identify the main areas where they have to make
decisions.

The main types of decisions that need to be made are:

● Investment decisions
● Sources of finance decisions
● Decisions regarding the level of dividend to be paid
● Decisions regarding the hedging of currency or interest rate risk

2. Investment, financing and dividend decision

The investment, financing and dividend decision cannot be treated in isolation as

there is an interrelationship between them. Financial managers need to forecast
financial statements and the future cash position which incorporates the policy
decision made.

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The​ investment decision​ can impact the company’s future profitability through an
increase in sales. This is usually achieved through the purchase of non-current
assets, which in turn increases the depreciation charge and reduces profitability.

The ​financing decision​ will have an impact on either the entity’s equity (share capital
and share premium) or non-current liability balances depending on whether the
decision involved issuing equity or debt finance.

● If debt finance is chosen this will increase the finance costs within the
statement of profit or loss and will therefore reduce profitability.
● If equity finance is chosen there is additional pressure to pay dividends, which
can only be paid if there is sufficient distributable profits and cash resources
available.

For both non-current asset and working capital investment, the financial manager
must decide on the most appropriate type and source of funding.

This will include such considerations as:

● the extent to which requirements can be funded internally, from the

organisation's operations. This will involve considerations of dividend policy
and tax implications;
● if new, externally provided, finance is required, whether it should be in the
form of equity or debt finance. This may affect the level of gearing (the ratio of
debt to equity finance) which can have implications for returns required by the
providers of capital;
● the extent to which working capital should be financed by long-term finance or
short-term credit.

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The​ dividend decision​ is discussed in further detail in a later chapter but the
decision on the level of dividend will have an impact on the financing decision as if
dividends are restricted then there is additional cash available for investment which
reduces the burden on finding additional finance to fund positive NPV projects.

It is important therefore to assess the impact of these decision not only on the
forecast financial statements and future cash position but also the impact the
decisions can have on the following:

● Investor ratios
● Lender ratios
● Compliance with debt covenants
● Attainment of financial objectives

Links between the three key decisions

Investment decisions cannot be taken without consideration of where and how the
funds are to be raised to finance them. The type of finance available will, in turn,
depend to some extent on the nature of the project – its size, duration, risk, capital
asset backing, etc.

Dividends represent the payment of returns on the investment back to the

shareholders, the level and risk of which will depend upon the project itself, and how
it was financed.

Debt finance, for example, can be cheap (particularly where interest is tax deductible)
but requires an interest payment to be made out of project earnings, which can
increase the risk of the shareholders' dividends.

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Objectives and economic forces

External influences on financial strategy

Major influences include:

• The need to maintain good investor relations and provide a satisfactory return on
investment

• Limited access to sources of finance, either due to weak creditworthiness or lack of

liquidity in the banking sector and capital markets

• Gearing level. The main argument in favour of gearing is that introducing

borrowings into the capital structure attracts tax relief on interest payments. The
argument against borrowing is that it introduces financial risk into the entity.
Financial managers have to formulate a policy that balances the effects of these
opposing features.

• Debt covenants. These are clauses written into debt agreements which protect the
lender's interests by requiring the borrower to satisfy certain criteria (e.g. a minimum
level of interest cover)

• Government influence

• Regulatory bodies

The impact of taxation on financial strategy

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Specific tax rules differ from country to country, but some general points are
explained below.

Domestic tax implications

Any profits generated by a new investment project will be taxable. However, tax
allowable depreciation will normally be available on assets purchased, to reduce the
overall tax liability.

Debt interest is tax deductible. Therefore if the entity decides to finance new
investments through debt finance, there will be tax savings when the interest is paid.
This is not the case with dividends to shareholders (if equity finance is used).

Dividends to shareholders will be taxed under income tax rules. However, if the
entity chooses not to pay out a dividend, any increases in share price will be taxed
under capital gains tax rules when the shares are sold. Therefore, most investors
have a preference as to whether they'd like the entity to pay out a dividend or not.

Where the entity meets certain conditions its shares may be issued under special
schemes that allow the investor tax relief on the investment, and/or when the shares
are sold. An example is the Enterprise Investment Scheme in the UK, which is
intended to encourage investors to subscribe for new shares in unquoted trading
companies.

International tax implications

The main additional tax consideration for an entity with international operations is
how to minimise the overall tax liability of the international entity.

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For example, a decision will need to be made as to where the head office of the entity
should be located. Multinational companies are often attracted to set up their
operations in a low tax economy.

Also, the group's transfer pricing policy will be an important consideration. Tax
authorities only allow transfer prices that are set at a fair, 'arm's length' level, so
there is no opportunity to manipulate the entity's tax liability. The authorities will
disallow any transfer prices that are considered to be set purely for the purposes of
moving as much profit as possible into the lowest tax country.

The tax authorities also monitor royalties and management charges alongside
transfer prices. Any royalties or management charges paid from one group company
to another will not be allowed if the authorities feel that they are being used to
increase profits in one group company (based in a low tax country) at the expense of
another (based in a higher tax country).

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27
Chapter 4 - ​Financing - Equity Finance

1. SOURCES OF FINANCE

The financing decision involves evaluating an appropriate method of finance, debt or

equity, to fund a new investment project. It is an important decision to get correct
because the type of finance used will have a direct impact on the value of the entity
as the change in the level of debt to equity impacts the cost of capital, which can then
affect the investment decision.

This chapter introduces the theories derived that look at how the finance issued
impacts the value of the business, and is otherwise referred to as the capital
structure theories.

● CAPITAL MARKETS

(A company must be quoted on a recognised stock exchange)

-New share issues

-Rights issues

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-Bonds

● BANK BORROWINGS

Long-term loans or short-term loans, including bank facilities such as revolving credit
facilities (RCFs)

● VENTURE CAPITAL FUNDS

High risk/High return type. Investors invest in such new companies that have good
growth prospects and plan.EX: Facebook-Jim breyir

2.CRITERIA FOR SELECTION OF SOURCES OF FINANCE

(To decide whether equity/debt financing)

a Cost of different sources

To analyse the cost of debt/equity finance .Debt is cheaper than equity as less
risk,interest is tax deductible .

b Duration of Finance

For how long is finance required?--EQUITY -long term permanent cap, DEBT-
obtained for fixed term(range from very short term (overdraft facility) to long-term).

c Lending restriction

Securities and debt covenants(protects lenders interest) are mainly needed for debt
financing.

d Gearing(capital structure)

Ratio of debt to equity finance.High ratio=High debt=high risk.

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e Liquidity Implications

The ability of the business to service the new debt, allocating sufficient cash
resources to meet interest and capital repayment obligations

f Currency of cash flows with new projects

EX: If the cash flows from new investment projects are in DOLLARS, then the entity
may decide to raise finance in DOLLARS, to reduce the risk of exchange rate
movements.

g Impact of different financing options on financial statements, tax positions,

financial stakeholders

(Debt holders + shareholders) are the stakeholders and they assess business
performance,impact of new financing,impacting the tax position of the business.

h Availability

The availability of debt finance is enhanced if an entity has a good credit rating or
liquidity of the capital markets for equity and bonds.

3.EQUITY FINANCE

(Equity is another name for shares or ownership rights in a business)

*Ordinary shares

● Ordinary shares pay dividends at the discretion of the entity's directors.

● Ordinary shareholders are the owners,right to vote,attend board meetings
● During wind up-after all they are paid.

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*Preference shares

● Preference shares are a form of equity that pays a fixed dividend in preference
to ordinary share dividends.
● During wind up- receive their payout before ordinary shareholders.

Differences between preference shares and debt and ordinary shares

Different types of preference shares

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CAPITAL MARKETS

The shares in a listed, or quoted, company will be traded on a capital market.

Primary function

➔ companies to raise new finance (either equity or debt).

➔ company can communicate with a large pool of potential investors

➔ easier for a company to raise finance

Secondary function

➔ enable investors to sell their investments to other investors.

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➔ A listed company's shares are more marketable than an unlisted companies

Private limited company

● has shareholders with limited liability

● its shares may not be offered to the general public

● the liability of the shareholders to creditors of the company is limited to the capital
originally invested

● disclosure requirements are lighter

● Example: Flipkart, Ola

Public limited company

● limited liability company that may sell shares to the public.

● can be either an unlisted company, or a listed company on the stock exchange.

● Example: Infosys ltd., McDonalds

A stock exchange listing

When an entity obtains a listing (or quotation) for its shares on a stock exchange this
is referred to as a flotation or an Initial Public Offering (IPO).

Impact of a listing on key stakeholders

Shareholders - shares become more marketable, the share price may rise.

Managers and the employees-

● The improvement in the company's reputation and profile that results from a
listing

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 ● Offer better pay and career progression opportunities.

Suppliers and lenders-

● Impacts company’s credit rating, reduces the risk of non-payment

● Listed companies are more likely to be viewed favourably by lenders, and to be
granted generous credit terms by suppliers.

The operation of stock exchanges

Prices of shares on the stock exchange are determined by the forces of supply and
demand in the market.

Example, if a company performs well, its shares become attractive to investors. This
creates demand which drives up the price of the shares. Conversely, investors who
hold shares in an underperforming company will try to sell those shares, creating
supply in the market. This drives down the price of the shares.

Methods of issuing new shares

An IPO (or flotation)

● offered for sale to investors, through an issuing house.

● made at a fixed price set by the company, or in a tender offer investors are invited
to tender for new shares issued at their own suggested price.

● offers may be of completely new shares or they may derive from the transfer to
the public of some or all of the shares already held privately

● EXAMPLES: government privatisations; and privately held shares transferred to the

public.

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Stagging: T
​ he practice of buying initial public offerings at the offering price and then
reselling them once trading has begun, usually for a substantial profit. These
investors are called Stags.

IPO lock-up period

Contractual restriction that prevents insiders who are holding a company's shares,
before it goes public, from selling the shares for a period usually lasting 90 to 180
days after the company goes public.

Insiders​- company founders, owners, managers, employees and venture capitalists.

Purpose-​ prevent the market from being flooded with a large number of shares,
which would depress the share price.

Tender Offer:

● A tender offer is an alternative to a fixed price offer.

● Once all offers have been received from prospective investors, the company sets a
'strike price' and allocates shares to all bidders who have offered the strike price or
more.

● The strike price is set to make sure that the company raises the required amount
of finance from the share issue.

● All bidders pay the strike price irrespective of what their original bid was.

Placing:

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● A placing ( 'placement' or 'private placement') is the sale of securities to a relatively
small number of select investors as a way of raising capital

● Investors involved in private placements are usually large banks, mutual funds,
insurance companies and pension funds

● This method is cheaper and quicker to arrange than most other methods.

Private Equity:

● Private equity is equity capital that is not quoted on a public exchange.

● It consists of investors who make investments directly into private companies

● Private equity investments often demand long holding periods to allow for a
turnaround of a distressed company or a liquidity event such as an IPO or sale to a
public company.

● Many private equity firms conduct leveraged buyouts (LBOs) of public companies

● Private equity firms will then try to improve the financial results and prospects of
the company in the hope of reselling the company to another firm or cashing out via
an IPO.

Advisors to an IPO:

● Investment banks usually take the lead role in an IPO and will advise on:

1. the appointment of other specialists (e.g. lawyers)

2. stock exchange requirements;

3. forms of any new capital to be made available;

36
4. the number of shares to be issued and the issue price:

5. arrangements for underwriting;

6. publishing the offer.

Stockbrokers​ provide advice on the various methods of obtaining a listing.

Institutional investors have little direct involvement other than as investors, agreeing
to

buy a certain number of shares.

Rights Issues:

● A rights issue is where new shares are offered for sale to existing shareholders, in
proportion to the size of their shareholding.

● The right to buy new shares ahead of outside investors is known as the 'pre-
emption rights' of shareholders

● Rights issues is cheaper than a public share issue, but more expensive than a
placing.

● Issue price is set low enough (i.e discount on MPS) to secure acceptance of
shareholders; but not too low, so as to avoid excessive dilution of the earnings per
share.

● Underwriters, in return for a fee, they agree to buy any shares that are not
subscribed for

in the issue. The underwriting costs could potentially be avoided through a deep-
discounted rights issue.

37
● Selection of Issue quantity : The proportion is normally stated in its simplest form,
for example, 1 for 4, meaning that shareholders may subscribe to purchase one new
share for every four they currently hold.

Terms of a rights issue

The company can set any issue price for the rights issue.

e.g.: A company may issue 1 million shares for $2 each or 5,00,000 shares for $4 each
if it wants to raise $2 million for a new investment project but needs to consider the
current market price while deciding the final price

Market price after issue

38
39
Yield adjusted ex-rights price

If an entity expects (and the market agrees) that the new funds will earn a different
return than is currently being earned on the existing capital then a ‘yield-adjusted’
TERP (theoretical ex-rights price) should be calculated.

Yield adjusted TERP = [Cum rights price × N/ (N + 1)] + [(Issue price/N + 1) ×

(Yn/Y0)]

Where,

Y0 = Yield on ‘old’ capital

Yn = Yield on ‘new’ capital

Courses of action open to a shareholder

40
· Do nothing. (Shareholders may be protected from the consequences of inaction by
the company selling the rights on behalf of inactive shareholders);

· Renounce the rights and sell them on the market;

· Exercise the rights (that is buy all the shares at the rights price);

· Renounce part of the rights and take up the remainder.

Implications of a rights issue

41
42
43
Chapter 5 - ​Financing - Debt Finance
This chapter looks into the different sources of debt finance, and the criteria to
consider when trying to manage the risk associated with an entity's debt finance.

DEBT FINANCE

The loan of funds to a business without conferring ownership rights.

Failure to make interest and principal payment by borrower -lender can apply to the
courts to have the borrower liquidated

Tax considerations

● tax-efficient form of financing.

● Interest- paid out of pre-tax profits (expense)- ↓ taxable profits - ↓ the tax
payable.

● Cost of servicing the debt < stated rate of interest on the borrowing.

44
Example, if a company borrows money from the bank at an interest rate of 5% per
year, and if the tax rate is 20%, the post-tax cost of debt from the company’s point of
view is only 4% (5% × (1 – 0.20)).

Security – charges

In the event of default, the lender will be able to take assets in exchange of the
amounts owing.

Two types of 'charge' or security

COVENANTS

Means of limiting the risk to the lender is to restrict the actions of the directors

They may include:

1. Dividend restrictions – Limitations on the level of dividends

2. Financial ratios – e.g. minimum interest cover, maximum gearing ratio, minimum
EBITDA / finance cost.

3. Financial reports – Lender monitoring regular accounts and financial reports

4. Issue of further debt – The amount and type of debt that can be issued may be
restricted.

Impact on lender and borrower

45
Protect the lender by requiring or prohibiting certain activities of the lender

Benefit the borrower by reducing the cost of borrowing (e.g. through lower interest
rates and higher credit ratings).

Negative debt covenants​ --(what the borrower cannot do)

• Incur additional long-term debt

• Pay cash dividends exceeding certain threshold

• Sell certain assets (e.g. sell accounts receivable)

• Enter into leases

• Combine in any way with another firm (e.g. takeover, merger)

• Compensate or increase salaries of certain employees

Positive debt covenants​-- (what the borrower must do )

• Maintain certain minimum financial ratios

• Maintain accounting records in accordance with generally accepted accounting

principles

• Provide audited financial statements

• Perform regular maintenance of assets used as security

• Pay taxes and other liabilities when due

Breach of a covenant

When breached by the borrower, the lender has a range of alternative responses

46
• Waive the breach and continue the loan

• Waive the breach and impose additional constraints

• Require penalty payment

• Increase interest rate

• Demand immediate repayment of the loan

• Increase security needed

• Terminate debt agreement.

Early negotiations can be started to minimise any penalties. Example:giving the

lender details of a recovery plan, additional security or parent company guarantees
(depends on the severity of the breach as well as the terms of the debt agreement)

Types of debt finance

1. Borrow from BANKS

2. Issuing financial instruments in CAPITAL MARKETS

Criteria for selecting debt instruments

Companies should consider the following three factors while deciding the way of
financing an investment:

● Liquidity
● Timescale
● Cost

47
Detailed considerations: Criteria to consider

· Bonds and bank borrowings are used to finance investment projects

48
More details on the capital market (bond market)

A firm can borrow a large amount of funds from a number of potential investors by
issuing bonds in the capital market.

There are 3 main groups in bond market, namely,

1. ISSUERS​: Sells bonds to gather funds. Consists mainly of,

a. Government: It is the biggest of all issuers as it helps in funding the entire country’s
operations through use of bond.

b. Bank: key issuers, can range from local banks to super national banks such as the
European Investment Bank.

c. Corporations: Issue bonds to finance their operations

2. UNDERWRITERS:

a. Investment banks and other financial institutions that help the issuers to sell
bonds in the market.

b. Sometimes issues bonds to specific investors (bond placement) or sell more widely
in the market

3. PURCHASERS​: Buys the bonds

49
★ GOVERNMENT: Lead player in the market as it borrows and lends money to other
governments and banks. They also often invest in bonds issued by other countries if
they have excess reserves of that country’s money.

International debt finance :

-Large companies can borrow money in foreign currencies as well as their own
domestic currency from banks at home or abroad.

( In most developing countries, companies will need to raise finance in an

international currency such as US dollars)

-Reason to borrow in a foreign currency

1. Provides a hedge of the value of the foreign investment project or subsidiary to

protect against changes in value due to currency movements.

2. It can be serviced from cash flows arising from the foreign currency investment.
Eurobond markets Issued on the international capital markets--self-regulated
off-shore market--denominated in any major international currency(NOT JUST
EURO)-- listed on the domestic currency stock exchange --but cannot be traded
through that exchange-- usually bearer instruments and pay interest annually, gross
of tax.

TARGET DEBT PROFILE

Upon deciding how much debt finance is needed, one needs to further analyse:

● entity borrow at a fixed or a floating (variable) rate?

● debt have a short-term or a long-term repayment date?
● domestic currency or foreign currency borrowings be used?

50
These will determine the level of:

Interest rate - (Risk to profitability as a change resulting from interest rates)

Refinancing - (Borrowings will not be refinanced or will not be refinanced at the same
rates because:

● Lenders maynot be willing

● Credit rating of company might have reduced.
● Need refinance quickly and might find it difficult to obtain best rates)

Currency risk -(Risk that arises from possible future movements in an exchange rate)

OTHERS SOURCES OF FINANCING-

Retained Earnings/ Existing cash balances:

● A company can only use internal sources of finance to fund new projects if it has
enough cash in hand.

● The level of retained earnings reflects the amount of profit accumulated over the
company's life. It is not the same as cash.

Sale and leaseback:

● This means selling good quality fixed assets such as high street buildings and
leasing them back over many years (25+). Funds are released without any loss of use
of assets.

● Capital gain is forgone

● Sale and leaseback is a popular means of funding for retail organisations with
substantial high street property

51
● Example: Tesco, Marks and Spencer

Grands:

Grants can be provided by local governments, national governments, and other

larger bodies such as the European Union to encourage the growth of a specific
sector. Example: Startups in India

Debts with warrants attached:

● A warrant is an option to buy shares at a specified point in the future for a

specified (exercise) price.

● It is used to encourage investors to purchase the bonds.

● The warrant offers a potential capital gain where the share price may rise above
the exercise price.

Convertible Debts:

The convertible debt is where the debt itself can be converted into shares at a
predetermined price at a date or range of dates in the future.

Venture Capitalists:

This is finance provided to young, unquoted profit-making entities to help them to

expand. It is usually provided in the form of equity finance, but may be a mix of
equity and debt.

Business Angels:

52
Business angels are similar to venture capitalists. Venture capitalists are rarely
interested in investing in very small businesses, on the grounds that monitoring
progress is uneconomic

Government Assistance:

Governments will often have a number of schemes, aimed at providing

assistance to:

● small- and medium-sized profit-making entities

● entities wanting to expand or relocate in particular region

● promote innovation and technology

● projects that will create new jobs or protect existing ones.

Lease Vs Buy:

● The decision to lease or buy an asset is a financing decision + investment decision.

● The decision to invest in the asset would be determined by its weighted average
cost of capital.

● Investing in the asset would be justified if a positive NPV is obtained.

● The financing decision is then concerned with identifying the least-cost financing
option.

● In evaluating the financing decision, it is usually assumed that the entity would
have to borrow funds in order to purchase the asset.

Lease or buy evaluation:

53
● The traditional approach to the evaluation is to use the NPV method i.e. determine
the present value cost of leasing and compare this to the present value cost of
borrowing to buy.

● In the lease v buy evaluation, it is considered that the risk associated with the
lease option is comparable to the risk associated with the borrow to buy option.
Hence the same discount rate should be used for both NPV calculations.

● The discount rate to use is the post-tax cost of debt finance .

Example:

To buy, Cost of asset = USD100,000,

Or lease it by paying USD29,500 per year in arrears for 4 years.

Actuarial method

● Here the implied interest rate is found by using an IRR approach.

● As a short cut, the 4 year annuity factor at the IRR can be found by dividing the
cost of the asset by the annual interest payment (i.e.100,000/29,500).

● This gives a 4 year annuity factor of 3.390, which (from tables) is very close to the
7% factor. Hence, the implied interest rate in the lease is (approximately) 7%.

Now the interest could be easily calculated. The lease interest payments have now
been allocated to years, so can be used to calculate the tax relief each year

Sum of digits method:

This is a simpler way of allocating interest, based on the sum of digits formula:

54
n(n+1)/2

In this example, the lease payments are to be made over 4 periods, so the sum of
digits is 10

(working: 4 × 5 /2 = 10)

Once again, the tax relief on the lease interest can now be calculated easily.

55
56
Chapter 6 - ​Financing - Capital Structure

● An analysis of capital structure, using the gearing ratio and interest cover, is
important to assess risk associated with a business.
● When a business changes its capital structure, there will be an impact
on its financial ratios and an impact on its weighted average cost of
capital (WACC).

THE IMPACT ON THE WACC OF A CHANGE IN CAPITAL STRUCTURE:

Formula:

Ko = Keg [Ve/Ve+Vd] +Kd (1-t) [Vd/ Ve+Vd]

So,

1. i​ f a company changes its capital structure (gearing level), the WACC will
change, since the ratio of debt to equity is a key variable in the formula.
2. since the value of (debt plus equity) can be calculated as the present value of
post-tax operating cash flows (before financing) discounted at the WACC, when
the WACC changes so does the value

The two opposing force which impact WACC:

57
 Downward force of WACC;

● Interest is an obligation which has to be paid out each year, This

means that debt holders face less risk, so accept lower returns.
● Interest is a tax deductible expense.
Therefore, the greater proportion of (cheaper) debt in the capital structure
exerts a downward force on the WACC.

Upward force on WACC:

● The extra interest payments to debt holders mean that the entity
being able to afford to pay dividends to shareholders reduces.
● This increases the risk perception of the shareholders, so they
demand higher returns to compensate for the increased risk.
This increase in the cost of equity exerts an upward force on the WACC.
Net effect:
Clearly, the two factors have opposing impacts on WACC.
There is no simple answer to these questions. In fact, the different gearing theories
propose different answers to the questions, based on different assumptions
Impact on capital structure by an equity investor
● High gearing increases the financial risk of the equity investor but the
reward can be in the form of increased dividends when profits rise. If profits
falter, the equity investor is at risk.

58
 ● Low gearing or no gearing may not be in the equity investor’s best interests
because the entity might then be failing to exploit the benefits which
borrowing can bring.
● Provided that the return generated from borrowed funds is greater than the
cost of those funds, capital gearing could be increased.
● The ordinary share price of highly geared entities will tend to be depressed in
times of rising interest rates.

Traditional view

· When debt is introduced in capital structure

● WACC falls
● Because, initially the benefit of financing through cheaper debt
outweighs any increases in the cost of equity required to
compensate equity holders for higher financial risk

· When Gearing/Debt financing continues to increase

● Cost of equity rises more

● Now, increase in the cost of equity will start to outweigh the
benefit of cheap debt finance
● Hence, WACC rise

· At extreme levels of Gearing

● Cost of debt also starts to rise (as debt holders become worried
about the security of their loans)
● This adds to further rise in WACC

Traditional view of gearing and the cost of capital

59
Where,

· K​e​ = cost of equity;

· K​d​ = cost of debt;

· K​o​ = overall or weighted average cost of capital

X = optimal level of gearing, where k​o​ is at a minimum

i.e. at X, the overall return required by investors (debt and equity) is minimised

· At point X, the c​ ombined market value of the entity's debt and equity​ securities
will also be ​maximised​ (because the value of the entity's debt and equity and the
WACC are i​ nversely related​ – ​discounting​ the future operating cash flows a
​ t a lower
cost of capital​ w
​ ill give a higher value​.)

Optimal capital structure

60
Capital structure: Modigliani and Miller's view

Criticised the traditional view of gearing

Assumed that the effect of tax relief on debt interest could be ignored

Modigliani and Miller without tax (1958)

M&M proposition without taxes (1958) M&M state that (ignoring tax) higher gearing
will create more risk for shareholders and hence the cost of equity will increase, but
that this is ‘compensated’ for by the lower cost of debt.

As a result, they stated that the weighted average cost of capital will stay constant for
a company, however the company is financed.

61
The implications of their results are as follows:

(1) It is irrelevant how a company raises finance – the overall cost of borrowing will
be unaffected

(2) All investments should be appraised at the WACC, however they are actually
financed.

A further implication is that the total market value of the company (equity plus debt)
will be unaffected by changes in gearing. This is to an extent logical, because
whichever way in which the company is financed, the total available for distribution
will be unchanged – if more goes to debt then there is less to equity, and vice versa,
but the total must be the same. Therefore, why should the total value of the
company be any different?

Note:​ Modigliani and Millers’ proof is outside the syllabus and is therefore not
reproduced in these notes. Although the above caused a lot of interest at the time, it
had limited practical relevance because it ignored all taxes.

62
 1. IF WACC IS CONSTANT AT ALL LEVELS OF GEARING
Any benefit from the increased proportion of cheaper debt finance
(downward force on the WACC) must be exactly ​offset​ by the increase in
the cost of equity (upward force on the WACC)

● If tax is ignored, the company should be indifferent between all possible

capital structures (against the belief of traditionalists)
● MM model states that market pressures will ensure that two companies
identical in every aspect apart from their gearing level will have the same
overall market value

1958 Modigliani and Miller view (with taxation)

In 1963, MM model was amended to include ​the impact of corporation tax c​ hanging
the results significantly.

63
Modigliani and Miller developed their theory further incorporating a world with
corporation tax (but initially ignored personal taxes).

Debt interest gets tax relief, which makes the effective cost of debt to a company
lower. However, corporation tax has no effect on the cost of equity because
dividends are not tax allowable.

As a result, even though the cost of equity will increase with higher gearing, the
WACC will fall. As a result, a company should raise as much debt as possible.

64
The implications of the above are as follows:

(1) the WACC will fall with higher levels of gearing

(2) a company should raise as much debt as possible (in order to get as much tax
relief as possible)

A further implication of the above is that as the level of gearing increases, the total
market value of the company (equity plus debt) will also increase. This is in fact
logical because as the company has more debt borrowing and therefore pays more
interest, they will pay less tax on the same (before interest) profits and therefore be
able to distribute more in total (to equity and debt together). If they are able to
distribute more then certainly the total value of the company should be higher.

Although the introduction of corporation tax did make the model more practical, it
did still ignore personal tax. They did do further work on the effect of personal
taxation, but this is not in the syllabus.

M&M assumptions

Their main assumptions are as follows:

● Shareholders have perfect knowledge

65
 ● Shareholders act rationally with regard to risk
● A perfect market exists
● Debt interest is tax allowable (and the company is able to get the benefit of it)
● Investors are indifferent between corporate gearing and personal gearing
● The debt borrowing is irredeemable

Graph of M & M model with tax

● Gearing increases
● WACC decreases
● Value of company (debt + equity) increases

1. IN THE PRESENCE OF TAX

Downward force on WACC/ impact of greater proportion of debt i​ s
stronger​ than the upward force/ increase in cost of equity.

2. IF OTHER IMPLICATIONS OF MM model are accepted (INTRODUCTION OF

TAX)
With a higher level of tax, the combined cost of capital will decrease.

66
M&M FORMULAE

Where,
V​ = Value of company (Vg = value of geared company, Vu = value of ungeared
company)
k e​ = Cost of equity (keg = cost of equity in geared co, keu = cost of equity in
ungeared co)
k d​ = Cost of debt (must be gross of tax)
k adj = ​ the weighted average cost of capital in a geared company
B,V D​ = MV of debt
V E​ = MV of geared company's equity
T, t​ = Corporation tax rate
WACC ​= weighted average cost of capital
TB​ is often referred to as the present value of the tax shield
The ​without-tax formulae​ are simply a special case of the with-tax formulae, wher​e
t = 0.
FORMULA INTERPRETATION
Without tax With tax

Company value (Vg = Vu ) Company value (Vg = Vu + TB )

WACC (kadj = keu) WACC [kadj = keu (1 – VD t / (VE + VD)]

Cost of equity (keg = keu + (keu – kd) VD

(1 – t) / VE)

67
Capital structure in the real world

We need to adjust M & M's theories to also take into account real life factors.

Practical considerations
1. Company's ability to borrow money (the company's 'debt capacity')​ - A
company can only increase its gearing if it can find a lender who will provide it
with debt finance.It is function of a company’s credit-worthiness and credit
scoring
2. Existing debt covenants​ - reduce the flexibility of management
3. Increasing costs of debt finance as gearing rises ​- In reality, an increased
level of gearing is likely to be perceived as risky by lenders, so the interest
rates on borrowings generally increase as gearing increases
4. Views of other stakeholders and rating agencies​-​ Example ​– customers
may be concerned about buying goods from companies that have poor credit
worthiness (due to concerns about warranties and guarantees being
honoured) – suppliers might not want to supply, or advance credit (due to the
risk of default) – employees and managers might choose to leave if they fear
for their job security
5. Tax exhaustion​ - At some level of gearing the interest payable will be so high
that taxable profit will be reduced to zero. Beyond this point, there will be no
further benefit of raising debt finance.
-However, in order for tax exhaustion to apply, the company must be
making a loss and will have breached any interest cover covenants. The
company is therefore likely to have much greater problems to contend with
than the loss of tax relief.

THE IMPACT ON FINANCIAL RATIOS OF A CHANGE IN CAPITAL STRUCTURE

Affects gearing ratio-----Capital gearing=​ D
​ EBT /DEBT+EQUITY * 100 ​ (common
formula)
(or)

D
​ EBT/EQUITY

Debt covenants​: 1.Useful application of impact on financial ratios

68
 2.Gearing ratios are used in debt covenants & must be below the
given % to comply with covenants.

STRUCTURING DEBT/EQUITY PROFILE OF GROUP COMPANIES

Considerations for group companies​:
● Tax issue
(Usually maximising borrowings with high tax rates happen to increase tax
relief.But these can limited via transfer pricing)
● Country risk
(Low risk if borrows in same country where net income is generated so that no
exchange rate worries)
● Type of finance by parent company
(If debt/equity supplied by parent co. then the subsidiaries do not have any
choice with regards to debt/equity as anyways they are financed by cash by
parent co.)
● Transfer pricing
(Necessary for transactions between connected companies to ensure that
companies cannot reduce their tax liability)
Thin capitalisation rules​:
● If co. pays dividend=no tax relief
● If co pays interest on borrowings=tax allowable
-so any co would choose debt over equity.
-so these rules are to stop companies from getting excessive tax relief on
interest.
-Usually because they have entered into a borrowing with a related party that
exceeds the amount a third party lender would be prepared to
lend-(​additional borrowing by parent co​)

The rules ensure that

• Interest on the part of the borrowing that an independent third party would be
prepared to lend the company is allowable
• The excess is disallowed
• The borrowing capacity of the individual company and its subsidiaries is considered
(but not the rest of the group).

69
Factors determining thin capitalisation
● Gearing
– A higher proportion of debt could cause thin capitalisation problems.
– In the UK a limit of around 50:50 is considered by the tax authorities to be
reasonable.
● Interest cover
– This is the ratio of earnings before tax and interest to interest on
borrowings.
– It measures how risky the loan is for the lender.
● – Many commercial lenders will look for a ratio of around 3, so this is the
figure considered by the tax authorities to be reasonable​A

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71
Chapter 7 -​ Dividend Policy
MM Dividend Irrelevance Theory:
As long as companies continue to invest in positive NPV projects, the wealth of the
shareholders should increase whether or not the company makes a dividend
payment this year.
M & M's argument here is built up as follows:
i. The return on a share is determined by the share's (systematic) risk.
ii. The return itself is delivered to shareholders in two parts: dividend paid &
capital gain/loss in share price.
iii. As the dividend decision does not affect the risk of the shares, it does not
affect their return. All the dividend decision therefore does is to determine
how the return is to be split up between dividends and capital gains.

72
 iv. Do shareholders mind how their returns are split between dividends and
capital gains? The answer according to M & M is: no, they do not if we assume:
a. There are no taxes (i.e. there are no differences between the taxation on
dividends and on capital gains).
If dividends were taxed and capital gains were tax free, shareholders
would mind how their return was delivered – they would strongly prefer
it to be delivered in the form of capital gains rather than dividends.
b. Shares can be bought and sold free of any transaction costs (such as
stock-brokers' commission). Investors who were holding shares for the
income they generated would mind how their return was delivered if
they had to incur transaction costs when realizing their capital gains so
as to turn them into income – such investors would strongly prefer if the
return were delivered in the form of dividends, rather than capital gains
Clientele Effect​: If a group of shareholders bought a company’s shares for a steady
income in the form of constant dividends, the company should continue this policy to
cater to such clientele of shareholders (who would otherwise sell the shares causing
share price to fall, if policy changes).
Bird-in-hand argument​: investors prefer a certain dividend now, to the promise of
uncertain future dividends.
Signaling Effect​: (I) a reduction in the dividend per share signals that the company is
in financial difficulties;
(II) A failure to pay out any dividend at all signals that the company is
very close to receivership.

However, there are exceptions to this interpretation. For many years, Apple
Computers paid no dividends to its investors, preferring instead to reinvest the
profits back into the business to fund new investments and to reduce the
requirement to raise finance externally. Despite the absence of a dividend, the
market responded positively to Apple throughout, and the share price rose strongly.
In conclusion, although paying dividends (or not paying dividends) can give investors
a signal as to how successful the company is likely to be in future, it is not the only
important indicator to investors. Other factors such as investment plans, gearing
levels, strategy and quality of management are also important as investors assess
the likely success of a business.
CASH NEEDS OF AN ENTITY:

73
 ● A small company, or a company with a poor credit rating, will often struggle to
raise finance from external sources, so its cash needs might have to be met by
restricting the amount of dividends it pays out.
● A growing company will have many potential investment opportunities. The
cash needs for these new investments will have to be met by balancing
dividend policy alongside external finance sources.
● A well-established, stable company might well be cash rich, in which case it
might be able to afford to pay out large dividends without compromising its
internal cash needs.
How to decide what dividend to pay?
● What dividends are the shareholders expecting (e.g. the clientele effect)?
● What are the cash needs of the company?
● What dividend did the company pay last year? Consider the signal that a
dividend announcement will give.
Other Factors:

● Is it legal to pay out a dividend?

● Is the cash available to pay out a dividend?
● Do we have a minimum gearing ratio imposed on the company as a financial
covenant in a debt agreement?
● What is the tax impact for shareholders of paying dividends?
● What investment opportunities does the company face?
● How difficult/expensive is it to raise external finance?
● What has been the rate of inflation (and so what dividend increase is needed
to maintain the purchasing power of last year's dividends)?
● What has been the capital gain/loss in the share price over the last year?

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Stable Dividend Policy​:

● Offers investors predictable cash flow

● Mature firms usually have this policy
● Risk: Reduced earnings would force a dividend cut.
Constant Payout Ratio​:

● Cash flow unpredictable

● Links dividend to earnings
● Gives no indication of management intention
Zero dividend Policy​:

● Common during ​growth phase

● Should be reflected in increased share price
Residual Dividend Policy​:
Dividend is paid only if no further positive NPV projects available. Popular for firms:
● in the growth phase
● Without easy access to alternative sources of funds.
However:
● cash flow is unpredictable for the investor
● Gives constantly changing signals regarding management expectations.

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RATCHET PATTERN:
Most firms adopt a variant on the stable dividend policy – a ratchet pattern of
payments. This involves paying out a stable, but rising dividend per share:
● Dividends lag behind earnings, but can then be maintained even when
earnings fall below the dividend level.
● Avoids ‘bad news’ signals.
● Does not disturb the tax position of investors.
Scrip/Bonus Dividends​:
● Where shareholders are offered bonus shares free of charge as an alternative
to a cash dividend
● They are useful where the company wishes to retain cash in the business or
where shareholders wish to reinvest dividends in the company but avoid
brokerage costs of buying shares.
● If all shareholders opt for bonus shares, the scrip issue has the effect of
capitalizing reserves
● The disadvantage to shareholders is that, unlike reserves, share capital is
non-distributable in the future. In addition, both share price and earnings per
share are likely to fall due to the greater number of shares in issue, although
the overall value of each shareholder’s shares and share in future earnings
should, theoretically, remain unchanged.

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Share Repurchase:

● A share repurchase can be used to return surplus cash to shareholders.

● It tends to be used when the company has no positive NPV projects to invest
the cash in, so it returns the cash to shareholders so that they can make better
use of it rather than sitting idle (in cash investments) in the company.
● Alternatively, a share repurchase can be used to privatize a company, by
buying back a listed company's shares from a wide pool of investors. However,
this is rare.
Share repurchase v one-off large dividend

❖ Both a share repurchase and a one-off large dividend have the same impact
on the cash, and the gearing of the company (they reduce the value of equity,
so increase the gearing and hence financial risk and cost of equity). Although
the impact on shareholder value is the same for any individual shareholder,
the impact on the price per share will differ.
❖ A dividend results in a lower share price as the number of shares remains the
same, but a share repurchase is unlikely to affect the individual share price but
only the number of shares in issue.
❖ The one-off dividend has the advantage of certainty of ultimate payout.
❖ However, a share repurchase has the following advantages:
● investors can choose whether or not to sell their shares back (they
may prefer to keep the shares if they feel that future returns will be
high)
● It avoids the risk of a false dividend signal – after a one-off large
dividend, the shareholders may be disappointed when the higher
level of dividend is not maintained in the future.
The impact of scrip dividends on financial ratios
❖ The impact of a scrip dividend on shareholder wealth is nil. There are more
shares in issue but the overall shareholder value stays the same, hence the
share price decreases.
❖ The impact of a scrip dividend on the entity's performance measures / ratios
is:
● total shareholder’s equity (in the statement of financial position)
remains the same

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 ● It doesn’t change the capital structure (and gearing ratio) because the
equity value stays the same.
The impact of Share Repurchase on financial ratios
❖ The impact of a share repurchase on shareholder wealth is nil.
❖ After a share repurchase there will be fewer shares in issue, so the earnings
per share of the entity will increase.

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79
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Chapter 8 - ​Financial Risk

Risk of change in financial condition due to exchange rate or credit rating of a

customer or price of a good.

Political Risk

Risk faced by a foreign investor,due to adverse action taken by the host country’s
government. After the company has invested In host country.Political risk is the risk
that political action will affect the position and value of a company.

Examples of macro (country specific) political risk​:

● outbreak of war / civil unrest

● confiscation of assets (nationalisation) / restrictions on foreign ownership
● import quotas / tariffs
● exchange controls

Examples of micro (firm specific) political risk

These are risks that affect only certain firms in certain industries, rather than all
foreign firms.

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 ● minimum wage legislation
● pollution controls ๏ product legislation
● health and safety legislation

Managing political risk

(a) negotiate the environment prior to investing

(i) negotiate an investment agreement

(ii) obtain insurance (either privately or through the home government)

(iii) gain local government support e.g. grants

(b) select risk reducing operating strategies

(i) control distribution channels / transportation / technology (e.g. oil refining away
from politically sensitive oil fields)

(ii) ensure that some components are imported from the home country

(c) marketing strategy

(i) branding

(ii) control of final product markets

(d) financial strategy

(i) low equity base / large local debt

(ii) multiple source (and therefore pressure) borrowing

(iii) shared ownership / joint venture with strong local partner

Interest rate risk

Risks of Gains or Losses on assets and liabilities due to fluctuation in interest rate

As a General rule-
-Interest on Bank loans and overdraft is payable at floating rate with interest rate set
above a benchmark rate

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-Interest on Bond, debenture and loan stock is paid at fixed rate

Note-
Benchmark rate maybe LIBOR-London interbank offer rate is a money market rate at
which top rated banks are able to borrow short term funds in London Sterling for Euro
currency market

Exposure to interest rate risk

It will depend on amount of asset and liability bearing interest and type of
interest

Types of interest rate risk exposure

Floating rate loans
If rate changes ,it directly affects cash flows and profits

Fixed rate loans

● If interest rate for competitor falls ,our cost will be relatively higher than those
with those with floating rate which will improve their profitability and competitive
strength
● Interest rate rises our assets with fixed interest rate will worth less

Refinancing Risk
There is a risk that loans will not be refinanced or will not be refinance at same rate
Reasons for refinancing risk-
1. Landers require higher rate
2. Credit Rating has gone down
3. Urgent requirement of funds

Currency risk

1. Economic risk

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 ● Risk of change in economy,home or abroad, affecting the value of transaction
● Even if company does not have transaction in foreign currency it may affect the
company due to-​Competitive position- if a competitor trades in foreign currency
and there are favourable changes in currency ,It will give that competitor
competitive strength

Management of economic risk

Efficient way is to diversify globally ,it reduces the risk by having operations all over the
world( also called portfolio theory).

Diversification of production and sales

If a company has established production plants all over the world ,even if the value of
one currency falls ,it is likely to be set off by other favourable currency movements.

Financing
When funding sources are spread across the globe, it is likely that they will be
strengthening the financial condition due to favourable currency changes.

M
​ easurement of economic exposure

● There are a very limited number of factors that can be observed to attempt to quantify
economic exposure, which include the price elasticity of demand for products.
● For example, as prices rise demand usually falls, but the rate at which it falls and the
resulting cash flows will impact on the value of a company. The price rise could be due
to a change in the exchange rate.

Transaction risk

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 This is the risk that a transaction in a foreign currency at one exchange rate is settled at
another rate (because the rate has changed). It is this risk that the financial manager
may need to manage and the methods of dealing with this risk are covered in a later
chapter (currency risk management).

Translation risk

● Risk associated with assets or liabilities denominated in foreign currencies.

● There is a risk is that exchange rate volatility will cause the value of assets to fall or
liabilities to increase resulting in losses to the company.

5 ​Using financing packages to split risks

● The two extremes of financing sources are Equity and Debt

1. Equity usually carries the highest risk (unsecured, uncertain dividend, share price
may fall, last in line in the event of a liquidation) but potentially the highest return.
2. Loan capital is usually lower risk (secured, specified interest) but has a lower typical
return.

In between these extremes are a wide range of alternatives with differing risk/return
profiles.Any financing package can be assessed by how it shares risks and returns out
between different investors.

6. Value at Risk

It is assumed that results from an investment or the value of a share portfolio has a
mean (average) value but that results vary around that mean following a normal
distribution curve. This will allow estimates to be made of the likelihood of possible
outcomes. Normal curves have the following general shape:

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If the possible results are closely clustered around the mean the standard deviation
of the distribution is small; if the results are very spread out, the standard deviation
of the distribution is large.
So if the mean daily value of a share is $30 and the standard deviation of its value is
$1 the share is rarely valued very far from $30.
If, however, the standard deviation were $10, then the share’s value would be very
volatile, often worth more than, say, $40 and less than say $20. Because all normal
curves are of the same basic shape, they can be described using a set of tables, as set
out below.
The area under the curve holds all possible results and the table gives the proportion
of those results between the mean and Z standard deviations above (or below) the
mean
Note, Z is the distance above or below the mean expressed as a number of standard
deviations, so for a value x, Z is:​ Z = x – μ / σ
So, if the mean height of a population was 178 cm with a standard deviation of 4cm,
we can work out what proportion of the population is 178 – 181 cm tall.
Z = 181 – 178 = 0.75 / 4

Look up the table value for Z = 0.75 by going down the left hand column until you get
to 0.7, then across until you get to 0.05 and the table figure is 0.2734.

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 That means 27.34% of the population is in the height range 178 – 181 cm tall.
Because the curve is symmetrical, the same proportion of people would be 175 – 178
cm tall.

VaR helps investors to assess the magnitude of the probable loss in their portfolio at a
defined level of probability. VaR is based on the assumption that investors care mainly
about the probability of a large loss.
The VaR of a portfolio is the maximum loss on a portfolio occurring within a given
period of time with a given probability (usually small).

• Calculating VaR involves using three components: a time period, a confidence level
and a loss amount or percentage loss.
• Statistical methods are used to calculate a standard deviation for the possible
variations in the value of the total portfolio of assets over a specific period of time
• Making an assumption that possible variations in total market value of the portfolio
are normally distributed, it is then possible to predict at a given level of probability the
maximum loss that the bank might suffer on its portfolio in the time period.
• A bank can try to control the risk in its asset portfolio by setting target maximum limits
for value at risk over different time periods (one day, one week, one month, three
months, and so on).

Value at risk – share values

What talking about value at risk, the commonest criterion is to work out the amount
you could lose over a period so that there is only a 5% chance of losing more. This
can be represented as follows on the curve:

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We are looking for where the cut-off is to leave only the 5% lowest values. Let’s say
that a shareholding has a mean value of $80,000 and the daily has a standard
deviation of $5,000.

The shareholding could easily have a value of $81,000, $78,000 and so on but you
would have had some bad luck if tomorrow’s value were only $60,000. However, that
low value would be possible.

So, below what value would only 5% or results lie?

5% splits the left hand side of the curve into 5%/45%, or 0.05/0.45. The normal curve
tables give the area under the curve from the mean down or the mean up so would
indicate the Z value for an area of 0.45.

Looking at the body of the tables for an area of 0.45, you will see that Z = 1.645
(mid-way between 1.64 and 1.65).

Z = 1.645 = 80,000 – x (Z is the distance below the mean as a number of

standard deviations) / 5,000

5,000 x 1.645 = 80,000 – x

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x = 80,000 – 5,000 x 1.645 = $71,775​.

So, there is only a 5% chance that after one day the shares will be worth less than
$71,775. There is a 95% chance that the shares will be worth more than that.

Another way of expressing that is to say that we are 95% confident that the shares
will not be worth less than $71,775. The value at risk (VAR) at the 95% confidence
level is the maximum you stand to lose with a 95% confidence, so that figure is:
80,000 – 71,775 = $8,225

Alternatively, the value at risk is simply 1

​ .645 x $5,000 = $8,225

If you were asked to calculate the VAR to the 99% confidence level, then you are
splitting the curve into 0.01, 0.49, 0.50 areas

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Chapter 9 - ​Currency Risk Management

Overview

The foreign exchange or forex market is an international market in national

currencies. Highly competitive and virtually no differences occur in prices in one
market compared with another

Increasingly, many businesses have dealings in foreign currencies and, unless

exchange rates are fixed with respect to one another, this introduces risk.

Exchange rates move up and down for all sorts of reasons, such as:

● Political uncertainty
● Economic prospects of the country
● Demand for the currency

Many of these factors are unpredictable, but there are three calculations that can be
performed to predict certain exchange rates and also to predict a country’s exchange
rate.

Spot rate:​ rate given for a transaction that is settled immediately. In practice within 2
working days.

Spread:​ Profit bank makes when buying or selling currency

Exchange Rate theory

Company may want to forecast exchange rate for a variety of reasons including:

1. Foreign debtor and creditor balances

2. Working capital – for companies with subsidiaries overseas
3. Pricing

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 4. Investment appraisal of foreign subsidiaries

Why exchange rates fluctuate:

1. Speculation
2. Balance of payments – trade between countries
3. Government policy
4. Capital movement between economies

Purchasing power parity

In theory, this predict future spot rates. The approach says that money obtains its
value with reference to what it can buy.
Therefore an exchange rate links what an item costs in two different currencies. So if
an item cost £1,000 in the UK and $1,500 in the US, then £1,000 must have the same
value as $1,500 and the exchange rate is therefore $1.5/£.
After a year, the purchase prices will have risen in each country by their inflation
rates. Say that in the UK inflation is 2% and in the US it is 3.5%.

Then in a year, the product will cost:

(1) In the UK: 1,000 x 1.02 = £1,020
(2) In the US: 1,500 x 1.035 = $1,552.50

These amounts must be worth the same because they buy the same item. Therefore
the exchange rate in 1 year is predicted to be: 1,552.5/1,020 = 1.522. In four years the
exchange rate would be predicted to be:

1,500 x (1.035)4 /1,000 x (1.02)4 = 1.59 $/£

Future spot rate = current spot rate x (1+if)/(1+ih)

If=inflation foreign country
Ih=inflation home country
PPPT is good for long term but not short/medium run prediction

Interest rate parity

The different interest rates in countries can be used to predict the forward exchange
rate. The forward exchange rate is the rate you would be quoted now for changing
currency at a specific date in the future.

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For example, say that the UK £ interest rate is 4% and the US $ rate is 6% and that
the current exchange rate (the spot rate) is US$ 1.4 = £1.00

An investor might therefore see a way to make money by borrowing, say £1,000 at
4% in the UK, changing this into $1,400 and investing at 6% in the US. There seems to
be a 2% margin in doing this.
However, the investor would not be sure of making money unless he or she knew
how many £ they would get back at the end of the period. If the US$ at weakened to
say £1 = $2, the investor might lose a lot of money. To prevent that, the investor
could agree now a rate (a forward rate) at which to change back the US $ at the end
of the period.
The forward rate must be a rate that means the investor would break-even
(otherwise there would be the odd situation where people could make money, risk
free, by simply borrowing and investing)

So, looking at a period of a year:

Borrow £1,000 add 1 year’s interest @ 4%
Amount owing becomes £1,040
Convert into US$ at 1.40$/£ Invest $1,400​ a
​ dd 1 year’s interest @ 6%

Amount available becomes $1,484

Interest rate parity theory says that the 1 year forward exchange rate is therefore
1,484/1,040 = 1.427 $/£
After, say two more years, interest would have accrued for three years and the
forward exchange rate would be given by:
1,400 x (1.06)3/1,000 x(1.04)3 = 1.4823 $/£.

Forward rate = current spot rate x (1+intsf)/(1+intsh)

Intsf= risk free rate of interest in foreign country
Intsh= risk free rate of interest in home country

International Fisher Effect​:

Interest rate differentials between two countries provide unbiased predictor of
future changes of spot rate

Assumes: all countries have the same real rate of inflation and nominal rates differ
due to inflation. Interest rate differential between two countries should equal
expected inflation differential. Therefore countries with higher expected inflation will
have higher nominal rates

1+nominal rate=(1+real rate)x(1+inflation rate)

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This theory says that the real rate of interest is the same in every country and the
interest rates quoted on bank accounts (the nominal or money rate) is a combination
of this rate (the real rate) and the inflation rate.
1 + Nominal Rate = (1 + Real Rate) x (1 + Inflation Rate)

Say a country had in inflation rate of 2.5% and a nominal interest rate of 5%. If
another country had an inflation rate of 6%, then we can predict its nominal rate of
interest as follows:
1 + 0.05 = (1 + Real Rate) x (1 + 0.025) 1 + Real Rate = 1.05/1.025 = 1.02439
The nominal rate in the other country is therefore given by:
1 + Nominal Rate = (1.02439) x (1 + 0.06) = 1.08585
The nominal rate is therefore 8.585%
Remember, the nominal rate is higher when inflation is higher because money on
deposit has to increase by inflation just to stand still with respect to inflation, then
investors expect a real rate of interest on top ie they expect to be able to buy more
even after inflation.

Cross rates

Cross rates allow you to work out the exchange rate between to currencies when
their rate with respect to a third currency are known
For example, on 3 May 2016, published exchange rates were:
US$/£ = 1.45 €/£ = 1.26
We can therefore work out €/US$ as follows:
Look at what you want ie
€/US$ €/US$ = €/£ x £/US$ £/US$ = 1/(US$/£) So, €/US$ = 1.26 x 1/1.45 = 0.87
The published rate was indeed 0.87

Types of currency risk

There are three types of currency risk:

Economic risk​.
The source of economic risk is the change in the competitive strength of imports and
exports.
For example, if a company is exporting (let’s say from the UK to a Eurozone country)
and the euro weakens from say €/£ 1.1 to €/£ 1.3 (getting more euros per pound
sterling implies that the euro is less valuable, so weaker) any exports from the UK will
be more expensive when priced in euros. So goods where the UK price is £100 will
cost €130 instead of €130, making those goods less competitive in the European
market.

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Similarly, goods imported from Europe will be cheaper in sterling than they had
been, so those goods will have become more competitive in the UK market. Note that
a company can therefore experience economic risk even if it has no overt dealings
with overseas countries. If competing imports can become cheaper you are suffering
risk arising from currency rate movements.
Doing something to mitigate economic risk can be difficult – especially for small
companies with limited overseas dealings.
In general, the following approaches might provide some help:
● Try to export or import from more than one currency zone and hope that they
don’t all move together, or at least to the same extent. For example, over the
three months 14 January 2010 to 14 June 2010 the €/US$ exchange rate moved
from about €/$ 0.6867 to €/$ 0.8164. This means that € had weakened relative
to the US $ (or US $ strengthening relative to the € by 19%). This would make it
less competitive for US manufacturers to export to a Eurozone country. In the
same period the £/$ exchange rate moved from 0.6263 £/$ to 0.6783 £/$, a
strengthening of the $ relative to £ of only about 8%. Trade from the US to the
UK would not have been so badly affected.
● Make your goods in the country you are selling them in. Although raw
materials might still be imported and affected by exchange rates, other
expenses such as wages are in the local currency and not subject to exchange
rate movements.

Translation risk.

This affects companies with foreign subsidiaries. If the subsidiary is in a country

whose currency weakens, the subsidiary’s assets will be less valuable in the
consolidated accounts. Usually, this effect is of little real importance to the holding
company because it does not affect its day-to day cash flows.
However, it would be important if the holding company wanted to sell the subsidiary
and remit the proceeds. It also becomes important if the subsidiary pays dividends.
However, the term ’translation risk’ is usually reserved for consolidation effects. It can
be partially overcome by funding the foreign subsidiary using a foreign loan.

Transaction risk.​ This arises when a company is importing or exporting. If the

exchange rate moves between agreeing the contract in a foreign currency and paying
or receiving the cash, the amount of home currency paid or received will alter,
making those future cash flows uncertain.
For example, in June a UK company agrees to sell an export to Australia for 100,000
Australian $, payable in three months. The exchange rate at the date of the contract
is AUD/£ 1.80 meaning that there are 1.80 AUD for every £. Confusingly, this could
also be written as

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1£/AUD 1.80, where the key is noticing that it is ‘1£’, meaning 1£ - 1.8AUD

So the company is expecting to receive 100,000/1.8 = £55,556. If, however, the

Australian $ weakened over the three months to become worth only 1£/AUD 2.00,
then the amount that would be received would be worth only £50,000. Of course, if
the Australian $ strengthened over the three months more than £55,556 would be
received.
It is important to note in the following discussions that transaction risk management
is not concerned with achieving the most favourable cash flow: it is aimed at
achieving a definite cash flow as only then can proper planning be undertaken.

Dealing with transaction risks

Assuming that the business does not want to tolerate exchange rate risks (and that
could be a reasonable choice for small transactions), transaction risk can be treated
in the following ways:
1. Invoice. Arrange for the contract and the invoice to be in your own currency.
This will shift all exchange risk from you onto the other party. Of course, who
bears the risk will be a matter of negotiation, along with price and other
payment terms. If you are very keen to get a sale to a foreign customer you
might have to invoice in their currency.

2. Netting. If you owe your Japanese supplier 1 million ¥, and another Japanese
company owes your Japanese subsidiary 1.1 million ¥, then by netting off
group currency flows your net exposure is only for 0.1 million ¥. This will really
only work effectively when there are many sales and purchases in the foreign
currency. It would not be feasible if the transactions were separated by many
months. Bilateral netting is where two companies in the same group
cooperate as explained above; multilateral netting is where many companies
in the group liaise with the group’s treasury department to achieve netting
where possible.

3. Matching. If you have a sales transaction with one foreign customer then, a
purchase transaction with another (but both parties operating with the same
foreign currency) then this can be efficiently dealt with by opening a foreign
currency bank account. For example: 1 November: should receive $2 million
from US customer 15 November: must pay $1.9 million to US supplier. Deposit
the $2 million in a US $ bank account and simply pay the supplier from that.
That leaves only US $0.1 million of exposure to currency fluctuations. Usually
for matching to work well, either specific matches are spotted (as above) or
there have to be many import and export transactions to give opportunities
for matching. Matching would not be feasible if you received $2 million in
November, but didn’t have to pay $1.9 million until the following May. There

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 aren’t many businesses that can simply keep money in a foreign currency bank
account for months on end.

4. Leading and lagging. Let’s imagine you are planning to go to Spain and you
believe that the euro will strengthen against your own currency. It might be
wise for you to change your spending money into euros now. That would be
‘leading’ because you are changing your money in advance of when you really
need to. Of course, the euro might weaken and then you’ll want to kick
yourself, but remember: managing transaction risk is not about maximising
your income or minimising your expenditure, it is about knowing for certain
what the transaction will cost in your own currency. Let’s say, however, you
believe that the euro is going to weaken. Then you would not change your
money until the last possible moment. That would be ‘lagging’, delaying the
transaction. Note however that this does not reduce your risk. The euro could
suddenly strengthen and your holiday would turn out to be unexpectedly
expensive. Lagging does not reduce risk because you still do not know your
costs. Lagging is simply taking a gamble that your hunch about the weakening
euro is correct.
5. Forward exchange contracts. A forward exchange contract is a binding
agreement to sell (deliver) or buy an agreed amount of currency at a specified
time in the future at an agreed exchange rate (the forward rate). In practice
there are various ways in which the relationship between a current exchange
rate (spot rate) and the forward rate can be described. Sometimes it is given as
an adjustment to be made to the spot rate or the forward rates might be
quoted directly.
However, for each of spot and forward there is always a pair of rates given.
For example:​ Spot €/£ 1.2025 ± 0.03 ie 1.2028 and 1.2022
3 month forward rate ​€/£ 1.2020 ± 0.06 ie 1.2026 and 1.2014

One of each pair is used if you are going to change sterling to euros. So £100
sterling would be changed now for either €120.28 or €120.22. Guess which
rate the bank will give you! You will always be given the exchange rate which
leaves you less well off, so here you will be given a rate of 1.2022, if changing £
to euros now, or 1.2014 if using a forward contract. Once you have decided
which direction one of the rates is for, the other rate is used when converting
the other way. So: € to £ £ to € Spot €/£ 1.2028 – 1.2022 3 month forward rate
€/£ 1.2026 – 1.2014 So, let’s assume you are a manufacturer in Italy, exporting
to the UK.
You have agreed that the sale is worth £500,000, to be received in three
months and wish to hedge (reduce your risk) against currency movements. In
three months you will want to change £ to € and you can enter a binding

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 agreement with a bank that in three months you will deliver £500,000 and that
the bank will give you​ £500,000 x 1.2014 = €600,700​ in return.
That rate and the number of euros you receive is now guaranteed irrespective
of what the spot rate is at the time. Of course if the £ had strengthened against
the € (say to €/£ = 1.5) you might feel aggrieved as you could have then
received €750,000, but income maximisation is not the point of hedging: its
point is to provide certainty and you can now put €600,700 into your cash flow
forecast with confidence.
However, there remains here one lingering risk:
what happens if the sale falls through after arranging the forward contract. We
are not necessarily talking about a bad debt here as you might not have sent
the goods, but you have still entered a binding contract to deliver £500,000 to
your bank in three months’ time.
The bank will expect you to fulfil that commitment, and so what you might
have to do is go to the bank, exchange enough € for £500,000, then
immediately use that to meet your forward contract, receiving €600,700 back.
This process is known as​ ‘closing out’,​ and you could win or lose on it
depending on the spot rate at the time. There is one other way that forward
rates might be given and this is as an adjustment to the spot rates. ​For
example: Spot rate €/£ 1.2501 – 1.2631

3 month forward margin 0.3c – 0.4c pm

Here ‘pm’ appears after the margin. This means SUBTRACT the margin. Note
that the margin is in cents. If ‘dis’ had been after the margin, this means a
discount and this would be ADDED to the spot rate. Note premium and
discount appear to have the reverse meanings to normal. ADD a DISCOUNT,
SUBTRACT a PREMIUM.
Forward contracts are known as ‘over the counter’ arrangements. You have to
meet with your bank and set up the contract on an individual basis/

6. Money market hedging.

Let’s say that you were a UK manufacturer exporting to the US so that in three
months you are due to receive $2 million. You would suffer no currency risk if
that $2 million could be used then to settle a $2 million liability; that would be
matching the currency inflow and outflow.
However, you don’t have a $2 million liability to settle then – so create one that
can soak up the US $. You can create a $ liability by borrowing $ now and then
repaying that in three months with the $ receipt. So the plan is:

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To work out how many $ need to be borrowed now, you need to know $ interest
rates. For example, the US$ 3 month interest rate might be quoted as:

0.54% – 0.66%

It is important to understand that, although this might be described as a ‘3 month

rate’ it is always quoted as an annualised rate. One rate is what you would earn
interest at on a deposit, and the other the rate you would pay on a loan. Again, no
prizes for guessing which is which: you will always be charged more than you earn.
On the dollar loan we will be charged 0.66% pa for three months and the loan has to
grow to become $2 million in that time.

So, If X is borrowed now and three months’ of interest is added:

X(1 + 0.66%/4) = 2,000,000

X = $1,996,705

This can be changed now from $ to £ at the current spot rate, say $/£ 1.4701, to give
£1,358,210.

This amount of sterling is certain: we have it now and it does not matter what
happens to the exchange rate in the future. Ticking away in the background is the

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US$ loan which will amount to $2 million in three months and which can then be
repaid by the $2 million we hope to receive from our customer. That is the hedging
process finished because exchange rate risk has been eliminated

Why might this somewhat complicated process be used instead of a simple forward
contract?

Well, one advantage is that we have our money now rather than having to wait three
months for it. If we have the money now we can use it now – or at least place it in a
sterling deposit account for three months. This raises an important issue when we
come to compare amounts received under forward contracts and money market
hedges. If these amounts are received at different times they cannot be directly
compared, because receiving money earlier is better than receiving it later. To
compare amounts under both methods we should see what the amount received
now would become if deposited for three months. So, if the sterling 3 month deposit
rate were 1.2%, then placing £1,358,210 on deposit for three months would result in:

£1,358,210 (1 + 1.2%/4) = £1,362,285

It is this amount that should be compared to any proceeds under a forward contract.
The example above dealt with hedging the receipt of an amount of foreign currency
in the future. If foreign currency has to be paid in the future, then what the company
can do is change money into sufficient foreign currency now and place it on deposit
so that it will grow to be the required amount by the right time. Because the money
is changed now at the spot rate, the transaction is immune from future changes in
the exchange rate.

Money market hedging is also an over-the counter operation.

Further methods of exchange risk hedging

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There are two other methods of exchange risk hedging which you are required to
know. They involve the use of derivatives: financial instruments whose value derives
from the value of something else – like an exchange rate.

Currency futures​. Simply think of futures contracts as items you can buy and sell on
the futures market and whose price will closely follow the exchange rate.

● Currency futures are standardised contracts for the sale or purchase at a set
future date of a set quantity of currency.
● Contracts have a market price and they can be bought and sold on the futures
market. The market prices follow the exchange rate approximately.
● Losses or profits can be made on futures trading

To hedge​: do the same to the futures now [Buy/sell] as you would do to the currency
in the future Let’s say that a US exporter is expecting to receive €5 million in three
months and that the current exchange rate is $/€1.24. Assume that that is also the
price of $/€ futures. The US exporter will fear that the exchange rate will weaken over
the three months, say to $/€1.10 (that is fewer dollars for a euro). If that happened
then the market price of the future would decline too, to around 1.1. The exporter
could arrange to make a compensating profit on buying and selling futures: sell now
at 1.24 and buy later at 1.10. Therefore any loss made on the main currency
transaction is offset by the profit made on the futures contract.

This approach allows hedging to be carried out using a market mechanism rather
than entering into individual tailored contracts that the forward contracts and money
market hedges required. However, this mechanism does not offer anything
fundamentally new.

Practical points relating to futures

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 ● All futures are priced in US $, eg US $/£ or US $/€
● Contracts are standard sizes: £ = £62,500; € = 125,000; Japanese Yen = 12.5m
● All contracts of standard maturity
● A tick is the smallest movement of a contract price and is 0.0001 of the
contract
● Value of tick = 0.0001 x contract size (€ contract, tick = $12.50 NB priced in $).
● Choose nearest whole number of contracts.
● Choose first expiry contract date after the transaction
● To enter the contract, you have to pay a margin up-front (like a deposit).

Options

Options are radically different. They give the holder the right, but not the obligation,
to buy or sell a given amount of currency at a fixed exchange rate (the exercise price)
in the future. (If you remember, forward contracts were binding.) The right to sell a
currency at a set rate is a put option (think: you ‘put’ something up for sale); the right
to buy the currency at a set rate is a call option.

Suppose a UK exporter is expecting to be paid US$ 1 million for a piece of machinery

to be delivered in 90 days. If the £ strengthens against the US$ the UK firm will lose
money, as it will receive fewer £ for the US$ 1million.

However, if the £ weakens against the US$, then the UK company will gain additional
money. Say that the current rate is $/£ 1.40 and that the exporter will get particularly
concerned if the rate moved beyond $/£1.50. The company can buy £ call options at
an exercise price of $/£ = 1.50, giving it the right to buy £ at $1.50/£. If the dollar
weakens beyond $/$1.50, the company can exercise the option thereby guaranteeing
at least £666,667. If the US$ stays stronger – or even strengthens to say $/£1.20, the
company can let the option lapse (ignore it) and convert at 1.20, to give £833,333.

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This seems too good to be true as the exporter is insulated from large losses but can
still make gains. But there’s nothing for nothing in the world of finance and to buy the
options the exporter has to pay an up-front, non-returnable premium. Options can
be regarded just like an insurance policy on your house. If your house doesn’t burn
down you don’t call on the insurance, but neither do you get the premium back.

If there is a disaster the insurance should prevent massive losses. Options are also
useful if you are not sure about a cash flow. For example, say you are bidding for a
contract with a foreign customer. You don’t know if you will win or not, so don’t know
if you will have foreign earnings, but want to make sure that your bid price will not be
eroded by currency movements. In those circumstances, an option can be taken out:
used if necessary or ignored if you do not win the contract or currency movements
are favourable.

Option pricing

There are two elements to the price of an option:

● Intrinsic value
● Time value

The intrinsic value is determined by the exercise price compared to the current price
of the underlying asset.

For example: a put option allowing you to sell an asset at $5 when the current market
price of the asset is $4, gives an intrinsic value of $1.

Similarly: a call option at an exercise price of $7 when the actual purchase price of
$10 gives an intrinsic value of $3.

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In the two examples above, the option would be said to be ‘in the money’. A put
option at an exercise price of $6 when the market price is $7 is ‘out of the money’ and
has no intrinsic value.

The time value related to the length of time that the option lasts and therefore what
protection it might offer against adverse price movements. Think of how you would
be prepared to pay more for an insurance policy if:

● The period of the insurance increased; and/or

● The volatility of the underlying security increased (greater volatility implies
more protection is given by the option).

In addition the value of a call option increases if general interest rates increase
because the call option allows you to safely defer purchase and to keep your money
earning interest for longer.

Netting Centers
issues that need to be met for success in netting- Currencies, credit
period,settlement dates,exchange rates, conflict resolution, bank managed/bespoke
system)

- Net of cash flows in just one currency, it is more usual for a netting centre to
manage cash ​fl​ ows in several currencies
- Used by a multinational company that has many production and sales
divisions in a number of countries
- Process takes place on a cyclical basis, typically monthly

Without Netting

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With netting (each company pays or receives a single local currency balance to
or from the netting centre)

Swaps

● A cross currency swap allows a company to swap a currency it currently holds

for a different currency for a fixed period, and then swap back at the same
rate at the end of the period.
● Company’s counterparty is generally a bank.
Two elements-

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 - An exchange of principals in different currencies, which are swapped back at
the original spot rate.
- An exchange of interest rates – the timing of these depends on the individual
contract.

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F3 - Chapter 10
Interest Rate Risk Management
Introduction

Risk arises for businesses when they do not know what is going to happen in the
future, so obviously there is risk attached to many business decisions and activities.
Interest rate risk arises when businesses do not know:

● how much interest they might have to pay on borrowings, either already made
or planned; or
● how much interest they might earn on deposits, either already made or
planned.

If the business does not know its future interest payments or earnings, then it cannot
complete a cash flow forecast accurately. It will have less confidence in its project
appraisal decisions because changes in interest rates will alter the weighted average
cost of capital and the outcome of net present value calculations.

There is, of course, always a risk that if a business had committed itself to variable
rate borrowings when interest rates were low, a rise in interest rates might not be
sustainable by the business and that liquidation becomes a possibility.

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Note carefully that the primary aim of interest rate management (and indeed
currency rate management) is not to guarantee a business the best possible
outcome, such as the lowest interest rate it would ever have to pay. The primary aim
is to limit the uncertainty for the business so that it can plan with greater confidence.

Traditional and basic approaches

Matching and smoothing

When taking out a loan or depositing money, businesses will often have a choice of
variable or fixed rates of interest. Variable rates are sometimes known as floating
rates and they are usually set with reference to a benchmark such as LIBOR, the
London Interbank Offered Rate.

For example, LIBOR +3%. If fixed rates are available then there is no risk from interest
rate increases: a $2 million loan at a fixed interest rate of 5% per year will cost
$100,000 per year.

Although a fixed interest loan would protect a business from interest rates rises, it
will not allow the business to benefit from interest rates decreases and a business
could find itself locked into high interest costs and thereby losing competitive
advantage.

Similarly if a fixed rate deposit were made a business could be locked into
disappointing returns.

Smoothing

In this simple approach to interest rate risk management the loans or deposits are
simply divided so that some are fixed rate and some are variable rate. Looking at
borrowings, if interest rates rise, only the variable rate loans will cost more and this

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will have less effect than if all borrowings had been at variable rate. Deposits can be
similarly smoothed. There is no particular science about this.

The business would look at what it could afford, its assessment of interest rate
movements and divide its loans or deposits as it thought best. Matching This
approach requires a business to have both borrowed and deposited money. The
closer the two the amounts the better.

For example, let’s say that the deposit rate of interest is LIBOR + 1% and the
borrowing rate is LIBOR + 4%, and that $500,000 is deposited and $520,000
borrowed. Assume that LIBOR is currently 3%.

Currently:

Annual interest paid = $520,000 x (3 + 4)/100 = $36,400

Annual interest received = $500,000 (3 + 1)/100 = $20,000

Net cost = $16,400

Now assume that LIBOR rises by 2% to 5%

New interest amounts:

Annual interest paid = $520,000 x (5 + 4)/100 = $46,800

Annual interest received = $500,000 (5 + 1)/100 = $30,000

Net cost = $16,800

The increase in interest paid has been almost exactly offset by the increase in
interest received. The extra $400 relates to the mismatch of the borrowing and
deposit of $20,000 x increase in LIBOR of 2% = $20,000 x 2/100 = $400.

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Asset and liability management

This relates to the periods for which loans (liabilities) and deposits (assets) last. The
issues raised are not confined to variable rate arrangements because a company can
face difficulties where amounts subject to fixed interest rates or earnings mature at
different times.

Say, for example, that a company borrows using a ten-year mortgage on a new
property at a fixed rate of 6% per year. The property is then let for five years at a rent
that yields 8% per year. All is well for five years but then a new lease has to be
arranged. If rental yields have fallen to 5% per year, the company will start to lose
money. It would have been wiser to match the loan period to the lease period so that
the company could benefit from lower interest rates – if they occur.

Forward rate agreements (FRA)

These arrangements effectively allow a business to borrow or deposit funds as

though it had agreed a rate which will apply for a period of time. The period could,
for example, start in 3 months’ time and last for 9 months after that.

Such an FRA would be termed a 3 – 12 agreement because it starts in 3 months and

ends after 12 months. Note that both parts of the timing definition start from the
current time. The loans or deposits can be with one financial institution and the FRA
can be with an entirely different one, but the net outcome should provide the
business with a target, fixed rate of interest.

This is achieved by compensating amounts either being paid to or received from the
supplier of the FRA, depending on how interest rates have moved. Technically, if you
are borrowing, you buy an FRA; if you are depositing money you would sell an FRA.
FRAs are ‘over the counter’ instruments.

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Interest rate derivatives

The interest rate derivatives that will be discussed are:

● Interest rate futures

● Interest rate options
● Interest rate caps, floors and collars

Interest rate futures

Futures contracts are of fixed sizes and for given durations. They give their owners
the right to earn interest at a given rate, or the obligation to pay interest at a given
rate.

Selling​ a future creates the obligation to borrow money and the obligation to pay
interest

Buying​ a future creates the obligation to deposit money and the right to receive
interest.

Interest rate futures can be bought and sold on exchanges such as LIFFE, the London
International Financial Futures Exchange.

The price of futures contracts depends on the prevailing rate of interest and it is
crucial to understand that as interest rates rise, the market price of futures contracts
falls. In fact, the price of a futures contract is 100 – the interest rate.

Think about that and it will make sense: say that a particular futures contract allows
borrowers and lenders to pay or receive interest at 5%, which is the current market
rate of interest available. Now imagine that the market rate of interest rises to 6%.
The futures contract has become less attractive to buy because depositors can earn

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6% at the market rate but only 5% under the futures contract. The price of the
futures must fall.

Similarly, borrowers will now have to pay 6% but if they sell the future contract they
have to pay at only 5%, so the market will have many sellers and this reduces the
selling price until a buyer-seller equilibrium price is reached.

● A rise in interest rates reduces futures prices.

● A fall in interest rates increases futures prices.

Remember: price of the futures contract = 100 – interest rate.

Interest rate option contracts are for fixed amounts (typically £500,000) lasting for
only 3 months.

So to obtain cover for a £3m loan for 6 months the number of contracts needed
would be

£
​ 3m/£0.5m x 6 months/3 months = 12 contracts.
In practice, futures price movements do not move perfectly with interest rates so
there are some imperfections in the mechanism. This is known as b ​ asis risk.

The approach used with futures to hedge interest rates depends on two parallel
transactions:
● Borrow/deposit at the market rates
● Buy and sell futures in such a way that any gain that the profit or loss on the
futures deals compensates for the loss or gain on the interest payments.

Borrowing or depositing can therefore be protected as follows:

Depositing and earning interest

The depositor fears interest rates falling as this will reduce income.
If interest rates fall, futures prices will rise, so buy futures now (at the relatively low

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price) and sell later (at the higher price).
The gain on futures can be used to offset the lower interest earned. Of course, if
interest rates rise the deposit will earn more, but a loss will be made on the futures
(bought at a relatively high price then sold at a lower price).
As with FRAs, the objective is not to produce the best possible outcome but to
produce an outcome where the interest earned plus the profit or loss on the futures
deals is stable.

Borrowing and paying interest

The borrower fears interest rates rising as this will increase expense.
If interest rates rise, futures prices will fall, so sell futures now (at the relatively high
price) and buy later (at the lower price).

The gain on futures can be used to offset the lower interest earned.

Students are often puzzled by how you can sell something before you have bought it.
Simply remember that you don’t have to deliver the contract when you sell it: it is a
contract to be fulfilled in the future and it can be completed by buying in the future.
Of course, if interest rates fall the loan will cost less, but a loss will be made on the
futures (sold at a relatively low price then bought at a higher price). Once again, the
aim is stability of the combined cash flows.

Summary
The summary rule for interest rate futures is:

● Depositing: buy futures then sell

● Borrowing: sell futures then buy

Interest rate options

Interest rate options allow businesses to protect themselves against adverse interest
rate movements whilst allowing them to benefit from favourable movements.
They are also known as interest rate guarantees. Options are like insurance policies:
(1) You pay a premium to take out the protection. This is non-returnable whether or

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not you make use of the protection.
(2) If interest rates move in an unfavourable direction you can call on the insurance.
(3) If interest rates move favorably you ignore the insurance.
Options are taken on interest rate futures and they give the right, but not the
obligation, either to buy the futures or sell the futures at an agreed price at an
agreed date.
Interest rate option contracts are for fixed amounts (typically £500,000) lasting for
only 3 months. So to obtain cover for a £3m loan for 6 months the number of
contracts needed would be £3m/£0.5m x 6 months/3 months = 12 contracts.

Using options when borrowing

As explained above, if using simple futures the business would sell futures now then
buy later. When using options, the borrower takes out an option to sell a future at
today’s price (or another agreed price).
Let’s say that price is 95. An option to sell is known as a put option (think about
putting something up for sale). If interest rates rise the futures price will fall, let’s say
to 93.
Therefore the borrower will buy at 93 and will then choose to exercise the option by
exercising their right to sell at 95. The gain on the options is used to offset the extra
interest that has to be paid. If interest rates fall the futures price will rise, let’s say to
97. Obviously, the borrower would not buy at 97 then exercise the option to sell at
95, so the option is allowed to lapse and the business will simply benefit from the
lower interest rate.

Using options when depositing

As explained above, if using simple futures the business would buy futures now then
sell later. When using options, the investor takes out an option to buy at today’s price
(or another agreed price). Let’s say that price is 95.
An option to buy is known as a call option. If interest rates fall the futures price will
rise, let’s say to 97. The investor would therefore sell at 97 then exercise the option to
buy at 95. The gain on the options is used to offset the lower interest that has been
earned. If interest rates rise the futures price will fall, let’s say to 93.
Obviously the investor would not sell futures at 93 and exercise the option by
insisting on their right to sell at 95. The option is allowed to l​ apse​ and the investor

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enjoys extra income from the higher interest rate.
Options therefore give borrowers and lenders a way of guaranteeing minimum
income or maximum costs whilst leaving the door open to the possibility of higher
income or lower costs.
These ‘heads I win, tails you lose’ benefits have to be paid for and a non-returnable
premium has to be paid up front to acquire the options.

Interest rate caps, floors and collars

Interest rate cap​: A cap involves using interest rate futures options to set a
maximum interest rate for borrowers. If the actual interest rate is lower, the option is
allowed to lapse. This is simply the explanation above of using an option when
borrowing and the borrower would buy a put option.

Interest rate floors:​ A floor involves using interest rate futures options to set a
minimum interest rate for investors. If the actual interest rate is higher the investor
will let the option lapse. This is simply the explanation above of using options wen
depositing and the investor would buy a call option.

Interest rate collar:​ A collar involves using interest rate options to confine the
interest paid or earned within a predetermined range. A borrower would buy a cap
(buy a put) and sell a floor (sell a call), thereby offsetting the cost of buying a cap
against the premium received by selling a floor.
Note this is the first time we have dealt with selling an option: previously we have
bought puts or calls. Selling the call option allows the other party to insist on
receiving interest at a minimum rate. If actual rates are lower than this, we will end
up having to pay that person interest – hence a floor is set for us as borrowers.

A depositor would buy a floor and sell a cap.

Interest rate swaps

In interest rate swaps: two parties agree to exchange interest payments with each
other over an agreed period.

● There have to be advantages to both parties.

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 ● The advantages usually arise because the parties are offered different terms
for fixed and floating rate loans and these differences can be exploited.

For example:
Company A can borrow at a fixed rate of 8% or at a variable rate of LIBOR + 2%
Company B can borrow at a fixed rate of 9% or at a variable rate of LIBOR + 5%.

Company A wants to have a fixed rate loan and Company B wants a variable rate
loan. Show how both companies can borrow from an interest rate swap. If each
company borrows the type of loan it wants, Company A will borrow fixed at 8% and
Company B will borrow variable at LIBOR + 5%.
The total interest bill will be:
LIBOR + 5% + 8% = LIBOR + 13%
If they borrow in the ways they don’t want, Company A will borrow variable at LIBOR
+ 2% and
Company B will borrow fixed at 9%.
The total interest bill will be: LIBOR + 2% + 9% = LIBOR + 11%.

There is therefore a 2% difference that the companies should be able to exploit by

borrowing in the ways they don’t want then swapping the interest rate payments so
that they pay fixed/variable as they wish.
They can split the 2% advantage in whatever way they want to. In the following
solution it has been assumed that they enjoy 1% each, so at the end of the swap,
Company A will be paying fixed rate interest but at 8 – 1 = 7%, and Company B will be
paying variable rate interest but at LIBOR + 4%.

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In practice there are many ways in which the swap could take place, but the key is to
ensure that each party ends up better than they would have if borrowing what they
wanted directly.
In this example, two companies cooperated without any intermediary. In practice,
this matchmaking can be difficult to bring off as each company needs to find another
it trusts with complementary needs.
Instead, swaps are often arranged directly with a bank, or through a bank which will
either pay or accept LIBOR in exchange for fixed interest. The bank will take a cut.

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119
Chapter 11 - ​Financial and strategic implications
of mergers and acquisitions

MERGER ​: Two entities joining together to submerge their entity to form a new entity.

ACQUISITION ​: an entity acquires majority shares of another.

TYPES OF ACQUISITIONS OR MERGERS

Horizontal integration:
A company acquires or merges with a similar or competitive business.
Eg: standard oil’s acquisition of 40 other refineries.

Vertical integration:
A company takes control of one or more stages in the production or distribution of a
product.
Eg: Carnegie steel company bought iron mines to ensure supply and railroads to
strengthen distribution.

Conglomerate:
Two entities of unrelated business combine
Eg: amazon acquiring whole foods.

REASONS FOR GROWTH BY ACQUISITION OR MERGER:

● Increased market share:

In a market with limited product differentiation price is the competitive weapon.
In this case larger market share enables to drive prices, eg: reduce prices and later
increase.
● Economies of scale:
Horizontal and vertical integration gains economies like avoiding duplication
Conglomerate gains economies like offices, accounting departments being
rationalized.
● Combining complementary needs:

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When a small company with a unique product idea and with a lack of engineering to
market it on a large scale merges with a large company, the small entity gets the
marketing departments and the large company enjoys the benefits of selling unique
products.
● Improving efficiency
A company with poor management, when acquired the management can be
improved.
● Lack of profitable investment opportunities- surplus cash:
A company with surplus cash and with few profitable investment opportunities can
use this cash to acquire entities.
● Tax relief:
An entity unable to claim tax relief due to insufficient profit can merge with a
company with sufficient profit to gain tax relief.
● Asset stripping:
Acquiring an undervalued company and selling off its individual assets like fixed.
● Big data:
The knowledge and expertise of the target company can increase the amount of big
data in predator companies.

SYNERGY:

Two or more entities combining together to produce a result that is not

independently attainable.

SOURCES OF SYNERGY:

Operating economies:

● Economies of scale:
Horizontal integration is often said to reduce costs and increase profit. This is not
automatic, and diseconomies can also be experienced.

● Economies of vertical integration:

Eg: manufacturer buying our retailer. This increases profit by ‘cutting the middleman’.

●Complementary resources:
Combining the strengths of two companies a synergic result is obtained. Eg; a
company specialising in R&D merging with a company specialised in Marketing area
could lead to gains.

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 ●Elimination of inefficiency:
When the victim company is badly managed its value can be improved by elimination
of inefficiency.

Financial synergy:

● Diversification:
Though the merging company’s earnings stays the same without any operating
economies there is still an increase in value by reducing risk.

● The ‘boot strap’ or Pe game

A company with high PE ratios aae good to acquire as they could impose its PE ratio
and increase the value of the company.
Other synergy effects
● Surplus management talent:

Companies with highly skilled managers can use the managing skill only during
crises.
Acquiring inefficient companies is a way to use surplus management skills.

Speed :
●
Acquisition is faster than the organic growth in obtaining a presence in a new and
growing market.

IMPACT OF MERGERS AND ACQUISITIONS:

● Impact on acquiring company’s shareholders

The acquisition must also benefit the acquiring company’s shareholders
The acquiring company often pays a premium to shareholders of the target company
to encourage them to sell the shares, thus they have a financial benefit.

● Impact on lender or debt holders

The risk profile of the acquirer company is different from the original borrower, most
of the banks do not have the change control clause.
Thus the acquirer company has to make arrangements for new financing, prior to
takeover.

Impact on managers and staffs:

●
The acquirer may make some staff of the acquiring company redundant, so it is a
dread to them.
Managers of acquiring companies can demand for a hike in salary as they have got to
manage a larger company.

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 ● Impact on society as a whole:
The government monitors takeovers carefully, if they feel that it is not in its best
interest then the takeover can be stopped.
Competition laws in many countries prevent the creation of a monopoly as it may
lead to exploitation.

PROBLEMS WITH ACQUISITIONS:

● The benefits of acquisitions cannot be attained automatically, the company

has to work effectively to attain the desired result.
● The cultural clashes between two companies can make the integration difficult.
● The premium paid on acquisition is may be too high so that the shareholder
value of the acquiring company is reduced as a result of acquisition.
● The opportunity cost of the investment may be too high.

TAX IMPLICATIONS OF MERGERS AND ACQUISITIONS:

1. Difference in tax rates and double tax treaties:

● Different countries around the world have different tax rates.
● When a company acquires another company based in a different country,
there are different tax rates for two companies.
● The Organisation of Economic Cooperation Development has published a
double taxation convention.
● The double tax treaty is drawn up between two counties to decide which
country shall have the right to tax income.
1. Group relief:
● Group loss relief allows members of a group of companies to transfer certain
losses to other members of the group.
● Group loss is available for losses and profits generated only after the company
joins the group.
1. Withholding tax:
● A government requirement for the payer of an item of income to withhold or
deduct tax from the payment, and pay that tax to the government.
● In the context of groups of companies, withholding taxes need to be
considered when one company makes payments to another within the group
(for example as dividends, or interest on loans).

THE ROLE AND SCOPE OF COMPETITION AUTHORITIES:

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Due to the existence of well-developed capital markets it is comparatively easy to
launch takeovers in the UK and the US. To prevent monopolies forming, the US has
strong anti-trust legislation and the UK has the Competition and Markets Authority
(CMA).
In continental Europe and Japan, banks (rather than shareholders) have traditionally
taken a more direct role in financing and directing corporate activity. Other
stakeholders such as employees and suppliers have also been more influential.
However, the growth of global capital markets has seen the market for corporate
control expand into Europe and the Far East. If capital is to be attracted to markets
then there must be attractive investment opportunities available to it.

The following are examples of the general principles of the City Code:
(1) All shareholders of the same class must be treated the same and given the same
information
(2) Sufficient relevant information and time must be given to shareholders
(3) Once an offer is made, directors cannot frustrate it without shareholders approval
(4) General offer to all other shareholders is required if the predator acquires control.

Anti- competitive ;
A merger or acquisition is said to be anti-competitive when it seems to lessen the
competition or that would impede effective competition.

Public interest

To assess whether a merger or acquisition is in the 'public interest', the competition

authorities will consider factors such as

• National security (including security of energy and food supplies)

• Media quality
• Financial stability (e.g. protecting the stability of banks and financial services)

Predator issues on takeover

The investment decision

● How much is the target worth to the predator?
● Are the target shareholders willing to sell?
● What economic / industry and company assumptions underlying the
valuation?

The financing decision

(1) Matching

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has the predator adequate surplus cash / borrowing capacity / ability to issue shares?
can the group service the new finance required for the acquisition?

(2) Cost
will the use of cash or shares change the predator’s capital structure for better or
worse?

(3) Capital providers

will any existing debt covenants or existing shareholder expectations be affected?
could the predator issue convertibles to delay control dilution issues? is the current
dividend policy desirable / sustainable after the acquisition? will the EPS be affected,
and does it matter?

Market issues
Often target companies are overvalued because of:

● Over optimism with regard to economies of scale

● The victim’s share price anticipating synergistic gains
● The victim’s share price may be ‘bid up’ in an auction

Target issues on takeover

● What is the target worth to the predator – can we extract maximum value?
● What is the target worth to us?
● Do we want to sell?
● What is the after personal tax value of the offer?
● If the offer is in shares, are they attractive?

Market issues
The target company shareholders are the ones who must approve the offer.
Generally, most of the benefits on a takeover accrue to the target company
shareholders.

Defensive tactics

(1) Provide more information Contest the offer on terms of being a poor offer, having
no obvious advantage, and / or employee opposition Issue forecasts to indicate that
the sale of the shares is not a good option Revalue the assets Advertise (subject to
the City Code)
(2) Lobby to have the offer referred to the Competition Commission

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(3) Stop shares falling into the predator’s hands Find a White Knight (an alternative
bidder who would be more acceptable) Arrange a management buyout
(4) Poison Pill tactic, whereby the target builds in a tripwire to make itself less
attractive. E.g. create a new class of stock which automatically becomes redeemable
at a high price in the event of a take-over.

DIVESTMENT:

Disposing of part of its activity by an entity.

Reason for divestment:

Sum of parts of the entity is worth more than the whole:

● A business with many disparate parts actually ends up suffering from the
opposite effect.
● Eg: a company could spend money to integrate units where there are no
benefits. Such units must be considered to diversify.

​ Diversifying unwanted or less profitable parts:

● An underperforming business unit fails to meet general company performance

targets.
● The management should also consider the effect of divestment on other parts
of the company.

S
​ trategic change;

● A part of business which operates in different market sectors has to be

considered for divested.
● Increased focus on the company's core activities should help to develop
expertise in management.

​ A response to crisis:

● When cash is needed in a crisis time quickly, a part of business has to be

divested to make cash.

Examples of divestment:
Sell off​ : sale of part of an entity to third party usually in return for cash

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Spin off: new company is created through the sale or distribution of an existing
business.

MANAGEMENT BUYOUTS:

● Purchase of business from its existing owners by members of the

management team.
● The management provides some of the capital but majority is provided by
other financiers like financial institutions.

Considerations before MBO:

● Do the currents owners wish to sell

● Potential of the business: the performance of the business has to be analysed
and a business plan has to be drawn. The managers must attempt to
appreciate the risks that would arise and take steps to reduce the risk.
● Loss of head office support: many of the services are lost in an MBO like
support in areas of financing, research and development etc. though head
office fees might me saved after buyouts the support services can involve
considerable expenses when purchases outside the market.
● Quality of management team : the success of the MBO will be influenced by
the quality of the management team. A united approach is needed in all
negotiations and clear responsibility structure should be made within the
team.

Financing the MBO:

In an MBO, unlike a corporate-backed takeover, the acquiring group usually lacks the
financial resources to fund the acquisition. For small buyouts the price may be within
the capabilities of the management team, but it is unlikely that many managers could
raise the large amounts involved in some buyouts. Several institutions specialise in
providing funds for MBOs.

These include the following:

• venture capitalists
• banks
• private equity firms
• other financial institutions.

EXIT STRATEGY:

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An exit strategy is a contingency plan that is executed by an investor, trader, v ​ enture
capitalist​,​ or business owner to ​liquidate​ a position in a financial asset or dispose of
tangible business assets​ once predetermined criteria for either has been met or
exceeded.

Exit strategy for equity shareholders:

The most common exit strategy is selling of shares to another investor. That selling
can be done in following ways.

Trade sale:

● In a trade sale normally the shares are acquired by the bidding

company,so the management would have to sell their shares to their
own company.

​ Initial public offering:

● The IPO gives a chance to the financiers to sell their shares on the stock
market.
● The problem is the company has to satisfy certain criteria in order to
join the stock exchange.
● After the IPO the shares will be freely traded which will increase the
marketability and hence their value.
● The company ao becomes susceptible to take over when its shares are
listed.

I​ ndependent sale to another shareholder:

● The managers could try to increase their shareholdings in the company

by 'buying out' the other financiers.
● This would be expensive, but if the managers could afford it, it would
prevent other external shareholders buying the shares and having a say
in the running of the business.

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Chapter 12 - ​Business Valuation

Introduction

In this chapter we will look at what, in theory, determines the market value of equity
and of debt. It is this theory which forms the basis for most of the arithmetic that is
generally required in the examination in questions on this area.

In practice many other factors are likely to be relevant. These will be covered in the
next chapter, and although important they are more relevant for discussion
questions than for computations.

T
​ he valuation of equity – constant dividends

The market value of a share is effectively determined by the shareholders – it is the

price that shareholders are prepared to pay for a share on the stock exchange. In
theory, the amount that shareholders are prepared to pay depends on two factors:

● the dividends that they expect to receive in the future

● the rate of return that shareholders require

The valuation of equity – constant growth rate in dividends

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We can use the dividend valuation model to derive a formula for the market value of
a share.

The proof of this is not in the examination syllabus – you are only expected to be
able to use the following formula:

P0 (ex-div) = D0 (1 + g) / P0 (ex-div) = (ke − g)

where: D0 = the current dividend ke = the shareholder’s required rate of return g =

the expected rate of growth in dividends.

In practice, it is unlikely that dividends will grow at a constant rate. However,

appreciate that the market value is based on the dividends that shareholders expect
to receive. Shareholders are perhaps more likely to expect an average rate of growth
p.a. than expect that the dividends will grow at different specific rates each year.

In the examination you will only be expected to deal with a constant rate of growth
and therefore to use the formula.

The valuation of equity – discounted cash flow

The free cash flow is the cash available for distribution to lenders and shareholders.
It can be calculated from accounting information as follows:

Profit before interest and tax (operating profit) X

Add: Depreciation (non-cash) X

Less: Investment in non-current assets (X)

Less: Investment in working capital (X)

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Less: Tax (X)

FREE CASH FLOW ​ XX

The value of the business can then be found by discounting the free cash flows at the
weighted average cost of capital, and the value of equity is then found by deducting
the value of debt.

The free cash flow to equity is the cash available for distribution to shareholders,
taking into account the free cash flows after payment of interest to the debt holders.
The value of equity is then calculated by discounting the free cash flows to equity at
the cost of equity.

The valuation of debt

Here we are talking about traded debt. This is debt borrowing that is traded on a
stock exchange and therefore has a market value. Unless you are told otherwise,
debt is traded in units of $100 nominal and is referred to as ‘debentures’, ‘loan stock’,
or ‘bonds’ – they are essentially different words for the same thing.

Debt (in the examination) carries a fixed rate of interest, but this is based on the
nominal value of the debt. This rate of interest is known as the coupon rate. The
market value at any time will depend on the rate of return that investors are
currently requiring. The basis of valuation is, in theory, exactly the same as for equity:
The market value of debt is the present value of future expected receipts
discounted at the investors required rate of return.

The valuation of debt – irredeemable debt

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Irredeemable debt is debt that is never repaid. The holder of this debt will simply
receive interest each year for ever (unless they choose to sell it on the stock
exchange, in which case the purchaser will continue to receive the interest).

The market value of irredeemable debt can be expressed as a formula as follows:

P0 (ex-int) = I / kd

Where:

I = the interest per annum on $100 nominal

kd = the investors required rate of return

The valuation of debt – redeemable debt

In practice, debt is not irredeemable but redeemable which means that the company
will repay the borrowing at some specified date in the future. The valuation of
redeemable debt is the one place where there is no formula and where we have no
choice but to use first principles and discount the future cash flows to present value
at the investor’s required rate of return.

Limitations of the dividend valuation model

Although expected future dividends and the shareholders required rate of return
certainly do impact upon the market value of shares, it would be unrealistic to expect
the theory to work perfectly in practice.

Main reasons for this include:

● The stock exchange is not perfectly efficient, and therefore the market value of
a share may be distorted from day-to-day by factors such as rumours about a
takeover bid.

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 ● In practice, market values do not change instantly on changes in expectations
– the speed at which the market value changes depends on the volume of
business in the share.
● The model only deals with constant growth in dividends. In practice this may
not be the case. However, do appreciate that the growth used in the model is
the future growth that shareholders are expecting – this is perhaps more likely
to be at a constant rate. The big problem is determining the rate of growth
that shareholders expect! It is clearly impossible to ask them and to any
estimate that we make for our calculations is only an estimate and of course
be completely different from the rate of growth that shareholders are in fact
expecting.

Financial accounts based valuations of equity

Other common, practical approaches to valuing shares in unquoted companies are:

Net assets basis

The value of the entity is based upon the value of the net assets in its financial
statements.

A problem of this valuation is on what basis to value the net assets.

The following basis can be considered:

● Realisable value – this would only be sensible if the company was about to be
wound up
● Replacement value – this would be more sensible from the point of view of
another company considering making an offer for the shares in our company.
However, it would be ignoring the value of any goodwill.
● Book value – this is normally of little relevance, since the book values of assets
are unlikely to even approximate to the actual values.

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Further issues are the value of intangibles that may not be recognised in the financial
statements and contingent liabilities that are not recognised either. If the values of
both are included, it will impact the value of the net assets. This valuation method is
the minimum value of an entity but can be an appropriate valuation technique for a
capital intensive business.

Earnings basis

This approach uses the price earnings ratio of a similar quoted company, which can
then be applied to the earnings of the target company to calculate a value of the
entity.

Market value per share = P/E ratio x EPS

For example, if the latest set of accounts for a publishing company show earnings per
share of 50c, and quoted publishing companies currently have P/E ratios of 18, then
the price per share for our company would be

50c × 18 = $9 per share.

If the predator company believes that it can improve the earnings of the target
company it may choose to use a higher P/E ratio to apply to the target company’s
earnings, commonly using its own P/E ratio. This process is referred to as
bootstrapping.

Intangible asset valuations

To calculate the value of a company’s intangible assets the calculated intangible value
(CIV) approach is commonly adopted. The calculation involves comparing the
company’s return on assets with the industry average and any excess is deemed to
be attributable to the company’s intangible assets.

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Systematic and unsystematic risk

There are two elements that make up the risk associated with a company:

•​ Unsystematic (or specific) risk​ is the risk of the company's cash flows being
affected by specific factors like strikes, R&D successes, systems failures, etc.

•S
​ ystematic (or market) risk​ is the risk of the company's cash flows being affected
to some extent by general macro-economic factors such as tax rates, unemployment
or interest rates.

The impact of diversification

By holding a portfolio of investments, the unsystematic risk is diversified away but

the systematic risk is not, so will be present in all portfolios.

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For example, the return from a single investment in an ice-cream entity will be
subject to changes in the weather – sunny weather producing good returns, cold
weather poor returns. By itself the investment could be considered a high risk. If a
second investment were made in an umbrella entity, which is also subject to weather
changes, but in the opposite way, then the return from the portfolio of the two
investments will have a much- reduced risk level. This process is known as
diversification, and when continued can reduce portfolio risk to a minimum.

If an investor enlarges his portfolio to include approximately 25 shares the

unsystematic risk is reduced to close to zero, the implication being that we may
eliminate the unsystematic portion of overall risk by spreading investment over a
sufficiently diversified portfolio.

Asset betas, equity betas and debt betas

In order to calculate the cost of equity and / or WACC for use in business valuation,
we first need to expand our understanding of beta factors.

• The beta factor is a measure of the systematic risk of an entity relative to the
market.

• This risk will be dependent on the level of business risk and the level of financial risk
(gearing) associated with an entity.

• Hence, the beta factor for a geared company will be greater than the beta factor for
an equivalent ungeared company.

The relationship between the beta factors for ungeared and geared companies is
given by the following formula (given in the exam):

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Application to business valuation

There are two ways in which the gearing/gearing formula above can be used in order
to derive a cost of equity and/or a WACC that can be used in business valuation.

Both methods start from the assumption that you have been given an equity beta for
a proxy company.

•​ Method 1:​ Use the formula to derive the proxy entity's ungeared beta factor.
Assume that this beta factor also reflects the business risk of the entity being valued,
so regear this ungeared beta to reflect the capital structure of the entity being
valued. Then use CAPM to derive a cost of equity for the entity being valued and (if
necessary) use this ke in the standard WACC formula to find the entity's WACC.

• Method 2​: Use the formula to derive the proxy entity's ungeared beta factor, then
use CAPM to find an 'ungeared cost of equity' (keu) for the proxy entity. On the
assumption that this key is also a measure of theungeared cost of equity of the entity

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being valued (same business risk), use M & M's WACC formula to calculate the WACC
of the entity being valued.

(Note: Method 2 can only be used to calculate WACC, whereas Method 1 derives both
cost of equity and WACC.)

Both methods will now be illustrated, to show that they give the same answer for
WACC.

The EMH and business valuation

Implications of the Efficient Market Hypothesis (EMH) in business valuation

The level of efficiency in the market is very important when considering the value of a
business.

According to the Efficient Market Hypothesis (EMH) the share price is a sum of all the
known information about a company. As such the share price is always a ‘fair price’
and a true valuation – a particular share is neither under or over valued at any point
in time. This means that without additional information, currently not taken into
account by the share price, no investor will be able to ‘beat the market’.

The only way to get higher returns, would be to invest in higher risk (higher beta
factor) investments.

Weak form of efficiency

In the weak form of market efficiency, the share price will reflect any and all
information that can be discerned by past trends in share prices. The day traders and
other investors who attempt to speculate by studying past trends and predicting
future movements will be wasting their time (and money) if markets are weak form
efficient.

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If such speculators can foresee movements then their actions will have the effect of
updating the share price. The very fact of them, say, buying shares that are going to
increase in price will push up the price.

Semi-strong form of efficiency

In the semi-strong form of the EMH, the share price will reflect all information that is
publicly available. Analysts who study press reports, financial statements and
economic figures in order to identify mispriced shares are wasting their time if the
semi-strong form of the EMH is true.

Again, though, it could be possible to benefit from the ability to follow news in real
time and to respond to events before they become public knowledge. Investors
generally subscribe to information sources that give immediate access to news as
soon as it is released, and before it has been broadcast. Again, their response to such
news will enable the market to update itself because a flurry of sales by major
investors will signal that "bad" news has become available.

Strong form of efficiency

In the strong form of the EMH, the share price will reflect all information, even if it
has not been made publicly available. That may not seem credible, but information
could be leaked because of, say, insider trading.

The markets may not know why blocks of shares are being purchased or sold, but
the fact that someone is trading will suggest that an unknown person is in possession
of some facts and the price may respond accordingly. Insider trading is illegal, but
that does not always deter perpetrators.

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Chapter 13 - ​Pricing Issues and Post Transaction
Issues

Defenses against hostile takeover bids

A hostile takeover bid occurs when an entity attempts to take control of a publicly
traded company without the consent or cooperation of the target company's ​board
of directors​. In this case the shareholders might be interested in the bid.

Pre-bid defences

● Communicate effectively with shareholders

● Revalue non-current assets
● Poison pill strategy
● Super majority
● Post-bid defences
● Appeal to their own shareholders
● Attack the bidder
● White Knight strategy
● Counterbid, or Pacman defence
● Competition authorities

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The form of consideration for a takeover Introduction

When one firm acquires another, two questions must be addressed regarding the
form of consideration for the takeover:

● What form of consideration should be offered? Cash offer, or share exchange,

or earn-out are the three main choices.
● if a cash offer is to be made, how should the cash be raised? The choice is
generally debt finance or a rights issue to generate the cash (if the entity does
not have enough cash already).

Cash

SHARE EXCHANGE

In a share exchange, the bidding company issues some new shares and then
exchanges them with the target company shareholders.

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Earn out

Earnout or earn-out refers to a pricing structure in ​mergers and acquisitions​ where

the sellers must "earn" part of the purchase price based on the performance of the
business following the acquisition

Earn-out arrangements are often employed when the buyers and sellers disagree
about the expected growth and future performance of the target company. The
financial targets used in an earn-out calculation may include revenue, net income,
EBITDA or EBIT targets.

Limitations of earn-outs

Earn-outs have several fundamental limitations

They generally work best when the business is operated as envisioned at the time of
the transaction, rather than in circumstances where the business plan changes, often
in response to a change in the business environment. In some transactions, the
buyer may have the ability to block the earn-out targets from being met. Outside
factors may also impact the company's ability to achieve earn-out targets. Sellers
need to negotiate earn-out terms very carefully, taking into account all these issues.

Summary of the key issues relating to forms of consideration

Methods of financing a cash offer

If the bidding company has a large cash surplus, it might be able to make a cash offer
without raising any new finance. However, in most cases, this will not be the case, so

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various financing options will have to be considered by the bidding company. The
main two options are debt or a rights issue.

Debt​-

The bidding company could borrow the required cash from the bank, or issue bonds
in the market. The advantage of using debt in this situation is the low cost of
servicing the debt. However, raising new debt finance will increase the bidding
company's gearing. This will increase the risk to the bidding company's shareholders,
so might not be acceptable to the shareholders

Rights issue-

If the bidding company shareholders do not want to suffer the increased risk which
debt finance would bring, the alternative would be for the bidding company to offer a
rights issue to its existing shareholders. The funds raised can then be used to buy the
shares in the company being acquired. Gearing levels are thereby protected. From
the shareholders' point of view, the problem with this financing option is that it is the
shareholders themselves who have to find the money to invest.

Evaluating a share for share exchange

One popular question is to comment on the likely acceptance of a share for share
offer. It is vitally important to be able to identify the likely synergy generated in the
acquisition in order to assess the attractiveness of the offer accurately. The
procedure is as follows:

● Value the predator company as an independent entity and hence calculate the
value of a share in that company.
● Repeat the procedure for the victim company
● Calculate the value of the combined company post integration. This is
calculated as: Value of predator company as independent company X Value of
victim company as independent company X Value of any synergy X Total value
of combined company X
● Calculate the number of shares post integration: Number of shares originally
in the predator company X Number of shares issued to victim company X -
Total shares post integration X

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 ● Calculate the value of a share in the combined company, and use this to assess
the change in wealth of the shareholders after the takeover.

Treatment of target entity debt

A material adverse change clause is often used to make the target entity's
borrowings repayable if the company is sold. Therefore, when considering how to
fund a takeover, the bidding company will have to ensure that sufficient funds are
available to purchase the shares from the target entity's shareholders, and to repay
the debt in the target entity

The post-merger or post-acquisition integration process

Introduction to the post-merger or post-acquisition process Mergers and acquisitions

often fail to deliver the anticipated synergies as a result of failing to effectively
integrate the newly acquired entity into the parent. Poor planning and a lack of
information to guide the integration plans ahead of the acquisition will lead to
post-acquisition integration problems.

Druker’s Golden Rules P. F. Druker (1981) identified five Golden Rules to apply to
post-acquisition integration.

1 Ensure a ‘common core of unity’ is shared by the acquired entity and

acquirer. Shared technologies or markets are an essential element.

2 The acquirer should not just think ‘What is in it for us?’, but also ‘What can we
offer them?’

3 The acquirer must treat the products, markets and customers of the
acquired entity with respect

4 Within 1 year, the acquirer should provide appropriately skilled top

management for the acquired company.

5 Within 1 year, the acquirer should make several cross-entity promotions of

staff.

Impact on ratios or performance measures

Following the completion of an acquisition the purchaser will need to examine

thoroughly the financial and management accounting records of each business unit

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of the acquired entity. Thus, the directors of the acquirer will be particularly
interested in the financial condition of those units which they might plan to dispose
of. From a strategic point of view these are likely to be of more use to another entity
with whom they would form a better fit. However, it is still essential that financially
and operationally they should be in as good shape as possible to ensure that a good
price can be obtained for them.

The impact of an acquisition on the acquirer’s post-acquisition share price

A very important aspect for an acquirer is the post-acquisition effect on its earnings
per share (EPS), and the impact on the share price and P/E ratio arising from the
market’s perceived views on the acquisition. Once again, detailed analysis of the
accounts, and comparison to other companies in similar business sectors can help to
assess whether the likely impact will be favourable.

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