CIMA P9 SLFS Revision Notes May 2009

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Strategic Level
CIMA
P9 Financial Strategy

Exam Focused
Revision Notes
May 2009
These notes are not intended to cover the whole syllabus, but target key examinable areas.

Tutor Contact Details

Tutor: Mobile: 07833 096979
Sunil Bhandari E-mail: via
www.IntelligentAccountancyTutorsLtd.co.uk

Copyright to Intelligent Accountancy Tutors Ltd

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Exam Technique
First 20 minutes

 Read section B questions

 Pick 2, cross out 2

 Rank them

 Jot down / plan them

Next 180 minutes

 Do section B questions first

 Don’t exceed 90 minutes, target 85 minutes

 Target marks 2 x 15 = 30

 Do section A last

 Should have 95 minutes

 Target marks 1 x 25 = 25

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General
Numerical Questions

 State formula

 Show method

 Explain as you go

 Make assumptions if in doubt

Written Questions

 Check format – report / essay

 Headings / subheadings / columnar

 Simple short paragraphs

 Number points / paragraphs (report)

 Use a “catch-all” paragraph if under time pressure

 Use bullet points as matter of very last resort (unless

requirements says “list” – then this format is OK)

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Tips

These will be distributed to on the last day of revision. If you

are not attending one of my revision courses please let me
know and I will email them out to you.

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Chapter One
Financial Objectives
1 Primary Financial Objective

1.1 For profit making business “Maximise Shareholder(S/H)

Wealth”

1.2 To Measure S/H wealth

Value of Equity (Ve) =Number of issued Equity/Ordinary

Shares X Current Market Price (Po)

1.3 To find Po:

 Given in the Question if it is a multinational

corporation or listed company

 Compute Using:-

 Asset Valuation Models

 Dividend Valuation Model(DVM)
 Earnings Based Models
 Discounted Cash Flow Approach(DCF)

1.4 Check the question very carefully for the size of the
company is it:-

 Multinational Company(MNC) *
 Listed*
 Private Company

*Only for these will a market value exist on a stock

exchange
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2 Indicators

2.1 Financial indicators pointing towards maximising S/H

wealth include:-

 Earning per share(EPS)

 Dividend per share(DPS)
 Return on Capital Employed(ROCE)
 Return on Shareholder Capital(ROSC)
 Profit after tax
 Revenue

2.2 Non-Financial Indicators include:

 Market Share
 Customer Satisfaction
 Quality Measures

The above are all Key Performance Indicators (KPI’s)

that need to be measured and reviewed on a regular
basis by the board of directors. (Board)

3. External Factor Affecting Ve & Po

3.1 The Board cannot control all aspects that effect

Ve and/or Po. Two major external factors are:-

 Economic Variables
 Regulators

3.2 Economic Variables

3.2.1 Interest Rates- If they fall:-

 Stimulate Demand and Revenue

 Lower the cost of debt and improve profits
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 Investors switch to share market for better

returns

3.2.2 Inflation Rates- If it rises:-

 Costs rise causing a drop in profits

 Cause interest rates to rise.
 Devalues the home currency

3.2.3 Foreign Exchange Rate(FOREX)- If it rises:-

 Reduce cash receipts for exporters

 Lowers the cost for importers
 Discourage exporting

3.2.4 Gross Domestic Product- If it falls:-

 Reduce demand and revenue

 Cause interest rates to fall to stimulate demand

3.2.5 General Taxation –If it rises:-

 Damage company profits

 Not encourage investment by companies

Important to relate your comments to the effect upon

Po & Ve.

3.3 Regulators

3.3.1 Are there to control the excesses of natural

monopolies like utility companies.

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3.3.2 Regulator actions generally reduce S/H wealth

via:

 Fines
 Restricting Dividends
 Capping Selling Price Increases
 Enforcing Reinvestment of Cash.

4 The Three Key Decisions

4.1 To maximize S/H wealth the board must take

 Investment
 Finance
 Dividend

4.2 Investment

4.2.1 Allocate cash for:-

 Organic Growth (Projects)

 Acquisitions

4.2.2 Must always consider how investments

impact upon:-

 Company Liquidity
 Future Profits and Asset values
 Business Risk Profile i.e. effect upon
variability of the cash flows and profits.

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4.3 Finance

4.3.1 To finance investments the board have to

decide the best balance of equity and debt.

4.3.2 They will consider:-

 Cash available within the company

 Access to new sources of finance
 Impact on KPI’s like gearing
ratio(Debt:Equity)
 Cost of Finance (WACC or Ko)

4.4 Dividends

4.4.1 The Board needs to establish a dividend policy –

see Chapter 2

4.5 The three decisions are interlinked.

Example:New projects need new finance but must

generate cash to service the finance providers
including paying dividends to the shareholders.

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5 Objectives of Not-For-Profit- Organisations (NFP’S)

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Chapter Two
Dividend Policy

1 Introduction

To maximise S/H wealth the Board should establish a

dividend policy-the payment pattern to the equity investors.

2 Theories

Several theories have been put forward to assist:-

2.1 Residual – If spare cash exists at the end of the year pay
dividend.

2.2 Pattern – Be consistent with dividend payments. Either

a) Pay the same dividend per share (DPS) each year.

b) Maintain the payout ratio (DPS/EPS)
c) Maintain the same year-on-year growth rate in
dividends.The latter links into the Po via the
dividend valuation model (DVM)

2.3 Irrelevancy (M&M)

In a perfect capital market providing the directors can

invest in projects with a positive NPV no dividends
are required. The Ve will rise and the S/H can sell shares
to create the cash the need(Manufacture Dividends).

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3 Practical Considerations

There are many to consider:

 Availability of Cash
 What dividends to S/H want (clientele effect)?
 Signalling effect –payment of dividends indicates a
healthy company
 Retaining cash is a key source of Finance.
 Dividend growth should be greater than inflation
 Tax impact upon S/H
 Effect the dividend will have on dividend
cover(EPS/DPS)
 Number of investment opportunities will restrict
dividend payments.
 Risk-paying now is safer than promising to pay next
year
 Is the dividend within the company law regulations?

4 Alternatives to Cash Dividends

4.1 Scrip Dividends

4.1.1 The S/H will receive extra shares instead of cash on a

pro rata basis.

4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.

4.1.3 The effect will:-

a) Increase the issued equity capital

b) Dilute EPS and Po values
c) Create pressure for the board to pay more total
dividends in the future as more shares are in issue

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4.2 Share Buy Back

4.2.1 If the board has “one off” period of excess cash, they
could consider a share buy back.

i.e. Buy back shares at Po and cancel them.

4.2.2 Considerations:-

a) Allowable under company law.

b) Increase gearing as Ve may fall.
c) Tax implications for the S/H(CGT)
d) Reduced number of shares will cut supply for
trading purposes.
e) Less dividend pressure on the board in future.
f) Criticism-is this the best use of company cash.

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Chapter Three

Cost of Capital

1 Weighted Average Cost of Capital (WACC or Ko)

Ke=Cost of Equity
Kd=Should be “Kd(1-t)”=Cost of Debt
Ve=Market Value of Equity
Vd=Market Value of Debt

2 Market Values

2.1 Ve=Total Number of Issued Shares X Po

2.2 Vd=Total Book value of the Debt X Po

$100

2.3 Alternative Presentations

a) Ratio (Vd:Ve) e.g. 1:4

b) Gearing Percentage e.g. 35%

Hence Vd=35,Ve=65
For WACC equation

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3 Cost of Equity (Ke)

3.1 The minimum return required by the S/H to compensate

for the risks they face from the equity investment.

3.2 CAPM

Ke=Rf+ (Rm-Rf)βe

where Rf=Risk free return

Rm=Return on the market portfolio
(Rm-Rf)=Market premium
βe=Risk measure for the risks being
faced by the S/H

3.3 DVM

Where Po=Ex Dividend Share Price

d1=The DPS at Time 1
do=The DPS at Time 0
g =Constant annual future growth rate
in the DPS

3.4 Other Ke Formulae

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4 Cost of Debt (Kd (1-t))

Depends upon the type of Debt

Also note:-

a) Kd=Called Yield
b) “Kd (1-t)”=Cost of Debt

4.1 Non traded debt (Bank Loans)

 Kd is the Interest rate on the loan(i.e. the yield)

 “Kd (1-t)”=Interest Rate X (1-t)

4.2 Traded Bonds

4.2.1 These are issued and traded in blocks of $100

or £100.Do all computations per block of “100”.

4.2.2 Undated Bonds-the process is:-

a) Establish the Kd(Yield)

 Given in the question
 Kd(Yield)= Ints
Po
b) “Kd (1-t)”= Yield X (1-t)

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4.3.3 Redeemable Bonds-the process is via IRR computation

Time $
To Po (X) Take two guesses at
the Kd(1-t) like
Ti-Tn Ints x (1-t) X 10% & 1% and
Perform IRR computation
Tn Capital Repayment X

5 Uses of the WACC(Ko)

5.1 The Ko is the money or nominal cost of capital to use in

project DCF approaches.

5.2 The Ko is useable if the new project under

consideration:-

a) Is a core activity –same as the company’s

normal activities
b) Does not alter the capital structure of the
company (Vd:Ve)

6 What if’s?

6.1 Extend the WACC formula for all extra methods of

company finance. So you could have a WACC with:-

 Equity
 Preference Capital
 Bank loans
 Traded Bonds

6.2 Be ready to rearrange the WACC to find missing figures

e.g. Ke

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Chapter Four

Bonds –Yields and Market Values

1 Bonds

Debt which is issued in blocks of “100” and trades on the

stock exchange.

2 Market Value

2.1 The market value is Po/$100 and can be established via

the DVM

“The present value of future cash flows received by the

investor and discounted at the yield(Kd)”

2.2 Undated Debt

Po= Ints
Yield

2.3 Redeemable Bonds

Time $ Yield% PV

T1-Tn Ints X X X

Tn Capital X X X
Repayment*

Po = XX

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2.4 Convertible Bonds

Replace the * Capital repayment with the share value if

higher than the cash repayment.

3 Yield

3.1 Undated Bonds

Yield = Ints
Po

3.2 Redeemable Bonds

Time $

To Po (X) Take two guesses at

the yield say 10% &
T1-Tn Ints X 1% and perform IRR
computation
Tn Capital Repayment X

4 Bank Loans

 Yields=Interest Rate
 No Market value

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Chapter Five

Risk Adjusted WACC

1 Uses

This is the money cost of capital for DCF project appraisal

when:-

 Project is non-core
 No change in company’s capital structure or told a
specified project gearing ratio.

2 Process

a. Take the Proxy Company Beta equity and degear via

b. Re-gear βa to find the project βe

c. Put the Project βe into CAPM

Project Ke =Rf + (Rm-Rf) Project βe

d. Establish the company’s “Kd (1-t)”-See Chapter 3

e. Risk adjusted WACC=

Project Ke (Ve/Ve+Vd) + Kd(1-t)(Vd/Ve+Vd)

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3 Concerns

 Will the project finance truly have no effect upon the

company’s gearing?
 Proxy company βe:-

a) Does it exist?
b) Does the proxy company specialise in the non-
core field or does it have many different business
activities
c) If we are not listed-how do we gear up the βa

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Chapter Six

CAPM

1 CAPM Equation

Minimum return = Rf+ (Rm-Rf) β

There are several uses of the CAPM equation:-

 To find the company’s Ke(Chapter 3)

 Risk Adjusted WACC(Chapter 5)
 Assist a stock market investor to buy or sell equities

2 CAPM & Buy/Sell Equities

2.1 Single Equity

 Take/Find βe
 Put into CAPM
Minimum Return = Rf+(Rm-Rf)βe
 Forecast a return for the investment (could use
past returns)
 Forecast exceeds/equals
minimum return-Buy or Keep the share

2.3 Combining Equities

a) Created a weighted average portfolio Beta

i.e (Cash in Share (1)/Total Cash in Equities X β1) + (Cash

in Share (2)/Total Cash in Equities X β2 )
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b) Put into CAPM

Minimum Return = Rf+(Rm-Rf)Weighted Average β

3 Meaning of a βe

3.1 A βe is the measure of risk being faced by equity

shareholders

3.2 βe can be split into:-

 Systematic Business Risk-measured by βasset

 Financial Risk

3.3 Sytematic risk is how market factors effect that

investment. Market factors are:-

 Macroeconomic variables
 Political factors

The measure is relative to the benchmark of the

market portfolio.

3.3 CAPM assumes that the investor eliminated the

unsystematic risk.

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4 Criticisms of CAPM

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5 Arbitrage Pricing Theory

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Chapter Seven

Capital Structure

1 Introduction

How should the company decide the mix of

equity and debt capital?

2 Practical Issues

If the company uses Debt capital funding it should

consider:-

 Credit Rating of the company

 Rate of interest it will pay
 Market conditions- access to Debt capital
 Forecast Cash Flows-to service and repay the debt.
 Level of Tangible Assets on which secure the loans.
 Interest will lead to tax savings i.e Tax Shield
 Constraints on the level of debt from
a) Articles Of Association
b) Loan Agreements.

 Effect upon the company gearing ratio

Debt/Equity+Debt OR Debt/Equity

 Will the debt providers exercise influence over the

company?
 The chance of bankruptcy.

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3 Theories of Optimal Capital Structure

3.1 Common Ground-both major views accept two facts:-

a) Yield<Ke
b) Gearing causes Ke to rise

3.2 Traditional View

Key Points:-

1) Ke rises due to financial risk caused by gearing.

2) Kd is initially uneffected by gearing but rises at “high”
gearing levels due to the perception of the possibility of
bankruptcy.

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3) Ko-trade off of Ke and Kd. Point X is the optimum

gearing level where WACC is lowest.
4) Once point X is reached via trial and error it must be
maintained.

3.3 MM and Tax

Key points:-

1) Assumption behind the model:-

 All debt is risk free

 Only corporation tax exists
 Debt is issued to replace Equity
 All types of debt carry one yield, the risk free
rate
 Full distribution of profits
 Perfect Capital Market

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2) MM concluded companies should gear up to the

maximum levels.

3) Specific Equations under MM and tax.

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Chapter Eight

Project Appraisal

1 Accounting Rate of Return (ARR)

1.1 Average Annual Post Depreciation Profit X 100

Investment

1.2 Investment is:-

a) Initial Investment
b) (Initial Investment +Scrap Value)
2
1.3 Decision rule is:-

ARR> Target return-accept the project

OR
Take the project with the highest ARR

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1.4 Limitations and Strengths

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2 Net Present Value (NPV)

2.1 NPV is the increase in S/H wealth arising from the

project.

2.2 Two formats to consider

Format (A)

Format B

Time CF R% PV$’000
To (X) 1.0 (X)
T1-Tn X X X
T2-Tn X X X
NPV $XXX
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2.3 Incremental Cash Flows

 Result from/caused by the project

 Include opportunity cash flows
 Ignore:-
 Non-Cash Flows
 Sunk Costs
 Interest /Dividend payments

2.4 Financial Maths Required:-

1) Compounding
2) Discounting(tables)
3) Annuity Discounting(tables)
4) Delayed Annuity
5) Perpetuity
6) Delayed Perpetuity
7) Perpetuity with Growth
8) Delayed Perpetuity with Growth

2.5 Inflation-incorporate into:-

a) Cash Flows
i.e. Money Cash Flow=Real Cash flow X(1+i)n

b) Cost of Capital-Money/Nominal
Cost of Capital. This can be:-

i. Given
ii. Ko or Risk Adjusted Ko
iii. (1+m)=(1+r)(1+i)

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2.6 Working capital-think of as a project bank account:-

i. Invest at To
ii. Adjust each year
iii. Close at end of the project.

2.7 Forecasting Exchange rates can use either:-

a. PPPT

b. IRPT

2.8 Taxation-relevant cash flows to be included in the NPV

computation.

1) Operating Flows x Tax rate

2) Tax saved on Capital allowances or Tax Allowable

Depreciation(TAD):-

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a) Tax saved on Capital Allowances

To T1 T2

Buy Asset CLAIM Save Tax

WDA

Tax Saved
Time $’000
T2 asset value X 25% X
X Tax %

T3 last year tax saved X

X 75%

T4 last year tax saved X

X 75%

(Sell Asset) T5 last year tax saved X

X 75%

T6 Balance figure X

Tax %( Asset Value-Scrap) XX

b) TAD normally straight line

(Asset Value-Scrap Value) =TAD

Life of Asset

TAD x Tax Rate=Tax Saving

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3) Double tax –Regular issue with Forex NPV

Example-Taxable flow abroad in year 2 is

$100K.Tax abroad is 20% and in the UK
is 30% Spot rate at T2 is $1.60/£.

Foreign tax = $100K X 20% = $20K

Additional UK Tax = $100K X 10% =£6.25K

$1.60

3 Internal Rate of Review (IRR)

3.1 The cost of capital that gives an NPV=Nil

3.2 Approach-Take the following example:

NPV@ 10% =$200K

NPV@ 20% = ($15K)

IRR= 10+ (200/200-(-15)) x (20-10) =19.30%

3.3 Decision Rule

IRR>Project Cost of Capital-Accept

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3.4 PROS CONS

*Easier to explain *Will mislead if comparing

*Simple decision rule projects
* If cash flows are non-
regular (-, +, +, +,-)
IRR computed above is
incorrect

4 Modified IRR (MIRR)

4.1 Solves the weakness of IRR

4.2 Approach via example

Time $’000
To (50)
T1 40
T2 40
T3 (5)

R =10%

i. Terminal Value of Future cash flows

Time $’000
T1 40 x 1.10 x 1.10 48.4
T2 40 x 1.10 44
T3 (5)

87.4

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ii) Effective Discount Rate

$50K = 0.572
$87.4K

iii) Check the tables for a T3df aprrox equal to 0.572 i.e.
20%

4.3 Decision Rule

MIRR>Project cost of capital-Accept

5 Capital Rationing

5.1 A restriction of cash preventing the Co from accepting

all projects with a positive NPV

5.2 Causes:

Hard Soft

External constraint on Internal within the

Raising cash.Eg:- Credit Company
Crunch Crisis Eg:- Capex Budget

5.3 Period –only single period is examinable i.e. cash may

Be restricted at T0 or T1.

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5.4 Divisible projects –can invest in proportions of a project

from 0% to 100% maximum.

Approach:-

1) Compute Project NPV’s

2) Compute Profitability Index(PI)
= NPV
Cash available at critical Period
3) Rank-High to Low PI

5.5 Non-Divisible –take all or none of any project.

Approach:-

1) Compute Project NPV’S

2) Take best combination of projects that maximise
The total NPV but spend less than or equal to cash
available in the critical period.

6 Equivalent Annual NPV

6.1 If projects are mutually exclusive and of unequal lives –

basis of comparison.

6.2 E.A.NPV = NPV

Annuity Factor for life of the project @cost of capital

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7 Accruing for Risk or Uncertainty within NPV

Several methods, the best are:-

1) Certainty Equivalents-Reduce cash flows by C.E

factor prior to discounting .Example:-

Time $’000 C.E Factor Adj CF RF%

T0 (1000) 1.0 (1000) 1.0
T1 700 0.90 630 X
T2 900 0.85 765 X

2) Probabilities –One project cash flow may be

uncertain.

Example Sales in year 1

$’000 P
2000 0.70
1000 0.30
1.0

Sales in T1 for NPV=

(2000 X 0.70)+ (1000 X 0.30) =$1700K

3) Risk adjusted WACC –See Chapter 5

4) Real Options – may exist for a project

if:-
 Option to have a follow on project
 Option to abandon early
 Option to wait and see
 Strategic option-open up new markets

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8 Post Completion Audit (PCA)

9 Adjusted Present Value (APV)

9.1 Used when project:-

 Core of non-core
 Specific project Finance including Debt

9.2 Two stages

 Stage one NPV@Keu
 Stage two PV of finance cash flows

APV is combined stage one plus two.

9.3 Stage One

1. Ascertain Keu for the project:-
 Given
 Use βasset & CAPM
 Rearrange

2. Compute NPV@ Keu

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Stage Two

1. Choose discount rate from:-

 RF% or
 Kd%
2. PV of issue costs .Take care with:-
 Timings
 Tax deductible

3. PV of Tax Sheild

i.e. Debt Raised X Kd X Tax Rate X Annuity factor at RF% or

Kd% for relevant period

9.4 Other Finance Cash Flows to be aware of:-

a) PV of tax shield may be bared upon debt capacity

and not loan raised .Hence

Debt capacity X Kd X Tax rate X Annuity factor at RF% or

Kd% for relevant period
b) Subsidised loan-if a loan is at a subsidised
rate, an additional benefit is

Subsidised Loan X Ints saved X(1-T)X Annuity factor at RF% or

Kd% for relevant period

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Chapter Nine

Business Valuations & Mergers

&Acquisitions

1 Pre-Acquisition Values

1.1 The aim is to find a range of values for a

company. The answer can be presented:-
a) Ve
b)Po

1.2 Net Asset Valuation

1.2.1 Business is worth just the value of it’s Net Assets.

To establish the net assets:-

Total Assets-(Total Liabilities +Preference Shares)

1.2.2 The Net Asset value equals the Ve and can be

based on:-
a) Book Values
b) Net Realisable Value
c) Replacement cost

1.2.3 Useful For:-

a) “Seller “ to set minimum value of the
company (NRV)
b) Companies with lots of tangible high value
assets.Eg: Property Investment company
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1.2.3 Major Weaknesses are:-

a) Not include non-tangible assets

b) Excludes what all assets generate future:-
i. Dividends
ii. Profits
iii. Cash Flows

1.2.4 Dividend Valuation Model

1.3.1 The company is worth the present value of it’s future

dividends discounted at the cost of equity

1.3.2 Ve = Total Do(1+g)

(Ke-g)

OR

Po = Do(1+g)
(Ke-g)

1.3.3 Take Care:-

Growth may not be constant forever

Where to we get “g” from?
CAPM may be needed to find Ke
Often better for valuing a small shareholding

1.3 Price –Earnings Model

1.4.1 A business is worth a multiple of it’s profits.

1.4.2 Ve=Sustainable PAT X Suitable P/E

Po=Sustainable EPS X Suitable P/E

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1.4.3 Sustainable PAT-have to adjust the latest reported

reports for non-reoccurring items (post tax)

1.4.4 Suitable P/E:-

a) Take a proxy Company P/E

b) Adjust to suit the company we are valuing.
c) Simple rules
i. Ltd Co’s – deduct 30%off proxy Co P/E
ii. Non-listed PLC’s-add/deduct 10% to
proxy Co P/E

1.4.5 Concerns are:-

 Finding a proxy Co P/E

 Adjustments are arbitrary
 Sustainable profits needs forecasting
adjustments.

1.4 Present value of Future Cash Flows

1.5.1 A business is worth the discounted value of the

future cash flows.

1.5.2 Establish:-

a) Future Cash flows and timescales

b) Cost of capital (WACC or Risk adjusted WACC)

1.5.3 Weaknesses are:-

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1.5.4 Rapid initial growth

The approach is:-

a) PV of the cash flows for the rapid initial

growth period.

b) PV of the cash flows for the remaining period.

Therefore, Ve is (a) plus (b).

1.5 Intellectual Capital(IC)

1.6.1 There are two methods of valuing IC and /or other

non-tangible assets.

1.6.2 Simple estimate

Ve under DVM or P/E Book value of Net

Or PV of CF’s method - Assets

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1.6.3 Computed Intangible value (CIV)- to compute this

an industry /proxy return on total assets % must be
given in the question.

Approach:-

$ ‘000

1) Last reported profit before tax X

Less: Industry of Proxy x Co’s total (X)
Return on assets assets

Value Spread X

2) Take value spread X

Tax @X% (X)

Post tax value spread X

3) Assume post tax value spread will stay constant

From time 1 to perpetuity.

Value of IC=Post tax value Spread x 1/r

r =Cost of Capital

4) Value of Equity is

Value of IC + Book value of the Assets

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2 Post Acquisitions Values

Follow a 3 step approach

2.1 PreAcquisition Data

Predator Target

No of Equity shares X X
in Issue

PAT X X

EPS X X

Pre acquisition Po X X

P/E Ratio X X

If the P/E ratio of Predator is greater than target

then a bootstrap method is possible

2.2 Post Acquisition value of Predator

a) Using Bootstrap

$000

Predator PAT X

Target PAT X

Total PAT X

Total PAT X PREDATOR P/E = Ve*

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b) Using Add Together

$000

Predator Preacquisition Ve X

Target Preacquisition Ve X

PV of Synergy Cash flows X

Ve *

*Divide this by the new number of total issued

shares in Predator to find Post Acquisition Po

2.3 Assess the Takeover

Predator

Check the KPI’s post acquisition against

pre acquisition:-

a) Po risen?
b) EPS risen?

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Target

Compute the Bid Premium:-

Per Share $

Value received post acquisition X

Per target share

Preacquisition price (X)

3 Factors to consider in Mergers and Takeovers

3.1 Assets of shares-most companies buy the victim

company’s shares rather than transferring their
assets. Both are feasible.

3.2 Synergies-concept of “2+2=5”.Many sources exist:

a) Economies of scale from horizontal combinations

reduces costs and increase profits.

b) Buying suppliers can reduce profit charged on

purchases i.e. cut out the middle man.

c) Improve badly managed /inefficient businesses.

d) Diversify to stabilise profits and cash flows.

e) Access companies that generate cash

(Cash Cow)

f) Use the managerial talent of the victim in a

more productive way.

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g) Market power may allow consumer price

increases and more profits.

3.3 Finance-to fund the takeover the predator company

Could use:-

a) Cash
b) Shares
c) Loan Stock

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3.4 Regulation of Takeovers

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3.5 Defences-The victim company could defend a

take-over in several ways:-

a) Appeal to the Competition Commission

indicating the takeover is anticompetitive.

b) Find an alternative/Friendly buyer (White

Knight)

c) Appeal to the shareholders and manage a

defence showing that the takeover will not
benefit them.

d) Super majority-set up in the Articles requiring a

high proportion of S/H to agree on takeovers.

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e) Poison pill strategy –creation of “tripwires”

invoked on a takeover causing the acquirer to
spend more money.

4 Efficient Market Hypothesis

Data Reflected in Po

3 forms exists

Weak Semi-Strong Strong

Past Data Past Data Past Data
Public Data Public Data
Insider Data

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Chapter Ten

Sources of Finance

1 Introduction

Where and how to companies raise long term capital.

2 Equity –General Factors

2.1 Ordinary shares of the company with voting rights.

2.2 Carry the greatest risk but also the best possible
returns.

2.3 Could be traded on the stock exchange if company is

listed.

2.4 “A Stock Exchange listing”

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3 Equity- Raising New Capital

3.1 Retained Earnings-First source of cash. Hold back the

payment of dividends. Will effect the dividend policy
and can raise a small amount of cash.

3.2 Rights Issue-Pro Rata issue to existing S/H.

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3.2.3 From the exam questions will need to obtain or

compute:-

a) Po just before the rights issue (Cum Rights

price)

b) Issue Price

c) Ex Rights Price-price directly after the share

issue (TERP)

For Example: 1 for 3 rights issue at 550p and

cum rights is 600p

No £
3 at 600p 18.00
1 at 550p 5.50
4 £ 23.50

TERP =£ 23.50/4 =£5.88

d) Value of the right

£ 5.88- £5.50 =38p

3.2.4 Shareholder can sell the rights to another

shareholder at the value of the rights.

3.3 Placing- Sell a large batch of new shares to

institutions.

3.4 Prospectus- Sell shares to investors at a fixed price

after issuing a prospectus.

3.5 Tender- Request investors to tender for the shares

at a price they would want to pay. The board then

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establishes final price.

4 DEBT

4.1 Loans provided to the company on a long term basis.

Debt holders will:-

a)Interest paid from pre-tax profits

b) Security via
 Fixed charged
 Floating charge
 Securitisation of future income.

c) Covenants-restrict company activity in areas

such as:
 Dividend payments
 Issues of further debt

4.2 Bank Loans

4.2.1 Funds come from one bank or group of banks.

4.2.2 Terms & Conditions depend upon market

conditions and credit rating.

4.3 Traded Bonds

4.3.1 Loan is split into blocks of $100 and issue on the

market.

4.3.2 Can be undated or redeemable.

4.3.3 Bond has a yield and market value (Chapter 4)

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4.4 Other Types of Debt

a) Convertible Bonds-Debt that can be converted

to shares, normally at redemption.

b) Eurobonds-Rare large foreign currency loan in

the home country. Used by MNC’s and minimum
values normally $1m.

c) Mezzanine Loan-Loan used in MBO’s. Loan that

carries high interest but normally only paid if
profits are made.

d) Grants-Free government finance providing

conditions are met.

5 Leases

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5.2 Lease Vs Buy Evaluation

3 Step approach

1. Ascertain the post tax cost of debt

i.e Pretax % X (1-t)

2. NPV of the lease cash flows using (1)

Lease cash flows are:
 Payments/Rental
 Tax savings caused by rentals.

3. NPV of buy cash floes using (1)

Relevant flows are:-
 Capital Cost
 Scrap value
 Tax saved on Capital allowances or Tax
allowable depreciation.

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6 The role of Treasury Function

6.1 Treasury functions mainly exist in Large MNC.

6.2 Roles include:-

Managing the groups cash resources

Liaise with the banks.
Advising on Heading strategies for:-
 Forex Risk
 Interest Rate Risk
Establishing source of Finance and cost of capital
for the group.
 Deciding upon investment policy.

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Chapter Eleven
Ratios & Financial Forecasting

1. Ratios

1.1 Investor ratios

EPS = PAT less Preferred Dividends

No of ordinary shares in issue

P/E = Po
EPS

Dividend Cover= EPS

DPS

Payout Ratio = DPS

EPS

Dividend Yield = DPS

Po

1.2 Gearing

Capital Gearing= Debt or Debt X 100

Equity Debt+Equity

NB Preference shares are debt if dated!!

Interest Cover = Operating Profit

Interest

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1.3 Profitability

ROCE = Operating Profit X 100

Equity +Debt

ROE = PAT X 100

Equity

Margin = Operating Profit X 100

Turnover

1.4 Liquidity

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2 Financial Forecasting

2.1 “Technique” type question which requires you to

Follow the rules of the question.

2.2 Proforma’s for the Income Statement and Statement

of Financial Position are normally given in the question.

2.3 Cash flow Statement Proforma

‘$000
Operating profit X
Add: Depreciation X
(Increase)/Decrease in Inventory (X)/X
(Increase)/Decrease in Receivables (X)/X
(Decrease)/Increase in Payables (X)/X

Cash from Operations X

Other sources of Cash:

Share issue X
Loan issue/Raised X
Sale of NCA X

Payments from cash

Finance Charges (X)

Tax (X)
Dividends (X)
Purchase of NCA (X)
Loans Repaid (X)

Net cash for the year X

Balance B/F X
Balance C/F X

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Chapter Twelve

Working Capital

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