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ICAEW

Advanced Stage
Strategic Business
Management
2015 edition
Workbook

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ii

Contents
Page
Chapter 1

Strategic analysis, choice and


implementation

Chapter 2

Strategic performance management and


HRM

13

Chapter 3

Business risk management

21

Chapter 4

Data analysis

27

Chapter 5

Information systems

41

Chapter 6

Corporate governance

49

Chapter 7

Assurance

57

Chapter 8

Ethics

63

Chapter 9

Business and securities valuation

67

Chapter 10 Investment appraisal

99

Chapter 11 Finance awareness

119

Chapter 12 Financing

123

Chapter 13 International financial management

143

Chapter 14 Treasury and working capital


management

155

Chapter 15 Financial risk management

161

Appendix 1 Corporate reporting appendix

213

Appendix 2 Discount tables and formula sheet

245

Quality and accuracy are of the utmost importance to us so if you spot


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iii

iv

Chapter

Strategic analysis, choice


and implementation
Chapter learning objectives

Apply appropriate strategic analysis tools to complex scenarios.

Analyse, evaluate and advise on strategy choices.

Explain and evaluate international expansion strategies.

Evaluate and explain the impact of methods of development and


organisation structures on strategy.

Advise on the implementation of change in complex scenarios.

Demonstrate and explain the techniques that may be used to


reduce costs, including supply chain management, business
process re-engineering and outsourcing.

Assess strategic marketing issues and demonstrate the


application of marketing techniques in complex scenarios.

Develop and explain marketing strategies using databases and IT


applications such as social media.

Demonstrate how appraisal techniques can be used for valuing


brands.
1

Strategic analysis, choice and implementation

Strategic analysis

Internal and external analysis models were covered in detail in business


strategy and are summarised in the pre-course reading for SBM.
You are unlikely to be asked to, for example, produce a five forces
analysis at the advanced stage.
However, it may be beneficial to use such models to help you analyse
the key issues in the scenario or to answer certain requirements.
Key analysis skills
Using the skills developed in the professional level and revised during
the pre-course reading, you should be able to:

Analyse and evaluate the external environment that a firm faces

Evaluate the industry environment in which a firm operates

Analyse the current position of a firm, from both a financial and


non-financial perspective

Strategic choice

Strategy choice questions have historically been common at the


advanced stage
Typical requirement:
Evaluate/analyse the strategy proposals / options given in the question
Such questions could cover:

Methods of development (e.g. franchising vs organic growth)

Overseas expansion

Generic strategies (e.g. whether to launch a lower cost product if


the company is currently a differentiator)

Growth strategies from Ansoff (e.g. market development vs


product development)

Approach

Use appropriate headings for each option, usually:

Advantages

Disadvantages

Or

Operational issues, strategic issues, financial issues

Chapter 1

Or

Suitability, feasibility, acceptability

Explain each point specifically using names, facts or figures from


the scenario where possible

Present a balanced argument

Conclude overall (providing a clear answer to the question and the


main reason why)

You can use your knowledge of the generic pros and cons of different
strategies from the professional level and the following generic points to
generate ideas.
Strategy Choice: Generic ideas
Financial issues

NPV (if choosing between projects)

Financial statement impact (e.g. increased sales / profits)

Cash flow impact

Access to high growth markets (if entering new markets)

FX risk (if exposed)

Additional costs not considered (training, redundancy, closure


costs, legal and professional fees)

Reduced production and warehousing costs (O/S production)

New strategy may have a higher level of risk than existing


business

Operational

May be able to utilise spare capacity

Volume increases generate economies of scale

More assets to offer as security / increased debt capacity

Timescale to implement change

Strain on management time

Increased operating gearing (due to more automated / capital


intensive process)

Compliance risk (particularly for new products / markets)

Longer lead times (new product / OS manufacture)


3

Strategic analysis, choice and implementation

Adherence to local law and regulations (O/S manufacture or


market)

Strategic

Fit with current brand / generic strategy

Diversify markets / customers

Use existing competencies / experience

Access to 3rd party expertise / knowledge (joint development


strategies)

Reputational impact

Brand awareness (e.g. lack of brand awareness if entering a


new market

Loss of control and quality issues (joint development strategies /


outsourcing)

Introduction to exam technique for SBM


Planning

Read requirements carefully and allocate time per requirement


should be roughly equal

Give more marks to subjective calculations

Identify headings from the requirement to ensure that you cover


every part of the requirement.

Plan the number of points per heading

Writing style
Similar to business strategy / case study:

Use headings to structure answer

Write in concise well explained points

Write in full sentences

Ensure points are relevant to specific scenario

To ensure clarity of explanation only explain one point at a time

Space out each separate point (each explained point should be its
own separate mini paragraph).

Chapter 1

Test your understanding 1 Ribs


The directors of Ribs Co, a listed company, are reviewing the
company's current strategic position. The firm makes high quality
garden tools which it sells in its domestic market but not abroad.
Over the last few years, the share price has risen significantly as the
firm has expanded organically within its domestic market.
Unfortunately, in the last 12 months, the influx of cheaper, foreign
tools has adversely impacted the firm's profitability. Consequently, the
share price has dropped sharply in recent weeks and the
shareholders expressed their displeasure at the recent AGM.
The directors are evaluating two alternative investment projects which
they hope will arrest the decline in profitability.
Project 1: This would involve closing the firm's domestic factory and
switching production to a foreign country where labour rates are a
quarter of those in the domestic market. Sales would continue to be
targeted exclusively at the domestic market.
Project 2: This would involve a new investment in machinery at the
domestic factory to allow production to be increased by 50%. The
extra tools would be exported and sold as high quality tools in foreign
market places.
Both projects have a positive Net Present Value (NPV) when
discounted at the firm's current cost of capital.
Required:
Discuss the strategic, operational and financial issues that this
case presents.

Strategic choice: International expansion

Although international expansion was covered at the professional level


in both FM and BS, it is examinable in more detail at the advanced
stage.
Deciding what markets to enter
The three main headings from Kotler's market entry matrix can be used
to help evaluate possible markets for expansion:

Market attractiveness considerations include income per head


and forecast demand

Competitive advantage the expected level of competitive


advantage can be judged by previous experience in similar
markets

Strategic analysis, choice and implementation

Risk especially, the risk of currency fluctuations and remittance


restrictions which are covered in more detail in the international
financial management chapter

The best markets to enter will be low risk but also have high market
attractiveness and potential for competitive advantage.
Market entry modes
There are two main methods of entering overseas markets:

Exporting

Overseas production, which can be subdivided into:

Overseas production (owned facilities)

Outsourced / contracted manufacture

Exporting
Pros:

Economies of scale from concentrated production in one location

Opportunity to test the success of a product overseas before


committing to an overseas operation

Can be done on a small scale / accessible for smaller companies

Avoid set up costs of overseas operation / minimise operating


costs (no real need of overseas staff etc.)

Can gain access to local knowledge by using a local distributor


(indirect exporting)

Cons:

Exposure to FX risk

Export taxes / tariffs and red tape

Production costs may be lower with overseas manufacture

Overseas production (owned facilities)


This section focuses on the advantages and disadvantages of overseas
production compared to exporting. Setting up an overseas operation is
discussed in the international financial management chapter.
Pros:

May enable a better understanding of the overseas market

Potential access to cheaper labour and factory costs

Chapter 1

Lower storage and transportation costs if also serving that market

Local production may help win public sector orders

Reduced FX risk if also serving that market

Cons:

Significant investment in overseas plant

Higher transport costs / longer lead times if serving home market

Compliance with local health and safety regulations

Potential loss of control / quality issues

Problems recruiting local staff / managers

Outsourced / contracted manufacture


Pros:

No investment in overseas operation required

Access to 3rd party expertise in production / local compliance


issues

Cons:

Finding a suitable overseas producer

The need to train the contractee's personnel

Contractee may copy designs and set themselves up as a


competitor

Loss of control / quality issues

Strategic implementation

Assumed knowledge
Your bought forward knowledge of the following areas may be useful in
analysing and interpreting exam scenarios:

Generic pros and cons of organic growth, acquisition, and joint


development strategies

Change management

Generic pros and cons of different organisation structures

Marketing (the marketing mix and positioning are most likely to be


useful)
7

Strategic analysis, choice and implementation

In addition, there is also some new terminology that you may see in
scenarios and some new content on brand value and CRM. These
areas are covered below.

Strategic implementation: New terminology

Supply chain management


Definition: The planning and management of all activities involved in
sourcing and procurement, conversion and all logistics management
activities.
Importantly, it also includes co-ordination and collaboration with channel
partners, which can be suppliers, intermediaries, third-party service
providers and customers.
Thus a key element of supply chain management is knowledge sharing
and collaboration with suppliers and distributors, to ensure customer
needs are met.
Drivers of supply chain performance
These could be used as headings to generate ideas of how to improve
a company's supply chain management:
Facilities Location, flexibility and capacity of facilities for production
and storage e.g. a cost leader is likely to prefer high capacity,
centralised facilities to maximise economies of scale.
Inventory Key decision is whether to carry a buffer of inventory to
better meet customer demand or to minimise inventory and thus holding
costs.
Transportation Generally, there is a speed / time trade-off (e.g. an
online business can guarantee next day delivery but it will be more
expensive)
Information Knowledge sharing (e.g. information about production
plans and demand forecasts) across the supply chain (often using
shared IT systems) can significantly improve efficiency through better
planning and utilisation.
Sourcing Choosing supply chain partners (often the key decision is
whether to perform a function in house or to outsource it).
Pricing The prices charged at each stage of the supply chain
(generally, more flexible / responsive partners will charge premium
prices)

Chapter 1

Business process re-engineering


Definition: BPR is the fundamental rethinking and radical redesign of
business processes to achieve dramatic improvements in measures
such as cost, quality, service and speed.
BPR is similar to zero based budgeting as it involves looking at a
process from first principles.

Brand valuation

Basic approach
IFRS 3 states that brands acquired should be valued at 'fair value'.
IFRS 13 defines fair value as the price that would be received to sell an
asset or paid to transfer a liability in an orderly transaction between
market participants at the measurement date.
IFRS 13 requires the fair value to be determined on the basis of its
highest and best use from a market participants perspective. This
needs to consider what is physically possible, legally permissible and
financially feasible.
Hierarchy of inputs
IFRS 13 requires that entities should maximise the use of relevant
observable inputs when determining fair value. Thus IFRS 13 presents
a fair value hierarchy (with level 1 inputs being preferred):
Level 1 inputs are quoted prices in an active market for identical
assets. This is not normally reasonable for a brand given its unique
nature.
Level 2 inputs are inputs other than quoted prices which are
observable. This might include prices in markets which are not active.
Level 3 inputs are unobservable inputs, including internal company
data.
Valuation bases
IFRS 13 sets out 3 possible valuation techniques which can be used to
value a brand (the most appropriate technique to use is partly
determined by the quality of inputs available see above):
The market basis this uses market price and other market
transactions. Given the nature of a brand is unique this would be
difficult to use.
The income basis This would consider the present value of the
incremental income generated by the brand. Note: A recognised brand
may enable a firm to sell at a higher price or in greater volume or both.
9

Strategic analysis, choice and implementation

The cost basis this is the current replacement cost of the brand.
Thus this would be an estimate of the PV of costs (R&D, advertising,
promotion etc.) that would need to be incurred to develop a comparable
brand from scratch.
Any such estimate would be highly judgemental.
More detail on IFRS 3, 13 and valuing other intangible assets under IAS
38 are included in the CR appendix.

Customer relationship management (CRM)

Definitions
Database marketing: Builds a database of all communications with
customers and then uses individually addressable marketing media
(e.g. email) to contact them further (e.g. with promotional messages).
CRM: The use of database technology and ICT systems to help an
organisation develop, maintain and optimise long-term, mutually
valuable relationships between the organisation and its customers.
Web 2.0 technologies: Refers to a new generation of web
technologies and software (mainly related to social media).
Web 2.0 technologies such (as blogs, Twitter, podcasts etc.) can be
used by companies to strengthen their brands and their relationships
with customers.
E-marketing: The application of the internet and related digital
technologies to achieve marketing objectives.
These internet and online techniques often play an important role in the
three phases of CRM described below.
The three phases of CRM
These could be used to generate ideas of how to apply CRM and
database marketing to a scenario:
Customer acquisition: Attracting customers to make their first
purchases (using promotions, incentives and direct email)
Customer retention: Encouraging customers to become repeat
purchasers (using personalised promotions and loyalty schemes)
Customer extension: Encouraging existing customers to make
additional supplementary purchases (using personalised
recommendations / direct email and personalised on-site promotions)

10

Chapter 1

Chapter summary

Key areas:

Advising a client on strategy choice has historically been a


common requirement at the advanced stage

A strategy choice requirement relating to overseas expansion is


very examinable

Brand valuation links well with an asset based valuation approach


and is thus very examinable

CRM could feature as part of a requirement

Your brought forward knowledge of BS models will help you


analyse and interpret exam scenarios

11

Strategic analysis, choice and implementation

Test your understanding answers


Test your understanding 1 Ribs
Note: The first part of this answer is written out in full as you would do
in the exam, the latter parts are presented in note form.
Project 1
Strategic Issues
This will enable Ribs to compete more effectively on price in the
domestic market place, where consumers appear to be switching to
cheaper products in the recession.
Producing the goods in a lower cost country may damage Ribs
reputation for making high quality goods, preventing them from
charging a premium price in the future.
Note: The rest of this answer is presented in note form and the
following points would need to be expanded to score well in the exam.
Operational Issues
Longer lead times
Adherence to local employment/health and safety laws
Financial issues
Both projects create FX risk
Redundancy and closure costs
Project 2
Strategic Issues
Consistent with current differentiation strategy shouldnt damage
domestic reputation
Lack of knowledge of foreign markets e.g. unable to identify which
products will be popular
Operational Issues
More capital intensive process will increase operational gearing
Financial Issues
May be able to offer new assets as security for a loan
Likely to need risk adjusted cost of capital as entering new markets

12

Chapter

Strategic performance
management and HRM
Chapter learning objectives

Advise on, and develop, appropriate performance management


approaches for businesses and business units.

Use financial and non-financial performance data to measure


multiple aspects of performance at a variety of organisational
levels.

Advise on, and develop, appropriate remuneration and reward


packages for staff and executives.

Assess, explain and advise on the role of human resource


management in implementing strategy.

Demonstrate and explain how human resource management can


contribute to business strategy.

Identify the impact of remuneration structures on organisational


behaviour and other aspects of human resource management,
and show the corporate reporting consequences.

Demonstrate and explain the role and impact of human resource


management in change management.
13

Strategic performance management and HRM

Introduction

This chapter covers three main areas:

Performance measurement and management

Executive remuneration

Human resource management

Performance measurement and management

Assumed knowledge
There is no significant new content in SBM in respect of performance
measurement and performance management.
The key point is to realise that poor performance may be partly caused
by poor performance measurement systems and inappropriate
performance management.
The following lists of red flags may help you identify where the
performance measurement or performance management systems are
contributing to poor performance.
Performance measurement:

Using solely short-term measures

Using purely financial measures

Using conflicting measures

Using measures which may lead to sub-optimal decisions (such as


ROI)

Performance management:

Evaluations based solely on meeting fixed budgets

Centrally imposed (top down) budgets

Managers being assessed on uncontrollable factors

Potential improvements
Performance measurement: Use the balanced scorecard
Why:

14

Promotes a balanced range of performance measures (financial


and non-financial)

Chapter 2

Helps overcome the limitations of using purely financial


information (Historic easy to manipulate short-termist)

Promotes consideration of a wider range of stakeholders

Performance management: Beyond budgeting approach

The manager sets their own 'stretch targets' (therefore takes more
ownership)

The manager is given full support to achieve the targets but


carries sole responsibility for meeting them

Targets are both strategic and financial

Monthly balanced scorecards are produced and measures are


compared to last year, other divisions and competitors

Performance reviews are called on an ad hoc basis when there is


a blip in performance. These reviews focus on action plans and
possible improvements

Advantages of the beyond budgeting approach:

Managers are not punished for failing to reach the full target
(improving motivation)

The use of the BSC promotes a balanced range of performance


measures

Managers set their own targets increasing ownership

Reviews of action plans encourage feedback and learning

Beating internal and external competitors is motivational

Managers share a bonus pool that is based on share price or longterm performance against a basket of competitors (encouraging
teamwork and a long-term perspective

Executive remuneration

In the exam, you may be expected to evaluate, and advise on,


executive pay packages.
Therefore you need an idea of what is good practice and what is not.
Key principles
The Greenbury Report identified three key principles of good executive
pay:

Directors' remuneration should be set by independent nonexecutive directors


15

Strategic performance management and HRM

Any bonuses should be related to measurable performance on


increases in shareholder value

There should be full transparency of directors' remuneration in the


annual accounts

Generally, remuneration packages should be sufficient to attract, retain


and motivate directors of appropriate quality.
However, they should also be designed to align the interests of
directors with those of the shareholders and to promote the long-term
success of the company.
Components of reward packages
Basic salary: Determined by the experience of the director and the
market rate.
Performance related bonuses: Should be linked to measurable longterm performance or enhanced shareholder value.
Ideally the criteria for paying bonuses should be risk adjusted to prevent
excessive risk taking
Potential poor practice:

Transaction bonuses, where executives receive a bonus for


making an acquisition regardless of the subsequent performance
of the acquired entity

Loyalty bonuses, where executives receive a bonus for staying


with the company even if they are underperforming

Share options
Good practice:

The UK Corporate Governance Code states that options granted


should not vest or be exercisable in less than 3 years

Directors should be encouraged to hold on to their shares after


exercise

If directors receive a number of share options in one package,


they shouldn't all be first exercisable on the same date (as this
may encourage short-term manipulation of accounting data around
that date)

Potential poor practice:

16

Granting share options that become exercisable in a short period


of time or all become first exercisable on the same date (as above)

Compensatory bonuses or modification of the exercise prices such


that directors still receive a bonus even if they underperform

Chapter 2

Failure to take account of general increases in the stock market


when setting exercise prices, meaning that directors may get a
large gain even if the share price has failed to outperform the
market.

Advantages of share options:

Should align management and shareholder interests

Can encourage cautious managers to take positive action to


increase the value of the company

Disadvantages of share options:

There is no downside risk, so they may encourage directors to


proceed with high risk projects

Directors have an incentive to manipulate accounting data and


thus the share price leading up to the exercise date

Underwater options: If options become significantly out-of-themoney this may have de-motivational impact on management

The long vesting periods may tie de-motivated and unhappy


managers to the company

Benefits in kind: Could include company cars, life assurance,


healthcare etc. Ideally, the package offered to directors should not be
excessive compared to that offered to other employees.
Potential poor practice:

Directors loans; excessive directors' loans are likely to be


considered a significant agent cost

Pensions:
Good practice:

The UK Corporate Governance Code states that, as a general


rule, only basic salary should be pensionable

The remuneration committee should consider the pension


consequences of any increases in the basic salaries of directors

Potential poor practice:

Granting a full pension to directors who leave early (as this may be
a reward for underperformance)

Note: Pensions and share options also have CR implications which are
covered in the CR appendix.

17

Strategic performance management and HRM

Human resource management

Definition
HRM includes all the activities management engage in to attract and
retain employees, and ensure that they perform at a high level and
contribute to achieving organisational goals.
Exam context
The SM introduces some new HRM models (for example, Guest's
model) in addition to the assumed knowledge from B&F and BS.
However, you will not be expected to discuss the theory of any of these
models by name in your exam.
Rather, you will be expected to apply the key concepts in a practical
context.
For example, you should be aware that there is a link between the
reward system and performance.
Therefore, if a scenario describes concerns around performance and
provides details of the reward system, you should consider whether the
reward system is contributing to the performance issues.

18

Chapter 2

Chapter summary

Key areas:

Good and bad practice in respect of executive pay

Practical application of assumed knowledge on performance


measurement and management (e.g. BSC)

Practical application of assumed knowledge on HRM

19

Strategic performance management and HRM

20

Chapter

Business risk
management
Chapter learning objectives

Analyse and evaluate the key types of business risks and assess
their implications within a given scenario, for business strategy
and corporate reporting disclosures.

Assess the impact of risk on a variety of stakeholders.

Explain and assess the various steps involved in constructing a


business risk management plan by establishing context, identifying
risks and the assessment and quantification of risks.

Using data provided, analyse quantitatively business risks under a


range of complex scenarios.

Evaluate and explain the limitations of business risk management.

21

Business risk management

Introduction

This chapter covers two main areas, both of which are assumed
knowledge from the professional level:

Identifying, explaining and mitigating risks

The risk management process

Exam context
In the exam you may be asked to:

Identify or evaluate risks arising in the scenario

Make recommendations on how to mitigate the risks identified

In addition, you may be asked to recommend an overall approach to


risk management.

Identifying, explaining and mitigating risks

Approach
Identifying and explaining risks

Use the scenario to generate ideas giving prominence to key


issues

Can use PESTEL / generic types of risk in the background to


generate additional ideas

Be sure to explain why each factor identified is a risk

Ensure points are specific to the scenario by using facts, figures,


names etc. from the scenario

You can use the 'factor / explain / impact' approach; to ensure you
fully explain each risk include the following:

The factor (ideally from the scenario)

Explanation of how this affects the firm

The specific negative impact on the firm

Recommendations on how to mitigate risks

22

Explain specifically how you would address the risk

Often this can be simple and practical advice, for example


suggesting additional staff training to mitigate a health and safety
risk

Chapter 3

Test your understanding 1 Choco


Choco plc is a major confectionery and non-alcoholic beverage
company which has a large manufacturing plant based in the UK and
several sales divisions across the world.
The firm was set up over 100 years ago and it has a number of very
well-known brands which have sold well over the years. However, in
recent years, the global marketplace has become more competitive
partly due to new competitors based in developing countries. A
significant portion of Choco's cost of goods sold relates to sugar and
cocoa.
Required:
Identify and explain the risks the company may face and suggest
how these risks could be managed.
(8 marks)

The risk management process

The risk management process is assumed knowledge and was covered


both in BS and the pre-course reading.
You should at least be aware of the key stages in the process as you
may have to advise a company on risk management.
New terminology: Enterprise risk management (ERM)
Definition (based on that provided by the COSO): ERM is a process,
effected by an entity's board and management, applied in strategy
setting and across the enterprise, designed to identify and manage
risks.
ERM may sound new but actually it is just a slight variation on the
generic risk management process you saw in BS.
The 8 components of ERM are:

Objective setting

Event identification

Risk assessment

Risk response

Internal environment and control environment

Control activities or procedures

Information and communication

Monitoring

Note: These components are very similar to the stages of the risk
management process you saw in BS.
23

Business risk management

Chapter summary

Key areas:

24

Identifying and explaining risks facing the business

Suggesting recommendations to mitigate identified risks

Providing practical advice on the risk management process

Chapter 3

Test your understanding answers


Test your understanding 1 Choco
Note: This is not an exhaustive list you may have thought of
different examples that are equally relevant.
The first risk is presented as we would recommend in the exam;
concise, well explained points which are clearly spaced out.
Raw materials prices
Increases in prices of sugar and cocoa on world markets may be
difficult for Choco to pass on to customers in a competitive market,
reducing their profits and cash flow.
Mitigation: The risk of price increases could be hedged with forwards,
futures or options.
Options are likely to be more expensive, but are more flexible and
would allow Choco to benefit from any fall in prices.
Note: The remainder of the answer provides more detailed
explanations for tutorial purposes.
Competition the confectionery and non-alcoholic beverages
markets are highly competitive. If there is a particular product that
contributes a large proportion of sales revenue, there is a
considerable risk that a rival company will bring out a similar product
and take some of the market share. The extent of this risk will depend
very much on the power of the brand.
Risk management Choco plc needs to maintain a broad portfolio of
products and invest in marketing to keep its famous brand names in
the public eye (risk reduction).
Role of food in public health with lots of publicity about levels of
obesity, children's eating habits, heart disease and diabetes, there is
a significant threat to the confectionery and fizzy drinks markets.
There is potential for governments to restrict advertising of certain
products and to impose additional taxes on confectionery and fizzy
drinks, which could make marketing more difficult. This could have a
significant downward effect on sales and profits. Consumer tastes
may change for health-related reasons. If the company is unable to
respond, this will also result in declining sales or margins.
Risk management Choco plc could reduce sugar content of its
products (and use this as a unique selling point) and/or add healthy
snacks into its product portfolio (risk reduction).

25

Business risk management

Product recalls and incorrect labelling of merchandise the


confectionery industry is particularly susceptible to the risk of product
recalls and incorrect labelling. The necessary publicity given to the
potential consequences of nut allergies, for example, has led to much
stricter regulation of labelling information. There have been instances
of products being recalled due to failure to include warnings of nut
content on labels. It is not just the product recall itself that is
expensive the potentially damaging effect on the company's
reputation could have an even greater impact.
Risk management Although product recalls are infrequent, their
considerable impact is such that very tight internal controls are
necessary to prevent their occurrence (risk reduction). Choco plc
could also consider insurance to cover this sort of unexpected event
(risk transfer).
Sales in foreign currency Choco plc has sales divisions
worldwide, so the firm will receive revenues in many different
currencies. There is a significant exposure to exchange rate
fluctuations, but the risk is mitigated by the fact that many currencies
are involved (there isnt an over reliance on one particular
currency).
Risk management Choco plc needs to consider hedging. Any large
transactions should be hedged to eliminate the risk (risk avoidance),
but to reduce the cost of hedging, it would be advisable not to hedge
the smaller transactions (risk retention / acceptance).
Labour costs Choco plcs manufacturing plant is in the UK, where
labour costs are higher than in some developing countries. This
exposes Choco plc to the risk that foreign competitors might be able
to undercut Choco plc on selling price and/or make larger profits.
Risk management Choco plc needs to ensure that it motivates the
workers to ensure they are highly productive and give good value for
their high labour costs (risk reduction). Alternatively, the firm could
spread its risk by moving some of its manufacturing to a low wage
country, or by automating some of its processes (risk avoidance).

26

Chapter

Data analysis
Chapter learning objectives

Undertake appropriate data analysis, business analysis and


financial statement analysis.

Explain financial and operational data and other management


information, drawing inferences relating to its completeness,
accuracy and credibility, as a basis for a meaningful analysis of
the position, future prospects and risks for a business.

Demonstrate how suitable financial, strategic and operational


analysis can be used to analyse financial and operational data and
to evaluate business position, prospects and risks.

Communicate an explanation (stating any reservations regarding


transparency and objectivity of data and information) of the
position, prospects and risks of a business, based on analysis of
financial and operational data and information.

27

Data analysis

Data analysis

Exam context
The data analysis skills you developed in BS are assumed knowledge
for this exam.
Data analysis is even more important at the Advanced Level, because
of the requirement to analyse more complex scenarios.
In the exam you may need to analyse financial and/or non-financial
data, as well as financial statements.
There is a wide range of possible exam requirements that could involve
data analysis, thus the following list of possibilities is not exhaustive:

Performance measurement (including assessment of KPIs)

Evaluation of proposals

Evaluating performance of divisions or SBUs

Cost analysis

A common weakness in data analysis at this level is failing to tell the


underlying story behind the numbers.
Recommended approach
You can use the following 7 step process to tackle data analysis
questions (it is very similar to the 5 step approach presented in the SM):

Step 1: Initial review of scenario and requirements

Step 2: Decide on appropriate analysis to undertake

Step 3: Produce the necessary calculations

Step 4: Select appropriate headings

Step 5: Interpretation of your analysis

Step 6: Additional information required / limitations of the analysis

Step 7: Conclusion

Step 1: Initial review of scenario and requirements

28

Read the requirements carefully

Identify key issues in the scenario this will help you identify how
to focus your analysis

Chapter 4

Step 2: Decide on appropriate analysis to undertake


Unless the examiner tells you otherwise, you will need to decide what
calculations to do.
The majority of marks are for interpretation not calculations, so you
should plan to do relatively few, simple calculations.
To do:

Review the key issues in the scenario and the data provided

Pick the most relevant and interesting calculations to perform

Step 3: Produce the necessary calculations


Tips:

Produce a table of calculations at the front of your answer

Perform really simple calculations (e.g. % changes) complicated


ratios are not required

If assessing performance over a period and the trend is consistent,


calculate % changes for the whole period, not for each individual
year

Calculate relative measures if possible (e.g. Revenue per staff


member)

Step 4: Select appropriate headings

Use headings based on data given (e.g. Revenue, V.C. etc.) or


type of calculation performed to give your answer structure

Step 5: Interpretation of your analysis


To present quality analysis, you need to 'make the numbers talk'.
A great approach to achieving this is to identify interesting financial
facts and then provide a cause and / or effect for each fact.
The fact cause effect approach
Fact:
Identify interesting financial facts/comparisons with commentary.
The components of a quality financial fact:

An interesting and relevant % change or ratio calculation

Basic commentary / evaluation (e.g. significant increase or notable


decrease)

Benchmark or yardstick (if relevant, using information from the


scenario if possible)
29

Data analysis

Never just present facts (e.g. revenue has increased by 10%) without
adding some commentary or evaluation.
Instead, demonstrate your ability to apply judgement by adding some
commentary or evaluation (e.g. the company has achieved strong
revenue growth of 10%, despite the tough economic climate).
Cause:

Explain the underlying reason why the number / ratio has changed

Avoid explaining a movement by just providing another number,


also give an underlying reason

Use facts and figures from the scenario to support your reasons
wherever possible

Effect / implication

What does it mean for the business now or in the future?

Step 6: Additional information required / limitations of the analysis

Identify the specific information that would be required to provide a


fuller analysis and explain why it would be useful

Expect some marks to be available for limitations & additional


information, even if it is not specifically requested in the
requirement

Step 7: Conclude

30

Provide a summary or conclusion at the end of your analysis to


ensure you give an overall answer to the question

A conclusion should include a clear answer to the question set and


the main reason why.

Chapter 4

Test your understanding 1 Selworthy plc


Selworthy plc is a listed company which operates in the chemical
industry manufacturing paints.
You are Claire Gull, a newly-appointed assistant accountant reporting
to the Selworthy finance director, Rogan Richards, who is an ICAEW
Chartered Accountant. Today Rogan sent the following email to you:
From:

Rogan Richards

Sent:

8 November 20X1

To:

Claire Gull

Subject: CEOs 60-day review document and potential acquisition


I have a meeting next week with our new chief executive, Wesley
Wilson. He has made it clear that he wants to change our strategy
and expand the business. I realise that you are new to Selworthy, so I
have provided you with a brief summary of the companys
background (Exhibit 1). Wesley has prepared some notes which
summarise his review of the strategic issues and operational matters
which have come to his attention during the first 60 days since his
appointment (Exhibit 2). He has asked me to provide an initial
response to his review at next weeks board meeting.
Wesley is keen to make an acquisition. There are two possible
targets, but we are in a position to acquire only one of them, so we
would need to make a choice and it is quite urgent. I have prepared a
paper giving details of the two target companies based on preliminary
due diligence and draft forecast financial statements for the year
ending 31 December 20X1 (Exhibit 3).
I have just been to a conference on the state of the paint
manufacturing industry, and I took notes on the keynote speech
(Exhibit 4). I suspect that some of the issues in my notes could have
relevance for our growth strategy and any decision to acquire one of
the two companies. I havent discussed the issues with my colleagues
yet, but before I do I should like you to carry out a preliminary
assessment.
As a result, I would like you to do the following:
With respect to the two potential target acquisitions (Exhibit 3):
1

Recommend, with reasons and supporting analysis, which


company would be the better strategic and operational fit with
our business. I appreciate that the acquisition price is a key
issue, but ignore this for the purpose of your analysis.

31

Data analysis

State any additional factors that we should consider before


deciding on a final price for the two targets and identify the key
matters that we would require the auditors to address during
detailed due diligence procedures.

For the purpose of requirements 1 and 2, please ignore my notes on


the state of the paint manufacturing industry.
3

Use my notes on the state of the paint manufacturing industry


(Exhibit 4) to indicate how this information could have
implications for Selworthys decision to acquire either of the two
companies, and for the companys growth strategy in general.

Required:
Respond to the instructions of the finance director.
Exhibit 1 Company background
Selworthy is a relatively small producer of paints in the context of the
global industry. It makes all its sales in the UK, where it has a 7%
market share. It has one factory in the South of England and a
distribution warehouse in central England.
Selworthys average cost of producing one litre of paint is 2; it
produces approximately 15 million litres per year. The average cost
per litre at this level of output is made up as follows:
Materials
Factory labour
Distribution
Fixed production overheads
Fixed administrative expenses

0.40
0.80
0.10
0.20
0.50

The average selling price of one litre of paint is 2.10, with its sales
being both to small and large retailers and wholesalers. This price
reflects a very competitive market with tight margins.
Exhibit 2 CEOs notes Review of the business
I have spoken to many people, inside and outside of the company,
during the 60 days since my appointment. There are many good
aspects of our business, but there are also some things I would like to
change. I have set out a summary of my initial thoughts below.
Objectives
Growth has been too slow in the past. My target for Selworthy is to
provide shareholders with 15% per annum sustainable growth in profit
before tax. There are no other specific objectives as I believe that, if
we meet this target growth rate, all reasonable requirements of other
stakeholders can be satisfied.
32

Chapter 4

Business strategy
We operate in a mature industry which has shown no growth in
revenues in the past few years. It is unreasonable to suggest that our
target profit growth can be met from increased UK market share or
from margin increases. I therefore propose three elements to the
strategy for growth:
(i)

Commence exporting to expand sales into new geographical


markets;

(ii)

Make acquisitions financed by increased borrowing; and

(iii)

Adopt more aggressive choices of accounting policies and


estimates, within permitted financial reporting standards, in order
to increase reported earnings over time.

Exhibit 3 Two target acquisitions


Target 1 Colour Chem Ltd
Colour Chem Ltd (CC) is a private company which produces solvents
and other chemicals for sale to paint industry manufacturers
throughout Europe, but with 50% of sales being in the UK. About 20%
of its total sales are to Selworthy.
Most of CCs property, plant and equipment is held under operating
leases of 8 to 15 years. About 60% of CCs cost of sales comprises
fixed costs with the remainder being variable costs. All administrative
expenses are fixed. Distribution costs are all variable.
A working assumption is that all sales volumes will grow at 10% per
annum over the next three years from 1 January 20X2 but, thereafter,
zero growth is expected for the foreseeable future. Prices, variable
costs per unit and total fixed costs are assumed to remain constant in
sterling terms in the foreseeable future, reflecting competition in the
market. There will be no synergistic cost savings or surplus assets as
a consequence of the acquisition.
Target 2 Puma Paints Ltd
Puma Paints Ltd (PP) is a manufacturer of quality paints, which is
currently owned by a large chemicals company. While in the same
industry as Selworthy, its paints sell for about twice the price of
Selworthys paints. Sales are to upmarket retailers throughout
Europe. The market is stagnant so no increases in sales volumes or
prices are expected in the foreseeable future.
Material costs make up 50% of the cost of sales, and 70% of the cost
of sales consist of variable costs. Cost savings of about 100,000 per
annum will arise from the acquisition of PP, mainly in administrative
and distribution costs. Surplus assets can be sold off immediately for
their carrying amount of 500,000.
33

Data analysis

With either target company, the acquisition would take place on


1 January 20X2.
Draft forecast statements of profit or loss for the year ending
31 December 20X1
000
Revenue
Cost of Sales
Administrative expenses
Distribution costs
Operating profit
Finance costs
Profit before tax
Tax (23%)
Profit after tax

000
Non-current assets
Property, plant and
equipment
Current assets
Inventories
Receivables
Cash and cash equivalents
Total assets
Equity and liabilities
Issued capital
1 ordinary shares
Share premium
Retained earnings
Equity
Non-current liabilities
Long-term loan
Current liabilities
Trade payables
Total equity and liabilities

34

Selworthy
31,500
(21,000)
(7,500)
(1,500)

1,500
(1,000)

500
(115)

385

CC
10,000
(8,000)
(1,000)
(1,000)

PP
9,800
(5,000)
(1,500)
(800)

2,500
(500)

2,000
(460)

1,540

Selworthy

CC

PP

65,000

5,000

20,000

3,500
4,000
1,000

73,500

3,000
2,000
2,000

12,000

1,500
2,000

23,500

20,000
15,000
15,500

50,500

5,000
4,000
2,500

11,500

6,000
4,000
5,000

15,000

20,000

7,500

3,000

73,500

500

12,000

1,000

23,500

Chapter 4

The carrying amounts of assets approximately reflect their fair values.


Note: The current share price for Selworthy equity is 15 pence per
share.
Exhibit 4 Notes on the state of the paint manufacturing
industry
Paints produced by the industry consist mainly of household paints
(40% of total sales revenue), product finishes for cars and furniture
etc. (25%), industrial coatings (20%) and other products such as
varnish removers and paint thinners. Profitability depends on
technological expertise and efficient production. Small manufacturers
are able to compete with larger groups because of the large range of
paints and coatings used for many different applications. The industry
continues to innovate. Recent developments have been improved
water-resistant and corrosion-resistant paints, and a niche market is
developing in ecologically-friendly green paints.
There is strong brand dominance in some parts of the market, notably
in household paints. However there is strong competition throughout
the industry, which means that prices have remained fairly stable for
the past five years, and are expected to remain stable in the future
in spite of a forecast rise of 5% per year in raw material costs. Profit
margins in general are small.
Growth in sales in the industry as a whole has been slow for the past
five years, and is expected to remain at about 1% in the foreseeable
future. Faster growth is not expected until there is a significant
increase in economic activity.

35

Data analysis

Chapter summary

7 steps for tackling data analysis questions:

36

Step 1: Initial review of scenario and requirements.

Step 2: Decide on appropriate analysis to undertake.

Step 3: Produce the necessary calculations.

Step 4: Select appropriate headings.

Step 5: Interpretation of your analysis.

Step 6: Additional information required / limitations of the analysis.

Step 7: Conclusion.

Chapter 4

Test your understanding answers


Test your understanding 1 Selworthy plc
Strategic and operational issues
Colour Chem Ltd
Strategic issues
CC is a current supplier of Selworthy and hence an acquisition would
be upstream (or backward)vertical integration. Sales to Selworthy are
2 million per annum so this is substantial.
It is not clear what the strategic benefit might be, as there appear to
be few operating synergies given the absence of cost savings and no
sales of surplus assets.
While in some industries upstream vertical integration may secure
uncertain supplies, this seems unlikely to be the case in chemicals,
which is an open and competitive market unless there is a particular
attribute to CC chemicals that Selworthy needs in its paints which is
not readily available.
There are prospects for growth, but these will be priced into the
acquisition valuation. If this is part of the strategy towards profit
growth, it is merely buying revenues rather than generating them
organically.
Operating issues
From an operating perspective, upstream vertical integration can
restrict choice of supplies and flexibility in changing suppliers as there
are likely to be corporate instructions to make internal purchases from
CC in the proposed new group.
This acquisition would mean that costs which were variable will
become fixed costs, which has the effect of increasing operating
gearing and operating risk.
There will also be an operating issue of determining appropriate
transfer prices in order to determine divisional profit and thereby
measure performance. Unless divisional managers are autonomous
and can purchase chemicals from other suppliers, the extent to which
performance of divisions can be reliably measured under the new
regime is questionable.

37

Data analysis

Puma Paints Ltd


Strategic issues
PP is a horizontal acquisition, but in a more upmarket niche than
Selworthy. There is the benefit that PP exports its products to Europe,
so this may give core competencies for Selworthy's own products as
part of the new export strategy.
There may also be a reputational effect for Selworthy's products by
having an upmarket brand in the range where some cross branding
could be achieved as part of a marketing strategy.
Operating issues
There appears to be some operating synergies, as indicated by the
synergistic cost savings and the sale of surplus assets.
Whilst similar operations may be an advantage in saving costs and
identifying surplus assets there may also be initial problems in
internally integrating the two sets of operations. This may involve
identifying one set of operating and IT systems, developing a
common corporate culture and developing an integrated corporate
structure.
Given that PP operates in a different market segment (i.e. significantly
higher price) to Selworthy, externally there may be some brand
confusion and ambiguity of market positioning if the two types of
product are marketed side by side.
Recommendation
Overall, Puma Paints appears a better strategic and operating fit with
more cost synergies than with CC and with the greater potential
reputational effect. A vertical integration with CC appears to offer few
benefits and may increase operational risk.
Additional matters
There are however a number of factors which would suggest a much
lower price and valuation for both companies.

38

A significant proportion of the valuation relies on longer term


returns (e.g. for CC over 80% of the NPV depends on earnings
beyond 3 years). While this is a mature market, tastes and
competition may change, placing significant risk on longer term
returns.

There may be some impact with transfer prices which may not
be at arm's length. This needs to be established as part of due
diligence.

Chapter 4

The discount rate of 10% is a key variable which impacts on


valuation. The validity of the 10% needs to be established during
due diligence.

The CC growth rate of 10% pa for three years is a forecast and


the basis and validity of the forecast needs to be reviewed as
part of due diligence.

The detail of the synergistic cost savings and the surplus assets
for PP needs to be established.

Due diligence

Assurance over the historical financial statements from financial


due diligence procedures.

Valuation of key assets to establish that fair value is similar to


their carrying amounts.

Undisclosed potential liabilities through legal due diligence.

Assurance over the projections of future revenue growth and


underlying assumptions (e.g. order book, contracts in place,
records of discussions with major customers).

Commercial due diligence to establish the business model and


source of synergistic cost savings and surplus assets for PP.

Details of transfer prices to establish whether they are at arm's


length (e.g. prices on internal invoices compared to external
invoices for the same goods).

The validity of the 10% discount rate needs to be explored as an


appropriate risk adjusted rate of return to equity in current
market conditions.

Implications of the information about the state of the industry


Inevitably, forecasts and estimates for the future are subject to
uncertainty and error; however, the notes on the state of the paint
manufacturing industry cast some doubts on the assumptions that
have been used in the previous valuations of the two potential target
companies.
Colour Chem
An assumption used in the valuation of CC is that sales volumes will
increase by 10% per annum for the next three years. This suggests
that either the market as a whole will grow by 10% per annum over
this period, or that CC will increase market share.

39

Data analysis

About 20% of CC sales are to Selworthy, but there is no obvious


indication that Selworthy is increasing its sales and profits at this rate
of growth. The current share price is 15 pence per share, giving a
total market value of just 3.0 million. Forecast earnings for 20X1 are
385,000, giving a P/E ratio of 7.8. If Selworthy is expecting to grow
at 10% per year, a higher P/E ratio might be expected.
If CC is unable to increase sales by 10% in order to restore its
profitability, the valuation that has been produced for the company
becomes highly questionable.
Puma Paints
The valuation of Puma Paints will be based on an assumption of no
foreseeable increase in sales volumes or sales prices. This seems
consistent with the notes on the state of the industry. However
although sales prices are unlikely to increase, there may be pressure
on material costs. These are expected to increase industry-wide by
5% per annum.
If this increase in materials costs applies to Puma Paints, we may
expect annual earnings to decline in the future. This might suggest that
Selworthy could be at risk of offering an excessive price for Puma
Paints that could result in the loss of value for Selworthy shareholders.
Broader strategic implications
Selworthy operates in a fragmented market, in which there are many
specialist producers of paints and many different niche markets.
An acquisition of CC would be a form of backward vertical integration,
to acquire control of a company operating in an earlier stage of the
industry supply chain. Acquiring PP would gain entry for Selworthy
into a different market niche. In both cases, the growth strategy could
be described as concentric diversification moving into a related but
different part of the industry. Any form of diversification should be
regarded as a fairly high-risk strategy, especially in a stagnant or lowgrowth industry.
The board of Selworthy no doubt has a broad strategy for growth, but
it is not clear how the two possible acquisition targets would fit in with
this strategy. The board may be reacting to acquisition possibilities
that have arisen, but the choice of acquisitions for growth should be
consistent with the broad strategic aims of the company, and
consistent also with the risk appetite of the board.
Although the industry is expecting low growth, it seems that product
innovation is continuing. Key requirements for growth and profitability
in the future are likely to be technical excellence and reacting to
market innovations. These should perhaps be a core part of the
companys long-term strategy. Acquiring companies simply for the
purpose of growth in sales and earnings may not be consistent with
these key requirements.
40

Chapter

Information systems
Chapter learning objectives

Develop outline proposals and advise on outline requirements for


information technology applications to support business strategy,
for example in the context of e-commerce, e-business and virtual
arrangements.

Use management accounting information (for example costs,


prices, budgets, transfer prices) and management accounting
tools (for example, break-even, variances, limiting factors,
expected values, ABC, Balanced Scorecard) to evaluate short and
long-term aspects of strategy.

Explain and appraise how management information systems can


provide relevant data to analyse markets, industry and
performance.

Demonstrate and explain methods for determining the value of


information in the context of developing an information strategy.

Assess financial and operational data, and information from


management information systems, drawing inferences to its
completeness, accuracy and credibility, and provide an evaluation
of assurance procedures in evaluating information risks.

Demonstrate and explain how businesses capture, analyse and


utilise information to develop competitive advantage.
41

Information systems

Introduction

This chapter covers two main areas:

Information systems

Management accounting information

Information systems

Remember: The terms information system and information technology


are not interchangeable.
Information systems are all the processes used to produce information
and may be at least partly manual.
Exam context
It is unlikely that a question will focus solely on information systems in
their own right.
Thus the brought forward knowledge of information systems from B&F
and BS is expected to be of limited importance.
Exam questions are far more likely to be about information (the output
of information systems) and how a company can use it.
Thus two main types of information systems requirement are possible:
1

Explain how the company could use the information available from
its information system to measure performance / to help
implement its chosen business strategy / to control operations

Assess whether the information produced by companys


information systems are suitable for its needs and whether further
information is required

Type 1: Explain how the company could use information


Approach

42

Identify the types of information available from the scenario

Generate specific ideas of how they could use each type of


information

For each idea explain why the information would be useful /


beneficial

Chapter 5

Type 2: Assess the suitability of an information system


Ideally an information system (even for a small company) should be
capable of producing the following three main types of information:
1

Operational Information To help make day to day decisions


(e.g. costing information)

Tactical Information To help with marketing and resource


planning (e.g. staff planner)

Strategic information To make long term decisions that affect


the whole company (e.g. Investment appraisal reports and
forecasting)

Approach

Identify specific relevant types of information that the company is


likely to need

Use the headings operational, tactical and strategic to generate


ideas

Comment on whether the existing system can produce each


specific type of information

Conclude on whether the range of information produced is


adequate

Management accounting information

Techniques such as break-even and expected values are assumed


knowledge from your previous studies and could potentially feature as
part of a data analysis question.
ABC costing, however, was only covered very briefly in MI and may be
seen in more detail here.
Activity Based Costing (ABC)
ABC is an alternative approach to absorption costing.
Traditional absorption costing calculates an overhead absorption rate
for each cost centre.
However, ABC effectively calculates a different overhead absorption
rate for each activity in the factory. So, should lead to more accurate
absorption of fixed costs.
Steps
1

Identify major activities.

Identify appropriate cost drivers


43

Information systems

Collect costs into pools based upon the activities.

Charge costs to units of production based on cost driver volume.


Cost driver rate =

Total cost in pool


Volume of cost driver

Test your understanding 1 Tammy

Tammy plc currently makes and sells four products, cost and output
details of which are below:
Product

Alpha

Bravo

Echo

Oscar

500

300

400

200

Material

60

42

80

100

Labour

32

20

35

50

165

200

300

500

20

15

30

35

Orders

11

12

16

25

Spare parts required

15

20

10

15

Output (units)
Cost per unit ():

Selling price ()
Activities number of:

Set ups
Times material handled

You are also given the following details of total overhead costs:
Total overhead costs
Set up costs
Material handling costs
Ordering costs
Engineering costs
Total

()
25,000
69,000
32,000
45,000

171,000

Required:

44

(a)

Identify the most suitable cost driver for each overhead


cost.

(b)

Calculate the total product cost for each of the four


products.

(c)

Evaluate the pricing strategy of Tammy plc.

Chapter 5

Advantages of ABC

More realistic costs

Better insight into cost drivers, resulting in better cost control

Particularly useful where overhead costs are a significant


proportion of total costs.

Recognises that not all overhead costs are related to production


and sales volume.

Can be applied to all overhead costs, not just production


overheads.

Can be used just as easily in service costing as in product costing

Criticisms of ABC

It is difficult to allocate all overhead costs to specific activities.

The choice of both activities and cost drivers might be


inappropriate.

ABC can be more complex to explain to the stakeholders of the


costing exercise.

The benefits obtained from ABC might not justify the costs.

45

Information systems

Chapter summary

Key areas:

46

Exam technique for information systems

ABC costing

Chapter 5

Test your understanding answers


Test your understanding 1 Tammy

(a) and (b)


(c)

See Interactive Question 3 answer in ICAEW Study


Manual p 647.

Product Bravo is being sold for 200, but according to our ABC
calculations it costs 205.83 to make. Clearly this is
unsustainable. Tammy plc needs to raise the price if possible
(depending on the nature of the market) or find ways of adapting
the production process to reduce the cost and to improve
profitability that way. If this is not possible, Product Bravo should
be discontinued, unless this would have an adverse effect on
any of the other products (for example, it may be a loss leader
which customers buy in conjunction with one of the higher
margin items).
Product Alpha costs 163.10 and is being sold for 165. This is
a very low margin. Again, Tammy plc needs to consider raising
the selling price if possible, or reducing the cost of manufacture.
Products Echo and Oscar have selling prices much higher than
cost. This appears to be a good pricing strategy at first glance,
given that both products have high margins.
However, it may be that the high prices are putting some
customers off, and that profitability could be increased by
reducing prices to stimulate demand.
Tammy plc needs to analyse the price-demand relationship for
these two products, and to set prices to target profit
maximisation. An analysis of competitors prices may well
indicate that Tammy plcs current prices are too high.

47

Information systems

48

Chapter

Corporate governance
Chapter learning objectives

Assess the nature of governance and explain the characteristics


and principles of good governance in a variety of scenarios.

Assess the interests and impact of organisational stakeholders in


determining strategy and the consequences for stakeholders of
strategic choices.

Evaluate the impact of governance mechanisms on a range of


stakeholders.

Assess and advise on appropriate corporate governance


mechanisms and evaluate stakeholder management.

Explain the role of boards in monitoring corporate performance


and risk.

Analyse and evaluate the strengths and weaknesses of corporate


governance mechanisms and processes.

Evaluate the suitability of corporate governance and organisational


structures for implementing strategy.

Explain the nature, and assess the consequences of, the legal
framework within which businesses, assurance and governance
systems operate.
49

Corporate governance

Introduction

This chapter covers two main areas, both of which are assumed
knowledge from the professional level:

Principles of corporate governance

Board structures

Exam context
In the exam you may have to evaluate a company's current governance
mechanisms, identify weaknesses and make suggestions for
improvement.
Definitions
Corporate governance: The system by which businesses are directed
and controlled.
Good corporate governance: Seeks to align the interests of the
directors with shareholders (and the other stakeholders) thus reducing
agency costs.
Executive directors: Run the business on a day-to-day basis (e.g. the
production director, the marketing director etc.)
Their key roles are:

Strategy formulation

Strategy implementation

Company supervision

Non-executive directors: Directors who have no executive


(managerial) responsibilities.
They should provide a balancing influence, and play a key role in
reducing conflicts of interest between management (including executive
directors) and shareholders.
Their key roles are to:

50

Bring an independent viewpoint

Provide additional expertise and advise to the executive directors

Challenge strategy

Scrutinise management performance

Chapter 6

Principles of corporate governance

General principles
The companies that feature in your SBM exam won't always be UK
companies and the UK Corporate Governance Code won't always be
relevant.
However, the key principles of corporate governance are pretty
consistent the world over.
Key general principles:

The Chairman (who runs the board) and the Chief Executive
(CEO) who runs the company should be separate individuals to
prevent one individual having too much power

There should be an appropriate balance between executive


directors (EDs) and independent non-executive directors (INEDs);
generally at least 50% of the board should be INEDs

There should be an audit committee to monitor the independence


of the external auditors and this should be made up solely of
independent non-executive directors

The executive directors' remuneration should be set by the


remuneration committee (typically made up of INEDs) so that EDs
don't have the power to set their own pay

There should be a nomination committee charged with ensuring


the board has the appropriate skills, knowledge and experience

There should be a sound risk management process in place

The board should communicate clearly and honestly with


stakeholders, particularly shareholders

Summary of the UK Corporate Governance Code 2010


This may be useful for questions where the code is relevant (e.g. a UK
listed company, or a UK company which plans to list in the future).
CEO, Chairman and Executive directors

CEO and Chairman must be different individuals

The CEO cannot go on to be Chairman of the same company

Chairman should be independent on appointment

A full time ED cant also take on more than 1 FTSE 100 NED role

A full time ED cant also be the chairman of a FTSE 100 company

A significant portion of EDs pay should be performance related


51

Corporate governance

Non-executive directors

Appoint one independent non-executive director (INED) as the


senior independent director

A director may not be independent if they:

Were an employee within the last 5 years

Represent a significant shareholder

Have close family ties with co.

Receive other pay or benefits in addition to a directors' fee


(e.g. share options, pension)

Had material business relationship with the company within


the last 3 years

Have served on the board for more than 9 years

NEDs serving longer than 6 years should be subjected to a


rigorous review

The board

Larger listed companies (FTSE 350): At least 50% of the board


(excluding the Chairman) should be independent

Smaller listed companies (sub FTSE 350): Should have at least 2


INEDs

Each director should be evaluated based on effectiveness of


contribution and time commitment

The board should review the effectiveness of risk management


and internal controls at least annually

Nomination committee

Over 50% of the NC should be INEDs

Audit committee

52

Should be 100% INEDs

FTSE 350 should have least 3 members

Smaller listed companies should have at least 2 members

At least one member should have recent and relevant financial


experience

Chapter 6

Remuneration committee

Should be 100% INEDs

FTSE 350 should have least 3 members

Smaller listed companies should have at least 2 members

Board structures

You may have to advise companies on their corporate governance


mechanisms and this could involve discussing the pros and cons of
different board structures.
Unitary boards
A single board made up of a mixture of executive and non-executive
directors (this is the structure used in the UK):
Pros:

Common legal responsibility: All directors have a legal


responsibility for the management of the company (encouraging
non-executive directors to be proactive)

As all directors attend the same meetings, INEDs are less likely to
be excluded from decision-making

The scrutiny of the INEDs should lead to better quality decisions

The single board may encourage better working relationships


between EDs and INEDs

Cons:

INEDs may become too actively involved in decisions,


undermining their independence

Creates a division between the employees and the directors

Also, potentially creates a division between the directors and the


shareholders

Multi-tier boards
In some countries, for example Germany and Japan, it is common to
have multi-tiered boards.
In a dual board system there is a separate supervisory board that is
made up of employee and other stakeholder representatives.
It has no management role but is responsible for monitoring
management and safeguarding stakeholder interests.
53

Corporate governance

Pros:

Clear separation between the executives and the supervisory


board which is monitoring them

Supervisory board involves shareholder, employee and bank


representatives so should act in the interests of stakeholders.

Cons:

54

Potential confusion over authority leading to lack of accountability

The management board may limit the information passed on the


supervisory board restricting its effectiveness

Chapter 6

Chapter summary

Key areas:

Applying the principles of good governance to complex scenarios

Evaluating the governance mechanisms presented in a scenario

55

Corporate governance

56

Chapter

Assurance
Chapter learning objectives

Demonstrate and explain the role of assurance in respect of


acquisitions and joint development strategies.

Suggest and explain assurance risks and procedures relating to


business plans.

Demonstrate and explain the role of assurance in the evaluation of


outsourced service providers.

57

Assurance

Introduction

This chapter covers three main areas:

Due diligence

Assurance on business plans and forecasts

Assurance on service providers (e.g. providers of outsourced


services such as payroll)

Due diligence

Usually takes place in an acquisition or refinancing, therefore its likely


to be a common requirement in the SBM exam.
Objectives may include:

Confirming the accuracy of information

Providing the bidder with an independent assessment of the target


business

Identifying and quantifying areas of commercial and financial risk

Giving assurance to finance providers

Place the bidder in a better position to determine the value of the


target company

There are several types of due diligence work:

Financial

Commercial

Technical

IT

Legal

HR

Tax

However, financial due diligence will most likely be the focus in this
exam.

58

Chapter 7

Typical questions

Set out preliminary financial due diligence procedures on the draft


financial statements

An explanation of the key issues that your due diligence will need
to consider and the procedures that you would perform to address
these

Note: These types of requirements are actually similar to the planning


questions you did in professional level audit and assurance.
You are effectively required explain risks and describe procedures.
However, the nature of the risks and procedures (even for financial due
diligence) are different than those required for a statutory audit.
Approach
Due diligence risks:
You need to identify due diligence risks from the information provided.
Financial due diligence risk = risk of misstatements in the financial
statements which will impact the valuation.
Key risks:
Overstatement of earnings and assets (or understatement of liabilities).
Generic DD risk areas

Draft, unaudited, financial statements are being used increasing


the risk of error

Analytical review identifies unusual relationships, suggesting


earnings or assets are overstated

Accounting estimates that could be manipulated to overstate


earnings or assets (e.g. excessive useful economic lives)

Highly complex or subjective areas which are more likely to be


misstated (e.g. pension asset or liability)

Due diligence procedures:


You need to describe specific procedures.
Aim to perform a specific action on a specific source (making use of the
information in the scenario wherever possible).
Example:
Inspect borrowing agreements to ensure there are no restrictive
covenants of which the bidder was not aware.
59

Assurance

Assurance on business plans and forecasts

Typical questions
Historically, the advanced stage questions on assurance engagements
have focussed on the form of the report (particularly the level of
assurance given) and the relevant procedures.
Example:
We require an assurance report on the forecasts. Please explain the
level of assurance that could be provided and explain the key
assurance procedures that would be required.
Approach
Note: ISAE 3400: Review of forecasts is a very useful resource for
answering this type of question.
Level of assurance / content of report
Limited assurance is given in the form of a negatively worded opinion
(more detail paragraphs 27 and 28 of ISAE 3400)
Procedures (paragraphs 18 25)

60

Review evidence provided to support managements underlying


assumptions to ensure that they are reasonable

Review management's assumptions to assess whether they are


consistent with similar historic information

Check that the forecasts are properly prepared on the basis of the
assumptions provided

Check the forecasts for mathematical accuracy

Perform sensitivity analysis on the forecasts to identify the critical


estimates within the forecast, and consider the need for gathering
additional evidence over these critical estimates

If any of the period covered by the forecast has already elapsed,


compare to historic information

Ensure the forecasts are properly presented and all material


assumptions are adequately disclosed

Confirm that the forecasts are prepared on a consistent basis with


historical financial statements

Obtain a written representation from management confirming the


intended use of the prospective financial information

Chapter 7

Obtain a written representation from management confirming the


completeness of significant management assumptions

Obtain a written representation from management confirming their


responsibility for the preparation of the prospective financial
information

Assurance on service providers

ISAE 3402 gives guidance on assurance reports on controls at a


service organisation.
These assurance reports can then be used by the user organisations
and their auditors.
Example:
A Ltd outsources its payroll function to a payroll bureau, PB Ltd.
PB Ltd obtains an assurance report over its internal controls which can
be used by A Ltd, and the auditors of A Ltd when trying to obtain
evidence over the payroll costs in As financial statements.
Key procedures

Assess the description of the service organisations system


provided to user organisations

Evaluate whether the controls related to control objectives stated


in the description were suitably designed

Test controls to assess whether they were operating effectively


throughout the period (only relevant for type 2 reports)

Types of report
Type 1 report:
Report on description and design of controls only.
Type 2 report:
Report on description, design and operating effectiveness of controls.
Note: Both types of report provide reasonable assurance and thus the
conclusions are positively worded
ISAE 3402 Appendix 2 provides examples of both types of report.

61

Assurance

Chapter summary

Key areas:

62

Due diligence risks and procedures

Risks and procedures for assurance work on forecasts

Chapter

Ethics
Chapter learning objectives

Recognise and explain ethical issues.

Explain the relevance, importance and consequences of ethical


issues.

Evaluate the impact of ethics on an entity, its stakeholders and its


strategies.

Recommend and justify appropriate actions where ethical


dilemmas arise in a given scenario.

Design and evaluate ethical safeguards.

63

Ethics

Introduction

Ethics forms an important part of the SBM syllabus and will make up 5
10% of your exam.
In SBM, ethical issues are likely to be more subtle than those covered
in your earlier studies and may be embedded in strategy choice
questions.

Ethical issues

Types of ethical issue


A wide range of different types of ethical issues are potentially
examinable in SBM, including:

Lack of professional independence

Conflict between the accountant's professional obligations and


their responsibilities to the organisation

Attempts to intentionally mislead key stakeholders

Conflicts of interest among stakeholders or senior management

Doubtful accounting or commercial practice

Inappropriate pressure to achieve a reported result

Breaches of laws, regulations or standards

Ethics in the exam


It is likely that you will be expected to:

Identify relevant ethical issues and explain their implications

Discuss alternative courses of action to address the issues (if


relevant)

Suggest practical recommendations to mitigate the issues

Approach

64

Identify issue from the scenario, you can use the following to
generate ideas:

Have there been breaches of laws / regulations

Does the ICAEW code of ethics apply (only relevant if a


professional accountant is involved in the issue)

Business ethics has the company behaved in a way that


has failed to live up to societys expectations

Chapter 8

Generic issues relating to business ethics


Misleading statements / non-disclosure of information
Mistreatment of staff (poor pay, redundancies, discrimination, etc.)
Issues in the supply chain (breach of contract, abuse of power, unfair
prices etc.)
Aggressive / misleading advertising
Unsafe or socially undesirable manufacturing processes
Product quality / safety
Corporate social responsibility / sustainability
Weak corporate governance

Explain the implications of the ethical issues. You can use the
following to help explain the implications:

Effect Is a certain group of stakeholders being hurt?

Fairness Would a reasonable 3rd party consider it to be


fair?

Transparency Is the company reluctant to let others know


about it? / has the company made misleading statements?

Legality

Discuss alternative courses of action to address the issues (if


relevant)

Suggest practical recommendations / safeguards

Note: Ethical issues can be positive or negative (particularly, when the


question asks you to discuss ethical issues).

Corporate social responsibility

Definition
Corporate social responsibility (CSR): Is a belief that a firm owes a
responsibility to society and stakeholders.
A firm with good CSR goes beyond its minimum contractual obligations
to its stakeholders
This is also a wide concept, covering all stakeholder groups.

65

Ethics

CSR issues could include:

Protecting the environment

Staff welfare

Customer welfare

Using fair trade suppliers

Charitable giving

Sustainability

Sustainability: The ability to meet the needs of present without


compromising the ability of future generations to satisfy their own needs
This is a wide concept and is not limited to 'green' issues. There are
three main types of issues to consider:

Social e.g. negative impact on society due to low pay, lack of


diversity etc.

Environmental e.g. pollution etc.

Economic e.g. lack of economic growth, leading to fewer


opportunities in the future

These are also good headings to use if you are asked about measuring
sustainability. They are the criteria that the Dow Jones Sustainability
Index uses to assess sustainability.

66

Chapter

Business and securities


valuation
Chapter learning objectives
Upon completion of this chapter you will:

Explain and demonstrate appropriate valuation methods (including


asset-based, adjusted-earnings-based and cash-based methods)
for acquisitions and other scenarios.

Critically appraise business and securities valuation methods in


the context of specified complex scenarios.

Assess the impact of corporate reporting issues and due diligence


procedures on acquisitions.

Explain and demonstrate the techniques used to value debt.

67

Business and securities valuation

Business valuation general principles

Business valuation is not a precise, scientific process. There is an


element of judgement involved.
Use of listed company data to value unquoted firms
The models shown below often value unquoted firms using data derived
from proxy quoted companies e.g. Ke, beta, dividend yield, P/E ratio
In practice, it can be difficult to find a similar quoted company.
The final answer may have to be discounted by to to account for:

relative lack of marketability of unquoted shares

lower levels of scrutiny

higher risk

Discounting delayed perpetuities

When using discounting techniques to value companies, the default


assumption is that the cash flows go on forever.
Hence, most DCF valuations will involve a perpetuity calculation (a
perpetuity which starts later than T1.
This is often a delayed perpetuity so it is vital you are comfortable with
this type of calculation.
Delayed perpetuities a general formula
PV of
whole
CF
stream

CF
(at the start
of the
delayed
perpetuity)

F
P

1 r

PF without growth

68

g
r

F
P

PF with growth

PF
(either with
or without
growth)

DF
(for the period
before the
delayed
perpetuity starts)

Chapter 9

Test your understanding 1 Delayed perpetuity


Calculate the present value of the following:
A perpetuity of 4,000 starting in T4. The amount received will grow at
3% per year from T4 onwards. The discount rate is 10%.

Business valuation income based measures

Dividend valuation model (DVM)


The DVM is generally used for valuing minority shareholdings, as
minority shareholders don't control the whole earning stream of the
company but only how they spend the dividends they receive.
Theory
Theoretically, the share price should be equal to the present value of
future dividends, discounted at the cost of equity.
Triggers

The requirement asks you to value a minority holding

You are provided with Ke and dividend information

Approach
Take the dividend figure from the scenario (carefully checking
whether it is a t0 or t1 CF)

Apply the DVM formula (assuming constant growth):

P0

g
D1 e
k
r
o
g g
1 e
0
D k

The Ke is very likely to be given in the question and may have been
calculated using data taken from a similar quoted company.

V
P

1g
Ft
C r

Note: The DVM is just a more specific version of the perpetuity with
growth formula from above:

69

Business and securities valuation

Test your understanding 2 DVM


Target has just paid a dividend of 250,000. The current return to
shareholders in the same industry as Target is 12%, although it is
expected that an additional risk premium of 2% will be applicable to
Target, being a smaller and unquoted company.
Required:
Compute the expected valuation of Target, if
(a)

Dividends are expected to be constant

(b)

Dividends are expected to grow at 4% per annum

(c)

Dividends are expected to stay constant for 3 years, and


then grow at 4% per annum thereafter.

Price Earnings (P/E) method


This method is very commonly used in practice.
Theory
P/E ratio =

Share price
EPS

or

P/E ratio =

Market capitalisation
Total earnings

If the market is efficient, assets with similar risk and growth prospects
should trade at a similar multiple of earnings.
Trigger

Question asks you to do an earnings based valuation and provides P/E


information rather than a Ke
Approach

MV equity = P/E ratio earnings

Earnings = PAT (less preference dividends if relevant)

The P/E ratio is likely to be given in the question, typically that of a


similar quoted company.
Complications

70

The valuation will need to be adjusted downwards, if listed


company data is used to value an unquoted company

For controlling interests, the valuation may need to be adjusted


upwards to reflect the value of synergies

Chapter 9

The EPS used should be adjusted (normalised) to reflect the


sustainable earnings of the company

When valuing an unlisted entity it is likely to be difficult to find a


proxy listed entity on which to base the P/E used (i.e. the similar
listed entity is likely to be different in terms of size, risk or growth
potential)

Test your understanding 3 P/E ratio

A client of yours is considering acquiring Tiny Tantrum Ltd, a fast


growing unlisted music recording business.
Big Sound plc is a listed company in the same industry.
Current share price
No. of shares
PAT

Tiny Tantrum

1m
500k

Big Sound
6.70
10m
4,752k

Value Tiny Tantrum using a suitable P/E ratio and identify any
concerns you have with the valuation.
Discounted earnings

This method is conceptually similar to the FCF method (covered later).


The theory

The PV of future earnings discounted at the shareholders required rate


of return equals the market value of equity.
Triggers

The requirement asks you to discount earnings or to use a


discounted earnings based model

The discount rate given in the question is the cost of equity

Approach

Take the earnings figure from the scenario (PAT less any
preference dividends if relevant)

If requested to do so, you should adjust the earnings figures used


to reflect the sustainable (normalised) earnings of the company

Discount at the cost of equity

The resulting PV = MV of equity

71

Business and securities valuation

Note: The adjustments required to normalise earnings will be financial


reporting adjustments.

The aim is not to make the earnings figure a better approximation of


cash flows but simply to make it more representative of future
sustainable earnings.
Adjustments may include:

Additional depreciation of FV of assets

Adjusting directors' salaries to reflect the market rate

Removal of one-off items

Stripping out the impact of aggressive revenue recognition /


estimates

Layout

At this level, understanding the principles of valuation will be vital.


Do not expect to be able to apply a standard pro-forma to all questions.
Below is a rough guide to the main types of layout you will see in
answers:

Situation 1: Perpetuity starting at T1 Formula / Annuity followed


by a perpetuity 2 formulas

Situation 2: Annuity / period of growth followed by a delayed


perpetuity NPV style table

Situation 3: Perpetuity (where different CFs or divisions have


different growth rates) Use a separate perpetuity formula for
each CF / Division which has a different growth rate

Test your understanding 4 QE discounted earnings


Perform an earnings based valuation of the Quantitative Easing
Ltd (QE) using a discount rate of 12%.

QE's forecast earnings (for y/e 31/12/X1):


Revenue
Cost of sales
Depreciation
Other operating costs
PBT
Tax
PAT

72

k
2,110
(640)
(500)
(450)
520
(130)
390

Chapter 9

Working assumptions:

Assume the acquisition will take place on the 1/1/X1 and the
valuations should be determined at this date

The fair value of the non-current assets of QE at 31/12/X0 is


13m and this amount has been unchanged for some years.
The current book value of these assets is 10m

The directors currently receive both salaries and dividends, thus


their salaries will need to be increased by 50% to reflect a fair
market rate once they are no longer shareholders. Other
operating costs currently include directors' salaries totalling
200k

Growth in earnings (after any adjustments) is expected to be


4%

The corporation tax rate is 25% and is expected to remain at this


level in the future

Hint: Assume the depreciation charge rises in line with asset values.

Test your understanding 5 JB discounted earnings

Your client is considering purchasing the entire share capital of Justin


Believer Ltd (JB). JB has recently enjoyed rapid growth in the market
for its trademark high-pitched noises, but growth is expected to slow
in the future. The date is currently the 1st July X1
Current and forecast PAT for JB:

PAT

Y/E
30/6/X1
(Draft)
k
323

Y/E
30/6/X2
(Forecast)
k
340

Y/E
30/6/X3
(Forecast)
k
357

Y/E
30/6/X4
(Forecast)
k
371

Value the entire share capital of JB, using an earnings based


valuation method
Working assumptions:

PAT is expected to grow at 2% a year from 30/6/X4 onwards

Use a 12% per annum cost of equity to discount earnings

73

Business and securities valuation

Discounted earnings Summary

When asked to discount earnings assume earnings are a good


proxy for CFs, thus there is no need to adjust them to make them
more like CFs (e.g. by adding back depreciation)

Any adjustments required will be to make the figure more


representative of sustainable future earnings

Earnings discounted at Ke = MV of equity

Note: Discounting earnings at WACC would be inappropriate as this


would double count interest costs (interest cost would be reflected in
the discount rate and as an expense within the earnings figure).

Business valuation cash based measures

Free Cash Flow method

This method of business valuation is similar both to the discounted


earnings approach (above) and NPV method of project appraisal.
In the exam it is unlikely that you will be given the cash flows directly.
Expect to have to estimate the cash flows from readily available
accounting information (normally the P&L).
The theory

Free cash flow = the total free cash flow which is available to reward all
of the investors (shareholders and lenders).
Hence, FCF is the total CF remaining after capital expenditure and tax
but before interest and dividend payments.
The PV of future FCF (the total CFs available to reward all investors)
discounted at the WACC (the cost of meeting the required rate of return
of all the investors) equals the enterprise value (the MV of the debt plus
equity).
Triggers

The requirement asks you to use the discounted free cash flow
method

The discount rate given in the question is the WACC

The MV of debt is likely to be provided in the scenario

Approach (estimating FCFs)

Standard approach to estimating FCF from accounting information:

74

Earnings before interest and tax (EBIT),

Less: Tax @ the standard rate

Chapter 9

Add back: Non-cash items (e.g. depreciation)

Less: Capital expenditure

Less: Working Capital investment

= Estimated FCF
Note: The existing tax figure from the P&L should not be used as this
includes a tax saving on interest which is already reflected in the
discount rate (WACC).
Note: This standard approach assumes that depreciation approximately
equals capital allowances.

Hence, tax should be calculated before adding back depreciation to


ensure that the tax saving on depreciation / capital allowances is
correctly included as a cash flow.
Approach (discounting FCFs)

Discount estimated FCFs at WACC

Resulting PV = Enterprise value (MV of debt plus MV of equity)

Less the MV of debt

= MV of equity
FCF Summary

Calculate forecast EBIT (if necessary)

Estimate FCFs from the EBIT figures

Discount FCFs at WACC to obtain the enterprise value

Deduct the MV of debt

Equals the MV of equity

Note: Interest costs should not be included as an outflow within the


FCF figure as they are already reflected in WACC.
Common errors in FCF calculations

Including interest costs (as an outflow) within FCFs

Failing to deduct the MV of debt from the enterprise value to get


the MV of equity

Errors in delayed perpetuity calculations (if relevant)

75

Business and securities valuation

Test your understanding 6 Bland Burgers FCFs

Your client is considering the acquisition of bland burgers (BB) Ltd,


which makes ready prepared microwavable burgers for the
undiscerning customer.
Calculate the value of the entire ordinary share capital of BB
using discounted free cash flow method and the following
working assumptions.
Current year P&L:

PBIT
Interest
Tax
PAT

3m
(0.5m)
(0.65m)
1.85m

Working assumptions:

76

No growth is expected for the next 4 years and then profits/cash


flows are expected to grow at 2%.

Depreciation = 500k per year

Actual capital expenditure = 600k per year

MV of debt = 7m

The corporation tax rate is 24% and is expected to remain at this


level in the future

The annual discount rate after tax for free cash flow is 10%

Chapter 9

Test your understanding 7 FCF (Chassagne and Butler)

Chassagne plc is considering making a bid for Butler plc, a rival


company. The following information should be used to value Butler
plc.
Income statement for the most recent accounting period.

Revenue
Cost of Sales
Gross profit
Operating expenses (including depn 12.3m)
Profit from operations
Finance costs
Profit before tax
Taxation (23%)
Profit after tax

m
285.1
(120.9)

164.2
(66.9)

97.3
(10.0)

87.3
(21.6)

65.7

Other information

Selling prices are expected to rise at 3% pa for the next 3 years


and then stay constant thereafter.

Sales volumes are expected to rise at 5% pa for the next 3 years


and then stay constant thereafter.

Assume that cost of sales is a completely variable cost, and that


other operating expenses (including depreciation) are expected
to stay constant.

Butler plc invested 15m in non-current assets and 2m in


working capital last year. These amounts of annual incremental
investment are expected to remain constant going forward.

The WACC of Butler plc is 12% and Butler plc has 200m of
irredeemable 5% debentures in issue, which are trading at par.

Required:
Calculate the value of Butler plc using the Free Cash Flow
model.

77

Business and securities valuation

Free cash flow to equity

This is similar to the discounted earnings approach above, except


earnings are now adjusted to make them more like CFs.
Theory

The PV of future CFs attributable to equity shareholders discounted at


the shareholders required rate of return equals the market value of
equity.
Triggers

The requirement asks you to use a DCF approach and the


discount rate provided in a cost of equity

Note: This approach is not explicitly defined in the SM but it is used in


the question bank.
Approach

Calculate / obtain forecast PAT from the scenario (remembering to


include any interest costs as an expense)

Estimate FCFs to equity from the PAT figures, making the


following adjustments as necessary:

Add back depreciation

Deduct actual capital expenditure

Deduct incremental working capital investment

Discount FCFs to equity at Ke to obtain the MV of equity

Note: Interest costs should be included as an outflow within the FCF to


equity figures as they are not reflected in Ke.

Business valuation asset based measures

Net assets approach


Theory

The starting point for an asset valuation is the NBV of the company's
net assets (the book value of total equity).
However, this figure is unlikely to represent the acquisition value of the
company as:

78

NBV is based on historic cost and doesn't reflect current market


values

Many intangibles are not recognised on the SFP

Chapter 9

Ideally the NBV of equity should be adjusted to reflect the fair value of
the net assets.
Guidance on measuring the fair value of assets and liabilities is
provided by IFRS 13 (see Appendix 3).
Approach

Take the NBV of equity from the SFP

Adjust this figure to reflect fair values (using information from the
scenario), often uplifting land and buildings to fair value is the only
adjustment required

Concerns

The valuation of many intangible assets is subjective

Financial liabilities recorded using the amortised cost basis may


not be reflective of fair value

The valuation of pension assets / liabilities are highly sensitive to


changes in the underlying assumptions (such as the discount rate
used)

Test your understanding 8 Net assets (Ray and Ribbon)

Ray plc, a manufacturing company, is considering a takeover bid for


Ribbon Ltd, a smaller company in the same industry.
Extracts from Ribbon Ltds Statement of Financial Position
Non-current assets (Note 1)
Current assets (Note 2)
Total assets
Share capital
Reserves
Equity
Loan
Current liabilities
Total equity and liabilities

000
1,207
564

1,771

100
553

653
600
518

1,771

Note 1: The non-current assets includes a property which has


recently been valued at 1.5m (the NBV of this property is 1m)

79

Business and securities valuation

Note 2: Receivables contain an amount of 120,000 from a large


customer which has just gone into liquidation. A contract for the same
customer, included in work in progress (inventory) at a value of
30,000 will now have to be scrapped.
Required:
Estimate the value of the entire share capital of Ribbon Ltd using
the net assets model, for the purpose of Ray making a bid.
Explain any concerns you have with your valuation.

Business valuation other approaches

Adjusted present value approach

The APV approach to investment appraisal was covered in FM and was


very similar to NPV.
The APV = Base case NPV + PV of the tax shield.
Thus APV of a project is essentially a modified NPV calculation.
Similarly, the APV valuation approach is essentially a modified version
of the discounted FCF approach.
The theory

APV is based on M&M's with tax theory, which states:


The value of the
leveraged firm

The value of the


unleveraged firm

PV of the tax
shield

Hence the company is valued in two parts:


The base case PV (total FCFs discounted at the unleveraged cost of
equity)

The PV of the tax shield (the tax savings on interest discounted at


the pre-tax cost of debt)

Hence APV separates the calculation of the asset values from the
effects of the financing.

The key advantage of APV over a WACC based FCF valuation


approach:

It is better suited to valuing a company where the target capital


structure is expected to change over time

Note: Using a constant WACC (in a based FCF valuation) implicitly


assumes that the gearing of the target company (based on market
values) is to remain constant over time.

80

Chapter 9

Triggers

The requirement may ask you to use the APV valuation method

The discount rate given in the question is the unleveraged cost of


equity

The scenario states that the gearing of the target is going to


change over time

Approach

Estimate the FCFs (using the same approach as for the FCF
method)

Discount estimated FCFs at the unleveraged cost of equity*

Equals the base case PV

Forecast the tax savings on future interest payments on the target


companys debt

Discount these future tax savings at the pre-tax cost of debt (which
reflects the required rate of return of the lenders and thus the risk
associated with these CFs)

Equals the PV of the tax shield

APV = Base case PV + the PV of the tax shield = The enterprise


value (MV of equity + MV of debt)

Less the MV of debt

= MV of equity

*Note: Keu represents the required rate of return of 100% of the


investors, thus discounting total FCFs at this rate gives the enterprise
value (ignoring the benefit of the tax shield).
Test your understanding 9 APV (WH and BMI)

Your client Well Hard plc (WH) is considering purchasing the entire
share capital of Buy Me If You Think Your Hard Enough Ltd (BMI).
BMI is partly financed by a loan and the carrying amount and market
value of this debt are both currently equal to 600k. If the acquisition
goes ahead WH plans to gradually pay off this loan of time with the
cash flows generated by BMI. Therefore gearing will fall over time and
a WACC based FCF valuation will be difficult to apply.
The FD of WH has requested that you value the entire share
capital of BMI using the APV approach. Your valuation should be
based on the following forecast management accounts and
working assumptions.

81

Business and securities valuation

Working assumptions:

All available CFs are to be applied to repaying the debt until it is


fully paid off (this is already reflected in the forecast financial
statements below).

Other working capital is self-financing (increases in stock and


debtors are financed by increases in payables), such that no
incremental investments in working capital are required.

The interest rate on the debt is 8%.

Assume an annual depreciation charge of 210k and actual


capital expenditure of 240k per year. Both these amounts are
expected to remain constant in the future.

The unleveraged cost of equity is 13%.

Assume the current date is 1/1/X1 and that the acquisition would
take place immediately.

Assume profits / CFs will grow at 2% per annum from 31/12/X5


onwards.

The corporation tax rate is currently 24% (and is expected to


remain unchanged in the future).

Forecast management accounts


Income statement

Revenue
Operating
costs
(including
depreciation)
PBIT
Interest
PBT
Tax
PAT

82

Y/E
31/12/X1
k
642

Y/E
31/12/X2
k
655

Y/E
31/12/X3
k
707

Y/E
31/12/X4
k
760

Y/E
31/12/X5
k
775

(389)

(399)

(419)

(440)

(449)

253
(48)
205
(49)
156

256
(38)
218
(52)
166

288
(27)
261
(63)
198

320
(14)
306
(73)
233

326
326
(78)
248

Chapter 9

Statement of financial position

Non-current
assets
Cash
Other
working
capital
Total C.E
Equity
L.T Loans
Total C.E

As at
31/12/X1
k

As at
31/12/X2
k

As at
31/12/X3
k

As at
31/12/X4
k

As at
31/12/X5
k

1,230

1,260

1,290

1,320

1,350

33

251

1,230
756
474
1,230

1,260
922
338
1,260

1,290
1,120
170
1,290

1,353
1,353
1,353

1,601
1,601
1,601

Economic value added (EVA)


Theory

EVA is an estimate of the amount of shareholder value created year by


year. It is conceptually similar to residual income and is calculated as:
Net Operating Profit after Tax (NOPAT) (WACC Capital Employed*)
NOPAT is essentially EBIT (1 T), however in theory the accounting
figures should be adjusted to make them more meaningful (e.g. current
values rather than historic costs, R&D expenditure is capitalised).
*Use the capital employed at the start of the period.
EVA valuation approach

EVA can be used as the basis of a business valuation method as


follows:

Estimate the NOPAT and capital employed for each year in the
future.

Use the NOPAT and capital employed estimates to calculate the


EVA for each year

Discount the EVA figures to present value using the WACC

The PV of future EVAs + the opening invested capital (the book


value of debt plus equity on the valuation date) = Enterprise value

Enterprise value value of debt = MV of equity

Note: The EVA valuation approach can be seen as an alternative way


of presenting the FCF valuation approach and both should give the
same result.

83

Business and securities valuation

Market value added (MVA)

MVA is the present value of the future EVAs of the business (calculated
in Step 3 above).
It shows how much value the management have created, above the
value of the capital invested by the finance providers.
Test your understanding 10 EVA (Mr Hemmingway)

Your client Championship Foods plc (CF) is considering the


acquisition of Mr Hemmingway Ltd (H), who manufacture cakes of
an exceedingly average quality.
Required:
Estimate the value of the entire ordinary share capital of H for
the purpose of CF making a bid. CF has requested that you make
separate estimates using each of the following valuation
methods: (i) EVA approach; and (ii) discounted FCF model. Use
the forecasts and working assumptions provided below.
Current and forecast management accounts
Income statement

Revenue
Operating
costs
PBIT
Interest
PBT
Tax
PAT
Dividend
Retained profit
for the year

84

Y/E
31/12/Y0
k
500

Y/E
31/12/X1
k
530

Y/E
31/12/X2
k
552

Y/E
31/12/X3
k
590

Y/E
31/12/X4
k
635

(300)

(321)

(332)

(357)

(377)

200
(24)
176
(42)
134
-

209
(27)
182
(44)
138
-

220
(30)
190
(46)
144
-

233
(34)
199
(48)
151
-

258
(38)
220
(53)
167
(167)

134

138

144

151

Chapter 9

Statement of financial position


As at
31/12/Y0
k

As at
31/12/X1
k

As at
31/12/X2
k

As at
31/12/X3
k

As at
31/12/X4
k

860

860

860

860

860

140

337

543

750

750

1,000

1,197

1,403

1,610

1,610

700
300

838
359

982
421

1,133
485

1,113
485

1,000

1,197

1,403

1,610

1,610

Non-current
assets
Net working
capital
Capital
employed
Equity
L.T Loans
Capital
employed

Working assumptions:

The gearing of H will remain approximately constant over time

The WACC to be used for your calculations can be assumed to


be 10% per annum

Hs capital expenditure (CAPEX) in cash terms will equate


approximately to historical cost depreciation

Future corporation tax rates will be 24% for all relevant years

The acquisition will take place on the 1 January 20X1

Operating profit from 1 January 20X5 onwards will remain


constant indefinitely at its 20X4 level

Operating cash flows occur at the end of each year

Valuation of debt

Theory

The market value of any investment is PV of future cash flows to the


investor discounted at the investors required rate of return.
Hence for debt:

The current MV = future interest payments plus any capital redemption


discounted at the investors required rate of return (yield to maturity).
Summary of assumed knowledge

Irredeemable debt
P0 =

i
r

Where r = the required rate of return of debt holders


85

Business and securities valuation

Redeemable debt
Time

CF

T1 Tn Interest
Tn
Redemption value

DF @ investors
required rate of return
Annuity factor T1 Tn
Discount factor Tn
Total PV =

PV

CF DF
CF DF
MV

Convertible debt

As for redeemable debt except the redemption value used is the higher
of the conversion value and the cash redemption amount.
Floating rate debt

Floating or variable rate debt is difficult to value using standard DCF


techniques as the future coupon rates are unknown.
The mechanics of floating rate debt:

The coupon rate is reset to reflect prevailing interest rates at each


payment date
e.g. if the interest rate on similar risk assets falls to 3% during the
year, then the coupon rate will be reset to 3% at the next payment
date

The next interest payment is set on the previous payment date


e.g. if the coupon rate is reset to 10% at to, then the t1 interest
payment will be 10 per certificate. However, the t2 interest
payment is uncertain at t0 as it depends on what the coupon rate is
reset to at t1.

Implication: Immediately after the coupon has been reset it will reflect
the opportunity cost of capital and as the coupon rate is applied to
nominal value the bond must be valued at par.
Alternative explanation: The EVA of the bond is zero; the income of
10 per year exactly equals the finance charge per year of 10
(invested capital of 100 the cost of capital of 10%). Thus book value
= market value.

As we know that the market value of a floating rate bond will be 100
(par) on the reset date, the value now can be calculated as:
P0 =

Next coupon + Par value


1 + (r d / 365 )

Where d = number of days until next coupon date

86

Chapter 9

Test your understanding 11 Floating rate debt


Value a floating rate bond, using the following information:

The coupon rate was reset to 10% at the last coupon date. The
interest rate on equivalent risk bonds has just fallen to 9% and is
expected to remain at that level until at least the next coupon date.
The next coupon payment is exactly 9 months away.

87

Business and securities valuation

Chapter summary

Key valuation approaches

88

Net assets

DVM

Discounted earnings

FCF

Chapter 9

Test your understanding answers


Test your understanding 1 Delayed perpetuity

Using the general formula and treating the perpetuity as starting in t4:
CF at the
start of the
perpetuity
CF@t4
4K

PF (with
growth)

PF (with
growth)

DF for the period


before the start of the
perpetuity

PV

DF@t3

PV

1
0.75131 = 42,932
0.1 0.03

Note: The question essentially tells you to treat the perpetuity as


starting in t4; however you could have got the same answer by
starting at t5 and thus using the t5 cash flow and the t4 discount factor
Alternative presentation: (treating the delayed perpetuity as starting
at t5):

4k 1.03

1
0.68301 = 40,200
0.1 0.03

PV of T4 cash flow (not included in the above):


4k 0.68301 = 2,732
PV of whole stream:
40,200 + 2,732 = 42,932

Test your understanding 2 DVM

(a)

Standard perpetuity without growth

P0 =

D0
ke

MV =
(b)

250k
= 1,785,714
0.14

Standard perpetuity with growth


P0 =

D0 (1 + g)
ke g

MV =

250k 1.04
= 2,600,000
0.14 0.04

89

Business and securities valuation

(c)

2 year annuity plus a delayed perpetuity starting at t3:


2 year annuity

CF AF (2 period) = PV of annuity
250k 1.647 = 411,750
Delayed perpetuity starting at t3

CF at the
start of the
perpetuity
CF@t3
250k

PF (with
growth)

PF (with
growth)

DF for the period


before the start of
the perpetuity

PV

DF@t2

PV

1
0.769 = 1,922,500
0.14 0.04

Total present value

PV of delayed perpetuity + PV of annuity = Total PV


411,750 + 1,922,500 = 2,334,250
Alternative presentation: 3 year annuity plus a delayed
perpetuity starting at t4:
2 year annuity

CF AF (3 period) = PV of annuity
250k 2.322 = 580,500
Delayed perpetuity starting at t3

CF at the
start of the
perpetuity

PF (with
growth)

DF for the period


before the start of
the perpetuity

PV

CF@t4

PF (with
growth)

DF@t3

PV

250k 1.04

1
0.675 = 1,755,000
0.14 0.04

Total present value

PV of delayed perpetuity + PV of annuity = Total PV


580,500 + 1,755,000 = 2,335,500
Note: The 1,250 difference in the 2 answers is entirely due to
rounding. If you use the formula to calculate the discount factors
(without rounding) the answer would be 2,335,334 in both
cases.

90

Chapter 9

Test your understanding 3 P/E ratio


Calculation of P/E ratio:

P/E ratio =

Market capitalisation
Total earnings

Market capitalisation = 6.70 10m = 67m


P/E = 67m / 4,752k = 14.1
Market value of TT:

MV = P/E Earnings
= 14.1 500k = 7m
Concerns

The valuation will need to be adjusted downwards to reflect the lack


of marketability in unlisted shares
There are likely to be synergies (cost savings) arising on the
combination e.g. they may be able to share recording facilities. These
have not been reflected in the valuation.
TT appears to be the faster growing company and the valuation
should be adjusted upward to reflect this.
Adjustments may be required to normalise TTs earnings.
Exam tip: It is often more efficient to address any concerns you have
with a valuation in the written part of your answer rather than trying to
adjust your calculations.

Test your understanding 4 QE discounted earnings


Additional depreciation calculation

Assume that the depreciation charge rises in line with asset values.
Hence as the fair value is 30% higher than the book value, the
revised depreciation must be 30% higher than the amount forecast.
Additional depreciation = 500k 0.3 = 150k
Additional directors salaries

Sustainable earnings going forward should reflect the fair market rate
for directors salaries. Hence we need to adjust earnings to reflect the
additional costs:
200k (current directors salaries) 0.5 (percentage increase) =
100k
91

Business and securities valuation

Adjusted earnings

k
520
(150)
(100)
270
(67.5)
202.5

PBT
Additional depreciation
Additional directors salaries
Adjusted PBT
Tax @ 25%
PAT
PV of perpetuity with growth

202.5k

1
= 2,531k
0.12 0.04

Market value of equity = 2.53m


Note: The adjusted PAT of 202.5 is already a T1 figure (it is based
on forecast earnings for next year) hence there is no need to multiply
it by 1+g.

Test your understanding 5 JB discounted earnings


PV of earnings

Y/E 30/6/X2
(Forecast)
T1
k
340
0.893
303.6

PAT
DF@12%
PV

Y/E 30/6/X3
(Forecast)
T2
k
357
0.797
284.5

Y/E 30/6/X4
(Forecast)
T3
k
371
7.97*
2,956.9

Sum of PVs = MV of equity = 3.55m


*Delayed perpetuity factor

PF (with
growth)
PF (with
growth)

DF for the period before the start


of the perpetuity

DF@t2

1
0.797 = 7.97
0.12 0.02

92

Delayed
PF
Delayed
PF

Chapter 9

Test your understanding 6 Bland Burgers FCFs


Estimated FCFs (standard approach)

PBIT
Post tax PBIT ( 0.76)
Add depreciation
Less CAPEX
Adjusted Profit / Estimated FCF

3m
2.28m
0.5m
(0.6m)
2.18m

Note: In this scenario profits / CFs are constant for until T4 and then
start to grow from T4 onwards. You can treat this either as a:

3 year annuity and a delayed perpetuity starting in T4, or

4 year annuity and a delayed perpetuity starting in T5

Both approaches will give the same result.


3 year annuity and a delayed perpetuity starting at T4
PV of the 3 year annuity

2.18m 2.487 = 5.42m


PV of delayed perpetuity starting at T4

CF at the
start of the
perpetuity

PF (with
growth)

DF for the period


before the start of
the perpetuity

PV

CF@t4

PF (with
growth)

DF@t3

PV

2.18m

1
0.751 = 20.46m
0.1 0.02

MV of Equity & Debt = 5.42 + 20.46 = 25.88m

Less MV of debt: 25.88m 7m


= MV of Equity = 18.88m
4 year annuity and a delayed perpetuity starting at T5
PV of the 4 year annuity

2.18m 3.17 = 6.91m

93

Business and securities valuation

PV of Delayed perpetuity starting at T4

CF at the
start of the
perpetuity
CF@t5

PF (with
growth)

PF (with
growth)

2.18m 1.02

DF for the period


before the start of
the perpetuity

PV

DF@t4

PV

1
0.683 = 18.98m
0.1 0.02

MV of Equity & Debt = 6.91 + 18.98 = 25.89m

Less MV of debt: 25.89m 7m


= MV of Equity = 18.89m

Test your understanding 7 FCF (Chassagne and Butler)

m
Sales ( 1.03 1.05)
Cost of sales ( 1.05)
Gross profit
Operating expenses
Operating profit (EBIT)
Less: Tax (23%)
Add: Depn
Less: CAPEX
Less: WC investment
Free Cash Flow

Discount factors (12%)


Present value

Year 1
308.3
(126.9)

181.4
(66.9)

114.5
(26.3)
12.3
(15.0)
(2.0)

83.5

0.893
74.6

Year 2
333.5
(133.3)

200.2
(66.9)

133.3
(30.7)
12.3
(15.0)
(2.0)

97.9

0.797
78.0

Year 3 etc
360.6
(140.0)

220.6
(66.9)

153.7
(35.4)
12.3
(15.0)
(2.0)

113.6

6.642
754.5

Total PV = 907.1m (= value of equity and debt)

Therefore, value of equity = 907.1m 200m = 707.1m


*Adjusted PF

PF

PF

DF for the period before


the start of the perpetuity
DF@t2

1
0.797 = 6.642
0.12
94

Delayed PF

Delayed PF

Chapter 9

Test your understanding 8 Net assets (Ray and Ribbon)


Adjusted Net Assets of Ribbon

NBV of equity
Property uplift
Current asset write downs (120k + 30k)
Adjusted Net Assets

k
653
500
(150)
1,003

This suggests Ribbon should be valued at 1m


Concerns

This valuation assumes the carrying amount of the loan is equal to


fair value. This may not be the case if the amortised cost method is
being used.
The valuation is highly dependent on the fair value of property, which
is presumably a subjective estimate. Ray should obtain independent
valuations before finalising their bid.
The value of some intangibles may not be included on the SFP.

Test your understanding 9 APV (WH and BMI)


Base case PV

PBIT
Post tax
( 0.76)
Add back
depreciation
Less actual
CAPEX
FCF
DF@13%
PV

T1
31/12/X1
k
253

T2
31/12/X2
k
256

T3
31/12/X3
k
288

T4
31/12/X4
k
320

T5-
31/12/X5
k
326

192

195

219

243

248

210

210

210

210

210

(240)

(240)

(240)

(240)

(240)

162
0.885
143.4

165
0.783
129.2

189
0.693
131.0

213
0.613
130.6

218
5.573*
1,214.9

Base case PV = 1,749.1k


*Delayed PF

1
0.613 = 5.573
0.13 0.02

95

Business and securities valuation

PV of the tax shield

Interest per P&L


Tax saving
@ 24%
DF @ 8%
PV

T1
48

T2
38

T3
27

T4
14

11.5

9.1

6.5

3.4

0.926
10.6

0.857
7.8

0.794
5.2

0.735
2.5

PV of the tax shield = 26.1k


APV

Base case PV + PV of tax shield = APV = Enterprise value


1,749.1k + 26.1k = 1,775.2k
Enterprise value (MV of equity + MV of debt) MV of debt =
MV of equity
MV of equity = 1,775.2k 600k = 1,175.2k

Test your understanding 10 EVA (Mr Hemmingway)


PV of EVA approach
T1
31/12/X1
k
Total capital at the start
of the year (memo)
PBIT
Post tax ( 0.76) =
NOPAT
Capital charge
(0.1 capital at the start
of the year)
EVA
DF@10%
PV of EVA

T2
31/12/X2
k

T3
31/12/X3
k

T4-
31/12/X5
k

1,000

1,197

1,403

1,610

209

220

233

258

159

167

177

196

(100)

(119.7)

(140.3)

(161)

59
0.909
(53.6)

47.3
0.826
(39.1)

36.7
0.751
(27.6)

35
7.51*
262.9

Total PV of EVA= MVA = 383k

Enterprise value = Opening capital + MVA


Enterprise value = 1,000k + 383k = 1,383k

MV of equity = Enterprise value value of debt (assume book value =


market value)
MV of equity = 1,383k 300k = 1,083k

96

Chapter 9

Discounted FCF approach

PBIT
Post tax ( 0.76)
Incremental working
capital
FCF
DF@10%
PV

T1
31/12/X1
k
209
159

T2
31/12/X2
k
220
167

T3
31/12/X3
k
233
177

(197)

(206)

(207)

(38)
0.909
(34.5)

(39)
0.826
(32.2)

(30)
0.751
(22.5)

T4-
31/12/X5
k
258
196
196
7.51*
1,472

Total PV = Enterprise value = 1,383k

MV of equity = Enterprise value value of debt (assume book value =


market value)
MV of equity = 1,383k 300k = 1,083k
* Delayed PF

1
0.751 = 7.51
10%

Test your understanding 11 Floating rate debt

P0 =

Next coupon + Par value


1 + (r d / 365 )

P0 =

10 + 100
1 + (0.09 3 / 4)

P0 = 103.04

The MV now is greater than nominal value, partly due to accrued


interest and partly due to the next coupon being greater than the
opportunity cost of capital.

97

Business and securities valuation

98

Chapter

10

Investment appraisal
Chapter learning objectives

Select and advise on investment appraisal techniques which are


appropriate for the scenario.

Select and advise on appropriate measures of return and risk for


assessing business projects.

Demonstrate and evaluate investment appraisal techniques for


international projects (identifying tax and corporate reporting
impacts).

Appraise and evaluate the quantitative issues surrounding


international investment appraisal.

Explain and appraise real options and determine the impact of


options to abandon, expand, delay and redeploy.

Evaluate the impact of externalities when making investment


appraisal decisions.

Identify social responsibility, sustainability and environmental


consequences of investment decisions, explaining corporate
reporting issues in relation to such policies.

99

Investment appraisal

Introduction

NPV is still very examinable at this level, particularly:

Foreign NPV

Relatively simple NPVs as part of a wider strategy choice question

Summary of assumed knowledge

Discounting
1

Single cash flow (occurring at tn):

r
1

F
D

Present Value (PV) = cash flow at tn discount factor (DF)

Or use tables
)
Annuity cash flow:
Annuity: A constant annual cash flow occurring for a set number of
years.
PV = constant annual CF annuity factor (AF)
1

1
1 r

Ft
A

n
t
1

=
n
(1 + r )

Or use tables
3

Perpetuity cash flow:


Perpetuity: A constant annual cash flow occurring forever.
1r
F
P

PV = constant annual CF perpetuity factor (PF)


=

Perpetuity with growth: An annual cash flow occurring forever and


growing at a constant rate.
PV = CF at t1 PF (with growth)
PF (with growth) =

1
r g

Note: All the perpetuity and annuity formulas assume the first cash flow
occurs at t1.

100

Chapter 10

Net Present Value (NPV)


NPV = PV of future cash flows associated with a project
Decision rule:

Accept if NPV >0, as NPV = change in wealth for the investor

More detail on NPV can be found in the FM appendix.


Exam style NPV question
Test your understanding 1 Blaize plc
Blaize plc is a listed manufacturer of hi-fi speakers. The company was
founded 20 years ago and after several years of impressive growth in
sales and profits, it was listed on the London Stock Exchange 4 years
ago. The company produces a single product, the B100, which has
won several design awards over the years and has traditionally been
seen as a high quality, expensive luxury item. Blaize plc sells the
B100 to 7 major retail outlets, based solely in the UK, at a selling
price of 600 (a mark up of 100% on variable cost).
Unfortunately, over the last 4 years, the many technological
developments in the industry have left the B100 looking quite outdated and over-priced. The share price of Blaize plc has been falling
as sales have levelled out at about 90,000 B100s per annum.
The board of directors met last week to discuss an appropriate
response to the lack of growth in the business. Two alternative
strategies emerged from these discussions. The board believes that it
would be possible to adopt only one strategy.
Strategy 1:
Purchase equipment to adapt an existing production line, which is
currently unused. This equipment will be used to make a new speaker
system (the B80), whose variable cost will be 30% less than the
B100s, and whose selling price will be approximately 450. The
Blaize plc marketing director believes that about 60,000 of these B80
speaker systems could be sold annually in the UK. These would be
spread over the 7 existing retail customers. The new plant for the
assembly line would have an initial cost of 10 million and a useful life
of four years. Due to the specialist nature of this plant, a 100% first
year capital allowance would be available.
Production would commence on 1 January 20X0. The existing B100
speakers would continue to be sold to the existing customers at a
price of 600 each.

101

Investment appraisal

Strategy 2:
Negotiations with a Veravanian hi-fi retailer, SSS, have resulted in the
possibility of a 4-year contract from 1 January 20X0 to deliver a
minimum of 75,000 B100s per annum.
The contract may be renewed after four years, but would be subject
to renegotiation. The price would be denominated in Veravanian
dollars (V$) and would be fixed over the four-year period at V$750 per
unit which, at the current exchange rate, is equivalent to 550. The
marketing director believes that it would be necessary to reduce the
price charged to the existing customers to the same sterling
equivalent price as that offered to SSS if this contract went ahead.
Spare capacity in the existing factory means that no additional fixed
costs would be incurred.
Working assumptions:
The corporate tax rate is 23%
Blaize plc has a weighted average cost of capital of 10%
For the purpose of calculations assume that the Veravanian dollar /
Sterling exchange remains constant over the four-year period
Required:
Evaluate the benefits and risks of the two proposed strategies
for expansion. Advise which strategy you would recommend,
showing any supporting calculations.
Internal Rate of Return (IRR)
You are unlikely to be requested to use IRR as an investment appraisal
technique in the exam.
However, it has historically been a common calculation at the advanced
stage as part of a financing question.
Definition
The IRR is the discount rate which gives an NPV=0.
Alternatively:
The IRR is the annualised rate of return implicit in the project cash
flows.
Decision rule:
Accept projects if IRR > cost of capital

102

Chapter 10

Calculation
The true IRR can be calculated using a spreadsheet or specialist
calculator.
However, in the exam we will estimate the IRR using the estimation
formula (linear interpolation).
IRR approach

Calculate 2 NPVs (ideally one positive NPV and one negative


NPV)
Hint: If unsure which discount rates to use calculate one NPV
using a low discount rate (say 1%) and one using a high discount
rate (say 20%)
Apply the IRR estimation formula:

ra

rb

ra
R
R
I

Vb
P
VaN
P
N Va
P
N

Where r represents the discount rate chosen.


NPV
Estimated IRR

Na

Nb

rb

ra

Discount rate

A useful shortcut can be used for perpetuity projects i.e. an initial


investment followed by a simple perpetuity of returns:
IRR = Annual CF / initial investment

103

Investment appraisal

Test your understanding 2 IRR


A company is considering the following investment project:
Net cash flow

Year 0
(12,000)

Year 1
5,669

Year 2
4,050

Year 3
5,500

Required:
Calculate an estimate of the IRR of the project.
Problems with IRR

A project can have no IRR, or multiple IRRs

Ranking projects according to which has the highest IRR can give
a different ranking to NPV

The IRR only represents the return from a project if funds can be
reinvested at the IRR*

*It is not intuitively obvious that the standard IRR calculation assumes
project inflows are reinvested at the IRR. Hence the following example
demonstrates that this is the case:
Reinvestment rate example
Take the following simple project, which has an IRR of 10%:

CFs

To

T1

T2

(100)

10

110

Annualised rate of return

n
/
1

t
n
e
m
t
s
e
v
n
i
l
a
i
t
i
n
I

n
r
u
t
e
r
f
o
e
t
a
r
d
e
s
i
l
a
u
n
n
A
1
+

t
c
e
j
o
r
p
f
o
d
n
e
t
a
h
s
a
C

We can calculate the annualised rate of return for a simple investment


project using the following formula:
)

Cash at the end of the project assuming inflows can be reinvested at


the IRR:
T1 CF reinvested for 1 period at the IRR of 10%
(10 1.1)

104

11

T2 CF

110

Total cash at T2

121

Chapter 10

Annualised rate of return:


(

1
.
1

2
/
1

1
2 0
1 0
1

n
r
u
t
e
r
f
o
e
t
a
r
d
e
s
i
l
a
u
n
n
A
1

Hence annualised rate of return on the project equals 10%, which


equals the IRR.
Assuming the inflows are not reinvested
Cash at the end of the project assuming inflows are not reinvested:
T1 CF (kept under a mattress for one period)

10

T2 CF

110

Total cash at T2

120

Annualised rate of return


(

5
9
0
.
1

2
/
1

0
2 0
1 0
1

n
r
u
t
e
r
f
o
e
t
a
r
d
e
s
i
l
a
u
n
n
A
1

Hence, if we dont assume project inflows can be reinvested at the IRR


(10%) the annualised rate of return (9.5%) does not equal the IRR.

Modified Internal Rate of Return (MIRR)

A modified version of IRR which assumes the reinvestment rate is the


cost of capital rather than IRR.
It overcomes the 3 key problems we identified with the IRR above.
Calculation

s
w
o
l
f
t
u
o
l
a
u
n
n
a
t
e
n
f
o
V
P

n
/
1

s
w
o
l
f
n
i
l
a
u
n
n
a
t
e
n
f
o
e
u
l
a
v
l
a
n
i
m
r
e
T

R
R
I
M
1
+

Approach

Take net annual inflows and multiply each one by the relevant
compounding factor (based on the cost of capital) to obtain the
TVs

Sum the TVs

Take the net annual outflows and multiply each one by the
relevant discount factor (based on the cost of capital) to obtain the
PVs

Sum the PVs

Apply the MIRR formula above


105

Investment appraisal

Test your understanding 3 MIRR


The following cash flows are relevant for a project:
Year 0
Sales
Operating costs
Tax
Capex
Net cash flow

(10,000)

(10,000)

Year 1
25,000
(20,000)
(1,300)
(10,000)

(6,300)

Year 2
30,000
(25,000)
(1,300)

Year 3
45,000
(30,000)
(3,900)

Year 4
45,000
(30,000)
(3,900)

3,700

11,100

11,100

Required:
Calculate the MIRR of the project at a discount rate of 10%.

Real options

Key concept
Flexibility (due to choices implicit in the project) has value.
Conventional valuation techniques tend to undervalue projects as they
ignore this flexibility (real options). These can be valued and
incorporated separately.
Hence:
Traditional NPV + Value of real options = Total project value
The main types of real options are:

Option to delay The right but not the obligation to delay starting
the project until a later date (effectively a call option)

Option to expand The right but not the obligation to make further
investments which are enabled by the original project (effectively a
call option)

Option to abandon The right but not the obligation to sell the
projects underlying assets (effectively a put option)

Option to redeploy The right but not the obligation to abandon


the current project and use the underlying assets on another
project
or
The right but not the obligation to use different inputs for the
current project

106

Chapter 10

Foreign investment appraisal

When appraising investments which are denominated in foreign


currency, the standard NPV method needs to be adapted. There are
two alternative approaches to working out the NPV of a foreign project:
1

Convert foreign cash flows into the home currency, then discount
using the firms normal cost of capital.

Leave the cash flows in foreign currency and discount using a


foreign (adjusted) cost of capital. Then translate back into the
home currency at the current spot rate.

r
1

d
e
t
s
u
j
d

ra
1
+

e tt
et
t
a
a
r
r
X X
F F

This foreign (adjusted) cost of capital can be found using the


International Fisher Effect equation:

( +

Interpreting exchange rate information


Expect the examiner to give you the exchange rate information in the
following format (as this will enable either method to be used):
The current exchange rate is $1.3/ and the is expected to
depreciate at 10% per year.
Note: As in FM you can expect the examiner to quote rates in terms of
F.C. / (this is the normal convention in the UK).
Calculating future exchange rates:
This means the buys 10% less $s each year, so the T1 rate =
$1.3/ 0.9 = $1.17/
If the foreign currency is appreciating or depreciating
If the question says The current exchange rate is $1.3/ and $ is
expected to appreciate against the at 10% per year.
This means each year the $ will buy 10% more s each year.
If the $ is appreciating at 10% a year, is roughly equivalent to the
depreciating at 10% a year, therefore it is permissible use the same
approach as above:
$1.3/ 0.9 = $1.17/

107

Investment appraisal

Alternative approach (foreign currency appreciating /


depreciating):
Rate is currently $1.3/, so each $ is worth 76.9p (1/1.3) now.
Next year one $ will buy 10% more, so is worth (0.769/$ 1.1) =
0.846/$
Equivalent rate in F.C. / = 1/0.846 = $1.18/
Note: The same result could be calculated as:
$1.3/ 1.1 = $1.18/
This alternative approach is technically more accurate but either
approach would get full credit in the exam.
Foreign NPV exam question approach
Method 1 is generally more flexible as it can:

Deal with exchange rates which are not changing at a constant


rate

Be adapted more easily to incorporate additional UK cash flows

However method 2 may be preferable in some circumstances (e.g.


where the foreign cash flows are a long annuity)
Method 1 approach

Prepare a standard NPV schedule for foreign currency CFs


(including any F.C. tax)

Calculate FX rates for each year (as above)

Use the calculated FX rates to translate the net flows into s

Add in any additional CFs

Discount net flows at the UK discount rate (normally cost of


capital)

Method 2 approach
Prepare a standard NPV schedule for foreign currency CFs
(including any F.C. tax)

Calculate the FX rate for T1 if not given (as above)

Calculate the adjusted discount rate, using the following formula to


adjust the UK discount rate using the T0 and T1 FX rates

108

r
1

d
e
t
s
u
j
d

ra
1
+

e tt
et
t
a
a
r
r
X X
F F

( +

Chapter 10

Discount the net FC flows at the adjusted discount rate

Convert the PV to s using the current spot rate

Add in the PV of any additional cash flows discounted at the


standard UK cost of capital

Test your understanding 4 Foreign NPV


Bromwich plc is a UK based manufacturer of bicycles. The UK market
for bicycles is dominated by 3 large multinational firms and Bromwich
plc has seen its sales fall over the last two years as a price war has
developed between the main competitors.
The directors are considering a new strategy which would see
Bromwich plc expanding into the huge European bicycle market.
They are considering undertaking a new investment project in
Portugal. This will require initial capital expenditure of 1,250m, with
no scrap value after its five year life. There will also be an initial
working capital requirement of 500m, which will be recovered at the
end of the project. Pre-tax net operating cash inflows of 800m are
expected to be generated each year from the project.
Corporate tax will be paid in Portugal at a rate of 40%, with straight
line depreciation being an allowable deduction for tax purposes. The
tax will be paid at the end of the year in which the taxable profit arose.
Due to a double taxation agreement, no further UK tax will be
payable.
The current spot rate is 1.60 = 1, and the euro is expected to
appreciate against the pound by 5% per year.
A project of similar risk recently undertaken by Bromwich plc in the
UK had a required post-tax rate of return of 10%.
Required:
Evaluate the foreign investment strategy, showing all supporting
calculations.

109

Investment appraisal

Possible further complications in foreign NPV


Double taxation
Under a double taxation agreement a UK company will only pay UK tax
on foreign income to the extent that the UK tax rate exceeds the foreign
tax rate. Hence:

If the foreign tax rate is higher than the UK rate:

The company will simply pay foreign tax on the foreign


income

No additional tax on that income will be payable in the UK

If the UK tax rate is higher than the foreign rate:

The company will pay foreign tax on the foreign income

Plus extra tax will be payable in the UK on the same income


(UK tax payable: Foreign income (UK rate foreign rate)

Subsidies
The benefit of any foreign subsidies should be included in the NPV
calculation
Exchange restrictions
Any CFs that can't be repatriated to the UK should be not be included in
the NPV calculation

Externalities and social responsibilities

The wider environmental impact of a project should be considered when


a company decides whether to proceed.
If a company does proceed with a project that results in some negative
environmental impact, it should consider the need to provide for the
cleanup costs under IAS 37.

110

Chapter 10

Chapter summary

Key topics

Discounting techniques are highly likely to feature in the exam

NPV with strategic discussion

Foreign NPV

111

Investment appraisal

Test your understanding answers


Test your understanding 1 Blaize plc
Benefits and risks of the two proposed strategies
Strategy 1
Benefits
Strategy 1 creates significant additional sales which generate a large
positive contribution per unit of 240, compared to a selling price of
only 450. Sales volumes of 60,000 per annum are also significant,
compared to existing annual sales volumes of only 90,000 units.
These favourable figures are reflected in the profitability and NPV of
Strategy 1.
In terms of NPVs, (see working 1 below) Strategy 1 generates an
NPV of around 27 million, which is significantly positive.
While the B80 is not identical to the B100 it is of the same product
type and will draw upon existing core competences in both production
and marketing terms. It will also allow common processes and
procedures to be used, as indicated by the fact that there are no
incremental fixed costs to be incurred with Strategy 1 according to the
working assumptions.
In time, there may be economies of scale from the increased
production which may reduce variable cost per unit although the
current working assumptions do not suggest this.
It is assumed that the new sales generate revenues in the same
currency as most costs are being incurred ( sterling) so exchange
rate risk is reduced.
Risks
The strategy requires significant additional investment in plant of 10
million. If the strategy fails, then it may be difficult and costly to exit
from this project as most of the cost is likely to be sunk. This may
affect the viability of the business.
The sales forecasts relate to a product in new price-quality space in
terms of market positioning. The degree of confidence in these
estimates is likely to be low (unless contracts are already in position)
as sales have not yet commenced. Given the large initial outlay, then
profits and NPV may be sensitive to changes in sales.
The new strategy is likely to be higher risk than the existing strategy
and thus it may be inappropriate to use the existing WACC to obtain
the NPV. Nevertheless, any reasonable rate would provide a positive
NPV.

112

Chapter 10

The B80 is lower quality than the B100 and so there may be a risk of
damage to the company's reputation as an up-market manufacturer.
The ultimate customers may choose to buy the new, cheaper B80
rather than the existing high quality B100, thus reducing sales
revenue and profit.
Strategy 2
Benefits
In common with Strategy 1, Strategy 2 creates significant additional
sales which generate a large positive contribution per unit of 250,
compared to a selling price of 550. However, Strategy 2 generates
75,000 units of sales volume compared to Strategy 1 which has only
60,000 per annum. These figures are reflected in the NPV of Strategy
2.
Unlike Strategy 1, once the contract is signed there is some degree of
assurance about future sales. At present however there seems little
guarantee about the amount and variability of sales under Strategy 1
which need to be established and maintained.
In terms of NPVs, (see working 2 below) Strategy 2 generates an
NPV of around 34 million, which is significantly positive and higher
than Strategy 1 (ignoring the PV of any residual value with Strategy
1).
Reputation is protected by continuing to produce only high-quality
B100s.
There is no initial outlay with Strategy 2 thus, if the contract fails, the
exit costs are likely to be low (in contrast to Strategy 1).
Risks
A key risk with Strategy 2 is currency risk. The contract with SSS is
denominated in Veravanian dollars and hence if the exchange rate
varies the sterling value will vary. This is fixed over the four year
period, hence the scope for change is substantial. While a substantial
change in the exchange rate would be needed to generate a negative
NPV, only a relatively small adverse movement in exchange rates
would mean that Strategy 2 could become inferior to Strategy 1. To
manage this risk it would be desirable to hedge the V$ forward it will
be critical to review forward rates, as this will be a factor in
determining just how profitable this strategy will be given that prices
are fixed for 4 years.
However there may still be currency exposure, as hedging forward for
four years is unlikely to be possible.

113

Investment appraisal

The lower price for SSS of 550 per unit has meant that all existing
sales prices have needed to be reduced from 600 to 550. If the
SSS contract is terminated then there is a risk that the price to other
customers cannot be restored to previous levels. There may thus be a
permanent cost as a consequence of a temporary benefit.
The contract term is only four years with no guarantee of renewal
thereafter. While the life of the plant is four years in Strategy 1 there is
no suggestion that sales will not continue well beyond that period. A
key risk compared to Strategy 1 is therefore that the contract with
SSS may be terminated or renegotiated unfavourably after four years.
Strategy 2 is dependent on one customer, while Strategy 1 is
diversified with seven customers.
Recommendation
Strategy 2 has the higher positive NPV and requires no initial outlay,
so appears to be the more attractive project. As long as the exchange
rate risk on the project can be managed effectively, I recommend that
Strategy 2 should be undertaken.
Working 1 NPV of Strategy 1
Annual sales of the B80 = 60,000 450 = 27m
Annual variable costs for the B80 = (600/2) 70% 60,000 =
12.6m
i.e. net annual contribution = (27m 12.6m) = 14.4m (240 per
item)
Annual net of tax contribution = 14.4m (1-0.23) = 11.088m
Capital allowance tax relief = 10m 100% 23% = 2.3m assume
in year 1
Therefore, NPV = -10m + (2.3m DF1 @ 10%) + (11.088m
AF1-4 @ 10%)
=-10m + (2.3 0.909) + (11.088 3.170)
= 27.2m
Note: In evaluating Strategy 1 we have ignored the potential residual
value of the investment, and assumed that there will be no
incremental fixed costs. Without further information it is impossible to
say whether these items would impact the NPV here.

114

Chapter 10

Working 2 NPV of Strategy 2


Annual sales of the B100 = 75,000 550 = 41.25m
(assuming that the exchange rate stays constant).
Annual variable costs for the B100 = (600/2) 75,000 = 22.5m
(assuming the costs are the same as for the existing B100s).
Lost revenue on existing sales of B100 each year = 90,000 50 =
4.5m
i.e. net annual contribution = (41.25m 22.5m 4.5m) = 14.25m
Annual net of tax contribution = 14.25m (1-0.23) = 10.973m
Therefore, NPV = 10.973m AF1-4 @ 10%
=10.973 3.170
= 34.8m

Test your understanding 2 IRR


Stage 1 Calculate 2 NPVs (one using a low discount rate and one
using a high discount rate):
NPV 1 (using a 1% discount rate)

Net CFs

To

T1

T2

T3

(12,000)

5,669

4,050

5,500

0.990

0.980

0.971

(12,000)

5,612.3

3,969

5,340.5

DFs @ 1%
PVs
NPV = 2,921.8

NPV 2 (using a 20% discount rate)

Net CFs

To

T1

T2

T3

(12,000)

5,669

4,050

5,500

0.833

0.694

0.579

(12,000)

4,722.3

2,810.7

3,184.5

DFs @ 20%
PVs

NPV = (1,282.5)

115

Investment appraisal

Stage 2 apply the IRR estimation formula


(

ra

rb

Vb
P
V aN
P
N Va
P
N

ra

R
R
I

2,921.8
(20% 1%)
IRR = 1% +
2,921.8 (1,282.5)

IRR = 14.2%
Note: The true IRR is actually 13% (calculated using a spreadsheet)
If we had used more accurate guesses of 10% (NPV = 629) and
15% (NPV = (387.2) would have got a better estimate of 13.1%,
which is much closer to the true IRR.
However, in the exam you will get full credit for using an appropriate
method and using 1% and 20% will get the same number of marks as
using more accurate guesses.

Test your understanding 3 MIRR


PV of outflows = 10,000 + (6,300/1.10) = 15,727
TV of inflows = (3,700 1.102)+ (11,100 1.10) + 11,100 = 27,787

%
3
.
5
1
1

4
1

116

7
2
7
,
5
1
7
8
7
,
7
2

MIRR =

Chapter 10

Test your understanding 4 Foreign NPV


Method 1
All figures in
T0
millions
Operating flows
Operating
flows
Tax @ 40%
Asset flows
Purchase
(1,250)
Scrap
Tax saving on
depreciation
(1,250/5 0.4)
Working capital
Incremental WC
(500)
Net flows
(1,750)
FX rates (W1)
1.6
Net flows
(1,093.75)
DF @ 10%
1
PVs
(1,093.75)

T1

T2

T3

T4

T5

800

800

800

800

800

(320)

(320)

(320)

(320)

(320)

100

580
1.52
381.58
0.909
346.86

100

580
1.44
402.78
0.826
332.7

100

580
1.372
422.74
0.751
317.48

100

100

580
1.303
445.13
0.683
304.02

500
1,080
1.238
872.37
0.621
541.74

NPV = 749.05m
W1: FX rates
The Euro appreciating against the by 5% per year, is roughly
equivalent to the depreciating by 5% a year.
Therefore:
T1 rate: 1.6/ 0.95 = 1.52
T2 rate: 1.6/ 0.952 = 1.44
T3 rate: 1.6/ 0.953 = 1.372
T4 rate: 1.6/ 0.954 = 1.303
T5 rate: 1.6/ 0.955 = 1.238
Note: The alternative method of calculating the exchange rates would
give:
T1 rate: 1.6/1.05 = 1.524
T2 rate: 1.6/1.052 = 1.451
T3 rate: 1.6/1.053 = 1.382
T4 rate: 1.6/1.054 = 1.316
T5 rate: 1.6/1.055 = 1.254
Thus this more accurate approach would give a notably different
answer (particularly in the 5th year) but no additional credit would be
given.
117

Investment appraisal

Method 2

5
4
0
.
1
1
.
1
2 6
5 .
.
1
1

d
e
t
s
u
j
d

ra
1
+

r
1

d
e
t
s
u
j
d

ra
1
+

e tt
et
t
a
a
r
r
X X
F F

Adjusted discount rate:


( +

Therefore adjusted r = 4.5%


All figures in
millions
Net flows
(from above)
DF @ 4.5%
(W2)
PVs

T0

T1

T2

T3

T4

T5

(1,750)

580

580

580

580

1,080

0.957

0.916

0.876

0.839

0.802

(1,750)

555.06

531.28

508.08

486.62

866.16

NPV = 1,197.5m
Translate at spot rate:
NPV = 1,197.5m/1.6 = 748.25m
The difference between the NPVs calculated using the two different
methods is due to rounding only.
W2: DFs
T1: 1/1.045 = 0.957
T2: 1/1.0452 = 0.916
T3: 1/1.0453 = 0.876
T4: 1/1.0454 = 0.839
T5: 1/1.0455 = 0.802

118

Chapter

11

Finance awareness
Chapter learning objectives

Explain how past financial crises may impact on approaches to


financial risks and may inform corporate reporting practice.

Assess and explain current and emerging issues in finance.

119

Finance awareness

Introduction

The examiners will expect you to have an understanding of current


issues and new developments in finance.

Summary of the Eurozone crisis

The examiners are unlikely to expect you to regurgitate this summary of


the Eurozone crisis; however an understanding of this and other current
issues will help you interpret scenarios.
Background
One of the key disadvantages of the single currency is the individual
countries have effectively lost control over monetary policy.
In particular, members of the Eurozone cannot

let their currencies devalue which can help a country restore


competitiveness after an economic shock;

control interest rates without discretion over interest rates,


countries have limited options to stimulate the economy in a
recession (or dampen demand in a boom).

The European sovereign debt crisis


Membership of the Euro meant that the ClubMed countries (Italy, Spain,
Portugal and Greece) were able to borrow more cheaply than before.
Essentially, their credit ratings were improved by association with
Germany's strong credit rating.
These countries (amongst many others in Europe) took advantage of
the relatively cheap credit and borrowed extensively in the boom years
leading up to 2007.
Then the financial crisis hit in 2007 and economic activity contracted
reducing tax revenues for governments across Europe.
Given their reduced tax income, the debt levels of Portugal, Italy and
Greece started to appear unsustainable.
As a result, the spreads on government bonds issued by these
countries started to widen. Thus the cost of borrowing rose when they
were least able to afford it.
Greek default
As the economy contracted Greece's debt as a percentage of GDP rose
sharply.
Borrowing costs continued to rise despite austerity measures and
eventually Greece had to seek IMF/EU assistance in 2010.
120

Chapter 11

This assistance was not enough and eventually a 130bn bail-out


package (which involved forgiving approximately half or Greece's debt)
was agreed.
Arguably, Greece's default could have been avoided if it had the
freedom to devalue its currency, but it had no such freedom within the
constraints of the Euro.
Portugal and Ireland also sought IMF/EU assistance in 2010-11.
Financial contagion
The initial problems encountered in Greece and Portugal spread
throughout Europe as confidence fell in other European economies.
This spread occurred for a number of reasons including:

Severe recession and austerity measures in the ClubMed


countries (and Ireland) led to reduced trading with other member
states, reducing economic activity across Europe

Concerns about which other banks were exposed to risky


sovereign debt, made banks reluctant to lend to each other

Other current issues in finance

Lending to small businesses


The banking crisis has led to increased banking regulations. As a result,
UK banks now need to hold significantly higher reserve ratios than
before the crisis.
This means less money is available for lending and small businesses in
particular have struggled to gain access to bank finance.
Dark pool trading
Dark pools are private forums for trading securities.
Therefore, dark pool trades:

Take place outside of regulated exchanges

Are conducted anonymously to avoid influencing securities prices

Are not made public until after the trades have been completed

The majority of dark pool trades are between large financial institutions.
Key advantage:
Large institutions can trade large blocks of securities without revealing
their intentions or creating a price impact.
121

Finance awareness

Key disadvantage:
Reduced transparency (as trades are not made public until afterward),
which may compromise market efficiency.

Keeping abreast of current issues

As the exam scenarios may involve current issues in finance we


recommend that you read the financial headlines on a regular basis.

122

Chapter

12

Financing
Chapter learning objectives

Assess and explain types of finance and derivative securities and


evaluate the implications for disclosure, presentation, recognition
and measurement.

Analyse and evaluate the cost of equity, portfolio theory and the
use of appropriate asset pricing models.

Appraise and explain the characteristics of financial markets.

Explain and appraise bond valuation techniques and assess bond


yields.

Explain and appraise yield curves, sensitivity to yield and


components of the yield.

Appraise and evaluate credit risk and credit spread.

Advise and develop proposals for determining the appropriate


financing mix for new projects.

Explain and advise on issues relating to the cost of capital.

Appraise and explain how the choice of finance impacts on


reported corporate performance.

Show and explain how dividend policy impacts upon equity value
and upon financing and investment decisions.
123

Financing

Chapter learning objectives (continued)

124

Show and explain how financial reconstruction takes place,


evaluate the given proposals and explain the consequences for
corporate reporting and the role of assurance procedures.

Explain the different reasons for refinancing and demonstrate how


companies in financial distress can be managed, having regard to
insolvency law.

Explain and appraise the workings and the reasons for


securitisation and leveraged buy-outs, showing the impact on
financial statements.

Explain, appraise and evaluate the various forms of


reconstruction.

Explain and demonstrate appropriate valuation techniques in the


context of demergers and for disposal of entities and show the
impact on corporate reporting.

Appraise and evaluate the various methods of financing available


to small and medium sized enterprises and explain the nature and
role of assurance.

Chapter 12

Introduction

The financing decision is very closely related to the investment


decision.
For example, even if a new investment project is very attractive and has
a positive NPV, the business will not be able to undertake the project
unless suitable financing can be sourced.
When raising finance to fund a new investment project, the key decision
is whether to use equity or debt finance.

Equity financing options

Equity finance is sometimes known as share capital. The shareholders,


or equity holders, own the company and receive dividends (at the
discretion of the directors).
Equity financing options for a new project include:

Rights issues issuing shares to the existing shareholders in


proportion to their existing holdings

Public issues (only for listed companies) issuing new shares to


the public via the Stock Market

Public issues can be performed on various markets such as:

London Stock Exchange (LSE) if the company has an


expected market value of shares to be 700,000

Alternative Investment Market (AIM) which has fewer


regulations than the LSE and has no minimum market value

PLUS stock exchange (now renamed ISDX) to allow member


firms to deal in the securities of unlisted companies

International stock exchanges

Placings issuing shares to a new investor

Retained earnings the retained earnings in the Statement of


Financial Position represent the amount of profit generated by the
business. However, this is not the same as cash. Unless the
business has sufficient cash reserves, this is not an appropriate
financing option. For companies this is the most important source
of finance

When considering equity as a financing option it is important to think


about the future impact to the share price and whether this will restrict
the availability of finance. If the amount of finance cannot be raised then
further shares may need to be sold at a discount, which may cause
further reductions to the share price.
125

Financing

Debt financing options

Debt holders lend money to a business, and receive interest for a fixed
period of time until the debt is repaid.
Debt financing options for a new project include:

Term loans usually from a bank, at a fixed or floating rate of


interest

Bonds also known as a debenture or loan stock is debt capital


issued by companies, the government and local authorities. There
are many types of bond that a company may issue; a few of the
common types listed below:

Eurocurrency loan which is a loan in a foreign currency (not


necessarily the Euro)

Eurobonds which are long term loans raised by


international companies and sold to investors in several
countries at the same time. These are normally repaid after
5-15 years and are for large amounts, usually $10m or more

Deep discount bonds which are sold at a low market price


and tend to carry a low rate of interest, giving the investor a
larger capital gain on redemption

Convertible bonds which allow the holder the right to


convert the loan at a predetermined price/ time, usually into
ordinary shares

Commercial paper short term unsecured corporate debt


(usual term is around 30 days) which can be cheaper than
bank credit

Islamic bonds these are set in accordance with Islamic


principles, which states that interest is not allowed to be
charged. Instead the lender will participate in any losses/
profits that arise from the use of the loan and therefore
sharing the risk

Choosing an appropriate financing option

The choice of which financing option to use in a particular case will


depend upon the specific circumstances of the project, the business
making the decision, and the general business environment.
The main considerations are:

126

Cost (as a general rule kd < ke)

Current level of gearing not only the mix of debt to equity a


company currently has, but also the mix of short to long term debt

Chapter 12

The signalling effect (issuing equity may be seen as a last resort)

What sources are available

Security is often needed for debt finance

Duration match the term of finance to the term of the proposed


project

Control equity issues may change the balance of control

Cash flow equity is more flexible if cash flows are uncertain

Covenants in existing debt agreements

Bonds

If a company wants to issue a bond, it needs to know what return (yield)


is required by the lenders so that it can set the appropriate issue price /
coupon rate / redemption premium.
Yield on a bond
Three things affect the yield required on a bond:
1

Base rates e.g. if base rates are low then the required yield will be
low too

The credit worthiness of the company. For major listed companies,


ratings agencies will issue a credit rating see detail below

The liquidity and marketability of the bonds. The smaller the


number of bonds that are issued the less liquid they are, and
therefore more risky requiring a higher yield

Calculation of yield
There are two ways of calculating the yield on a bond:
1

Flat yield
This is simply the coupon rate divided by current market value.
Consequently, it ignores the impact of any redemption payment,
so the flat yield is of little use in practice.

Gross redemption yield (yield to maturity)


This is the more commonly used definition of yield. It is calculated
by finding the IRR of:

the current market value

the gross interest payments

the redemption amount


127

Financing

Illustration 1 Gross redemption yield


Cabe plc has 5% loan stock in issue, which is redeemable in three
years at par. Its current market value is 97.25%
t0 Value
t1 t3 Interest
t3 Redeem

(97.25)
5
100

DF 5%
1
2.723
0.864

PV 5%
(97.25)
13.62
86.40
2.77

DF 8%
1
2.577
0.794

PV 8%
(97.25)
12.89
79. 40
(4.96)

2.77
IRR = 5% +
(8% 5%) = 6% approx
(2.77 + 4.96 )

Implicit rate of interest


A similar technique (i.e. calculating the IRR of cash flows) can be used
to calculate the implicit rate of interest for any financing method (e.g.
bank loan, bond, finance lease).
This can be useful when trying to identify financing costs to be recorded
in a companys accounts.
Test your understanding 1 IRR
Heaton plc has 25 million 3% coupon bonds in issue, which are
redeemable in four years at a 20% premium. The current market
value is 96%.
Required:
Calculate the implicit interest rate on the loan, and calculate the
annual financing costs for each year until redemption.
The yield curve for a bond
The yield curve is a graph of gross redemption yield against time to
maturity (redemption) of a bond.
Yield

Time to maturity
128

Chapter 12

The upward slope shows that the yield on a bond is greater the longer
there is to maturity.
For example this means that 5% Treasury bills with 3 years to maturity
will have a lower yield than 5% Treasury bills with 5 years to maturity.
The main reason for the shape of the yield curve is the Liquidity
Preference Theory.
This states that investors will demand a higher return the longer they
have to wait for redemption. If the bond is long dated then the yield will
rise compared to a short dated bond.
Credit ratings credit risk and credit spread
The yield on a bond will be influenced by the risk that the company
issuing the bond is likely to default (credit risk).
Credit rating companies (such as Standard and Poors, Moodys and
Fitch) assess this risk, and bond yields are determined accordingly.
Yield on a corporate bond = risk free rate + credit spread
The credit spread is determined by the assessed credit risk of the
company.
Illustration 2 Credit spreads and bond yields
Table of credit spreads (in basis points) prepared by Standard and
Poors (extract)
Time to maturity
Rating

1 year

2 year

3 year

4 year

5 year

AAA

33.35

38.55

44.89

50.93

58.53

AA

39.44

46.61

54.77

61.10

70.04

47.94

58.99

70.63

85.01

97.15

BBB

66.55

80.00

97.83

115.98

140.41

BB

98.64

120.85

140.54

180.67

210.11

156.93

189.09

221.36

250.90

298.66

The current 4 year risk free rate is 4%, and corporation tax is 23%.
Thus, an AA rated company wishing to issue a 4 year bond will have
to offer a yield of 4% plus a credit spread of 61.10 basis points
(0.6110%).
This is a yield of 4.6110%
(Note that the companys cost of debt can be estimated as
4.6110% (1-0.23) = 3.55%)

129

Financing

Volatility of a bonds value


There is an inverse relationship between interest rates and bond prices.
So if interest rates rise bond prices fall (and vice versa).
However, the prices of some bonds are more sensitive to changes in
interest rates than others (their prices are more volatile).
The price of a bond is more volatile if the bond has a:

Longer time until maturity

Lower coupon

Lower yield

In order to be able to compare the volatility of two different bonds we


can use the Macauley Duration.
This calculation gives a measure of the sensitivity of a bond's price to
changes in interest rates (more sensitive / volatile bonds have longer
durations).
It is the weighted average length of time to the receipt of a bonds
benefits.
The calculation itself is not examinable, but an awareness of the model
can be useful when assessing two different bond options.
Exam-style financing question
Test your understanding 2 Grant
Grant plc, a listed company, is considering a takeover of Murdoch Ltd,
a smaller company in the same industry. The directors have
estimated that 10m would be a suitable purchase price, so they are
now considering the various financing options available.
Grant plc has a very low level of gearing, so the directors are keen to
use debt finance to avoid the high issue costs on equity and to attract
tax relief on the debt interest. The following two options have been
identified:
Option 1 Loan notes
Grant plc has been advised by its investment bankers that it could
issue to the public 10 million of 2% coupon loan notes at par on 1
January 20X0 with interest paid annually in arrears. The loan notes
would be redeemable on 31 December 20X3 at a premium of 30%.
The loan notes would require a fixed and floating charge over the
assets of Grant and Murdoch. There would be some covenants in the
loan note agreements.
130

Chapter 12

Option 2 Bank loan


Alternatively, Grant plcs bank has offered a 10 million variable
interest rate loan at LIBOR plus 3% (LIBOR is currently 5% p.a.).
Interest would be payable half yearly in arrears and the rate then
reset for the next six months. The loan would be available from 1
January 20X0 and the 10 million would be repayable in full on 31
December 20X5. The loan would also require a fixed and floating
charge over the assets of Grant and Murdoch. There would be
extensive covenants in the loan agreement.
Required:
(a)

Explain, with supporting calculations, how the financial


statements of Grant plc for the years ending 31 December
20X0 and 31 December 20X1 would be affected by the loan
notes (Option 1) and the bank loan (Option 2).

(b)

Provide a reasoned recommendation, advising which of


these two debt instruments you would choose to finance
the potential acquisition.

Dividend policy

Retained earnings are an important source of finance for a company,


but a process of reinvesting money back into the company can have an
impact on the money being paid out as dividends.
If investors are used to having a stable dividend policy, which is then
changed, it can impact on the value of the firm.
This impact can be assessed through a valuation model, such as the
formula:
g = b (ROA +

D
(ROA i(1 t)))
E

Where:
g

is the growth rate

ROA is the return on the net assets of the company


b

is the retention rate

is the book value of debt

is the book value of equity

is the cost of debt

is the corporate tax rate

131

Financing

Illustration 3 Impact of changes in dividend policy

A firm currently has a debt-equity ratio of 0.34 and a return on assets


(ROA) equal to 20 per cent. The current interest rate is 5%. The tax
rate is 24%. The retention rate has been 40%. However the firm plans
to reduce its dividend payout to 50%. Find the impact of the change in
dividend policy on the growth rate.
Solution

Before the change in dividend policy we have:


ROA = 0.20

D/E = 0.34

b = 0.40

t = 0.24

i = 0.05

Therefore:
g = 0.40 ( 0.20 + 0.34 (0.20 0.05( 1 0.24))) = 0.102
The growth rate after the decrease in dividends is:
g = 0.50 ( 0.20 + 0.34 (0.20 0.05( 1 0.24))) = 0.128
By increasing the earnings retention rate the potential earnings
growth rate increases from 10.2% to 12.8%.

Financial reconstruction

Financial reconstruction schemes are undertaken when companies


have got into difficulties or as part of a strategy to enhance the value of
the firm for its owners.
Designing a reconstruction

Step 1: Estimate the position of each party if liquidation is to go


ahead. This will be the minimum acceptable.

Step 2: Assess additional sources of finance.

Step 3: Design the reconstruction according to the details of the


question.

Step 4: Calculate and assess the new position and also how each
group has fared, compare to step 1.

Step 5: Check that the company is financially viable after the


reconstruction.

Methods of reconstruction

132

Leveraged capitalisation a firm replaces the majority of its equity


with a package of debt.

Debt-equity swap A portion of the debt is exchanged for a


predetermined amount of equity, possibly done to reduce the
gearing level.

Chapter 12

Equity-debt swap shareholders are given the right to exchange


their shares for a predetermined amount of debt.

Refinancing a firm may replace current debt with a package of


cheaper or more flexible debt, but the benefits may be outweighed
by penalty clauses or transaction fees from paying off the original
debt early.

Securitisation is the process of using non-liquid assets, such as


future season ticket sales for football clubs, or trade receivables as
collateral for a loan.

Test your understanding 3 Bobs Building

Bobs building trade took out a substantial loan of 2.5m two years
ago to take advantage of the booming industry, however sales have
been down and Bob is now worried about how to continue in
business. He is currently looking to restructure his finance in order to
improve cash flow and avoid liquidation.
His current SFP is as follows:
Non-current assets
Freehold property
Plant and machinery
Motor vehicles

Current assets
Current liabilities
Trade payables
Overdraft (unsecured)
Net current liabilities
Long term liabilities
10% debentures 20X6
Net assets
Ordinary shares (1 par value)
Accumulated deficit

000
2,500
1,500
600

4,600

1,500

1,000
600
1,600
(100)

(2,500)

2,000
3,000
(1,000)

2,000

133

Financing

Other information:

The 10% debentures are secured on the freehold property

Break-up values

Property

2,500

Plant

400

Motors

300

Current assets

700

Liquidation costs

Possible refinancing scheme

300,000

Issue 1.5m new shares at 1 each

Replace the existing loan with 1,800,000 new 15%


debentures plus 800,000 new ordinary shares with a par
value of 1 each

Transfer the current overdraft to a 5 year loan that is


secured with a floating charge over the current assets,
whilst keeping the current overdraft limit

Required:
Calculate the amount each stakeholder will receive if the
company goes into liquidation and discuss whether the refinancing scheme is acceptable to both the company and the
various stakeholders.

Financial distress

Legal consequences of financial distress

Fraudulent trading occurs where a company has traded with


intent to defraud creditors.

Wrongful trading occurs when directors have continued to trade


when the company is no longer financially viable and should be in
liquidation.

Management of companies in financial distress

134

Administration the powers of management are subjugated to the


authority of the administrator, who has the same powers as those
of the directors and may do anything necessary to try and save the
company if possible.

Company voluntary arrangement the directors retain control and


manage the company and they must put together a proposal to put
to creditors as an acceptable alternative to liquidation.

Chapter 12

Demergers and disposals

A company may voluntarily decide to divest part of its business for


strategic, financial or organisational reasons. Forms of unbundling are:

Divestments

Demergers

Sell-offs

Spin-offs

Carve-outs

Going private/ leveraged buy-outs

Management buy-outs

10 Financing options for small and medium sized


companies
Small and medium sized enterprises (SMEs) often find it difficult to raise
finance to fund their business plans, because they are usually unquoted
and they have relatively few assets which can be offered as security for
loans.
However, there are numerous sources of finance available, such as:

owner financing

business angels

venture capital

leasing

debt factoring

bank loans

government grants and loans

a medium sized company can issue their share on the Alternative


Investment Market (AIM). This market has no minimum market
value and has fewer rules to comply with than the stock exchange.

135

Financing

Test your understanding answers


Test your understanding 1 IRR

First calculate the IRR for a 100 bond:


t0 Value
t1 t4 Interest
t4 Redeem

(96)
3
120

DF 5%
1
3.546
0.823

PV 5%
(96)
10.64
98.76

13.40

DF 10%
1
3.170
0.683

PV 10%
(96)
9.51
81.96

(4.53)

13.40
IRR = 5% +
(10% 5%) = 8.74%
(13.40 + 4.53 )

So the bonds implicit interest rate is 8.74%


Therefore the annual financing costs (in the accounts) will be:
m

Bal b/f

Year 1
Year 2
Tear 3
Year 4

24.00
25.35
26.82
28.41

Interest @
8.74%
2.10
2.22
2.34
2.48

Paid

Bal c/f

(0.75)
(0.75)
(0.75)
(30.75)(W1)

25.35
26.82
28.41
0.14 i.e.
approx zero

(W1) The repayment in year 4 is the interest (3% 25m = 0.75m)


plus the redemption at a 20% premium (25m 1.20 = 30m)
Alternatively: Quick short cut to implicit interest rate.

Annual return = (3/96) = 3.12%


Plus: annualised premium on redemption is
Total = 3.12% + 5.74% = 8.86%

136

(120 / 96 ) 1 = 5.74%

Chapter 12

Test your understanding 2 Grant

(a)

Impact on financial statements


Option 1 Loan notes

First, the implicit interest rate needs to be determined. This is


the IRR of the initial value of the loan notes, the gross interest
payable, and the redemption amount:
m

DF(7%)

PV(7%)

DF(10%)

PV(10%)

T0

Initial value

10

10

10

T1-T4

Interest
(2%)

(0.2)

3.387

(0.677)

3.170

(0.634)

T4

Redemption
(+30%)

0.763

(9.919)

0.683

(8.879)

(13)

(0.596)

0.487

0.596

IRR = 7% +
(10% 7%)) = 8.65%
0.596 0.487
So now the effective interest charge for each year can be
calculated, along with the outstanding year-end balance:
m
Year ended
31/12/X0
31/12/X1
31/12/X2
31/12/X3

Opening

Interest
(8.65%)

Paid

Closing

10
10.665
11.388
12.173

0.865
0.923
0.985
1.053

(0.2)
(0.2)
(0.2)
(13.2)

10.665
11.388
12.173
0 (approx)

The accounts of Grant plc would show the following information


if the loan notes were issued:
Year ended 31/12/X0

Year ended 31/12/X1

Income statement

Interest charge
0.865m

Interest charge
0.923m

SOFP

Closing balance
10.665m

Closing balance
11.388m

Option 2 Bank loan

It is not possible to determine accurately the interest to be


charged to profit in respect the bank loan as it carries a variable
rate. The financial liability in the statement of financial position
will however be known with certainty as 10m.
If the rate remains at 8% then in the financial statements for the
year ended 31 December 20X0 interest charged should be
800,000 and there will be a financial liability of 10m.
137

Financing

Note: The APR with 6 monthly rests is 8.16% (calculated as


(1.04)2 1).

In the financial statements for the year ended 31 December


20X1 interest charged should also be 800,000 and again there
will be a financial liability of 10m.
(b)

Discussion of options, and recommendation


Difference in interest rates

In terms of costs, the bank loan is currently cheaper at 8% than


the loan notes which have an effective rate of interest of 8.65%.
This however is not a reasonable comparison because the fixed
coupon bond will have an implicit interest rate which reflects the
required return of the investors over the time to maturity (4 years
here). By contrast, the interest rate on the bank loan simply
fluctuates with LIBOR, so just reflects the current rate of return
on that debt, with no thought to future rates at the moment.
Of course, in future if required rates of return increase (because
LIBOR increases) the loan interest rate will rise to reflect this,
but we cant predict this at the moment. Therefore, the fact that
the bond holders are factoring in their required return over 4
years, coupled with the fact that interest rates on longer term
debt are usually higher (upward sloping yield curve) means that
the implicit interest rate on the bond (8.65%) is higher than the
current rate of interest rate required on the bank loan.
Financial risks

There are a number of risk factors to be considered:


Refinancing risk

Both the debt instruments are medium term but they are financing
a long-term investment. The loan stock has a four year term while
the bank loan has a six year term. A key risk is therefore whether
at the end of these periods adequate replacement finance will be
available, or whether Grant plc will have generated sufficient cash
flows for the loan not to require replacement. Given that the bank
loan is not repayable until 20X5 there is a lower repayment risk
than the loan notes. This has a liquidity advantage from delaying
refinancing or repayment by two years.
Interest rate risk

The bank loan is subject to interest rate risk as if LIBOR


changes then the company will be required to pay more interest
and it is tied into the loan agreement for six years. If this risk
became unacceptable then a pay-fixed receive-variable swap
arrangement could be entered into, but this would depend on a
counterparty being available and agreement being reached on
suitable terms.
138

Chapter 12

With the loan notes, after they are issued the interest rate and
the cash interest payments are fixed so there is no interest rate
risk. However, up until the time of issue, unexpected changes in
interest rates may alter the terms of the agreement.
Fair value risk

The fair value of the debt varies inversely with interest rates.
Thus, if interest rates fall in the economy, the fair value of the
obligation to repay would increase. If the loans are held to
maturity then this may not be a major factor but it may hinder
any possible swap arrangement if interest rates changes and
would alter the terms of any refinancing deal.
Gearing

Both types of debt instrument will increase financial gearing and


will therefore increase the financial risk of the business. This is
as a consequence of increasing the volatility of equity returns
and but also it increases bankruptcy risks if interest or capital
repayments cannot be met.
Cash flow and liquidity

In terms of cash interest payments, the loan notes provide a


cash flow advantage as they are at only 2% coupon rate,
compared to 8% on the loan. However, overall any liquidity
advantage from the deferral of interest payments is far
outweighed by the requirement on the loan notes for capital
repayment plus the redemption premium in 4 years time. This is
a major liquidity risk compared to the bank loan.
Covenant risk

Typically there are more covenants on bank loans than publicly


issued debt. To the extent that this is true of these
arrangements, the bank loan may reduce financial flexibility in
restricting the ability of Grant plc to raise additional finance
elsewhere within the loan period. Private debt does however
normally have less onerous public reporting requirements.
Availability

The bank has indicated that the bank loan should be available,
but the investment bank is only an intermediary and it may be
that the loan note issue will not be taken up. The investment
bank may underwrite the issue to ensure take up but this may
add significant additional cost and therefore increase the implicit
interest rate.

139

Financing

Advice

If debt markets are efficient then the two debt instruments


should be more or less equivalent in terms of interest rates, risks
and other terms.
However, for our purposes the bank loan may be preferable on
the grounds that there is more time to arrange refinancing,
perhaps by an equity issue particularly as the investment is
long term. In addition, there is a lower cost of financing and
more certainty over availability and lower costs of issue.
Nevertheless, the interest rates on both instruments seems very
high compared to real world interest rates (LIBOR is given as
5%), and therefore due consideration needs to be given to
whether the financial risks and costs, in addition to the business
risks, make the acquisition a viable proposition.

Test your understanding 3 Bobs Building

First of all we need to have a look at how much will be received upon
liquidation:
Break-up value of assets

3,900,000

Total liabilities

4,100,000

So we do not have enough cash to pay for all of our liabilities


NRV of assets
Liquidator fees
Secured loan

Remaining liabilities

000
3,900
(300)
(2,500)

1,100
1,600

= 68.75p per
outstanding

Acceptability of refinancing

140

Ordinary shareholders they are having to put more money into


the business for less control. Although if they do not do this they
will receive nothing. However, after the new shares have been
issued they still retain 56.6% of the control.

Debenture holder they are replacing their package of debt with


a new lower amount of debt, but with a higher rate of interest.
They were originally getting 10% on 2.5m = 250,000 per year
and are now receiving 15% on 1.8m = 270,000 per year.
Therefore they are getting a 20,000 increase in income per
year, with a lower repayment on the redemption date.

Chapter 12

However they are receiving a package of ordinary shares as


compensation. If the restructure allows the company to be
successful then this could be an attractive bonus this will
depend on how well the markets perceive this company in the
future.

Bank they are swapping the overdraft into a short term loan,
which provides them with some security over the amount.
However if the overdraft is still to remain it could be seen as
risky.

Trade payables if the company goes into liquidation they will


receive 68.75p in the . If the company continues then they
should receive the full amount, but this may be after a delay in
getting the cashflow back into the company again. If the
company continues to trade then the payables should receive
future income from this company.

141

Financing

142

Chapter

13

International financial
management
Chapter learning objectives

Demonstrate and explain the risks associated with international


trade and the ways in which these risks can be managed.

Appraise and evaluate the different methods for setting up


overseas operations, identifying tax and CR consequences.

Explain and appraise the various methods of financing available


for overseas investments and evaluate CR implications.

Appraise and evaluate the factors affecting the capital structure of


a multinational company.

Explain and appraise the benefits and risks of international


borrowing.

Assess and explain the impact of exchange controls and how


companies can mitigate their effects.

Appraise and evaluate the management of dividends in


multinational organisations.

Appraise and evaluate the management of transfer prices in


multinational organisations (including tax and CR implications).
143

International financial management

Risks of international trading

International trade exposes companies to greater risk than just trading


domestically.
These risks and how to mitigate them is assumed knowledge from B&F
and FM:

Physical risk: Goods being lost / damaged in transit can be


mitigated with insurance

Trade risk e.g. faulty products causing injury can be mitigated


with insurance

Liquidity risk: Inability to finance a longer operating cycle

Credit risk: Increased risk of bad debts

FX risk (covered in more detail on the self-managed learning day)

Mitigating credit and liquidity risks


Key ways of mitigating credit and liquidity risks:
Bill of exchange: A document drawn up by the exporter (seller) and
sent to the overseas buyers bank.
The bank accepts the obligation to pay the bill by signing it and
therefore payment is guaranteed.
The seller can sell or discount the bill to a third party for cash now.
Helps to reduce the risk of bad debts and improve liquidity.
Forfaiting: A form of medium term, non-recourse, export financing,
whereby a 3rd party (the forfaiter) effectively purchases the receivable
from the exporter.
Generally receivable is first converted into a financial instrument such
as a bill of exchange which is then purchased for cash at a discount by
the forfaiter.
Export factoring: Similar to domestic factoring
Documentary Credit / Letter of credit: Letters of credit provide a
method of payment in international trade which is risk free.
The arrangement between the exporter, the buyer and participating
banks must take place before the export sale takes place.
The exporter receives immediate payment of the amount due to him,
less the discount from the bank.
The buyer is often able to get a period of credit before having to pay for
the imports.
Export credit insurance: Insurance against the risk of non-payment by
foreign customers for export debts.
144

Chapter 13

Setting up an overseas operation

There are 4 main ways of setting up an overseas operation:

Acquisition

Setting up a overseas subsidiary

Overseas branch

Joint ventures

An exam question may ask you to evaluate several options for setting
up an overseas operation.
Thus an awareness of the generic pros and cons of each alternative will
help you generate specific ideas in the exam.
Acquisition
Pros:

Acquiring an established business grants access to:

Knowledge of the local market

Established customer base / market share

Established distribution channels / customer relationships

Existing brand / reputation

Management expertise in local marketing / distribution /


production

Any intangible assets such as patents and trademarks

Access to finance may be improved by access to additional cash


or debt capacity in the acquired company

Circumnavigating trade barriers

Removal of a competitor

Start-up costs avoided

Other synergies, for example:

Increased utilisation of shared central services e.g. finance

Economies of scope in marketing

Rationalisation and sale of surplus assets

145

International financial management

Cons:

Culture clashes

Integration costs / problems e.g. unforeseen costs in integrating IT


systems

Acquisition cost may be expensive (and may reduce S/H wealth if


premium paid to obtain control plus fees exceeds synergies)

Higher than expected reorganisation costs e.g. redundancies etc.

Duplication of resources / operations across the new group

Potential reputational damage from prior actions of target

Setting up an overseas subsidiary


Pros:

A local company may be better received by local consumers

As a separate local legal entity, a subsidiary may be able to qualify


for government grants and tax reliefs that a branch cannot

The parent will have greater control of systems and processes


(compared to the acquisition of an existing company)

Limited liability can protect the parent company if the subsidiary


suffers losses (with a branch the parent would be liable)

Cons:

Legal costs to set-up overseas

Significant regulatory burden

In some regimes, the activities of the subsidiary may be limited to


the objects set out in its constitution

Legal complexities of dissolving a subsidiary on exit

Unlike an acquisition, there is no access to established local


brands, distribution networks etc.

Overseas branch
Pros:

146

Establishment of a branch likely to be simpler than a subsidiary

Remitted profits from a subsidiary may be taxed at a higher rate


than those of a branch

It may be easier to utilise the tax relief generated by the initial


losses in a branch than if those losses were in a foreign subsidiary

Chapter 13

Cons:

The parent company will be fully liable for any obligations of the
branch

Customers and banks may prefer to deal with a local company


rather than a branch of an O/S company

Joint ventures
Pros:

Gives relatively low cost access to O/S markets

Working with a local partner may make it easier to raise finance in


a foreign country (in particular the JV may have access to
government grants and tax reliefs that a O/S company wouldn't
qualify for)

Access to existing local knowledge, contacts and skills of the JV


partner

Sharing of set up and operating costs

Sharing of risk

If there are legal restrictions on foreign ownership of local


branches / companies, a JV may be the only way to access the
O/S market

Cons:

Culture clashes

Lack of freedom to determine systems, processes and strategic


direction (has to be agreed with partner)

Potential disagreements over operating decisions and ownership


structure

Sharing of profits

Risk of the JV partner gaining information / technology that could


later be used in competing businesses

147

International financial management

Financing overseas investments

Factors affecting the financing decision


Tax:

If interest isn't tax deductible in the O/S country, then debt finance
becomes notably less attractive

High local taxes increase the benefit of tax deductibility

High withholding taxes or other remittance restrictions makes


equity less attractive

Exchange rate risk:

Financing an O/S investment with a loan in another currency is


risky, especially if the exchange rate is volatile

Financing a foreign investment with a local currency loan would


remove this risk (but borrowing in local currency may be more
expensive for a foreign company)

Business risk:

International diversification may reduce the volatility of the firm's


operating profits, enabling the firm to take on more borrowing

Guarantees:

A parent company may guarantee the debts of a subsidiary


enabling it to have a more highly geared capital structure than
normal

Remittance restrictions

Remittance restrictions are a type of exchange control where certain


types of payments abroad are restricted or banned.
For example the payment of dividends to foreign shareholders by local
companies may be suspended.
Impact of remittance restrictions on NPV
The most likely scenario is that no repatriation of funds is allowed until
the end of the project.
However, a common assumption is that CFs generated by the foreign
subsidiary can earn interest in a foreign bank account until the
suspension of repatriation is lifted at the end of the project.
The approach to this type of question is very similar to a normal foreign
NPV question.
148

Chapter 13

Approach

Calculate the net foreign currency CFs for each year

Convert the initial investment in to home currency using the T0


spot rate

Calculate the terminal value of the foreign currency CFs


(assuming the CFs can be reinvested at the rate given)

Deduct any withholding tax from the terminal value

Convert the FC terminal value net of withholding tax into home


currency using the FX rate at the end of the project

Discount at the domestic cost of capital

Less the initial investment in home currency

= The home currency NPV


Test your understanding 1 Flagwaver
Flagwaver Inc, a US company, is considering whether to establish a
subsidiary in Aspavia, where the currency is the E, at a cost of E20m.
The subsidiary will run for four years and the net cash flows from the
project are shown below.

Year 1
Year 2
Year 3
Year 4

Net CF
E000
3,600
4,560
8,400
8,480

There is a withholding tax of 10% on remitted profits and no funds can


be repatriated for the first 3 years, but all the funds are allowed to be
remitted to the home market in year 4. The funds can be invested at a
rate of 5% per year.
At the end of the 4 year period the Aspavian government will buy the
plant for E12m, this amount can be repatriated free of withholding
taxes. The exchange rate is expected to remain constant at E1.50/$
throughout the project.
Required:
Calculate the $ NPV using a discount rate of 15%.

149

International financial management

Overcoming remittance restrictions


Remittance restrictions or other exchange controls can be overcome by
extracting funds from a foreign subsidiary via:

High transfer prices

Large royalty payments

High interest charges on inter-company loans

High management fees

Dividend management

Factors to consider when deciding the amount of dividends foreign


subsidiaries should pay the parent company:

Whether cash is needed to finance domestic investment

Whether cash is needed to pay domestic dividends / maintain the


domestic dividend payout ratio

The tax treatment in the foreign country:

If undistributed earnings are taxed this will encourage


distributions

If withholding taxes are high it may discourage distributions

Agency problems: High dividends can be used to restrict the funds


available to local managers, who may not be expected to act in a
goal congruent manner.

Exchange rates: The parent will wish to take higher dividends now
if they expect the foreign currency to depreciate in the future (and
vice versa)

Transfer pricing for multinationals

BS recap: Market price is generally considered to be an appropriate


transfer price, which should lead to division managers making goal
congruent decisions.
However, MNCs may wish to charge higher or lower prices to artificially
reduce or increase profits in a foreign subsidiary.
Reasons for transfer price manipulation

150

To shift profits from high tax countries to low tax countries

Low transfer prices may be used to avoid 'ad valorem' export


taxes

To avoid remittance restrictions (using high prices to reduce profits


in the foreign sub)

Chapter 13

Response of government / tax authorities


Generally, the response of tax authorities has been to write tax rules
which say all international transfer prices should be set with reference
to the 'arms length standard'.
Arms-length standard: Intra-firm trade of multinationals should be
priced as if they took place between unrelated parties acting at arm's
length in competitive industries.
There are several different methods of calculating the arms-length
transfer price:
The comparable uncontrolled price method (CUP): Take a 3rd party
market price for identical (or very close to identical) goods or services.
Most tax authorities prefer this method as it is based on actual
transactions.
The resale price method: The resale price less the expected margin.
For example, the manufacturing division sells a product to distributing
division for the TP. To calculate the arms-length TP; the tax authorities
find the selling price of comparable distributors, selling comparable
products, and deduct the distributors expected margin.
Cost plus: The costs of the selling division / subsidiary plus the
expected mark-up of similar companies.
The comparable profit method (CPM): Uses accounting ratios of
similar companies (e.g. ROAs) to calculate the expected profit. The TP
is then derived from this expected profit.
The profit split method (PSM): This splits the consolidated profit from
a transaction or group of transactions between the related parties
(normally, on the basis of operating assets).

151

International financial management

Chapter summary

Key areas:

152

Setting up an overseas operation

Financing overseas investments

Remittance restrictions (as part of a foreign NPV)

Chapter 13

Test your understanding answers


Test your understanding 1 Flagwaver
To
Operating E
CFs

(20,000)

Compounding
factor @ 5%
TV

T1

T2

T3

T4

3,600

4,560

8,400

8,480

1.1576

1.1025

1.05

4,167.36

5,027.4

8,820

8,480

Sum of TV E
operating CFs

26,494.76

Withholding
tax @ 10%

(2649.48)

Asset sale
Net E CFs
FX rate
Net $ CFs
DFs @15%
PVs

12,000
(20,000)

35,845.28

1.5

1.5

1.5

1.5

1.5

(13,333.3)

23,896.9

N/A

N/A

N/A

0.572

(13,333.3)

13,669

NPV = $335.7k

153

International financial management

154

Chapter

14

Treasury and working


capital management
Chapter learning objectives
Upon completion of this chapter you will be able to:

demonstrate and explain the role and responsibilities of the


treasury management function

demonstrate and explain the role of treasury management in


short-term finance, short-term investment and liquidity risk

appraise and explain global treasury organisation and international


liquidity management

appraise and evaluate the contribution of working capital


management to short term and long term financing

evaluate the risks arising from working capital management and


how these may be mitigated

evaluate and explain working capital requirements for a range of


different organisations and circumstances

demonstrate and explain the nature and role of working capital


management within financial management

appraise, evaluate and advise with respect to working capital


management techniques.
155

Treasury and working capital management

Introduction

This chapter covers three main areas:

The role of treasury management

Global treasury management

Working capital financing

The majority of this chapter is brought forward knowledge from


your professional stage studies.

Treasury management

The role of the treasury management function


The role of a treasury manager is to:

Meet corporate financial objectives

Manage the liquid funds

Implement the funding policies

Manage the currency

Corporate finance

These departments require expertise in an ever growing financial world


and can be outsourced in order to take advantage of such expertise.
Centralised vs decentralised treasury management
Large companies with many divisions/ subsidiaries need to decide
whether to have one treasury management department, that services all
of the company; or whether to allow each division to have the individual
control.
Advantages of a centralised department:

156

Avoids a mix of cash surpluses and overdrafts in different


accounts

Facilitates bulk cash flows, so that lower bank charges can be


negotiated

Larger volumes are available to invest, opening up more


investment opportunities

Foreign currency risk management is improved, allowing the


process of matching to be more useful

A specialised department will employ more expertise

Chapter 14

Less money will be required to be held for day-to-day transactions

Focus will be on achieving higher profits through good cash


management

Standardised practices are easier to implement

Disadvantages of a centralised department:

Local knowledge is not utilised when raising the finance

Autonomy is restricted for the managers of the subsidiaries

Requests for finance may be slower to be raised, a decentralised


system is often more responsive

Global treasury management

Issues affecting global treasury management:

Cash flow issues

Legal issues

Political issues

Tax issues

International liquidity management techniques

Pooling asking the bank to pool the amounts of its subsidiaries


when considering interest levels and overdraft limits. It requires all
of the group companies maintaining accounts at the same bank

Netting a process in which payments are netted off receipts, with


only the reduced balance remaining due to be paid

Bilateral netting only two companies, within the same


group, are involved, with the lower amount deducted from the
higher amount and the difference remaining to be paid

Multilateral netting occurs when several companies within


the same group interact with the centralised treasury
department to net off their transactions

Multilateral netting
The process involves establishing a base currency to record all intragroup transactions. The central treasury department will then record the
amounts payable/ receivable to settle transactions
It reduces the need for money to be transferred for each intra-group
transaction but requires strict controls to be in place. In addition there
are restrictions of netting in some countries as it can be seen as a tax
avoidance scheme.
157

Treasury and working capital management

Illustration 1 Multilateral netting


At 30th September 20X3 Turtle Power Plc had the following intercompany transactions
Debtor

Creditor

Amount

US

Thailand

500,000 bht

US

Germany

200,000 Euro

Germany

Thailand

800,000 bht

Thailand

US

50,000 dollars

Thailand

Germany

400,000 Euro

It is the companys policy to net off inter-company balances and the


base currency is the home currency of UK. The following exchange
rates have been given:
UK 1 = 1.2 / 1.7$ / 54.6 bht
Solution
Step 1 convert the balances into the base currency

158

Debtor

Creditor

Amount

US

Thailand

9,157

US

Germany

166,667

Germany

Thailand

14,652

Thailand

US

29,412

Thailand

Germany

333,333

Chapter 14

Step 2 net off the currencies


Receiving
subsidiaries

Paying subsidiaries
US
Thailand
Germany

US
Thailand
Germany
Total
payments
Total
receipts
Net receipt/
(payment)

29,412

9,157
166,667

14,652
333,333

(175,824)

(362,745)

29,412

23,809

500,000

(146,412)

(338,936)

485,348

(14,652)

Total

29,412
23,809
500,000

553,221

So, the US subsidiary should pay 146,412 to the German subsidiary


and Thai subsidiary should pay 338,936 to the German subsidiary.
This is a much more simple transaction with less transaction costs
than all of the subsidiaries carrying out their original transactions.

Working capital financing

Working capital is the excess of current assets over current liabilities.


The volume of assets to liabilities for a company will largely depend on
the nature of the business, e.g. a manufacturing company with a long
lead time from overseas suppliers may need to hold a high level of raw
materials.
There are three main approaches that a company can follow when
providing finance for the working capital.

An aggressive approach relies heavily on short term finance


which is risky, and is useful for a company with a low level of
current assets

A conservative approach relies more on long term finance which


can be more expensive, but is safer for a company with a high
level of working capital

A moderate approach which provides a more balanced mix


between short and long term finance

Getting the mix of short and long term finance can be vital for a
business to balance the day to day demands of working capital with the
cost of available funds.
This mismanagement can be a factor in causing financial distress and
driving the need to re-finance.
159

Treasury and working capital management

Chapter summary

Key areas:

160

Understanding the role of treasury management

Being able to formulate a strategy for coping with overseas intragroup transactions

Chapter

15

Financial risk management


Chapter learning objectives
Upon completion of this chapter you will be able to:

analyse and evaluate financial risks and their implications and


show the application of risk disclosures (including those under
IFRS 7)

evaluate and explain interest rate risks

appraise and advise on appropriate methods to assess and


manage financial risks in specific business scenarios

explain and appraise financial instruments available for hedging


against interest rate and foreign exchange rate risk, for example
swaps, collars and floors

demonstrate and explain how interest rate hedging strategies and


foreign currency risk management strategies can be formulated,
both at the individual level and for macro hedging arrangements

demonstrate and explain the nature and operation of financial


instruments underlying the disclosure, recognition and
measurement requirements of IAS 32, IAS 39, IFRS 7 and IFRS 9.

161

Financial risk management

Introduction

The focus of this chapter will be on hedging techniques and associated


disclosures relating to:

Interest rate risk

Foreign exchange rate risk

However, exam questions may also feature other types of financial risk.
With the exception of the FR implications of hedging essentially all this
material is assumed knowledge from the FM paper.
However, due to their technical nature, the hedging calculations and
definitions are covered again in detail in this chapter.

Key types of financial risks (assumed knowledge)

Financing risk: Primarily the risk that a certain type of finance e.g.
bank loans becomes unavailable to the firm in the future.
The risk that the firm will breach loan covenants is another key source
of financing risk.
Liquidity risk: The risk the firm will be unable to pay its debts as they
fall due.
Cash flow risk: The risk that due to the volatility in the firms day to day
operating cash flows, they have insufficient cash available.
Credit risk: The risk of customer (or counterparty) default
Market risk: The risk of losses due to changes in market prices or rates
Interest rate risk and foreign exchange rate risk, which are covered in
detail below, are examples of market risk.

Hedging products and terminology

Key product definitions


Forward: An obligation to buy/sell a set amount of an underlying asset
on a set future date at price/rate agreed today
Future: A standardised and thus tradable version of a forward contract.
An agreement to buy or sell a standard quantity of a specified
underlying asset on a fixed future date at a price/rate agreed today
Over-the-counter (OTC) option: The right, but not the obligation, to
buy or sell a specific quantity of an underlying asset on a future date at
a price/rate agreed today
162

Chapter 15

Traded option: This is a standardised and thus tradable version of


OTC option.
A standardised contract which gives the right, but not the obligation, to
buy or sell a specific quantity of an underlying asset on a future date at
a price/rate agreed today
Interest rate swap: An agreement whereby two parties agree to swap
a floating stream of interest payments for a fixed stream of interest
payments and vice versa.
There is no exchange of principal. The companies involved are termed
counterparties.
This is the most common type of interest rate swap and is sometimes
referred to as a coupon swap.
Other terminology
Hedging: Taking an action that will offset an exposure to a risk by
incurring a new risk in the opposite direction.
Macro hedging (or portfolio hedging): Where financial instruments with
similar risks are grouped together and the risks of the portfolio are
hedged together.

The mechanics of a futures transaction

This is assumed knowledge but is repeated here for clarity.


When using futures there will be two separate elements to the
transaction:
1

The underlying transaction at the open market rate

The futures transaction

Commodities futures example


A chocolate manufacturer Chunky Choc Ltd (CC) needs to purchase
some cocoa in 3 months time.
They are worried that cocoa prices will rise before they make their
purchase and wish to hedge this price risk using futures.
1

The underlying transaction at the open market (spot) rate


CC will go and purchase the required cocoa at the open market
rate on the transaction date (3 months from now).
If cocoa prices rise, CC will effectively make a loss on the
underlying transaction as they will pay more than they initially
expected.
163

Financial risk management

Alternatively, if cocoa prices fall, CC will effectively make a gain on


the underlying transaction as they will pay less for the cocoa than
they initially expected.
2

The futures transaction


CC will buy cocoa futures contracts now (this is essentially a bet
that the cocoa price will rise).
CC will then close out its futures position on the transaction date
(in 3 months time) by entering an equal and opposite transaction
(selling cocoa futures).
If cocoa prices have risen the CC will pay more than expected for
the underlying transaction but will be compensated by a gain on
the futures position.
Alternatively, if cocoa prices have fallen CC will pay less than
expected for the underlying transaction but this gain will be offset
by a loss on the futures position.
The net outcome is that the company will effectively be locked in
to the current futures price as the net cost of the cocoa (ignoring
any basis risk etc.)

Other futures terminology


The contract size: The contract size is the fixed quantity of the
underlying asset which can be bought or sold using a futures contract.
Futures price: The current futures price reflects what the market
expects the spot price will be on the expiry date of the future.
Basis risk: Basis risk refers to the fact that the hedge may be imperfect
due to the basis.
The basis is the difference between futures price and the spot price of
the underlying asset. It will be zero at the expiry of the contract but
theoretically should be non-zero at any other time.
Hence closing out a futures position before the expiry date should result
in an imperfect hedge due to basis risk.
The workings of futures markets
How futures markets work in practice is beyond the scope of the
syllabus. However there are a few key rules you should be aware of:
The futures market is highly liquid so we will always be able to
enter a contract when we want and we will always be able to close out
our position when we need to.
We can always sell futures when we need to (we dont need to buy
them first) If we sell a future we are simply entering a contract to sell
the underlying asset in the future.
164

Chapter 15

We are not actually selling anything when we enter the contract; we are
simply promising to sell something in the future.
There are cash flow implications associated with futures These
are not included in the calculations but you should be aware of them:

Initial margin: This is the initial deposit required to be posted with


a broker to set up a futures position

Variation margin: Additional payments that are required to be


made to the broker (on a daily basis if necessary) to cover losses
on the futures position

Interest rate risk

Explanation of interest rate risk


As the diagram below demonstrates, interest rate hedging focuses on
the period before the loan or deposit commences.
Any risk during the actual loan or deposit period can be managed by
entering a fixed rate agreement.

Now

Risk period:

Start of fixed rate


loan agreement

We are taking out a loan


in the future and are
worried about rates
rising before then

Loan period:

End of
loan term

We take out a loan at a


fixed rate so face no
interest rate risk during
the loan period

Interest rate futures

The calculation of the outcome of interest rate futures hedge is


assumed knowledge from FM. Thus these notes focus on a reminder of
the approach and the required pro-forma.
Scenario: A business has identified the need to borrow (or deposit)
funds at some point in the future and is worried that the rate will rise (or
fall) before the borrowing (deposit) agreement starts.
Interest rate futures (IRFs) terminology
Underlying asset: The underlying asset for interest rate futures is
either a debt security (e.g. 90-day T-bills) or an interbank deposit (e.g.
90-day Libor).

165

Financial risk management

Futures price: As a convention short term interest rate futures are


priced at 100 minus the expected annualised reference rate (the
markets expectation of the short term interest rate, normally 90-day
LIBOR, at the expiry of the future).
Long term IRFs prices reflect the market prices of the underlying bonds
(hence prices may exceed 100 if the bond is trading in excess of its par
value) but there are no calculations involving these in the SM.
Expiry dates: Expect the standard expiry dates for interest rate futures
to be the last day of March, June, September and December (unless
told otherwise).
Contract length: Expect each contract to cover 3 months worth of
interest unless told otherwise.
Approach
Buy/sell decision
Borrowers

Savers

To set up the futures


position (now)

Sell

Buy

To close out the position


on the transaction date

Buy

Sell

What expiry date to pick


Pick the first expiry date on or after the date the borrowing/lending
starts e.g. If you need to borrow on 31 March, use March contracts. If
you need to borrow on 3 August, use September contracts.
How many contracts
No. of contracts =

Loan/depos it amount Loan/depos it period

Contract size
Contract length

Futures are only traded in whole contracts, so the no. of contracts


needs to be rounded to the nearest whole number.
Calculating the profit or loss on the future
Futures prices are quoted at 100 interest rate. Therefore the profit or
loss will be a percentage.
Then calculate the total gain or loss as: % gain/loss contract size
standard contract length (3/12 for a 3 month future) no. of contracts.

166

Chapter 15

Pro-forma
You should recall a 4 stage pro forma from FM:

Approach (buy/sell decision, choice of expiry date)

No. of contracts

Underlying transaction

Futures position

Video illustration
View the Interest rate futures illustration video on My Kaplan for an
example of how to apply the pro-forma to the following TYU.
Test your understanding 1 Supercool Ltd
Supercool Ltd wants to invest 1.6m starting on the 10th of June for 6
months
Current futures prices (contract size 500k):
June
September
December

97.3
97.36
97.47

The current spot interest rate is 2.5%. On the 10th of June the spot
rate is 3% and the relevant futures price is 96.9.
Required:
Calculate the net outcome of the hedge and the effective interest
rate.
Estimating the futures price on the transaction date
In FM you were always either:

Given the futures price on the transaction date (as in the above
example)
Or

Told that the transaction date was the expiry date, so the futures
price equals the spot price (remember basis always equals zero at
expiry)

However, in the SBM exam you may not be given this information and
yet still be expected to estimate the futures price on the transaction
date.
We can do this by assuming that the basis (the difference between the
futures price and the spot price) declines evenly over time.
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Financial risk management

Example:
Today is the 1st of March. June IRFs are currently quoted at a price of
96.5, hence the implied short-term interest rate is (100 96.5) = 3.5%.
LIBOR is currently 4%, hence the basis (the difference between the
spot price and the futures price) on the 1st of March is:
4% 3.5% = 0.5%
It is now the beginning of March and the future expires at the end of
June, so there are 4 months to expiry. Assuming that it declines in a
linear fashion, basis will reduce by (0.5 / 4) = 0.125 per month.
Hence if we plan to close out our futures position on the 31st of May, we
can estimate the remaining basis on that date to be:
0.5 (0.125 3) = 0.125
Thus, if the LIBOR spot rate on the 31st of May is 3.6%, we can
estimate the futures price on that date to be:
100 (3.6 + 0.125) = 96.525
Test your understanding 2 Boom Town Inc
Boom Town Inc has taken out a 6 month $7m loan with interest
payable of 5.4% (this is a fixed rate of interest based on LIBOR plus
3% at the start of the loan). The loan is due for rollover on the 31st of
May 20X1 and Boom Town expects the new fixed interest rate to be
set at LIBOR plus 3% on that date.
Todays date is the 1st of February and the company treasurer has
become worried that interest rates will rise before the rollover date.
LIBOR is currently 2.5%.
The treasurer is considering using interest rate futures to hedge this
interest rate risk. The Chicago Board of Trade is currently quoting the
following prices on standardised $1m three month contracts:
March
June
September

97.23
97.02
96.87

Contracts are assumed to expire at the end of the quoted months.


Required:
Illustrate the outcome of the hedge assuming the LIBOR spot
rate is 3% on the 31st of May.
Assume the basis declines evenly over time.

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Forward rate agreements (FRAs)

Definition
A FRA is a cash-settled forward contract on a short term loan.
Explanation
It is typically an agreement with an investment bank which is separate
from the underlying loan. It effectively fixes the interest suffered on a
future loan agreement, as:

If the reference rate (typically LIBOR) on the transaction date (the


date the loan commences) is greater than the FRA rate, the
investment bank pays the difference to the FRA holder

If the reference rate on the transaction date is less than the FRA
rate, the holder pays the difference to the investment bank

As a bespoke over-the-counter (OTC) product, an FRA can be flexed to


the users exact requirements.
Terminology
Quote terminology: A 2 v 5 FRA, for example, covers a loan than
starts in 2 months and finishes in 5 months (i.e. it is a 2 month forward
rate for a 3 month loan).
Trade date / Spot date: Effectively, both dates reflect when the FRA
was initially set up (i.e. now). Technically, the spot date is 2 working
days after the trade date.
Fixing date: The date on which the reference rate used for the
settlement is determined (may be just before the settlement date)
Settlement date: The day the underlying loan starts (i.e. the
transaction date). The FRA is settled with a single cash payment on this
date.
Calculation of settlement amount

Settlement amount = Loan amount

(rREF rFRA ) Length of loan (days)


365 *
Length
of
loan (days)

1 + rREF

365 *

Where:
rREF = The reference rate (typically LIBOR)
rFRA = The forward rate or FRA rate
*Some contracts may use 30 day-months and 360 days in the year
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Financial risk management

Note: The settlement amount is discounted back from the end of the
loan period to the settlement date, as the interest on the underlying loan
wont actually be paid until the end of the loan period.
Test your understanding 3 Hot Dog Inc
Hot Dog Inc has entered a $10m 5 vs 8 FRA. The FRA rate is 3%.
Assume the reference rate ($ LIBOR) is 3.2% on the fixing date.
Required:
Calculate the settlement amount. (Note: The US$ money market
uses a 360-day year.)

Traded interest rate options

The calculation of the outcome of a traded interest rate options hedge is


assumed knowledge from FM. Thus these notes focus on a reminder of
the approach and the required pro-forma.
Scenario: A business has identified the need to borrow (or deposit)
funds at some point in the future and is worried that the rate will rise (or
fall) before the borrowing (deposit) agreement starts.
General options terminology
Exercise price/Strike price: The price/rate at which the underlying
asset can be bought/sold using the option.
Call option: The right, but not the obligation, to buy the underlying
asset for the strike price on a future date.
Put option: The right, but not the obligation, to sell the underlying
asset for the strike price on a future date.
American style options: Can be exercised at any point until the expiry
date.
European style options: Can be exercised only on the expiry date.
In the money: Exercising today would give a profit (ignoring the
premium cost).
Out of the money: Exercising today would give a loss (ignoring the
premium cost).
Intrinsic value: The profit (ignoring the premium cost) that would arise
by exercising today (i.e. the difference between the current price and
the exercise price). Note: Options that are out of the money will have
no intrinsic value.
Premium: The market value of the option. Hence, when you buy an
option you pay the premium.
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Chapter 15

Time value: The difference between the premium and the intrinsic
value. This will be positive before expiry and zero at expiry. The positive
time value before expiry reflects the probability that the option will have
a greater intrinsic value in the future.
Traded interest rate options terminology
Traded interest rate options are options on interest rate futures, hence a:
Call option: The right, but not the obligation, to buy one interest rate
future for the strike price on or before the expiry date.
Put option: The right, but not the obligation, to sell one interest rate
future for the strike price on or before the expiry date.
The option contract size and expiry date will match that of the
underlying futures contract.
Approach
Put/Call decision

Which option to buy


now

Borrowers

Savers

Put: Gives the right to


sell an IRF for the
strike price on the
transaction date

Call: Gives the right


to buy an IRF for the
strike price on the
transaction date

Buy

Sell

To close out the


futures position on
the transaction date if
exercised
What expiry date to pick

Pick the first expiry date on or after the borrowing/lending starts e.g. If
you need to borrow on 31 March, use March contracts. If you need to
borrow on 3 August, use September contracts.
How many contracts
No. of contracts =

Loan/depos it amount Loan/depos it period

Contract size
Contract length

Traded options are only traded in whole contracts, so the no. of


contracts needs to be rounded to the nearest whole number.
Calculating the profit or loss on the options/futures position
Futures prices are quoted at 100 interest rate. Therefore the profit or
loss will be a percentage.
Then calculate the total gain or loss as: % gain/loss contract size
standard contract length (3/12 for a 3 month future) no. of contracts
171

Financial risk management

Calculating the option premium


The premiums will generally be given in a table and expressed as a
percentage. The calculation basis is the same as for the gain or loss (%
contract size standard contract length no. of contracts).
Pro-forma
You should recall a 6 stage pro forma from FM:

Approach (Put/Call decision, choice of expiry date)

No. of contracts

Underlying transaction

Options / futures position

Exercise decision

Premium cost

Video illustration
View the Traded interest rate options illustration video on My Kaplan
for an example of how to apply the pro-forma to the following TYU.
Test your understanding 4 Desperado
Desperado Ltd wants to borrow 5.2m starting on the 30th of August
for 1 year. It is now May and the spot rate is currently 2.5%.
LIFFE options on IRFs (contract size 500k, premiums in % p.a.):
Puts

Calls

Exercise price

June

Sept

June

Sept

97.25

0.020

0.071

0.065

0.175

97.50

0.030

0.081

0.005

0.160

97.75

0.041

0.099

0.036

0.135

On the 30th of August the spot rate is 2.75% and the relevant futures
price is 97.21. The company wants to lock in a rate no worse than
2.5%.
Required:
Calculate the net outcome of the hedge.

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Chapter 15

Additional practice question


Test your understanding 5 Rumble
Rumble Inc. wants to borrow $4m for three months, starting in 3
months time. However, interest rates are currently volatile and it is
worried about adverse movements in these rates before it takes out
the loan.
Rumble is considering using traded interest rate options to hedge the
interest rate exposure. It is now the 1st of March and the LIBOR spot
rate is 3.5%. Rumble can borrow at a fixed rate of LIBOR plus 1%
(based on the spot rate for LIBOR at the commencement of the loan).
Options on three-month futures ($1,000,000 contract size, premium
cost in %) are available as follows:
Calls

Puts

Strike
prices

March

June

Sept

March

June

Sept

9600

0.120

0.195

0.270

0.020

0.085

0.180

9625

0.015

0.075

0.155

0.165

0.255

0.335

9650

0.001

0.065

0.085

0.400

0.480

0.555

The relevant future is currently priced at 96.10, assume the basis


declines evenly over time.
Required:
Illustrate an option hedge at 3.75%, assuming that in 3 months
time; the loan is taken out at LIBOR + 1% and the LIBOR spot
rate is 4%.
Traded caps, collars and floors
Traded cap: This is a traded interest rate put option (giving the right to
sell an interest rate future), which sets a maximum interest rate for a
borrower.
Traded floor: This is a traded interest rate call option (giving the right to
buy an interest rate future), which sets a minimum interest rate
receivable for a saver.
Traded collar: For a borrower, this is the combination of buying a
traded interest rate put option, whilst selling a traded interest rate call
option at a lower strike price (in terms of the interest rate).
Example:
Buying a traded interest rate put option at a strike price of 95, effectively
sets a maximum interest rate the company can pay of 5%.
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Financial risk management

Selling a traded interest rate call option at a strike price of 97, effectively
sets a minimum interest rate the company can pay of 3%.
Hence the company is only exposed to interest rate movements
between 3% and 5%.
Setting up a collar is cheaper than just setting up a cap, as the income
from selling the call offsets the cost of the put.

OTC interest rate options

Over-the-counter interest rate options can be purchased from major


banks. They are bespoke contracts and can be tailored to the
purchaser's exact requirements.
The underlying variable for an OTC option is normally a reference rate
such as 3 month LIBOR.
There are no numerical examples of OTC interest rate options in the
Study Manual.

10 Basic interest rate swaps (coupon swaps)


One company (A) will want to borrow at a fixed rate, but it is relatively
more efficient at borrowing at the variable rate.
Another company (B) will want to borrow at a variable rate, but is
relatively more efficient at borrowing at the fixed rate.
Instead of the companies borrowing as they want to:

A will borrow at a variable rate and B will borrow at a fixed rate.

B will make a variable interest payment to A and A will make a


fixed interest payment to B

Thereby the companies effectively swap interest payments.


Approach

174

Calculate the total annual cost of the borrowing without a swap

Calculate the total annual cost of the actual borrowing with a swap
(including any bank fees)

Establish the total benefit to be gained from the swap (the


reduction in the total cost from doing the swap)

Establish the final rates that can be achieved by each party, by


splitting the benefit between them (equally unless told otherwise)

Establish the payments between the parties that will achieve this
result (there will be typically two payments between the counterparties, the fixed leg and the variable leg)

Chapter 15

Note: To avoid mistakes, remember that the counter-party that wants a


fixed rate will pay the fixed leg and the counter-party that wants a
variable rate will pay the variable rate.
Video illustration
View the Interest rate swaps illustration video on My Kaplan for an
example of how to apply the pro-forma to the following TYU.
Test your understanding 6 Stylefish and Cool Kangeroo
Stylefish Ltd (SF) wishes to raise 6m. They would prefer to issue
fixed rate debt because they want certainty about their future interest
payments
They can borrow at 7% fixed or LIBOR + 3% floating.
SF's bankers have suggested that another one of their clients, Cool
Kangeroo Ltd (CK), would be interested in a swap arrangement. The
bank would charge a fee of 0.25% to each counter-party, for
brokering the swap.
CK also wishes to raise 6m, but wishes to pay interest at a floating
rate, as it would like to be able to take advantage of any fall in interest
rates. It can borrow for one year at a fixed rate of 4% or at a floating
rate of 2% above LIBOR.
Required:
Illustrate the working of the swap and calculate the effective
swap rate for each company assume savings are split equally
and the variable leg of the swap is set at LIBOR.
Additional practice question
Test your understanding 7 Seeler Muller
Seeler Muller wishes to borrow 300 million euros for five years at a
floating rate to finance an investment project in Germany. The
cheapest rate at which it can raise such a loan is Euro LIBOR +0.75%.
The companys bankers have suggested that one of their client
companies, Overath Maier, would be interested in a swap
arrangement. This company needs a fixed interest loan at 300
million. The cheapest rate at which it can arrange the loan is 10.5%
per annum. It could, however, borrow in euros at the floating rate of
Euro LIBOR +1.5%.
Seeler Muller can issue a fixed interest 5 year bond at 9% per annum
interest. The banker would charge a swap arrangement fee of 0.15%
per year to both parties.
You are required to devise and illustrate a swap by which both
parties can benefit.
175

Financial risk management

Other swap terminology


Basis swap: An agreement whereby two parties agree to swap a
floating stream of payments for another floating stream of payments
which have been calculated on a different basis.
For example, swapping a stream of payments based on three-month
LIBOR for a stream of payments based on six-month LIBOR.
Total return swap: An agreement whereby two parties agree to swap a
floating stream of payments based on a reference rate such as LIBOR,
for a floating stream of payments based on the total return of an
underlying asset (e.g. an equity portfolio).
Swaption: An option on a swap. It gives the buyer the right, but not the
obligation, to enter a swap with the seller.
For example, for a borrower a swaption may give the right to enter in to
a swap as the fixed rate payer. Hence if interest rates rise above the
specified fixed rate exercising the swaption becomes attractive.

11 Foreign exchange rate risk


Types of foreign currency risk
Firms which trade in different territories face three types of foreign
currency risk:
Transaction risk the risk of exchange rates changing before the
settlement date of a transaction. This risk can be reduced or eliminated
using hedging methods.
Economic risk the risk that long-term adverse movements in foreign
exchange rates make the company less competitive internationally.
Over-reliance on a particular currency increases a firms exposure to
economic risk. Diversifying internationally enables a firm to reduce its
exposure.
Translation risk the risk of exchange rate movements between one
year and the next causing fluctuations in values of foreign currency
assets and liabilities in consolidated accounts. Beware that unrealised
translation losses can affect borrowing capacity. Translation risk can be
mitigated by financing foreign investments (assets) with foreign loans
(liabilities).

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Chapter 15

Forecasting exchange rates parity theories


Both of the following methods are revision from FM:
Interest Rate Parity (IRP)
IRP can be used to calculate forward exchange rates, as follows:
Forward rate = Spot rate

(1 + i

foreign

(1 + ihome )

This assumes the spot rate is expressed as F.C / home currency.


Purchasing Power Parity (PPP)
PPP can be used to estimate future spot rates, as follows:
Future spot rate = Spot rate

(1 + Inflation

foreign

(1 + Inflationhome )

This assumes the spot rate is expressed as F.C / home currency.


Practical hedging methods
Again the following methods are revision from FM:
Seller invoices in home currency: Transfers all exchange rate risk to
the buyer, but is unlikely to be commercially acceptable in a competitive
market.
Matching receipts and payments: If a company expects to receive
and make payments in the same foreign currency at the same future
date, then only the net amount is exposed to FX rate risk.
Foreign currency bank accounts: Effectively an automatic matching
process. Only the net balance on the account is exposed to FX risk.

12 Currency forward contracts


Quoted exchange rates
The convention in the UK is to quote exchange rates in terms of foreign
currency (F.C) / (the indirect method), thus in the FM exam rates were
always quoted this way.
However, at the advanced stage you may see rates quoted by the direct
method (domestic currency / F.C).
Whether rates are quoted by the direct or indirect method, we can
always refer to the numerator of the fraction as the variable currency
and the denominator as the base currency (VC / BC).
Banks will quote a spread of exchange rates (the bid-offer spread). The
bank will make its profit on the difference between these two prices.
177

Financial risk management

A company will:

Buy the variable currency at the low rate

Sell the variable currency at the high rate

Or

Buy the base currency at the high rate

Sell the base currency at the low rate

Quoted forward rates


Forward rates are often not quoted directly but as a premium or
discount to the spot rate.
A premium means that the variable currency is expected to strengthen
in the future (hence the VC / BC rate is expected to fall, as the base
currency is expected to weaken).
A discount means that the variable currency is expected to weaken in
the future (hence the VC / BC rate is expected to rise).
Thus, to convert a VC / BC spot rate to a forward rate, we need to:

Add a discount
Or

Deduct a premium

Note: The discount or premium may be expressed in a different unit


than the spot rate (e.g. the spot rate may be in $/ and the premium
may be in cents/).
Approach
No pro forma is required as this is simply a conversion at a pre-agreed
rate.
Follow this two step process:

178

Take the forward rate from the question (or calculate it by


adjusting the spot rate for the discount/premium given)

Convert the future payment or receipt at the forward rate, if:

The hedging companys home currency is the variable


currency; multiply the foreign currency amount by the forward
rate

The hedging companys home currency is the base currency;


divide the foreign currency amount by the forward rate

Chapter 15

Test your understanding 8 Hans Gruber


A German exporter, Hans Gruber, will receive an amount of
$1,500,000 from a US customer in three months time. He can arrange
a forward exchange contract to cover this transaction. The current
spot rate is $1 = 0.7810 0.7840 and the 3 month forward rate is
quoted as 0.0005 0.0003 premium.
Required:
Calculate how much the exporter will receive under the terms of
the forward contract.
Synthetic foreign exchange agreements (SAFEs): Are forward
contracts, where only the gain or loss on the contact ((SAFE rate spot
rate) notional foreign currency amount) is settled. Hence they operate
in a similar way to FRAs.

13 Money market hedge


A money market hedge (MMH) is a DIY forward contract. It effectively
sets a certain exchange rate now, for a future foreign currency
transaction.
The FX risk is removed by converting the currency at the current spot
rate (which is known with certainty).
Hedging payments
Scenario: The hedging company needs to pay a foreign currency
creditor in the future.
Approach:

Borrow the appropriate amount in home currency now

Convert the home currency to foreign currency immediately

Put the foreign currency on deposit in a foreign currency bank


account

On the settlement date, pay the creditor with the foreign currency
asset and repay the domestic loan

Note: Expect that the borrowing and lending rates given the question
will be annual rates and that they will need to be adjusted to reflect the
length of time until settlement.

179

Financial risk management

Pro forma:
(F.C payment)
e.g. ($1m)
Now

Present value
of F.C asset
e.g. $950k

Convert
F.C at
spot
rate

Discount at F.C deposit rate

The future

F.C
(1 + r )

F.C asset (to


exactly offset
payment)
e.g. $1m

Where:

r = Annual rate

n
12

Compound at home
currency borrowing rate

Home currency (1 + r )
Home currency
Where:
liability
e.g. (600k)
n
r = Annual rate
12

Effective payment
in home currency
e.g. (660k)

Hedging receipts
Scenario: The hedging company is to receive a foreign currency
amount in the future.
Approach:

180

Borrow the appropriate amount in foreign currency now

Convert it immediately to home currency

Place it on deposit in the home currency

On the settlement date, use the foreign currency receipt to repay


the foreign currency loan and take the home currency deposit as
the effective receipt

Chapter 15

Pro forma:

F.C receipt
e.g. $1.5m
Now

Discount at F.C borrowing


rate

F.C
(1 + r )

Present value
$
of F.C liability Where:
e.g. ($1.3m)
n
r = Annual rate
12
Convert
F.C at
spot
Compound at home currency
rate
deposit rate

Home
currency
asset
e.g. 800k

Home currency (1 + r )
Where:
n
r = Annual rate
12

The future

F.C liability (to


exactly offset
receipt)
e.g. ($1.5m)

Effective receipt
in home currency
e.g. 850k

Test your understanding 9 Jungle Curry

A Thai company 'Jungle Curry Co Ltd' owes a New Zealand Company


'Hokey Pokey Ltd' NZ$ 3,000,000 payable in 3 months time. The
current exchange rate is NZ$1 = Thai Baht 19.0300 19.0500.
'Jungle Curry' elects to use a money market hedge to manage the
exchange rate risk.
The current borrowing and lending rates in the two countries are:
Investing
Borrowing

New Zealand
2.5%
3.0%

Thailand
4.5%
5.2%

Required:
Calculate the cost to 'Jungle Curry' of using a MMH.

181

Financial risk management

Test your understanding 10 Nicole

Nicole, a French company, has made a large sale worth $5,000,000


to a US company, Sims Inc. Sims Inc is due to settle the amount it
owes to Nicole in 3 months time, 15 December.
Currency Market Rates

Spot rate $ per

1.5904 1.5912

Money Market Rates p.a.

Euro
US

2.6%
1.6%

Required:
Demonstrate how Nicole can use the money market to hedge the
foreign currency receipt.

14 Currency futures
The calculation of the outcome of a currency futures hedge is assumed
knowledge from FM. Thus these notes focus on a reminder of the
approach and the required pro-forma.
Scenario: A business is making a significant purchase or sale in a
foreign currency. The business is worried that the currency will
strengthen (for a purchase) or weaken (for a sale) between the invoice
date and the settlement date.
Currency futures terminology
Underlying asset: The underlying asset for a currency future is the
contract currency i.e. if the contract size is in s then the underlying
asset is s.

For example, a commonly traded currency future on the Chicago


Mercantile Exchange (CME) for $/ has a contract size of 62,500.
Buying one of these futures contracts means you have entered a
contract to buy 62,500 in exchange $s on the expiry date of the future.
Futures price: Represents the markets expectation of the relevant spot
exchange rate on the transaction date.
Expiry dates: Expect the standard expiry dates for currency futures to
be the last day of March, June, September and December (unless told
otherwise).

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Chapter 15

Approach
Buy/sell decision
General rule: Whatever we plan to do with the contract currency (the
underlying asset) in the future, we should do with futures now.
Contract size in home currency (underlying asset = home currency):
FC payment

What company plans


to do with contract
currency in the future

FC receipt

Pay FC, therefore first Receive FC, therefore


sell FC and buy HC
buy FC and sell HC

To set up the futures


position (now)

Sell

Buy

To close out the


position on the
settlement date

Buy

Sell

Contract size in foreign currency (underlying asset = foreign


currency):
FC payment

What company plans


to do with contract
currency in the future

FC receipt

Pay FC, therefore first Receive FC, therefore


buy FC
sell FC

To set up the futures


position (now)

Buy

Sell

To close out the


position on the
settlement date

Sell

Buy

Note: If both payments and receipts are occurring on the settlement


date in the same foreign currency only the net amount needs to be
hedged.
What expiry date to pick

Pick the first expiry date on or after the settlement date e.g. If the
settlement date is the 30th of June, use June contracts. If it is the 1st of
July use September futures.
How many contracts
If the contract size is in FC:

No. of contracts =

Foreign currency amount


Contract size
183

Financial risk management

If the contract size is in HC:

No. of contracts =

FC amount converted in to HC
Contract size

The FC amount should be converted into home currency by dividing by


the current futures price (in FC per unit of HC) as the exchange rate.
Futures are only traded in whole contracts, so the no. of contracts
needs to be rounded to the nearest whole number.
Calculating the profit or loss on the future

The profit or loss on the future will be in the same units as the futures
price e.g. if the futures price is $1.60/, the gain or loss will be in $s per
pound.
The total gain or loss will be: Futures price movement standard
contract size no. of contracts.
If the contract size is in home currency, then the gain or loss will be in
foreign currency. This should be converted back into home currency
using the spot rate on the settlement date.
Note: This should always be the same rate as you use for the
underlying transaction.
Pro-forma

You should recall a 4 stage pro forma from FM:

Approach (buy/sell decision, choice of expiry date)

No. of contracts

Underlying transaction

Futures position

Video illustration

View the Currency futures illustration video on My Kaplan for an


example of how to apply the pro-forma to the following TYU.

184

Chapter 15

Test your understanding 11 Doughnut plc

Doughnut plc is expecting to receive $1.5m on the 20th February


20X1 it is also expecting to have to pay $1m on the same date. It
wishes to hedge the transaction risk using futures.
Futures are available with a contract size of 62,500, prices are as
follows:
December 20X0
March 20X1
June 20X1

$/
1.615
1.613
1.611

The spot rate on the 20th February is 1.726 and the relevant futures
price is 1.695.
Required:
Demonstrate how a futures hedge could be set up and calculate
the net outcome.
Additional practice question
Test your understanding 12 Mediocre Movies

A US company 'Mediocre Movies' (MM) buys goods for 720,000


from a German company 'Efficient Engines' (EE), the invoice is due to
be settled in approximately 1 month's time on the 27th of April.
Current spot is 1 = $0.9215 0.9221 and futures contracts are
currently trading at the following prices:
futures (contract size 125,000)
Contract settlement date
March
June
Sept

Contract price $/
0.9223
0.9245
0.9255

On the 27th of April the spot rate has moved to $/0.9345 0.9351
and the relevant futures price is 0.9367.
Required:
Illustrate the futures hedge and calculate the net outcome.

185

Financial risk management

15 OTC currency options


An OTC option is the a bespoke agreement giving the right, but not the
obligation, to buy/sell an agreed amount of foreign currency at a agreed
rate of exchange
Approach
Put/Call decision
Note: As per the definition above you can expect the underlying asset
for an OTC option to be the foreign currency.
Hence:
FC payment

What company plans


to do with FC in the
future
Option required

FC receipt

Pay FC, therefore first Receive FC, therefore


buy FC
sell FC
Call
Gives the right to buy
FC

Put
Gives the right to sell
FC

No pro forma is required as this is simply a choice between conversion


at the strike rate or the spot rate (on the settlement date).
Follow this three step process:

186

Calculate the outcome if you convert the FC at the strike rate (if
the option is exercised)

Calculate the outcome if you convert the FC at the spot rate on the
settlement date (if it is abandoned)

Pick the best outcome and deduct the premium cost

= Net outcome

Chapter 15

Test your understanding 13 Edted

Edted is a UK company that has purchased goods worth $2,000,000


from an American supplier. Edted is due to make payment in three
months time. Edted's treasury department is looking to hedge the risk
using an over-the-counter option.
At strike price of $1.48/ there is a three month dollar call option
available for a premium of 50,000 and a three month dollar put is
available for a premium of 55,000.
Required:
Calculate the cost to Edted if the exchange rate at the time of
payment is:
(a)

1 = $1.46

(b)

1 = $1.5

16 Traded currency options


The calculation of the outcome of a traded currency options hedge is
assumed knowledge from FM. Thus these notes focus on a reminder of
the approach and the required pro-forma.
Scenario: A business is making a significant purchase or sale in a
foreign currency. The business is worried that the currency will
strengthen (for a purchase) or weaken (for a sale) between the invoice
date and the settlement date.
Key features of traded currency options
Underlying asset: The underlying asset for a traded currency option is
the contract currency i.e. if the contract size is in s then the underlying
asset is s.
Settlement: Traded currency options are cash settled products. Unlike
traded interest rate options they are not options on futures.
Call option: The right, but not the obligation, to buy a set amount of the
contract currency for the strike price before the expiry of the option.
Put option: The right, but not the obligation, to sell a set amount of the
contract currency for the strike price before the expiry of the option.

187

Financial risk management

Approach
Put/Call decision
Contract size in home currency (underlying asset = home currency):

FC payment
What company plans
to do with contract
currency in the future

FC receipt

Pay FC, therefore first Receive FC, therefore


sell FC and buy HC
buy FC and sell HC

Type of option to buy


now

Put

Call

Contract size in foreign currency (underlying asset = foreign


currency):
FC payment

What company plans


to do with contract
currency in the future

FC receipt

Pay FC, therefore first Receive FC, therefore


buy FC
sell FC

Type of option to buy


now

Call

Put

Note: If both payments and receipts are occurring on the settlement


date in the same foreign currency only the net amount needs to be
hedged.
What expiry date to pick

Pick the first expiry date on or after the settlement date e.g. If the
settlement date is the 30th of June, use June contracts. If it is the 1st of
July use September options.
How many contracts
If the contract size is in FC:

No. of contracts =

Foreign currency amount


Contract size

If the contract size is in HC:

No. of contracts =

FC amount converted in to HC
Contract size

The FC amount should be converted into home currency by dividing by


the strike price (in FC per unit of HC).
Traded options are only available in whole contracts, so the no. of
contracts needs to be rounded to the nearest whole number.
188

Chapter 15

Calculating the profit or loss on the option

The profit or loss per unit of base currency should be calculated as the
difference between the strike price and the spot rate on the settlement
day (the same rate as you use for the underlying transaction).
This profit or loss will be in the same units as the strike price e.g. if the
exercise price is $1.60/, the gain or loss will be in $s per pound.
The total gain or loss will be: Difference between strike price and spot
rate on settlement day standard contract size no. of contracts.
If the contract size is in home currency, then the gain or loss will be in
foreign currency. This should be converted back into home currency
using the spot rate on the settlement date.
Note: This should always be the same rate as you use for the
underlying transaction.
Calculating the option premium

The premiums will generally be given in a table and expressed in terms


of the other currency per unit of the contract currency (e.g. cents per ).
The calculation basis is the same as for the gain or loss (amount per
unit of contract currency contract size no. of contracts).
If the premium is in foreign currency it will have to be converted into the
home currency using the current spot rate, as the option is purchased
now.
Pro-forma

You should recall a 6 stage pro forma from FM:

Approach (Put/Call decision, choice of expiry date)

No. of contracts

Underlying transaction

Options position

Exercise decision

Premium cost

Video illustration

View the Traded currency options' illustration video on My Kaplan for


an example of how to apply the pro-forma to the following TYU.

189

Financial risk management

Test your understanding 14 Percy Pigs

A UK co 'Percy Pigs' (PP) is to pay $1m in 1 months time (todays


date is the 1st of May X1). PP wishes to lock in a rate no worse than
$1.6 / using options. The following traded options are available.
Sterling options (contract size 31,250)
Puts

Exercise price ($/)

Calls

June

Sept

June

Sept

1.585

0.2

0.4

0.7

0.9

1.600

1.2

1.4

0.4

0.5

1.615

2.7

2.9

0.3

0.4

Premiums are in cents per

The current spot price is 1.59 1.61 $/. In one months time the spot
rate is 1.48 1.49 $/.
Required:
Illustrate the appropriate traded currency options hedge and
calculate the net outcome.
Additional practice question
Test your understanding 15 Vinnick

Vinnick, an American company, purchases goods from Santos, a


Spanish company, on 15 May on 3 months credit for 600,000.
Vinnick is unsure in which direction exchange rates will move so has
decided to buy options to hedge the contract at a rate of 1 =
$1.2987.
The details for 10,000 options at $1.2987/ are as follows:
Calls

Puts

July

Aug

Sept

July

Aug

Sept

2.55

3.57

4.01

1.25

2.31

2.90

Premiums are in US cents per

The current spot price is 1.2821.


Required:
Calculate the dollar cost of the transaction if the spot rate in
August is:

190

(a)

1.3333

(b)

1.2500

Chapter 15

17 FX swaps
Definition

An FX swap is an arrangement whereby two counterparties agree to


swap currency amounts now and agree to swap them back on a future
date.
Hence, an FX swap has two distinct components a spot FX transaction
and a forward FX transaction (which is in the opposite direction).
Note: The spot and forward transactions can be at different rates and
maybe for different amounts.
Example:

Trumper Towers (TT) is a US company that wishes to build a


skyscraper in London. The skyscraper will cost 50m (payable now) to
build and can be sold for 100m in one years time.
To hedge the risk of sterling weakening over the next year, TT enters a
FX swap with a UK bank.
Thus the bank buys $s from TT in exchange for 50m now (at the
current spot rate) and agrees to sell $s to TT in one years time in
exchange 100m at an agreed forward rate.

18 Hedge efficiency
Reasons for an imperfect hedge

Futures and traded options are standardised products. They come in


standard sizes with standard expiry dates.
This means that a hedge may be imperfect for two reasons:

The rounding of the number of contracts

Basis risk (only relevant for futures and traded interest rate
options, which are options on futures)

A measure of hedge efficiency

A common measure of hedge efficiency is:


Hedge efficiency =

Total gain / loss on the derivative position


Total gain / loss on the underlying transaction

This measure of hedge efficiency is often used to determine whether a


hedge is effective from a financial reporting perspective.

191

Financial risk management

Calculation pro forma for a futures hedge

Underlying transaction @ spot rate on transaction date (as per


futures pro forma, using same sign as pro forma)

X/(X)

Underlying transaction @ spot rate now (opposite sign to the


above)

X/(X)

Gain / (loss) on underlying transaction

Gain / (loss) on futures position from pro forma (using same


sign as pro forma)

Hedge efficiency =

B
A

Test your understanding 16 Hedge efficiency


Calculate the hedge efficiency of the futures hedge set up by
Doughnut PLC in TYU 11.

Assume the current spot rate (at the outset of the hedge) is $1.654/.

19 Pros and cons of different hedging methods


The advantages and disadvantages of the key hedging methods are
assumed knowledge from FM.
However, this content is very examinable in a discussion question at the
advanced stage.
Forwards
Pros

Price/rate is agreed now so risk is removed

As a bespoke product it can be tailored to the users exact


requirements

FRAs are typically low cost

Cons

192

Removes upside as well as downside risk (unlike options)

Difficult to cancel if transaction is no longer required

The settlement/delivery date for a forward transaction is inflexible


and cant be altered if the companys requirements change

Risk of default by the counterparty to the contract

Rate available: If the market expects the spot rate to move


adversely then forward rate will be less favourable than the current
spot rate

Chapter 15

Futures
Pros

Assuming a perfect hedge a future fixes the price/rate now so that


both upside and downside risk is removed

As a standardised product initial cash outflows (for futures these


are mainly a deposit called the initial margin) will be reasonably
low

Can hedge a large exposure with a small initial cash outflow (as
the firm only needs to commit the initial margin to set up the
position)

The futures position can be closed out at any time if the


transaction is no longer required or is required to occur earlier

Default risk is effectively nil, as the contract is with the


clearinghouse not the counterparty

Cons

Standardised dates and amounts are unlikely to match the users


exact requirements. Therefore the hedge is unlikely to be perfect

Currency futures: Only certain currencies are available

Removes upside as well as downside risk (unlike options)

Daily settlement of profits and losses, so hedging company will


need to make additional margin payments if the position is loss
making

OTC Options
Pros

Removes downside risk but allows the user to take advantage of


upside potential

Can let the option lapse if the transaction is no longer required

As a bespoke product it can be tailored to the users exact


requirements

Cons

The premium cost is likely to be relatively expensive compared to


the transaction costs for other hedging methods

The premium cost is payable up-front whether the option is


exercised or not

193

Financial risk management

Traded Options
Pros

Allows the user to take advantage of upside potential

Can sell the option if the transaction is no longer required

Cons

The premium cost is likely to be relatively expensive compared to


the transaction costs for other hedging methods

The premium cost is payable up-front whether the option is


exercised or not

Standardised amounts are unlikely to meet the users exact


requirements

Large contract sizes make traded options impractical for smaller


transactions / companies

Traded options are only generally available with maturities of one


year or less

Interest rate swaps


Pros

Swaps are flexible; they can be arranged for any size of loan and
can be reversed if necessary (by entering another interest rate
swap with exactly opposite terms to the original swap)

Can be used for the very long term (up to 30 years) unlike options,
forwards and futures

Can be used to remove interest rate risk and move to a fixed rate

Can be used to move to a variable rate and take advantage of


favourable interest rate movements

Can result in a lower borrowing rate (due to comparative


advantage)

Transaction costs are low and generally cheaper than an


arrangement fee on a new loan

Cons

194

Default risk counter party may default

Market risk adverse movements in rates

Transparency risk hard to disclose

Lack of a secondary market for swaps can make it difficult to


liquidate a swap contract

Chapter 15

20

Chapter summary

Key interest rate hedging techniques:

FRAs

Interest rate futures

Traded interest rate options

Basic interest rate swaps (coupon swaps)

Key currency hedging techniques:

Money market hedge

Currency forwards

Currency futures

OTC currency options

Traded currency options

Key discursive topics:

Pros and cons of hedging methods

195

Financial risk management

Test your understanding answers


Test your understanding 1 Supercool Ltd
Approach

As Supercool plans to invest 1.6m starting on the 10th of June, it


needs to buy June* interest rate futures now.
*June is the appropriate expiry date as it is the first expiry available on
or after the transaction date (10th June).
No. of contracts

No. of contracts =

Loan/depos it amount Loan/depos it period

Contract size
Contract length

1.6m 6 months

= 6 .4
500k 3 months

Therefore, buy 6 contracts (remember normal rounding rules apply)


Underlying transaction

Interest receivable on the deposit commencing on


the transaction date
(1.6m 6/12 3%)

24,000

Futures position

Now: Buy
Transaction date: Sell
Loss

(97.3)%
96.9%

(0.4)%

Total loss:

0.004 500k 3/12 6

(3,000)

21,000

Outcome (net interest paid)


Effective interest rate:

Length of loan/depos it (months)

Net interest paid


Effective interest rate =

Loan/depos it amount

12
21,000
6 = 2.625%
Effective interest rate =
1,600,000

196

12

Chapter 15

Test your understanding 2 Boom Town Inc


Approach

As Boom Town is worried about interest rates rising before it


refinances its loan on the 31st of May, it needs to sell June* interest
rate futures now.
*June is the appropriate expiry date as it is the first expiry available on
or after the transaction date (31st May).
No. of contracts

No. of contracts =

Loan/depos it amount Loan/depos it period

Contract size
Contract length

$7m 6 months

= 14 contracts
$1m 3 months

Underlying transaction

$
Interest payable on loan commencing on the
transaction date
Note: Loan rate = LIBOR (3% on the 31st of May)
plus 3%:
(7m 6/12 6%)

(210,000)

Futures position

Now: Sell
Transaction date: Buy (W1)
Gain

97.02%
(96.904)%

0.116%

Total gain:

0.00116 $1m 3/12 14


Outcome (net interest paid)

4,060

205,940

Estimated futures price on transaction date (W1)


Calculation of the estimated basis

The basis at the outset of the hedge is the difference between the
current June futures price and the current LIBOR spot rate.
As the futures price is shown as 100 i, the current June futures price
implies an interest rate of:
i = 100 97.02 = 2.98%

197

Financial risk management

The current basis equals:


Interest rate implied by June futures price LIBOR now = current
basis
2.98% 2.5% = 0.48%
It is the 1st of February now, so there is 5 months to expiry. Thus
assuming that the basis declines in a linear fashion, each month it will
reduce by:
0.48 / 5 = 0.096%
At the 31st of May there will be just one month remaining before expiry
so basis is estimated to be 0.096%.
The estimated futures price:

Assuming LIBOR is 3% on the 31st of May and the basis has fallen to
0.096%, the interest rate implied by the futures price can be
estimated as:
3% + 0.096% = 3.096%
Therefore the futures price can be estimated as:
100 3.096 = 96.904

Test your understanding 3 Hot Dog Inc


Note: The U.S. money market uses a 30-day month, 360-day year
convention so the formula becomes:

Settlement amount = Loan amount

(rREF rFRA ) Length of loan (days)

1 + rREF

360
Length of loan (days)
360

The notation 5 vs 8 FRA, means a 3 month loan starting in 5 months.


Hence the loan period will be 90 days (assuming 30-day months):
90
360
Settlement amount = $10m

90
1 + 0.032

360

(0.032 0.03 )

Settlement amount = $4,960.32

198

Chapter 15

Test your understanding 4 Desperado


Note: This question (like those you did in FM) assumes that the
company can borrow at the reference rate (normally, LIBOR).

In Advanced Stage questions it is likely that the fixed rate the


company will pay will be dependent on the reference rate (LIBOR) but
will also include a risk premium. Hence, the company may pay a fixed
interest rate of LIBOR plus 1% (so, if LIBOR is 3% at the start of the
loan, the company will pay a fixed rate of 4%).
Approach

As Desperado is worried about interest rates rising above 2.5%


before it enters a loan agreement on 30th of August, it needs to buy
September* put options on interest rate futures at a strike price of
97.50.
*September is the appropriate expiry date as it is the first expiry
available on or after the transaction date (30th August).
No. of contracts

No. of contracts =

Loan/depos it amount Loan/depos it period

Contract size
Contract length

5.2m 12 months

= 41.6 contracts
500k 3 months

Therefore, buy 42 contracts.


Underlying transaction

Interest payable on the loan commencing on the


transaction date
(5.2m 12/12 2.75%)

(143,000)

Options/Futures position

Put: Right to sell futures


Transaction date: Buy
futures to close out position
Gain

97.50%
(97.21)%

0.29%

Exercise decision yes, its a gain


Total gain:

0.0029 500k 3/12 42

15,225

Premium cost

0.00081 500k 3/12 42


Outcome (net interest paid)

(4,253)

(132,028)
199

Financial risk management

Test your understanding 5 Rumble


Approach

Rumble wants to borrow $4m starting on the 31st of May and wants to
hedge against the risk of LIBOR rising above 3.75% before the loan
rate is set. Therefore, it needs to buy June* put options on interest
rate futures at a strike price of 96.25.
*June is the appropriate expiry date as it is the first expiry available on
or after the transaction date (31st May).
No. of contracts

No. of contracts =

Loan/depos it amount Loan/depos it period

Contract size
Contract length

$4m 3 months

= 4 contracts
$1m 3 months

Underlying transaction

Interest payable on the loan commencing on the


transaction date
($4m (4% + 1%) 3/12)

(50,000)

Options/Futures position

Put: Right to sell futures


Transaction date:
Buy futures to close out
position (W1)
Gain

96.25%
(95.90)%

0.35%

Exercise decision yes, its a gain


Total gain:

0.0035 $1m 3/12 4

3,500

Premium cost

0.00255 $1m 3/12 4


Outcome (net interest paid)

200

(2,550)

(49,050)

Chapter 15

(W1) Estimated futures price on 31st May:


Calculation of the estimated basis

The basis at the outset of the hedge is the difference between the
current relevant futures price and the current LIBOR spot rate.
As the futures price is shown as 100 i, the current futures price
implies an interest rate of:
i = 100 96.10 = 3.9%
The current basis equals:
Interest rate implied by June futures price LIBOR now = current
basis
3.9% 3.5% = 0.4%
It is the 1st of March now, so there are 4 months to expiry. Thus
assuming that the basis declines in a linear fashion, each month it will
reduce by:
0.4 / 4 = 0.1%
At the 31st of May there will be just one month remaining before expiry
so basis is estimated to be 0.1%.
The estimated futures price:

Assuming LIBOR is 4% on the 31st of May and the basis has fallen to
0.1%, the interest rate implied by the futures price can be estimated
as:
4% + 0.1% = 4.1%
Therefore the futures price can be estimated as:
100 4.1 = 95.90

201

Financial risk management

Test your understanding 6 Stylefish and Cool Kangaroo


Gain and outcome
SF

CK

Wants

Fixed

Variable

Without SWAP (A)

(7%)

(L+2%)

(L+9%)

With SWAP

(L+3%)

(4%)

(L+7%)

Fee

(0.25%)

(0.25%)

(0.5%)

(L+3.25%)

(4.25%)

(L+7.5%)

0.75%

0.75%

1.5%

(6.25%)

(L+1.25%)

(L+7.5%)

SF

CK

Total

(4.25%)

(L+7.5%)

Net cost with swap


(B)

Total

Gain after fee (C)

(Total gain is difference


between totals of A +
B, this is then split
between the
counterparties)
Outcome (A + C)
Cash flows

Net cost with swap


(B from above)
Variable leg
(set at LIBOR as per
question):

(L+3.25%)

L%

(L%)

(3.25%)

(L+4.25%)

(L+7.5%)

(3%)

3%

(6.25%)

(L+1.25%)

(L+7.5%)

CK pays SF
Sub total
Fixed leg (balancing
figure):
SF pays CK
Outcome (from above)

202

Chapter 15

Test your understanding 7 Seeler Muller


Note: This is interactive question 5 from the study manual, however
our answer is presented differently.
Gain and outcome
SM

OM

Wants

Variable

Fixed

Without SWAP (A)

(L+0.75)

(10.5%)

(L+11.25%)

(9%)

(L+1.5%%)

(L+10.5%)

Fee

(0.15%)

(0.15%)

(0.3%)

Net cost with swap (B)

(9.15%)

(L+1.65%)

(L+10.8%)

Gain after fee (C)*


(Total gain is difference
between totals of A + B,
this is then split between
the counterparties)

0.225%

0.225%

0.45%

(L+0.525%)

(10.275%)

(L+10.8%)

With SWAP

Outcome (A + C)

Total

*As the question doesnt tell us exactly how to split the gain, we would
use the default assumption that it is split equally.
Cash flows

Net cost with swap


(B from above)
Variable leg* (assumed
to be set at LIBOR):

SM

OM

Total

(9.15%)

(L+1.65%)

(L+10.8%)

(L%)

L%

(L+ 9.15%)

(1.65%)

(L+10.8%)

8.625%

(8.625)%

(L+0.525%)

(10.275%)

(L+10.8%)

SM pays OM
Sub total
Fixed leg (balancing
figure):
OM pays SM
Outcome (from above)

*The question doesnt tell us what the variable leg is set at.
Essentially we could use LIBOR plus or minus any figure, as the fixed
leg is a balancing payment which will offset whatever figure we select.

For example, the answer in the ICAEW study manual sets the
variable leg at L+1.5%; as their variable leg is 1.5% greater than our
solution, their fixed leg also needs to be 1.5% greater (8.625% +
1.5%) = 10.125% to get back to the same outcome.

203

Financial risk management

Test your understanding 8 Hans Gruber


Note: This is based on interactive question 10 from the study manual,
however our answer is presented differently. The level of explanation
shown is for clarity only, and is way beyond what would be expected
in the exam.
Calculating the forward rate
Which rate to use:

Hans is going to receive $s in the future and will want to convert them
into s. Thus he will need to sell $s and buy s in the future. As the
quoted rate is in /$, we can say he plans to buy the variable currency
(or sell the base currency). Thus he will use the low rate.
Dealing with premium/discount:

The premium needs to be deducted from the spot rate to calculate the
forward rate (as a premium suggests that the variable currency is
strengthening and the base currency is weakening):
Spot rate:
Deduct premium
Forward rate:

0.7810/$
(0.0005/$)
0.7805/$

Converting the F.C amount

As Hanss home currency is the variable currency, we multiply the


foreign currency amount by the forward rate to convert:
$1,500,000 0.7805 = 1,170,750

204

Chapter 15

Test your understanding 10 Jungle Curry


Note: This is based on the hedging payments worked example from
the study manual, however our answer is presented differently.

F.C payment
NZ$(3,000,000)

NZ$

Now

Discount at F.C
deposit rate

NZ$3m
1.00625
= NZ$2,981,366

3
r = 2 .5 %
= 0.625%
12

PV =

Convert
F.C at
spot rate*

Bt

3 months time

F.C asset
NZ$ 3,000,000

Compound at home
currency borrowing rate

Home currency
liability
=NZ$2,981,366
19.05 =
Bt(56,795,022)

r = 5 .2 %

3
= 1 .3 %
12

Effective
payment in
home currency
Bt56,795,022
1.013 =
Bt(57,533,357)

*Buying base currency therefore use high rate and multiply the F.C
amount by this rate as the home currency is the variable currency.

Test your understanding 10 Nicole


Note: This is based on interactive question 11 from the study manual,
however our answer is presented differently.

F.C receipt
$5m

Now

Discount at F.C
borrowing rate

$5m
1.004
= $4,980,080

3
r = 1 .6 %
= 0 .4 %
12

PV =

Convert
F.C at
spot rate*

Home
currency asset
$4,980,080
=
1.5912
= 3,129,764

15 December
(3 months time)

F.C liability
$5m

Compound at home
currency deposit rate

3
r = 2 .6 %
= 0.65%
12

Effective receipt
in home currency
3,129,764
1.0065 =
3,150,107

*Selling the variable currency so use the high rate and divide the F.C
amount by this rate as the home currency is the base currency.

205

Financial risk management

Test your understanding 11 Doughnut plc


Approach
Notes:

Net receipt of $500k

UK co. expects to receive $s, so will then need to sell $s and


buy s

Contract size of futures is in s, so underlying asset is s

As Doughnut plans to buy the underlying asset in the future they


should buy futures now

Doughnut plc needs to buy March futures now, to hedge the


transaction risk.
*March is the appropriate expiry date as it is the first expiry available
on or after the settlement date (20th Feb).
No. of contracts
As the contract size is in HC:

No. of contracts =

FC amount current futures price


Contract size

No. of contracts =

$500k 1.613
= 4.96
62.5k

Therefore, buy 5 contracts.


Underlying transaction

FC receipt:
FC amount by spot rate on settlement date
(we divide as the base currency in the rate given is
the HC)
$500k $1.726/

289,687

Futures position

Now: Buy
Settlement date: Sell
Gain

(1.613)$/
1.695$/

0.082$/

Total gain:

0.082$/ 5 62,500 = $25,625


Convert at spot rate on settlement date:
$25,625 1.726 = 14,846
Outcome (net receipt)
206

14,846

304,533

Chapter 15

Test your understanding 12 Mediocre Movies


Approach
Notes:

Contract size of futures is in foreign currency, so underlying


asset is foreign currency

MM plans to make a foreign currency payment, therefore plans


to buy FC in the future and needs to buy FC futures now

The first expiry date available on or after the settlement date is


June

As MM wants to make a payment on the 27th of April they need to


buy June futures now.
No. of contracts
If the contract size is in FC:

No. of contracts =

Foreign currency amount


Contract size

No. of contracts =

720,000
= 5.76
125,000

Therefore, buy 6 contracts.


Underlying transaction

$*
FC payment:
(Buying the base currency/selling the variable
currency thus use the high rate and multiply the FC
amount by this rate as the home currency is the
variable currency)
720k $0.9351/

(673,272)

Futures position

Now: Buy
Settlement date: Sell
Gain

(0.9245)$/
0.9367$/

0.0122$/

Total gain:

0.0122$/ 6 125,000 = $9,150


Outcome (net $ cost)

9,150

(664,122)

*The outcome column should always be in home currency, in this


case $s.
207

Financial risk management

Test your understanding 13 Edted

(a)

If the option is exercised:

cost =

$2,000,000
= (1,351,351) payment
1.48

If the option is not exercised:

cost =

$2,000,000
= (1,369,863) payment
1.46

Exercising results in the lower payment and is therefore


preferable.
Net cost = (1,351,351) premium cost
Net cost = (1,351,351) 50,000 = (1,401,351)
(b)

If the option is exercised:

cost =

$2,000,000
= (1,351,351) payment
1.48

If the option is not exercised:

cost =

$2,000,000
= (1,333,333) payment
1.5

Abandoning the option results in the lower payment and is


therefore preferable.
Net cost = (1,333,333) 50,000 = (1,383,333)

Test your understanding 14 Percy Pigs


Approach
Notes:

Contract size of traded options is in s (home currency), so


underlying asset is s

PP plans to make a foreign currency payment, therefore plans to


buy FC and sell HC in the future

Thus needs to buy put options on HC now

The first expiry date available on or after the settlement date is


June

Therefore PP needs to buy June put options at a strike price of 1.6$/

208

Chapter 15

No. of contracts
As the contract size is in HC:

No. of contracts =

FC amount strike price


Contract size

No. of contracts =

$1m 1.6
= 20
31.250

Underlying transaction

FC payment:
(Buying the variable currency/selling the base
currency thus use the low rate and divide the FC
amount by this rate as the home currency is the
base currency)
$1m $1.48/

(675,675)

Options position

Put: Right to sell s


Compare to spot rate on
settlement date
(with opposite sign)*
Gain

1.60$/
(1.48)$/

0.12$/

*Use the same rate as for the underlying transaction i.e. in this case
the underlying transaction was to buy the variable currency so use the
low rate.
Exercise decision yes, its a gain
Total gain:

$0.12 20 31,250 = $75,000


Convert @ spot on transaction date
$75,000 / 1.48 = 50,675

50,675

Premium
Note: Premium is in cents per and to avoid mistakes this should be
converted into $s by multiplying by 0.01

$0.012 20 31,250 = $7,500


Convert @ spot now (using the low rate as we need
to buy the variable currency to purchase the option)
$7,500 / 1.59 = 4,717
Net outcome

(4,717)

(629,717)

The outcome column should always be in home currency, in this case


s
209

Financial risk management

Test your understanding 15 Vinnick

(a)

Approach
Notes:

Contract size of traded options is in (foreign currency), so


underlying asset is s

Vinnick plans to make a foreign currency payment,


therefore plans to buy FC in the future

Thus needs to buy call options on FC now

The first expiry date available on or after the settlement


date is August

Therefore Vinnick needs to by August call options at a strike


price of $1.2987 /.
No. of contracts
As the contract size is in FC:

No. of contracts =

Foreign currency amount


Contract size

No. of contracts =

600k
= 60
10k

Underlying transaction

$
(799,980)

FC payment:
600k 1.3333$/
Options position

Call: Right to buy s


Compare to spot rate on
settlement date
(with opposite sign)*
Gain

(1.2987)$/
1.3333$/

0.0346$/

*Use the same rate as for the underlying transaction


(1.3333 $/)
Exercise decision yes, its a gain
Total gain:

As Vinnick is a US company and the gain is in $s there is no


need to convert this, it can go straight into the outcome column
0.0346$/ 60 10,000
210

20,760

Chapter 15

Premium
Note: Premium is in US cents per and to avoid mistakes this
should be converted into $s by multiplying by 0.01

The premium cost will be in $s and as Vinnick is a US company


there is no need to convert this.
0.0357$/ 60 10,000

(21,420)

(800,640)

Net outcome

(b)

Approach

Therefore Vinnick needs to by August call options at a strike


price of $1.2987/, as above.
No. of contracts

60, as above
Underlying transaction

$
FC payment:
600k 1.2500$/

(750,000)

Options position

Call: Right to buy s


Compare to spot rate on
settlement date
(with opposite sign)*
Loss

(1.2987)$/
1.2500$/

(0.0487)$/

*Use the same rate as for the underlying transaction


(1.2500 $/)
Exercise decision abandon, its a loss
Premium
Note: Premium is in US cents per and to avoid mistakes this
should be converted into $s by multiplying by 0.01

The premium cost will be in $s and as Vinnick is a US company


there is no need to convert this.
0.0357$/ 60 10,000 (as above)
Net outcome

(21,420)

(771,420)

211

Financial risk management

Test your understanding 16 Hedge efficiency

Underlying transaction @ spot rate on transaction


date (as per answer for TYU 11)
Underlying transaction @ spot rate now (opposite sign
to the above) $500k 1.654
Gain / (loss) on underlying transaction
Gain / (loss) on futures position (as per answer for
TYU 11)
Hedge efficiency =

289,687
(302,297)

(12,610)
14,846

14,846
= 117.7%
12,610

The hedge was not 100% efficient due to basis risk and the rounding
of the number of contracts (such that the futures position was slightly
larger than the underlying transaction).

212

Appendix

Corporate reporting
appendix

213

Corporate reporting appendix

Contents

214

Page

IAS 1: Presentation of financial statements

207

IAS 10: Events after the reporting period

207

IAS 16: Property, plant and equipment

207

IAS 17: Leases

208

IAS 18: Revenue

209

IAS 19: Employee benefits

210

IAS 21: The effects of changes in foreign exchange rates

210

IAS 23: Borrowing costs

212

IAS 27: Separate financial statements

213

IAS 28: Investments in associates and joint ventures

213

IAS 32: Financial instruments: Presentation

213

IAS 33: Earnings per share

214

IAS 36: Impairments

215

IAS 37: Provisions

215

IAS 38: Intangible assets

216

IAS 39: Financial instruments: Recognition and


measurement

217

IFRS 2: Share based payments

220

IFRS 3: Business combinations

223

IFRS 5: Assets held for sale and discontinued operations

225

IFRS 7: Financial instruments: Disclosures

228

IFRS 8: Operating segments

228

IFRS 9: Financial instruments (hedge accounting)

229

IFRS 10: Consolidated financial statements

233

IFRS 11: Joint arrangements

234

IFRS 12: Disclosure of interests in other entities

235

IFRS 13: Fair value measurement

235

Appendix 1

IAS 1: Presentation of financial statements


It is management's responsibility to make an assessment of whether the
company is a going concern.
The assessment should be supported by forecasts covering at least 12
months after the SFP date.
If there is significant uncertainty over going concern this should be
disclosed in the financial statements
If the company is not considered to be a going concern the basis on
which the accounts have been prepared (generally the break-up basis)
and the reasons why the company is not considered a going concern
should be disclosed.

IAS 10: Events after the reporting period


There are a number of events which may occur (or information which
may come to light) after the period end but before the accounts are
signed, which may need to be disclosed in the financial statements
under IAS 10.
Examples of issues which would require accounts to be adjusted
include:

Subsequent evidence of impairment of assets

Subsequent determination of the costs of assets

Examples of events requiring disclosure include:

A major business combination

Announcing a plan to discontinue an operation

Major purchases of assets

Destruction of assets

Abnormally large changes in asset prices or foreign exchange


rates

IAS 16: Property, plant and equipment


Recognise PPE if:

It is probable that future economic benefit will flow to the entity

It can be measured reliably

Initial measurement is at cost which includes:

Purchase price

Any other costs incurred in bringing the asset into working


condition
215

Corporate reporting appendix

Subsequently, PPE should be depreciated:

Write off the cost less any residual value over the useful economic
life (UEL)

Choose a depreciation method to match the flow of economic


benefit

Review the method, residual value and UEL at year end, and
revise if necessary

Any changes will be regarded as a change in an accounting


estimate

IAS 17: Leases


IAS 17 identifies two types of lease, an operating lease or a finance
lease. It determines the type by considering the substance.
IAS 17 identifies five situations that would normally lead to a lease
being classified as a finance lease:

The lease transfers ownership at the end of the lease term

The lessee has the option to purchase the asset for < fair value

The lease term is for the major part of the assets economic life

Present value of the minimum lease payments are substantially


all of the assets fair value

The leased asset is so specialised it can only be used by the


lessee

Operating lease lessee


Accounting treatment:

Rentals are charged to the income statement on a straight line


basis over the period of the lease

Incentives to sign operating leases are spread over the life of


lease

Finance lease lessee


Accounting treatment:

216

Capitalise the asset and recognise the liability, at the lower of the
fair value and the present value of the minimum lease payments

Add any direct costs to the amount recognised as an asset

Appendix 1

Depreciate the asset over the shorter of the lease term and the
useful economic life

Apply the finance charge to give a constant rate on the


outstanding liability (using the implicit rate)

Rental payments are split between interest and the repayment of


capital

IAS 18: Revenue


General principles
Revenue can be recognised when:

Probable future benefits flow to the entity

These benefits can be measured reliably

Revenue is measured at:

The fair value of the consideration

Sale of goods
Revenue from the sale of goods can be recognised when:

The entity has transferred the risks and rewards to the buyer

There is no continuing managerial involvement from the entity

The revenue can be measured reliably

It is probable that economic benefit can flow to the entity

The costs incurred in respect of the transaction can be measured


reliably

Rendering of services
Revenue from the rendering of services can be recognised when:

The revenue can be measured reliably

It is probable economic benefit will flow to the entity

The stage of completion can be measured reliably at the reporting


date

The costs incurred in respect of the transaction can be measured


reliably

217

Corporate reporting appendix

IAS 19: Employee benefits


There are two types of pension scheme:
Defined contribution schemes Set contribution by employer
variable benefit for employees
Defined benefit schemes Variable contribution by employer
guaranteed benefit for employee
Defined contribution accounting:

The entity should recognise contributions payable as an expense


in the period in which the employee provides services

A liability should be recognised for contributions (relating to the


year) which remain unpaid at the year end

Defined benefit plan accounting:

The defined benefit plan is recognised on the company's SFP as


either a liability or asset depending on whether the plan is in deficit
or surplus

The deficit or surplus of the plan is determined by deducting the


fair value of the plan assets from the present value of the defined
benefit obligation

Components of the cost of defined benefit plans are broken down into
constituent parts and accounted for separately:

Service cost is included in profit or loss

Net interest on the net defined benefit liability (asset) is included in


profit or loss

Re-measurements of the net defined benefit liability (asset) are


included in other comprehensive income

IAS 21: The effects of changes in foreign exchange


rates
IAS 21 applies in the following cases:

218

In accounting for transactions and balances in foreign currencies,


except for derivative transactions and balances within the scope of
IAS 39 Financial Instruments: Recognition and Measurement

In translating the results and financial position of foreign


operations within group accounts

In translating an entitys results and financial position into a


presentational currency.

Appendix 1

Definitions
Exchange rates:

Historic rate: Rate in place at the date the transaction takes


place, sometimes referred to as the spot rate.

Closing rate: Rate at the reporting date.

Opening rate: Rate at the opening reporting date.

Average rate: Average rate throughout the accounting period.

Assets and liabilities:

Monetary assets/liabilities: Items that can be easily converted


into cash e.g. Receivables, Payables, Loans

Non-monetary items: Items that give no right to receive or deliver


cash e.g. inventory, PPE

Currency:

Functional currency: The currency of the primary economic


environment in which an entity operates

Presentational currency: The currency in which the financial


statements are presented

Translating transactions
Initial transactions

Translate using the historic rate prevailing at the transaction date

The average rate can also be used if it does not fluctuate


significantly during the accounting period

Settled transactions
If a transaction is settled (payment or receipt occurs) during the
accounting period:

Translate at the date of payment/receipt using the historic rate


prevailing at that date

As this may be different to the initial transaction an exchange


difference may arise, this is posted to the Income Statement

Unsettled transactions

If a transaction is still unsettled at the reporting date, there will be


an outstanding asset or liability on the statement of financial
position

If the asset/liability is a monetary item: retranslate at closing rate


219

Corporate reporting appendix

If the asset/liability is a non-monetary item: leave at historic rate

Exchange differences will arise on the translation of the monetary


items; these are also posted to the Income Statement

Non-monetary Items
Cost Model

Non-monetary items that are held at cost are initially translated at


the historic rate and carried forward at this value, they are not
retranslated

Fair Value Model

A non-monetary asset held at fair value, is initially translated at the


historic rate and retranslated at the spot rate each time a new fair
value is determined

Translating the results of a foreign operation


The results and financial position of an entity are translated into a
different presentation currency using the following procedures:

Assets and liabilities for each balance sheet presented are


translated at the closing rate at the date of that balance sheet

Income and expenses for each income statement are translated at


exchange rates at the dates of the transactions (the rate
average can be used as an approximation)

All resulting exchange differences are recognised in other


comprehensive income

IAS 23: Borrowing costs


If borrowing costs can be directly attributed to the acquisition,
construction or production of a qualifying asset, then the borrowing
costs should be capitalised.
A qualifying asset is an asset that necessarily takes a substantial period
of time to get ready for its intended use or sale.
Borrowing costs eligible for capitalisation are those that would have
been avoided otherwise.
If the firm uses a range of debt instruments / general finance to
construct an asset, WACC should be used to calculate the capitalised
finance costs

220

Appendix 1

IAS 27: Separate financial statements


Where a parent company presents separate financial statements (i.e.
individual FS separate from the group FS) it shall account for
investments in subsidiaries, joint ventures and associates either:
(a)

At cost, or

(b)

In accordance with IFRS 9.

IAS 28: Investments in associates and joint ventures


An associate is an entity over which the investor has significant
influence. Remember that holding 20% of voting power creates a
presumption of significant influence.
Investments in associates shall also be accounted for using the equity
method.
The equity method means that the investment will be recognised initially
at cost and then adjusted for the post-acquisition change in the share of
the investments net assets.
IAS 28 requires investments in joint ventures to be accounted for via the
equity method in the venturer's consolidated FS.

IAS 32: Financial instruments: Presentation


Equity instrument is any contract that evidences a residual interest in
the assets of an entity after deducting all of its liabilities.
Under IAS 32 whether a financial instrument is classified as an equity
instrument should depend on the substance of the contractual terms.
The critical feature in the contractual terms is whether there is an
obligation to deliver cash or another financial asset.
If the issuer does not have an unconditional right to avoid delivery of
cash or other financial asset, then the instrument is a liability.
This definition of equity could also include preference shares.
Interest, dividends, losses and gains arising in relation to a financial
liability should be recognised in profit or loss for the relevant period.
Distributions, such as dividends, paid to holders of a financial
instrument classified as equity should be charged directly against
equity.

221

Corporate reporting appendix

Compound financial instruments


A compound or hybrid financial instrument is one that contains both a
liability component and an equity component.
For example, the issuer of a convertible bond has:

The obligation to pay annual interest and eventually repay the


capital the liability component

The possibility of issuing equity, should bondholders choose the


conversion option the equity component

In substance the issue of such a bond is the same as issuing separately


a non-convertible bond and an option to purchase shares.
Split accounting:
The net proceeds of the issue should be split between the liability and
equity components as follows:

The fair value of the liability component should be measured at the


present value of the payments on the bond (both interest and
capital)

Note: The discount rate used to calculate the present value should
be the yield to maturity of a comparable bond (same CFs and
default risk) which doesn't have the conversion option

The fair value of the equity component should be measured as the


remainder of the net proceeds

Note: The split between debt and equity is determined at recognition


and is not revisited due to changes in interest rates, share prices etc.
The annual interest expense arising on the liability component is
recognised in the P&L. It should be calculated using the interest rate
used to initially determine the liability component.
Conversion:
If all or part of the compound financial instrument is eventually
converted into equity, the relevant proportion of the carrying amount of
the financial liability should be reclassified as equity, being added to the
equity amount initially recognised.
No gain or loss should be recognised on conversion of the instrument.

IAS 33: Earnings per share


You may be asked to calculate EPS (per IAS 33) in the exam but
detailed knowledge of the standard is not required.
Note: EPS figures calculated in line with the standard may need to be
normalised (to reflect the sustainable earnings of the company) to be
useful as a basis for a valuation.
222

Appendix 1

IAS 36: Impairments


You may be asked to identify or evaluate risks in the exam and such
risks may indicate that an asset is impaired.
If there is any indication that an asset may be impaired, recoverable
amount shall be estimated for the individual asset.
The recoverable amount is the higher of fair value less costs of disposal
and value in use.
If the recoverable amount is less than the carrying value the firm must
write the asset down to its recoverable amount and recognise an
impairment loss.

IAS 37: Provisions


General provisions were used in the past as creative accounting
devices to smooth earnings.
Therefore, IAS 37 specifically restricts entities from making 'general'
provisions.
According to IAS 37 Provisions, Contingent Liabilities and Contingent
Assets a provision shall be recognised when:

An entity has a present obligation (either legal or constructive) as


a result of a past event

It is probable that an outflow of resources embodying economic


benefits will be required to settle the obligation

A reliable estimate can be made of the amount of the obligation

If these conditions are met then a provision must be recognised.


If the outflow of economic benefits is only possible, or can't be reliably
estimated, then a contingent liability should be disclosed in the FS.
Measurement
The amount recognised as a provision shall be the best estimate of the
expenditure required to settle the present obligation at the end of the
reporting period.
The best estimate of the liability may be calculated as either:

The liability associated with the most likely outcome

The expected value of the liability

223

Corporate reporting appendix

Examples to be aware of for the exam

Provisions cannot be made for future losses (as these are not
obligations at the year-end)

Provisions for restructuring costs are only allowed if a detailed


formal plan is in place and this has either been commenced or
announced to those affected

Environment issues can result in provisions being recognised (e.g.


in respect of clean up or decommissioning costs), provided the
recognition criteria are met

IAS 38: Intangible assets


Key points
An intangible asset:

Has no physical substance

It is identifiable either separable or arises from a contractual or


legal right

Should be recognised if there is a probable economic benefit


flowing to the entity as a result and it can be measured reliably

Recognition and measurement:

Initially (if the intangible meets the criteria to be recognised) it


should be capitalised at cost

The company can choose to use either the cost or revaluation


model (the revaluation model can only be used if there is an active
market in the intangible asset)

Subsequently, the intangible should be amortised (from the date it


is ready for use) if there is a UEL

Residual values should be assumed to be nil (except in rare cases


e.g. where there is an active market)

Annual impairment reviews should be performed if the asset has


an indefinite UEL (i.e. there is no UEL)

Any gain or loss on disposal of the intangible should be


recognised in the P&L

Acquired intangibles:

224

Acquired separately recognise at cost

Acquired with a business combination if it can be identified


separately recognise at fair value otherwise include in goodwill

Appendix 1

Internally generated intangibles:

Internally generated goodwill should not be recognised

Research write off as an expense immediately

Development must capitalise if meet certain criteria

Expenditure incurred prior to the criteria being met may not be


capitalised retrospectively

Brands
IAS 38 states that internally generated brands, mastheads, publishing
titles, customer lists, customer relationships and similar items must not
be recognised as intangible assets.
Thus marketing / brand building costs should be expensed as incurred.
However, acquired brands should be capitalised at their fair value at
acquisition, and subsequently reviewed for impairment on an annual
basis.

IAS 39: Financial instruments: Recognition and


measurement
A derivative is a financial instrument:

Whose value is derived from the value of an underlying item; as


there is a change in the value of the underlying item, the value of
the derivative changes in response

Which requires no or a small initial investment

Which is settled at a future date

Accounting for derivatives


Recognition
A derivative should be recognised when the entity enters into the
contract.
Measurement
Derivatives are classified as held for trading unless they are hedging
instruments, so should be measured at fair value.
Any subsequent changes in fair value should be recognised in the P&L.
Fair value will preferably be the quoted market price at which the latest
transaction occurred.
If there is no active market for a particular derivative, then fair value
should be determined using valuation techniques (e.g. an option pricing
model).
225

Corporate reporting appendix

Such valuations are problematic as the value is highly dependent on the


underlying assumptions used.
Points to be aware of:

An option would still qualify as a derivative even if it is out of the


money and the holder is expected to abandon it

The initial margin payment made in respect of a futures contract


does not represent part of the net investment in the derivative
(because it is a deposit)

Generally interest rate swaps will meet the above definition of a


derivative under IAS 39

However, a prepaid pay-variable, receive fixed interest rate swap


would not (as the future receipt would not depend on a underlying
variable)

Derecognition
When a derivative is derecognised the difference between the carrying
value and the proceeds should be recognised in the P&L.
Any accumulated gains or losses that had been previously recognised
in OCI should be transferred to the P&L.
Special cases relating to derivatives and derecognition of financial
assets
Financial assets shouldn't be derecognised, if transferred:

Under a total return swap

Under a repurchase agreement where there is an obligation to


repurchase the asset at specified price

To a SPV in a securitisation but the risks and rewards haven't


been fully passed over to the SPV

Disclosures
For derivatives that are financial liabilities, the entity should disclose:
The amount of change, during the period and cumulatively, in the fair
value of the financial liability that is attributable to changes in the credit
risk of that liability.
The difference between the financial liabilitys carrying amount and the
amount the entity would be contractually required to pay at maturity to
the holder of the obligation.
The valuation techniques and inputs used to develop fair value
measurements (under IFRS 13)

226

Appendix 1

Calculation (relating to above disclosures)


Change in fair value due to change in credit risk:

Total change in fair value less change in fair value due to market
risk

Embedded derivatives
Sometimes a contract that isnt a derivative (e.g. a bond) can have a
derivative contract included in it (e.g. an option to convert the bond into
a fixed number of ordinary shares at a future date).
The non-derivative contract is called a host contract.
The derivative included therein is called an embedded derivative.
An embedded derivative is one that cannot be transferred
independently of the host contract.
Accounting for an embedded derivative
The derivative must be accounted for as a separate financial instrument
at fair value through the P&L (FVPL) if the following three conditions are
met:

The combined contract is not FVPL

A separate instrument with the same characteristics would meet


the definition of a derivative

The characteristics and the risks of the embedded derivative are


not closely related to the host contract

IAS 39 gives guidance as to when an embedded derivative is deemed


to be closely related to the host contract and when it is not.
Examples of situations in which embedded derivatives are deemed to
be closely related to the host contract, and therefore arent accounted
for separately to the host are:

Contingent lease rentals linked to the lessees future sales


included in a lease contract.

A lease whereby the future rise in lease rentals is linked to a


consumer price index

Fixing a future price for the purchase of a commodity in a foreign


currency, provided the price is fixed in the functional currency of
either the buyer or the seller, or in a third currency in which the
contracted goods or services are routinely denominated

See AG 30 and 33 IAS 39 for further guidance.

227

Corporate reporting appendix

Examples of embedded derivatives that are not deemed to be closely


related to the host contract and should therefore be accounted for
separately are:

The option element of convertible debt

A lease whereby the future rise in lease rentals is determined by a


multiple of a consumer price index

Fixing a future price of a commodity in a currency that is not the


functional currency of the buyer or the seller, or a third currency in
which the contracted goods or services are routinely denominated

An option included in a fixed price contract to extend the contract


at the end of the period without reviewing the prices

IFRS 2: Share based payments


The basics
IFRS 2 requires an expense representing the fair value of the options to
be recognised over the period from the grant date to the vesting date.
The fair value is initially calculated using an option pricing model (e.g.
Black-Scholes or Monte Carlo simulation).
The reasoning behind IFRS 2
Prior to IFRS 2 if a company paid its employees in cash, an expense
was recognised in profit or loss, but if the payment was in share
options, no expense was recognised.
IFRS 2 resolved this anomaly by requiring an expense to be recognised
in the P&L in relation to share-based payments.
Accounting for employee share options
Transactions with employees are normally:

Measured at the fair value of equity instruments granted at the


grant date

Spread over the vesting period (often a specified period of


employment)

The fair value should be based on market prices if available.


Otherwise, the fair value should be estimated using an appropriate
valuation technique (e.g. Black-Scholes model or Binomial model).

228

Appendix 1

When is the expense recognised?


The recognition depends upon whether there are vesting conditions in
place.
Vesting conditions mean that certain conditions must be met in order for
the employee to be entitled to receive the share-based payment.

No vesting conditions the expense is recognised in the


statement of profit or loss immediately.

Vesting conditions in place the expense must be spread over


the vesting period.

The vesting period is the period between the grant date and the vesting
date the date from which the conditions associated with share based
payment (SBP) are achieved by employee, allowing access to the SBP.
The actual exercise of the options (on the exercise date) may occur
sometime after the vesting date.

Grant date

Vesting date

Exercise date

Vesting period
Impact of vesting conditions
As well as affecting when the expense is recognised, vesting conditions
can also affect the value.
There are two types of vesting condition:

Non-market based which are conditions unrelated to the market


value of the share

Market based which are conditions linked to the price of the


share in some way

Non-market based vesting conditions include the following:

Completing a minimum service period required for employees

Achieving a minimum sales or profit target

Achieving a specific earnings per share ratio

Successfully completing a particular project

229

Corporate reporting appendix

They affect the accounting treatment as follows:

Fair value is still calculated at the grant date

This fair value is still spread over the vesting period BUT each
year the value is revised to take into account the number of
shares expected to vest

If the vesting conditions are subsequently not met, any previously


recognised expense will be reversed

Market based vesting conditions include the following:

A minimum increase in the share price of the entity

A minimum increase in the shareholder return

A specific target price relative to an index of market prices

They affect the accounting treatment as follows:

Fair value is still calculated at the grant date, this fair value takes
into account the expected market conditions

This fair value is still spread over the vesting period using the
original estimate of the number of shares expected to vest

If the shares or share options do not vest, any amount already


recognised in the financial statements remain

Vested options not exercised


If, after the vesting date, options are not exercised or the equity
instrument is forfeited, there will be no impact on the financial
statements. This is because the holder of the equity instrument has
effectively made that decision as an investor.
Disclosures
In the FS entities should disclose:

The total expense recognised for the period relating to sharebased payment transactions

A separate disclosure of that portion of the total expense that


arises from equity-settled share-based payment transactions

In respect of share-based payment liabilities, entities should disclose:

230

The total carrying amount at SFP date

The total intrinsic value at the end of the period of liabilities (in
respect of options which had vested at the SFP date)

Appendix 1

Impact on EPS
IAS 33 requires that all dilutive securities are taken into account when
calculating the weighted number of shares for diluted EPS.
Hence non-vested employee share options will be treated as
outstanding options at the grant date (even though they are yet to vest).

IFRS 3: Business combinations


An acquirer of a business recognises the assets acquired and liabilities
assumed at their acquisition-date fair values.
IFRS 3 requires that one of the combining entities must be identified as
the acquirer.
Fair values
Under IFRS 3 is that the subsidiary's assets and liabilities must be
measured at fair value except in certain, specific cases.
IFRS 13 provides the detailed guidance on how the fair values should
be calculated.
Intangible assets
IFRS 3 states intangible assets can only be recognised separately from
goodwill if they are identifiable.
An intangible asset is identifiable only if it:

Is separable

Arises from contractual or other legal rights

Note: Some intangibles that may be important to the acquirer won't be


recognised separately under this approach.
Exceptions to the IFRS 13 principles:

Deferred tax: use IAS 12 values

Employee benefits: use IAS 19 values

Share-based payment: use IFRS 2 values

Assets held for sale: use IFRS 5 values

There are also special rules for required rights and indemnification
assets

231

Corporate reporting appendix

Special cases
Restructuring and future losses
An acquirer should not recognise liabilities for future losses or other
costs expected to be incurred as a result of the business combination.
A plan to restructure a subsidiary following an acquisition is not a
present obligation of the acquiree at the acquisition date.
Note: There is no obligation so it is not contingent liability either.
Such a provision could only be recognised on acquisition if the acquired
business was already committed to the plan before the acquisition.
Contingent liabilities
IAS 37 states that contingent liabilities should only be disclosed and not
recognised on the SFP.
Exception under IFRS 3: Contingent liabilities of the acquired business
are recognised on the SFP in a business combination if their fair value
can be measured reliably.
After their initial recognition, the acquirer should measure contingent
liabilities that are recognised separately at the higher of:

The amount that would be recognised in accordance with IAS 37

The amount initially recognised

Valuation of previously-held stake


If an acquirer makes an acquisition, having previously held an equity
interest in the company being acquired, the previously held interest will
be remeasured to fair value immediately before control is achieved.
Any gain or loss is taken to profit or loss.
Valuation of non-controlling interest
Non-controlling interest (NCI): The equity in a subsidiary not
attributable, directly or indirectly, to a parent.
Any NCI in an acquired subsidiary is measured at fair value or as the
NCIs proportionate share of the identifiable net assets.
Fair value of consideration
Deferred consideration should be measured at its fair value at the
acquisition date.
The fair value depends on the form of the deferred consideration.

232

Appendix 1

Where the deferred consideration is in the form of equity shares:

Its fair value should be measured at the acquisition date

The deferred amount should be recognised as part of equity,


under a separate heading such as 'shares to be issued'

Where the deferred consideration is payable in cash:

A liability should be recognised at the present value of the amount


payable

Contingent consideration
Contingent consideration is additional consideration which is contingent
on future events/conditions (such as a particular level of financial
performance being achieved).
IFRS 3 requires contingent consideration to be recognised as part of
the consideration transferred and measured at its fair value at the
acquisition date.
Goodwill on acquisition
IFRS 3 requires goodwill acquired in a business combination (or a gain
on a bargain purchase) to be measured as the difference between:
(a)

The aggregate consideration transferred plus any NCI

(b)

The net identifiable assets acquired

This difference will, generally, be recognised as goodwill.


If the acquirer has made a gain from a bargain purchase that gain is
recognised in profit or loss.

IFRS 5: Assets held for sale and discontinued


operations
Discontinued operations
A discontinued operation is an operation that is either disposed of in
the reporting period or classified as held for sale and:

Represents a separate major line of business

Is part of a single co-ordinated plan

Is a subsidiary acquired exclusively for resale

Component of an entity: Operations and cash flows that can be


clearly distinguished, operationally and for financial reporting purposes,
from the rest of the entity.
233

Corporate reporting appendix

IFRS 5 also applies to groups of assets and associated liabilities which


will be disposed of in a single transaction, described as a disposal
group.
The definition of a disposal group includes, but is not limited to:

A subsidiary which the parent is committed to selling

A cash-generating unit of the entity

The results of a disposal group should be shown as discontinued


operations, provided it is a:

Component (as per above definition)

Separate major line of business

Note: Not all divestments will meet the recognition criteria under
IFRS 5.
For example:
A demerger will be recognised as a discontinued operation but wont
qualify as an asset held for sale (see below) as it is not being sold.
Assets held for sale
An asset can be classified as held for sale if

The carrying value will be recovered through selling the asset not
through continued use

The asset is available for immediate sale

The sale is highly probable

For the sale to be highly probable, the following must all apply:

Management must be committed to a plan to sell the asset

There must be an active programme to locate a buyer

The asset must be marketed for sale at a price that is


reasonable in relation to its current fair value

The sale should be expected to take place within one year from
the date of classification

It is unlikely that significant changes to the plan will be made or


that the plan will be withdrawn

Even if the asset is not sold within one year, it can still be classified as
held for sale, provided the delay is due to events outside the entitys
control.
If the asset is abandoned it cannot be classified as held for sale.
234

Appendix 1

If the asset is classified as held for sale, it is valued at the lower of its
carrying value and fair value (less costs to sell) and recognised as a
current asset. It is no longer depreciated.
The fair value for CGUs should be calculated in line with IFRS 13.
Disclosures
Discontinued operations
An entity should disclose a single amount on the P&L comprising the
total of:

Post tax profit/loss of the operation

Post tax profit/loss on re-measuring the operation to fair value less


any costs to sell.

An entity should also disclose an analysis of this single amount into:

The revenue, expenses and pre-tax profit or loss of discontinued


operations

The related income tax expense

Post tax profit/loss on re-measuring the operation to fair value less


any costs to sell

The related income tax expense

This analysis may be presented either:

On the face of the P&L (in a separate section for discontinued


operations), or

In the notes

Assets held for sale


An asset held for sale should be presented separately on the SFP.
The following would need to be disclosed in respect of assets held for
sale:

The major classes of assets and liabilities classified as held for


sale shall be separately disclosed (on the SFP or in the notes)

Any cumulative income or expense recognised directly in equity


relating to a held for sale asset

Note: If the disposal group is a newly acquired subsidiary that meets


the criteria to be classified as held for sale on acquisition, disclosure of
the major classes of assets and liabilities is not required.

235

Corporate reporting appendix

The following information should be disclosed in the notes in the period


in which a non-current asset (or disposal group) has been either
classified as held for sale or sold:

A description of the non-current asset (or disposal group)

A description of the facts and circumstances of the sale, or leading


to the expected disposal, and the expected manner and timing of
that disposal

The gain or loss recognised in profit or loss or the caption in the


statement of comprehensive income that includes that gain or loss

If applicable, the segment in which the non-current asset (or


disposal group) is presented in accordance with IFRS 8 Operating
Segments

IFRS 7: Financial instruments: Disclosures


IFRS 7 requires disclosures on:

The significance of financial instruments for the entitys financial


position and performance

The nature and extent of risks arising from financial instruments to


which the entity is exposed and how they are managed (the
disclosures on risk are both qualitative and quantitative)

IFRS 8: Operating segments


An operating segment is one which:

Engages in business activities from which it may earn revenues


and incur costs

Its operating results are reviewed by the CEO to make decisions

Discrete financial information is available

Disclosures

Operating segment profit or loss

Segment assets

Segment liabilities

Information must also be given about the determination of the operating


segments and the products and services provided.

236

Appendix 1

IFRS 9: Financial instruments (hedge accounting)


Note: The hedge accounting rules relevant for your syllabus partly
come from IAS 39 and partly from IFRS 9.
All the hedge accounting rules have been presented here in one place
for clarity.
IAS 39 has specific rules on how to account for a hedge, although these
are optional and are only allowed if the hedging arrangement passes
certain criteria.
Components of a hedge
There are 3 elements to a hedge:

The hedged item

The hedging instrument

The hedged risk

The hedged item


The hedged item is the item that generates the risk and what the entity
is trying to protect. There are 3 types of hedged item:

A recognised asset or liability this already exists on the


statement of financial position and the entity is trying to protect its
value

An unrecognised firm commitment a transaction that is not yet


recognised on the statement of financial position but for which a
fixed term contract does exist. The entity is trying to protect the
terms of the contract

A highly probable forecast transaction the transaction does not


exist at all but the entity is sure that it will take place at some
future point and is trying to protect future cash flows

Other points:

A group of assets can be hedged if they share the same risk

IAS 39 allows for only a portion of the risks or cash flows


associated with an asset/liability to be hedged e.g. a fixed rate
liability could be hedged for interest rate risk but not for credit risk

It is not possible to hedge an overall net position e.g. an entity has


a contract to sell $100m in 2 months, it also has a contract to buy
$80m in 2 months; it cannot net off and hedge $20m, it has to treat
them as separate hedged items

237

Corporate reporting appendix

The hedging instrument


Hedging instruments are derivatives entered into in order to offset the
risk generated by a hedged item.
Non-derivatives can be used but only to hedge against foreign currency
risk e.g. an overseas investment which is financed by an overseas loan
the overseas loan is not a derivative but can be deemed to be a
hedging instrument.
The hedged risk
The following are all types of risk the entity may choose to hedge
against:

Currency risk e.g. movements in exchange rates

Market risk e.g. movements in commodity prices

Interest rate risk e.g. movements in interest rate

Credit risk e.g. risk of customer bad debt

Liquidity risk e.g. risk of entity being unable to pay suppliers.

Criteria for hedging


Hedge accounting is a choice but to be able to hedge account certain
criteria need to be met:

At the inception, the hedge has to be formally designated as a


hedge and there must be formal documentation

The hedge is expected to be highly effective

A hedge is effective if the actual results fall between a range of 80% to


125% calculated as:
Change in the value of the hedging instrument
Change in the value of the hedged item

238

The effectiveness can be reliably measured

Hedge is assessed on an ongoing basis

If the hedged item is a forecast transaction then the transaction


is highly probable

Where a cash flow hedge (see below) is not 100% effective it is


assessed on a cumulative basis

Appendix 1

Types of hedge
How an entity accounts for hedging depends upon the type of hedge.
There are 3 types of hedge:

Fair value hedge hedge against exposure to changes in the fair


value of either of the following:

A recognised asset or liability

A firm commitment

Cash flow hedge hedge against exposure to changes in future


cash flows, can be used for hedging of either of the following:

Cash flows associated with a recognised asset or liability

A highly probable future transaction

Note: A hedge of the foreign currency risk of a firm commitment


(or the hedge of foreign currency assets or liabilities using a
forward) may be designated as either a fair value or cash flow
hedge.

Net investment hedge hedge against fall in value of an


overseas investment by financing with an overseas loan. The net
investment hedge is only used in group financial statements

Fair value hedge


Measurement
The hedging instrument is remeasured to fair value at the reporting date
and any gains or losses go to the income statement (i.e., the normal
accounting rules for derivatives)
Any change in fair value of the hedged item between the inception of
the hedge and the year-end is accounted for by adjusting the carrying
amount of the hedged item and putting the resulting gain or loss to the
income statement. This treatment overrides the normal accounting rules
for the hedged item.
Effectiveness
Hedge accounting is only permitted if the hedging arrangement is
calculated to be effective. It is effective if:
80%

Change in the value of the hedging instrument


125%
Change in the value of the hedged item

For example if the item moved 10,000 but the instrument only moved
9,000 the hedge would be 90% effective (9,000/10,000)

239

Corporate reporting appendix

Effectiveness can be determined on either an annual or cumulative


basis (over the whole period of the contract). This should be designated
on inception.
If cumulatively assessed, hedge accounting can be used even if the
hedge is not effective as at the year end, as long as the arrangement is
expected to be effective overall.
If a fair value hedge is 100% effective, the change in fair value of the
hedging instrument and the hedged item will exactly offset and there will
be no P&L impact.
If the hedge is not 100% effective there will be either a net gain or loss
recognised in the P&L as the movement on the hedged item will be
different to the movement on the hedging instrument.
Cash flow hedge
With a cash flow hedge:

The portion of the gain or loss on the hedging instrument which is


determined to be effective should be recognised in other
comprehensive income (OCI) and held in equity

The over-effective portion should be recognised in profit or loss.


This is the amount of the gain or loss on the hedging instrument
that exceeds the change in fair value of the hedged item

The hedged item itself is a future cash flow and is not yet
recognised in the financial statements

When the cash flow occurs and the hedged item is recognised in
the accounts the gains or losses in the reserves are then recycled
into the income statement

Note: For cash flow hedges over-effectiveness can only be assessed


on a cumulative basis.
Ineffectiveness of a cash flow hedge
Note: The term ineffectiveness is used here for a hedge which qualifies
for hedge accounting (i.e. between 80 100% effective) but is not
100% effective.
As detailed above, the over-effective portion of the hedge must be
recognised in profit or loss.
If the gain or loss on the hedging instrument is larger than the change in
fair value of the hedged item, it is over hedged and the over-effective
element has to go to P&L.
If the change in fair value on the hedged item is larger than the gain or
loss on the instrument, it is under hedged and the whole movement
goes to reserves.
240

Appendix 1

Net investment hedge


A net investment hedge is a hedge used only in group accounting. It is
usually where a parent company buys a foreign subsidiary and is
concerned about the exchange rate risk.
To hedge against this risk the parent takes out a foreign loan of the
same currency, so the movements in the loan will offset the movements
in the investment.

The hedged item is the amount of the reporting entitys interest in


the opening net assets of the operation at the date of acquisition
and the goodwill

The hedging instrument is usually, but does not have to be, a


foreign loan taken out to buy the investment

The accounting treatment is similar to that of a cash flow hedge:

The portion of the gain or loss which is effective is recognised in


other comprehensive income

The ineffective portion is recognised in the consolidated income


statement

The gain or loss held in equity is reclassified on disposal of the


subsidiary

Proposed changes under IFRS 9


The IASB proposes to remove the 80%125% test to see if a hedging
relationship qualifies for hedge accounting. This has been replaced by
an objective-based assessment.
The treatment of a fair value hedge is unchanged except if the hedged
item is an investment in an equity instrument held at fair value through
OCI, gains and losses on both the hedging instrument and item are
recognised in OCI.
Cash flow hedges will not change.

IFRS 10: Consolidated financial statements


Control
Consolidated Financial Statements are required when one entity has
control over another entity.
Control is presumed to exist when the parent owns > 50% of the voting
power of an entity.

241

Corporate reporting appendix

An investor (the parent) controls an investee (the subsidiary) if and


only if it has all the following:

Power over the investee

The investor is exposed, or has rights to variable returns from its


involvement with the investee and

Has the ability to affect those returns through its power over the
investee

Power is defined as existing rights that give the ability to direct the
relevant activities of the investee.
If control exists, then consolidated financial statements should be
prepared showing the results of the parent and all its subsidiaries as a
single entity.
When assessing if an entity has control over another entity it should
consider the existence and effect of potential voting rights. This is the
case if there are warrants or share call options convertible into ordinary
shares. The holder must have the practical ability to exercise the right
(i.e. funds must be available) for them to be considered.

IFRS 11: Joint arrangements


A Joint Arrangement is an arrangement where two or more parties have
joint control. This will only apply if the relevant activities require
unanimous consent of those who collectively control the arrangement
There are two main types of joint arrangements per IFRS 11:

Joint operations

Joint ventures

Joint operations
Normally no separate entity is set up.
Parties with joint control have rights to the assets and obligations for the
liabilities.
Parties to the transaction share the activities.
Each operator will recognise assets it controls and liabilities and
expenses it incurs, and share of the revenue from the sale of goods or
services. This treatment is applicable in both the separate and
consolidated financial statements of the joint operator.

242

Appendix 1

Joint ventures

Separate entity set up

Parties with joint control have rights to the net assets of the
arrangement

Equity accounted under IAS 28 in the consolidated financial


statements

Individual joint venture party will recognise the cost of the


investment and returns in the form of dividends

IFRS 12: Disclosure of interests in other entities


It requires disclosure of a reporting entitys interests in other entities in
order to help identify the profit and loss and cash flows available to the
reporting entity.
Disclosures are required for entities which have interests in:

Subsidiaries

Joint arrangements

Associates

Unconsolidated structured entities

The disclosures include:

Detailing any restrictions on assets, liabilities and the movement of


funds

Details about the nature of, and changes in, risks associated with
the investments

IFRS 13: Fair value measurement


IFRS 13 defines fair value as the price that would be received to sell an
asset or paid to transfer a liability on an orderly transaction between
market participants at the measurement date.
When determining fair value the standard requires that the following are
considered:

The asset or liability being measured

The principal market (where the most activity takes place) or in the
absence of a principal market, the most advantageous market
(where best price can be achieved)in which an orderly transaction
would take place for the asset or liability

243

Corporate reporting appendix

The highest and best use of the asset or liability

Assumptions that market participants would use when pricing the


asset or liability

Once the above is established a hierarchy of inputs to determine fair


value is considered:

Level 1: Quoted prices in active markets that can be accessed at


the measurement date

Level 2: Inputs other than quoted prices

Level 3: Unobservable inputs for the asset

In business combinations it is likely fair value adjustments are required


in relation to non-financial assets such as land and plant.
Fair value is determined based on the highest and best use of the asset
as determined by the market participant. IFRS 13 has illustrative
examples.

244

Appendix

Discount tables and


formula sheet

245

Discount tables and formula sheet

Discount tables

Discount factors: Present value of 1 to be received after n years


Present Value (PV) = cash flow at tn discount factor (DF)
DF =
No. of
years
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
No. of
years
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

246

1
(1 + r )n
Discount rate per year
1%
0.990
0.980
0.971
0.961
0.951
0.942
0.933
0.923
0.914
0.905
0.896
0.887
0.879
0.870
0.861
0.853
0.844
0.836
0.828
0.820

2%
0.980
0.961
0.942
0.924
0.906
0.888
0.871
0.853
0.837
0.820
0.804
0.788
0.773
0.758
0.743
0.728
0.714
0.700
0.686
0.673

3%
0.971
0.943
0.915
0.888
0.863
0.837
0.813
0.789
0.766
0.744
0.722
0.701
0.681
0.661
0.642
0.623
0.605
0.587
0.570
0.554

4%
0.962
0.925
0.889
0.855
0.822
0.790
0.760
0.731
0.703
0.676
0.650
0.625
0.601
0.577
0.555
0.534
0.513
0.494
0.475
0.456

5%
0.952
0.907
0.864
0.823
0.784
0.746
0.711
0.677
0.645
0.614
0.585
0.557
0.530
0.505
0.481
0.458
0.436
0.416
0.396
0.377

6%
0.943
0.890
0.840
0.792
0.747
0.705
0.665
0.627
0.592
0.558
0.527
0.497
0.469
0.442
0.417
0.394
0.371
0.350
0.331
0.312

7%
0.935
0.873
0.816
0.763
0.713
0.666
0.623
0.582
0.544
0.508
0.475
0.444
0.415
0.388
0.362
0.339
0.317
0.296
0.277
0.258

8%
0.926
0.857
0.794
0.735
0.681
0.630
0.583
0.540
0.500
0.463
0.429
0.397
0.368
0.340
0.315
0.292
0.270
0.250
0.232
0.215

9%
0.917
0.842
0.772
0.708
0.650
0.596
0.547
0.502
0.460
0.422
0.388
0.356
0.326
0.299
0.275
0.252
0.231
0.212
0.194
0.178

10%
0.909
0.826
0.751
0.683
0.621
0.564
0.513
0.467
0.424
0.386
0.350
0.319
0.290
0.263
0.239
0.218
0.198
0.180
0.164
0.149

18%
0.847
0.718
0.609
0.516
0.437
0.370
0.314
0.266
0.225
0.191
0.162
0.137
0.116
0.099
0.084
0.071
0.060
0.051
0.043
0.037

19%
0.840
0.706
0.593
0.499
0.419
0.352
0.296
0.249
0.209
0.176
0.148
0.124
0.104
0.088
0.074
0.062
0.052
0.044
0.037
0.031

20%
0.833
0.694
0.579
0.482
0.402
0.335
0.279
0.233
0.194
0.162
0.135
0.112
0.093
0.078
0.065
0.054
0.045
0.038
0.031
0.026

Discount rate per year


11%
0.901
0.812
0.731
0.659
0.593
0.535
0.482
0.434
0.391
0.352
0.317
0.286
0.258
0.232
0.209
0.188
0.170
0.153
0.138
0.124

12%
0.893
0.797
0.712
0.636
0.567
0.507
0.452
0.404
0.361
0.322
0.287
0.257
0.229
0.205
0.183
0.163
0.146
0.130
0.116
0.104

13%
0.885
0.783
0.693
0.613
0.543
0.480
0.425
0.376
0.333
0.295
0.261
0.231
0.204
0.181
0.160
0.141
0.125
0.111
0.098
0.087

14%
0.877
0.769
0.675
0.592
0.519
0.456
0.400
0.351
0.308
0.270
0.237
0.208
0.182
0.160
0.140
0.123
0.108
0.095
0.083
0.073

15%
0.870
0.756
0.658
0.572
0.497
0.432
0.376
0.327
0.284
0.247
0.215
0.187
0.163
0.141
0.123
0.107
0.093
0.081
0.070
0.061

16%
0.862
0.743
0.641
0.552
0.476
0.410
0.354
0.305
0.263
0.227
0.195
0.168
0.145
0.125
0.108
0.093
0.080
0.069
0.060
0.051

17%
0.855
0.731
0.624
0.534
0.456
0.390
0.333
0.285
0.243
0.208
0.178
0.152
0.130
0.111
0.095
0.081
0.069
0.059
0.051
0.043

Appendix 2

Annuity tables

Annuity factors: Present value of 1 to be received each year for n


years
Present Value (PV) = constant annual cash flow annuity factor (AF)
1
1

AFt1 tn = 1
r (1 + r )n
No. of
years
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
No. of
years
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20

Discount rate per year


1%
0.990
1.970
2.941
3.902
4.853
5.795
6.728
7.652
8.566
9.471
10.37
11.26
12.13
13.00
13.87
14.72
15.56
16.40
17.23
18.05

2%
0.980
1.942
2.884
3.808
4.713
5.601
6.472
7.325
8.162
8.983
9.787
10.58
11.35
12.11
12.85
13.58
14.29
14.99
15.68
16.35

3%
0.971
1.913
2.829
3.717
4.580
5.417
6.230
7.020
7.786
8.530
9.253
9.954
10.63
11.30
11.94
12.56
13.17
13.75
14.32
14.88

4%
0.962
1.886
2.775
3.630
4.452
5.242
6.002
6.733
7.435
8.111
8.760
9.385
9.986
10.56
11.12
11.65
12.17
12.66
13.13
13.59

11%
0.901
1.713
2.444
3.102
3.696
4.231
4.712
5.146
5.537
5.889
6.207
6.492
6.750
6.982
7.191
7.379
7.549
7.702
7.839
7.963

12%
0.893
1.690
2.402
3.037
3.605
4.111
4.564
4.968
5.328
5.650
5.938
6.164
6.424
6.628
6.811
6.974
7.120
7.250
7.366
7.469

13%
0.885
1.668
2.361
2.974
3.517
3.998
4.423
4.799
5.132
5.426
5.687
5.918
6.122
6.302
6.462
6.604
6.729
6.840
6.938
7.025

14%
0.877
1.647
2.322
2.914
3.433
3.889
4.288
4.639
4.946
5.216
5.453
5.660
5.842
6.002
6.142
6.265
6.373
6.467
6.550
6.623

5%
0.952
1.859
2.723
3.546
4.329
5.076
5.786
6.463
7.108
7.722
8.306
8.863
9.394
9.899
10.38
10.84
11.27
11.69
12.09
12.46

6%
0.943
1.833
2.673
3.465
4.212
4.917
5.582
6.210
6.802
7.360
7.887
8.384
8.853
9.295
9.712
10.11
10.48
10.83
11.16
11.47

7%
0.935
1.808
2.624
3.387
4.100
4.767
5.389
5.971
6.515
7.024
7.499
7.943
8.358
8.745
9.108
9.447
9.763
10.06
10.34
10.59

8%
0.926
1.783
2.577
3.312
3.993
4.623
5.206
5.747
6.247
6.710
7.139
7.536
7.904
8.244
8.559
8.851
9.122
9.372
9.604
9.818

9%
0.917
1.759
2.531
3.240
3.890
4.486
5.033
5.535
5.995
6.418
6.805
7.161
7.487
7.786
8.061
8.313
8.544
8.756
8.950
9.129

10%
0.909
1.736
2.487
3.170
3.791
4.355
4.868
5.335
5.759
6.145
6.495
6.814
7.103
7.367
7.606
7.824
8.022
8.201
8.365
8.514

18%
0.847
1.566
2.174
2.690
3.127
3.498
3.812
4.078
4.303
4.494
4.656
4.793
4.910
5.008
5.092
5.162
5.222
5.273
5.316
5.353

19%
0.840
1.547
2.140
2.639
3.058
3.410
3.706
3.954
4.163
4.339
4.486
4.611
4.715
4.802
4.876
4.938
4.990
5.033
5.070
5.101

20%
0.833
1.528
2.106
2.589
2.991
3.326
3.605
3.837
4.031
4.192
4.327
4.439
4.533
4.611
4.675
4.730
4.775
4.812
4.843
4.870

Discount rate per year


15%
0.870
1.626
2.283
2.855
3.352
3.784
4.160
4.487
4.772
5.019
5.234
5.421
5.583
5.724
5.847
5.954
6.047
6.128
6.198
6.259

16%
0.862
1.605
2.246
2.798
3.274
3.685
4.039
4.344
4.607
4.833
5.029
5.197
5.342
5.468
5.575
5.668
5.749
5.818
5.877
5.929

17%
0.855
1.585
2.210
2.743
3.199
3.589
3.922
4.207
4.451
4.659
4.836
4.988
5.118
5.229
5.324
5.405
5.475
5.534
5.584
5.628

247

Discount tables and formula sheet

Discounting formulas

Single cash flow (occurring at tn):


Present Value (PV) = cash flow at tn discount factor (DF)
DF =

1
(1 + r )n

Or use tables
2

Annuity cash flow:


Annuity: A constant annual cash flow occurring for a set number of
years.
PV = constant annual CF annuity factor (AF)
1
1

AFt1 tn = 1
r (1 + r )n
Or use tables

Perpetuity cash flow:


Perpetuity: A constant annual cash flow occurring forever.
PV = constant annual CF perpetuity factor (PF)

PF =

1
r

Perpetuity with growth: An annual cash flow occurring forever and


growing at a constant rate.
PV = CF at t1 PF (with growth)
PF( with growth) =

1
r g

Note: All the perpetuity and annuity formulas assume the first
cash flow occurs at t1.

Delayed perpetuities a general formula


PV of
whole
CF
stream

248

CF

PF

DF

(at the start


of the
delayed
perpetuity)

(either with
or without
growth)

(for the period


before the
delayed
perpetuity
starts)

Appendix 2

Other key formulas

IRR approach

Calculate 2 NPVs (ideally one positive NPV and one


negative NPV)

Apply the IRR estimation formula:

NPVa
IRR = ra +
(rb ra )
NPVa NPVb

Where r represents the discount rate chosen

MIRR

Terminal value of net annual inflows


1 + MIRR =

PV of net annual outflows

(1/ n )

DVM

DVM formula (assuming constant growth):

P0 =

D0 (1 + g)
ke g

or

D1
ke g

Note: The DVM is just a more specific version of the perpetuity


with growth formula from above:

PV =

CFt1
r g

249

Discount tables and formula sheet

250