Course notes

ICAEW Professional Level

Financial Management
For exams in 2025

Tutor details
ii I n t ro d u c t i on Fina nc ia l Ma na g e m e nt

3B

No part of this publication may be reproduced, stored in a retrieval system

or transmitted, in any form or by any means, electronic, mechanical,
photocopying, recording or otherwise, without the prior written permission
of First Intuition Reading Ltd.

Any unauthorised reproduction or distribution in any form is strictly

prohibited as breach of copyright and may be punishable by law.

© First Intuition Reading Ltd, 2025

DECEMBER 2024 RELEASE

Fina nc ia l Ma na g e m e nt I n t ro d u c t i on iii

Contents
Page

1 The ACA qualification and Financial Management (FM) v

Accessing the First Intuition online content vi

1: Objectives 1

1 Business and financial strategy 2

2 Stakeholders and their objectives 2
3 Sustainability and ESG 4

2: Investment appraisal 7

1 Recap of investment appraisal techniques 8

2 Relevant cash flows 13
3 Taxation 17
4 Inflation 19
5 Replacement analysis 25
6 Capital rationing 27
7 Investment appraisal in a strategic context 30
8 Investing overseas 31
9 Environmental costing and social costing 31

3: Risk and decision making 35

1 Introduction to risk and uncertainty 36

2 Sensitivity analysis 36
3 Predictive analytics 41
4 Statistical tools 46
5 Expected values and attitude to risk 50
6 The portfolio effect and the Capital Asset Pricing Model (CAPM) 52

4: Sources of finance 57

1 Capital markets, risk and return 58

2 Sources of equity finance 59
3 Sources of debt finance 65
4 ESG lending and green finance 67
5 Ethics 68
6 Capital market efficiency 69
7 Behavioural finance 70
8 Developing technologies and the financing decision 70

5: Cost of capital 75

1 Cost of equity 76
2 Cost of debt 82
3 Weighted average cost of capital 88
iv I n t ro d u c t i on Fina nc ia l Ma na g e m e nt

6: Capital structure 93

1 Capital structure 94
2 Capital structure and high gearing 99
3 WACC – what to do when things change 99

7: Dividend policy 107

1 M&M and dividend policy 108

2 Share buy-backs and scrip dividends 109

8: Business planning, valuation and restructuring 111

1 Methods of growth 112

2 Valuation 113
3 Forecasts 130

9: Managing financial risk: interest rates and other risks 135

1 Introduction to derivatives 136

2 Hedging commodities prices 136
3 Hedging shareholdings 138
4 Hedging interest rate risk 146

10: Managing financial risk: overseas trade 159

1 Exchange rate basics 160

2 Risk and foreign exchange 161
3 Forwards and futures 162
4 Money market hedges 171
5 Currency options 176
6 To hedge or not to hedge? 180
7 Hedging economic exposure and risks of overseas trade 181

11: Answers to chapter examples 183

Fina nc ia l Ma na g e m e nt I n t ro d u c t i on v

1 The ACA qualification and Financial Management (FM)

There are 15 modules that can be taken in any order with the exception of the Case Study which you
must be attempt last. You must pass every exam (or receive credit) – there are no options. Once
qualified, all ICAEW Chartered Accountants have a consistent level of knowledge, skills and experience.

Professional Level
The six Professional Level modules build on the fundamentals and test students' understanding and
ability to use technical knowledge in real-life scenarios. Each module has a 2½ – 3 hour exam, which
are available to sit four times per year. These modules are flexible and can be taken in any order. The
Business Planning: Taxation and Business Strategy modules in particular will help students to
progress to the Advanced Level.

Specification grid and weightings for FM

FM enables you to recommend relevant options for financing a business, recognise and manage
financial risks and make appropriate investment decisions.
Weighting
(1) Financing options 35%
(2) Managing financial risk 30%
(3) Investment decisions and valuation 35%
 vi I n t ro d u c t i on Fina nc ia l Ma na g e m e nt

Method of assessment
FM will be examined as a computer-based exam requiring typed answers.
For more information and practice on the software please visit
http://www.icaew.com/en/for-current-aca-students/exam-resources/computer-based-exams-
guidance-and-support
The ICAEW will be making the software available to students to practise questions, allowing the
printing and email of answers that have been created using it.
 The exam will contain 3 questions
 Time available: 2.5 hours examination
 Section 2 (managing financial risk) will be examined discretely and sections 1 and 3 could be
examined discretely or as integrated topics
 Pass mark 55%

Accessing the First Intuition online content

You have access to FIs online course which includes recorded lectures, question debriefs, your mock
exams and step by step guidance to help you succeed in the exam.
A link to FI Learn should have been sent to you by your centre, giving full access to the online content.
When you access the link for the first time you will be prompted to create a password. Please contact
your centre if you have not received the link to access the course.
If you are an online learner, it is important that you log in and listen to the introductory videos in the
getting started pod of the course. These videos explain the FM exam and the resources you have to
help you pass.
Good Luck with your studies!
The FI Team
 1

Objectives

Topic List
1. Business and financial strategy
2. Stakeholders and their objectives
3. Sustainability and ESG

Learning Objectives
 Explain the general objectives of financial management, understand and apply the fundamental
principles of financial economics and describe the financial strategy process for a business
 Explain the roles played by different stakeholders, advisors and financial institutions in the
financial strategy selected by a business and identify possible conflicts of objectives including
those relating to sustainability issues
 Evaluate the ethical implications of an entity's financial strategy (including those for the
organisation, individuals and other stakeholders) and suggest appropriate courses of action to
resolve any ethical and sustainability dilemmas that may arise
 2 1: O b j e c t i v e s Fina nc ia l Ma na g e m e nt

1 Business and financial strategy

1.1 What is strategy?
Strategic planning is concerned with the long-term direction of the business (eg which products should
it sell in which markets), and how the business will achieve its objectives, ie its business strategy

1.2 Financial strategy

This is concerned with the financial aspects of the strategic planning process. Having decided on its
overall direction and objectives, a firm must then make more detailed supporting financial decisions
over the medium to short term.
The four key decisions we have to consider include:
 Financing (how to fund the existing operations of the company and any new projects)
 Investment (which new projects to invest in)
 Dividend (how much profit to pay back to ordinary shareholders and when)
 Risk management (how to manage risks relating to e.g. investments, financing and foreign
exchange)
These decisions are inter-related – for example:
– If a company increases its dividends (the dividend decision), this will reduce the level of
retained cash and increase the need for external finance (the financing decision) in order
to fund capital investment projects (the investment decision).
– An increase in capital investment expenditure (the investment decision) would also
increase the need for finance (the financing decision) which may be internally generated
by reducing dividends (the dividend decision).

2 Stakeholders and their objectives

A stakeholder is an individual or group of individuals with an interest in the organisation.
Stakeholder Objectives
Shareholder Share price maximisation, dividend maximisation, earnings growth,
maintenance of control
Lenders Certainty of payment, security of capital, further loans
Directors/Senior managers Maximise remuneration, Security of tenure, maximisation of power and
influence
Employees Maximise remuneration, security of tenure, career development, training
Customers VFM, high quality, reliable service, innovation
Suppliers Certainty of payment, further business
Government Creation of employment, payment of taxes
Community Environmental improvements, creation of wealth
Fina nc ia l Ma na g e m e nt 1: O b j e c t i v e s 3

2.1 Possible conflicts between stakeholder objectives

As can be seen in in the table above, different stakeholders will have different objectives and some of
these may not be consistent, for example:
 Maximising the dividend and maximising directors’ remuneration; the more the directors are
paid, the less that is left to pay out a dividend
A firm may choose to:
 Focus on maximising shareholder wealth and then deal with the problem of other conflicting
objectives
 Make decisions which allow the partial satisfaction of stakeholder objectives and do not
maximise shareholder wealth (‘satisficing’). Here the aim is to increase value for shareholders,
rather than maximising their wealth.

2.2 Agency theory and the agency problem

It is the manager’s role to balance the objectives of the different stakeholders and where there are
conflicts, deciding upon which objective should take priority.
 The shareholders are the owners of a company, however the owners do not also have to be the
managers and so they appoint directors (who can also be shareholders) to manage the company
for them.
 In legal terms the directors are the shareholders’ agents and an agent should always act in the
best interests of their principals i.e. the shareholders.
Agency theory says the directors will always put the shareholders’ objectives first. That is not to say
the directors will ignore all other stakeholders’ objectives as if the remaining stakeholders are
unhappy, then it will be difficult to maximise shareholder wealth.
The Agency Problem refers to the situation where the directors may be tempted to act in their own
best interests rather than the shareholders.
The agency problem may be addressed by using a mixture of appropriate managerial reward schemes
(e.g. share option schemes), corporate governance and audits. The costs of these arrangements are
referred to as agency costs

EXAMPLE 1: CONFLICTS BETWEEN SHAREHOLDERS AND DIRECTORS

Specific areas in which conflicts of interest might occur between directors and shareholders include
the following.

Takeovers

Time horizon

Risk
 4 1: O b j e c t i v e s Fina nc ia l Ma na g e m e nt

Debt

2.3 Ethical considerations

Directors and managers face ethical considerations in setting objectives and making financial
decisions, relating to:
 Dealing with customers
 Fair treatment of employees
 Use of suppliers who may make use of child / slave labour or employ people to work in
dangerous conditions.
 Protection of the environment.
Allegations of unethical behaviour can cause tremendous brand damage and have a large adverse
impact on the value of a company.

3 Sustainability and ESG

Sustainability is about meeting the needs of current generations without compromising the needs of
future generations.
Sustainable development recognises the interdependence between business, society and the
environment. Initiatives by governments, business and organisations to promote sustainable
development include:
 Taxes and subsidies
 Voluntary codes
 Stakeholder engagement

3.1 Impacts and dependencies

There are two fundamental aspects to sustainability:
 Impacts consider how the decisions or actions of an organisation either positively or negatively
affect environmental, societal and governance issues. They include human rights, waste and
water usage. Information on impacts is generally useful for broader stakeholders, including
consumers, civil society and employees. An organisation’s impacts can be financially material
due to reputational impacts such as reduced consumer demand.
 Dependencies consider how current and future environmental, social and governance issues
can affect the organisation’s ability to create and maintain value. Examples include workplace
diversity and consumer expectations. Information on dependencies is generally more useful for
investors, who want to assess how well a company is managing its exposure to long-term ESG
risks to inform their investment decisions.
Double materiality, which is incorporated in the Corporate Sustainability Reporting Directive (CSRD),
means that companies must report not only on how sustainability issues might create financial risks
for the company (financial materiality), but also on the company’s own impacts on people and the
environment (impact materiality).
Fina nc ia l Ma na g e m e nt 1: O b j e c t i v e s 5

3.2 Sustainability versus ESG

Sustainability is a general term and can be vague whereas ESG is specific and measurable. ESG
(environmental, social and governance) is criteria used to measure and report sustainability and is
focussed on issues that affect financial value (rather than society more broadly).
 Environmental – issues relating to the quality and functioning of the natural environment and
natural systems e.g. greenhouse gas emissions and waste management (impacts), water
shortages and severe weather events (dependencies), fines and loss of reputation due to poor
environmental behaviour
 Social – issues relating to the rights, wellbeing and interests of people and communities e.g.
labour standards in the supply chain and workplace health and safety
 Governance – issues relating to the way in which a company is directed and controlled such as
stakeholder interaction and business ethics, as well as matters of business strategy
Investors are increasingly looking for the companies they invest in to adopt ESG objectives as well as
financial objectives.

3.3 ESG reporting

There is an increasing sense of urgency to adopt a uniform strategy to address ESG issues.
The aim of the IFRS Sustainability Disclosure Standards is to provide high-quality, transparent and
comparable information which covers a range of ESG topics about which investors want information.
The Task Force on Climate-related Financial Disclosure (TCFD) focus their recommendations on
forward-looking financial disclosure. They ask organisations to identify climate-related risks and
opportunities, to consider the financial implications, and to assess the resilience of the business
strategy to future climate outcomes. To achieve this, TCFD recommend climate-related risk disclosure
around four core elements:
 Governance (around the risks and opportunities)
 Strategy (the actual and potential impacts of the risks and opportunities on strategy)
 Risk management (how the risks are identified, assessed and managed)
 Metrics and targets (to assess and manage the risks and opportunities)
The TCFD recommendations enable companies to understand the risks and feed this understanding
into strategic decision making. Disclosure evidences this process to investors, allowing them to see
how much risk the business is exposed to and how the risks are managed year on year.
Although not stipulated by any standard, as a general rule a sustainability report should include:
 Environmental factors including environmental complaint mechanisms and climate related
disclosures
 Social factors such as employment practices and product responsibility
 Governance factors relating to the procedures to manage economic, environmental and social
performance
 Policies, practice and performance including actual performance versus targets for the ESG
factors identified
 Targets for each ESG factor
 6 1: O b j e c t i v e s Fina nc ia l Ma na g e m e nt

3.4 Measuring ESG performance

Increasingly stakeholders, from regulators to investors, customers and the public, are requiring
organisations to monitor and report on ESG metrics.
ESG factor Examples of ESG performance indicators
Environment – taking action to protect the  Pollutants and effluents released
environment  Percentage of waste recycled
Social – building and maintaining relationships with  Employee turnover
stakeholders  Number of notifiable accidents
 Supply chain sustainability
Governance – ensuring leadership is transparent and  Diversity of the board
accountable in their stewardship of the organisation  Bribery and corruption training for employees
 Board member expertise

Measuring, reporting and evaluating ESG data brings challenges:

 Lack of comparability. Companies can choose which ESG metrics they want to report, which
results in a lack of comparability between competitors.
 Insufficient measurable outcomes. Data is often non-financial and therefore difficult to measure
(eg employee satisfaction).
 Lack of assurance. The data is not subject to a company’s normal assurance and control
processes.
 Greenwashing. Companies may provide the public with misleading or false information about
the environmental impact of their products and operations.
Organisations need to develop their management information and data analytics systems to meet the
requirements of ESG monitoring, reporting and evaluation.
ESG ratings
ESG rating agencies use ESG metrics to grade a company’s ESG performance. A good rating not only
helps improve brand image but can also help companies to secure finance at a lower cost.

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.
Confirm your learning Yes/No

Can you explain the three key decisions embedded in a company’s financial strategy?

Can you name five stakeholders?

Do you know what the overriding objective of a listed company is?

Can you explain the roles played by different stakeholders and identify possible
conflicts of objectives?

Can you identify sustainability impacts and dependencies?

Can you explain the main contents of a sustainability report?

 7

Investment appraisal

Topic List
1. Recap of investment appraisal techniques
2. Relevant cash flows
3. Taxation
4. Inflation
5. Replacement analysis
6. Capital rationing
7. Investment appraisal in a strategic context
8. Investing overseas
9. Environmental costing and social costing

Learning Objectives
 Outline the investment decision making process and explain how investment decisions are
linked to shareholder value
 Appraise an investment from information supplied, taking account of relevant cash flows,
inflation and tax
 Explain how the results of the appraisal of projects are affected by the accuracy of the data on
which they are based and strategic factors (such as real options and sustainability issues) which
could not be included in the computational analysis
 Identify in the business and financial environment factors that may affect investment in a
different country
 Calculate the optimal investment plan when capital is restricted
 Recommend and justify a course of action which is based upon the results of an investment
appraisal and consideration of relevant non-financial factors such as sustainability and which
takes account of the limitations of the techniques being used
 Organise, structure and assimilate date in appropriate ways, using available statistical tools,
data analysis and spreadsheets to support business decisions
 8 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

1 Recap of investment appraisal techniques

Businesses will regularly need to evaluate potential investments. These could include investing in new
machinery, launching new products, or opening new factories or shops.
 Investment appraisal techniques help us to evaluate whether to proceed with these
investments.
 Investment appraisal was introduced at the certificate level in the Management Information
paper. These techniques are taken further in this subject where they are applied to more
involved scenarios. This allows for a progression of skills from knowledge into application.

1.1 Payback period

Description
How many years of project cash flows are needed to recover initial investment? Shorter = better
How to calculate
Calculate when the cumulative cashflow on the project hits zero. Assume that project inflows happen
evenly through the year.

1.2 Accounting rate of return (ARR)

Description
This represents the annual % return on the project (based on accounting profits)
How to calculate
Average annual profit
The ARR = Average (or initial) investment
Initial outlay + scrap value
The average investment = 2

1.3 Net present value (NPV)

Description
By summing the present value (PV) of future cashflows (discounted at the cost of capital) on a project
and deducting the upfront cost, you find the net present value (NPV) of the project.
The NPV (in £) represents the present value of the excess return on the project over and above the
financing costs of the project (the cost of capital).
 If the NPV is positive, the return on the project beats the cost of capital (hence proceed with the
project)
 If the NPV is negative, then the financing cost of the project (the cost of capital) exceeds the
return on the project (and hence the project should not be accepted)
How to calculate
𝟏𝟏
 To calculate the PV of each cashflow, multiply it by (𝟏𝟏+𝒓𝒓)𝒏𝒏 (the ‘discount factor’) where r is the
cost of capital and n is the number of periods into the future that the cashflow occurs
 Standardised results for discount factors can be found in the exam formula sheet.
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 9

Shortcuts can be used to quickly PV groups of similar cashflows:

Valuing Annuities
 An annuity is a constant annual cashflow (with the cashflow at the end of each year and the first
cashflow in one year’s time) – e.g. a 4 year £100 annuity would be:
T0 T1 T2 T3 T4
– 100 100 100 100
𝑨𝑨 𝟏𝟏
 To PV an annuity, you can use the formula PV = 𝒓𝒓 �𝟏𝟏 − (𝟏𝟏+𝒓𝒓)𝒏𝒏�

 Hence, if our cost of capital is 5%, the PV of the above annuity would be (100/0.05) × (1-
(1/1.05^4)) = £355
 You could also use the annuity factor table provided  PV = 100 × 3.546 = £355
Valuing Perpetuities
 A perpetuity is a never-ending constant annual cashflow (with the cashflow at the end of each
year and the first cashflow in one year’s time) – e.g. a £100 perpetuity would be:
T0 T1 T2 T3 T4 ….
– 100 100 100 100 ….
𝑨𝑨
 To PV a perpetuity, you can use the formula PV = 𝒓𝒓

 Hence, if our cost of capital is 5%, the PV of the above perpetuity is 100/0.05 = £2000
Using a spreadsheet function to calculate NPV
In the exam, you can use a spreadsheet function to calculate an NPV. For example, suppose a project
has an initial cash outflow of £100,000 and then cash inflows of £30,000 at time 1, £40,000 at time 2
and £50,000 at times 3 and 4. The discount rate is 10%. These might be input into a spreadsheet as
follows:
A B C D E
1 Time 0 Time 1 Time 2 Time 3 Time 4
2 -100,000 30,000 40,000 50,000 50,000
The spreadsheet formula to use is =NPV(discount, cell range), which for this example Is
=NPV(0.1, B2:E2)
This gives the PV of the future cash flows in cells B2 to E2 at 10% (£132,046.99). The initial outflow at
time 0 is excluded from this calculation because the formula assumes the first cash flow is at the end
of time 1.
The NPV of the project is therefore arrived at by deducting the outflow of £100,000, to give an NPV of
£32,046.99.

1.4 Internal rate of return (IRR)

Description
The IRR represents the actual annual % return on the project (based on discounted future cashflows).
How to calculate
 As the NPV represents the value of the excess return over and above the cost of capital, if we
can find a cost of capital that gives a zero NPV on the project then this cost of capital = the %
return on the project (the IRR)
 To find an approximate value for the IRR, we first find two different costs of capital, one (L%)
which gives a positive NPV (NPVL) and another (H%) which gives a negative NPV (NPVH).
10 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

 We then interpolate between the two to find an approximate IRR:

NPVL
IRR=L+ ×(H-L)
(NPVL -NPVH )

Using a spreadsheet function to calculate IRR

You can also use a spreadsheet function to calculate an IRR. Using the same example as for the NPV
above:
A B C D E
1 Time 0 Time 1 Time 2 Time 3 Time 4
2 -100,000 30,000 40,000 50,000 50,000

The spreadsheet formula to use is =IRR(cell range), giving for this example =IRR(A2:E2)
This gives the IRR of the cash flows in cells A2 to E2 at 10% of 23%.

EXAMPLE 1: REVISION OF BASIC TECHNIQUES

A company is considering expanding its business. The expansion will cost £350,000 initially for the
premises and a further £150,000 to refurbish the premises with new equipment. Cash flow projections
from the project show the following cashflows over the next six years.
Year Net cash flows
£
1 70,000
2 70,000
3 80,000
4 100,000
5 100,000
6 120,000
The equipment will be depreciated to a zero resale value over the same period and, after the sixth
year, it is expected that the new business could be sold for £350,000.
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 11

Requirements
Calculate:
(a) The payback period for the project
(b) The ARR (using the average investment method)
(c) The NPV of the project. Assume the relevant cost of capital is 12%
(d) The IRR of the project
SOLUTION
12 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

1.5 Pros and cons of different techniques

The examiner will expect you to be able to compare the pros and cons of each investment appraisal
technique:
Accounting Rate of Internal Rate of
Payback Period Return or ROCE Net Present Value Return
Pros Simple to calculate and Simple to calculate and Takes into account the Allows for the time
understand understand time value of money value of money
Can use as initial Looks at the entire life Shows the shareholders Does not require an
screening tool of the project wealth created by the exact cost of funds to
project be estimated
Recognises importance Reflects the way that Can allow for risk (by Easy to interpret
of liquidity external investors adjusting the cost of (% return of a project)
judge the organisation capital
Focuses on nearest (% return)
Clear decision Looks at entire project
(most certain) future Looks at entire project
cashflows
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 13

Accounting Rate of Internal Rate of

Payback Period Return or ROCE Net Present Value Return
Cons Ignores the time value Ignores the time value Requires the cost of Ignores the size of
of money (discounted of money capital to be estimated investment required
payback can be several years into the and total cash inflows
calculated) future
Only considers the Based on profits, not Calculations can be Can give a conflicting
cashflows up to the relevant cashflows time consuming and answer to NPV when
payback date. easily misunderstood. evaluating mutually
Encourages short- Doesn't consider the Doesn't factor in exclusive projects (if
termism length of the project liquidity / time taken projects of different
(and hence liquidity). to generate return. length / size)

No clear decision rule No clear decision rule Assumes you can Assumes you can
reinvest proceeds at reinvest proceeds at
cost of capital the IRR

NPV is the technically superior method for project appraisal. If the results from the different
investment appraisal methods conflict the project with the highest NPV should be chosen.

1.6 Consideration of non-financial factors

As well as interpreting a positive or negative NPV, we must consider the non-financial factors associated
with a decision, namely:
 Compliance with current / future legislation
 Impact on staff morale
 Impact on suppliers and customers
 Reputation of organisation
 Sustainability

2 Relevant cash flows

2.1 Definition of relevant costs
When calculating the payback period, NPV or IRR of a project, only relevant cashflows should be
considered. Relevant cashflows are:
Incremental
 Costs and revenues impacted by the decision
 Include lost opportunity costs (cashflows foregone if we proceed with the project)
 Exclude committed costs (e.g. overheads that will not be impacted by the project)
Future
Only consider cashflows arising in the future – ignore past (sunk) costs
Cashflows
Ignore non-cash items such as depreciation
14 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

2.2 Opportunity costs and revenues

The opportunity cost of a resource may be defined as the cash flow forgone if a unit of the resource is
used on the project instead of in the best alternative way.

WORKED EXAMPLE: RELEVANT COST OF MATERIAL

A new contract requires the use of 50 tonnes of metal ZX 81. This metal is used regularly on all the
firm's projects. At the moment there are in inventory 100 tonnes of ZX 81, which were bought for £200
per tonne. The current purchase price is £210 per tonne, and the metal could be disposed of for net
scrap proceeds of £150 per tonne.
With what cost should the new contract be charged for the ZX 81?
SOLUTION
The use of the material in inventory for the new contract means that more ZX 81 must be bought for
normal workings. The cost to the organisation is therefore the money spent on purchase, no matter
whether existing inventory or new inventory is used on the contract.
Assuming that the additional purchases are made in the near future, the relevant cost to the
organisation is current purchase price, ie 50 tonnes × £210 = £10,500.

EXAMPLE 2: MATERIAL WITH NO ALTERNATIVE USE

Suppose the organisation has no alternative use for the ZX 81 in inventory.

What is the relevant cost of using it on the new contract?
SOLUTION

EXAMPLE 3: MATERIAL WITH A SCRAP VALUE

Suppose again there is no alternative use for the ZX 81 other than a scrap sale, but that there are only
25 tonnes in inventory.
SOLUTION
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 15

EXAMPLE 4: RELEVANT COST OF SURPLUS LABOUR

The contract also needs 200 hours of skilled labour time. There is a surplus of skilled labour sufficient
to cope with the new project. The idle workers are paid £20 per hour.
SOLUTION

EXAMPLE 5: RELEVANT COSTS

A research project, which to date has cost the company £150,000, is under review. If the project is
allowed to proceed it will be completed in approximately one year, when the results are to be sold to a
government agency for £300,000. Shown below are the additional expenses which the managing
director estimates will be necessary to complete the work:
Materials: This material has just been purchased at a cost of £60,000. It is toxic; if not used in this
project, it must be disposed of at a cost of £5,000.
Labour: Skilled labour is hard to recruit. The workers concerned were transferred to the project from a
production department, and at a recent meeting the production manager claimed that if these people
were returned to him they could generate sales of £150,000 in the next year. The prime cost of these
sales would be £100,000, including £40,000 for the labour cost itself. The overhead absorbed into this
production would amount to £20,000.
Research staff: It has already been decided that, when work on this project ceases, the research
department will be closed. Research wages for the year are £60,000, and redundancy and severance
pay has been estimated at £15,000 now, or £35,000 in one year's time.
Equipment: The project utilises a special microscope which cost £18,000 three years ago. It has a
residual value of £3,000 in another two years and a current disposal value of £8,000. If used in the
project it is estimated that the disposal value in one year's time will be £6,000.
Share of general building services: The project is charged with £35,000 per annum to cover general
building expenses. Immediately the project is discontinued, the space occupied could be sub-let for an
annual rental of £7,000.
Requirement
Advise the managing director as to whether the project should be allowed to proceed, explaining the
reasons for the treatment of each item.
(Note: Ignore the time value of money.)
SOLUTION
16 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

EXAMPLE 6: RELEVANT COST OF ASSET

A company has a printing press which needs to be used on a new contract.

The press could be sold for £1,000 or made use of to service the needs of existing customers for
business which has a value (in present value terms) of £1,500.
Requirements
(a) What is the opportunity cost of using the machine on a new contract?
(b) If the printing press could be replaced at a cost of either
(i) £800
(ii) £1,800
What would the relevant cost be?
SOLUTION

2.3 Working capital

When a company invests in a new project (e.g. launching a new product), the project may have an
impact on the company’s investment in working capital (e.g. increasing the value of receivables and
inventory).
Any increase in working capital investment ties up cash, hence we need to treat this as a cash outflow
in our NPV calculation, with any decrease in working capital treated as a cash inflow.
Notes:
 The working capital investment for a new project will usually need to be in place at the start of
the project (at t0).
 If the project will be wound down fully at the end of its life, then we may assume that there will
be a full recovery of any working capital at the end of the final year
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 17

EXAMPLE 7: WORKING CAPITAL FLOWS

A company plans to make sales of £100,000 at t1, increasing by 10% per annum until t4. Working
capital equal to 15% of annual sales is required at the start of each year.
What are the working capital cash flows?
SOLUTION

3 Taxation
3.1 Impact of taxation
Taxation has two effects in investment appraisal, both giving rise to relevant cash flows.

3.1.1 Taxation of operating cashflows

 Operating cashflows will be subject to corporation tax at a flat rate.
 This will either be payable in the year the cashflows are generated, or one year in arrears (be
careful to read the question).

3.1.2 Capital allowances

 The purchase of qualifying plant and machinery generates capital allowances (allowable
deductions from taxable profits), usually on a reducing balance basis
 These capital allowances will lead to a reduction in tax outflows and these tax savings should
therefore be included in the NPV calculation as cash inflows
Note: A full writing down allowance will be available in the accounting period of purchase:
– If our year end is 31st December and the machinery is purchased on 31st December 20X1,
the first capital allowance will be in the year ended 31st December 20X1
– However, if the machinery is purchased on 1st January 20X2, the first capital allowance
will be in the year ended 31st December 20X2
Note: In the final period the capital allowance will equal the difference between the carrying value and
the disposal value:
– If disposal value < tax written-down value, you get an extra capital allowance
(a ‘balancing allowance’)
– If disposal value > tax written-down value, you get a negative capital allowance
(a ‘balancing charge’)
18 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

EXAMPLE 8: CAPITAL ALLOWANCES

A company buys an asset for £10,000 at the end of its accounting period, 31 December 20X0 to
undertake a two year project.
Net trading inflows at t1 and t2 are £5,000. The asset has a £6,900 scrap value when it is disposed of at
the end of year 2. Tax is charged at 17%. WDAs are available at 18% pa.
Requirement
Calculate the net cash flows for the project.
SOLUTION

EXAMPLE 9: TIMING ISSUES

As in example 8, except that the asset is now bought on 1 January 20X1.

Requirement
Calculate the net cash flows for the project.
SOLUTION
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 19

4 Inflation
4.1 General and specific inflation rates
Inflation describes the decrease in purchasing power of £1 over a period of time due to prices rising on
goods and services.
 A specific inflation rate is the rate of inflation on an individual item or service (e.g. material
price rises, staff wage rises)
 A general inflation rate is a weighted average of many specific inflation rates (e.g. CPI) and is
applied to the real rate of interest in order to derive the money rate (see below)

4.2 Money and current cash flows

As examination questions are normally answered using the money method (see below), it is vital to
determine whether the cash flows are given in money or current terms.
 Money (or nominal) cash flows are cash flows where any inflationary effects have already been
taken into account (inflation compounds each year, so e.g. a year 2 cashflow would need to be
multiplied by (1 + 𝑖𝑖)2 to get it into money terms)
 Real cash flows are cash flows expressed in today's terms and have not yet been adjusted for
any future inflation

4.3 Real and money (or nominal) rates

 Real rates of interest are the rates of interest that would be required in the absence of inflation
in the economy.
 Money (or nominal) rates of interest are achieved by adjusting real rates of interest for the
effect of general inflation, measured by the consumer prices index (CPI)
Money rates, real rates and general inflation (CPI) are linked by the following:
(1 + m) = (1 + r) (1 + i)
Where:
m = money rate
r = real rate (assume 10%)
i = general inflation (assume 5%)

4.4 Discounting
It is essential to match like with like when performing NPV calculations. Hence, you either need to use
money cashflows and a money rate of interest, or real cashflows and a real rate of interest:
(1) Money method ('money @ money')
 Adjust the individual cash flows to incorporate specific inflation (money cashflows)
 Discount these cashflows using the money rate (which incorporates general inflation)
(2) Real method ('real @ real')
 Remove the effects of general inflation from money cash flows to generate real cash
flows
 Discount using real rate.
 Although this achieves the same NPV as the money method, it is often very long winded
and would only be useful in a question where the real flows and interest rate were
already given.
20 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

EXAMPLE 10: MONEY @ MONEY

A project requires an investment of £10,000 at t0 in new plant and equipment

The project returns £5,000 pa in current terms for three years, inflating at 7% pa
Money rate of interest is 10%
Requirement
Calculate the project's NPV using the money method.
SOLUTION

EXAMPLE 11: REAL @ REAL

Calculate the NPV of the project in Example 10 using the real method.
SOLUTION

4.5 Alternative way of dealing with a growing perpetuity

A useful shortcut to use when trying to use the money method to discount perpetuity cashflows which
1+𝑚𝑚
are inflating at a steady rate is to find the ‘effective rate’ = 1+𝑖𝑖 – 1

(1) (where m = money rate and i = the specific inflation on the cashflow)
(2) This effective rate can then be used in a perpetuity formula to discount the perpetuity
cashflows.
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 21

EXAMPLE 12: USING THE 'EFFECTIVE RATE’

What is the PV of a current cash flow of £100 which will grow at 2% pa forever, if the cost of capital is
6% and the first cash flow is at time 1?
SOLUTION

4.6 NPV proforma

The following proforma summarises the topics dealt with so far and provides a layout for NPV
calculations useful in many exam situations:

4.6.1 Lead schedule (£000s)

A B C D E F G
1 Time 0 1 2 3 4 5
2 Revenue 0 250 220 200 190 170
Operating cashflows

3 Variable costs 0 (100) (88) (80) (76) (68)

4 Contribution 0 150 132 120 114 102
5 Fixed costs 0 (20) (20) (20) (20) (20)
6 Net operating cash flow 0 130 112 100 94 82
7 Tax at 17% 0 (22) (19) (17) (16) (14)
8
Capital cashflows

9 Capital expenditure (400)

10 Scrap value 100
11 Tax saving on cap. all. (W) 12 10 8 7 6 8
12 Working capital (25) 3 2 1 2 17
13 Net cashflow (413) 121 103 91 86 193
14
15 PV of cash flows at 10% T1-5 442
16 Less outflow at T0 (413)
17 NPV 29

PV in cell B15 uses the NPV spreadsheet function = NPV(0.1, C13:G13)

22 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

Conclusion
The project has a positive NPV and hence we should proceed with the project (as its return beats our
cost of capital)  always remember to conclude (usually worth 1 mark!)

4.6.2 Capital allowance workings

Capital Allowances (W)
Time 0 1 2 3 4 5
Opening TWDV of equipment 400 328 269 221 181 148
Closing TWDV of equipment 328 269 221 181 148 100
Capital Allowances 18% WDA on opening TWDV) (72) (59) (48) (40) (33) (48)
Tax Saving (17%) (included in NPV proforma) 12 10 8 7 6 8

4.6.3 SUM spreadsheet function

You may find the SUM spreadsheet function useful in answering exam questions, particularly those on
investment appraisal (such as the example below).
The SUM spreadsheet function adds the values in a range of cells.
The SUM formula format is =SUM(cell range)
In the spreadsheet extract above, the net cash flow in column B could be calculated using
=SUM(B9:B12).
The following exam-style example brings together many of the elements of investment appraisal that
we have looked at so far and gives you the opportunity to use spreadsheet functions.

EXAMPLE 13: COMPREHENSIVE EXAMPLE

Funtime Co, a toy company, has developed a new game, ‘Zoom’, which it plans to launch in time for
the school summer holidays. Sales of the new game are expected to be very strong, following a
favourable review by a national newspaper. Sales and production volumes and selling prices for ‘Zoom’
over its four-year life are expected to be as follows:
Year 1 2 3 4
Sales and production (no. of games) 150,000 70,000 60,000 60,000
Selling price (per game) £25 £24 £23 £22
Financial information on ‘Zoom’ in current prices is as follows:
Direct material cost £5.40 per game
Other variable production cost £6.00 per game
Apportioned fixed costs £4.00 per game
Advertising costs to stimulate demand are expected to be £650,000 in the first year of production and
£100,000 in the second year of production. No advertising costs are expected in the third and fourth
years’ of production. ‘Zoom’ will be produced on a new production machine costing £800,000, which
will be purchased at the very beginning of year 1. Capital allowances can be claimed at 20% on a
reducing balance basis, starting in the year of expenditure, with a balancing allowance or balancing
charge in the final year. It is expected that the machine will be sold for £150,000 at the end of the
project.
Funtime Co pays tax on cash flows at the rate of 25% per year and tax liabilities are settled at the end
of the year in which they arise. Inflation at 3% pa is expected to apply to the production costs for the
duration of the project.
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 23

If the new game is launched then sales of another game ‘Skip’ would be reduced due to lack of
resources to devote to this other game. This reduction in sales would amount to 10,000 units per year.
‘Skip’ currently earns a contribution of £15 per game and this would be expected to remain constant
over the next four years.
Working capital equal to 10% of the annual sales revenue is needed at the start of each year. All
working capital will be released at the end of the project. You can ignore any working capital impact of
‘Skip’
Requirement
Calculate the net present value of the proposed investment using an after tax nominal discount rate of
15%.
SOLUTION
24 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 25

5 Replacement analysis
Sometimes an investment decision will involve choosing between two alternatives where the benefits
are unequal e.g. comparing renting one property for five years and an alternative for seven years.
In such situations comparing the NPVs would not necessarily give the correct decision, so an
alternative appraisal technique is required.

WORKED EXAMPLE: REPLACEMENT DECISION

A decision has to be made on replacement policy for vans. A van costs £12,000. Vans can be replaced
after 1,2, or 3 years. The following additional information applies:
Maintenance cost Scrap value
Year (paid at end of year) (at end of year)
1 1,000 9,000
2 2,500 7,500
3 3,500 7,000
Calculate the optimal replacement policy at a cost of capital of 15%. Ignore taxation and inflation.
SOLUTION
NPVs
1 year cycle NPV = -12,000 + (9,000 – 1,000) x 0.870 = -5,040
2 year cycle NPV = -12,000 – 1,000 × 0.870 + (7,500 – 2,500) x 0.756 = -9,090
3 year cycle NPV = -12,000 – 1,000 × 0.870 – 2,500 × 0.756 + (7,000 – 3,500) × 0.658 = -12,457
These costs are not comparable, because they refer to different time periods.

5.1 Equivalent annual cost (EAC)

Recall the formula for PVing an annuity:
PV of an annuity = Annuity cashflow × Annuity Factor (for n periods at a discount rate r)
We can re-purpose this to find an equivalent annual cost for each of our three replacement cycles:
NPV
 EAC = Annuity factor for the project life

 The EAC represents a constant annual cashflow that has the same present value as the actual
cashflows arising under each proposal.
 The proposal with the lowest EAC should be chosen.
26 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

EXAMPLE 14: EAC

Calculate the EAC for each option in the scenario, above. Which replacement cycle is preferred?
SOLUTION
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 27

EXAMPLE 15: EAC

A machine costs £20,000 and it can be replaced every year or every two years. Delaying the
replacement causes the running costs to increase and the scrap proceeds to decrease as follows:
Running Scrap
costs proceeds
£ £
Year 1 5,000 16,000
Year 2 5,500 13,000
Company's cost of capital = 10%.
Requirement
Should the machine be replaced every one or every two years?
SOLUTION

6 Capital rationing
 Ordinarily a company would invest in all positive net present value projects (in order to
maximise shareholder wealth).
 Capital rationing describes the situation where a company does not have sufficient funds to
invest in all positive NPV projects
28 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

6.1 Two types of rationing

(1) Hard capital rationing is where an organisation would like to raise more funds, but no
stakeholder is prepared to invest. This may result from the potential returns not being high
enough to compensate for the perceived risks involved.
(2) Soft capital rationing is where an organisation could raise more funds, but has decided not to.
This may result from a concern that the available finance is too expensive or may result in a loss
of control.

6.2 Single period rationing

When funds are scarce in one year only and projects are divisible:
 If the investment projects are divisible then investing only a proportion of the initial investment
required would result in the same proportion of the project NPV being achieved.
 In such situations we need to rank the projects by identifying the net present value generated
from the each £1 of the initial investment. This measure is known as the Profitability Index (PI):
Net Present Value
 Profitability Index = Initial investment

EXAMPLE 16: CAPITAL RATIONING (DIVISIBLE)

A business has £50,000 available at t0 for investment.

Four divisible projects are available:
Project Project NPV Funds required at t0
A 100,000 (50,000)
B (50,000) (10,000)
C 84,000 (10,000)
D 45,000 (15,000)
Requirement
Which project(s) should be undertaken?
SOLUTION
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 29

6.3 Indivisible projects

The solution to the previous example assumes it is possible to accept half of project A and achieve half
of the NPV.
In reality projects may be indivisible (all or nothing), in which case trial and error is necessary to find
the optimal combination.
Note: The assumption is that any funds not invested in a project will be deposited at the cost of
capital.

EXAMPLE 17: CAPITAL RATIONING (INDIVISIBLE)

Which project(s) from example 16 should be undertaken if the projects are indivisible?
SOLUTION

EXAMPLE 18: PROJECT SYNERGY

A firm has £100,000 available for investment at t0.

Three divisible projects are available:
Project NPV Funds required at t0
£ £
X 25,000 100,000
Y 11,000 50,000
Z 8,000 40,000
If Y and Z were undertaken together an extra £4,400 of NPV could be earned.
Requirement
Which project(s) should be undertaken?
SOLUTION
30 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

7 Investment appraisal in a strategic context

7.1 Shareholder value analysis
So far we have been appraising the value of individual projects, but now we need to consider all of the
activities of a business and their impact on the value of the business and the wealth of the shareholders.
Shareholder value analysis (SVA) is the process of analysing the activities of a business to identify how
they will result in increasing shareholder wealth.

7.1.1 The principles of SVA

A business has a particular value at a particular time as determined by the present value of the
projected future cash flows from its activities.
 According to the philosophy of SVA, the value of the business is affected or 'driven' by just
seven factors, known as 'value drivers'.
 To increase the value of the business, i.e. to generate additional value, one or more of these
seven will need to alter in a favourable direction:
Value Driver How to positively impact on the value drivers
Sales growth rate Increase the rate / prevent decline (using marketing, new products, changes
to existing products)
Operating profit margin Increase the margin by increasing prices and/or reducing operating costs
(using marketing, product improvements, cost control)
Corporation tax rate Reduce the effective rate (using careful tax planning)
Investment in non-current Reduce investment without impacting business (try to increase useful life of
assets assets)
Investment in working Reduce investment without impacting business (e.g. reduce stock levels using
capital careful inventory management)
Cost of capital Reduce cost of capital (by finding cheaper sources of finance – see chapter 5)
Life of projected cash flows Increase the life of projected cashflows (e.g. by face-lifting older products)

We will use SVA to value a business in chapter 8.

7.2 Real options

One problem of NPV analysis is that it only considers cash flows related directly to the project. It is
possible that a project with a negative NPV is accepted for 'strategic' reasons.
This is because management accept that there are options associated with a particular project which
outweigh the conventionally calculated negative NPV.
Such options are termed Real options and can take varying forms:
 Follow-on options: the ability to launch future products off the back of this one, or extend the
life of this project.
 Abandonment options: the ability to exit the project early and sell the assets.
 Timing options: the ability to delay the start of the project to wait for favourable market
conditions.
 Growth options: the ability to ‘dip your toe in the water’ with a small initial investment and
then grow (e.g. by launching in additional locations)
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 31

 Flexibility options: the ability to change suppliers / materials / locations in the future if a
cheaper option becomes available.
The revised decision model becomes: Project worth = NPV + value of real options

8 Investing overseas
8.1 Political risks
When considering whether to invest in an overseas project a company must consider the political risk,
as well as the attractiveness of the market and the competitive advantage they would enjoy.
 Political risk is the risk that action by a foreign government will affect the position and value of a
company.
 If a government tries to prevent the exploitation of its country by multinationals, it may take
various measures, including the following:
Measure Description
Quotas Limits on quantities of goods a subsidiary may buy from its parent for domestic
sale
Tariffs Extra tax or duty applied to imports in order to make domestic goods more
competitive
Non-tariff barriers Extra quality or safety checks applied to imported goods
Restrictions E.g. foreign companies prevented from buying domestic companies in certain
industries (e.g. defence, energy)
Nationalisation Nationalisation of foreign owned companies and their assets (without
compensation)
Minimum shareholding Insistence of a minimum shareholding in companies by residents

8.1.1 Dealing with political risks

Measure Description
Negotiations with host Agree concessions with the host government
government
Insurance The Export Credits Guarantee Department (ECGD) provide protection against
nationalisation, currency problems, war and revolution
Production strategies Contract out some production to local sources, or locate key parts of production
and distribution overseas
Management structure Use of joint ventures with domestic companies or ceding control to local investors

9 Environmental costing and social costing

 Environmental cost – the cost of making sure that a company’s activities do not damage the
environment or that any such damage is put right
 Social cost – the total cost to society of a new venture or project
32 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

9.1 Managing environmental costs

Accountants need to be aware of the environmental costs associated with business activities (e.g.
energy costs and waste disposal costs) because customers’ habits and choices are increasingly being
influenced by how ‘green’ a business is perceived to be.
Businesses often face difficulties in defining, identifying and controlling some environmental costs as
they are not easily identified by cost management systems. For example, they are often treated as
production overheads and so are effectively hidden from management scrutiny.
There are also many aspects of environmental costing that go beyond purely financial costs but are
still relevant for investment appraisal. They may be difficult to quantify however e.g. reputational
impact of complying with or failing to comply with environmental regulations.

9.2 Benefits of understanding environmental costs

Environmental costs should be identified, recorded and monitored not only for ethical reasons, but
also to:
 Determine the correct cost and hence price of products/services
 Reduce the chances of incurring fines and/or liability for environmental taxes
 Ensure any regulatory compliance
 Reduce costs (saving energy generally leads to cost savings)

9.3 Environmental cost classification

The US Environmental Protection Agency made a distinction between four types of environmental
cost, to try to ensure that environmental costs are effectively identified and controlled:
Classification Description Examples
Conventional costs Costs addressed in traditional cost accounting  Cost of raw materials
and investment appraisal but not usually  Cost of utilities
considered as environmental costs. Less use
and waste of raw materials, say, is
environmentally positive, however, and so
these costs should be factored into the
investment appraisal process.
Potentially hidden Costs captured by accounting systems which  Cost of complying with
costs lose their identity in ‘general overheads’ environmental laws
(regulatory costs)
 Cost incurred going beyond
compliance (voluntary costs)
e.g. outreach programmes
Contingent costs Costs to be incurred at a future date. Given  Cost of remedying and
their uncertain nature, expected values could compensating for future
be used to build these costs into the accidental releases of
investment appraisal process. contaminants to the
environment e.g. oil spills
Image and Costs incurred to affect subjective (though  Cost of preparing
relationship costs measurable) perceptions of management, environmental reports
customers, employees, communities and  Costs to improve the
regulators. Although the costs themselves are company’s image (e.g. tree
not intangible, they are often called ‘less planting)
tangible’ or ‘intangible’ because the direct
benefits that result from relationships/
corporate image expenses often are.
Fina nc ia l Ma na g e m e nt 2: I n v e s t me nt A p p rai s a l 33

A project’s impact on the environment and resulting environmental costs should be accounted for as
part of the investment appraisal process.

EXAMPLE 19: ENVIRONMENTAL COSTS

Lomond Tours plc is a company that specialises in adventure holidays. The Finance Director has just
completed the investment appraisal of a proposed new hotel based in the Highlands of Scotland. The
project looks promising, with a forecast NPV of £3.5 million.
The company has hired an external environmental consultant to ensure that the project complies with
the company’s sustainability policy as the hotel will be built in a National Park. The consultant has
estimated the following environmental costs associated with the project:
(1) Site survey costs: £100,000
(2) Installation of recycling equipment: £200,000
(3) Staff training to ensure operational environmental policies are adhered to: £5,000
(4) Installation of a wind turbine onsite: £345,000
Requirement
Discuss the impact of the environmental costs on the project.
SOLUTION

9.4 Social costing

Social costing considers the impact and dependence of new ventures on society.
The activities of an organisation may impact on social issues, which relate to the rights, wellbeing and
interests of people and communities. These impacts may be positive (eg job creation in deprived
areas) or negative (e.g. noise pollution affecting a local community).
An organisation’s ability to create value may also be dependent on social issues. Dependencies may
create costs (e.g. paying a higher minimum wage) or may create opportunities (e.g. attracting better
staff if the organisation creates a reputation for dealing fairly with staff).

9.4.1 Benefits of identifying key social impacts and dependencies

 It affects (positively or negatively) an organisation’s relationships with key stakeholders
(employees, local community).
 It affects an organisation’s reputation.
 It can assist in ESG reporting.
34 2: I n v e s t me nt A p p rai s a l Fina nc ia l Ma na g e m e nt

9.4.2 Social cost-benefit analysis

There are some projects that may not offer attractive commercial returns but are still undertaken
since they have social implications e.g. public projects like transport projects, irrigation projects and
wind power projects.
Social cost-benefit analysis is a tool for evaluating value of money, particularly of public investments,
but can also be extended to the private sector. It aids decision making with respect to the various
social implications of a project and has become more important in recent years due to the focus on
ESG performance and reporting.

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Can you calculate the ARR?

Can you explain what a relevant cost is?

Can you calculate the tax relief generated by capital allowances?

Can you apply the money approach to NPV?

What is the name of the technique needed to identify the optimal replacement cycle?

When can the profitability index be used to assess capital rationing?

What are the seven drivers of SVA?

Can you explain four examples of political risk?

What are the four classifications of environmental cost?

 35

Risk and decision making

Topic List
1. Introduction to risk and uncertainty
2. Sensitivity analysis
3. Predictive analytics
4. Statistical tools
5. Expected values and attitude to risk
6. The portfolio effect and the Capital asset Pricing Model (CAPM)

Learning Objectives
 Calculate and justify an appropriate discount rate for use in an investment appraisal taking
account of both the risk of the investment and its financing
 Calculate and examine the sensitivity of an investment decision to changes in the input factors
 Discuss how the interpretation of results from an investment appraisal can be influenced by an
assessment of risk, including the impact of data analytics and sustainability issues on that risk
assessment
 Recommend and justify a course of action which is based upon the results of an investment
appraisal and consideration of relevant non-financial factors such as sustainability and which
takes account of the limitations of the techniques being used.
 Organise, structure and assimilate data in appropriate ways, using available statistical tools,
data analysis and spreadsheets, to support business decisions
36 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

1 Introduction to risk and uncertainty

1.1 Risk
Decisions are subject to risk where there are several possible outcomes and the likelihood of those
outcomes can be quantified in the form of probabilities.

1.2 Uncertainty
Decisions are subject to uncertainty where there are several possible outcomes, but the likelihood of
those outcomes cannot be quantified.

1.3 Methods of dealing with decision making under risk and uncertainty
 Setting a minimum payback period
 Increasing the discount rate (to use a higher hurdle rate and get a more conservative NPV)
 Calculating worst case outcome
 Calculating a range of outcomes
 Sensitivity analysis

2 Sensitivity analysis
2.1 The technique
 In chapter 2 we stated that positive NPV projects should be accepted, as the return on the
project beats the cost of capital.
 However, NPV analysis depends on estimated future cashflows which are based on estimated
variables (e.g. sales prices, volumes, costs, residual value of machinery, tax rates, the cost of
capital), any of which may be incorrect.
 Sensitivity analysis determines how sensitive the NPV of the project is to an individual
estimated variable.
 The sensitivity shows the % change in the variable necessary to change our decision – e.g. the
change needed to result in a zero NPV.
The method of calculation of the sensitivity will depend on the variable – for example:
NPV of project
 The sensitivity to variables impacting on cashflows = PV of cashflows impacted by the variable

For example you may have to calculate the sensitivity to a change in material cost or sales
volume
IRR - Cost of Capital
 The sensitivity to the cost of capital = Cost of Capital

For example you may have to calculate the sensitivity to a change in the WACC
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 37

EXAM SMART
Using contribution as the starting point
When the question asks you to calculate sensitivity to sales volume you will need to think
about contribution. This is because selling one fewer unit will mean not only do you lose
revenue, but you will save on variable costs of the product.
Be careful, sometime the exam will use the term sales revenue in a sensitivity question – if
you see this you need to treat it in the same way as sales volume.

WORKED EXAMPLE: SENSITIVITY ANALYSIS

Butcher Ltd is considering whether to set up a division in order to manufacture a new product, the
Azam. The following statement has been prepared, showing the projected profitability per unit of the
new product.
£ £
Selling price 22.00
Less Direct labour 5.00
Material 3 kg @ £1.50 per kg 4.50
Variable overheads 2.50
(12.00)
Net contribution per unit 10.00
It is expected that 10,000 Azams would be sold each year at the above selling price. Demand for Azams
is expected to cease after five years. Direct labour and material costs would be incurred only for the
duration of the product life.
Other relevant annual overheads have been calculated as follows.
£
Rent 8,000
Salary 5,000
 Manufacture of the Azam would require a specialised machine costing £250,000.
 The cost of capital of Butcher Ltd is estimated at 5% pa in real terms.
 Assume all costs and prices given above will remain constant in real terms.
 All cash flows would arise at the end of each year, with the exception of the cost of the machine
which would be payable immediately.
Requirements
(a) Prepare net present value calculations, based on the estimates provided, to show whether
Butcher Ltd should proceed with the manufacture of the Azam.
(b) Prepare a statement showing the sensitivity of the net present value of manufacturing Azams to
errors of estimation in each of the three factors: material cost per unit, annual sales volume,
and product life.
Ignore taxation
38 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

SOLUTION
(a) NPV calculation
Cash flows resulting from manufacture and sale of Azams:
Time Cash Discount Present
flows factor value
£'000 £
0 Machine (250) 1 (250,000)

1–5 Factory rent (8) 4.329 (34,632)

1–5 Manager's salary (5) 4.329 (21,645)
1–5 Materials cost (45) 4.329 (194,805)
1–5 Direct labour (50) 4.329 (216,450) 432,900
1–5 Variable overheads (25) 4.329 (108,225)
1–5 Sales revenue 220 4.329 952,380
Annual cash flow 87
Net present value 126,623

On the basis of the estimates given, manufacture of the Azam is worthwhile.

(b) Sensitivity to forecast errors
A summary of the analysis is shown in the following table:
Item Upper/lower limit for Maximum percentage error
project acceptability not affecting decision
Material cost per Azam (W1) £7.425 65%
Annual sales volume (W2) 7,075 units 29%
Product life (W3) 3.2 years (approx) 36%
The table shows that the manufacture of Azams would still be worthwhile if product life were to
fall to about 3.2 years, or if annual sales were to fall to 7,075 units, or if material costs were to
increase to £7.43 per Azam. These figures represent percentage errors of 36%, 29% and 65%
respectively on the original estimates. If the actual figures were within these percentages of the
original estimates, the decision to go ahead would still have been valid. These are large
percentages and the net present value is, therefore, remarkably insensitive to errors of
estimation in the three factors.
WORKINGS
The approach taken is:
NPV of project
Sensitivity = PV of cashflows subject to uncertainty

(1) Material price

For the project to break even:
The NPV must fall by £126,623
The PV of materials cost (£194,805) must rise by £126,623
This PV must rise by £126,623 ÷ £194,805 = 65%.
Annual materials cost, and therefore unit materials cost, must rise by 65%.
If this unit price rise were caused entirely by a rise in material price:
the increase per unit would be £4.50 × 0.65 = £2.925
and the break-even materials price would be £7.425 (£4.50 + £2.925).
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 39

(2) Annual sales volume

The part of NPV that is affected by change in sales volume is:
(£952,380 revenue – £108,225 variable overheads – £216,450 direct labour – £194,805
materials) = £432,900
(see cash flow table in NPV above)
If the project NPV is to fall by £126,623 as a result of the sales volume falling, this PV of
£432,900 must fall by £126,623. This is a fall in PV contribution of:
NPV of project
Sensitivity = PV of cashflows subject to uncertainty
£126,623
£432,900
= 0.2925 (29%)

The way in which the PV of annual contribution will fall by 29% is if contribution itself falls by
29%. This in turn is the result if sales volume falls by 29%.

An alternative approach to this calculation is to use contribution and the annuity factor:
Contribution per unit = £10 (£22 sales revenue – £12 variable cost)
The fall in annual contribution which gives a drop in NPV to break-even point (ie a drop of
£126,623) is, using 4.329 the 5 year annuity factor:
Fall in annual contribution × 4.329 = £126,623
£126,623
Fall in annual contribution = = £29,250
4.329
ie if annual contribution falls by £29,250 pa the NPV will be zero.
This is caused by a fall in annual demand of:
£29,250
= 2,925 units
£10
ie a fall of 29.25% of the planned volume of 10,000 units. The breakeven volume is therefore
7,075 units (10,000 – 2,925).

(3) Product life

The approach to sensitivity analysis to find the breakeven position is to set the NPV equal to
zero.
ie NPV = (outlay) + PV of inflows
Zero = (250,000) + 87,000 × Annuity factor for product life at 5%
250,000
∴ Annuity factor for product life at 5% = = 2.874
87,000
It is necessary to know for how many years this is the 5% annuity factor:
From annuity tables
Annuity factor for three years @ 5% = 2.723
Annuity factor for four years @ 5% = 3.546
Therefore, project NPV is zero if life is greater than:
2.874 − 2.723
3+ years (approximately) = 3.2 years
3.546−2.723
40 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

(Strictly speaking it should be said that the project will only change from being a success to a
failure if its life falls from four to three years, as all cash flows are assumed to be at the
year-end.)
The project's planned life is 5 years. It can be shortened by 1.8 years (5 – 3.2 breakeven life)
which is 36% of the planned life.
In a practical situation this process would be continued to determine the sensitivity of the
project to all variables involved. This would include all costs, revenues and the discount rate (ie
finding the IRR of the project). Managers could then assess which variables were most crucial to
the success of the investment, and decide whether there were any ways of reducing the
uncertainty relating to them.

EXAMPLE 1: NON-RECURRING CASH FLOWS

A company is about to embark on a two year project. Estimates of relevant inflows and outflows in
current terms are as follows:
Year 1 Year 2
£ £
Sales 50,000 50,000
Costs 30,000 32,000
The following inflation rates are applicable to the flows:
Sales 6% pa
Costs 4% pa
Tax is payable at 17% on net flows.
The net cost of the project at t0, after allowing for capital allowance tax effects, is £20,000.
The money cost of capital is 10% pa.
Requirements
(a) Calculate the NPV of the project.
(b) Assess the sensitivity of the investment decision to changes in (i) sales price and (ii) the cost of
capital
SOLUTION
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 41

2.2 Strengths and weaknesses of sensitivity analysis

Strengths
 Facilitates decision making (once the sensitivity is known to an individual variable, management
can assess for themselves the likelihood of such a change)
 Identifies critical areas / variables (which should then be monitored)
 Simple to understand
Weaknesses
 Assumes that changes to variables can be made independently (unlikely – e.g. a drop in sales
volume would also likely impact on the selling price)
 Ignores probability (only identifies the magnitude of the change needed, not the likelihood of
such a change)
 No clear answer (it only gives context to the NPV calculation, rather than a clear decision)

3 Predictive analytics
Predictive analytics use historical and current data to create predictions about the future. The
increasing use of Big Data within organisations has created new forms of data that can be used to
create predictions.

3.1 Monte Carlo simulation

 In real life investment appraisal situations there will often be a very large number of variables
with a large range of possible values to enter into a NPV calculation (e.g. sales price, sales
volume, variable costs).
 In such situations, simulation is used to provide context for the investment appraisal.
 Simulation involves identifying each of the different variables, the range of the different values
of those variables and the probabilities of those values occurring.
 Hundreds, thousands or more simulations are then run to record the NPVs of the project for
different combinations of values for the different variables (using random numbers and
computers to select values for each of the variables).
 The results then show the expected NPV and the distribution of possible NPV values.
42 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

3.1.1 Advantages and limitations of simulation

Advantages
 It gives more information about the spread of possible outcomes
 It is useful for problems which cannot be solved analytically
Limitations
 It is not a technique for making a decision, rather it gives additional context
 It can be very time-consuming without a computer
 It can prove expensive to design and run
 Assumptions need to be made about the probabilities associated with the different variables

3.2 Linear regression models

Linear regression is a statistical technique that attempts to identify the factors that are associated with
a change in the value of a key variable (eg, sales or project NPV or the value of a company). The
variable that a business is trying to predict is called the dependent variable, and the factors that are
thought to have an impact on this are called independent variables.
Linear regression quantifies the relationship between the dependent variable and the independent
variables. For example we could use linear regression to quantifying how sales growth (the dependent
variable) has changed over time (the independent variable) in order to forecast how sales may be
expected to grow in the future.

3.2.1 Advantages and limitations of linear regression

Advantages of linear regression
 Linear regression models are simple to use and easy to explain to non-financial managers.
 Linear models can be used to predict the impact of expanding variables beyond current
estimates (such as identifying the impact of sales volumes or material costs being higher than
predicted).
Limitations of linear regression
 There will not always be a linear relationship between variables and outcomes.
 Basic linear regression models can only consider the impact of one variable at a time. More
complex multi-linear models are required to consider additional variables at the same time.
 Linear models may identify spurious relationships between variables and outcomes as they do
not consider the difference between correlation and causation.
 Will be less meaningful if the data collected is inaccurate or if the error term is large.

3.3 Correlation
3.3.1 Correlation versus causation
A cause and effect relationship (also known as a causal relationship) exists between two variables
when a change in one causes the change in the other. For example, if staff are paid hourly, then as
hours worked increase, wage costs will increase. The increase in hours worked has caused the increase
in wage costs. There is a positive correlation between the number of hours worked and wage costs
that, in this case, can be described as a cause and effect relationship.
However, correlation does not necessarily mean that a cause and effect relationship exists. There
may be a reason for the correlation that is not causal. For example, when the sales of sun cream
increase, the sales of ice cream also increase. The increase in sun cream sales is not causing the
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 43

increase in ice cream sales. There is a third variable, namely the weather, influencing both types of
sales. This variable is known as a confounding variable.

3.3.2 Data outliers

Data outliers are observations that are abnormal and can therefore significantly distort the results.
Sometimes outliers are removed from the data set before applying forecasting techniques.

3.3.3 Correlation coefficient

The correlation coefficient (a number between +1 and -1) indicates the strength and direction of a
relationship between variables.
The CORREL spreadsheet function can be used to calculate the correlation coefficient.
The CORREL formula format is =CORREL(cell range for array 1, cell range for array 2)
A B C D E F
1 Year 1 2 3 4 5
2 Share price £ 10.50 11.70 12.90 13.30 15.00
The correlation coefficient between time and the share price above is given by =CORREL(B1:F1,B2:F2),
which is 0.987.
This indicates that there is a strong, positive relationship between time and the share price:
 Strong because the coefficient is close to 1
 Positive because as time increases, the share price increases
If the correlation coefficient had been -0.134, say, there would have been a weak, negative
correlation.

3.4 Simulation, scenario analysis and ESG risk analysis

3.4.1 ESG risks

Environmental issues are giving rise to significant risks for businesses including:
 Physical risks (from the physical effects of climate change such as wildfires and flooding)
 Transition risks (relating to social and economic shifts to a low-carbon economy such as changes
to policy, regulations and technology)
Social risks include inadequate payment of labour and lack of assurance of product safety.
Governance risk includes compliance with tax law and lack of proper assurance of data protection.

3.4.2 Using simulation and scenario analysis

Simulation and scenario analysis enable better understanding and management of future risks.
 Simulation can be used to give more information about the impact of environmental costs on
new ventures as well as the impact of new ventures on the environment by incorporating
possible outcomes and their relative probabilities to provide management with better
understanding of the impact on shareholder value.
 Climate scenario analysis tests an organisation’s strategic resilience to future climate shocks and
can reassure investors that an organisation is prepared for future outcomes.
44 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

3.4.3 Mitigation and adaptation

 Climate change mitigation means avoiding and reducing emissions of greenhouse gases.
 Climate change adaptation refers to adjustments to strategies and to actions in response to the
effects and future risks of climate change.

3.5 Prescriptive analytics

By combining the statistical tools utilised in predictive analytics with Artificial Intelligence and
algorithms, prescriptive analytics software can be used to calculate the optimum outcome from a
variety of business decisions.
For financial management, these could include the following:
 Capital rationing decisions
 Replacement analysis
 Identifying the optimal balance of finance

3.5.1 Advantages and limitations of prescriptive analytics

Advantages
 Prescriptive models have the capability to identify optimum investment decisions whilst
considering the impact of multiple decisions and variables.
Limitations
 Creating reliable prescriptive models is complex and requires specialist data science skills, which
are typically outside the scope of finance managers.
 The reliability of such models depends on the reliability of the data that they use and the ability
to predict future outcomes accurately from past data.

3.6 Data bias and professional scepticism

Definition
Data bias: ‘Data is biased when it is not representative of the population. Data may be biased before
its analysed just because the method of collecting the data means that some members of the
population have a lower (or zero) chance of being included in the sample. People who analyse data
and reach conclusions can also introduce bias.’
There are several different types of data bias:
Bias Meaning and example
Selection Bias This occurs when the data is not selected randomly and leads to a sample that is not
representative of the population. In order to be representative, all items in the
population should have an equal chance of being selected for the sample.
Example – ease of selection
Selection bias sometimes occurs because it is more convenient to select a certain
group, for example, people in a particular geographic area.
Self-selection This occurs when individuals select themselves.
Example – new product survey
When customers choose whether to respond to a survey, those who
choose to respond may have a certain characteristic or interest that
leads them to respond. This creates a sample that is not representative of the whole
population.
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 45

Bias Meaning and example

Observer bias This occurs when observing and recording results, and relates to interpretation. The
researcher allows their assumptions (which may be unconscious) to influence their
observations.
Example – unconscious bias
Managers may be observing labour processes and draw conclusions based on their
unconscious bias towards particular staff members.
Omitted variable This links back to the section on cause and effect, earlier in the chapter. Omitted
variable bias is when a variable is excluded from the data model and therefore the
cause of a change in one variable is incorrectly attributed to another variable in the
model.
Example – sales budgeting
Sales of a product may depend on many variables such as advertising, price
competition, fashion and cost of living. It would be easy to attribute an increase or
decrease in sales volume to the wrong variable
Cognitive This relates to human perception and includes bias depending on how data is
presented (eg, infographics or the order of presentation, known as the ‘framing
effect’) and ‘anchoring’ (eg, being influenced by the first piece of information offered
or ‘stuck’ on last year’s numbers).
Example – budgeting
Budgeting based on last year’s figures is very common but may lead to poor decision
making and underachievement. Opportunities may be missed. This can be overcome
by using zero-based budgeting or by considering what the budget might be if last
year’s figures were unknown, ie, considering market size, growth, competition etc.
Confirmation This occurs when people see data that confirms their beliefs and they ignore
(consciously or sub-consciously) data that disagrees with their beliefs.
Example – new product/market research
Managers may have an idea for a new product and then ask for market research to
confirm the viability of the idea. If market research is being performed to assess the
popularity of a new product that the company has spent a lot of time and money
developing, there may be pressure on the market research department to conclude
that the product is not likely to fail. This could affect business performance if the
organisation develops a new product believing there is sufficient customer demand to
make the product viable, when in fact that demand does not exist.
Survivorship This is the tendency towards studying successful outcomes while excluding
unsuccessful outcomes. Only items that survived some previous event are included in
the sample. An accounting firm might decide to do a survey to find out how good its
programme for trainee accountants is, by surveying a sample of trainees who have
worked for the firm for one year. Such a survey would exclude trainees who left the
firm before the end of the first year, who were presumably not very happy with the
programme.
Example – performance management
Drawing conclusions from studying the departments that have performed well while
excluding the departments that have underperformed.

Users of information produced by data analytics should therefore take steps to ensure the analysis is
reliable, and should apply a degree of professional scepticism in their interpretation of this data.
Scepticism does not mean that the users assume that the data or its conclusions must be wrong;
rather it means being aware that data analysis is not always accurate.
46 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

4 Statistical tools
Where outcomes associated with a risk can be predicted reliably, and the probabilities of those
outcomes can be estimated, statistical techniques can be used to analyse the risks. The statistical
methods that you will need for your exam are as follows.
 Mean (or average)
 Standard deviation
 Co-efficient of variation
 Normal distribution

4.1 Mean
The mean (or average) of a set of data is calculated by taken the sum of all the values and dividing by
the number of values.
The AVERAGE spreadsheet function can be used to calculate the mean of a range of values.
The AVERAGE formula format is = AVERAGE(cell range)
A B C D E F
1 Year 1 2 3 4 5
2 Profit £ 25,000 37,000 55,000 60,000 48,000

The mean of the profit figures above is given by = AVERAGE(B2:F2), which is £45,000.

4.2 Standard deviation

This shows the average amount of variability in a data set, showing how far, on average, each result
lies from the mean (or expected value).

WORKED EXAMPLE: STANDARD DEVIATION

Explain how standard deviation could be used to show variability of outcomes

SOLUTION
Standard deviation can be used to monitor daily maximum temperatures. Consider two cities, one on
the coast and one inland. During the day they both have the same average maximum temperature of
25°C. Based on this data, it could be said that the temperatures of the two cities are the same.
However, let us examine the variation in temperatures further. The coastal city has a more stable
temperature than inland. Temperatures can rise to 28°C but rarely fall below 22°C. The inland city sees
greater temperature fluctuations. Temperatures have been known to rise to 40°C and fall to 10°C.
It can be seen that there is much greater variability in daily temperature in the inland city than the
coastal city. The standard deviation for the inland city is therefore greater than that of the coastal city,
whose temperatures are clustered around the mean. Standard deviation is useful in showing the level
of variation and therefore uncertainty that exists.
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 47

THE STDEV spreadsheet function can be used to calculate the standard deviation of values in a range
of cells.
The STDEV formula format is =STDEV(cell range)
A B C D E F
1 Year 1 2 3 4 5
2 Share price £ 10.50 11.70 12.90 11.10 9.90

The standard deviation of the share prices above is given by =STDEV(B2:F2), which is £1.15.

4.3 Coefficient of variation

Care must be taken when interpreting the standard deviation, as it can be misleading. A standard
deviation may be larger in comparison to others, simply because the values in the data set used to
calculate the standard deviation are higher. A more meaningful measure in such circumstances is the
co-efficient of variation, which measures the standard deviation as a percentage of the mean. The
higher the percentage, the wider the dispersion of data around the mean.

EXAMPLE 2: MEAN, STANDARD DEVIATION, COEFFICIENT OF VARIATION AND CORRELATION

COEFFICIENT

(a) East Ltd’s sales volumes over the last five years are shown in the spreadsheet below.
A B C D
1 Year Sales volume
2 1 30,000
3 2 40,000
4 3 37,000
5 4 55,000
6 5 50,000
7
8 Mean annual sales volume
9 Standard deviation for the sales volume
10 Coefficient of variation for the sales volume
Correlation coefficient between sales
11 volume and time

Replicate this spreadsheet (using the same cells) and calculate, using spreadsheet formulae:
(i) The mean annual sales volume in cell D8
(ii) The standard deviation for the sales volumes in cell D9
(iii) The coefficient of variation for the sales volume in cell D10
(iv) The correlation coefficient between sales volume and time in cell D11
48 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

(b) Set out below are the share prices of T plc and the RPI for the 12 months of 20X3.
A B C D
T plc share price
13 Month RPI (£)
14 Jan 20X3 317.7 303.40
15 Feb 20X3 320.2 286.55
16 Mar 20X3 323.5 275.75
17 Apr 20X3 334.6 272.00
18 May 20X3 337.1 258.50
19 Jun 20X3 340.0 254.80
20 Jul 20X3 343.2 262.60
21 Aug 20X3 345.2 252.70
22 Sep 20X3 347.6 206.80
23 Oct 20X3 356.2 212.70
24 Nov 20X3 358.3 235.00
25 Dec 20X3 360.4 224.20
26
27 Mean share price
28 Standard deviation for the share price
29 Coefficient of variation for the share price
30 Correlation coefficent between the RPI and share price

Replicate this spreadsheet (using the same cells) and calculate, using spreadsheet formulae:
(i) The mean share price in cell D27
(ii) The standard deviation for the share price in cell D28
(iii) The coefficient of variation for the share price in cell D29
(iv) The correlation coefficient between the RPI and share price in cell D30
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 49

4.4 Normal distribution

Many large data sets in the real world approximate a normal distribution.

As illustrated in the diagram, 68.2% of the values in the data set lie within one standard deviation (σ)
of the mean (µ), 95.4% within two standard deviations and so on.

WORKED EXAMPLE: NORMAL DISTRIBUTION

Suppose an organisation wants to invest in a new piece of machinery, the daily output of which follows
a normal distribution. If the average daily output of the machine is 500 units and the standard
deviation is ten units, what is the probability that the daily output will lie between 470 units and
510 units?
SOLUTION
470 units is three standard deviation units below the mean of 500 units. 510 units is one standard
deviation about the mean
Referring to the diagram above, there is therefore an 83.9% ((34.1% + 13.6% + 2.1%) + 34.1%) chance
that daily output will lie between 470 and 510 units.

4.4.1 Skewness
Most distributions are not symmetrical but are skewed to some degree. Skewed distributions may be
left (negatively) skewed or right (positively) skewed.

Skewness is often indicative of bias in data.

50 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

5 Expected values and attitude to risk

5.1 Expected values
 The simplest way to work with a spread of possible outcomes is to use expected values or
averages.
 The expected value is the probability-weighted average of the possible outcomes
 Expected value = ∑(probability of the outcome × the outcome)

WORKED EXAMPLE: EXPECTED VALUES

A firm has to choose between two possible projects, the outcome of which depend on whether the
economy is in recession or boom:
Project A Project B
Probability NPV NPV
£m £m
Recession 0.6 – 100 – 50
Boom 0.4 + 250 + 200
Using expected values which project should be chosen?
SOLUTION
Project A expected NPV = (0.6 × – £100m) + (0.4 × £250m) = £40m
Project B expected NPV = (0.6 × – £50m) + (0.4 × £200m) = £50m
Based on expected values, project B is the better project.

EXAMPLE 3: UNCERTAIN SALES

Harry is trying to evaluate a two year project using NPV. There is uncertainty as to the level of sales (in
units) in each of the two years:
Year 1 sales (units) Probability Year 2 sales (units) Probability
10,000 0.3 8,000 0.2
10,000 0.8

15,000 0.7 20,000 0.6

10,000 0.4
Requirement
On what expected level of sales in years 1 and 2 should Harry base his NPV calculation?
SOLUTION
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 51

5.2 Analysing the outcomes

Alternate presentation of Example 3 (assuming initial outlay £230,000, unit contribution £10, cost of
capital 10%).

* probability of year 1 sales × probability of year 2 sales, eg year 1 (10,000) and year 2 (8,000), overall
probability is 0.3 × 0.2 = 0.06.
There are now four possible outcomes with NPVs as follows:
Probability £
A 10,000 × £10
+
8,000 × £10
– £230,000 = £(72,975)
1.1 1.12 × 0.06 = (4,379)
B 10,000 × £10
+
10,000 × £10
– £230,000 = £(56,446)
1.1 1.12 × 0.24 = (13,547)
C 15,000 × £10
+
20,000 × £10
– £230,000 = £71,653 × 0.42 =
1.1 1.12 30,094
D 15,000 × £10
+
10,000 × £10
– £230,000 = £(10,992) (3,078)
1.1 1.12 × 0.28 =
The expected NPV can be calculated as: 9,090

Range of It can be argued that as the expected NPV is positive, the project is worthwhile. However,
outcomes the expected outcome of £9,090 cannot occur if this project is undertaken only once,
because a loss of £72,975 or £56,446 or £10,992, or a gain of £71,653 in NPV terms will
result.
Probability of In addition, the chance of a positive NPV is 0.42 (or 42%). The chance of a negative NPV
outcomes must therefore be (1 – 0.42) = 0.58 or 58%. If the project is undertaken once only, it does
not look particularly attractive despite the expected positive NPV.
Average return However, if the project were repeated very many times, then on average it would make
£9,090 and this would be acceptable.
52 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

5.3 Advantages and limitations of expected values

Advantages
 The information is reduced to a single number for each choice
 The idea of an average is readily understood
Limitations
 The probabilities may be difficult to estimate
 The expected value may not correspond to any of the possible outcomes
 The expected value represents a long-run average, hence in one-off situations (such as above) it
is less appropriate to use
 The expected value gives no indication of the spread of possible results (hence use it in
conjunction with e.g. simulation)

EXAMPLE 4: INTERPRETING STATISTICAL MEASURES

Badders plc is considering investment in one of three projects – Alpha, Beta and Gamma. Information
about those projects is shown below.
A B C D E
1 NPV of project
2 State of the UK economy Probability Alpha Beta Gamma
3 Good 35% 800 1,500 750
4 Average 45% 650 750 700
5 Poor 20% 400 100 650
6 Expected value (of project NPV) 652,500 882,500 707,500
7 Standard deviation (of NPVs) 142,719 513,633 36,315
8 Coefficient of variation 21.87% 58.20% 5.13%

Given the information above, advise Badders plc on which investment project should be selected.

6 The portfolio effect and the Capital Asset Pricing Model (CAPM)
Another way to allow for risk and uncertainty is to adjust the cost of capital (the hurdle rate) for risk
(so that riskier projects are assessed against a higher cost of capital

6.1 Types of risk

When appraising a potential investment (e.g. buying shares in a company), it is important to consider
the different risks that impact on the investment.
 Risk represents the likelihood and impact of returns being either higher or lower than expected
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 53

 Here, we will consider the business risk of an investment:

Business Risk
 Variability profits before interest and tax
 Comprises systematic and specific risks

Systematic Business Risk

Specific (unsystematic) Business Risk
 Variability in PBIT due to macro-economic
 Variability in PBIT due to factors specific
factors such as the state of the economy, FX
to a company
moves, interest rate moves, inflation.
 Examples include equipment failure, Cannot be eliminated by diversification
labour strikes, product faults, product
approval by regulators  Impacted by business sector of the company
and its level of operational gearing
 Investor exposure to these risks may be
 β measures a company’s exposure to
diversified away (see next section)
systematic business risk

6.2 Portfolio theory

Consider that we are investing in shareholdings in other companies.
 By investing in shares in just one company, we are exposed to both the specific and systematic
business risk of that company.
 Portfolio theory states that it is possible to diversify away exposure to specific risk by holding
shares in a diverse selection of different companies.
 The assertion is that for each company that generates lower than expected profits due to
specific risk factors, another company that you have invested in should generate higher than
expected profits due to specific risk factors.
 Holding a portfolio of 15-20 randomly selected shares should eliminate the majority of your
exposure to specific risk, leaving only the exposure to systematic risk:

Total Unsystematic risk

risk (unique risk or specific risk)

Systematic risk
(market risk)

15-20 Number of
securities securities

 The exposure to systematic risk cannot be diversified away, as all companies’ profits will be
affected to an extent by macro-economic factors (such as the state of the economy).
54 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

6.3 The Capital Asset Pricing Model (CAPM)

6.3.1 Risk and required return
The cost of capital used to appraise an investment represents the minimum required return from the
investment.
 This required return is set according to the risk associated with the investment (the higher the
risk, the higher the return required).
 If we assume that investors are well diversified, then for the purposes of investment appraisal
only the systematic risk of an investment should be considered (as its specific risk may be
diversified away)

6.3.2 Beta
The CAPM sets a required return (cost of capital) for an investment based on its exposure to
systematic risk.
 Its exposure to systematic risk is measured using a risk factor called Beta (β) which shows the
relative riskiness of the investment compared to the market portfolio of shares (e.g. the FTSE
100 – an index of the 100 largest companies on the London Stock Exchange – could be used).
 Beta is measured by comparing the change in the return on an individual share to the change in
return on the market portfolio in the same period.
β<1 β=1 β>1
Investment is less exposed to Investment has the same Investment is more exposed to
systematic risk than the exposure to systematic risk as systematic risk than the market
market portfolio the market portfolio portfolio

 Companies such as food retailers and drugs companies sell necessities and will be less exposed
to the state of the economy than the market average and hence will have a Beta score < 1
 Companies in industries involved in capital goods (construction, car manufacturing) or which sell
non-essential goods and services (airlines) will be more exposed to the state of the economy
than the market average and hence will have a Beta score >1

6.3.3 CAPM and required return

The CAPM sets the required return on an investment using the following equation (which is provided
for you in the exam):
𝒓𝒓𝒋𝒋 = 𝒓𝒓𝒇𝒇 + 𝜷𝜷𝒋𝒋 �𝒓𝒓𝒎𝒎 − 𝒓𝒓𝒇𝒇 �
Where:
rj = required rate of return on investment j
rf = risk-free rate of interest
rm = return on the market portfolio
βj = index of systematic risk for security j
Fina nc ia l Ma na g e m e nt 3: R i s k a n d d e c i s i on ma ki n g 55

The relationship between the required return and the exposure to systematic risk can be seen below:

Explanation of the CAPM

 When investing in any new investment, the investor needs to receive at least the risk free rate
of return (rf). This is the return given by securities that carry no risk at all (e.g. US Treasury Bills)
 However the investor is accepting some exposure to systematic risk (as measured by β) – hence
they need additional return over and above the risk free rate to compensate them for this. This
is given by β multiplied by the market premium (the additional return on the market portfolio in
excess of the risk free rate) – the higher the Beta score, the greater the additional return
required.
 In chapter 5 we will use the CAPM to determine the cost of equity for a company.

6.3.4 Advantages and limitations of the CAPM

Advantages
 The CAPM directly links the risk associated with an investment to the required return from that
investment
Disadvantages
 It assumes that the investor is diversified and hence that we only need to focus on systematic
risk (which may not be the case)
 It ignores the fact that other stakeholders (such as directors) are not diversified and will be
concerned by specific risks (leading to potential agency problems)
 It assumes that the investors can deposit and borrow at the risk free rate
 It assumes that exposure to all systematic risks can be grouped into one measure (β), that β can
be accurately measured and that β will remain unchanged over time
 Historic figures are used in the calculation (return on the market portfolio and Beta)
56 3: R i s k an d d e c i s i on maki n g Fina nc ia l Ma na g e m e nt

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Can you distinguish between risk and uncertainty?

Do you know how to perform sensitivity analysis on an NPV?

Can you explain the concept of simulation?

Can you calculate the expected value of a cash flow to use in an NPV?

Can you distinguish between systematic and unsystematic risk?

 57

Sources of finance

Topic List
1. Capital markets, risk and return
2. Sources of equity finance
3. Sources of debt finance
4. ESG lending and green finance
5. Ethics
6. Capital market efficiency
7. Behavioural finance

Learning Objectives
 Explain the roles played by different stakeholders, advisors and financial institutions in the
financial strategy selected by a business and identify possible conflicts of objectives including
those relating to sustainability issues
 Evaluate the ethical implications of an entity’s financial strategy (including those for the
organisation, individuals and other stakeholders) and suggest appropriate courses of action to
resolve any ethical dilemmas and sustainability issues that may arise
 Describe and analyse the impact of financial markets (including the extent to which they are
efficient) and other external factors on a business’s financial strategy
 Explain the implications of terms included in loan agreements in a given scenario (eg,
representations and warranties; covenants; guarantees)
 Identify the significance and effect of developing technologies in financing decisions
 Compare the features of different means of making returns to lenders and owners (including
dividend policy), explain their effects on the business and its stakeholders, and recommend
appropriate options in a given scenario
 Forecast the capital requirements for a business taking into account current and planned
activities and/or assess the suitability of different financing options (including green finance) to
meet those requirements, comparing the financing costs and benefits, referring to levels of
uncertainty and making reasonable assumptions which are consistent with the situation
58 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

1 Capital markets, risk and return

1.1 Capital markets
The capital markets provide a source of long-term funds for companies and an exit route for investors:
Capital market Description
Stock markets In the UK this includes the London Stock Exchange (LSE) and the Alternative
Investment Market (AIM) where companies can issue new shares and investors
can buy and sell existing securities
Bond (debt) markets Markets where companies can raise funds by issuing new bonds and investors
can buy and sell existing bonds
Banking system Split into the retail market (banks which service individuals and small
businesses) and the wholesale market (banks which service s large companies)
Leasing Allowing businesses to lease capital items instead of purchasing upfront
Debt factoring Allowing businesses to borrow against the value of their receivables
Government grants Financial assistance to e.g. help develop industry in underdeveloped areas
International markets Available to larger companies, allowing them to raise funds in multiple different
currencies

1.2 Risk and return

As mentioned in the last chapter, risk and return go hand in hand – the higher the risk faced by an
investor, the higher the return demanded.
Debt holders face lower risk than shareholders and hence require a lower return, as:
 Debt is generally secured
 The returns received by debt holders are more certain (interest, unlike dividends, is not
discretionary)
 Debt may be redeemable (unlike shares)
 Debtholders are paid before shareholders should the business fail

1.3 Comparing types of issued capital

Debt Preference shares Ordinary shares
Ranking in the Ranks higher than Rank below debtholders, but Rank last
event of preference and ordinary before ordinary
liquidation of shareholders shareholders
company May have security over
specific assets
Voting rights / No voting rights, but can Rights to vote at general Voting rights at general
control exercise influence through meetings only if dividend is meetings
covenants (see chapter 6) in arrears
Returns Fixed amounts of interest Fixed dividend, must be paid Discretionary dividend from
(based on nominal value) before dividends to ordinary accumulated profits – paid
shareholders after interest and preference
dividends
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 59

Debt Preference shares Ordinary shares

Capital return / If redeemable, then Assume irredeemable No obligation to redeem
liquidation redemption at nominal value If traded, then can sell on If company is listed, then can
(‘par’) or a premium. secondary market sell on secondary market
If traded, then can sell on
secondary market
Tax impact Interest is deductible from Dividends non-tax Dividends non-tax
(issuer) taxable profits, leading to deductible deductible
corporation tax saving

Tax impact Interest subject to income tax Dividends subject to income Dividends subject to income
(investor) Likely exempt from capital tax tax
gains tax Gains on sale subject to Gains on sale subject to
capital gains tax capital gains tax
Risk / reward Low risk, low reward Higher risk, higher reward Highest risk, highest reward

2 Sources of equity finance

2.1 Methods of raising equity finance
There are broadly three ways of raising equity finance:
Method Description
Retentions Retaining profits, rather than paying them out as dividends - by far the most
important source of equity finance (and cheapest as there are no issue costs) –
more on this method in chapter 7
Rights issues An issue of new shares to existing shareholders in proportion to their existing
holding - the next most important source of equity finance
New issues to public An issue of new shares to new shareholders – the least often used and most
expensive way of raising equity finance

2.2 Right issues

 Legally a rights issue must be made before a new issue to the public.
 Existing shareholders are offered the right to buy new shares (at a discount to the market price)
in proportion to the number of existing shares that they own.
 By taking them up their rights (and subscribing for the new shares), shareholders can maintain
their existing percentage holding in the company

2.2.1 Impact of a rights issue

 The new shares are issued at a discount in order to make the offer relatively attractive to
shareholders so that the rights issuance will be fully subscribed (and so that the company will
raise the funds required)
 The ex-rights price (the price at which the shares will settle immediately after the rights issue
has been made), is calculated as follows (assuming that the rights proceeds are invested in a
new project):
Market capitalisation pre-rights issue + rights proceeds + project NPV
Theoretical Ex-Rights Price (TERP) =
Total number of shares after the rights issue
60 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

 (the market capitalisation = total number or ordinary shares x the current share price
 This new share price is only theoretical, the actual share price post-rights issue will be
dependent on the market’s reaction to the issue (see the end of this chapter)
The rights holder can sell their rights if they don’t want to exercise them.
The value of one right = TERP – subscription price

WORKED EXAMPLE: THEORETICAL EX-RIGHTS PRICE

A company has 100,000 shares with a current market price of £2 each.

It announces an increase in share capital to be achieved by a rights issue of one new share for every
two existing shares. The rights price is £1 per new share, thus raising £50,000 for investment in the
new project.
Requirements
(a) Work out the theoretical ex-rights price
(b) Calculate the value of the right to subscribe for each new share
SOLUTION
(a)
Each shareholder Company as a whole
Value of existing shares 2 at £2 = £4 100,000 at £2 = £200,000
Value of capital injected by rights issue 1 at £1 = £1 50,000 at £1 = £50,000
3 shares £5 150,000 £250,000
Theoretical ex-rights price = £5/3 shares = £1.6667 per share
(b) Value of the right to subscribe for each new share
= ex rights price – subscription price
= £1.6667 – £1
= 66.67 p
Value of a right per existing share = 66.67p / 2 = 33.33p

2.2.2 Impact of a rights issue on shareholder wealth

Does it make any difference to the wealth of an existing shareholder, whether they sell the rights,
exercise the rights or simply do nothing?

EXAMPLE 1: IMPACT OF A RIGHTS ISSUE ON SHAREHOLDER WEALTH

Assume a shareholder owns 1,000 shares in the company whose share value was described above:
Pre-rights price = £2
Ex-rights price = £1.6667p
Subscription price = £1
A 1 for 2 rights issue
Requirement
Show the shareholder's position if:
(a) He takes up his rights
(b) He sells his rights for £0.6667 per new share
(c) He does nothing.
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 61

SOLUTION

EXAMPLE 2: RIGHTS ISSUE TO FINANCE A PROJECT

The above company raises the £50,000 in order to take on a project with an expected NPV of £25,000.
Summary of data
Current market price is £2 per share
100,000 shares currently in issue
A 1 for 2 rights issue at £1 will raise the £50,000
Requirements
(a) What is the value of the company after the new project and the new issue?
(b) What is the ex-rights price per share and the value of the right?
(c) Assume a shareholder owns 1,000 shares. What is the effect on the shareholder's wealth if he:
(i) takes up his rights
(ii) sells his rights
(iii) does nothing
62 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

SOLUTION

2.2.3 Changing the terms

WORKED EXAMPLE: CHANGING THE TERMS

The company in Example 1 raises the required £50,000 by issuing new shares on a one-for-one basis at
50p per new share. Show what would happen to the shareholder's wealth (from the worked example)
if he:
(a) Takes up his rights
(b) Sells his rights
SOLUTION
Number of shares issued = 100,000
Amount raised = 100,000 × 50p = £50,000
(100,000 × £2) + (100,000 × £0.50) + £25,000
Ex-rights price = 100,000 + 100,000

= £1.375
Value of the right = £1.375 – £0.5 = 87.5p
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 63

(a) Take up rights

£
Wealth prior to rights issue 1,000 × £2 2,000
Wealth post rights issue 2,000 × £1.375 2,750
Less Rights cost 1,000 × 50p (500)
2,250
∴ £250 better off
(b) Sells rights
£
Wealth prior to rights issue 1,000 × £2 2,000
Wealth post rights issue
Shares 1,000 × £1.375 1,375
Sale of rights 1,000 × £0.875 875
2,250
∴ £250 better off
Thus the terms and price do not affect shareholders who take up or sell their rights – they gain
the same amount.

2.2.4 Factors to consider when making rights issues

 Issue costs – estimated at 4% on £2m raised, but % falls as proceeds rise (most costs are fixed)
 Issuance price – the issue needs to be priced at a sufficient discount to persuade shareholders
to subscribe.
 Shareholder reactions – shareholders may react badly to continually being asked for additional
funds, which may prompt them to sell their shares (driving down the share price)
 Control – if all shareholders exercise their rights there will be no change in the control of the
company
 Unlisted companies – rights issuances may be difficult to use, as shareholders may not be able
to sell their rights or to raise funds to exercise them

2.3 New issues of shares

New share issuances to the public are often used when the company needs to raise a large amount of
money.
When they coincide with a company obtaining a stock exchange listing they are called Initial Public
Offerings (IPOs)
64 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

There are two methods of making an IPO:

Note: Offers for sale are more popular and both methods are likely to be underwritten

2.3.1 Underwriting
 Underwriting is the process whereby, in exchange for a fixed fee (usually 1–2% of the total
finance to be raised), an institution or group of institutions will undertake to purchase any
securities not subscribed for by the public
 This ensures that the total funds needed by the company are raised
 Underwriting is one of the many reasons that new public issuances of shares are the most
expensive way of raising equity finance.

2.4 Venture capital

Venture capital is risk capital, normally provided by a venture capital firm or individual venture
capitalist, in return for an equity stake. Venture capitalists seek to invest cash in return for shares (and
sometimes debt) in private companies with high growth potential. They seek a high return and accept
that this will mean that the investments are often high risk.
Venture capitalists often invest in small companies that already have a track record of business
development and which need additional finance to grow, or in start-up companies with innovative
technologies and high growth potential.
Characteristics of venture capital financing include:
 Usually expect 20 – 49.9% of the shares of a company – enough to exert some control but
avoiding being the majority shareholder
 Able to provide advice and influence management
 Exit route often achieved after three to five years via selling shares to another company or by a
stock market flotation.

2.5 Angel investors

An angel investor is an individual who invests their own money in a company (usually a start-up) in
return for a minority stake (usually between 10% and 25%). They often provide mentorship and
expertise along with the capital.
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 65

3 Sources of debt finance

3.1 Convertible loans
Convertible loans are fixed return securities (either secured or unsecured) which may be converted, at
the option of the holder, into ordinary shares in the same company at either;
 a conversion ratio (a set number of shares per £100 of loan stock); or
 a conversion price (a set amount of loan notional value per share)
Benefits for the issuing company:
 Obtaining funds at a lower rate of interest (as holder has the benefit of potential conversion)
 Encouraging investors (with prospect of share in future profits)
 Introducing an element of short-term gearing (see chapter 6)
 Avoiding redemption problems (if the debt is converted into equity)
 Being able to issue equity cheaply (if converted)

3.2 Loan stock with warrants

Here the loan stock is not convertible into shares, but it comes with call options (the warrants),
allowing the holder to separately buy shares in the future at a set price.
Again, this ‘sweetener’ allows the issuer to pay lower interest on the loan stock (as with convertibles).

3.3 Loan documentation

Lenders seek to lower their risk by using loan documentation:
Documentation Category Examples
Is the company legally allowed to borrow?
Legality of Is the signatory authorised to sign?
Representations
borrowing Is the loan within the provisions of the Articles of Association?
and warranties
(checks before Does the loan breach existing loan agreements?
the loan is
Do the accounts show a true and fair view?
made)
Financial condition Are there any impending court cases which will affect the
company’s financial position?
The lender seeks a A parent guarantees the loan payments of a subsidiary
Guarantees guarantee from a A subsidiary guarantees the loan payments of a parent
guarantor
Providing Providing the lender with financial statements / management
Covenants*
information accounts
(the borrower
commits to do Negative pledges Pledging not to use assets as security for other borrowings
/refrain from Financial limits placed on the borrower - e.g. maximum gearing,
certain things to Financial covenants
minimum interest cover
protect the
E.g. restrictions on taking on more debt, paying dividends, making
lender) Restrictions
significant investments

*Failure to adhere to covenants could trigger penalties and/or early redemption of the loan
66 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

WORKED EXAMPLE: FUNDING A BUSINESS THROUGH ITS GROWTH PHASE

Ian's Sandwich Empire

This one-person business starts up selling sandwiches from home and develops into a national
business over time. Given the characteristics at each stage, suggest possible sources of funds.
Stage Characteristics Possible source of funds
Start-up Very small scale. Savings or second mortgage on home. Borrow from
Make at home family and friends (no security or past record, so
Deliver by car to local customers bank reluctant to lend).
(offices, trading estates etc)
Growth £100,000 Need small premises and a van Borrowing from bank to purchase premises
revenue pa (secured by premises and personal guarantees) or
lease premises. Possibly grant, but unlikely as not
innovating, employing people in an area of high
unemployment (eg former coalfield) or
manufacturing.
Organic growth to Need new larger premises with Borrowings from bank secured by premises or
£500,000 revenue refrigeration and refrigerated lease.
pa vans Become a limited company (Ltd) and bring in new
shareholders/money.
Possibly grant, as it may be possible to site the new
premises in an area offering grants to create
employment.
Growth to £2 Established a brand / name / Secured) bank borrowings remain. Acquisition is
million revenue pa reputation and wants to expand higher risk; main possibilities:
by acquisition regionally  Issue more shares.
 Venture capital or business angels (although
they tend to prefer bigger deals than this).
 Loans (at higher interest than bank,
acknowledging the higher risk and lack of
security).
Growth to £5 Want to use brand / name / Main sources likely to be:
million revenue pa reputation more widely – sell  Continuing bank borrowings (secured).
ready-made sandwiches to local  Venture capital or business angels.
independent retail outlets and (Now at a viable size for this)
local branches of national retail
 Loans/debentures.
chains (using their brand) on
credit  Invoice discounting (now they have
receivables and they are reputable).
Growth to £50 Expand to national scale, by Convert to plc and float on Stock Exchange (AIM or
million revenue pa combination of organic growth full listing).
and acquisition
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 67

3.4 Choosing between debt and equity finance

There are a range of Issues to consider when determining which type of finance is appropriate for a
particular company.
Debt finance versus equity finance: issues to consider
Impact on financial Measured by e.g. earnings per share, return on shareholder funds
performance Compare to historic performance and/or industry average
Impact on financial position Measured by gearing, interest cover (high gearing and/or low interest cover
mean greater financial risk)
Compare to historic performance and/or industry average
Cost of the finance / impact Cost of debt is cheaper than the cost of equity
on the WACC (covered in Use traditional theory / M&M to discuss the expected impact on WACC
Chapter 5) (covered in Chapter 6)
Impact on the shareholders Will their control of the company be impacted (e.g. by new public share
issuance)?
Do they have to fund the new project?
Matching to term / risk Will the source of finance last as long as the proposed investment? (Risky if
it doesn’t!)
If the project is risky (and hence returns are not certain), equity finance is
more appropriate (as dividends are discretionary)

4 ESG lending and green finance

ESG lending encompasses social loans, green loans and sustainability linked loans.
Green finance has many different definitions but can be thought of as the financing of investments
that provide environmental benefits, as part of a broader context of encouraging environmentally
sustainable development. This could include green crowdfunding for small-scale, community schemes
or green bond issuance for major infrastructure projects.

4.1 Greening finance

Green finance needs to be a whole-organisation approach, driving strategy, culture and business
processes throughout a firm. There is increasing pressure from governments and regulators for listed
companies to include consideration of the impact of their activities on global warming as a normal part
of their decision making.

4.2 Financing green

Methods of 'financing green'
Green loans Loans specifically to help finance green projects. The market for green
loans is growing rapidly and often lenders offer better terms to borrowers
that can show they are reducing their environmental impact
Sustainability linked loans SSLs differ from green loans in that they are loans for any purpose but the
pricing mechanism means that the loan is cheaper if the borrower achieves
certain sustainability related targets
Green bonds A green bond is a type of fixed-interest bond used to raise money for
climate and environmental projects. These bonds are typically secured and
have the same credit rating as a company’s other debt obligations but may
come with tax incentives
68 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

Methods of 'financing green'

Green funds To help investors target investments in companies with higher standards of
social responsibility many stock markets produce an index of firms that
satisfy social and environmental criteria.
Social bonds Used to raise funds for projects that address or mitigate specific social
issues and/or seek to achieve positive social outcomes

4.2.1 Green loan principles

The Green Loan Principles set out a clear framework, enabling all market participants to clearly
understand the characteristics of a green loan, based around the following four core components:
 Use of proceeds – designated green projects should provide clear, quantifiable and measurable
economic benefits that are reported by the borrower
 Process for project evaluation and selection – the borrower of a green loan should clearly
communicate:
– Its environmental sustainability objectives
– How it appraises and selects its environmental projects
– How it identifies and manages material environmental risks
 Management of proceeds – borrowers should establish an internal governance process where
they can track the allocation of funds towards green projects
 Reporting – Borrowers should make available up to date information on the use of proceeds.

5 Ethics
5.1 Fundamental principles
Fundamental Principle Description
Confidentiality  Don't disclose client information
 Don’t use it to gain a personal advantage (e.g. insider information)
Objectivity  Avoid bias, conflict of interest, undue influence
Professional Behaviour  Comply with laws and regulations
 Avoid discrediting the profession
 Be honest when marketing yourself (avoid exaggerated claims)
Professional Competence  Maintain appropriate professional knowledge and skill
or Due Care  Act diligently and in accordance with technical and professional standards
 Distinguish between opinion and fact
Integrity  Be straightforward and honest

5.2 Conflicts of interest

Where our interests are in conflict with the interests of a client, or where there is a conflict between
the interests of two or more clients:
Actions to take Controls to mitigate threat
Notify both clients of COI Use of separate engagement teams
Notify other relevant parties of COI Restricted access to info
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 69

Actions to take Controls to mitigate threat

Declare that you do not in the interests of one Clear guidelines for engagement team members on
party alone confidentiality & security
If conflict cannot be reduced to acceptable level, Use of agreements signed by employees & partners
resign from one or both engagements Regular review of the application of safeguards by
senior partner / compliance team

5.3 Ethical situations specific to Financial Management

 Ensure that written consent is needed for anyone to share documents prepared for client use
 Take into account the interests of all shareholders, unless acting for a specific group of them
 Avoiding advising assurance clients on takeovers
 Avoiding sponsoring / marketing / underwriting securities issuances for assurance clients
 Avoid undertaking management responsibilities of an assurance client
 Beware of self-interest threats / familiarity threats to objectivity during corporate finance
assignments (especially where you are privy to insider information)

6 Capital market efficiency

6.1 Introduction
Prices on the bond / stock market are fair if the market is efficient, i.e. the price reflects all known
information about the business and its prospects.

6.2 Workings of the Stock Exchange

On the LSE only members can directly buy or sell shares. Members have two main roles:
Dealers
Members may act as market-makers or dealers specialising in particular securities (providing liquidity
to the market):
 Will normally buy or sell irrespective of whether they actually have the securities
 Hold a trading stock of the securities in which they deal.
Brokers
Members may act as stockbrokers, i.e. as agents for the public who wish to buy/sell:
 Client contacts broker with buy or sell order
 Broker determines best prices at which to transact

6.3 Efficient market hypothesis

An efficient market is one where:
 Share prices are fair (shares can’t be bought on the cheap and immediately sold at a profit)
 No individual dominates the market
 Transaction costs are not significant
 Share prices follow a random walk (rise on good news, fall on bad news)
 Share prices change ‘quickly’ to reflect information about a company
70 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

There are different degrees of efficiency which reflect different interpretations of the word ‘quickly’:
When a positive NPV
project is reflected in the
Method Share prices reflect: How to beat the market share price
Weak form efficiency Information about past Analysis of forecasts and When its value has been
price moves and past the actions of the evidenced (e.g. reflected
information which has company in published accounts)
become fact
Semi-strong efficiency All publicly available Insider trading (illegal) When the project is
information announced
Strong form efficiency All information about a Luck When the board agree to
company undertake the project

7 Behavioural finance
Occasionally the market can appear inefficient, with share prices not moving in the expected way after the
release of new information.
This can be explained by behavioural finance – irrational behaviour by investors which cause share prices to
move in strange ways:

Tendency Description
Overconfidence Making bad investments due to lack of knowledge and high self-belief
Representativeness Over-reaction to news (based on perceived trends)
Narrow framing Concentrating too heavily on one piece of information
E.g. over-estimation of the probability of success of dotcom businesses in
Miscalculation of probabilities
the late 90s
Ambiguity aversion Aversion to investing in new business areas
Assumption that rising shares will continue to rise and falling shares will
Positive feedback
continue to fall
Cognitive dissonance Holding onto long-held beliefs in the face of evidence to the contrary
Paying undue attention to the latest piece of news about a company and
Availability bias
disregarding the bigger picture
Under-reaction to good news / bad news due to resistance to changing
Conservatism
their opinion (leads to the Fama and French ‘momentum’ factor)

8 Developing technologies and the financing decision

8.1 Financial technology (FinTech)
 Crowdfunding
 Peer-to-peer lending
 Crypto apps enabling cryptocurrency transactions
 Digital wallets such as Apple Pay
 Financial advice driven by algorithms (cheaper than traditional financial advisors)
 Digital-only banks, with no legacy of branch networks, call centres or complex systems
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 71

8.1.1 Definitions
Cryptocurrencies are a digital asset that are designed to function as a medium of exchange and store
of value. They are secured by cryptography to prevent counterfeiting and fraudulent transactions.
They are an alternative to traditional currencies.
One of the major differences between traditional and cryptocurrencies is that making payments using
cryptocurrencies does not involve a third party. Unlike traditional financial systems, where banks verify
transactions, cryptocurrencies operate through peer-to-peer transactions. There are no intermediaries
involved, just direct exchanges between users.
Risks of cryptocurrencies include:
 Volatility. The price of cryptocurrencies is subject to large swings.
 Security. Online digital wallets where the currencies are stored can be hacked.
 Privacy. The privacy associated with using cryptocurrencies for payments could provide
opportunities for criminals to avoid money laundering regulations.
Distributed ledger technology (DLT) encompasses a range of decentralised database systems where
transactions are recorded and validated across multiple sites.
Blockchain is a specific form of distributed ledger technology used by cryptocurrencies.

8.2 Crowdfunding
Crowdfunding allows a company to access finance by using an online crowdfunding platform to pitch
for finance from a large number of investors who choose whether or not to invest. A successful
crowdfunding pitch will be based on an attractive business plan that reassures prospective investors
about the prospects for the proposed product or service, and also about the quality of the
management team (ie, their skills and experience). A business might also include a short video
summarising the plan.

8.2.1 Advantages and disadvantages of crowdfunding

Advantages
 Available to start-up companies who often struggle to secure more regular sources of finance
 Helps to attract customer and to build awareness of company
 Can be a quick process, e.g. 30 days
Disadvantages
 A fee is payable to crowdfunding site
 Legal / advisory costs
 Administrative cost of dealing with investor requests for more information

8.3 Initial coin offering (ICO)

Like an Initial Public Offering (IPO), an ICO raises finance from investors. However, there are two key
differences:
 The investor receives a token – this might be for a share or it might give entitlement to use a
product or service
 Payment is made in a cryptocurrency such as bitcoin
72 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt

One of the attractions of an ICO initially was simplicity. The issuer raise money by issuing a “white
paper” providing details of the concept and tokens that will be issued. However regulators are
increasingly judging ICOs to be securities and so there is greater regulatory criteria to be met. This has
led to a decrease in the use of ICOs.ICOs are high risk, speculative investments. Risks include:
 They are unregulated, enabling fraud.
 Price volatility, as they are influenced by supply and demand, investor and user sentiment,
government regulations and media hype.
 ICO projects are often earlystage projects and their business models are experimental

8.4 Peer to peer lending

Peer to peer (P2P) lending is usually facilitated via an online platform that connects established
businesses with investors without involving traditional banks. P2P is available for both short and long
term and can be offered both as secured or unsecured debt. Platforms usually require borrowers to
have a trading track record, to submit financial accounts, and will perform credit checks. P2P allows
customers and family / friends to share in the returns of the business.
Advantages of P2P compared to traditional bank lending
 Usually come with lower interest rates due to greater competition between lenders
 Can be quicker to arrange
 Provides a more accessible source of funding for borrowers with a low credit rating

8.5 Revenue-based finance

Revenue-based finance (RBF), also known as royalty-based finance, is a method of raising capital from
investors who receive a percentage of the company’s ongoing revenues in exchange for the money
they invest. The repayment duration is normally between 1 to 5 years depending on the capital raised.
It is therefore used to fulfil a business’s short to medium-term capital requirements.
There’s typically a maximum repayment amount (cap), which is often calculated as a multiple of the
initial investment. When the cap is reached, the RBF agreement ends.
This predetermined cap on repayments ensures that the investor receives an agreed return. The
multiple will vary based on the specific RBF agreement and will be influenced by risk factors (the
higher the risk, the higher the multiple) and the time period of the loan (the longer the period, the
higher the multiple).
RBF is considered a hybrid between debt financing and equity financing:
 Unlike traditional debt financing, there are no fixed repayments or interest on the outstanding
balance. Repayments adjust based on business performance, making RBF more practical than
traditional debt finance for a company with unpredictable future cash flows such as startups
and small businesses, or companies with seasonal revenue fluctuations. In addition, unlike
traditional debt for early-stage businesses, RBF does not require business owners to make
personal guarantees using personal assets as collateral, which can make RBF easier, and
therefore quicker, to organise.
 In contrast to traditional equity finance, investors do not have direct ownership of the business.
Owners therefore do not need to give up any control of their company.

8.6 Use of artificial intelligence in the financing decision

8.6.1 Definition of artificial intelligence
Artificial intelligence (AI) is the ability of computer systems to perform tasks that traditionally require
human intelligence such as learning from data, problem solving and language processing.
Fina nc ia l Ma na g e m e nt 4: So u rc e s o f fi n a n c e 73

AI systems are characterised by their ability to adapt to new information or environments, operate
with a degree of autonomy, and make informed decisions. AI often, but not always, involves the use of
machine learning.
Machine learning is the capability of computer systems to learn from and make predictions or
decisions based on large volumes of training data, without being explicitly programmed to do so.

8.6.2 How AI can influence the financing decision

Aspect of the financing
Detail
decision
AI-powered systems can swiftly analyse large volumes of data, such as
bank statements, credit scores, and even social medial profiles. In
Risk assessment and credit traditional lending systems, risk assessment and credit scoring often rely
scoring on manual evaluations that can be time-consuming and prone to bias. AI
models are significantly more accurate in assessing credit risk and can
reduce the likelihood of false approvals or rejections.
AI automates many tasks involved in loan approval and so speeds up the
Loan approval process, providing faster access to funds when they are needed. It also
minimises human bias, ensuring a fairer decision-making process.
With advancements in AI technology, this process has become more
Matching of lenders and streamlined and accurate. AI algorithms analyse vast amounts of data such
borrowers as credit history, financial information, loan preferences and borrower
profiles to identify suitable matches.
AI technology can act as a safeguard against fraudulent activities by
detecting patterns indicative of suspicious behaviour. For example, if an
Protection against fraudulent applicant’s documents present inconsistencies or anomalies, the AI system
activities can flag them for further investigation by the lending platform. By
automating the verification process and reducing the risk of human error,
AI enhances the efficiency and reliability of loan verification.
By analysing data patterns, AI can make predictions about future trends
Predications and forecasts with a high degree of accuracy, enabling businesses to make informed
decisions about their future financial strategy.

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Can you calculate the theoretical ex rights price of a share?

Can you list the five fundamental principles from ICAEW’s ethical guidance?

Can you explain the three forms of market efficiency?

Can you list five methods of ‘financing green’?

Do you understand what behavioural finance is?

74 4: So u rc e s o f fi n an c e Fina nc ia l Ma na g e m e nt
 75

Cost of capital

Topic List
1. Cost of capital
2. Cost of debt
3. Weighted average cost of capital

Learning Objectives
 Calculate and interpret the costs of different sources of finance (before and after tax) and the
weighted average cost of capital
 Calculate and justify an appropriate discount rate for use in an investment appraisal taking
account of both the risk of the investment and its financing
 Organise, structure and assimilate data in appropriate ways, using available statistical tools,
data analysis and spreadsheets, to support business decisions
76 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

1 Cost of equity
After having raised finance, a company must decide what to invest in.
 When appraising potential investments, directors will need to determine a cost of capital (the
minimum return required when using the company’s funds).
 An important component of this is the company’s cost of equity – the minimum return that
shareholders require from the funds they have invested in the company.
 There are two ways of estimating the cost of equity that we will see:
– the dividend valuation model
– the capital asset pricing model (CAPM)

1.1 The dividend valuation model

The dividend valuation model (DVM) is a method which calculates the current price of an ordinary
share as the present value of a stream of constantly growing dividends (valuing them as a growing
perpetuity discounted at the cost of equity).
𝑫𝑫𝒐𝒐 (𝟏𝟏 + 𝒈𝒈)
𝑷𝑷𝟎𝟎 =
(𝒌𝒌𝒆𝒆 − 𝒈𝒈)

Where:
Po = Current ex-div share price
Do = Current dividend
g = Constant growth in dividends
ke = Return on equity or the cost of equity
We can then rearrange this formula to calculate the cost of equity:
𝑫𝑫𝒐𝒐 (𝟏𝟏+𝒈𝒈)
𝒌𝒌𝒆𝒆 = 𝑷𝑷𝒐𝒐
+ 𝒈𝒈 (formula given in the exam)

 Share prices can be quoted cum div, meaning the current price includes the right to the
upcoming dividend i.e. the dividend is about to be paid, and ex div, meaning the current price
excludes the right to the upcoming dividend i.e. the dividend has just been paid.
 For the purposes of the DVM we need an Ex div share price, so if you are given a cum div share
price, deduct the value of the next dividend from it.
 In this model it is assumed that dividends are paid at annual intervals

1.1.1 Pros and cons of the DVM

Pros:
 Calculates ke based on market data (share price)
Cons:
 Constant dividend growth is assumed and this is unrealistic and based on historic data
 The model falls down if g > ke
 Identifying an ex-div share price is difficult for listed companies and very difficult for unlisted
companies and so the model is based on estimates
 It assumes that worth for shareholders is only represented by dividends (what if the company is
retaining profits to invest, causing a low dividend?
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 77

EXAMPLE 1: DIVIDEND VALUATION MODEL

A company's shares are quoted at £2.50 ex-div. The dividend just paid was 50p. No growth in dividends
is expected and dividends are forecast to continue indefinitely.
(a) What rate of return, ke, do the investors anticipate?

(b) Using the data above, but with an anticipated annual growth rate in dividends of 10%, what is
ke?

(c) Investors in a company are known to require a rate of return of 15%. Current dividends are 30p
per share, just paid. No increase is anticipated. Estimate the share price.

(d) As in (c), but dividends are expected to grow at 5% pa. Again, find P0.

EXAMPLE 2: COST OF EQUITY

The market value of a company's shares is £2.20. It is about to pay a dividend of 20p, which is
expected to grow at a rate of 3% per annum
Requirement
What is the cost of equity?
SOLUTION
78 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

1.1.2 Estimating growth rates

If the growth rate (g) is not provided in the question, we can use one of two methods to estimate g:
 Annualising growth as a geometric average of the historical dividend stream.
The POWER spreadsheet function can be used here.
POWER formula format :
= POWER(most recent value/oldest value, 1/number of periods of growth)
 The earnings retention method g = rb
(1) Historical pattern

EXAMPLE 3: EVALUATING FUTURE GROWTH BASED ON HISTORIC GROWTH

Assume the following data has been assembled concerning the net dividend per share paid in the last
five years:
Year Dividend per share (p)
20X1 1.00
20X2 1.10
20X3 1.20
20X4 1.34
20X5 1.48
SOLUTION

(2) Earnings retention model

Growth comes about by retaining and reinvesting profits on which a return is earned.
The relationship between these variables is shown by:
g = rb
Where:
g = growth in future dividends
PAT
r = the current accounting rate of return =
Opening shareholders' funds

b = the proportion of profits retained

Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 79

EXAMPLE 4: USE OF EARNINGS RETENTION MODEL

Consider the following summarised financial statements for XZ plc:

BALANCE SHEET AS AT 31 DECEMBER 20X1
£m £m
Assets 200 Ordinary shares 100
Reserves 100
200 200
Profit after tax for the year ended 31 December 20X2 £20m
Dividends (a 40% payout) £8m
BALANCE SHEET AS AT 31 DECEMBER 20X2
£m £m
Assets 212 Ordinary shares 100
Reserves £(100 + (20 – 8)) 112
212 212
If the company's accounting rate of return and earnings retention rate remain the same, what will be
the growth in dividends in the next year?
SOLUTION

Problems with the Earnings retention model

Note that the accounting rate of return is calculated with reference to opening balance sheet values.
The major problems with this model are:
 Its reliance on accounting profits
 The assumption that r and b will be constant
 Inflation can substantially distort the accounting rate of return if assets are valued on an
historical cost basis
 The model also assumes all new finance comes from equity
80 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

EXAMPLE 5: APPLYING THE EARNINGS RETENTION MODEL

A company has 300,000 ordinary shares in issue with an ex-div market value of £1.35 per share. A
dividend of £50,000 has just been paid out of post-tax profits of £75,000.
Net assets at the year end were valued at £1.06m.
Requirement
Estimate the cost of equity.
SOLUTION

1.2 The Capital Asset Pricing Model (CAPM)

As described in Chapter 3, the CAPM approach can be used to determine the cost of equity of a
company based on its exposure to systematic risk (as measured by Beta).
𝒌𝒌𝒆𝒆 = 𝒓𝒓𝒇𝒇 + 𝜷𝜷𝒋𝒋 �𝒓𝒓𝒎𝒎 − 𝒓𝒓𝒇𝒇 � (Formula given in the exam)
Where:
ke = the cost of equity
rf = risk-free rate of interest
rm = return on the market portfolio
β = the measure of the company’s exposure to systematic risk
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 81

EXAMPLE 6: CAPM

Bloggins plc is an all equity company with a βj = 1.10

The risk free rate is 4% pa and the return on the market is estimated at 11% pa
Requirement
Calculate Bloggins' cost of equity.
SOLUTION

1.3 Cost of preference shares

Preference shares usually have a constant annual dividend. Hence, the value of a preference share can
be considered to be the present value of the future dividends (a perpetuity) at the cost of preference
shares:
𝑫𝑫
𝑷𝑷𝟎𝟎 =
𝒌𝒌𝒑𝒑

This formula can then be re-arranged to find the cost of preference shares (if you know the current
share price):
𝑫𝑫
𝒌𝒌𝒑𝒑 =
𝑷𝑷𝟎𝟎

Where:
D = constant annual dividend
P0 = ex-div market value
Preference dividends are normally quoted as a percentage. Thus 10% £1 preference shares will
provide an annual dividend of 10% of the £1 nominal value (not of the market value).
82 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

EXAMPLE 7: COST OF PREFERENCE SHARES

A company has 100,000 12% preference shares in issue, nominal value £1.
The current ex-div market value is £1.15/share.
Requirement
What is the cost of the preference shares?
SOLUTION

2 Cost of debt
2.1 Cost of irredeemable debt
As with preference shares, the market value of irredeemable debt is taken to be the present value of
the annual interest cashflow (a perpetuity) to the debt holder at the cost of debt.
The key difference is that interest on debt is tax deductible for companies and hence we should only
consider the post-tax cashflows when valuing the debt (as this represents the genuine cost to the
company):
𝑰𝑰 (𝟏𝟏−𝑻𝑻)
𝑷𝑷𝟎𝟎 =
𝒌𝒌𝒅𝒅
Where
P0 = Current ex-interest price of the bond
I = Annual interest paid on the bond
kd = The post-tax cost of debt
T = the rate of corporation tax paid by the company
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 83

This can then be re-arranged to find the cost of debt:

𝑰𝑰 (𝟏𝟏−𝑻𝑻)
𝒌𝒌𝒅𝒅 =
𝑷𝑷𝟎𝟎

EXAMPLE 8: IRREDEEMABLE DEBT

Irredeemable debt is quoted at £40, the coupon (nominal) interest rate is 5% and the rate of
corporation tax is 17%.
What is the return on the security?
SOLUTION

2.2 Cost of redeemable debt

The cost of redeemable debt capital is more complex, as the future cashflows will include both interest
and redemption payments.
 It is still the case that we will be given a market value for the debt and then we will be required
to find the discount rate at which the present value of the future cashflows = the market value.
 This is achieved by calculating the IRR (see Chapter 2) of the redeemable debt cash flows
(shown below for debt redeeming at time n:
Timing Cash flow
$
0 (Po)
1–n I
n Rv
Where:
P0 = Current ex-interest price of the bond
I = Annual interest paid on the bond (this will be an n year annuity)
Rv = Redemption value at time n
84 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

Alternatively, we can use the RATE spreadsheet function to calculate

The RATE formula format is =RATE(number of periods, payment, present value, future value, type,
guess)
 The number of periods may be in annual or non-annual terms (eg six months) depending on
whether or not payments are made annually.
 The payment is the amount of interest paid in any single period.
 The present value is the current market value of the asset (the bond) ex interest (inserted as a
negative number).
 The future value is the redemption value (the amount paid at maturity).
 ‘Type’ and ‘Guess’ can be left blank.
Alternatively, you can use the RATE function from the ‘Financial’ drop down menu under ‘Formulas’ on
the toolbar.
Both approaches give the ‘gross redemption yield’ on the debt, which is the pre-tax cost of debt. We
must multiply by (1-T) to find the post-tax cost of debt (as again this shows the true cost of the debt to
the company).

EXAMPLE 9: REDEEMABLE DEBT

If a company's debenture stock is quoted at £65.75%, coupon interest is 9% pa just paid, redemption is
in ten years' time at par and the rate of corporation tax is 17%, then what is the cost of the debt
capital as an annual rate?
SOLUTION
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 85

EXAMPLE 10: PREMIUM ON REDEMPTION

A company has 10% debentures in issue quoted at £98 ex interest. The debentures will be redeemed
in five years at a premium of 5% compared to the nominal value.
Corporation tax rate = 17%
Requirement
What is the cost of debt if interest is paid annually?
SOLUTION

2.3 Cost of convertible debt

 Convertible debt is similar to redeemable debt; however at the end of the debt’s life it can
either be redeemed or converted into a certain number of ordinary shares.
 This is the debt holder’s decision and will depend upon the value of the shares compared to the
redemption value.
 The cost of debt is calculated in a similar way to redeemable debt:
(1) Find the expected share price at the conversion date. If you are not told the expected
price, it can be estimated as follows, using the expected dividend growth rate:
Price now × (1+g)n = price n years’ time
(2) The redemption value will then be included as the higher of the possible redemption
cashflow (at par or a premium to par) and the value of the conversion to shares
(3) The post-tax cost of debt is then the IRR of the future cashflows and the current market
value(as for redeemable debt) multiplied by (1-T). Or the post-tax cost of debt can be
found using the RATE function.
86 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

EXAMPLE 11: CONVERTIBLE DEBT

A company has in issue 8% convertible loan stock currently quoted at £85 ex interest. The loan stock is
redeemable at a 5% premium in five years' time, or can be converted into 40 ordinary shares at that
date.
The current MV ex div of shares is £2/share with a dividend growth of 7%.
Requirement
What is the cost to the company of the loan stock?
Corporation tax = 17%.
SOLUTION

2.4 Cost of revenue-based finance

The IRR spreadsheet function can be used to calculate the cost of revenue-based finance.

WORKED EXAMPLE: COST OF REVENUE-BASED FINANCE

WHR is an online subscription-based coaching company for ultra-runners.

It is looking to raise £100,000 to invest in a new project. It has approached an investor who has agreed
to provide the £100,000 upfront in exchange for 10% of the project’s monthly revenue until they
receive a total of £120,000.
WHR’s marketing director has prepared the following estimates of the best, medium and worst case
revenue forecasts for the project for the next 12 months.
WHR pays corporation tax at 25%.
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 87

A B C D
Worst case scenario Medium case scenario Best case scenario
1 Month £ £ £
2 January 80,000 96,000 120,000
3 February 84,000 100,800 126,000
4 March 88,200 105,840 132,300
5 April 92,610 111,132 138,915
6 May 97,241 116,689 145,861
7 June 102,103 122,523 153,154
8 July 107,208 128,649 160,811
9 August 112,568 135,082 168,852
10 September 118,196 141,836 177,295
11 October 124,106 148,928 186,159
12 November 130,312 156,374 195,467
13 December 136,827 164,193 205,241
14 Total for year 1,273,371 1,528,046 1,910,055

Compare the expected cost of the finance over the next 12 months based on the best, medium and
worst case scenarios for WHR’s revenue forecasts.
SOLUTION
Repayments based on 10% of monthly revenue would be:
A B C D
Worst case scenario Medium case scenario Best case scenario
1 £ £ £
2 Investment -100,000 -100,000 -100,000
3 January 8,000 9,600 12,000
4 February 8,400 10,080 12,600
5 March 8,820 10,584 13,230
6 April 9,261 11,113 13,892
7 May 9,724 11,669 14,586
8 June 10,210 12,252 15,315
9 July 10,721 12,865 16,081
10 August 11,257 13,508 16,885
11 September 11,820 14,184 5,411
12 October 12,411 14,145 0
13 November 13,031 0 0
14 December 6,346 0 0
15 Total 120,000 120,000 120,000
16 IRR (monthly cost) 2.79% 3.22% 3.84%
17 Compound annual cost 39.12% 46.34% 57.18%
18 Post tax cost to WHR 29.34% 34.75% 42.88%
88 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

The formula in cell B16 Is = IRR(B2:B14). This calculates the monthly return provided to the investor or
the pre-tax monthly cost of the finance.
The formula in cell B17 is = ((1 + B16)^12) – 1. This calculates the compound annual return provided to
the investor or the pre-tax annual cost to WHR.
The formula in cell B18 is = B17(1 – 0.25). This calculates the post-tax cost to WHR of using revenue-
based finance.
The cost to WHR is therefore cheaper if the company generates a lower level of revenue as the
investor will receive lower payments.

3 Weighted average cost of capital

 As we have seen, the different sources of finance in a company have different costs.
 When a company undertakes a new project the assumption is that the overall pool of funds in
the company will be used to fund the project.
 Hence, when appraising these new projects, we need to use a weighted average cost of capital
(WACC) that takes into account the cost of all of the different sources of finance in the company
that make up the overall pool.
 This WACC will reflect the required return of all of the different investors in the company.

WORKED EXAMPLE: WEIGHTINGS IN THE WACC

Sport plc has traditionally raised funds in the proportion 50% equity : 50% debt. Consultants have
estimated from current market data that these sources of finance have the following costs:
Cost of equity 20%
Cost of debt 10%
Sport plc is appraising a new project costing £1 million which it intends to finance entirely by a new
issue of debt.
(a) What discount rate should it use to appraise the project?
(b) If 50% equity : 50% debt is considered the best mix, why use just debt for the new project?
(c) If just debt is being used, why not discount the project using the cost of debt?
(d) What are the likely implications for the cost of equity, and thus the WACC, if the debt increases
significantly such that the long term gearing changes?
SOLUTION
(a) This depends upon what is assumed. The most likely situation is that in the long run the firm will
maintain its historical mix and raise funds in the proportion 50% equity : 50% debt. Presumably
the firm has traditionally used these proportions as it considers them to give the 'best' mix of
finance.
In this case the weighted average cost of capital (WACC) will be as follows:
Proportion of equity funding × cost of equity + Proportion of debt funding × cost of debt
= (0.5 × 20%) + (0.5 × 10%) = 15%
(b) If a capital structure of 50% equity and 50% debt is considered the best mix, why is the firm
raising new funds entirely by debt? The most likely answer is that transaction costs would make
the issue of small amounts of debt and equity prohibitively expensive.
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 89

The firm would therefore raise debt on this occasion, and equity on the next round of fund-
raising, aiming to keep its long-run structure at 50:50. This is a common practice and investors
would understand the firm's approach.
(c) Discounting using the cost of debt, i.e. 10%, is inappropriate because this represents the risk to
the lenders and not that of the project. Using specific costs of capital in this way would mean
that a project with a 15% return would be accepted if the cash were to come from a new issue
of debt but rejected if from a share issue.
(d) If the firm were to change to long-run proportions of finance involving much higher levels of
debt, then the underlying costs of funds would probably change.
Equity holders would see their position as being much more risky (as large amounts of debt
interest would need to be paid before they received a dividend) and debt investors would have
little security for their loans. Both would ask for higher returns to compensate for the increased
risk and the figures given in the illustration could well change.
What would be the result?
Suppose that financing the new project entirely by debt signals the firm's intention to change to
a new financing mix of 75% debt : 25% equity. Investors react to this change by adjusting their
required returns to:
Cost of equity 22%
Cost of debt 12%
The new combined cost of capital would then be:
(0.25 × 22%) + (0.75 × 12%) = 14.5%
In this case the move has been beneficial, resulting in a lower combined cost of funds. The most
important point, however, is that the costs of debt and equity have changed, and in this
situation the original estimates above, which were based on the current level of gearing, cannot
be employed.

3.1 Conclusion
 The cost of the overall pool of funds should be considered, not the costs of individual sources of
finance.
 The weightings should be based on the long-run proportions in which future funds are to be
raised. This is often estimated from the past proportions in which funds were raised. This
approach should be adopted unless there is good evidence that the future mix will change.
 Whenever possible calculations should be based on market weights.

3.2 Calculating the WACC

The company's weighted average cost of capital is defined as follows:
𝑀𝑀𝑀𝑀𝑒𝑒 ×𝑘𝑘𝑒𝑒 +𝑀𝑀𝑀𝑀𝑑𝑑 ×𝑘𝑘𝑑𝑑
WACC= 𝑀𝑀𝑀𝑀𝑒𝑒 +𝑀𝑀𝑀𝑀𝑑𝑑
Where
MVe = total market value of equity
MVd = total market value of debt
That is, the individual costs of equity and debt capital are taken and each is weighted by the
proportion of its market value to the company's total market value (which is much more useful than
using book values).
90 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt

EXAMPLE 12: CALCULATING WACC

The market value of the debt is £1m and its cost is 6%.
The market value of the equity is £2m and its cost is 15%.
Calculate the WACC
SOLUTION

3.3 When to use the WACC

The WACC reflects the company’s existing business risk and capital structure (financial risk), hence we
may use the current WACC to appraise new projects so as long as:
 The new project has the same business risk as our existing operations
 There will be no change in the long term capital structure of the company
 We are not using project specific finance (e.g. an interest-free government grant which is tied to
this specific project)
 The project is relatively small (so its NPV won’t have a significant effect on MV of equity)

3.4 Other problems with the weighted average cost of capital

Which sources of finance to include
We naturally use long term sources of finance in our WACC calculations, however if it is clear that
short-term finance is being used to fund long-term projects, it should also be included (e.g. a
permanent overdraft balance)
How to deal with loans that do not have market values
Bank loans do not have market values in the same way as debentures. The most practical approach in
this case is to take the book value of loans as an approximation to market value and use the interest
rate (adjusted for tax relief) currently payable on the loan as the cost of the loan.
Fina nc ia l Ma na g e m e nt 5: Co s t o f c a p i t a l 91

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Can you calculate growth using the Gordon growth model?

Can you calculate the cost of equity using CAPM and the dividend valuation model?

Can you calculate the cost of irredeemable and redeemable debt?

Can you calculate the cost of convertible loan stock?

Do you understand why we use WACC as the discount rate for investment appraisal?
92 5: Co s t o f c ap i t al Fina nc ia l Ma na g e m e nt
 93

Capital structure

Topic List
1. Capital structure
2. Capital structure and high gearing
3. WACC – what to do when things change

Learning Objectives
 Explain, in non-technical terms and using appropriate examples, the effect of capital gearing
both on investors' perception of risk and reward and the weighted average cost of capital
 Calculate and justify an appropriate discount rate for use in an investment appraisal taking
account of both the risk of the investment and its financing
94 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt

1 Capital structure
1.1 Business and financial risk
We discussed business risk in chapter 3:
 Business risk is the variability in earnings before interest and tax of a company, comprising of
systematic business risk (which cannot be diversified away) and unsystematic business risk
(which can)
Now we also need to consider the financial risk of a company:
 Financial risk is the additional variability in earnings after interest and tax as a result of having
fixed interest debt in the capital structure. Equity holders take this risk in particular, but debt
holders also suffer financial risk at high gearing levels (see later in chapter).
NB Financial risk is narrowly defined here for the purpose of this chapter. A wider definition of
financial risk might include liquidity risk, interest rate risk, currency risk etc. (see chapters 9 and 10)

1.2 Gearing
Operating gearing
 The extent to which a firm's operating costs are fixed, as opposed to variable.
 Having a high proportion of fixed operating costs means that a company’s profits are very
sensitive to changes in sales volumes and contributes to business risk
Financial gearing
 The extent to which debt is used in the capital structure. High financial gearing is associated
with high financial risk.
 This can be measured in two ways:
– Capital terms (normally by market values*)
debt debt
or
equity debt+equity
* Where no market values are available then book values should be used. For the
purpose of this exam the book value of debt is to be taken as its total nominal value.
Either of these expressions is acceptable.
– Income terms using interest cover
EBIT
Interest

1.3 A reminder: why debt is cheaper than equity

Debt holders face lower risk than shareholders and hence require a lower return, as:
 Debt is generally secured
 The returns received by debt holders are more certain (interest, unlike dividends, is not
discretionary)
 Debt may be redeemable (unlike shares)
 Debtholders are paid before shareholders should the business fail
Additionally, debt is made cheaper for the issuer due to interest payments being tax deductible
Fina nc ia l Ma na g e m e nt 6: Cap i t a l s t ru c tu re 95

1.4 What happens if gearing changes?

As a company gears up financially two things happen:

 Ke increases due to the increased  The proportion of debt relative to equity

financial risk in the capital structure increases
 This pushes up the value of the  Since kd < ke this pushes down the value
WACC (all else equal) of the WACC (all else equal)

1.5 Capital structure theories

 A company’s value is the present value of all of its future cash flows discounted at its cost of
capital (WACC). Hence, companies can maximise their value by attempting to minimise their
WACC.
 Theories as to how to minimise the WACC are presented below:

1.5.1 The traditional view of capital structure

We have just seen that debt is cheaper than equity and that introducing debt increases the risk for
shareholders and so the cost of equity. So is having cheaper debt and more expensive equity a good or
bad idea overall? The traditional view of capital structure states that:
 As an organisation introduces debt into its capital structure, the WACC will fall, because initially
the benefit of cheap debt finance more than outweighs any increases in the cost of equity
required to compensate equity holders for higher financial risk. Initially, there is very little
change in the shareholders' required returns.
 As gearing continues to increase, the equity holders will ask for progressively higher returns and
eventually this increase will start to outweigh the benefit of cheap debt finance, and the WACC
will rise.
 At extreme levels of gearing the cost of debt will also start to rise (as debt holders become
worried about the security of their loans) and this will also contribute to an increasing WACC.
The traditional view can be depicted graphically as follows:
96 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt

Conclusions:
 There is an optimal level of gearing
 There is no precise method of calculating ke or WACC, or indeed the optimal capital structure
 The above conclusion applies equally to situations either with or without corporation tax
 If simplifying assumptions are made (ie that both interest and dividends are constant
perpetuities and debt is irredeemable), then
earnings before interest (1–T)
MVe + MVd =
WACC

1.5.2 Modigliani and Miller 1958

The economists Modigliani & Miller made the following assumptions in their initial view of capital
structure:
 Capital markets are perfect
 Investors are rational and risk averse
 There are no transaction costs
 Debt is always risk free
 There is no taxation
The no taxation assumption is particularly important as this removes the tax benefit of paying interest
and means that the total payments to investors will be the same for equivalent companies with and
without debt, leading to the assertion that:

M&M’s initial views can be summarised as:

 As debt is introduced, the cost of equity rises
 Without any tax saving on interest payments, the benefit of the extra cheap debt is only enough
to offset the increased cost of equity
 Hence the WACC remains unchanged and there is no optimal capital structure:
Graphical representation of M&M 1958
Fina nc ia l Ma na g e m e nt 6: Cap i t a l s t ru c tu re 97

WORKED EXAMPLE: CAPITAL STRUCTURE (IGNORING EFFECT OF TAX) – ILLUSTRATION OF M&M ‘58

A company generates EBIT (earnings before interest and tax) of £100m. It currently has no debt in the
capital structure. It is considering the use of debt, and is exploring raising either £800 million or £1,800
million. Interest is payable at 5%.
Requirement
Ignoring taxation and assuming all earnings after interest are paid out as dividends, find out which is
the most attractive capital structure.
SOLUTION
The total returns to all investors needs to be calculated.
No debt £800m debt £1,800m debt
£m £m £m
EBIT 100 100 100
Interest (£800m @ 5%) – (40)
(£1,800m @ 5%) (90)
Dividends 100 60 10
Dividends + Interest 100 100 100
The total distributions to providers of finance are the same, no matter what the level of gearing.
Thus these firms should be worth the same in total, as they generate the same total distributions for
investors with the same business risk.

1.5.3 Modigliani and Miller 1963

M&M showed in 1963 that, in the presence of corporation tax, it is advantageous for firms to issue
debt (gear up).
 The effect of interest being allowable against tax means that geared companies pay less tax.
This means geared companies will have more cash to pay out to investors, and therefore are
worth more.
 The optimal capital structure is therefore a geared one.
More formally M&M showed in 1963 that:

 Here the benefits of the tax relief mean that increasing amounts of debt reduce the WACC and
this is less than offset by the increasing returns required by shareholders which push up the
WACC, i.e. overall the WACC declines.
 (The valuation of the tax shield is based on the assumption that debt is irredeemable, so that
the MV = the PV of the interest cashflows and hence DT = the PV of the tax saving on the
interest)
98 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt

Graphical representation of M&M 1963

WORKED EXAMPLE: CAPITAL STRUCTURE WITH EFFECT OF TAXATION - ILLUSTRATION OF M&M ‘63

The same situation as in the previous worked example, but this time corporation tax is payable at 21%.
No debt £800m debt £1,800m debt
£m £m £m
EBIT 100 100 100
Interest – (40) (90)
100 60 10
Requirement
Which capital structure is most attractive in terms of total amount paid to investors, taking into
account the tax payable?
SOLUTION
No debt £800m debt £1,800m debt
Profit before tax 100 60 10
Tax @ 21% (21) (12.6) (2.1)
PAT = divis paid out 79 47.4 7.9

Total outflows to investors:

Interest – 40 90
Dividends 79 47.4 7.9
Total 79 87.4 97.9

The extra distributions arise because of the corporation tax savings on debt interest. For example,
paying £40m interest saves £40m × 21% = £8.4m tax (which is the difference between the tax bills of
£21m and £12.6m in the first and second columns).
This gives rise to the extra £8.4m distributed (£87.4m – £79m).
The more highly geared a firm, the greater should be its total distributions.
Therefore the firm should become more valuable as gearing increases.
Fina nc ia l Ma na g e m e nt 6: Cap i t a l s t ru c tu re 99

2 Capital structure and high gearing

Although M&M advocated high levels of gearing in their 1963 theory, their assumptions ignored some
of the very real problems of high levels of gearing (as discussed below).

2.1 Problems associated with high levels of gearing

Problem Description
Bankruptcy costs At high levels of gearing, investors will demand a higher return to compensate
them for the risk of the company being unable to pay them back (due to
bankruptcy costs).
Bankruptcy costs include liquidation costs, redundancy payments and assets
being sold for less than book value
Agency costs In order to prevent directors acting in the interests of shareholders over lenders
(e.g. by paying out dividends), loan covenants will often restrict the actions of
directors in high gearing situations
The covenants may restrict the directors from issuing debt, paying dividends,
mergers or new investments.
Tax exhaustion Interest payments have a tax benefit due to the payments being deductible from
taxable profits. However, once the taxable profits have been reduced to zero
there is no tax benefit from any additional interest payments.

2.2 Practical aspects in the capital structure decision

In addition to the above points, the following practical aspects apply equally to the traditional and
M&M theories:
Consideration Description
Business risk Gearing adds financial risk to the existing business risk  hence high business risk
companies tend to have lower gearing
Quality of assets Firms with tangible assets (which can be used as security) find it easier to borrow
Availability of finance Small firms are less attractive to lenders (as they are high risk), hence they are
often forced to rely on equity finance
Cost of raising finance Issue costs are zero for retained earnings and high for new share issuances. Debt
is relatively cheap
Tax rate The higher the tax rate, the more desirable debt becomes

3 WACC – what to do when things change

3.1 CAPM & gearing
A company’s exposure to systematic risk is driven by both systematic business risk and also financial
risk (which is also applies systematically).
 Hence a geared company has a greater exposure to systematic risk than an identical ungeared
company and will therefore have a higher cost of equity (as shareholders face increased risk)
 It follows that the Beta score of a geared company (the ‘equity beta’ or βe) is greater than the
Beta of an identical ungeared company (the ‘asset beta’ or βa).
100 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt

They are linked by the following formula:

𝑫𝑫(𝟏𝟏−𝑻𝑻)
𝜷𝜷𝒆𝒆 = 𝜷𝜷𝒂𝒂 �𝟏𝟏 + � (formula given in the exam)
𝑬𝑬
Where D = the market value of debt in the company and E = the market value of equity

3.2 What to do if business risk changes  CAPM & gearing

If a company invests in a new project in a different industrial sector, then it will be exposed to new
business risks.
We will therefore need a new Beta to represent the systematic risk in the new sector, which we can
use to calculate a new project specific cost of equity and WACC.
Steps to take:
(1) Locate a suitable proxy company (operating in the new industry area);
(2) Determine the equity beta of the proxy company, their gearing and tax rates;
(3) Ungear the proxy equity beta to obtain an asset beta for the new industry area;
𝛽𝛽𝑒𝑒
𝛽𝛽𝑎𝑎 = 𝐷𝐷(1−𝑇𝑇)
�1+ �
𝐸𝐸

(4) Re-gear the asset beta using our gearing;

𝐷𝐷(1−𝑇𝑇)
𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 �1 + �
𝐸𝐸
(5) Use the CAPM to calculate a project specific cost of equity;
(6) Use this cost of equity to calculate a new project specific WACC (we will typically be told the
ratio of debt to equity to use to calculate this);
(7) Use this new project specific WACC to evaluate the new project;
Note:
 This generates a project specific WACC which can only be used to value projects in the new
business area.
 Alternatively, to find an overall WACC for valuing the ongoing activities of the business, you
need to find an average Beta (a weighted average of the βs for the different business areas) and
use this to find an overall ke and WACC.

EXAMPLE 1: CHANGE OF BUSINESS RISK

Hubba plc, a food manufacturer, is about to embark on a major diversification into the consumer
electronics industry. Its current equity beta is 1.15, while the average equity beta electronics firms is
1.6. Gearing in the electronics industry averages 30% debt, 70% equity by market values. Debt is
considered risk free.
rm = 25%, rf = 10%, T = 17%
Requirement
Estimate a suitable discount rate for the project if the company is financed:
(a) By 40% debt, 60% equity (by market values)
Fina nc ia l Ma na g e m e nt 6: Cap i t a l s t ru c tu re 101

SOLUTION
102 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt

WORKED EXAMPLE: OVERALL EQUITY BETA AND WACC

Dene plc, a sportwear manufacturer, is considering a diversification into bicycle manufacturing.

The following information is available for Dene plc’s current sportswear manufacturing operations at
30 June 20X3:
 Risk-free rate – 1.50%
 Return on the market – 11.00%
 Equity beta – 1.50
 Cost of equity – 15.75%
 Market value of equity – £11,000,000
 Market value of debentures – £2,850,000
 Cost of debt (post-tax) – 6.00%
 Corporation tax rate – 17%
The following information is available for the bicycle manufacturing sector at 30 June 20X3:
 Equity beta – 1.9
 Average debt:equity ratio (by market values) – 3:7
If the diversification goes ahead the overall equity beta of Dene plc will be made up of 90% sportswear
manufacturing and 10% bicycle manufacturing and the company’s existing debt:equity ratio (by
market values) will be unchanged.
Calculate Dene plc’s overall equity beta and its WACC assuming the diversification goes ahead.
SOLUTION
Degear the bicycle manufacturing industry equity beta to find the asset beta for that industry (using
the average debt:equity ratio of the bicycle manufacturing industry):
𝛽𝛽𝑒𝑒
𝛽𝛽𝑎𝑎 = 𝐷𝐷(1−𝑇𝑇)
�1+ �
𝐸𝐸

1.9
𝛽𝛽𝑎𝑎 = 3(1−0.17) = 1.4015
�1+ �
7
Fina nc ia l Ma na g e m e nt 6: Cap i t a l s t ru c tu re 103

Regear the bicycle manufacturing industry asset beta with Dene plc’s gearing (using Dene plc’s
debt:equity ratio) to produce an equity beta with the bicycle manufacturing industry’s business risk
and Dene plc’s financial risk:
𝐷𝐷(1−𝑇𝑇)
𝛽𝛽𝑒𝑒 = 𝛽𝛽𝑎𝑎 �1 + 𝐸𝐸
�
2.85(1−0.17)
𝛽𝛽𝑒𝑒 = 1.4015 �1 + 11
� = 1.7029

Calculate the overall equity beta of Dene plc after the diversification, which will reflect the weighted
systematic risk of both bicycle manufacturing and sportwear manufacturing and Dene plc’s financial
risk:
1.5 × 0.9 + 1.7029 × 0.1 = 1.52
Calculate a new Ke
Ke = Rf + βe (Rm − Rf) = 1.50% + 1.52(11.00% - 1.50%) = 15.94%
Kd = 6.00%
MVe = £11,000,000
MVd = £2,850,000
WACC = (0.1594 × £11m) + (0.06 × £2.85m)/(£11m + £2.85m) = 13.9%

3.3 What to do if capital structure changes  Adjusted Present Value

As discussed earlier in this chapter, if the capital structure (gearing) of a company changes, the existing
WACC can no longer be used due to the change in financial risk, as demonstrated below:

WORKED EXAMPLE: CHANGING GEARING

Spears Ltd is currently an all equity company. It is considering borrowing a significant amount to
finance a new project. The new project is similar, in terms of business risk, to the existing projects.
(a) What will happen to the company's cost of capital?
(b) What cost of capital should be used to assess the new project?
(i) The existing cost of capital?
(ii) The cost of the new debt?
(iii) The new WACC?
SOLUTION
(a) The increased level of gearing may cause the overall WACC to fall, due to the tax shield on the
debt interest.
(b)
(i) The company's existing cost of capital (the cost of equity ke) is inappropriate, as the new
gearing will have altered it.
(ii) The cost of the new debt is not the correct discount rate, because the cost of debt does
not reflect the risk that will be borne by the shareholders.
(iii) The new WACC is difficult to identify, for the following reason:
𝑀𝑀𝑀𝑀𝑒𝑒 ×𝑘𝑘𝑒𝑒 +𝑀𝑀𝑀𝑀𝑑𝑑 ×𝑘𝑘𝑑𝑑
WACC= 𝑀𝑀𝑀𝑀𝑒𝑒 +𝑀𝑀𝑀𝑀𝑑𝑑
104 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt

One component of the above is the market value of the shares (MVe in the above equation) – which
reflects the impact of both the new debt and the project.
The impact of the new project on the share value is its NPV – the value of the shares should reflect the
wealth created by the project.
The NPV requires the new cost of capital (the new WACC) to be known.
Thus there is a problem – to find the new cost of capital requires the new market value of the shares,
this requires the NPV to be known which in turn requires the new cost of capital.
Hence, we need an alternative approach – the adjusted present value (APV)

3.3.1 Adjusted present value

The Adjusted Present Value (APV) approach can be used to address the above problem by using the
assumptions of M&M 1963 (with tax):
 Calculate a base case value of a project using keu (giving the value of the project if the company
was ungeared)  you may need to find βa in order to calculate keu using CAPM
 Add the present value of the tax shield (PV of the tax saving on the interest, discounted at the
pre-tax cost of debt)
 Deduct costs of issuing the finance to arrive at the APV (if the APV is positive, then proceed with
the project)

EXAMPLE 2: APV

Toes Ltd, currently all equity financed, is considering a project which will involve investing £240 million
now and will generate annual net cash flows of £40 million for each of the next 10 years. The project
will use buildings and equipment which, when used as security, will enable Toes Ltd to borrow
£187.5 million at a rate of 8%. The costs of issuing the debt are £1 million. The debt will last as long as
the project: 10 years.
Corporation tax rate is 17%.
If the project were to be funded entirely by equity, the cost of capital would be 12%.
Requirement
Establish whether Toes should go ahead.
SOLUTION
Fina nc ia l Ma na g e m e nt 6: Cap i t a l s t ru c tu re 105

3.3.2 Problems with the APV approach

The technique is based upon the assumptions of M&M with tax. That means that issues such as agency
costs, bankruptcy costs and tax exhaustion are not reflected in this technique.

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Can you distinguish between business risk and financial risk?

Can you explain the impact on WACC using the traditional theory of gearing and both
of M&M’s theories?

Can you explain the three main problems associated with high gearing?

Can you calculate the APV of a project?

Can you adjust a beta for differences in gearing?

106 6: Cap i t al s t ru c tu re Fina nc ia l Ma na g e m e nt
 107

Dividend policy

Topic List
1. M&M and dividend policy
2. Share buy-backs and scrip dividends

Learning Objectives
 Compare the features of different means of making returns to lenders and owners (including
dividend policy), explain their effects on the business and its stakeholders, and recommend
appropriate options in a given scenario.
108 7: Di v i d e n d p o li c y Fina nc ia l Ma na g e m e nt

1 M&M and dividend policy

1.1 Dividend irrelevance theory (M&M)
Modigliani and Miller (M&M) proposed that in theory the pattern of dividends over time is irrelevant
in determining shareholder wealth (in a tax-free world), based on the following logic:
 A company will always invest in positive NPV projects.
 If the company can’t invest in a certain project out of its retained earnings (due to a dividend
having been paid out), then it will need to raise funds from other sources (which M&M assume
will always be possible for positive NPV projects).
 This will potentially lead to existing shareholders receiving proportionately less of the returns
from the new project, but this loss will be offset by the dividend they are receiving now.
 Hence, the ultimate pattern of dividend payments is irrelevant.
Modigliani and Miller stated that if a firm’s dividend policy was not to the taste of shareholders, the
shareholders could take action:
 If the dividend is lower than desired, simply sell a few shares to create some extra income to
replicate an increased dividend (a ‘manufactured dividend’)
 If the dividend is higher than desired, simply use the ‘excess’ dividend to buy some additional
shares.
In reality, tax and transaction cost implications means this logic is flawed.
Note: M&M are not saying dividends themselves are irrelevant (after all the value of a share is the
present value of the dividend stream) but they are saying that the pattern of payments (i.e. the
dividend policy) is irrelevant.

1.2 Arguments for the relevance of dividend policy

There are several practical reasons why dividend policy does matter in reality and why many boards of
directors agonise over dividend decisions:
Argument Description
Clientele effect Shareholders invest in a company because of the dividend policy  if it changes,
they may divest (leading to a fall in the share price)
Uncertainty Cash now is more certain for shareholders than possible future returns (‘bird in the
hand’), hence they would prefer a dividend now
Signalling Markets see dividend reductions as bad news  this may lead to a share price fall
(this argues against strong form market efficiency)
Agency problem Shareholders may be nervous that directors act in their own interests (the agency
problem) and hence would prefer a cash pay-out now to limit the impact of this
Taxation Dividends and capital gains on shares are taxed differently, hence depending on the
shareholder’s position they may favour one over the other
Cash availability Dividends can only be paid if a company has sufficient cash (otherwise new
investment could be cut back or additional funds borrowed if the directors want to
avoid signalling effects)
Fina nc ia l Ma na g e m e nt 7: Di v i d e n d p o li c y 109

1.3 Pecking order

Because of issuance costs, firms often follow a pecking order when it comes to raising equity finance:
(1) Retained earnings (no issuance costs)
(2) Rights issues and placings (next cheapest)
(3) New issues to the public (highest issuance costs)

2 Share buy-backs and scrip dividends

Share repurchases
As an alternative to dividend payments a company might consider using the cash to repurchase issued
shares (reducing equity and increasing gearing) – returning cash to the shareholders without
disrupting the pattern of dividends
An alternative to buying back shares would be to pay a 'special dividend' making it clear that it was a
one-off above normal sustainable levels

Stock (or scrip) dividends

Companies may offer scrip dividends (i.e. free shares) in lieu of cash dividends.
Scrips help companies to avoid liquidity problems and allows shareholders to swap cash now for
capital gain
110 7: Di v i d e n d p o li c y Fina nc ia l Ma na g e m e nt

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Do you know the pecking order for accessing equity finance?

Can you explain M&M’s dividend irrelevancy theory?

Can you explain what is meant by dividend signalling?

Can you calculate the impact on shareholder wealth of offering a scrip dividend?

Do you know why companies would choose to offer a scrip dividend to shareholders?
 111

Business planning, valuation

and restructuring

Topic List
1. Methods of growth
2. Valuation
3. Forecasts

Learning Objectives
 Outline the investment decision making process and explain how investment decisions are
linked to shareholder value
 Describe options for reconstruction eg, merger, takeover, spin-off, purchase of own shares and
calculate the value of minority and majority shareholdings in traditional and new businesses
using income and asset based approaches
 Forecast the capital requirements for a business taking into account current and planned
activities and/or assess the suitability of different financing options (including green finance) to
meet those requirements, comparing the financing costs and benefits, referring to levels of
uncertainty and making reasonable assumptions which are consistent with the situation
 Draft a straightforward investment and financing plan for a given business scenario
 Organise, structure and assimilate data in appropriate ways, using available statistical tools,
data analysis and spreadsheets, to support business decisions
112 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

1 Methods of growth
A key choice for all businesses will be whether to grow organically or through acquisition.

1.1 Organic Growth

This involves the retention of profits and/or the raising of new finance (equity and/or debt) to fund
internally-generated projects (such as new product and/or market development)
Advantages
 Costs are spread (as opposed to paying up front for acquisition – however, costs of organic
growth may be higher)
 Less disruption (as the need to integrate new staff and systems will be avoided along with
cultural problems)
Disadvantages
 More risky (high risk of failure in a new market / with a new product)
 The process may be too slow (may be too slow to market)
 There may be barriers to entry in new markets

1.2 Growth through acquisition

Here a bidder company will acquire a target company.
This may be referred to as a takeover or a merger (in this syllabus they are interchangeable)
There are many reasons why two businesses may combine:
Synergy
This describes the situation where the combination of two businesses is worth more than the separate
businesses on a stand-alone basis. Synergies may arise due to:
 Administration savings (e.g. cutting back office headcount)
 Economies of scale (greater purchasing power)
 Use of common investment in marketing, new technologies, research and development (no
need to spend twice)
 Leaner management structures (e.g. shed some of the management from the target company)
 Access to under-utilised assets (e.g. the target has fantastic technology that they are not using
to its full potential)
Risk reduction
 Specific risk is not reduced for shareholders through diversification (assuming the shareholders
are diversified), but the reduction of specific risk for the business may lead to cheaper
borrowing
Reduced competition
 Merging with a competitor reduces / eliminates competition in the market
Vertical integration
 Acquire a key supplier to safeguard the position of the business
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 113

1.2.1 Downsides of acquisition

 The bidding company shareholder often lose out due to over-paying, high transaction fees and
synergies being overestimated
 Takeovers are often in the interests of the directors rather than the shareholders

2 Valuation
There are several reasons why you may be required to place a value on a company:
(a) To establish merger/takeover terms.
(b) To be able to make share purchase/sale decisions.
(c) To value companies listing on the stock exchange.
(d) To value shares sold in a private company.
(e) For tax purposes.
(f) For divorce settlements, etc.
(g) To value subsidiaries for disposals, MBOs, etc.

2.1 Asset-based valuations

2.1.1 Historic cost (book value)
 Balance sheet value of equity.
 Meaningless because historic cost ≠ market value.

2.1.2 Net realisable value

 NRV of assets less liabilities.
 Minimum acceptable value to owners determined to sell.
Problems:
– Estimating NRV of assets, redundancy costs, liquidator's costs, tax
– Ignores goodwill (brand, customer relationships, staff)

2.1.3 Replacement cost

 Cost of setting up an identical business from scratch
 Maximum price for buyer
Problems
– Estimating replacement costs
– Ignores goodwill, or if not, this difficult figure would have to be valued.

General points
 Assets are more certain than income. Income is generated only if assets are well managed,
which is by no means certain.
 Asset valuations are useful for asset strippers.
 Service businesses often have very few tangible assets so asset methods would place very little
value on business. Most value in a successful service industry would reside in its goodwill.
114 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

2.2 Income-based approaches

General points (for income-based approaches)
 Forecasting problems – all income methods require an estimate of the future.
 Type of business – more appropriate than asset valuations for service businesses.

2.2.1 Present value of future cashflows

This is theoretically the best approach to valuing a company. The calculation approach is the same as
for investment appraisal (chapter 2)
Summary of approaches
 Strictly speaking, if you want to find the MV of the shares in a business you should take the cash
flows attributable to the shareholders (after interest and tax) and discount using the
shareholders’ required return (the cost of equity, ke).
 If cash flows (before interest but after tax) are discounted at the WACC the result will give the
total value (debt + equity) of the business, so to get the value of the shares only you need to
deduct the market value of any debt.
Cost of equity approach WACC approach
Cashflows to use Cashflow after interest and tax Cashflow before interest, but after tax
Discount rate to use Cost of equity WACC
Result MV of equity MV of equity + MV of debt

The maximum price a bidder should pay for a target is:

The market value of combined businesses less market value of bidder’s business (standalone)
Problems with this approach
 Estimating future cashflows (particularly synergies)
 Estimating discount rate (to allow for the risk)
 Time horizon – how far out should you estimate the cashflows? At some stage do you make the
simplifying assumption of a perpetuity?

EXAMPLE 1: PV OF CASHFLOWS

A plc generates constant annual cash flows of £15m. The appropriate discount rate for these flows is
20% pa. It plans to make a bid for the entire share capital of B plc. If B plc were acquired the combined
businesses would generate constant annual cash flows of £20m and the appropriate discount rate
would be 16% pa.
Requirement
What is the maximum price A plc should pay for all of B plc's shares?
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 115

Part of this maximum price arises because there is risk reduction (i.e. within the £20m annual cash
flows, A's flows are now being discounted at 16% rather than 20% – so some risk reduction has taken
place)
It is not unusual for the maximum price to be above the current market value of the target. Reasons
include the following:
 Synergy – an extra £20m – £15m = £5m of flows is discounted. Some of this may result directly
from B's activities and some may be as a result of synergy
 Risk profile – the overall risk of the combination may be less than the risk of B alone (however,
if we are using the principles of the CAPM our shareholders are already diversified – hence this
would not represent a reduction in specific risk for them!)

EXAMPLE 2: MAXIMUM PRICE (PV OF FUTURE CASHFLOWS)

Arrow plc is considering purchasing the entire share capital of Target plc. Arrow operates on a five year
planning horizon and believes that Target will be able to generate operating cashflows (after deducting
funds for necessary reinvestment) of £1 million per annum before interest payments.
The following information is also relevant but has not been included in the above estimates.
(1) Target's head office premises can be disposed of and its staff can be relocated in Arrow's head
office. This will have no effect on the operating cashflows of either business but will generate an
immediate net revenue of £2 million.
(2) Synergistic benefits of £200,000 per annum should be generated by the acquisition.
(3) Target has loan stock with a current market value of £1.5 million in issue. It has no other debt.
(4) Arrow estimates that in five years' time it could, if necessary, dispose of Target for an amount
equal to five times its annual cashflow.
Arrow believes that a WACC of 20% per annum reflects the risk of the cashflows associated with the
acquisition.
Requirement
Calculate the maximum price to be paid for Target plc. Ignore taxation.
SOLUTION
116 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

2.2.2 Price-Earnings ratio

Total market value of equity Share price
The P/E ratio = =
Earnings Earnings per share

This gives an indication of the market’s perception of the future growth potential of a business –
companies with a high PE ratio can be said to:
 carry low risk
 be large / stable / mature
 have excellent cashflow generation
 have good growth potential
A generalisation is that a high P/E ratio indicates a high degree of investor confidence in the future
prospects of the company.
Use in valuations:
By applying a suitable P/E ratio to the current earnings the valuation of a business can be estimated as:
 Total market value of equity = P/E ratio × current earnings
Where earnings = PAT less preference dividends
Or if trying to value an individual share:
 Share price = P/E ratio × EPS
Important points to note:
 If valuing a private company we will need to use the P/E ratio of similar listed company.
 The ratio used will then need to be adjusted to reflect any differences in likely growth
(e.g. expected growth, strength of team, quoted or unquoted status, R&D capability)
 Crucially it will need to be adjusted down to reflect the fact that listed companies are more
desirable than private companies (due to higher liquidity of the shares).
 The earnings figure used should be the sustainable earnings available to the ordinary
shareholders. If the PAT has been volatile over recent years, consider using an average of the
last few years’ PAT
Problems with the P/E valuation method:
 Estimating maintainable future earnings (particularly synergies)
 Accounting policies can be used to manipulate earnings figures.
 Selecting a suitable P/E ratio to value unquoted companies
 Finding a similar quoted company (same industry, size, gearing, risk, etc)
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 117

EXAMPLE 3: P/E VALUATION

You are given the following information regarding Accrington Ltd, an unquoted company.
(a) Issued ordinary share capital is 400,000 25p shares.
(b) Extract from Income Statement for the year ended 31 July 20X4
£ £
Profit before taxation 260,000
Less: Corporation Tax (72,800)
Profit after taxation 187,200
Less: Preference dividend 20,000
Ordinary dividend 36,000
(56,000)
Retained profits for year 131,200

(c) The P/E ratio applicable to a similar type of business (suitable for an unquoted company) is 12.5.
Requirement
Value 200,000 shares in Accrington Ltd on a P/E basis.
SOLUTION
118 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

EXAMPLE 4: MAXIMUM PRICE (P/E VALUATION)

Price plc wishes to acquire the entire share capital of Maine plc. Details of current earnings and P/E
ratios are as follows:
Earnings P/E
£m
Price plc 50 20
Maine plc 20 15
It is believed that as a result of synergies the combined earnings would be £75m and the market would
apply a P/E of 18 to the combination.
Requirements
(a) What is the maximum amount Price plc should pay for Maine plc?
(b) What price are Maine plc's shareholders likely to accept?
SOLUTION

2.2.3 Enterprise value / EBITDA multiple method

Enterprise value
 A measure of the total value of a company (valuing the ordinary shares, debt and preference
shares), i.e. the value of the company’s operations.
 Calculation: MV equity + MV debt + MV preference shares + minority interests* – cash**
* Minority interest added, as EBITDA includes the earnings from minority shares in subsidiaries
(by doing so, numerator and denominator for EVM are consistent)
** Cash is deducted as surplus cash is considered a non-operating asset
EBITDA
 A way of looking at a company’s performance without factoring in financing decisions,
accounting decisions or the tax environment.
 Calculation: PBIT + depreciation + amortization
Enterprise Value
The Enterprise Value Multiple =
EBITDA
 This can be used to value a company (by using someone else’s EVM and multiplying it by a
private company’s EBITDA), or to compare two companies
 It can also be used to compare the growth prospects of two companies (similar to P/E ratio)
 It is seen as an alternative to the P/E ratio (but one that doesn’t factor in financing, tax or
accounting decisions)
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 119

Valuing using the Enterprise Value Multiple

(1) EBITDA × EVM = Enterprise value
(2) As with PE ratios, to value a private company, we will need to use the EVM of a listed company
and then adjust for differences between the companies
To find the value of equity, we need to deduct the MV of debt from the enterprise value and add on
surplus cash

WORKED EXAMPLE: ENTERPRISE VALUE / EBITDA

The following financial information is available for Arlo Ltd (all figures in £m)
20X6
Revenue 39.6
Operating profit 8.70
Depreciation 0.50
Amortisation 0.30
Net asset value 24.40
Book value of debentures (trading at £80) 16.25
The closest comparable company to Arlo Ltd has been identified as its competitor Alfie plc, for which
you have been able to ascertain the following financial data (all figures in £m):
20X7
Revenue 57.7
Operating profit 10.0
Depreciation 2.2
Amortisation –
Net asset value 48.1
Book value of debentures (trading at £125) 20
Today’s share price for Alfie plc is 175p. Alfie has 27.3m shares in issue.
Use the information to derive an equity value for Arlo Ltd, based on an EBITDA multiple
SOLUTION
Stage One – Calculate EBITDA multiple for Alfie plc
Equity value = £1.75 × 27.3m = £47.8m
Debt value = £1.25 × £20m = £25m
Enterprise value (EV) = £47.8m + £25.0m = £72.8m
20X6
EBITDA multiples 72.8/(10 + 2.2)= 6.0
Stage Two – Apply multiple to value Arlo Ltd
20X6
Estimated enterprise value 6.0 × £9.5m= £57.0m
From this, the market value of Arlo’s debt (£16.25m × £0.8 = £13m) will need to be deducted to obtain
an equity valuation of £44m.
These figures are before any discount that might be made for the non-marketability of Arlo’s shares
(as it is private, but Alfie is listed). If we were to apply, say, a 25% discount, it would give an equity
value of £33m.
120 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

Advantages of EV / EBITDA
 Unaffected by financing / capital spend / accounting decisions and tax – enables the comparison
of two companies which may differ in these areas
 EBITDA is a key measure used by many investors
Disadvantages of EV/EBITDA
 It is simplistic (but no more so than P/E) and reflects a point in time (like P/E)
 Comparing the capital spend and tax management of two companies may be important (e.g. if
management add value through careful tax planning)

2.2.4 Dividend valuation model

A future dividend stream can be valued using the following formula:
𝑫𝑫𝒐𝒐 (𝟏𝟏 + 𝒈𝒈)
𝑷𝑷𝟎𝟎 =
(𝒌𝒌𝒆𝒆 − 𝒈𝒈)

Where:
Po = Current ex-div share price
Do = Current dividend
g = Constant growth in dividends
ke = Return on equity or the cost of equity
Advantages of DVM
 Bases valuation on future dividend stream (important to many investors)
 Useful for valuing minority shareholdings in private companies
Disadvantages of DVM
 Assumes constant dividend growth (unlikely)
 ke must be estimated (difficult)
 Assumes constant gearing
 Hard to use if company has deliberately low dividend policy in the short term
 Growth based on historic data
 Formula breaks down if g ≥ ke
 Estimated growth can be distorted by inflation
 If using ke of a quoted company to value private company, must adjust down for non-
marketability

EXAMPLE 5: DIVIDEND VALUATION

Claygrow Ltd is a company which manufactures flower pots. The following data are available.
Current dividend 25p per share
Required return on equities in this risk class 20%
Requirement
Value one share in Claygrow Ltd under the following circumstances.
(i) No growth in dividends
(ii) Constant dividend growth of 5% per annum
(iii) Constant dividends for five years and then growth of 5% per annum to perpetuity
(iv) Constant dividends for five years and then sale of the share for £2.00.
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 121

SOLUTION

2.2.5 Dividend Yield

Dividend per share
The dividend yield of a company = Share Price

This can be used to value a company:

𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
 𝑀𝑀𝑀𝑀 𝑜𝑜𝑜𝑜 𝑎𝑎𝑎𝑎𝑎𝑎 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 = 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦
𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑝𝑝𝑝𝑝𝑝𝑝 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎
 𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 = 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦

Important points to note:

 Dividend yields are only available for quoted companies, so if valuing an unlisted company you
will have to use the dividend yield of a similar listed company.
 You will then need to make some adjustments to your valuation for any differences between
the companies:
– E.g. as with P/E valuations, the valuation would need to be scaled down for an unlisted
company due to the lower liquidity of shares in a unlisted company vs. a listed company.
Advantages of Dividend Yield
 It values the company based on current market valuations of similar companies (i.e. it is a
market measure).
Disadvantages of Dividend Yield
 You need to find a comparable listed company whose dividend yield you can use
 The valuation is based on historic dividends – you need ensure that these are sustainable
 You will need to adjust downwards for non-marketability of unquoted companies
 It will undervalue companies who are profitable, but have a deliberately low dividend pay-out
122 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

2.2.6 Shareholder Value Analysis valuation method

As discussed in Chapter 2, a company’s value can be obtained through forecasting and present valuing
future free cash flows using these value drivers:
 Sales growth
 Operating profit margin
 Tax rate
 Investment in non-current assets
 Investment in working capital
 Cost of capital
 Life of cash flows
When valuing these free cash flows, exam questions may require candidates to consider individually
estimated annual cashflows for 3-4 years (the competitive advantage period) and then;
 Cash flows in perpetuity with / without growth; or
 Cash given as a lump sum, through using a P/E ratio at the end of the competitive advantage
period
REMEMBER: If cash flows attributable to lenders and shareholders are discounted at a WACC, the
resulting value will be the combined market value/worth of ‘debt and equity’. Should we require the
value of equity, we’d need to strip out the value of debt from this total.
Problems with the SVA method
 The constant percentage assumptions used in the valuation may be unrealistic.
 The input data may not be easily available
 It may be difficult to establish the length of the competitive advantage period (this can have a
substantial effect on the valuation).
 For many valuations, a large proportion of the value is made up of the terminal value (PV of
future cash flows after the competitive advantage period) which is an unreliable estimate.

WORKED EXAMPLE: SVA METHOD

Mark plc expects to have a competitive advantage over its competitors for the next three years. It has
the following estimates for its value drivers for this period and beyond.
Competitive
advantage period Beyond
Year 1 2 3 4+
Sales growth % 7 4 2 0
Operating profit margin % 10 12 12 12
Tax rate % 17 17 17 17
Incremental non-current asset investment (% of sales increase) 5 3 2 0
Incremental working capital investment (% of sales increase) 2 2 2 0
Other information is as follows:
 Current year sales are £380m
 The current WACC is 10%
 Depreciation for the current year will be £7m, increasing by £0.5m each year in the competitive
advantage period
 Replacement non-current asset expenditure is assumed to be equal to depreciation
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 123

 Short-term investments are held with a value of £2.5m

 Debt held by Mark plc has a nominal value of £120m and has a market value of £95 per £100
Calculate the value of equity using the SVA method.
SOLUTION
The information above can be used step by step to calculate the free cash flows
A B C D E F
1 Competitive advantage period
2 Time 1 2 3 4+
3 Sales (W) 406.6 422.9 431.3 431.3
4 Operating profit 40.7 50.7 51.8 51.8
5 Tax at 17% (6.9) (8.6) (8.8) (8.8)
6 Add back depreciation 7.0 7.5 8.0 8.0
7 Operating cash flow 40.8 49.6 51.0 51.0
8 Less replacement NCA exp. (7.0) (7.5) (8.0) (8.0)
9 Less incremental NCA exp. (W) (1.3) (0.5) (0.2)
10 Incremental WC investment (W) (0.5) (0.3) (0.2)
11 Free cashflow 32.0 41.3 42.6 43.0
12
13 PV at 10% of cashflows from year 1 to year 3 95.2
14 PV at 10% beyond year 4 322.9
15 Total PV 418.2
16 Less MV of short-term investments 2.5
17 Less MV of debt (£120m × 0.95) (114.0)
18 Value of equity 306.7

WORKINGS
The PV in cell B13 uses the the NPV spreadsheet function = =NPV(0.1,B11:D11)
The PV in cell B14 is calculated as 43 × 0.751 × 1/0.1
Year 0 1 2 3 4+
Sales 380.0 406.6 422.9 431.3 431.3
Sales increase 26.6 16.3 8.4 0
Incremental NCA 1.3 0.5 0.2 0
Incremental WC 0.5 0.3 0.2 0
124 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

2.2.7 Other factors in income valuations

 Maximum price a buyer would pay = value of combined business – value of buyer’s business
 Synergies – make sure you include annual cost savings of merged businesses in the future
cashflows you are valuing

2.2.8 Commenting/advising on a range of valuations

If an examination question asks you to comment or advise on a range of valuations that you have
calculated:
 Set out in a table the different valuation that you have calculated as a summary of your
workings.
 Provide a commentary on each individual valuation. Refer to the pros and cons of each and
relate these to the scenario and data used where possible.
– For example, what do the purchasers of shares in the scenario want? If they want
dividend income, the dividend yield approach is suitable, but if they want control, it is not
as relevant.
– Does the company have a low payout ratio despite strong profitability? If so, the dividend
yield approach will undervalue the company.
– Are purchasers of shares going to asset strip? Asset valuations might be most relevant.
 Conclude by suggesting a suitable range of values based on two or three that you have
calculated that appear to be most relevant and sensible given the question scenario.

EXAMPLE 6: VALUATIONS AND ADVICE

The directors of Lafayette Ltd, a medium-sized private company, have been approached by a large
public company which is interested in purchasing their business. The directors of Lafayette Ltd have
indicated that they would like to receive cash for their shares, and this is acceptable to the prospective
purchaser. They have been asked by the public company to state the price at which they would be
willing to sell. You have been asked to advise Lafayette Ltd.
Extracts from the last set of published financial statements for Lafayette Ltd for 20X2 are given below:
Income statement
£
Profit before interest and tax 5,337,349
Interest 1,000,000
4,337,349
Taxation (17%) 737,349
Profits after tax 3,600,000
Dividends paid – preference 200,000
Ordinary 1,000,000
Profits retained 2,400,000
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 125

Balance sheet as at 31 December 20X2

£'000 £'000
Non-current assets
Goodwill 5,000
Freehold property 10,000
Plant and equipment 20,000
Investments 5,000
40,000
Current assets
Inventory 3,000
Receivables 6,000
Cash 1,000
10,000
Less Payables: amounts due within 1 year
Payables 6,000
6,000
Less Payables: amounts due after 1 year
Loan stock 10,000
34,000
Ordinary share capital (£1 par) 20,000
5% preference shares 4,000
Retained earnings 10,000
34,000

For the year ending 31 December 20X0, the profits before interest and tax were £10 million and in the
year ending 31 December 20X1 they were £8 million. The depreciation charge in 20X2 was £750,000.
You are asked to take the following factors into account in calculating a value per share:
 The prospective purchaser has agreed to purchase the debentures at a price of £75 per £100
stock.
 It has been ascertained that the current rental value of the freehold property is £1.5 million per
annum, and that this could be sold to a financial institution on the basis of offering an 8% return
to the freeholder.
 The investments owned by Lafayette have a current market value of £7.5 million.
 There is an amount of £1 million shown in the 20X2 receivables figure which is now thought to
be irrecoverable.
Two companies in the same business as Lafayette Ltd are quoted on the stock market. However, both
are slightly bigger in size than Lafayette. The most recent financial data relating to the companies is
given below:
Par value Market Net dividend Times
per share price P/E ratio EV/EBITDA per share covered Yield %
X £1.00 £3.50 11.3 7 £0.12 2.6 4.9
Y £0.50 £1.25 8.2 8 £0.04 3.8 4.1
126 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

Requirements
(a) The directors of Lafayette Ltd are naturally interested in obtaining the highest price possible for
their shares. You are asked to determine the highest possible asking price for the shares that
can be justified on the basis of the available information and comment on the alternative prices
you have arrived at, based on the following valuation methods:
(i) The net asset value
(ii) The price/earnings ratio
(iii) The dividend yield
(iv) EV/EBITDA multiple
(b) Advise the directors on the lowest price at which they should be willing to sell.

2.3 Valuing debt

 The market value of debt can be calculated by present valuing the future cashflows at the pre-
tax cost of debt (‘redemption yield’).
 If you are given the post-tax yield, you can calculate the pre-tax yield by dividing by (1-t)
 The pre-tax cashflows to present value will include the annual interest (an annuity if the debt is
redeemable) and the redemption cashflow (a single cashflow at the maturity date of the debt).
 It is possible to use the PV spreadsheet function to calculate the MV of debt
– Format of the PV function = PV(rate, number of periods, payment, future value, type)
– The number of periods may be in years or in six-month periods.
– The payment is the cash paid in each period.
– The future value is the redemption value (the value of the bond at maturity).
– Type can be left blank.

2.4 Valuation of technology companies

The valuation of start-ups and technology companies presents a number of challenges for the methods
we have considered so far due to their unique characteristics.
 No track record of profit (often loss making)
 Unpredictable market acceptance of products
 Unknown competition
 Inexperienced management
 Difficulties associated with valuing digital assets and associated income streams
 Rapid technological change makes it challenging to predict future cashflows
 Volatile market conditions (due to investor sentiment, regulatory changes etc)
 Lack of comparable companies/transactions

2.4.1 Valuing digital assets

A digital asset is content that is stored electronically and provides value to a company. Types of digital
asset include digital photos, spreadsheets, websites, blockchain technology, cryptocurrencies, initial
coin offerings and big data.
The valuation of digital assets becomes a particular issue when valuing technology companies but in
any business model, data can be a valuable asset and can add value in many ways. For example, by
analysing customer data, companies can identify areas for improvement in products and services
which will enhance customer satisfaction and result in increased cashflows and hence increased value.
Some digital assets can directly create valuable income streams for a company, for example
subscriptions to a newspaper's website content. Digital subscriptions typically provide a predictable
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 127

and stable stream of income and, unlike physical distribution, digital content delivery has virtually no
marginal cost. As the subscriber base grows, the company can therefore generate more revenue
without significantly increasing costs, leading to higher profit margins and an increase in the valuation
of the company.
Valuing digital assets is difficult since value is only generated if the assets are well managed. Other
issues include:
 They are intangible and lack physical substance, which makes it difficult to assign a precise value
to these assets using traditional valuation methods.
 There are no universally accepted valuation methodologies or industry standards specifically
designed for these assets because they are relatively new and rapidly evolving.
 Many have uncertain future cashflows, making estimates of revenue streams and profitability
challenging.

2.4.2 Valuation methods

Valuing start-up and technology companies is complicated by periodic swings in stock market
sentiment (herd behaviour) that may result in over-valuation of these companies.
Valuation Method Description
Asset As tangible asset values may not be high using an asset valuation method is not
easy. Value could be assessed by estimating how much it would cost for an
investor to create the assets of the company from scratch (including R&D
spending, patent protection etc.) However, such approaches would not capture
the value resulting from the potential future growth.
Earnings The fact that there may be no earnings in the early years discredits this method.
It will also be difficult to find the P/E ratio of a comparable quoted company with
similar risk profile to use when valuing a start-up or unquoted tech company.
Dividend A start-up or technology company is unlikely to pay a dividend as it will be
retaining cash flow to fund future growth therefore this method will not be
appropriate.
Market multiples It is possible to use ratios based on acquisitions of similar companies (in terms of
their growth potential and stage of development) to create a valuation.
However, similar acquisitions may be difficult to identify, which may make this
approach difficult to apply
DCF Despite the problems with estimating future cash flows, the DCF approach is
likely to be the most valid approach. Revenue growth prospects and margins
could be estimated by comparing to more mature businesses in different
countries or companies that have a similar business model
Customer-based One example of this type of metric is Average Revenue Per User (ARPU),
metrics calculated as total revenue divided by the number of users or subscribers. This is
a useful metric for subscription-based entities such as Netflix.
Revenue projections, for inclusion in a NPV valuation say, could be determined
by taking into account:
 Current ARPU
 Growth trends in ARPU
 Strategies to increase ARPU
 Forecasts of the number of new users
 Other customer-based metrics such as the level of customer churn
(users leaving the platform)
The reasonableness of an acquisition price could be assessed by comparing
the price paid per user, or value per user, to the value per user in similar
acquisitions.
128 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

2.4.3 Financing for technology companies

 Angel investors
 Venture capital
 Crowdfunding
 P2P lending
 Revenue-based finance
 Start-Up Loans Scheme (a UK-government funded initiative that provides support (loans plus
business mentoring) to aspiring entrepreneurs

2.5 Methods of payment (for shares)

Consideration Pros/cons For buyer For seller
Cash Pros More attractive to seller – get a better Certain amount received
price?
Cons Causes liquidity problems for buyer Immediate tax issues (capital gains)
No ongoing stake in the business
Shares Pros Preserves liquidity No immediate tax issues (gain
Ensures cooperation of seller in deferred)
ongoing business
Cons Dilution of control of existing Uncertain value received
shareholders Transaction costs to sell shares
Loan stock Pros Avoids dilution of control for existing Lower risk than shares (more certainty
shareholders over return)
Preserves immediate liquidity
Cons Increases gearing May prefer higher return of equity

2.6 Reasons to divest

 To avoid the conglomerate discount (tendency for market to undervalue large conglomerates)
 Due to a bad fit with your other operations
 The business is too time intensive
 Due to poor results
 Due to a need for liquidity (cash)

2.7 Methods of divestment

 Management buy-out (MBO) – existing management of the business buy out the owners in
order to greater control and financial reward (usually heavily funded by debt and venture
capital)
 Management buy-in – as for an MBO, but external managers buy the business
 Spin-off (demerger) – holding company gives the shares in a subsidiary to its shareholders
(flexibility for shareholders over whether to sell the sub, avoids conglomerate discount)
 Trade sale – the trade and assets (but not the company itself) are sold to a third party
 Repurchase of own shares – to enhance share price (reduce supply), give exit route for
shareholders (in private company) or increase gearing (to achieve optimum capital structure)
 Liquidation – the company is wound up, with assets sold, creditors paid and amounts left
returned to shareholders
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 129

2.7.1 MBOs (in more detail)

Types of debt used to finance a MBO:

 Junk bonds (subordinated, rank below other forms of debt, high risk and high coupon)
 Mezzanine bonds (similar to junk, but lower coupon due to conversion option or warrants)

WORKED EXAMPLE: MBO

Can plc is divesting one of its subsidiaries and the managers of the subsidiary have offered an
attractive price of £20m subject to confirming a finance package with a venture capital provider (VC)
and a bank.
The finance package is as follows.
£m
Equity from managers 2
Equity from VC 1
Mezzanine finance from VC 7
Senior debt from bank 10
20

What are the objectives facing the various parties (sellers, managers, venture capitalists and the bank),
and how might they manage their specific risk?
SOLUTION
Seller: They will want to ensure that the amount offered from the managers is backed up by a reliable
financial package. Work by their financial advisers and lawyers will help to ensure that the finance is in
place. There may be other, lower bidders. Whilst those alternative offers may be lower, the finance
may be more easily available if the bidder is a large organisation with liquid assets.
Managers: The attractions of an MBO are:
 Independence
 Financial reward
 Motivation
The risks however are:
 Lack of support from within the business and also from suppliers and customers.
 Lack of skills within the business if key employees leave
 Financial risk. If business profits fall even by a little, it might become impossible to service the
large amount of debt.
130 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

VC: The objective will be to make a very high financial return. This is typically achieved by selling the
business within three to five years, by flotation or otherwise.
The VC will not be assured that the value of their shares will be as high as they want.
Their downside risk is typically managed by:
 Having board representation
 Investing a mixture of debt and equity
 Including convertible terms in the debt, such that debt converts into a higher equity share in the
event that the company on subsequent sale is worth less than originally envisioned.
Bank: The bank will manage their risk by investing in senior debt, ie debt which ranks higher than
other debt in terms of interest, security and repayment.
The bank might also want personal guarantees from the buyout team.

3 Forecasts
3.1 Forecasting future income statements and balance sheets
In the examination you may be given the most recent Income Statement and Balance Sheet of a
company and asked to forecast the IS and BS for the following year (sometimes based on either issuing
new debt or equity to fund expansion).
Here are some steps to follow:
 Forecast the income statement first
 Make sure to calculate the retained profits for the year (which will be added to reserves in the
balance sheet)
 Calculate the balance sheet lines that you can (often based on ratios e.g. receivables to sales)
 Leave cash as the balancing figure
 Remember for share issuances that you need to credit share capital with the nominal value of
the shares and share premium with the excess of issuance price over nominal value

EXAMPLE 7: FORECAST INCOME STATEMENT AND BALANCE SHEET

Bannon plc has decided to expand its operations by issuing £30m of 10% debentures at par and using
the funds to buy equipment. This will lead to:
– Revenue and direct costs increasing by 14%
– Other operating costs increasing by £9m
– Inventory increasing by £10m
– Receivables to sales and payables to direct costs ratios remaining the same
– The dividend payout ratio remaining the same (dividends are paid out in the year
following declaration)
Note: Depreciation is charged at 20% on a reducing balance basis and it can be assumed that capital
allowances will equal depreciation
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 131

Bannon’s Income Statement and Statement of Financial Position for the year ended 31st December
20X7 were:
Income Statement £000s Balance sheet £000s
Revenue 575,000 Plant & Machinery 124,000
Direct costs (317,000) Current assets
Depreciation (31,000) Inventory 75,000
Other operating costs (149,000) Receivables 118,970 193,970
Operating profit 78,000 317,970
Less: Interest (5,600) £1 ordinary shares 65,000
Profits before tax 72,400 Retained earnings 54,000
Tax at 17% (12,308) 8% Debentures 70,000
Profits after tax 60,092 Current liabilities
Dividend declared 30,000 Trade payables 78,000
Retained profits 30,092 Bank overdraft 20,970
Dividend payable 30,000 128,970
317,970

Requirement
(a) Prepare a forecast Income Statement and Balance Sheet for Bannon plc for the year ended
31st December 20X8.
(b) Calculate the following ratios for Bannon plc:
(1) Earnings per share for the year ended 31st December 20X8.
(2) Gearing ratio (debt/debt + equity) using book values at 31st December 20X8.
(3) Interest cover for the year ended 31st December 20X8

SOLUTION
132 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

3.2 Introduction to cash forecasts

A cash budget (or forecast) is a detailed budget of estimated cash inflows and outflows incorporating
both revenue and capital items.
Cash forecasts (or budgets) provide an early warning of liquidity problems, by estimating:
 How much cash is required
 When it is required
 How long it is required for
 Whether it will be available from anticipated sources
Fina nc ia l Ma na g e m e nt 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g 133

3.2.1 Cash forecasts based on the balance sheet

As described, when forecasting the balance sheet we leave cash as a balancing figure.
 Hence, by producing forecast balance sheets we can identify either the cash surplus or the
funding shortfall in the company's balance sheet at the forecast date.
 If there is a surplus of share capital and reserves over net assets (total assets minus total
liabilities) the company will be forecasting a cash surplus.
 If there is a surplus of net assets over share capital and reserves the company will be forecasting
a funding deficit.

3.2.2 Response to forecast deficits and surpluses

If you forecast a cash deficit If you forecast a cash surplus
Issue shares Use to increase sales via better credit terms
Borrow Reduce short term borrowing (e.g. overdrafts)
Sell surplus assets / liquid investments Put on deposit on the money markets
Lag on supplier payments, incentivise clients to pay earlier

In Chapter 4 we covered the issues to consider when deciding on the most appropriate source of
finance.
 Impact on financial performance
 Impact on financial position
 Cost of the finance/impact on WACC
 Impact on shareholders
 Matching to term/risk
134 8: B u s i n e ss p l an ni n g, v al u a t i on an d res t ru c t u ri n g Fina nc ia l Ma na g e m e nt

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Do you know the advantages of organic growth over growth by acquisition?

Can you value a business using the net assets approach?

Can you calculate the enterprise value of an entity?

Do you know the different methods of payment that can be used for an acquisition?

Can you explain the problems in applying traditional valuation methods to

technology companies?

Do you understand the motives for divestment?

Do you understand the difference between an MBO and an MBI?

Do you know what a spinoff is?

Can you prepare a set of forecast financial statements?

Can you advise on managing cash surpluses and deficits?

 135

Managing financial risk:

interest rates and other risks

Topic List
1. Introduction to derivatives
2. Hedging commodities prices
3. Hedging shareholdings
4. Hedging interest rate risk

Learning Objectives
 Identify and describe the key price risks facing a business in a given scenario
 Explain how financial instruments (eg, derivatives, hedging instruments) can be used to manage
price risks and describe the characteristics of those instruments
 Discuss different methods of managing interest rate risk appropriate to a given situation,
perform calculations to determine the cost of hedging that risk and select the most suitable
method of hedging
 Discuss different methods of managing share price risk, perform calculations to determine the
cost of hedging that risk and select the most suitable method of hedging
136 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

1 Introduction to derivatives
A derivative: is a financial instrument whose value is derived from the value and characteristics of an
underlying financial item. Option contracts, futures and swaps are types of derivative.
Over the course of the next two chapters we will use derivatives to hedge companies’ exposures to
certain financial risks
Note: when using derivatives to hedge, we can calculate the hedge efficiency:
gain (or loss)on the hedging instrument
Hedge efficiency =
gain (or loss) on the hedged item

EXAM SMART
Hedging questions in the exam
A common exam question for the examiner to ask is to calculate a range of outcomes using a
variety of hedging techniques (for example 10 marks for outcomes using forwards, futures
and options) and to follow this with a question asking you to evaluate the hedging
techniques that you have used.
It is vital that as well as being able to calculate the numbers you are able to discuss the
techniques that follow in this chapter and chapter 10. Knowing the characteristics of each
technique (for example which methods involve paying a premium) as well as knowing the
advantages and disadvantages of each technique will set you up well for the exam

2 Hedging commodities prices

Companies may need to make future purchases of raw materials (e.g. metals, oil) or make future sales
of a commodity they produce (e.g. coffee beans, sugar).
They may be nervous that prices could move unfavourably – if so, they can use the following financial
instruments to help set the price for a future transaction in that commodity:
 Forward contracts
 Futures

2.1 Forwards
A forward contract is a binding agreement to exchange a set amount of goods at a set future date at a
price agreed today.
These are bespoke agreements between two parties – referred to in finance as ‘Over the Counter’
(OTC)
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 137

WORKED EXAMPLE: COMMODITY FORWARD CONTRACT

A manufacturer of chocolate needs to purchase cocoa beans for future production and wants to
acquire them for a fixed price.
The manufacturers can achieve this by agreeing with the producer of cocoa beans to purchase a
quantity for delivery at a specific date in the future at a price agreed now.
 In January, when the price of a consignment of cocoa beans is £1,000, the chocolate
manufacturer agrees a price with the supplier of £1,100 for delivery at the end of March.
 The price for both parties is now set – and thus whilst the market price in March may be higher
or lower than the agreed price of £1,100, the benefit for both parties is that they have certainty,
and so are better able to plan and budget effectively.

2.2 Futures
A futures contract is a standardised contract to buy or sell a specific amount of a commodity, currency
or financial instrument at a particular price on a stipulated future date.
Hence, a future is similar to a forward, but has a standardised:
 Contract size (e.g. for a set number of cocoa beans)
 Maturity date (typically March, June, September and December)
These futures are ‘traded’ on centralised exchanges (hence you face the exchange rather than another
individual counterparty)

Buying a commodities futures contract is equivalent to agreeing to buy a set amount of that
commodity at a set price on a set future date.

E.g. a company looking to buy a commodity 3 months in the future will try to fix a price for that
commodity by:
(1) Buying commodity futures now (with a maturity as close as possible to the future transaction
date)
(2) Selling the same number of futures contracts in three months’ time to close out the position*
(triggering a net cash settlement for the difference between the sell price and the buy price)
(3) The company will then buy cocoa beans from their usual supplier at the ‘spot’ (current) price in
3 months’ time.
* Futures are very rarely physically settled; typically they will be closed out as described above,
leading to a net cash payment or receipt.
138 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

EXAMPLE 1: COMMODITY FUTURES

1 January
On 1 January the price (the spot price) of a consignment of cocoa beans is £1,000 in the cocoa market.
You want to buy a consignment of cocoa beans on 31 March on this cocoa market, but the price is
uncertain.
You buy separately on a futures market a three-month cocoa futures contract at £1,100 that expires
on 31 March. This means you are committing to buying a consignment of cocoa beans, not at today's
spot price, but at the futures price of £1,100, which represents what the futures market thinks the
spot price will be on 31 March.
31 March – assume you buy the cocoa at a spot price of £1,200 (and this is the same as the futures
price on 31 March), show the resulting transactions.
SOLUTION

3 Hedging shareholdings
Organisations such as pension funds and insurance companies may hold large portfolios of
shareholdings in other companies.
Their concern is that share prices fall (leading to a loss in value of their share portfolio) and they can
hedge against this eventuality using financial instruments:
 Index futures
 Share options
 Index options
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 139

3.1 Index futures

Index futures are cash settled futures based on the value of a stock index (e.g. the FTSE 100). These
can be used to hedge a portfolio of shares.
 Each contract is for a notional value of the index value multiplied by £10. Thus, if the FTSE index
stands at 4,500, the notional value of a contract is £45,000.
 Buying an index future is similar to agreeing to buy the index constituent shares at set price
 When you close out the futures you get a net cash payment or receipt (no shares change hands)

3.1.1 Hedging steps

Setup of the hedge
 Sell index futures (if hedging share portfolio)
 Choose futures date (based on when you want to hedge to)
 Note the futures price
Share portfolio value
 Calculate no. of future contracts to trade =
futures level ×£10
Outcome of the hedge
 Close out futures by buying same number of contracts  gain/loss on futures =
(Futures level at start – current futures level) × # contracts × £10
 Calculate gain/loss on portfolio

WORKED EXAMPLE: USING INDEX FUTURES TO SET UP A PORTFOLIO HEDGE

The investment manager of Moonstar Pensions Fund is concerned that share prices will fall over the
next month and wishes to hedge against this using FTSE stock index futures. The fund's pension
portfolio comprises investments which have a market value of £5 million on 1 June 20X3.
On 1 June 20X3 the following prices are observed:
 The prevailing value (ie spot value) of the FTSE 100 index is 5,000
 The quote for June FTSE 100 index futures is 4,980
 The face value of a FTSE 100 index contract is £10 per index point.
 Using the futures price, this gives a contract value of 4,980 × £10 = £49,800
Requirement
Demonstrate what hedge should be undertaken to protect the portfolio against falls in share prices.
SOLUTION
Calculate number of contracts
We should sell futures to protect our portfolio.
Number of contracts = Market value of portfolio / Value of one contract
= £5,000,000 / £49,800 = 100.4 100 contracts
140 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

EXAMPLE 2: HOW INDEX FUTURES PROVIDE A HEDGE IF THE MARKET FALLS

On 30 June 20X3, the market value of the shares in the portfolio was £4.8 million.
The FTSE 100 index and the futures index both stood at 4,800 on that date.
Requirement
Calculate the outcome of the hedge that Moonstar has undertaken.
SOLUTION

WORKED EXAMPLE: THE IMPACT OF HEDGING IF THE MARKET RISES

On 30 June 20X3, the market value of the shares in the portfolio was £5.1 million.
The FTSE 100 index and the futures index both stood at 5,100 on that date.
Requirement
Explain what happens as a consequence of the hedge.
SOLUTION
Step 1
Position in spot market
Gain on portfolio = £5.1 million – £5 million = £0.1 million
Step 2
Calculate gain or loss on futures
Initially sold futures for 4,980
Now buy futures for 5,100
Loss on closing out futures (120) × £10 × 100 contracts = £120,000
Step 3
Calculate net position
Net position £100,000 gain on portfolio
(120,000) loss on futures
£(20,000) loss overall
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 141

3.1.2 Pros and cons of index futures

Pros:
 Hedges away downside risk of share prices falling
 Can close out futures position at any time
Cons:
 Standardised contracts, so may under/over hedge the value of the share portfolio
 Only an appropriate hedge if the share portfolio is similar to the index
 Removes any upside potential
 Must post initial margin to the exchange (fixed amount of collateral) at the start
 Must post variation margin (more collateral) is you make losses on the futures position
 Basis risk (difference between spot index level and futures level before futures maturity date)
leads to hedge not being 100% efficient (due to change in the futures price ≠ change in the spot)

3.2 Options
Options may also be used to hedge against adverse price moves:
 An option is an agreement giving the buyer of the option:
– The right, but not the obligation
– To buy (call) or to sell (put) a specific quantity of something (eg shares in a company)
– At a set price (strike or exercise price) within a stated period.
 Options offer a choice between:
– Exercising the option; or
– Allowing the option to lapse.
 The buyer must pay a premium now to buy the option

3.2.1 Option terminology

 Options can be OTC (bespoke to your needs and written by a bank) or traded (standardised and
traded on exchanges)
 Options can be for:
– The right to apply for newly issued shares (‘share options’)
– The right to buy or sell existing shares (‘pure options’)
 Options can be:
– American (can be exercised at any point until the expiry date)
– European (can only be exercised on the expiry date)
 Options may be be:
– In the money (if they would generate a profit if exercised today)
– At the money (if the exercise price = current spot price)
– Out of the money (if a loss would be made if it were exercised today)
142 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

EXAMPLE 3: IMPACT OF A PUT OPTION

Illustrate the effect on an investor (who already owns one share in company X) of purchasing a put
option on a share in company X, given the following:
£
Current share price 1.70
Exercise price 1.60
Premium 0.10
(a) If the share price rises to £2.10
(b) If the share price falls to £1.30
SOLUTION

WORKED EXAMPLE: PRICES OF TRADED OPTIONS

Prices of traded share options are quoted in tables, such as this for options on shares in Reuters.
Reuters – underlying security price 679 (7 May) (1)
Calls (2) Puts (3)
Exercise price Jul Oct Jan Jul Oct Jan
(4) 650 52 67 84 14½ 24 31½
700 25 41 58 (5) 37½ 44½ 55
This table shows the following.
(1) Reuters shares are trading at 679 pence on 7 May.
(2) Call or buy options are available with expiry dates at the end of July, October and January.
(3) Put or sell options are also available with expiry dates at the end of July, October and January.
(4) Two possible exercise prices exist, one below the current share price (650p) and one above the
current share price (700p).
(5) The figures in the table show the price (premium) per share of each option contract in pence.
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 143

 A call option is in the money if the exercise price is below the underlying security price. All the
650 call options are in the money, and all the 700 call options are out of the money.
 A put option is in the money if the exercise price is above the underlying security price. All the
700 put options are in the money, and all of the 650 put options are out of the money.
 If the Reuters share price were to rise to 700p, all the 700 options would be at the money.
 For all traded options there will be at least one exercise price above the current share price and
another below it. If the Reuters share price were to rise above 700p (for at least three days) a
new series of options with exercise price 750p would be created.

3.2.2 Intrinsic value and time premium

In order to calculate the value of an option (which = the premium you are required to pay) you need to
think about the components that make it up:
Intrinsic value
 The intrinsic value is what the option would be worth if exercised today
 E.g. if share price is 100 and the strike price is 95, the intrinsic value of a call option would be 5
and for a put it would be 0)
Time premium
 The time premium is the difference between the total value (= the premium) and the intrinsic
value – driven by:
– Time to expiry (longer the time to expiry, the more valuable the option)
– Volatility of the underlying (the higher the volatility of the underlying share price, the
greater the option value)
– General level of interest rates (which impacts the PV of the future payments / receipts on
option exercise). E.g. if interest rates are high, then call options become more desirable
(with a higher premium), as the PV of the exercise price to be paid decreases.

WORKED EXAMPLE: INTRINSIC VALUES

Intrinsic values of the Reuters options as at 7 May in a particular year are shown in the table below.
Intrinsic values – Reuters share options (underlying share price = 679)
Calls Puts
Exercise price Jul Oct Jan Jul Oct Jan
650 29 29 29 0 0 0
700 0 0 0 21 21 21
144 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

WORKED EXAMPLE: TIME VALUES

Time values – Reuters share options (underlying share price = 679)

Calls Puts
Exercise price Jul Oct Jan Jul Oct Jan
650 23 38 55 14½ 24 31½
700 25 41 58 16½ 23½ 34
Note that the time value of all options increases with the time period to expiry. The time value
depends on:
 The time period to expiry of the option
 The volatility of the underlying security price
 The general level of interest rates

3.3 Index options

 Index options are cash settled options based on the value of a stock index (e.g. the FTSE 100).
 These can be used to hedge a portfolio of shares.
 Contract notional = index level × £10
 Premiums are points per contract (i.e. multiply by £10 to get premium for each contract).
 Buying call options is similar to having the option to buy the shares in the index (although index
options are only ever cash settled)

3.3.1 Hedging steps

Setup of the hedge
 Buy put index options (if hedging share portfolio)
 Choose strike level and maturity date (based on when you want to hedge until)
Share portfolio value
 Calculate number of contracts =
strike level ×£10
 Pay premium = points × £10 × # contracts
Outcome of the hedge
 Choose whether to exercise option
 Calculate gain on options if exercise =
 (Strike level – current spot index level) x # contracts x £10
 Calculate gain/loss on portfolio
 Deduct premium
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 145

WORKED EXAMPLE: INDEX OPTIONS

The investment manager of Moonstar Pensions Fund is concerned that share prices will fall over the
next month and wishes to hedge against this using June FTSE stock index options.
The fund's pension portfolio comprises investments, which have a value of £4 million on 1 June 20X3.
On 1 June 20X3 the following options are available.
FTSE 100 INDEX OPTION (*4000) £10 per full index point
3900 3950 4000 4050 4100
C P C P C P C P C P
June 135 30 100 44 70 66 45 95 30 130
July 210 90 180 110 150 130 120 155 100 185
August 270 130 240 150 215 175 185 195 160 220
*Underlying index value.
Requirement
Demonstrate what happens if either of the following two situations arises on 30 June.
(a) The portfolio value falls to £3.8 million, and the FTSE index drops to 3,800.
(b) The portfolio value rises to £4.1 million and the FTSE index rises to 4,100.
SOLUTION
Step 1 – set up the hedge
What sort?
The concern is that the value of the portfolio held by the fund will fall, so an option to sell is required.
Thus, a June put option with an exercise price of 4,000 is purchased. (I.e. the 4,000 exercise price is
closer to maintain the existing value of the portfolio)
How many?
The portfolio value is £4 million
The exercise price of the option is 4,000
The value of one contract is 4,000 × £10 = £40,000
The number of option contracts required to cover a portfolio of £4 million is therefore
£4million/£40,000 = 100 contracts
Step 2 – calculate premium
The premium payable for 100 June puts at 4,000 is 66 points per contract.
66 points × £10 per point × 100 contracts = £66,000
Step 3 – do we exercise?
Index rises Index falls
FTSE 100 index 4,100 3,800
Put option gives right to sell at 4,000 4,000
Abandon Gain 200 on exercising

Value of options 0 200 × £10 = 2,000

× 100 contracts = £200,000
146 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

Step 4 – overall position

£ £
Value of portfolio 4,100,000 3,800,000
Gain on option 200,000

(Note that the option removes

the downside risk but leaves the
upside potential).
4,100,000 4,000,000

Cost of the premium (66,000) (66,000)

£4,034,000 £3,934,000

3.3.2 Pros and cons of index options

Pros:
 Protects from downside risk and allows the buyer to benefit from upside (by e.g. letting put
option lapse if share prices rise)
Cons:
 Standardised contracts, so may under/over hedge the value of the share portfolio
 Only an appropriate hedge if the share portfolio is similar to the index
 Option premium can be expensive

4 Hedging interest rate risk

4.1 Risks from interest rate movements
 Having fixed rate debt in times of falling interest rates / floating rate debt in times of rising
interest rates
 Liquidity – can a company find the cash to repay a loan when it reaches its redemption date?
 Interest is paid at all times on a term loan, whereas you only pay interest on an overdraft when
overdrawn
 Depositing at variable rates in times of falling interest rates / fixed rates rate debt in times of
rising interest rates

4.2 Reducing interest rate risk

Methods of reducing interest rate risk include:
 Pooling of assets and liabilities
 Forward rate agreements (FRAs)
 Interest rate futures
 Interest rate options (or guarantees)
 Interest rate swaps
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 147

4.3 Pooling of assets and liabilities

Some interest rate risk may cancel out where there are assets and liabilities which both have exposure
to interest rate changes.

4.4 Forward Rate Agreements (FRAs)

FRAs are OTC contracts which fix the effective rate of interest to be paid on future borrowing
(eliminating uncertainty about the rate to be paid on the future borrowing)
 FRAs settle on the start date of the underlying loan (but no amounts are actually lent as part of
the FRA – still need to borrow from a bank).
 Borrowers buy FRAs, lenders sell FRAs
 Borrowers pay the FRA fixed rate and receive the spot (benchmark) rate (one net settlement).
 5.75-5.70 means you can fix the borrow rate at 5.75, deposit rate at 5.70
 A 3-6 FRA starts in 3 months, lasts 3 months
 The interest rates which banks will be willing to set for FRAs will reflect their current
expectations of interest rate movements.

4.4.1 Hedging steps

Setup of the hedge
 Buy a FRA (if borrowing in the future)
Outcome of the hedge (when the borrowing starts)
 Net settlement on the FRA =
(Spot rate – FRA rate) × Nominal value × # months /12
 Borrow money from your bank at spot rate

4.4.2 Pros and cons of FRAs

Pros:
 Hedges away downside risk (e.g. of rates rising if borrowing)
 Tailored to the investor (so won’t be under/over hedged)
Cons:
 Usually only available on loans > £500k
 Usually for < 1year
 Removes any upside potential (e.g. of rates falling if borrowing)
 Difficult to exit (e.g. if date or size of borrowing changes)
148 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

EXAMPLE 4: FORWARD RATE AGREEMENT

It is 30 June. Lynn plc will need a £10 million six month fixed rate loan from 1 October. Lynn wants to
hedge using an FRA. The relevant FRA rate on 30 June is 6%.
(a) State what FRA is required.
(b) Explain the result of the FRA and the effective rate if the 6m FRA benchmark rate has moved to
(i) 5%
(ii) 9%

4.5 Interest rate futures

Interest rate futures are similar to FRAs (attempt to set fixed rate for future borrowing, don’t actually
lead to any money being borrowed), but are standardised and traded on exchanges.
 Interest rate futures mature at end of March / June / September / December (the notional
period of borrowing / lending starts when the futures contract expires)
 Three month interest rate futures have a contract size of £500k and their price reflects the cost
of borrowing £500k for three months
 The futures price = 100-r (where r = fixed interest rate)
 Buying futures is akin to agreeing to receive fixed rate interest (like buying a bond) and selling
futures is akin to agreeing to make fixed interest payments (like issuing a bond), hence:
– Borrowers sell futures now & buy futures on date their borrowing starts
– Lenders buy futures now and sell futures on date their lending starts.

4.5.1 Hedging steps

Setup of the hedge
 Sell futures (if borrowing)
 Choose maturity date (as close to borrow start date as possible but not before)
Borrowing notional value borrowing period
 Calculate no. of contracts = ×
£500k 3

Outcome of the hedge (when the borrowing starts)

 Close out futures by buying same number of contracts  gain/loss on futures =
(Sell price – Buy price) 3
 100
× #contracts × £500k × 12

 Borrow money from your bank at spot rate

Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 149

4.5.2 Pros and cons of interest rate futures

Pros:
 Hedges away downside risk (e.g. of rates rising if borrowing)
 Can close out position at any time (more flexible than FRAs)
Cons:
 Removes any upside potential (e.g. of rates falling if borrowing)
 Standardised contracts, so may under / over hedge (as can only trade whole no.s of contracts)
 Basis risk (difference between spot rate and futures rate before futures maturity date) may lead
to hedge not being 100% efficient if futures maturity ≠ borrowing start date
 Must post margin (collateral) to the exchange

WORKED EXAMPLE: STANDARDISED INTEREST RATE FUTURES

If an investor buys one 3-month sterling £500,000 March contract for 93.00 what have they done?
What would happen if interest rates dropped by 2%?
SOLUTION
The features of this futures contract can be broken down as follows:
3-month March contract This notional investment will pay interest for three months only, from
March
Sterling The currency in which interest will be paid
£500,000 The standard contract size.
Buying a contract means investing, and thus receiving interest
Buying a future for 93.00 The price of a future =100 – r
Therefore a price of 93 implies a rate of 7%
If interest rates dropped by 2% to 5% the price would rise.
Price = 100 – 5 = 95
The investor could then close out his position by selling a March contract
 Buy at 93.00
 Sell at 95.00
 Gain 2.00%
The interest rate used to determine the price of a future is an annual rate, whereas the contract is for
three months.
In the example, the 2% refers to the change in the annual rate for 3-month deposits. As these are
3-month contracts, the gain on one contract is 2% × 3/12 × £500,000 = £2,500
150 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

EXAMPLE 5: FUTURES – MATURITY MISMATCH

On 5 June, a corporate treasurer decides to hedge a short-term loan of £17 million which will be
required for two months from 4 October to 3 December. Three-month sterling futures, December
contract, are trading at 98.15. The contract size is £500,000. How many contracts are required?
SOLUTION

EXAMPLE 6: INTEREST RATE HEDGE USING FUTURES

It is 1 January, and a company has identified that it will need to borrow £10 million on 31st March for
six months.
The spot rate on 1 January is 8% and March 3 month interest rate futures with a contract size of
£500,000 are trading at 91.
Demonstrate how futures can be used to hedge against interest rate rises. Assume that at 31st March
the spot rate of interest is 11% and the March interest rate futures price has fallen to 89.
SOLUTION
(a) Set up the hedge

(b) Outcome in futures market

Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 151

(c) Outcome in spot market

WORKED EXAMPLE: HEDGING BY A LENDER

A US company will have a surplus of £2 million for three months starting in August. The cash will be
placed on fixed interest deposit, for which the current rate of interest is 5% pa. How can the deposit
income be hedged using futures contracts? The September 3-month sterling futures contract is
currently trading at 94.00. It has a standard contract size of £500,000.
SOLUTION
The target interest to be earned is £2 million × 5% × 3/12 = £25,000. To hedge lending, buy four
3-month sterling September futures contracts now and sell four contracts in August. Suppose that by
August, interest rates have fallen by 1%. The £2 million is deposited at 4% for three months, yielding
£20,000, a shortfall on target of £5,000. If the futures market has also moved by 1%, the contract price
will have risen to 95.00, giving a gain of 1%. The gain from selling four contracts at the higher price is
1% × 3/12 × £0.5m × 4 contracts = £5,000. This compensates for the shortfall in actual interest.

4.6 Interest rate options

4.6.1 Interest rate options (guarantees)
An interest rate option grants the buyer of the option the right, but not the obligation, to
borrow/lend at an agreed interest rate (strike rate) at a future maturity date. On the date of expiry of
the option, the buyer must decide whether or not to exercise the right. An interest rate guarantee
(IRG) refers to an interest rate option which hedges the interest rate for a single period of up to one
year.
Tailor-made 'over-the-counter' interest rate options can be purchased from major banks, with specific
values, periods of maturity, denominated currencies and rates of agreed interest. The cost of the
option is the 'premium'. Interest rate options offer more flexibility than FRAs, although they are more
expensive.
152 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

WORKED EXAMPLE: OVER THE COUNTER INTEREST RATE OPTIONS

Allie plc needs to borrow £5 million for six-months to fund additional machinery purchases and is
concerned that interest rates will increase from their current spot rate of 6.5%. Allie decides to hedge
this exposure using OTC interest rate options, priced as follows:
Strike rate = 7.1%
Premium = 0.2% of the sum borrowed
Assume that on the day that the borrowing begins the spot rate has moved to a) 8% and b) 5.5%
Outcome
(a) (b)
Interest rate 8% 5.5%
Take up option Y N
Interest cost (%) 7.1% 5.5%
Interest cost (£) £5m × 6/12 × 7.1% (177,500)
£5m × 6/12 × 5.5% (137,500)
Premium £5m × 0.2% (10,000) (10,000)
Total cost (187,500) (147,500)

4.6.2 Traded interest rate options

Exchange-traded interest rate options are available as options on interest rate futures, which give the
holder the right to:
 Buy (call option) or sell (put option) one futures contract
 On or before the expiry of the option (i.e. American options) at a specified price (strike price)
As with all options, the buyer must pay a premium now (quoted in %)
 Borrowers buy puts
 Lenders buy calls

4.6.3 Hedging steps

Setup of the hedge
 Buy put options (if borrowing)
 Choose strike price (based on 1 - maximum rate you want to pay)
 Choose maturity date (as close to borrow start date as possible but not before)
Borrowing notional value borrowing period
 Calculate no. of contracts = ×
£500k 3

 Pay premium = # contracts × £500k × premium % × 3/12

Outcome of the hedge (when the borrowing starts)
(1) If rates rise above rate implied by strike price, exercise options:
 Sell futures at strike price
 Close out futures by buying same number of contracts  gain on futures =
(Sell price – Buy price) 3
100
× #contracts × £500k × 12

 Borrow money from your bank at spot rate

Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 153

(2) If rates fall below rate implied by strike price, let option lapse:
 Borrow money from your bank at spot rate

4.6.4 Pros and cons of traded interest rate options

Pros:
 Protects from downside risk and allows the buyer to benefit from upside (by e.g. letting put
option lapse if interest rates fall)
Cons:
 Option premium can be expensive and must be paid now
 May over/under hedge (as for futures, due to standardised contracts)
 Basis risk (difference between spot rate and futures rate before futures maturity date) may lead
to hedge not being 100% efficient if futures maturity ≠ borrowing start date

WORKED EXAMPLE: TRADED OPTION PRICING

UK futures options £500,000

Strike price Calls Puts
Nov Dec Jan Nov Dec Jan
95.00 0.87 1.27 1.34 0.29 0.69 1.06
95.50 0.58 0.99 1.10 0.50 0.91 1.32
96.00 0.36 0.76 0.88 0.77 1.18 1.60
Requirement
(a) Explain the components of the table
(b) Illustrate how a borrower would use the table to hedge against an interest rate rise.
SOLUTION
(a) The components of the table are as follows:
(i) The contract size is £500,000.
(ii) The strike price is the price that will be paid for the futures contract (if the option is
exercised).
(iii) A price of 96.00 represents an interest rate of 100 – 96 = 4% p.a
(iv) The numbers under each month represent the premium (in % terms) that must be paid
for the options.
For example, the cost of a November put option with an exercise price of 95.50 is
0.5% × £500,000 × 3/12 = £625
As with interest rate futures, the rates are expressed as annual interest rates, but as
these are 3 month contracts, the rates have to be adjusted to reflect this.
(b) Hedging a rate increase
Consider a borrower who is concerned that interest rates may rise. A rise in interest rates from
say 4% to 6% would cause interest rate futures to fall in price from 96 to 94.
The borrower would therefore want to have the right to sell a future at 96 (equates to
borrowing at 4%).
In the event that interest rates increased, the option would be exercised i.e. future sold for 96
and then the future would be closed out at the prevailing price of 94.
154 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

If interest rates fall to say 3% futures price would rise to 97 and so the option to sell at 96 would
be abandoned.
Rate increase to 6% Rate fall to 3%
Option to sell a future 96 96
Prevailing price of future (94) (97)
Effect exercise and gain 2% abandon
Thus the option will remove the downside to a borrower if interest rates rise, but leave the
upside if interest rates fall.

EXAMPLE 7: TRADED OPTIONS

Panda Ltd wishes to borrow £4 million fixed rate in June for nine months and wishes to protect itself
against rates rising above 6.75%. It is 11 May and the spot rate is currently 6%. The data is as follows:
SHORT STERLING OPTIONS (STIR)
£500,000
Strike price Calls Puts
June Sept Dec June Sept Dec
93.25 0.16 0.19 0.21 0.14 0.92 1.62
93.50 0.05 0.06 0.07 0.28 1.15 1.85
93.75 0.01 0.02 0.03 0.49 1.39 2.10
Panda negotiates the loan with the bank on 12 June (when the £4m loan rate is fixed for the full nine
months) and closes out the hedge.
What will be the outcome of the hedge and the effective loan rate if prices on 12 June are as follows:
Closing prices
Case 1 Case 2
Spot price 7.4% 5.1%
Futures price 92.31 94.75
SOLUTION
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 155

4.7 Interest rate swaps

An Interest rate swap is an OTC agreement whereby the parties to the agreement exchange interest
rate commitments.
 In the simplest form of interest rate swap, party A agrees to pay the interest on party B's loan,
while party B reciprocates by paying the interest on A's loan.
 If the swap is to make sense, the two parties must swap interest which has different
characteristics  i.e. one party must want fixed interest payments, the other must want
floating interest payments.

WORKED EXAMPLE: INTEREST RATE SWAPS

 Company A has borrowed £10 million at a fixed interest rate of 9% per annum.
 Company B has also borrowed £10 million but pays interest at SONIA + 1%. SONIA is currently
8% per annum.
 Company A would prefer variable whereas B would prefer fixed.
The best floating rate A could obtain without a swap is SONIA + 2% and the best fixed rate that B could
obtain without a swap is 10%
The two companies agree to swap interest payments.
A pays SONIA + 1% to B
B pays 9% to A
No loan principals are swapped and both parties retain the obligation to repay their original loans.
We can show a summary of the arrangements as follows:
Company A Company B
Interest paid on original loan (9%) (SONIA + 1%)
A pays to B (SONIA + 1%) → SONIA + 1%
B pays to A 9% ← (9%)
Net payment after swap (SONIA + 1%) (9%)
156 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

4.7.1 Savings on interest rate swaps

Aside from the benefit of changing the type of interest payments, companies can also benefit from a
overall interest rate savings by using swaps.
If the difference between the fixed rates which two parties can borrow at and the variable rates which
two parties can borrow at are not equal then it will be beneficial for them to enter into an IR swap:
(1) Set out the rates each company would pay (with no swap) and could pay (if they did the
opposite) and work out the total rate in each case
(2) Calculate the total potential benefit finding the difference between the two totals in part (1)
(3) Split this potential saving between the two parties as instructed in the question
(4) Calculate the overall effective rate with a swap for each party by deducting their share of the
saving from the rate they would pay with no swap
(5) Use this end result to calculate the two legs of the swap

EXAMPLE 8: HOW INTEREST RATE SWAPS WORK

Goodcredit plc has been given a high credit rating - It can borrow at a fixed rate of 11%, or at a variable
interest rate equal to SONIA, which also happens to be 11% at the moment. It would like to borrow at
a variable rate.
Secondtier plc is a company with a lower credit rating, which can borrow at a fixed rate of 12.5% or at
a variable rate of SONIA plus 0.5%. It would like to borrow at a fixed rate.
A swap allows both parties to pay interest at a lower rate via a swap than is obtainable from a bank:
Steps 1 & 2
Goodcredit Secondtier Sum total
Company wants Variable Fixed
Would pay (no swap)
Could pay
Potential gain
Step 3
If any gain was split evenly, Goodcredit and Secondtier would each be better off than their original
positions by %.
Step 4
Goodcredit ORIGINAL RATE was SONIA, so will pay
Secondtier ORIGINAL RATE was 12.5% fixed, so will pay
Fina nc ia l Ma na g e m e nt 9: M a n a g i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks 157

Step 5
OVERALL SWAP TERMS:

EXAMPLE 9: PRACTISE CREATING A SWAP

A plc wishes to borrow fixed but, because of its credit rating, the best rate it can obtain is 11% pa. It
can borrow variable at SONIA +2%. B plc can borrow fixed at 9% or variable at SONIA+1%. B plc is
happy to borrow variable.
Assume both wish to borrow £10m.
Requirement
Illustrate how a swap would benefit both parties, assuming the following:
(1) A plc borrows £10m variable at SONIA+2%
(2) B plc borrows £10m fixed at 9%
SOLUTION
158 9: M an ag i n g f i n an c i a l ri s k: i n t e re s t rat e s and o t he r ri s ks Fina nc ia l Ma na g e m e nt

4.7.2 Pros and cons of Interest rate swaps

Pros:
 Can either provide fixed or floating interest.
 Can be longer term than FRAs / futures / options
 Can be used to achieve lower borrowing costs for each counterparty
Cons:
 If you swap to pay fixed interest you lose the upside potential of variable rates
 If you swap to pay floating interest you risk the impact of rate rises
 There is a risk that the swap counterparty defaults
 There is a risk that the swap might make our accounts appear misleading (due to the
combinations of loans and derivatives)

Knowledge diagnostic
Before you move on to the next chapter, complete the following knowledge diagnostic and check you
are able to confirm you possess the following essential learning from this chapter. If not, you are
advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Do you know how a forward contract works?

Can you use index futures to set up a portfolio hedge?

Can you distinguish between a put and a call option?

Can you set up an interest rate futures hedge for a borrower?

Can you set up an interest rate options hedge for a borrower?

Can you explain how swaps work?

 159

10

Managing financial risk:

overseas trade

Topic List
1. Exchange rate basics
2. Risk and foreign exchange
3. Forwards and futures
4. Money market hedges
5. Currency options
6. To hedge or not to hedge?
7. Hedging economic exposure and risks of overseas trade

Learning Objectives
 Identify and describe the key price risks facing a business in a given scenario
 Explain how financial instruments (eg, derivatives, hedging instruments) can be used to manage
price risks and describe the characteristics of those instruments
 Discuss different methods of managing currency (including cryptocurrency) risks appropriate to
a given situation, , perform calculations to determine the cost of hedging that risk and select the
most suitable method of hedging
 Explain the additional risks of trading abroad and outline the methods available for reducing
those risks
 Identify in the business and financial environment factors that may affect investment in a
different country
160 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

1 Exchange rate basics

1.1 Quoting exchange rates
E.g. the current price of US dollars in £ (the ‘spot’ price) might be displayed as $1.2543 - $1.2594
 This means that if we want to sell $ for £, we will use a rate of $1.2594 : £1
 Whereas, if we want to buy $, we will use a rate of $1.2543 : £1
 Remember: WE ALWAYS LOSE OUT!

WORKED EXAMPLE: FOREIGN EXCHANGE QUOTES

A UK bank has quoted a spot spread for dollars of $1.7935 – $1.8075

A trading company has imported goods for which it must now pay US$10,000.
 It will need to buy $ from the bank: $10,000 @ $1.7935 per £1 =£5,575.69
 Similarly, an exporter making an overseas sale for $10,000 would receive £5,532.50 ($1.8075
per £1)

EXAMPLE 1: EXCHANGE RATES

Calculate how much sterling exporters would receive or how much sterling importers would pay,
ignoring the bank’s commission, in each of the following situations, if they were to exchange the
overseas currency and sterling at the spot rate.
(a) A UK exporter receives a payment from a Danish customer of 150,000 kroners.
(b) A UK importer buys goods from a Japanese supplier and pays 1 million yen.
Spot rates are as follows.
Bank sells (offer) Bank buys (bid)
Danish Kr/£ 9.4340 – 9.5380
Japan ¥/£ 203.650 – 205.781
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 161

2 Risk and foreign exchange

2.1 Currency risk
There are three different types of foreign currency risk:
 Transaction risk refers to the risk a business is exposed to when it enters into a short term
transaction involving credit in a non-native currency (changes in the FX rates before settlement
could lead to the business either losing or gaining)
 Economic risk refers to the longer term risk a business is exposed to by trading in a particular
foreign country (changes in FX rate may make it less able to compete against rivals)
 Translation risk refers to the danger of a business generating accounting losses when
translating the results of overseas subsidiaries
 In this syllabus we are primarily concerned with hedging transaction risk.

2.2 Should we hedge?

There are a number of factors to consider:
 Costs – how much will the hedge cost, does the risk warrant the cost?
 Exposure – is our exposure material? If not then consider not hedging
 Attitude to risk – are we risk seeking (if so don’t hedge) or risk averse (hedge)?
 Portfolio effect – what is the overall position for the company as a whole?
 Shareholders – are they diversified internationally? If so don’t hedge.
 Insolvency risk and cost of capital – hedging should reduce volatility of cashflows and hence the
cost of capital

2.3 Direct risk reduction methods (without using derivatives)

Hedging Method How it works
Invoice foreign customers in your domestic currency. This pushes the risk onto the
Invoice currency
customer and may prove unpopular
By setting up a foreign currency bank account a company can ensure it only has to
Match receipts and
hedge its net foreign currency position – this will prove easier and cheaper than
payments
separately hedging each transaction
Try to fund high value foreign assets (which will generate revenues in foreign
Match assets and
currency) with foreign borrowing (so that your interest payments are also in
liabilities
foreign currency) – this will decrease your net foreign currency exposure
You may lead on a payment to a foreign supplier if you fear that the foreign
currency will strengthen
Leading and lagging You may lag on a payment to a foreign supplier if you think that the foreign
currency will weaken
* Note – this is not hedging, rather it is speculation!
162 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

3 Forwards and futures

3.1 Forward exchange contracts
Forward exchange contracts (FX forwards) are binding agreement to buy or sell an amount of one
currency in the future for a set price in another currency (agreed today).
This can be used to eliminate the transaction risk of a future foreign currency payment to a supplier or
receipt from a customer.
 FX forwards are either quoted as discounts or premiums on the spot price
 Remember: ADDIS (add a discount, deduct a premium) – for example:
– The spot price is $1.2543 - $1.2594 : £1
– The 3 month forward is trading at a discount of 0.06c – 0.14c
– The 3m forward rate is:
($1.2543 + 0.06/100) – ($1.2594 + 0.14/100) = $1.2549 - $1.2608
– Remember: WE ALWAYS LOSE OUT!

3.1.1 Pros and cons of FX forwards

Pros:
 They lock in a price, hedging downside risk (e.g. of $ weakening if we have an expected future $
receipt)
 They are tailored to the investor (so you won’t be under/over hedged)
Cons:
 The investor loses any upside potential (e.g. of $ strengthening if we have an expected future $
receipt)
 It is difficult to unwind the hedge (no secondary market), so we must satisfy the contract even if
e.g. our foreign customer doesn’t pay us on time!

EXAMPLE 2: FORWARD EXCHANGE CONTRACTS

1 January: Spot rate US $ $1.9500 – 1.9610

One month forward discount: 0.20c – 0.22c
Three month forward premium: 0.22c – 0.18c
Requirement
What are the forward rates quoted for one and three month contracts respectively?
SOLUTION
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 163

3.1.2 Option forward exchange contracts

Option forward contracts are forward exchange contracts where the customer has the option to call
for the performance of the contract over a set date range

WORKED EXAMPLE: OPTION FORWARD CONTRACT

A UK company must pay $100,000 in approximately 1½ months’ time and takes out an option forward
exchange contract to eliminate the foreign currency transaction risk.
Exchange rate details are:
 Today’s spot rate $1.9500 to the £
 One month forward rate $1.9475 to the £
 Two month forward rate $1.9450 to the £
Requirement
Explain how the foreign debt will be settled in 1½ months’ time.
SOLUTION
The bank will offer an option forward exchange contract to the company, allowing the company to
choose when, between one month’s time and two month’s time, the currency is needed. The rate will
be either the one month rate or the two month rate, which ever is more beneficial to the bank.
At one month rate cost = $100,000 ÷ 1.9475 = £51,348
At two month rate cost = $100,000 ÷ 1.9450 = £51,414
The bank is selling the dollars and receiving sterling in exchange, so the two month rate will be used
(as it is the most beneficial to the bank)

3.2 Interest rate parity (IRP) – how the forward rates are set
Interest rate parity uses the nominal interest rates in two countries and the spot exchange rate to:
 Determine a fair forward exchange rate
 Predict the future expected spot rate
The basic idea behind IRP is that if an investor should be in the same position is they do either of the
following:
(1) Exchange Sterling for Dollars, deposit the Dollars in a US bank account for a set period and then
use an FX forward to convert back to Sterling
(2) Deposit the Sterling in a UK bank account for a set period
164 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

WORKED EXAMPLE: INTEREST RATE PARITY

A treasurer has £1m available to place on deposit for 12 months.

 Spot rate ($/£): $1.5234/£
 Average forward rate is $1.5407/£
 UK interest rate (average of borrow and deposit rates): 6%
 US interest rate (average of borrow and deposit rates): 7.2%
Requirements
(a) Using the average current spot and borrowing/lending rates for each country, determine what
would happen if the £1m was deposited in either the UK or the US .
(b) Explain the implication of this for the forward exchange rate.
SOLUTION
(a) The treasurer could convert the £1m into dollars at the spot rate of $1.5234/£ and put it on
deposit in the US at 7.2%. After a year, the dollar amount would be converted back to sterling.
Alternatively, the £1 could be invested at 6% in the UK.

Now One year

Cash Invest @ 7.2%

$
flow $1.5234m $1.6331m

Convert @ $1.5234

Cash
£
flows £1m £1.06m
Invest @ 6%

The two alternative investments would give $1.6331m and £1.06m respectively.
Which of these is preferable depends on the exchange rate in one year. If the exchange rate
stays at $1.5234, the US deposit converts into
($1.6331m @ $1.5234/£) = £1.072m  i.e., a 7.2% return instead of a 6% return.
(b) Interest rate parity predicts that there will be no benefit after the impact of the exchange rate is
taken into account.
Thus the forward rate of exchange predicted by IRP is $1.6331/1.06 = $1.5407/£.
If the forward rate were not set at $1.5407/£, a disequilibrium position is created. For example,
if the forward rate were set equal to the spot rate of $1.5234, the implications are that
investors would be keen to sell dollars in the forward market and buy sterling. These forces of
supply and demand would cause dollars to weaken and sterling to strengthen, and thus the
forward rate would change.
Note that is what the example has shown; a forward rate of $1.5407 is a weaker dollar rate than
the spot rate of $1.5234.
The process by which the relationship between spot and forward rates is maintained through
buying and selling of the currency is known as arbitrage.
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 165

3.2.1 Use of interest rate parity to set forward rates

The relationship between the spot and forward rates is shown algebraically as follows:
1+i
spot rate × 1 + i f = forward rate
UK

Where:
if is the overseas nominal interest rate
iuk is the domestic nominal interest rate
The interest rate parity formula links the forward exchange rate with interest rates in a fairly exact
relationship, because risk-free gains (arbitrage) are possible if the rates are out of alignment.
Note: when showing interest rate parity in the exam, you should use the mid-point (average) of the
spot rates and interest rates (see the following example).

EXAMPLE 3: INTEREST RATE PARITY

A UK company is expecting to receive $1 million in one year’s time. The spot rate spread ($/£) is 1.90 –
2.00/£. The US borrowing rate of interest is 6.2% pa, the depositing rate 5.8% pa. The rates for UK
borrowing and depositing are 5.2% pa and 4.8% pa respectively.
Calculate what the current 1 year forward exchange rate should be, using the average current spot and
borrowing/lending rates.
SOLUTION

3.3 Purchasing power parity (PPP) – how future spot rates can be predicted
Purchasing power parity is based on the idea that a basket of goods in one country will – after the
effect of the exchange rate – cost the same no matter where it is traded. It is sometimes called the law
of one price.
I.e. investors should be indifferent between buying goods in the UK in Sterling or converting money to
Dollars and buying the same goods in the US in Dollars
Hence, PPP uses the inflation rates in two different countries and the current spot exchange rate to
predict the future expected spot exchange rate:
1+ hf
spot rate × = expected future spot rate
1+ hUK

where hf is the overseas inflation rate and huk is the domestic inflation rate
166 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

WORKED EXAMPLE: PURCHASING POWER PARITY

Consider a collection of goods that sell for £1,000 in the UK.

If the exchange rate is $1.80/£, what are the implications of the same goods selling for $2,000 in the
US?
SOLUTION
In principle, if the same goods cost $2,000 in the US, instead of (£1,000 @ $1.80) = $1,800, then
consumers would buy from the UK (requiring £) and not in the US (therefore selling $).
These forces of supply and demand would ultimately cause the exchange rate to alter with dollars
weakening to $2.00/£, at which point the prices are effectively the same.

EXAMPLE 4: DIFFERENT INFLATION RATES

Taking the situation above, ie where an equilibrium rate of $2/£ exists, show what would happen if
 Expected inflation in the UK is 3%
 Expected inflation in the US is 4%
SOLUTION

If we assume that the only reason that the nominal interest rates in the two different countries are
different is due to differing levels of inflation (i.e. the real interest rates are equal), then we can
conclude that:
 The forward rate (as found using interest rate parity) is an unbiased predictor of the future
expected spot rate (as calculated using purchasing power parity).
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 167

3.4 Currency futures (FX futures)

Currency futures are standardised (‘traded’) contracts to buy a set amount of currency at a set rate for
a standardised delivery date in the future.
For example, Sterling futures traded on the Chicago Mercantile Exchange:
 Settle in March, June, September and December
 Have a standard contract size of £62,500
 Buying a Sterling future is akin to agreeing to buy Sterling for a set price at a set future date
(hence selling a Sterling future is akin to selling Sterling)
 FX futures don’t lead to any currencies being swapped, only a net gain or loss in the currency in
which the price is quoted

3.4.1 Hedging steps – e.g. for an expected $ receipt

Setup of the hedge
 If hedging an expected $ receipt  want to sell $, buy £, so buy £ futures
 Choose maturity date (as close to the receipt date as possible but not before)
$ receipt ÷ futures rate
 Calculate no. of contracts =
£62,500

Outcome of the hedge (when the $ are received)

 Close out futures by selling same number of contracts  gain/loss on futures =
(Sell rate – Buy rate) × #contracts × £62,500
 Convert the net of the $ receipt and the gain/loss on the future to £ using the spot rate (at the $
receipt date)

3.4.2 Pros and cons of FX futures

Pros:
 They attempt to lock in a price, hedging downside risk (e.g. of $ weakening if we have an
expected future $ receipt)
 Can close out position at any time (more flexible than forwards)
Cons:
 The investor loses any upside potential (e.g. of $ strengthening if we have an expected future $
receipt)
 Standardised contracts, so may under/over hedge
 Basis risk (difference between spot rate and futures rate before futures maturity date) may lead
to hedge not being 100% efficient if futures maturity ≠ transaction date
 Must post margin (collateral) to the exchange
168 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

EXAMPLE 5: CURRENCY FUTURES

A UK exporter is expected to receive $250,000 in December.

It is currently August.
 The spot rate now is: $1.85/£
 The quote for December Sterling futures is: $1.87/£.
 The UK exporter uses futures to hedge its currency risk. Contract size is £62,500.
 In December, the company receives $250,000
 The spot rate in December moved to $1.90
 The futures rate in December was also $1.90
Show the outcome of a futures hedge.
SOLUTION
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 169

3.5 Choosing between forward contracts and futures contracts

Advantages of futures over forward contracts
 Transaction costs should be lower
 The exact date of receipt or payment of the currency does not have to be known
Disadvantages of futures compared with forward contracts
 The contracts cannot be tailored to the user’s exact requirements.
 Hedge inefficiencies are caused by having to deal in a whole number of contracts and by basis
risk
 Only a limited number of currencies are available
 They are more complex to use than forwards

3.6 Cryptocurrencies
A cryptocurrency is a digital currency that uses cryptography to make sure payments are sent and
received safely. The oldest and best known cryptocurrency is Bitcoin.
Cryptocurrencies can be particularly useful for transactions involving foreign currency. Instead of
managing currency risk by using foreign currency hedging techniques, both parties to a transaction
could agree that payment will be made in Bitcoin (BTC). Alternatively, businesses can run BTC
accounts, converting to and from their respective currencies when the BTC exchange rate is in their
favour. Businesses that send and receive payments in multiple currencies could find that using BTC for
settlement helps to streamline cash flow management.
Using cryptocurrencies for international transactions presents two key problems:
 Exchangeability – cryptocurrencies are likely only to be exchanged for a narrow range of major
currencies, e.g. USD, Japanese Yen and Euros.
 Price volatility – Crypto currency rates are extremely volatile. For example Bitcoin moved from
being worth approximately $5,500 to over $10,000 in the space of a few weeks in November
2017. However, increasingly there are opportunities to hedge this risk using forward contracts
or futures.

WORKED EXAMPLE: USING FORWARDS TO HEDGE CRYPTOCURRENCY RISK

Ruzek plc is a UK company that is due to receive a payment from a customer of 10 Bitcoin in two
months’ time.
It is now 30 April 20X0, the following rates apply:
Spot rate: 1 Bitcoin = £7,700 – £7,800
Two month forward rate: 1 Bitcoin = £7,750 – £7,850
Requirement
Demonstrate the outcome of a forward hedge.
170 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

SOLUTION
The company will sell Bitcoin so the lower price of £7,750 will be offered.
10 Bitcoin × £7,750 = £77,500
This will be received in two months’ time.
Remember that foreign exchange dealers make their profit on the spread so companies will always
lose out, we therefore select the forward rate in this example that will result in the lower receipt for
Ruzek plc.

WORKED EXAMPLE: USING FUTURES TO HEDGE CRYPTOCURRENCY RISK

Ruzek plc is now considering the use of Bitcoin futures to hedge the risk of its receipt of 10 Bitcoin
(BTC) in two months’ time. It is 30 April 20X0, the current value of a Bitcoin is £7,750 and the price
quote for June Bitcoin future is £7,845. Bitcoin futures contract are available in a standard contract
size of 5 Bitcoin.
On 30 June 20X0, the settlement date for the June futures contract, the market value (and June
futures value) of a Bitcoin was £5,000.
Requirement
Demonstrate the outcome if Ruzek used Bitcoin futures to hedge against a fall in the £ value of Bitcoin
SOLUTION
Set-up
As Ruzek will want to sell Bitcoin when they receive it they will need to sell Bitcoin futures now
Number of contracts = 10 (transaction size) ÷ 5 (standard contract size) = 2 contracts
Outcome
Step 1 Position in spot market
Loss on transaction = 10 bitcoin × (£7,750 – £5,000) = £27,500
Step 2 Calculate gain or loss on futures
Buy futures at lower price than we sold them for (closing out). The price to close out the position is
£5,000.
Initially sold futures for: £7,845
Now buy futures for: £5,000
Gain on closing out futures: (£7,845 - £5,000) × 5 Bitcoin × 2 contracts = £28,450
Step 3 Calculate net position
Net position = £28,450 gain on futures – £27,500 loss on actual
= £950 gain overall
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 171

4 Money market hedges

Instead of using forwards and futures, we can instead use the following to hedge our transaction risk
exposure by fixing an effective forward exchange rate:
 Borrowing and lending on money markets
 Spot foreign exchange transactions
For example – if a company is expecting an to make a future Dollar payment:
(1) It borrows money now in Sterling
(2) It immediately converts the Sterling to Dollars (at the current spot rate) and deposits in an
interest-bearing account such that at the date of the payment it will have enough Dollars to
make the payment
The company then pays back the Sterling loan – the amount of Sterling to be paid back will be known
at the outset, hence the total Sterling cost of making the Dollar payment is fixed at the outset
If a company is expecting an overseas receipt, then the reverse process is followed (borrowing now in
the foreign currency, convert to Sterling at spot and depositing in an interest-bearing account).
 The effect is exactly the same as using a forward contract, and will usually cost almost exactly
the same amount.
 If the results from a money market hedge were very different from a forward hedge,
speculators could make money without taking a risk. Therefore market forces ensure that the
two hedges produce very similar results.

4.1.1 MM Hedge step-by-step guide:

To hedge future payment in Dollars: To hedge future receipt in Dollars:
Borrow in £ now Borrow in $ now
Convert to $ at spot Convert to £ at spot
Deposit $, earn interest Deposit £, earn interest
On payment date, settle payment out of $ deposit On receipt date, use receipt to pay back $ loan
account Withdraw £ from deposit
Pay back £ loan + interest.

4.1.2 Pros and cons of MM hedges

Pros:
 They attempt to lock in a price, hedging downside risk (e.g. of $ weakening if we have an
expected future $ receipt)
 Tailored to the investor (so won’t be under/over hedged)
Cons:
 The investor loses any upside potential (e.g. of $ strengthening if we have an expected future $
receipt)
 Difficult to unwind the hedge
 Unlikely to be cheaper than using a forward + greater admin + effort involved
172 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

EXAMPLE 6: MONEY MARKET HEDGE – FOREIGN CURRENCY PAYMENT

A UK company owes a Danish creditor Kr 3,500,000 in three months’ time. The spot exchange rate is
Kr/£ 7.5509 – 7.5548. The company can borrow in Sterling for three months at 8.60% per annum and
can deposit kroners for three months at 10% per annum. What is the cost in pounds with a money
market hedge and what effective forward rate would this represent?
SOLUTION
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 173

EXAMPLE 7: MONEY MARKET HEDGE – FOREIGN CURRENCY RECEIPT

A UK company is owed SFr 2,500,000 to be paid in three months’ time by a Swiss company. The spot
exchange rate is SFr/£ 2.2498 – 2.2510. The company can deposit in Sterling for three months at 8.00%
per annum and can borrow Swiss Francs for three months at 7.00% per annum. What is the receipt in
pounds with a money market hedge and what effective forward rate would this represent?
SOLUTION
174 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

4.2 Choosing the hedging method

The cheapest method available is the one that ought to be chosen.

EXAMPLE 8: CHOOSING THE CHEAPEST METHOD

Trumpton plc has bought goods from a US supplier, and must pay $4,000,000 in three months’ time.
The company’s finance director wishes to hedge against the foreign exchange risk, and the three
methods which the company usually considers are:
 Using forward exchange contracts
 Using money market borrowing or lending
 Making lead payments
The following annual interest rates and exchange rates are currently available.
US dollar Sterling
Deposit rate Borrowing rate Deposit rate Borrowing rate
% % % %
1 month 7 10.25 10.75 14.00
3 months 7 10.75 11.00 14.25

$/£ exchange rate ($ = £1)

Spot 1.8625 – 1.8635
1 month forward 0.60c – 0.58c pm
3 months forward 1.80c – 1.75c pm

Which is the cheapest method for Trumpton plc?

Forward Contract
Money Market hedge
Lead payment
SOLUTION
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 175
176 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

5 Currency options
A currency option is an agreement involving a right, but not an obligation, to buy or to sell a certain
amount of currency at a stated rate of exchange (the exercise price) at some time in the future.
Currency options protect against adverse movements in the exchange rate while allowing the investor
to take advantage of favourable exchange rate movements.

5.1 OTC currency options

OTC currency options allow you to pay a premium now to buy a tailored option to:
 Buy (call), or sell (put) a set amount of currency
 At a set price (in another currency)
 At a future date
OTC options allow the exchange of currencies if exercised (hence the spot market will not need to be
used upon exercise)
Note: be very careful to identify the underlying currency – e.g. if the option is ‘on €’:
– A call option will represent the option to buy € at a set price in £
– The premium will be payable in £

5.1.1 Hedging steps – e.g. for an expected $ receipt

Setup of the hedge
 As expecting a $ receipt, we will want to sell $, hence we need to buy a put option on $
 Choose strike price (based on the minimum £ you want to receive)
 Pay premium in £
Outcome of the hedge
(1) If Dollar weakens to worse than the strike price, exercise options:
 Convert $ to £ at the strike price
(2) If Dollar strengthens to better than the strike price, let option lapse:
 Convert the $ to £ at the spot price

EXAMPLE 9: OVER-THE-COUNTER CURRENCY OPTIONS

Sugar plc is expecting to receive 20 million South African rands (R) in one month's time. The current
spot rate is R/£ 19.3383 – 19.3582. Compare the results of the following actions.
(a) The receipt is hedged using a forward contract at the rate 19.3048.
(b) The receipt is hedged by buying an over-the-counter (OTC) option on Rand from the bank,
exercise price R/£ 19.30, premium cost of £24,000.
(c) The receipt is not hedged.
In each case compute the results if, in one month, the exchange rate moves to:
(i) R 21.00/£
(ii) R 17.60/£
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 177

SOLUTION

5.2 Traded currency options

A company wishing to purchase an option to buy or sell sterling can use traded options (e.g. those
traded on the Philadelphia Stock Exchange).
 These options are standardised with standard maturity dates and contract sizes (like futures)
 The contract sizes are quoted in Sterling
 Their premiums are quoted in cents
 If exercised, they will not lead to any currencies being exchanged, rather a gain or loss in the
foreign currency (i.e. you will still need to exchange currencies at the spot rate)
 When trying to determine whether to use a put or call, think “what do I want to do with £” – if
you want to buy £ then buy a call, if you want to sell £ then buy a put.
178 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

The schedule of prices for £/$ options is set out in tables such as the one shown below.
Philadelphia SE £/$ options £31,250 (cents per pound)
Calls Puts
Strike price Aug Sep Oct Aug Sep Oct
1.5750 2.58 3.13 – – 0.67 –
1.5800 2.14 2.77 3.24 – 0.81 1.32
1.5900 1.23 2.17 2.64 0.05 1.06 1.71
1.6000 0.50 1.61 2.16 0.32 1.50 2.18
1.6100 0.15 1.16 1.71 0.93 2.05 2.69
1.6200 – 0.81 1.33 1.79 2.65 3.30

Note the following points.

The contract size is £31,250.
If a firm wished to have the option to buy pounds (selling dollars) in September, it can buy a call option
on sterling. To have the option to buy pounds at an exchange rate of $1.5800/£, it would need to pay a
premium of 2.77 cents per pound.
A put option here is the option to sell sterling
Note that a call option with a strike price of 1.6000 $/£ exercisable in September will cost more than
an option with the same strike price which is exercisable in August.

5.2.1 Hedging steps – e.g. for an expected $ receipt

Setup of the hedge
 As expecting a $ receipt, we will want to sell $ and buy £, hence we need to buy a call
option on £
 Choose strike price and maturity date
$ receipt ÷ strike price
 Calculate the # contracts needed =
£31,250

 Pay premium in $ = # contracts × premium (cents)/100 × £31,250

 Need to pay this in $, so must buy $ at spot to do so
Outcome of the hedge
(1) If Dollar weakens to worse than the strike price, exercise options:
 Gain on the option = (Spot – strike) × #contracts × £31,250
 This gain is in $, so add to the $ receipt and convert the total to £ at the spot rate
(2) If Dollar strengthens to better than the strike price, let option lapse:
 Convert the $ to £ at the spot price
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 179

EXAMPLE 10: TRADED CURRENCY OPTIONS

Prices (premiums) on 1 June for Sterling traded currency options on the Philadelphia Stock Exchange
are shown in the following table.
Sterling £31,250 contracts (cents per £)
Exercise price Calls Puts
$/£ September December September December
1.5000 5.55 7.95 0.42 1.95
1.5500 2.75 3.85 4.15 6.30
1.6000 0.25 1.00 9.40 11.20
Prices are quoted in cents per £.
On 1 June, the current spot exchange rate is $1.5404 – $1.5425 and September futures are quoted at
$1.54 with a standard contract size of £62,500.
Stark plc, a UK company, is due to receive $3.75 million from a debtor in four months' time at the end
of September. The treasurer decides to hedge this receipt using either September £ traded options or
September futures.
Requirement
Compare the results of using an option to hedge with a futures contract.
Illustrate the results with an option exercise price of $1.55 if by the end of September the spot
exchange rate moves to (i) $1.4800; (ii) $1.5700.
Assume that at the end of September the quote for September futures is the same as the spot
exchange rate.
SOLUTION
180 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

5.3 Pros and cons of FX options

Pros:
 They protect from downside risk and allows the buyer to benefit from upside (by e.g. letting put
option lapse if exchange rate moves in our favour)
Cons:
 Option premium can be expensive and must be paid upfront
 If traded, we may over/under hedge (due to standardised contracts)
 If traded, not available in all currencies

6 To hedge or not to hedge?

In the exam you may be asked to explain whether a particular company should hedge, having
calculated the outcome for that company of different hedging method. Here are the areas you should
cover in your answer.
 Comparison of Sterling value of payment/receipt at the earlier / current / future predicted
spot rates. How volatile are the exchange rates, is there a trend? The greater the volatility, the
greater the reason to hedge.
 What does the forward rate suggest? For example, if a future $ receipt is expected and the $ is
trading at a discount in the forward market (more $ per £1), then we should be concerned that
this may predict a weakening of the $, giving us cause to hedge.
Fina nc ia l Ma na g e m e nt 10: M an ag i n g f i n a n ci a l ri s k: o v e rs e a s t ra d e 181

 Comparison of the results of the different hedging options. You will have already been asked
to calculate the outcome of different hedges, so list them in order of outcome and discuss the
pros and cons of each (e.g. futures are cheap and easy, but aren’t tailored to requirements and
may not lead to a perfect hedge). Consider the directors’ attitude to risk – if the directors are
risk seekers, they may choose not to hedge, in order to preserve 100% of the upside.

7 Hedging economic exposure and risks of overseas trade

7.1 Hedging economic exposure
 Diversifying operations world-wide and production management (so that your costs are in the
same currencies as your revenues)
 Market and promotional management (weigh the benefits of operating in each market against
the economic risk)
 Product management (factor in economic risk before launching new products)
 Pricing (consider exchange rate movements when setting prices)

Overseas trade – trading risks

 Physical risk (goods lost or stolen in transit)
 Credit risk (payment default by customer)
 Trade risk (risk of order cancellation whilst goods in transit or refusal to accept goods)
 Liquidity risk (inability to finance credit given to customers)
These risks can be mitigated using the help of insurers, banks, government agencies and credit
reference agencies
182 10: M an ag i n g f i n an ci al ri s k: o v e rs e as t rad e Fina nc ia l Ma na g e m e nt

Knowledge diagnostic
Before you move on to the next phase of your studies, complete the following knowledge diagnostic
and check you are able to confirm you possess the following essential learning from this chapter. If
not, you are advised to revisit the relevant learning from this chapter.

Confirm your learning Yes/No

Can you select the correct exchange rate to use from a spread?

Can you explain three internal hedging techniques?

Can you predict an exchange rate using IRP and PPP?

Can you set up a MMH for a foreign currency payment and receipt?

Can you prepare calculations to show the outcome of using an option to hedge
foreign currency risk?

Do you know the areas to include in answer to an exam question asking you to
determine whether or not an organisation should hedge?

Can you explain the difference between transaction, translation and economic risk?
 183

11

Answers to chapter examples

Chapter 1
Example 1
Takeovers
Victim company managers often devote large amounts of time and money to 'defend' their companies
against takeover. However, research has shown that shareholders in companies that are successfully
taken over often earn large financial returns. On the other hand, managers of companies that are
taken over frequently lose their jobs! This is a common example of the conflict of interest between the
two groups.
Time horizon
Managers know that their performance is usually judged on their short-term achievements;
shareholder wealth, on the other hand, is affected by the long-term performance of the firm.
Managers can frequently be observed to be taking a short-term view of the firm which is in their own
best interest but not in that of the shareholders.
Risk
Shareholders appraise risks by looking at the overall risk of their investment in a wide range of shares.
They do not have 'all their eggs in one basket', unlike managers whose career prospects and short-
term financial remuneration depend on the success of their individual firm.
Debt
As managers are likely to be more cautious over risk than shareholders, they might wish to adopt
lower levels of debt than would be optimal for the shareholders.
184 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Chapter 2
Example 1
(a)
Time Cumulative cash flow
0 (500,000)
1 (430,000)
2 (360,000)
3 (280,000)
4 (180,000)
5 (80,000)
6 40,000 ∴ Payback = 5 + 80k/120k = 5.67 years

(b) Profit calculation:

Total cash flows from operations 540,000
Total depreciation (150,000)
Total profits 390,000
Average profits (÷ 6) = £65,000 p.a.
500k + 350k
Average investment = 2
= 425k
65k
ARR= =15.3%
425k

(c)
A B C D E F G
1 Time 0 Time 1 Time 2 Time 3 Time 4 Time 5 Time 6
2 -500 70 70 80 100 100 470

PV of cash flows in cells B2 to G2 is =NPV(0.12, B2:G2), which gives £533,660.

Deducting the initial cash outflow of £500,000 gives an NPV of £33,660.
(d) Using the above spreadsheet, the IRR formula is = IRR(A2:G2), which gives an IRR of 14%.

Example 2
Now the only alternative use for the material is to sell it for scrap. To use 50 tonnes on the contract is to
give up the opportunity of selling it for 50 × £150 = £7,500. This is the relevant cost

Example 3
The relevant cost of 25 tonnes is £150 per tonne. The organisation must then purchase a further 25 tonnes
and, assuming this is in the near future, it will cost £210 per tonne.
The contract must be charged with:
25 tonnes @ £150 3,750
25 tonnes @ £210 5,250
9,000
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 185

Example 4
What revenue is lost if the labour is transferred to the project from doing nothing? Nothing, hence the
relevant cost is zero.

Example 5
Costs and revenues of proceeding with the project.
(1) Costs to date of £150,000 are sunk costs, therefore ignore.
(2) Materials – purchase price of £60,000 is also sunk.
There is an opportunity benefit of the disposal costs saved. 5,000
(3) Labour cost – the direct cost of £40,000 will be incurred regardless of
whether the project is undertaken or not – and so is not relevant.
Opportunity cost of lost contribution = 150,000 – (100,000 – 40,000) (90,000)
The absorption of overheads is irrelevant – it is merely
an apportionment of existing costs which do not change.
(4) Research staff costs
Wages for the year (60,000)
Increase in redundancy pay (35,000 – 15,000) (20,000)
(5) Equipment
Current disposal value foregone (8,000)
Disposal proceeds in one year 6,000
(All book values and depreciation figures are irrelevant)
(6) General building services
Apportioned costs – irrelevant
Opportunity costs of rental forgone (7,000)
(174,000)
Sales value of project 300,000
Increased contribution from project 126,000

Advice. Proceed with the project.

Example 6
(a) The existing customers create more value than selling the machine, so the machine would not
be sold. Hence the opportunity cost is the value in use of £1,500
Note: if the value in use ever dropped below the net realisable value (NRV), then the asset
would not be worth keeping.
(b)
(i) If the new contract will make use of a currently owned machine then in principle the cost
of using it will be the replacement cost. If the value in use is £1,500, and the replacement
cost is £800, then the machine will be replaced. The equipment cost of the new contract
would therefore be £800.
(ii) If however, the replacement cost is £1,800 then it is not worth replacing. Thus the
relevant cost of equipment for the new contract will be the opportunity cost or benefit
forgone – i.e. the £1,500.
In each case therefore the relevant cost is the cash flow effect of the decision to use the existing
resource – either the replacement cost or the benefit in the next best case.
186 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Example 7
t0 t1 t2 t3 t4
£ £ £ £ £
Sales 100,000 110,000 121,000 133,100
Working capital required 15,000 16,500 18,150 19,965 0
Cash flow (15,000) (1,500) (1,650) (1,815) 19,965

Example 8
t0 t1 t2
Net trading revenue 5,000 5,000
Tax @ 17% (850) (850)
Asset (10,000) 6,900
WDA (W) 306 251 (30)
Net cash flow (9,694) 4,401 11,020

Capital allowances (W)

Year Start value End value Capital allowance Tax saving (17%)
20X0 10,000 8,200 1,800 306
20X1 8,200 6,724 1,476 251
20X2 6,724 6,900 (176) (30)

Example 9
t0 t1 t2
Net trading revenue 5,000 5,000
Tax @ 17% (850) (850)
Asset (10,000)
Scrap proceeds 6,900
Tax savings on WDAs (W) 306 221
Net cash flow (10,000) 4,456 11,271

Capital allowances (W)

Year Start value End value Capital allowance Tax saving (17%)
20X1 10,000 8,200 1,800 306
20X2 8,200 6,900 1,300 221
WORKING
Tax computation
to t1 t2
PROFITS
IN
YEAR 1

 Asset purchased 1 Jan 20X1 which is effectively  Asset sold 31 Dec 20X2
(for discounting purposes) the same as
31 December 20X0, ie t0
 First WDA will be set off against profits earned in  No WDA in year of sale –
year 1 (t0 → t1) balancing adjustment instead
 First tax relief at t1
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 187

Tax relief at Timing

£ 17%
1 Jan 20X1 Investment in asset 10,000
31 Dec 20X1 WDA @ 18% (1,800) 306 t1
8,200
31 Dec 20X2 Proceeds 6,900
Balancing allowance (1,300) 221 t2

Example 10
A B C D E
1 t0 t1 t2 t3
2 Invest (10,000)
3 Returns inflated at 7% 5,350 5,725 6,125
4 Net cash flow (10,000) 5,350 5,725 6,125
5
6 PV at 10% of cash flows in t1 to t3 14,197
7 Less original investment (10,000)
8 NPV 4,197

The PV in cell B6 is given by = NPV(0.1,C4:E4)

Example 11
(1 + m) = (1 + r) (1 + i)
So (1 + 10%) = (1 + r)(1 + 0.07)
r = 2.8%
𝐴𝐴 1
PV of an annuity of £5,000 for time 1 to time 3 at 2.8% = 𝑟𝑟 �1 − (1+𝑟𝑟)𝑛𝑛 �, where A = £5,000, r = 0.028
and n = 3 is £14,198
NPV = £((–10,000 × 1) + 14,198) = £4,198
This is the same answer as for Example 10, bar a small difference for rounding.

Example 12
Most common approach
DF = 1/(r – g)
PV = cash flow at t1 × 1/(r – g)
Cash flow at t1 = £100 × 1.02 = £102
1
Therefore PV = £102 × 0.06−0.02 = £2,550

Using the ‘effective rate’

Effective rate = (1.06/1.02) – 1 = 0.0392 = 3.92%
PV = £100 × 1/0.0392 = £2,551
188 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Example 13
A B C D E F
1 Time 0 Time 1 Time 2 Time 3 Time 4
2 Sales (no of games × selling price) 3,750 1,680 1,380 1,320
3 Direct materials (W1) (834) (401) (354) (365)
4 Variable production costs (W2) (927) (446) (393) (405)
5 Advertising (650) (100) – –
Lost contribution on existing games
6 (10,000 × £15) (150) (150) (150) (150)
7 Net operating cash flow 0 1,189 583 483 400
8 Tax at 25% (297) (146) (121) (100)
9 New machine (800) 150
10 Tax saved on capital allowances (W3) 40 32 26 65
11 Working capital (W4) (375) 207 30 6 132
12 Net cash flow (1,175) 1,139 499 394 647
13
14 PV of net cash flows time 1 to time 4 1,997
15 Less net cash flow at time 0 (1,175)
16 NPV 822

The PV in cell B14 is given by = NPV(0.15,C12:F12).

As the net present value is positive, the proposed investment should be accepted as it will increase the
shareholders’ wealth by £822k.
(W1) Direct materials
Direct materials need to be inflated by 3% pa and so, at time n, direct materials is £5.40 × no of games
× 1.03n
(W2) Variable production costs
Variable production costs need to be inflated by 3% pa and so, at time n, variable production costs is
£6.00 × no of games × 1.03n
(W3) Tax saved on Capital Allowances
Tax Saved
Time Tax Cash Flow
£000 £000
0 Purchase 800
1 CA @ 20% of 800 (160) @25% 40
640
2 CA @ 20% of 640 (128) @25% 32
512
3 CA @ 20% of 512 (102) @25% 26
410
4 Sale Proceeds (150)
260
Balancing Allowance (260) @25% 65
Nil 163
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 189

Tax Saved
Time Tax Cash Flow
£000 £000
0 Purchase 800
1 CA @ 20% (160) @30% 48
640
2 CA @ 20% (160) @30% 48
480
3 CA @ 20% (160) @30% 48
320
4 Sale Proceeds (150)
170
Balancing Allowance (170) @30% 51
Nil 195

(W4) Working capital

Time 0 Time 1 Time 2 Time 3 Time 4
£000 £000 £000 £000 £000
Sales (no. of games × selling price) 3,750 1,680 1,380 1,320
Working capital needed (10% × sales) 375 168 138 132 0
Working capital cash flows (375) 207 30 6 132

Example 14
Replacement cycle NPV Annuity factor EAC
1 year -5,040 0.870 -5,793
2 years -9,090 1.626 -5,590
3 years -12,457 2.283 -5,456
Therefore, choose a three year replacement cycle (as it has the lowest EAC)

Example 15
Replace after two years
Discount factor Present
Time Narrative Cash flow @ 10% value
£ £
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
2 Running costs (5,500) 0.826 (4,543)
2 Scrap proceeds 13,000 0.826 10,738
NPV = (18,350)
£18,350 £18,350
Annual equivalent = = = £10,570
AF2 years@10% 1.736
Replace after one year
Discount factor Present
Time Narrative Cash flow @ 10% value
£ £
0 Purchase (20,000) 1 (20,000)
1 Running costs (5,000) 0.909 (4,545)
1 Scrap proceeds 16,000 0.909 14,544
NPV = (10,001)
190 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

£10,001 £10,001
Annual equivalent = = = £11,002
AF1 year@10% 0.909
The machine should be replaced after two years because the cost is lower in NPV terms.
Alternatively, you could use the NPV spreadsheet function to determine the PV of net cash flows as
shown below.
Replace after two years
The PV in cell B6 is given by =NPV(0.1,C5:D5)
A B C D
1 Time 0 Time 1 Time 2
2 Purchase (20,000)
3 Running costs (5,000) (5,500)
4 Scrap proceeds 13,000
5 Net cash flow (20,000) (5,000) 7,500
6 PV of net cash flow at 10% 1,653
7 Less outflow (20,000)
8 NPV (18,347)

Replace after one year

The PV in cell B6 is given by =NPV(0.1,C5)
A B C
1 Time 0 Time 1
2 Purchase (20,000)
3 Running costs (5,000)
4 Scrap proceeds 16,000
5 Net cash flow (20,000) 11,000
6 PV of net cash flow at 10% 10,000
7 Less outflow (20,000)
8 NPV (10,000)
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 191

Example 16
Project NPV ÷ outlay Rank
A 100,000 ÷ 50,000 = 2 3
C 84,000 ÷10,000 = 8.4 1
D 45,000 ÷15,000 = 3 2
Project B is rejected because of its negative NPV.
Plan:
NPV Funds
£ £
Accept C 84,000 10,000
Accept D 45,000 15,000
25,000
Accept ½ A 50,000 25,000
179,000 50,000 available

The solution assumes it is possible to accept half of project A, ie projects are perfectly divisible so that
half the outlay gives half the NPV, etc.

Example 17
The possible combinations are:
NPV Funds
£ £
A 100,000 50,000
C and D 129,000 25,000
Therefore choose C and D.

Example 18
Considering X, Y and Z independently
Project NPV ÷ outlay Rank
X 25,000 ÷ 100,000 = 0.25 1
Y 11,000 ÷ 50,000 = 0.22 2
Z 8,000 ÷ 40,000 = 0.20 3
∴ Project X using all £100,000 available, NPV £25,000.
Considering X and Y + Z
Project NPV ÷ outlay Rank
X 25,000 ÷ 100,000 = 0.25 2
Y+Z (11,000 + 8,000 + 4,400) ÷ (50,000 + 40,000) = 0.26 1
Plan:
NPV Funds
£ £
Accept Y + Z 23,400 90,000
Accept one tenth of X 2,500 10,000
25,900 100,000
∴ Accept Y + Z + one tenth of X
192 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Example 19
The total estimated environmental costs of the project are £650,000. Assuming that they are incurred
immediately (i.e. at time period 0) this would mean that the project NPV is reduced from £3.5 million
to £2.85 million. Although the project would still generate a positive NPV, inclusion of environmental
costs will reduce the NPV by almost 19%.

Chapter 3
Example 1
(a) NPV
A B C D
1 t0 t1 t2
2 Sales – current values inflated at 6% 53,000 56,180
3 Sales – current values inflated at 4% (31,200) (34,611)
4 21,800 21,569
5 Tax at 17% (3,706) (3,667)
6 Investment (20,000)
7 (20,000) 18,094 17,902
8
9 PV at 10% of cash flows in t1 and t2 31,244
10 Less investment at t0 (20,000)
11 NPV 11,244

The PV is cell B9 uses the NPV spreadsheet function = NPV(0.1,C7:D7)

(b) Sensitivity
Sales price
A B C
1 t1 t2
2 Revenue 53,000 56,180
3 Tax effect (9,010) (9,551)
4 43,990 46,629
5
6 PV at 10% of cash flows in t1 and t2 78,527
The PV is cell B6 uses the NPV spreadsheet function = NPV(0.1,B4:C4)
Sensitivity = 11,244/78,527 × 100% = 14.3%
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 193

Cost of capital
A B C D
1 t0 t1 t2
2 Net cash flows (20,000) 18,094 17,902
3
4 PV at 20% of cash flows in t1 and t2 27,510
5 Less investment at t0 (20,000)
6 NPV 7,510
7
8 IRR 0.50

The PV is cell B6 uses the NPV spreadsheet function = NPV(0.2,C2:D2)

The IRR in cell B8 uses the IRR spreadsheet function = IRR(B2:D2)
Sensitivity = (0.50 – 0.10)/0.10 = 400%

Example 2
(a)
A B C D
1 Year Sales volume
2 1 30,000
3 2 40,000
4 3 37,000
5 4 55,000
6 5 50,000
7
=AVERAGE(B2:B6)
8 Mean annual sales volume 42,400
=STDEV(B2:B6)
9 Standard deviation for the sales volume 10,065
=D9/D8
10 Coefficient of variation between sales volume and time 23.74%
=CORREL(A2:A6,B2:B6)
11 Correlation coefficient between sales volume and time 0.864
194 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

(b)

A B C D
T plc
13 Month RPI share price (£)
14 Jan 20X3 317.7 303.40
15 Feb 20X3 320.2 286.55
16 Mar 20X3 323.5 275.75
17 Apr 20X3 334.6 272.00
18 May 20X3 337.1 258.50
19 Jun 20X3 340.0 254.80
20 Jul 20X3 343.2 262.60
21 Aug 20X3 345.2 252.70
22 Sep 20X3 347.6 206.80
23 Oct 20X3 356.2 212.70
24 Nov 20X3 358.3 235.00
25 Dec 20X3 360.4 224.20
26
=AVERAGE(C14:C25)
27 Mean share price 253.8
=STDEV(C14:C25)
28 Standard deviation for share price 29.5
= D28/D27
29 Coefficient of variation between the RPI and share price =11.63%
=CORREL(B14:B25, C14:C25)
30 Correlation coefficient between RPI and share price -0.889

Example 3
Year 1 Expected sales = (10,000 × 0.3) + (15,000 × 0.7)
= 13,500
Year 2 Expected sales = (0.3 (8,000 × 0.2 + 10,000 × 0.8)) + (0.7 (20,000 × 0.6 + 10,000 × 0.4))
= 14,080

Example 4
Based on the probabilities of the different states of the UK economy and the potential NPVs of the
projects under those states, project Beta is expected to provide the highest NPV (as it has the highest
expected value of NPV).
The standard deviation of NPV measures the variability of a project’s NPVs around its expected NPV.
Project Gamma has the lowest standard deviation. The actual NPV of project Gamma is therefore likely
to be closest to the expected NPV compared with the other two projects. Project Gamma could
therefore be deemed less risky than projects Alpha and Beta. Project Beta could be deemed the
riskiest as it has the highest standard deviation.
Project Beta may have the largest standard deviation simply because the NPVs used to calculate the
standard deviation are higher under two of the three states of the UK economy than those of the
other two projects. The co-efficient of variation can provide a more meaningful indicator as it
measures the standard deviation as a percentage of the mean. The higher the percentage, the wider
the dispersion of NPVs around the expected NPV. Project Beta has the highest coefficient, project
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 195

Gamma the lowest. Project Beta could therefore again be deemed the riskiest project, project Gamma
the least risky.
The advice to Badders plc will depend on their attitude to risk. If they are risk averse, project Gamma is
recommended as its expected NPV is more likely to occur than those of the other two projects. If
Badders plc is not risk averse, project Beta is recommended as the expected NPV is considerably
higher than those of project Alpha and Gamma, although it is less certain.

Chapter 4
Example 1
(a) Takes up rights
£
Step 1: Wealth prior to rights issue 1,000 × £2 2,000
Step 2: Wealth post rights issue
Shares 1,500 × £1.662/3 2,500
Less rights cost 500 × £1 (500)
∴ No change 2,000

(b) Sells rights

£
Step 1: Wealth prior to rights issue 1,000 × £2 2,000
Step 2: Wealth post rights issue
Shares 1,000 × £1.66 2/3 1,667
Sale of rights 500 × £0.66 2/3 333
∴ No change 2,000

(c) Does nothing

£
Step 1: Wealth prior to rights issue 1,000 × £2 2,000
Step 2: Wealth post rights issue 1,000 × £1.66 2/3 1,667
∴ Loss of £333
In principle, the rights issue has no impact on shareholder wealth, unless the shareholder does nothing
at all. The above example is, however, simplified as companies don't usually have rights issues unless
they need the capital for some good reason – such as a project.

Example 2
£
(a) Value of the company now is 100,000 × £2 200,000
Increase in value due to new shares being sold 50,000
Impact of new project being taken on = NPV 25,000
Value of company after issue and project 275,000
MV of shares *pre-rights issue + rights proceeds + project NPV
(b) Ex-rights price =
number of shares ex-rights
(100,000 × £2) + (50,000 × £1) + £25,000
=
100,000 + 50,000
= £1.831/3
Value of the right = £1.831/3 − £1.00 = £0.831/3
196 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

* If the market price of the existing shares had been given post the announcement of the
project, then the project NPV of £25,000 would already be included in the MV of the old
shares (see market efficiency).
(c) (i) Takes up rights
£
Step 1: Wealth prior to rights issue 1,000 × £2 2,000
Step 2: Wealth post rights issue 1,500 × £1.831/3 2,750
Less Rights cost 500 × £1 (500)
∴ £250 better off 2,250

(ii) Sells rights

Step 1: Wealth prior to rights issue 1,000 × £2 2,000
Step 2: Wealth post rights issue
Shares 1,000 × £1.831/3 1,8331/3
Sale of rights 500 × £0.831/3 4162/3
2,250
∴ £250 better off
(iii) Does nothing
Step 1: Wealth prior to rights issue 1,000 × £2 2,000
Step 2: Wealth post rights issue 1,000 × £1.83 /3
1 1,8331/3
∴ Loss of £1662/3

Chapter 5
Example 1
D0 0.5
(a) ke = = = 0.2 or 20%
P0 2.5
D0 (1 + g) 0.5 × 1.1
(b) ke = +g= + 0.1 = 0.32 or 32%
P0 2.5
D0 £0.3
(c) P0 = = = £2
Ke 0.15
D0 (1 + g) £0.3 × 1.05
(d) P0 = = = £3.15
Ke −g 0.15 – 0.05

Example 2
MV (cum div) = £2.20
MV (ex div) = £2.00
0.2 × 1.03
𝑘𝑘𝑒𝑒 = 2
+ 0.03 = 13.3%
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 197

Example 3
An approximate average period growth rate can be taken by averaging the growth rates of the
individual years:
Period
1.1
20X1 – 20X2 –1 = 0.100
1.0
1.2
20X2 – 20X3 –1 = 0.091
1.1
1.34
20X3 – 20X4 –1 = 0.117
1.2
1.48
20X4 – 20X5 –1 = 0.104
1.34
0.412 ÷ 4 = 0.103 or 10.3%

A more direct compound growth calculation would be:

1.0 × (1 + g)4 = 1.48

4 1.48
(1 + g) = �
1.0

g = 1.103 – 1 = 0.103 = 10.3%

The POWER spreadsheet function can also be used for estimating the growth rate.
A B C D E
1 20X1 20X2 20X3 20X4 20X5
2 1.00 1.10 1.20 1.34 1.48

Using =POWER(most recent value/oldest value, 1/number of periods of growth), we have

=POWER(E2/A2, 1/4), giving 1.102974 and therefore a compound growth rate of 10.3%.

Example 4
£20m
The 20X2 profit after tax as a percentage of opening capital employed = = 10%.
£200m
Applying this to the end-20X2 capital employed (10% × £212m), gives a profit for 20X3 estimated at
£21.20m.
Therefore, the dividends for 20X3 will be 40% × £21.20m = £8.48m, representing a growth of 6% on
the previous year's dividends.
Normally, this is more directly calculated by the following equation:
g = r(accounting rate of return) × b(earnings retention rate) = 10% × 60% = 6%

Example 5
Growth rate: g = r × b where:
£25,000
(i) b = % profit retained = = 33%
£75,000
profit after tax
(ii) r = return on investment =
opening net assets
£75,000
= × 100% = 7.2%
£1,060,000 – £25,000
198 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

(iii) g = 0.33 × 0.072 = 0.024 = 2.4%

D0 (1 + g) £50,000(1.024)
Thus ke = + g, the cost of equity is + 0.024 = 15.0%
P0 300,000 × £1.35

Example 6
k e = 0.04 + 1.1 × (0.11 – 0.04) = 11.7%

Example 7
0.12
𝑘𝑘𝑝𝑝 = 1.15 = 10.4%

Example 8
For one £100 nominal value chunk of this debt, we would pay £40 now to receive £5 a year in interest.
As the tax rate is 21%, the net cost to the company is only £5 × (1 – 0.17) = £4.15
5 × (1 − 0.17)
Therefore, 𝑘𝑘𝑑𝑑 = 40
= 10.3%

Example 9
Select the RATE formula from the Financial dropdown menu of ‘Formulas’ on the toolbar.
The formula will be =RATE(B1, B2, B3, B4)
A B
1 Nper = number of periods 10
2 Pmt = the amount of interest paid in any single period 9
3 Pval = the present value of the asset (its market value) -65.75
4 Fval = the future value (the amount paid at maturity) 100
5 Yield to maturity 0.1612

Hence, the cost of debt (post-tax) = 16.12% × (1 – 0.17) = 13.38%

Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 199

Example 10
Select the RATE formula from the Financial dropdown menu of ‘Formulas’ on the toolbar.
The formula will be =RATE(B1, B2, B3, B4)
A B
1 Nper = number of periods 5
2 Pmt = the amount of interest paid in any single period 10
3 Pval = the present value of the asset (its market value) -98
4 Fval = the future value (the amount paid at maturity) 105
5 Gross redemption yield 0.1134

Post tax cost of debt = 11.34% × (1 – 0.17) = 9.41%

Example 11
Firstly we need to decide whether or not the loan stock will be converted in five years.
To do this we compare the expected value of 40 shares in five years' time with the cash alternative.
We assume that the MV of shares will grow at the same rate as the dividends.
MV/share in five years = 2(1.07)5 = £2.81
Therefore MV of 40 shares = £112.40
Cash alternative = £105
Therefore all loan stockholders will choose the share conversion.
To find the cost to the company, use the RATE spreadsheet function.
A B
1 Nper = number of periods 5
2 Pmt = the amount of interest paid in any single period 8
3 Pval = the present value of the asset (its market value) -85
4 Fval = the future value (the amount paid at maturity) 112
5 Gross redemption yield 0.1426

Therefore cost to the company = 14.26% × (1 – 0.17) = 11.84%.

Example 12
(£2m ×15%) + (£1m ×6%)
WACC = £2m+ £1m
= 12%

Chapter 6
Example 1
Find the systematic risk of the electronics industry – measured by βa.
30 × (1 − 0.17)
1.6 = 𝛽𝛽𝑎𝑎 × �1 + �
70
30 × (1 −0.17)
βa = 1.6 ÷ �1 + � = 1.18
70

(∴ riskier than existing activities where βa = 1.15 as no debt)

200 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Adjust to reflect new gearing.

40 × (1 − 0.17)
𝛽𝛽𝑒𝑒 = 1.18 × �1 + �
60

= 1.833
ke = 10% + [1.833 (25% – 10%)]
= 37.5%
kd = 10% (1 – 0.17)
= 8.3%
WACC = (37.5% × 0.6) + (8.3% × 0.4)
= 25.82%

Example 2
Base case NPV
Time £m DF@12% PV £m
0 (240) 1.00 (240)
1–10 40 5.65 226
(14)
PV of tax shield
Interest pa = £187.5m × 0.08 = £15m
Time £m DF @ 8% PV £m
1–10 15 × 0.17 = 2.55 6.710 17.11

Adjust for issue costs of £1m.

APV = £(14)m + £17.11m + £(1m) = £2.1m
∴ Project worthwhile overall.

Chapter 7
No Examples.

Chapter 8
Example 1
£m
£20m
Value of A and B combined 125
0.16
£15m
Value of A on its own (75)
0.20
Maximum price for B's shares 50
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 201

Example 2
A B C D E F G
1 Year 0 1 2 3 4 5
2 Operating cashflow 1.000 1.000 1.000 1.000 1.000
3 Sale of head office 2.000
4 Synergistic benefits 0.200 0.200 0.200 0.200 0.200
5 Disposal 5.000
6 Net cashflow 2.000 1.200 1.200 1.200 1.200 6.200
7 £m
PV at 20% of cashflows
8 yrs 1 – 5 5.598
Add funds from sale of
9 head office 2.000
10 Less value of loan stock (1.500)
11 Maximum value of target 6.098

Notes
(1) The estimated disposal value of Target is included to compensate for Arrow's short planning
horizon. It is assumed that the estimated disposal value is an approximation of the present
value of cashflows from year 6 onwards.
(2) The present value of the cash inflows is £7.598m. This is generated by a company funded by
equity and debt. Therefore, the market value of loan stock has to be deducted from the total
value of the business to arrive at an equity value.

Example 3
Valuation of 200,000 shares = 200,000 × P/E ratio × EPS
£187,200 − 20,000
= 200,000 × 12.5 ×
400,000
= £1,045,000

Example 4
£m
(a) Combined value = £75m × 18 = 1,350
Price plc on its own = £50m × 20 = (1,000)
Maximum amount 350
(b) Current value of Maine plc = £20m × 15 = 300

This is likely to be the minimum price. Anything between £300m and £350m splits the additional £50m
(1,350m – 1,000m – 300m) between both sets of shareholders.
202 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Example 5
£0.25
(i) Constant dividend P0 = = £1.25
0.2
£0.25 × 1.05
(ii) Constant growth in dividend P0 = = £1.75
(0.2 − 0.05)
(iii) Present value of five years' dividend of £0.25 pa = £0.25 × 2.991 = £0.748
Plus
£0.25 × 1.05 1
Present value of growing dividend from year 6 onwards × = £0.703
(0.2 − 0.05) 1.25
£1.451
(iv) Present value of five years' dividend of £0.25 pa = £0.25 × 2.991 £0.748
1
Present value of £2.00 in five years' time = £2.00 × £0.804
1.25
£1.552

Example 6
(a) Comment
There is clearly a big difference between the value per share arrived at on an asset basis and
one based on earnings. The highest price is £2.14 but the purchaser may not be willing to accept
this. It is based on the market value of the freehold property which presumably is needed by
Lafayette in order to continue in business. It also includes a valuation for goodwill, an intangible
asset. If the goodwill valuation is excluded, which might well be justified as the profits from
Lafayette are falling and the property is kept at its balance sheet value, the asset basis shows
the following valuation.
£'000
Property 10,000
Plant 20,000
Investments 7,500
Current assets 9,000
46,500
Debentures, payables, preference shareholders, as before 17,500
29,000

This is £1.45 per share, which is close to the price arrived at by the P/E ratio method and the
price based upon an EV/EBITDA multiple. A price of £1.50 or £1.60 would appear to be a
reasonable price, but in the negotiations Lafayette should start by asking for a higher figure,
nearer to the £2 per share based on asset values under one set of assumptions, namely
break-up value (see below).
(i) Asset basis
£'000 £'000
Revalued assets:
Goodwill 5,000
Property (1.5m/0.08) 18,750
Plant 20,000
Investments 7,500
Receivables 5,000
Inventories 3,000
Cash 1,000
60,250
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 203

£'000 £'000
Less:
Debenture payment 7,500
Payables 6,000
Assets of preference shareholders 4,000
(17,500)
42,750
Number of equity shares 20m
Price per share (£42.75m/20m) 2.14

(ii) P/E ratio

Earnings per share (20X2)
= Earnings after tax and pref divs/Number of shares
= £3.4m/20m
= £0.17
Higher of the P/E ratios = 11.3
Note that the higher value of the two is used here, given the requirement that the
directors are interested in the highest price possible.
£
Suggested price = £0.17 × 11.3 = 1.92
Less reduction for non-marketability (25% say) (0.48)
1.44

(iii) Dividend yield

(Dividend 20X2 ÷ Number of shares) = (£1m ÷ 20m) = £0.05
Lower of the dividend yields = 4.1
(The lower value is used, with the directors interested in the highest price possible.)
£
Suggested price = £0.05 ÷ 0.041 1.22
Less reduction for non-marketability (25%, say) (0.31)
0.91

(iv) EV/EBITDA
Using the higher EV/EBITDA multiple of 8:
EBITDA of Lafayette = £5,337,349 + £750,000 = £6,087,349
£6,087,349 × 8 = EV of £48,698,792
Less market value of net debt (£7.5m + £4m – £1m) = £38,198,792
Price per share = £38,198,792/20m shares = £1.91
Less reduction for marketability (25%, say) = £ 1.43
(b) Lowest price at which the directors should sell
The earnings-based figures calculated in (a) above are calculated using market ratios from
similar quoted companies, adjusted to reflect the non- marketability of Lafayette shares. The
earnings figures used are the 20X2 figures. However, a potential purchaser will be interested in
future maintainable earnings and the experience of the last three years suggests these may
continue to fall. Any earnings-based share price is therefore likely to be lower than those
calculated above.
204 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

In view of the low earnings- based valuations and the higher asset-based valuation, the
directors of Lafayette would be advised to consider the break-up value of the business as the
lowest possible price. As the directors wish to receive cash for their shares – that is, realise their
investment – it may be better to sell off the assets rather than sell the business as a going
concern.
Further work is required to ascertain the net break-up value of the business after disposal costs
and taxation (for example, what is the disposal value of the plant and machinery?) but this
figure should be regarded as the 'worst case scenario' for the directors and, therefore, the
lowest figure they should be prepared to accept.

Example 7
(a)
Income Statement £000s Workings
Revenue 655,500 575,000 × 1.14
Direct costs (361,380) 317,000 × 1.14
Depreciation (30,800) 124,000 × 0.2 + 30,000 × 0.2
Other operating costs (158,000) 149,000 + 9000
Operating profit 105,320
Less: Interest (8,600) 70,000 × 8% + 30,000 × 10%
Profits before tax 96,720
Tax at 17% (16,442) 72,400 × 17%
Profits after tax 80,278
Dividend declared 40,078 80,278 × (30,000/60,092)
Retained profits 40,200 80,278 – 40,078

Balance sheet £000s Workings

Plant & Machinery 123,200 124,000 × 80% + 30,000 × 80%
Current assets
Inventory 85,000 75,000 + 10,000
Receivables 135,626 655,500 × (118,970/575,000)
Cash 44,372 264,998 Balancing figure
388,198
£1 ordinary shares 65,000
Retained earnings 94,200 54,000 + 40,200
8% Debentures 70,000
10% Debentures 30,000
Current liabilities
Trade payables 88,920 361,380 × (78,000 / 317,000)
Dividend payable 40,078 128,998
388,198

(b) (i) EPS = £80,278/65,000 = £1.24

(ii) Gearing = £(70,000 + 30,000)/£(70,000 + 30,000 + (65,000 + 94,200)) = 38.6%
(iii) Interest cover = operating profit/interest = £105,320/£8,600 = 12.25 times
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 205

Chapter 9
Example 1
1 January
(a) On 1 January the price (the spot price) of a consignment of cocoa beans is £1,000 in the cocoa
market.
(b) You want to buy a consignment of cocoa beans on 31 March on this cocoa market, but the price
is uncertain.
(c) You buy separately on a futures market a three-month cocoa futures contract at £1,100 that
expires on 31 March. This means you are committing to buying a consignment of cocoa beans,
not at today's spot price, but at the futures price of £1,100, which represents what the futures
market thinks the spot price will be on 31 March.
31 March
(a) You buy the consignment of cocoa beans on 31 March from the cocoa market, while the spot
price on that date is £1,200.
(b) Under the futures contract you are still committed to buying the consignment at £1,100 on
31 March, but that will mean that you have two consignments of cocoa beans rather than just
the one you need. You therefore sell on 31 March the futures contract you bought on 1 January
to eliminate this additional commitment.
Assuming that the futures contract at 31st March is now priced at £1,200 (as this is the same as the
spot price on 31 March), you will sell the futures contract for £1,200.
(c) Because you have sold the contract for more than the purchase price, you have made a gain on
the futures contract of £1,200 – £1,100 = £100. This can be set against the purchase you made
in the cocoa market.
Net cost = £1,200 – £100 = £1,100
ie supplies have been obtained at a fixed price, being the futures price.
A summary of the transactions is as follows:
Prices on the cocoa market Prices on the futures market
1 January: prevailing Price for buying cocoa
£1,000 £1,100
price (the spot price) for March delivery
31 March: prevailing Price for selling cocoa
£1,200 £1,200
price (the spot price) for March delivery
Increase in cost of Gain from trading
£200 £100
cocoa in cocoa market futures contracts
As noted above, the increase in the cost of cocoa has been hedged by the trading carried out on the
futures market.
These are two separate markets – the cocoa market is involved with buying and selling physical
consignments of cocoa. The futures market is not. Notice that on the futures market no physical
delivery has taken place. Rather, the opening contract to buy in March has been cancelled by an
opposing contract to sell in March.
The net effect of these is:
 Buy the cocoa in the cocoa market for £1,200
 Take the gain on the futures market £100
 Overall cost of the cocoa £1,100
206 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Example 2
Step 1
Position in spot market
Loss on portfolio = £4.8 million – £5 million
= £0.2 million
Step 2
Calculate gain or loss on futures
Buy futures at lower price than we sold them for (closing out)
Gain on futures = (4,980 – 4,800) × £10 × 100 contracts
= £180,000
Step 3
Calculate net position
Net position = 180,000 gain on futures – 200,000 loss on portfolio
= (20,000) loss overall
Note: the hedge is less than 100% efficient because of basis (ie the 1 June FTSE index value and the
futures price are different).

Example 3
(a) If the share price rises to £2.10:
– You make a gain of £0.40 on the share
– You will let the option lapse (as it is out of the money)
– You have already paid £0.10 premium
– Hence, overall gain = £0.30
(b) If the share price falls to £1.30:
– You make a loss of £0.40 (£1.70 – £1.30) on the share
– You will exercise the option and sell the share for £1.60, making a gain of £0.30 (£1.60 –
£1.30)
– You have already paid £0.10 premium
– Hence, overall loss = (£0.20)

Example 4
(a) The Forward Rate Agreement to be bought by the borrower is '3-9' (or 3v9)
(b) (i) At 5% because interest rates have fallen, Lynn plc will pay the bank:
£
FRA payment £10 million × (5% – 6%) × /126
(50,000)
Payment on underlying loan 5% × £10 million × 6/12 (250,000)
Net payment on loan (300,000)
Effective interest rate on loan 6%
(ii) At 9% because interest rates have risen, the bank will pay Lynn plc
£
FRA receipt £10 million × (9% – 6%) × 6/12 150,000
Payment on underlying loan at market rate 9% × £10 million × 6/12 (450,000)
Net payment on loan (300,000)
Effective interest rate on loan 6%
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 207

Example 5
£17 million × 2 months
Number of futures contracts =
£0.5 million × 3 months
= 22.67 contracts, rounded to 23.

Example 6
The following steps should be taken.
(a) Setup
(i) What contract: 3-month contract
(ii) What type? Sell (as rates expected to rise)
Exposure Loan period 10m 6
(iii) How many contracts?: Contract size
× Length of contract = 0.5m × 3 = 40 contracts

(b) Futures outcome

At opening rate: 91 sell
At closing rate: 89 buy
Gain: 2%
Futures outcome: 2% × £0.5m × 3/12 × 40 contracts = £100,000
(c) Net outcome
Payment in spot market £10m × 11% × 6/12 (550,000)
Receipt in futures market 100,000
Net payments (450,000)

Spot rate at 1st January = 8%

31 March = 11%
Increase in interest on spot market = 3%
Increase in cost = 3% × £10m × 6/12 = £150,000
Gain on future 100,000
Hedge efficiency: = × 100% = 67%
Loss on spot market 150,000

Example 7
Step 1
Setup
(a) Which contract? June
(b) What type? As paying interest need a put option (the right to sell a future)
(c) Strike price 93.25 (100 – 6.75) Cap needed at 6.75%
(d) How many? £4m/£0.5m × 9/3 = 24 contracts
(e) Premium At 93.25 (6.75%) June Puts = 0.14%
Contracts × premium × contract size × contract duration = 24 × 0.14% × £500,000 × 3/12 = £4,200
Note: As these are 3-month contracts, the premium – which is quoted as an annual rate – needs to be
adjusted to reflect this.
Step 2
Closing prices
Case 1 Case 2
Spot price 7.4% 5.1%
Futures price 92.31 94.75
208 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Step 3
Outcome
Case 1 Case 2
(a) Options market outcome
Strike price right to sell (Put) at 93.25 93.25
Closing price buy at 92.31 94.75
Exercise? Yes No
If exercised, gain on future 0.94% –
Outcome of options position 0.94% × £500,000 × 3/12 × 24 –
= £28,200

(b) Net position £ £

Borrow spot £4m × 9/12 × 7.4% or 5.1% 222,000 153,000
Option (28,200) –
Option premium 4,200 4,200
Net outcome 198,000 157,200
198,000 12 157,200 12
(c) Effective interest rate × = 6.6% × = 5.24%
4,000,000 9 4,000,000 9

Example 8
Goodcredit plc has been given a high credit rating. It can borrow at a fixed rate of 11%, or at a variable
interest rate equal to SONIA, which also happens to be 11% at the moment. It would like to borrow at
a variable rate. Secondtier plc is a company with a lower credit rating, which can borrow at a fixed rate
of 12.5% or at a variable rate of SONIA plus 0.5%. It would like to borrow at a fixed rate.
A swap allows both parties to end up paying interest at a lower rate via a swap than is obtainable from
a bank. Where does this gain come from? To answer this question, set out a table of the rates at which
both companies could borrow from the bank.
Goodcredit Secondtier Difference
Can borrow at fixed rate 11% 12.5% 1.5%
Can borrow at floating rate SONIA SONIA + 0.5% 0.5%
Difference between differences 1.0%

Goodcredit has a better credit rating than Secondtier in both types of loan market, but its advantage
is comparatively higher in the fixed interest market. The 1% differential between Goodcredit's
advantage in the two types of loan may represent a market imperfection or there may be a good
reason for it. Whatever the reason, it represents a potential gain which can be made out of a swap
arrangement.
Goodcredit Secondtier Sum total
Company wants Variable Fixed
Would pay (no swap) (SONIA) (12.5%) (SONIA + 12.5%)
Could pay (11%) (SONIA + 0.5%) (SONIA + 11.5%)
Potential gain 1%
Assume that the potential gain of 1% is split equally between Goodcredit and Secondtier, 0.5% each.
Then Goodcredit will be targeting a floating rate loan of SONIA less 0.5% (0.5% less than that at which
it can borrow from the bank). Similarly, Secondtier will be targeting a fixed interest loan of 12.5% –
0.5% = 12%. These are precisely the rates which are obtained by the swap arrangement illustrated
below.
Goodcredit Secondtier Sum total
Split evenly 0.5% 0.5% 1%
Expected outcome (SONIA – 0.5%) (12%) (SONIA + 11.5%)
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 209

The rate that each company expects to pay after the swap is thus 0.5% less than it would pay without a
swap.
eg Goodcredit would pay SONIA, so will paySONIA– 0.5%
Secondtier would pay 12.5% fixed so will pay 12% fixed
Swap terms Goodcredit Secondtier Sum total
Could pay (11%) (SONIA + 0.5%) (SONIA + 11.5%)
Swap floating (SONIA + 0.5%) SONIA + 0.5%
Swap fixed 12% (12%)
Net paid (SONIA – 0.5%) (12%) (SONIA + 11.5%)
Would pay (SONIA) (12.5%) (SONIA + 12.5%)
Gain 0.5% 0.5% 1%
To construct a simple swap:
Let Goodcredit pay all of Secondtier's interest
ie SONIA + 0.5% paid to Secondtier, as shown above
Secondtier must then reciprocate by paying fixed interest to Goodcredit. However, Secondtier will only
pay 12% as calculated and shown above, in order to be 0.5% better off under the swap.
The overall effect of this is to leave each party 0.5% better off.
The results of the swap are that Goodcredit ends up paying variable rate interest, but at a lower cost
than it could get from a bank, and Secondtier ends up paying fixed rate interest, also at a lower cost
than it could get from investors or a bank.
Note that for the swap to give a gain to both parties:
(a) Each company must borrow in the loan market in which it has comparative advantage.
Goodcredit has the greatest advantage when it borrows fixed interest. Secondtier has the least
disadvantage when it borrows floating rate.
(b) The parties must actually want interest of the opposite type to that in which they have
comparative advantage. Goodcredit wants floating and Secondtier wants fixed.
Once the target interest rate for each company has been established, there is an infinite number of
swap arrangements which will produce the same net result. The example illustrated above is only one
of them.

Example 9
A pays 2% more for fixed debt, but only 1% more for variable debt. There is therefore a 1% possible
gain from a swap, that we will split evenly between the two participants.
A plc B plc
Borrow (SONIA + 2%) (9%)
Swap floating SONIA + ½% (SONIA + ½%)
Swap fixed (9%) 9%
Net interest cost (10½%) (SONIA + ½%)
210 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Chapter 10
Example 1
(a) The bank is being asked to buy the Danish kroners and will give the exporter:
150,000
= £15,726.57 in exchange
9.5380
(b) The bank is being asked to sell the yen to the importer and will charge for the currency:
1,000,000
= £4,910.39
203.650

Example 2
The forward adjustments here are given in cents and need to be converted to dollars.
For example: one month forward discount 0.20c – 0.22c
Equates to $0.0020 – $0.0022
Spot rate $1.9500 – $1.9610
one month forward 1.9520 – 1.9632
Obtained by adding the discount to the spot.
three month forward 1.9478 – 1.9592
Obtained by deducting the premium from the spot.

Example 3
Using interest rate parity, dollar is the numerator and sterling is the denominator. So the expected
future exchange rate dollar/sterling is given by:
1.06
$1.95/£ × = $1.9686/£
1.05
This prediction is subject to great inaccuracy, but note that the company could 'lock into' this exchange
rate, working a money market hedge by borrowing today in dollars at 6%, converting the cash to
sterling spot and putting them on deposit at 5%. When the dollars are received from the customer, the
dollar loan is repaid.

Example 4

Now One year

4%
US: Goods cost: $2,000 $2,080

Exchange rate: $2/£

UK: Goods cost: £1,000 £1,030

3%

A disequilibrium is created in one year which is then removed by the exchange rate altering.
The new equilibrium exchange rate would be $2,080/£1,030 =$2.0194/£
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 211

Note: This is the application of the same relationship as set out above:
1 + if
Spot rate × = Forward rate
1 + iuk
1.04
$2/£ × = $2.0194
1.03

Example 5
Set-up of the hedge:
We will need to sell $ and buy £ in the future – hence we want to buy £ futures now
$250𝑘𝑘 ÷1.87
# futures contracts needed = £62,500
= 2.139 ≈ 2 contracts

Hence, we will buy 2 December Sterling futures at a rate of $1.87/£

Outcome:
in December we will need to sell 2 Sterling futures at $1.90
The gain on the futures = ($1.90 – $1.87) × 2 contracts × £62,500 = $3,750
Hence, the net $ receipt is $250,000 + $3,750 = $253,750
Convert the $ to £ at the spot rate and receive $253,750 / $1.90 = £133,553
The effective FX rate = $250,000 / £133,553 = $1.8719 : £1 (we would have been able to lock in a rate
of $1.87 : £1 if we could have traded the exact number of contracts needed)

Example 6
The interest rates for three months are 2.15% to borrow in pounds and 2.5% to deposit in kroners. The
company needs to deposit enough kroners now so that the total including interest will be Kr3,500,000
in three months' time. This means depositing:
Kr3,500,000/(1 + 0.025) = Kr3,414,634.
These kroners will cost £452,215 (spot rate 7.5509). The company must borrow this amount and, with
three months' interest of 2.15%, will have to repay:
£452,215 × (1 + 0.0215) = £461,938.
Thus, in three months, the Danish creditor will be paid out of the Danish bank account and the
company will be paying £461,938 to satisfy this debt. The effective forward rate which the company
has 'manufactured' is 3,500,000/461,938 = 7.5768. This effective forward rate shows the kroner at a
discount to the pound because the kroner interest rate is higher than the sterling rate.
Step 2:
£ Convert Kr
7.5509
Step 1: Step 3:
Borrow Deposit
£452,215 Kr3,414,634

Interest Interest
paid: 2.15% earned: 2.5%

Step 4(b): Step 4(a):

Repay loan Pay creditor
£461,938 Kr3,500,000
212 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

Example 7
The interest rates for three months are 2.00% to deposit in pounds and 1.75% to borrow in Swiss
francs. The company needs to borrow SFr2,500,000/1.0175 = SFr 2,457,003 today. These Swiss francs
will be converted to £ at 2,457,003/2.2510 = £1,091,516. The company must deposit this amount and,
with three months interest of 2.00%, will have earned
£1,091,516 × (1 + 0.02) = £1,113,346
Thus, in three months, the loan will be paid out of the proceeds from the debtor and the company will
receive £1,113,346. The effective forward rate which the company has 'manufactured' is
2,500,000/1,113,346 = 2.2455. This effective forward rate shows the Swiss franc at a premium to the
pound because the Swiss franc interest rate is lower than the sterling rate.
SFr £
Convert
2.2510
Borrow Deposit
Now:
SFr 2,457,003 £1,091,516

Interest Interest
paid: 1.75% earned: 2.0%

3 months: SFr 2,500,000 £1,113,346

Example 8
The three choices must be compared on a similar basis, which means working out the cost of each to
Trumpton either now or in three months' time. In the following paragraphs, the cost to Trumpton now
will be determined.
Choice 1: the forward exchange market
Trumpton must buy dollars in order to pay the US supplier. The exchange rate in a forward exchange
contract to buy $4,000,000 in three months time (bank sells) is:
$
Spot rate 1.8625
Less three months premium 0.0180
Forward rate 1.8445

The cost of the $4,000,000 to Trumpton in three months' time will be:
$4,000,000
= £2,168,609.38
1.8445
This is the cost in three months. To work out the cost now, we could say that by deferring payment for
three months, the company is:
 Saving having to borrow money now at 14.25% a year to make the payment now, or
 Avoiding the loss of interest on cash on deposit, earning 11% a year
The choice between (a) and (b) depends on whether Trumpton plc needs to borrow to make any
current payment (a) or is cash rich (b). Here, assumption (a) is selected, but (b) might in fact apply.
At an annual interest rate of 14.25% the rate for three months is 14.25/4 = 3.5625%. The 'present cost'
of £2,168,609.38 in three months' time is:
£2,168,609.38
= £2,094,010.26
1.035625
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 213

Choice 2: the money markets

Using the money markets involves
(a) Borrowing in the foreign currency, if the company will eventually receive the currency
(b) Lending in the foreign currency, if the company will eventually pay the currency. Here,
Trumpton will pay $4,000,000 and so it would lend US dollars.
It would lend enough US dollars for three months, so that the principal repaid in three months time
plus interest will amount to the payment due of $4,000,000.
(a) Since the US dollar deposit rate is 7%, the rate for three months is approximately 7/4 = 1.75%.
(b) To earn $4,000,000 in three months' time at 1.75% interest, Trumpton would have to lend now:
$4,000,000
= $3,931,203.93
1.0175
These dollars would have to be purchased now at the spot rate of (bank sells) $1.8625. The cost would
be:
$3,931,203.93
= £2,110,713.52
1.8625
By lending US dollars for three months, Trumpton is matching eventual receipts and payments in US
dollars, and so has hedged against foreign exchange risk.
Choice 3: lead payments
Lead payments should be considered when the currency of payment is expected to strengthen over
time, and is quoted forward at a premium on the foreign exchange market. Here, the cost of a lead
payment (paying $4,000,000 now) would be $4,000,000 ÷ 1.8625 = £2,147,651.01.
Summary
£
Forward exchange contract 2,094,010.26 (cheapest)
Currency lending 2,110,713.52
Lead payment 2,147,651.01

Example 9
The target receipt at today's spot rate is 20,000,000/19.3582 = £1,033,154.
(a) The receipt using a forward contract is fixed with certainty at 20,000,000/19.3048 = £1,036,012.
This applies to both exchange rate scenarios.
(b) The cost of the option is £24,000. This must be paid at the start of the contract.
The results under the two scenarios are as follows.
Scenario (i) (ii)
Amount received at exchange rate R 20 million @ R21.0/£ = £952,381 @17.60 = £1,136,364
Amount received at exercise price R 20 million @ R19.30/£ = £1,036,269 @ 19.30 = £1,036,269
Does the company exercise the option? YES NO

(i) (ii)
£ £
Pounds received 1,036,269 1,136,364
Less option premium (24,000) (24,000)
Net receipt 1,012,269 1,112,364
214 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

(c) The results of not hedging under the two scenarios are as follows.
Scenario (i) (ii)
Exchange rate 21.00 17.60
Pounds received £952,381 £1,136,364
Summary. The option gives a result between that of the forward contract and no hedge.

Example 10
Hedging with futures
Setup of the hedge
 We want to sell $ and buy £ in the future, so we need to buy £ futures
$3.75m ÷ 1.54
 # contracts = £62,500
= 38.96 ≈39 contracts
 Therefore, we will buy 39 £ September futures at $1.54/£1
Outcome (in September)
 We will sell 39 futures to close our position
Spot moves to $1.48 Spot moves to $1.57
Gain / loss on futures (1.48 – 1.54) × 39 × ($146,250) (1.57 – 1.54) × 39 × $73,125
(in $) £62,500 = £62,500 =
Total $ receipt $3.75m – $146,250 = $3,603,750 $3.75m + $73,125 = $3,823,125
Convert to £ at spot $3,603,750 / $1.48 £2,434,966 $3,823,125/ $1.57 £2,435,111
Hence the futures hedge away both the upside and the downside, resulting in roughly £2.435m net
receipt

Hedging with traded options

Setup of the hedge
 We want to sell $ and buy £ in the future, so we need to buy £ call options
 Maturity = September (to match receipt date) and strike = $1.55 (told in the Q)
$3.75m ÷ 1.55
 # contracts = £31,250
=77.41 ≈77 contracts

 Therefore, we will buy 77 £ September call options, strike $1.55/£1

 Premium = 2.75/100 × 77 × £31,250 = $66,172
 We need to buy $ at spot to pay the premium  cost in £ = 66,172 / 1.5404 = £42,958
Outcome (in September)
Spot moves to $1.48 Spot moves to $1.57
Exercise the option? No Yes
Gain on option – 77 × (1.57 – 1.55) × £31,250 = $48,125
Total $ receipt $3,750,000 $3,750,000 + $48,125 = $3,798,125
Convert to £ at spot $3,750,000 / $1.48 = £2,533,784 $3,798,125 / 1.57 = £2,419,188
Net receipt (after £2,533,784 – £42,958 = £2,490,826 £2,419,188 – £42,958 = £2,376,230
premium)

Hence the option leaves us better off if $ strengthens (as we get to take advantage of the upside), but
is not as favourable as the futures if $ weakens (due to the expensive premium and high strike).
Fina nc ia l Ma na g e m e nt A n s w e rs t o c h ap t e r e xamp l e s 215
216 A n s w e rs t o c h a p t e r e xamp l e s Fina nc ia l Ma na g e m e nt

ICAEW takes no responsibility for the content of any

supplemental training materials supplied by the Partner
in Learning

The ICAEW Partner in Learning logo, ACA and ICAEW

CFAB are all registered trademarks of ICAEW and are
used under licence by First Intuition Reading Ltd.

ICAEW learning materials © ICAEW 2025

All rights reserved. Reproduced by First Intuition Reading Ltd.
with the permission of ICAEW

V2023