AFM BPP Notes

No. Chapters
1 Financial strategy : formula3on
2 Financial Strategy : Evalua3on
SKILL CHECKPOINT 1 : Addressing the secnario
3 Discounted Cashflow Technique
4 Applica3on of op3on pricing theory to investment decisions
5 Interna3onal investment & Financing decision
SKILL CHECKPOINT 2 : Analysing investment decisions
6 Cost of capital and changing risk
7 Financing and credit risk
8 Valua3on for acquisa3on and merger
9 Acquisa3on : Stragegic issues and regula3on
10 Financing acquisa3on and merger
SKILL CHECKPOINT 3 : IdenKfying the required numerical techniques
11 The role of treasury func3on
12 Managing currency risk
13 Managing interest rate risk
SKILL CHECKPOINT 4 : Applying risk management techniques
14 Financial restructuring
15 Busines reorganisa3on
16 Planning and trading issues for mul3na3onal
Chapter # 1
Financial strategy:
Formulation
Reasons why profit is not a sufficient objective
1. Investors care about the future

2. Investors care about the dividend

3. Investors care about financing plans

4. Investors care about risk management

Profit is NOT the key financial goal

(1) It is historic

(2) It is not cash

(3) It ignores other factors, such as risk

The key financial objective is total shareholder return, measured as dividend yield + capital
gain.

A financial strategy should organise an organisation's resources to maximise returns to

shareholders by focussing on future cash flows, financing and risk.

Investment decisions (in projects or by making acquisitions) are often seen as the key
mechanism for creating shareholder wealth, but they will need to be carefully analysed to
ensure that they are likely to be beneficial to the investor.

Practical issues of financing decisions

When a company is cash-rich the senior financial adviser will have to decide whether to do one
(or more) of the following:

(a) Plan to use the cash, for example for a project investment or a takeover bid for another
company

(b) Repurchase its own shares (share buyback)

(c) Pay out the cash to shareholders as dividends, and let the shareholders decide how best.

to use the cash for themselves

The dividend decision is related to how much a firm has decided to spend on investments and
also to how much of the finance needed for investments is being raised externally (financing
decision); this illustrates the interrelationship between these key decisions.

Lifecycle of dividend policy

Dividend capacity: the cash generated in any given year that is available to pay to ordinary

shareholders (it is also called free cash flow to equity).

Formula :

Practical Dividend Policies

Possible dividend policies:

(1) Constant payout

(2) Stable growth

(3) Residual

(4) Scrip dividends

(5) Special dividends

(6) Share buyback

Script dividend ( Bonus issue )

A company will sometimes offer a scrip dividend (extra shares) instead of cash. Compared to a
cash dividend, a scrip dividend boosts a company's cash flow and may benefit shareholders if
the cash is re-invested in positive NPV projects that could not otherwise have been financed.

Share buybacks
Advantages of share buybacks:

(a) Avoids increasing expectations of higher dividends in future (which may be a problem if
dividends are increased).

(b) Taxed as a capital gain which may be advantageous if the tax on capital gains is below the
rate used to tax dividend income.

(c) If shares are under-valued, the company may be able to buy shares at a low price which
will benefit the remaining shareholders. Fewer shares will improve EPS and DPS ratios.

Special Dividend

Another way of returning significant amounts of cash to shareholders is by a special dividend; a

cash payment far in excess of the dividend payments that are normally made. This has a
similar effect of returning significant amounts of cash to shareholders, but unlike a share
buyback it impacts all shareholders.

A special dividend is more attractive than a share buy-back if shares are over-valued, and
avoids shareholders potentially diluting their control by participating in a share buyback.

Stakeholders groups:

(1) Internal – managers, employees

(2) Connected – shareholders, banks, customers, suppliers

(3) External – government, pressure groups, local communities

Ethical issues often arise from a conflict between the needs of different stakeholder groups.
Questions which include ethical considerations are likely to be of a practical nature and are
likely to require you to give practical advice on a fair resolution of stakeholder conflict. Most
commonly this will be a conflict between shareholder needs (ie financial gain) and the needs of
another stakeholder, but other conflicts may also need to be managed.

Governance

Safeguarding against the risk of unethical behaviour may also include the adoption of a
corporate governance framework of decision making that restricts the power of executive
directors and increases the role of independent non-executive directors in the monitoring of
their duties.

In some countries this can include a non-executive supervisory board with representatives from
the company's internal stakeholder groups including the finance providers, employees and the
company's management. It ensures that the actions taken by the board are for the benefit of all
the stakeholder groups and to the company as a whole.

Integrated reporting

The aim of integrated reporting is to explain how an organisation creates value over time and
the nature and quality of an organisation's relationships with its stakeholders.

Integrated reporting will involve reporting, among other things, on sustainability/environmental

issues and this may help to enhance the importance with which these issues are treated.

Integrated reporting is designed to make visible the capitals (resources and relationships used
and affected by the organisation) on which the organisation depends, and how the organisation
uses those capitals to create value in the short, medium and long term.

General factors affecting dividend policy

(a) The need to remain profitable. Dividends are paid out of profits, and an unprofitable
company cannot go on indefinitely paying dividends out of retained profits made in the
past.

(b) The law on distributable profits. Companies legislation may make companies bound to pay
dividends solely out of accumulated net realized profits, as in the UK.

(c) The government may impose direct restrictions on the amount of dividends that companies
can pay.

(d) Any dividend restraints that might be imposed by loan agreements and covenants. A loan
covenant may restrict the amount of dividends that the company can pay, because this will
provide protection for the lender.

(e) The effect of inflation. There is also the need to retain some profit within the business just to
maintain its operating capability.

(f) The company's gearing level. If the company wants extra finance, the sources of funds
used should strike a balance between equity and debt finance.

(g) The company's liquidity position. Dividends are a cash payment, and a company must have
enough cash to pay the dividends it declares.

(h) The need to repay debt in the near future. The company must have enough cash to pay
debts as they fall due.

(i) The ease with which the company could raise extra finance from sources other than
retained cash. Small companies which find it hard to raise finance might have to rely more
heavily on retained cash than large companies.

(j) The signalling effect of dividends to shareholders and the financial markets in general. See
below for more details.

CSR reporting; the triple bottom line approach

The triple bottom approach to reporting on corporate social responsibility (CSR) involves
consideration of social, economic and environmental factors.

Under the triple bottom line (TBL) approach decision making should ensure that each
perspective is growing but not at the expense of the other. That is, economic performance
should not come at the expense of the environment or society.

The TBL can be defined conceptually as economic prosperity, environmental quality and
social justice.

Many companies, thinking it is just a matter of pollution control, are missing the bigger picture
that meeting the needs of the current generation will destroy the ability of future generations to
meet theirs.

Advantages of TBL reporting

(1) Better risk management and higher ethical standards through:

– Identifying stakeholder concerns

– Employee involvement

– Good governance

– Performance monitoring

(2) Improved decision making through:

– Stakeholder consultation

– Better information gathering

– Better reporting processes

(3) Attracting and retaining higher calibre employees through practising sustainability and
ethical values

Chapter # 2
Financial strategy:
Evolution
Financing decision

The primary objective of a profit-making company is normally assumed to be to maximise

shareholder wealth. Investments will increase shareholder wealth if they cover the cost of
capital and leave a surplus for the shareholders. The lower the overall cost of capital the
greater the wealth that is created.

In order to be able to minimise the overall cost of finance, it is important initially to be able to

estimate the costs of each finance type.

The cost of the different forms of capital will reflect their risk. Debt is lower risk than equity
because debt ranks before equity in the event of a company becoming insolvent, and because
interest has to paid. Therefore, debt will be cheaper than equity and the more security attached
to the debt the cheaper it should be.

Risk

Unsystematic (or specific) risk: the component of risk that is associated with investing in that
particular company. This can be reduced by diversification.

Systematic (or market) risk: the portion of risk that will still remain even if a diversified
portfolio has been created, because it is determined by general market factors.

The risk that remains, for a diversified shareholder, is called systematic (or 'market') risk.

Beta factor: a measure of the sensitivity of a share to movements in the overall market. A beta
factor measures market risk.

Capital asset pricing model

The Capital Asset Pricing Model (CAPM) calculates the expected return (or cost) of equity
(Re or Ke) on the assumption that investors have a broad range of investments, and are only
worried about market risk, as measured by the beta factor.

Cost of debt

There are many sources of debt finance including:

Bank loans

The cost of a loan will be given: because a company will obtain tax relief on interest paid, the

cost will be multiplied by (1 – t) to get the post-tax cost of debt.

The cost of a bond can be estimated by considering:

(a) The risk free rate derived from the yield curve for a bond of that specified duration

(b) The credit risk premium – derived from the bond's credit rating

There are a number of explanations of the yield curve; at any one time both may be influencing
the shape of the yield curve.

(a) Expectations theory – the curve reflects expectations that interest rates will rise in the
future, so the government has to offer higher returns on long-term debt.

(b) Liquidity preference theory – the curve reflects the compensation that investors require
higher annual returns for sacrificing liquidity on long-dated bonds.

Credit Rating

The extra return (or yield spread) required by investors on a bond will depend on its credit
rating, and its maturity. This is often quoted as an adjustments to the risk free rate (as indicated
by the yield curve) in basis points (1 point = 0.01%).

Weighted average cost of capital

To calculate a project NPV, or to assess a proposed financing plan, you may be required to
calculate the weighted average cost of capital for the business (WACC).

To value debt you need to calculate the present value of its future cash flows, discounted at
the required return (pre-tax).

Assumptions made when using WACC for project evaluation

The WACC can only be used for project evaluation if:

(a) In the long term the company will maintain its existing capital structure (ie financial risk is
unchanged)

(b) The project has the same risk as the company (ie business risk is unchanged)

If these factors are not in place (ie risk changes) then the company's existing cost of equity will
change.

Assessing corporate performance

Key profitability ratios

1. Return on capital employed

ROCE should ideally be increasing. If it is static or reducing it is important to determine

whether this is due to a reduced profit margin (which is likely to be bad news) or lower asset
turnover (which may simply reflect the impact of a recent investment).

Capital employed = shareholders' funds + long-term debt finance

Alternatively, capital employed can be defined as Total assets less Current liabilities.

If ROCE is calculated post tax then it can be compared against the weighted average cost of
capital (also post tax) to assess whether the return provided to investors is adequate.

Shareholder investor ratios

2. Total shareholder’s return

Total shareholder return is often used to measure changes in shareholder wealth.

3. Other ratios

Risk management

(1) Business risk

Business risk arises from the type of business an organisation is involved in and relates to
uncertainty about the future and the organisation's business prospects.

(a) Political risk – the risk of government action which damages shareholder wealth (eg
exchange control regulations could be applied that may affect the ability of the subsidiary
to remit profits to the parent company).

(b) Economic risk – for example the risk of a downturn in the economy.

(c) Fiscal risk – including changes in tax policies which harm shareholder wealth.

(d) Operational risk – human error, breakdowns in internal procedures and systems

(e) Reputational risk – damage to an organisation's reputation can result in lost revenues or
significant reductions in shareholder value.

Business risk is a mixture of systematic and unsystematic risk.

The systematic risk comes from such factors as revenue sensitivity to macro-economic
factors and the mix of fixed and variable costs within the total cost structure.

Unsystematic risk is determined by such company-specific factors as management

mistakes, or labour relations issues, or production problems.

(2) Non-business/financial risk

Non-business risk may arise from an adverse event (accident/natural disaster) or to risks
arising from financial factors (financial risk).

Financial risk: the volatility of earnings due to the financial policies of a business.

Relationship between business and financial risk

A business with high business risk may be restricted in the amount of financial risk it can
sustain because, if financial risk is also high, this may push total risk above the level that is
acceptable to shareholders.

It will be important for the financial strategy of an organisation facing high business risk to
minimise debt finance, and to hedge a greater proportion of its currency and interest rate
exposure, ie to minimise financial risk.

Arguments about risk management

(1) Arguments against risk management

In order to generate returns for shareholders a company will need to accept a degree of risk. In
addition, as we have seen, shareholders can diversify away some of the risk that they face
themselves.

If risk management is unnecessary then the time and expense that it involves, it could be
argued, reduces shareholder wealth.

(2) Arguments in favour of risk management

The main arguments in favour of risk management (eg hedging) are based on the idea that in
reality there is no guarantee that firms will be able to raise funds to finance attractive projects
(ie capital markets are imperfect). Hedging should reduce the volatility of a company's
earnings, and this can have a number of beneficial effects:

(a) Attracting investors: because there is a lower probability of the firm encountering financial
distress.

(b) Encouraging managers to invest for the future: especially for highly geared firms, there
is often a risk of underinvestment because managers are concerned about the risk of not
being able to meet interest payments. Risk management reduces the incentive to
underinvest, since it reduces uncertainty and the risk of loss.

(c) Attracting other stakeholders: for example, suppliers and customers are more likely to
look for long-term relationships with firms that have a lower risk of financial distress.

Common risk management techniques

(1) Risk mitigation

– The process of transferring risks out of a business. This can involve hedging

(2) Risk diversification

– Reducing the impact of risk by investing in different business areas. However, the benefits
from diversification can normally be gained by shareholders building portfolios of different
shares. If this has already been done then diversification by a company may not benefit
shareholders unless it involves moving into business areas that shareholders cannot access by
themselves (eg new international markets where foreign share ownership is regulated), or if the
diversification creates synergy with existing operations

Behavioural finance

Behavioural finance considers the impact of psychological factors on financial strategy. This
challenges the idea that managers and investors behave in a rational manner based on sound
economic criteria.

Management behaviour

(1) Overconfidence – tendency to overestimate their own abilities. This may help to explain
why many acquisitions are overvalued . This could also help to explain why many boards
believe that the stock market undervalues their shares.
This can lead to managers taking actions that may not be in their shareholders' best
interests, such as delisting from the stock market or defending against a takeover bid that
they believe undervalues their company.

(2) Entrapment – managers are also reluctant to admit that they are wrong (they become
trapped by their past decisions, sometimes referred to as cognitive dissonance). This helps
to explain why managers persist with financial strategies that are unlikely to succeed.
For example, in the face of economic logic managers will often delay decisions to terminate
projects because the failure of the project will imply that they have failed as managers.

(3) Agency issues – managers may follow their own self-interest, instead of focusing on
shareholders.
Analysis of these types of behavioural factors can help to evaluate possible causes behind
a failing financial strategy.

Investor’s behaviour

(1) Search for patterns – investors look for patterns which can be used to justify investment
decisions. This might involve analyzing a company's past returns and using this to
extrapolate future performance, or comparing peaks or troughs in the stock market to
historical peaks and troughs. This can lead to herding.
This is compounded by a reluctance of investors to admit that they are wrong (sometimes
referred to as cognitive dissonance).

(2) Narrow framing – many investors fail to see the bigger picture and focus too much on
short-term fluctuations in share price movements; this can mean that if a single share in a
large portfolio performs badly in a particular week then, according to theories such as
CAPM, this should not matter greatly to an investor who is investing in a large portfolio of
shares over, say, a 20-year period. However, in reality, it does seem to matter – which
indicates that investors show a greater aversion to risk than the CAPM suggests they
should.

(3) Availability bias – people will often focus more on information that is prominent (available).
Prominent information is often the most recent information; this may help to explain why
share prices move significantly shortly after financial results are published

(4) Conservatism – investors may be resistant to changing their opinion so, for example, if a
company's profits are better than expected the share price may not react significantly
because investors underreact to this news.

If the stock markets are not behaving in a rational way, it may be difficult for managers to
influence the share price of their company and the share price may not be a reliable estimate of
the company's value.

Chapter # 3
Discounted Cash flow
Techniques
Capital investment monitoring

Net present value (NPV)

The net present value (NPV) of a project: the sum of the discounted cash flows less the initial
investment.

(1) Impact of inflation

In exam questions, it will normally be the case that cash flows are forecast to inflate at a variety
of different rates. If so, inflation will have an impact on profit margins and therefore inflation
must be included in the cash flows.

Investors will anticipate inflation, so the cost of capital will normally include inflation. So there
will be no need to adjust the cost of capital for inflation unless it is stated to be 'in real terms'. If
this happens, which is rare in the AFM exam, the following formula (known as the Fisher
formula) is provided and can be used to adjust a cost of capital for inflation.

[1 + real cost of capital] * [1 + general inflation rate] = [1 + inflated cost of capital]

(2) Impact of tax

Corporation tax can have two impacts on NPV calculations in the exam:

(a) Tax will need to be paid on the cash profits from the project

(b) Tax will be saved if tax allowable depreciation can be claimed

These impacts can be built into project appraisal as a single cash flow showing the tax paid
after tax allowable depreciation (TAD) is taken into account .

However, care must be taken to add back TAD because it is not in itself a cash flow.

In the final year a balancing allowance or charge will be claimed to reduce the written down
value of asset to zero (after accounting for any scrap value).

The timing and rates of tax, and of tax allowable depreciation will be given in an exam question

There will be circumstances when TAD in a particular year will equal or exceed before-tax
profits.

In most tax systems, unused TAD can be carried forward so that it is set off against the tax
liability in any one year includes not only TAD for that year but also any unused TAD from
previous years.

IRR and MIRR

Internal rate of return (IRR) of any investment: the discount rate at which the NPV is equal to
zero. Alternatively, the IRR can be thought of as the return that is delivered by a project.

A project will be accepted if its IRR is higher than the required return as shown by the cost of
capital.

NPV versus IRR

IRR, as a percentage, is potentially an easier concept to explain to management.

However NPV is theoretically superior because IRR it has a number of drawbacks when used
to make decisions between competing projects (mutually exclusive projects).

(1) IRR ignores the size of a project, and may result in a small project with a better IRR being
chosen over a bigger project even though the larger project is estimated to generate more
wealth for shareholders (as measured by NPV).

(2) For projects with non-normal cash flows, eg flows where the present value each year
changes from positive to negative or negative to positive more than once, there may be
more than one IRR.
(3) IRR assumes that the cash flows after the investment phase (here time 0) are
reinvested at the project's IRR; this may not be realistic.

Modified IRR (MIRR)

IRR assumes that the cash flows after the investment phase (here time 0) are reinvested at the
project's IRR. A better assumption is that the funds are reinvested at the investors' minimum
required return (WACC), here 12%. If we use this re-investment assumption we can calculate
an alternative, modified version of IRR.

The extent to which the MIRR exceeds the cost of capital is called the return margin and
indicates the extent to which a new project is generating value.

Advantages of MIRR

MIRR makes a more realistic assumption about the reinvestment rate, and does not give the
multiple answers that can sometimes arise with the conventional IRR.

Risk and uncertainty

Before deciding to spend money on a project, managers will want to be able to make a
judgement on the possibility of receiving a return below the projected NPV, ie the risk or
uncertainty of the project.

Technically there is a difference between risk and uncertainty; risk means that specific
probabilities can be assigned to a set of possible outcomes, while uncertainty applies
when it is either not possible to identify all the possible outcomes or assign probabilities
to them.

Project duration

Project duration: a measure of the average time over which a project delivers its value.

Project duration shows the reliance of a project on its later cash flows, which are less certain
than earlier cash flows; it does this by weighting each year of the project by the % of the
present value of the cash inflows received in that year.

Unlike payback (or discounted payback), this measure of uncertainty looks at all of a project's
life.

The lower the project duration the lower the risk/uncertainty of the project.

Value at Risk

A modern approach to quantifying risk involves estimating the likely change in the value of an
investment by using the concept of a normal distribution. Some of the properties of a normal
distribution are shown below (σ = standard deviation):

Value at risk is the maximum likely loss over a set period (with only an x% chance of being
exceeded

Z = (Required Value - Mean) / Standard Deviation

Drawbacks of value at risk

Value at risk is based on a normal distribution, which assumes that virtually all possible
outcomes will be within three standard deviations of the mean and that success and failure are
equally likely.

Neither is likely to be true for a one-off project.

Value at risk is also based around the calculation of a standard deviation and again this is hard
to estimate in reality since it is based on forecasting the possible spread of the results of a
project around an average.

Capital rationing

Capital rationing problems exist when there are insufficient funds available to finance all
available positive NPV projects.

Single-period capital rationing

For single-period capital rationing problems, divisible projects are ranked according to the
profitability index.

This gives the shadow price of capital or the maximum extra a company should be prepared to
pay to obtain short-term funds in a single year.

Multiple-period capital rationing

Where capital rationing exists over a number of years, mathematical models are used to find
the optimal combination of divisible or indivisible projects to invest in.

For this exam you only need to be able to formulate the problem and to interpret the
solution.

Soft and hard capital rationing

If an organisation is in a capital rationing situation it will not be able to invest in all available
projects (whether involving organic growth or acquisition) because there is not enough capital
for all of the investments. Capital is a limiting factor.

Capital rationing may be necessary in a business due to internal factors (soft capital
rationing) or external factors (hard capital rationing).

Soft capital rationing

Soft capital rationing may arise for one of the following reasons:

(a) Management may be reluctant to issue additional share capital because of concern that
this may lead to outsiders gaining control of the business.

(b) Management may be unwilling to issue additional share capital if it will lead to a dilution of
earnings per share.

(c) Management may not want to raise additional debt capital because they do not wish to be
committed to large fixed interest payments.

(d) Capital expenditure budgets may restrict spending.

Note that whenever an organisation adopts a policy that restricts funds available for
investment, such a policy may be less than optimal, as the organisation may reject projects
with a positive NPV and forgo opportunities that would have enhanced the market value of the
organisation.

Hard capital rationing

Hard capital rationing may arise for one of the following reasons:

(a) Raising money through the stock market may not be possible if share prices are depressed.

(b) There may be restrictions on bank lending due to government control.

(c) Lending institutions may consider an organisation to be too risky to be granted further loan
facilities.

(d) The costs associated with making small issues of capital may be too great.

Chapter # 4
Application of Option
Pricing Theory to
Investment Decision
Limitations of traditional DCF analysis

Some investments have an added attraction because they offer real options/strategic
flexibility, the value of which is ignored in traditional DCF analysis – this can lead to potentially
lucrative investments being rejected.

Real options can be valued using the Black–Scholes option valuation model (BSOP).

The value of an option can then be added to the traditional NPV to give a revised and
(arguably) more accurate assessment of the value created by a project.

Types of real options

Limitations of the Black–Scholes model

The most significant limitation of the Black–Scholes model is the estimation of the standard
deviation of the asset. Historical deviation is often a poor guide to expected deviation in the
future, so in reality the standard deviation is based on judgement.

The formulae also assume that the options are 'European', ie exercisable on a fixed date. An
alternative model (the binomial model) can be used to value 'American' style options which
are exercisable over a range of dates; this model is beyond the scope of this syllabus. If using
the BSOP model to value an American style option in the exam then you should note that the
BSOP model will undervalue American style options because it does not take into account this
time flexibility (this is the case in the preceding activity).

Other assumptions include:

(a) The risk-free interest rate is assumed to be constant and known.

(b) The model assumes that the return on the underlying asset follows a normal distribution.

(c) The model assumes that the volatility of the project is known and remains constant.
throughout its life.

Chapter # 5
International
Investment &
Financing Decision
Motives for international investment

Economic risk

Economic risk: the risk that the present value of a company's future cash flows might be
reduced by adverse exchange rate movements.

If there is a long-term decline in the value of the foreign currency after an international
investment has been made then the net present value of the project in the domestic
currency ($s) may fall. This is an aspect of economic risk.

So, before an international investment proceeds, the risk of the foreign currency falling in value
should be carefully assessed.

PPP and the international Fisher effect

If an exam question provides interest rates instead of inflation rates, the PPP formula can still
be used (inserting interest rates instead of inflation rates) on the assumption that interest rate
differentials between economies of similar risk are simply a reflection of different expectations
of inflation. The idea that if long-term $ interest rates are higher this is an indication that $
inflation will be higher is the international Fisher effect because it is an extension of the Fisher
formula

Other danger signals

Taxation

To prevent 'double taxation', most governments give a tax credit for foreign tax paid on
overseas profits (this is double tax relief, or DTR).

The home country will only charge the company the difference between the tax paid overseas
and the tax due in the home country. This extra tax will appear as an extra cash flow in the
project NPV.

Intercompany transactions

Companies may charge their overseas subsidiaries for royalties and components supplied.
These charges will affect the taxable profit, and therefore the tax paid, in the foreign country.
Domestic tax may also be payable on the profits from these transactions.

Exchange controls

Another potential problem is that some countries impose delays on the payment of a dividend
from an overseas investment. These exchange controls create liquidity problems and add to
exchange rate risk because the exchange rate may have worsened by the time that dividends
are permitted.

The impact of the delay in the timing of remittances may have to be incorporated into the
international project appraisal.

Multinational companies have used many different strategies to overcome exchange controls,
the most common of which are:

Financing decision: managing risk of international investments

Hedging economic risk

Various actions can reduce economic risk, including the following:

(a) Matching assets and liabilities : A foreign subsidiary can be financed, as far as possible,
with a loan in the currency of the country in which the subsidiary operates. A depreciating
currency results in reduced income but also reduced loan service costs. A multinational will
try to match assets and liabilities in each country as far as possible

(b) Diversifying the supplier and customer base : For example, if the currency of one of the
supplier countries strengthens, purchasing can be switched to a cheaper source.

(c) Diversifying operations worldwide: On the principle that companies which confine
themselves to one country suffer from economic exposure , international diversification is a
method of reducing such exposure.

Use of IRP to compute the effective cost of foreign loans

Loans in some currencies are cheaper than in others. However, when the likely strengthening of
the exchange rate is taken into consideration, the cost of apparently cheap international loans
becomes much more expensive and may not offer any saving compared to a domestic loan.

Financial strategy

A firm that is planning a strategy of international expansion, does not only have to consider
new 'direct' investments, for example in manufacturing facilities. This may be a sensible
approach because it does allow a firm to retain control over its value chain, but it may be slow
to achieve, expensive to maintain and slow to yield satisfactory results. So other forms of
expansion may be preferable.

(a) A firm might take over or merge with established firms abroad. This provides a means of
purchasing market information, market share and distribution channels. If speed of entry
into the overseas market is a high priority, then acquisition may be preferred to a start-up.
However, the better acquisitions may only be available at a premium.

(b) A joint venture with a local overseas partner might be entered into. This will allow
resources and competences to be shared. Depending on government regulations, joint
ventures may be the only, or the preferred, means of access to a particular market.

Alternatives to international investment

Exporting and licensing

Exporting and licensing are alternatives to foreign direct investment (FDI).

Exporting may be direct selling by the firm's own export division into the overseas markets, or
it may be indirect through agents.

Licensing involves conferring rights to make use of the licensor company's production process
on producers located in the overseas market.

Advantages of licensing

(a) It can allow fairly rapid penetration of overseas markets.

(b) It does not require substantial financial resources.
(c) Political risks are reduced since the licensee is likely to be a local company.

(d) Licensing may be a possibility where direct investment is restricted or prevented by a

country.

(e) For a multinational company, licensing agreements provide a way for funds to be
remitted to the parent company in the form of licence fees.

Disadvantages of licensing

(a) The arrangement may give the licensee know-how and technology which it can use in
competing with the licensor after the license agreement has expired.

(b) It may be more difficult to maintain quality standards, and lower quality might affect the
standing of a brand name in international markets.

(c) It might be possible for the licensee to compete with the licensor by exporting the produce
to markets outside the licensee's area.
(d) Although relatively insubstantial financial resources are required, on the other hand
relatively small cash inflows will be generated.
Joint ventures

Advantages of joint ventures

(1) Relatively low-cost access to new markets

(2) Easier access to local capital markets, possibly with accompanying tax incentives or
grants

(3) Use of joint venture partner's existing management expertise, local knowledge,
distribution network, technology, brands, patents and marketing or other skills

(4) Sharing of risks

(5) Sharing of costs, providing economies of scale

Disadvantages of joint ventures

(1) Managerial freedom may be restricted by the need to take account of the views of all the
joint venture partners.

(2) There may be problems in agreeing on partners' percentage ownership, transfer prices,
reinvestment decisions, nationality of key personnel, remuneration and sourcing of raw
materials and components.

(3) Finding a reliable joint venture partner may take a long time.

(4) Joint ventures are difficult to value, particularly where one or more partners have made
intangible contributions.

Eurobonds

Eurobond (or international bond): a bond sold outside the jurisdiction of the country in whose
currency the bond is denominated.

In recent years, a strong market has built up which allows very large companies to borrow in
this way, long term or short term. Again, the market is not subject to national regulations.

Eurobonds are long-term loans raised by international companies or other institutions and
sold to investors in several countries at the same time. Eurobonds are normally repaid after 5
to 15 years, and are for major amounts of capital ie $10m or more.

How are eurobonds issued?

Step (1) A lead manager is appointed from a major merchant bank; the lead manager liaises
with the credit rating agencies and organises a credit rating of the eurobond.

Step (2) The lead manager organises an underwriting syndicate (of other merchant banks) who
agree the terms of the bond (eg interest rate, maturity date) and buy the bond.

Step (3) The underwriting syndicate then organise the sale of the bond; this normally involves
placing the bond with institutional investors.

Advantages of eurobonds

(a) Eurobonds are 'bearer instruments', which means that the owner does not have to
declare their identity.

(b) Interest is paid gross and this has meant that eurobonds have been used by investors to
avoid tax.

(c) Eurobonds create a liability in a foreign currency to match against a foreign currency asset.

(d) They are often cheaper than a foreign currency bank loan because they can be sold on by
the investor, who will therefore accept a lower yield in return for this greater liquidity.

(e) They are also extremely flexible. Most eurobonds are fixed rate but they can be floating
rate or linked to the financial success of the company.

(f) They are typically issued by companies with excellent credit ratings and are normally
unsecured, which makes it easier for companies to raise debt finance in the future.

(g) Eurobond issues are not normally advertised because they are placed with institutional
investors and this reduces issue costs.

Disadvantages of eurobonds

Like any form of debt finance, there will be issue costs to consider (approximately 2% of funds
raised in the case of eurobonds) and there may also be problems if gearing levels are too high.

A borrower contemplating a eurobond issue must consider the foreign exchange risk of a
long-term foreign currency loan. If the money is to be used to purchase assets which will earn
revenue in a currency different to that of the bond issue, the borrower will run the risk of
exchange losses if the currency of the loan strengthens against the currency of the revenues
out of which the bond (and interest) must be repaid.

Chapter # 6
Cost of Capital &
Changing Risk
The impact of debt finance on the cost of capital

The traditional view of WACC

The traditional view is as follows:

(a) As the level of gearing increases, the cost of debt remains unchanged up to a certain
level of gearing. Beyond this level, the cost of debt will increase as interest cover falls, the
amount of assets available for security falls and the risk of bankruptcy increases.

(b) The cost of equity rises as the level of gearing increases and financial risk increases.
(c) The WACC does not remain constant, but rather falls initially as the proportion of debt
capital increases, and then begins to increase as the rising cost of equity (and possibly of
debt) becomes more significant.

(d) The optimum level of gearing is where the company's WACC is minimised.

The traditional view about the cost of capital is illustrated in the following figure. It shows that
the WACC will be minimised at a particular level of gearing P.

The traditional view is that the WACC, when plotted against the level of gearing, is saucer
shaped. The optimum capital structure is where the WACC is lowest, at point P.

Modigliani and Miller (M&M) theory

Irrelevancy theory

M&M demonstrated that, ignoring tax, the use of debt simply transfers more risk to
shareholders, and that this makes equity more expensive so that the use of debt does not
reduce finance costs, ie does not reduce the WACC.

Assumptions

Modigliani and Miller made various assumptions in arriving at this conclusion, including:

(a) A perfect capital market exists, in which investors have the same information, on which
they act rationally, to arrive at the same expectations about future earnings and risks.

(b) There are no tax or transaction costs.

(c) Debt is risk free and freely available at the same cost to investors and companies alike.

If MM's theory holds, it implies:

(a) The cost of debt remains unchanged as the level of gearing increases.

(b) The cost of equity rises in such a way as to keep the WACC constant.

This would be represented on a graph as shown below.

Modigliani and Miller (M&M) theory with tax

M&M then introduced the effect of corporation tax to demonstrate that if debt also saves
corporation tax , then this extra effect means that the WACC will fall. This suggests that a
company should use as much debt finance as it can.

Weaknesses in MM theory

MM theory has been criticized as follows:

(a) MM theory assumes that capital markets are perfect. For example, a company will always
be able to raise finance to fund worthwhile projects. This ignores the danger that higher
gearing can lead to financial distress costs.

(b) Transaction costs will restrict the arbitrage process.

(c) Investors are assumed to act rationally which may not be the case in practice.

Relationship between WACC and value

As you would expect, a fall in the WACC benefits shareholders. This is because the present
value of the cash flows generated by a company to its investors (shareholders and debt
holders) will be higher if it is discounted at a lower rate. In an efficient market this would
imply that the market value of equity plus debt will rise as the WACC falls.

Revised formula for Ke

M&M's formula for the Ke of a geared company reflects the effects of using debt finance ie the
benefit of the tax relief and the extra financial risk that it brings.

Drawbacks of M&M

A key assumption of M&M theory is that capital markets are perfect, ie a company will
always be able to raise finance to fund good projects. In reality this is not true.

Static trade-off theory

Myers argues that these imperfections (static) mean that the level of gearing that is appropriate
for a business depends on its specific business context.

This suggests that a company should gear up to take advantage of any tax benefits available,
but only to the extent that the marginal benefits exceed the marginal costs of financial
distress.

After this point, the market value of the firm will start to fall and its WACC will start to rise.

Other theories

Pecking order theory suggests that, partly due to issue costs, the preferred 'pecking order'
for financing is as follows: 1, retained earnings; 2, debt; 3, new equity.

Managers will prefer to issue equity when the share price is high (even to the point of being
overvalued). They will prefer not to issue equity when the share price is considered to be low
(or undervalued).

Investors will use the issue of equity as a signal from managers as to the true worth of the
company's shares. Managers typically have better information than investors that can be used
to value the shares (information asymmetry).

Market signals

If equity is issued, the market will take this as a signal that shares are overvalued. This may
result in investors selling their shares (thus making substantial gains) which will lead to a fall
in the share price. If this happens, the cost of equity may rise, which will result in a higher
marginal cost of finance. To avoid this possibility, managers may decide to issue debt even if
shares are seen as being overvalued.

Conversely, an issue of debt may be interpreted as an undervaluation of the shares. Investors

will want to 'get a bargain' and will thus start to buy the shares, leading to an increase in share
price.

Issues costs

In addition a new issue of equity is normally significantly more expensive than a debt issue, this
again makes an issue of new equity less attractive.

Agency theory suggests that if a company is mainly equity financed there is less pressure on
cash flow, and managers will often embark on 'vanity projects' such as ill-judged acquisitions.
Higher gearing creates a discipline that can effectively deal with this agency problem.

A practical advantage of debt finance is that it enforces financial discipline on the management
of a company. If a company is all equity financed there is less pressure on cash flow, and
managers will often embark on 'vanity projects' such as ill-judged acquisitions. Higher gearing
creates a discipline that can effectively deal with this agency problem.

Investments that change financial risk

When NOT to use the WACC

The current WACC cannot be used as a discount rate at which to appraise projects if:

(a) A project causes a company to change its existing capital structure (financial risk)

(b) A project incurs higher than normal business risk

Where the financial risk or business risk of an extra project is different from normal, there is
an argument for a cost of capital to be calculated for that particular project; this is called a
project- specific cost of capital.
Changing financial risk – adjusted present value (APV)

Modigliani and Miller's theory on gearing tells us that the impact of debt finance is purely to
save tax. If so, then the value of this can be quantified and added as an adjustment to the
present value of a project.

If a question shows an investment has been funded by an unusually high level of debt or asks
for project appraisal using 'the adjusted present value method', you must apply the following
steps.

If you are told in an exam question that a subsidised loan is offered then this clearly adds
some extra value to the APV. This should be factored into Step 2 and calculated as the present
value of the net interest savings due to the subsidy, discounted at the normal pre-tax Kd.

Alternative method of ungearing the cost of equity in Step 1

An alternative method of calculating an ungeared Ke in Step 1 of APV is to adjust the

company's equity beta by stripping out the effect of gearing to create an ungeared or an
asset beta. This beta is then input to the capital asset pricing model to calculate an ungeared
cost of equity.

Note that in most exam questions the debt beta can be assumed to be zero (this assumption

can be made unless a debt beta is provided).

The beta of a company is called an equity beta – this reflects both business risk (the risk of
the business operations) and financial risk (the risk of using debt finance in the capital
structure).

To understand the level of business risk (only) faced by a business, an equity beta can be
adjusted to show its value if the company was ungeared. An ungeared beta therefore
measures only business risk, not financial risk.

An asset beta will be smaller than an equity beta because an asset beta only measures
business risk, whereas an equity beta measures business risk and financial risk.

Equity beta: a measure of the market risk of a security, including its business and financial risk.
Asset beta: an ungeared beta measuring only business risk.

Investments that change business risk

Adjusting information from a comparative quoted company (CQC)

For projects with different business risk (compared to current operations) it is inappropriate to
use the existing WACC to calculate a project NPV; instead a marginal cost of capital (using the
CAPM) should be used.

When a company is moving into a new business area it can use the beta of a company in that
sector (a comparable quoted company, CQC) and ungear their cost of equity or their equity
beta to establish the business risk of this new area.

This ungeared cost of equity or ungeared beta can then be adjusted again to reflect the debt
level of the company making the investment so that it reflects the appropriate level of financial
risk when evaluating an investment.

This involves three steps:

Drawbacks of approach

Finding a suitable CQC

The key problem with using the geared and ungeared beta formula for calculating a firm's
equity beta from data about other firms is that it is difficult to identify a comparative company
with identical operating characteristics to use as a benchmark.

For example, there may be differences between firms caused by different cost structures (eg
the ratio of fixed costs to variable costs), and the type of products and markets of a
comparative company business is unlikely to be a perfect match to a proposed project.

Other issues

In addition there are technical flaws in the models used (either adjusting beta factors or using
M&M theory to adjust the cost of equity)

Chapter # 7
Financing & Credit
Risk
Credit risk and the cost of debt

One of the drawbacks of M&M theory is that it fails to recognize that a significant increase in
gearing will alter the credit rating of a company, which can impact on the cost of capital and
therefore on shareholder wealth.

Estimating the yield curve

The yield curve can be calculated by comparing government bonds with different prices
and maturities.
Credit risk and the cost of debt

Criteria for establishing credit ratings

The issuer of debt will pay for a credit rating; this will involve the disclosure of confidential
information to a credit rating agency. The criteria for rating debt encompasses the following:

Impact of a change in credit rating

Impact of a new debt issue on the WACC

One reason that a company's credit rating can worsen is due to the issue of new debt; this can
have a number of potential impacts on the weighted average cost of capital:

Exam questions often specify that the impact of the new debt issue on the value or cost of
equity is not known, or can be assumed to be insignificant. If so, there is no need to adjust the
cost of equity using the M&M cost of equity formula.

Other impacts of a new debt issue

Additional debt may have other restrictive covenants which may restrict a company from
buying or selling assets, this may restrict a company from being able to maximise returns to
shareholders.

Debt repayment covenants require a company to build up a fund over time which will be
enough to redeem the debt at the end of its life. These may make it harder to pay dividends to
shareholders.

If the WACC rises (which does not necessarily happen as shown in Activity 2), this will reduce
the value of a company to its investors.

Duration of a bond

We have seen, in Chapter 3, the concept of duration in the context of project appraisal to give
a measure of the average amount of time over which a project delivers its value. Duration is
also known as Macaulay duration.

The same concept can be applied to a bond, where it helps to explain the risk of a bond to
investors.

Calculation

The average amount of time taken to recover the cash flow from a bond is not only affected by
its maturity date – it is also affected by the size of the interest (coupon) payments, eg a 5%
bond maturing in three years will not give cash back as quickly as a 10% three-year bond.

Duration measures the weighted average number of years over which a bond delivers its
returns. As we have seen, duration is calculated by multiplying the present value of cash
inflows to the time period of that inflow and then dividing by the total present value of the cash
inflows.

Duration allows bonds of different maturities and coupon rates to be directly compared. The
illustration below is a recap of the calculation of duration.

Influences on duration

Duration will be higher if the bond has:

(a) A long time to maturity

(b) A low coupon rate

Modified duration

Modified duration is a useful measure of the risk of a bond to an investor. Modified duration is
calculated as:

This is a useful measure of the price sensitivity (risk) of a bond to changes in interest rates.

Convexity and modified duration

A limitation of modified duration is that it assumes a linear relationship between the yield and
the price.

In fact, the actual relationship between price and yield is given by the curve below.

The impact of convexity (ie a non-linear relationship) will be that the modified duration will tend
to overstate the fall in a bond's price and understate the rise. Therefore modified duration
should be treated with caution in your predictions of interest rate/price relationships.

The problem of convexity only becomes an issue with more substantial fluctuations in the yield.

Sources of finance (1) – Initial coin offering (ICO)

What is an ICO?

An Initial Coin Offering (ICO) is a new way for organizations to raise capital. Like an Initial Public
Offering (IPO), an ICO raises finance from investors. However, there are two key differences:

(a) Instead of receiving shares, an investor receives a new type of coin or token

(b) Payment is made in a cryptocurrency such as bitcoin or ether

Types of tokens/coins
Regulatory status

The attitude of regulators to ICOs differs around the world; in some countries (China and South
Korea) ICOs are banned.

In general, regulators are less concerned with ICOs that do not offer investors the reasonable
expectation of profit eg where an ICO aims to simply develop technology or where investors
receive utility tokens to exchange for future services (these ICOs currently tend to be outside
the definition of a 'security' and therefore are not normally of interest to regulators).

ICOs that in some way offer future income streams are likely to be judged to be securities (eg
equity tokens or tokens that can also serve as a 'payment voucher' for an underlying service).
These ICOs are likely to have to fulfil the related regulatory criteria for an issue of securities (full
prospectus etc). There may also be a risk that if this has not been done then fines may be
levied (which may be severe), or the regulator puts a stop to the ICO.

Mechanism for an ICO

One of the attractions of an unregulated ICO is its simplicity, the issuer raises money by issuing
a 'white paper' providing details of the concept that the venture intends to build, and details of
the tokens that will be issued in exchange for cryptocurrency.

The white paper is available via the venture's website, which also provides the mechanism for
payment of cryptocurrency to the venture's account (typically bitcoin or ether). It is now more
common for payments to be made into an escrow account (an account established by an
independent third party), to provide greater assurance of the venture's validity.

Most ICO sites include instructions for how investors should go about buying their bitcoins or
ether – the assumption being that they don't already own any cryptocurrency (ACCA, 2018).

Advantages of an ICO

Since 2017, there has been a dramatic increase in ICO activity, due to:

(a) Its speed and ease of use as a source of finance for new ideas, compared to traditional
methods

(b) Investor interest, often based on a speculative expectation of rapid, high returns

Disadvantages of an ICO

To investors

To the issuer

Sources of finance (2) – Islamic finance

The justification for the use of Islamic finance may be either religious or commercial reasons;
here we focus on commercial reasons:

(1) Availability of finance. The impact of the credit crash on Islamic nations, eg wealthy Gulf
countries, has been less than in many other parts of the world. The Gulf countries own
approximately 45% of the world's oil and gas reserves.

(2) Islamic finance may also appeal due to its more prudent investment and risk philosophy.
Conventional banks aims to profit by taking in money deposits in return for the payment of
interest (or riba) and then lending money out in return for the payment of a higher level of
interest. Islamic finance does not permit the charging of interest and invests under
arrangements which share the profits and losses of the enterprises.

Products based on equity participation

To tap into the Islamic equity markets, a company must be sharia compliant. To achieve this,
there are two key screening tests:

1. Does the company engage in business practices that are contrary to Islamic law, eg
alcohol, tobacco, gambling, money lending and armaments are not acceptable.

2. Does the company pass key financial tests, eg a low debt–equity ratio (less than approx
33%); in theory any interest-based transaction is not permitted, but in reality it is accepted
that this is not realistic.

To establish social justice, Islam requires that investors and entrepreneurs share risk and
reward; there are two main products that are offered by Islamic banks that facilitate this
(remember that Islamic banks cannot lend money out in a conventional way in exchange for
interest repayments). Despite being offered by banks, both products actually create equity
participation.

1 Mudaraba
Profits are shared according to a pre-agreed contract. There are no dividends paid. Losses are
solely attributable to the provider of capital, eg a bank. The entrepreneur (the mudarib) takes
sole responsibility for running the business, because they have the expertise in doing so – if
losses are made the entrepreneur loses their time and effort.

Mudaraba contracts can either be restricted (to a particular project) or unrestricted (funds can
be used in any project).

2 Musharaka
Profits are shared according to a pre-agreed contract. There are no dividends paid. Losses are
shared according to capital contribution. Both the organisation/investment manager and
finance provider participate in managing and running the joint venture.

Profits are normally shared in a proportion that takes into account the capital contribution and
the expertise being contributed by the bank and the entrepreneur/joint venture partners.
Losses are shared in proportion to the % capital being contributed by each party.

Under a diminishing musharaka agreement the mudarib pays increasingly greater amounts to
increase their ownership over time, so that eventually the mudarib owns the whole venture or
asset.

Sukuk bonds

The other key product that allows equity participation is a sukuk bond. Although these are
often referred to as Islamic bonds, the sukuk holders share risks and rewards, so this
arrangement is more like equity. The sukuk holder shares in the risk and rewards of ownership
of a specific asset, project or joint venture.

Sukuks require the creation of a special purpose vehicle (SPV) which acquires the assets. This
adds to the costs of the bond-issuing process, but they are often registered in tax-efficient
jurisdictions, eg Bahrain.

The prospectus for a sukuk must clearly disclose its purpose, its risk and the Islamic contract
on which it is based (mudaraba, musharaka, ijara (see below)) – all of which will be crucial in
obtaining sharia compliance (which must be disclosed in the prospectus too).

Product based on investment financing (ie no equity participation)

Debt-based finance is also possible but, even here, no interest can be charged; the products
ensure both parties involved share risk (eg late payment fees can be applied by the bank but
any such fees must be given to charity), and no money is actually loaned (the finance is linked
to an asset being purchased on behalf of the client).

Pros and cons of Islamic finance

Advantages of Islamic finance

Islamic finance operates on the underlying principle that there should be a link between the
economic activity that creates value and the financing of that economic activity. The main
advantages of Islamic finance are as follows:

(a) Following the principles of Islamic finance allows access to a source of worldwide funds.
Access to Islamic finance is also not just restricted to Muslim communities, which may
make it appealing to companies that are focused on investing ethically.

(b) Gharar (speculation) is not allowed, reducing the risk of losses.

(c) Excessive profiteering is also not allowed; only reasonable mark-ups are allowed.

(d) Banks cannot use excessive leverage and are therefore less likely to collapse.

(e) The rules encourage all parties to take a longer-term view and focus on creating a
successful outcome for the venture, which should contribute to a more stable financial
environment.

(f) The emphasis of Islamic finance is on mutual interest and co-operation, with a partnership
based on profit creation through ethical and fair activity benefiting the community as a
whole.

Drawbacks of Islamic finance

The use of Islamic finance does not remove all commercial risk. Indeed, there may even be
additional risk from the use of Islamic finance. There are the following drawbacks from the use
of Islamic finance:

(a) There is no international consensus on Sharia interpretations, eg some Murabaha contracts

have been criticised because their products have been based on prevailing interest rates
rather than economic or profit conditions.

(b) There is no standard Sharia model for the Islamic finance market, meaning that
documentation is often tailor-made for the transaction, leading to higher transaction costs
than for the conventional finance alternative.

(c) Trading in Sukuk products has been limited. Since the financial crisis, issuance of new
Sukuk products has decreased.

(d) Corporations may not be able to demonstrate that contracts are effectively debt and they
therefore may not attract a tax shield, meaning that their cost of capital will increase.

(e) Restrictions are placed on a company's business operations and financial structure.

(f) Approval of new products can take time.

Chapter # 8
Valuation for
Acquisition &
Mergers
The overvaluation problem

When a company acquires a target company, it will pay a 'bid premium' above the target's
current market value. Where this premium is excessive, this creates a problem of
overvaluation.

Many studies suggest that the target company shareholders enjoy the benefit of the 'bid
premium' but the shareholders of the acquirer often do not benefit as a result of overvaluation.

Behavioural finance and overvaluation

A number of behavioural factors may explain why acquisitions are often overvalued.

Overconfidence and confirmation bias

People tend to overestimate their capabilities. If this is happening at board level it may lead the
board to overestimate their ability to turn around a firm and to produce higher returns than its
previous management.

Overconfidence can result from managers paying more attention to evidence supporting the
logic of an acquisition than they will to evidence that questions this logic. This is confirmation
bias.

Loss aversion

Many takeover bids are contested, ie more than one company is involved in bidding for a firm.
In this situation there is a likelihood that the bid price will be pushed to excessively high levels.
This can be explained in psychological terms in that there is a stronger desire to possess
something because there is a threat of it being taken away from you. This is sometimes called
loss aversion.

Entrapment

Where a strategy is failing, managers may become unwilling to move away from it because of
their personal commitment to it (for example, it may have been their idea). This entrapment
may mean that they commit even more funds (eg buying another company even if this means
paying a price that is excessive) in an increasingly desperate attempt to turn around failing
businesses.

Entrapment can help to explain excessive prices being paid to acquire companies that are
seen as crucial to helping to turn around a failing strategy.

Anchoring

If valuing an unlisted company, the bidder may be strongly influenced by that company's initial
asking price, ie this becomes a (biased) reference point for the valuation (however irrational it
is).

Agency issues and overvaluation

Managers may follow their own self-interest, instead of focusing on shareholders. For example,
managers may look to make large acquisitions (and may pay too much for them) primarily to
reduce the vulnerability of their company to being taken-over.

Approaches to business valuation

Overvaluation may also arise due to a miscalculation of the value of an acquisition.

To ensure that a company does not overpay for a target, it is important that careful analysis is
undertaken to establish a realistic valuation for a potential acquisition.

There are three basic approaches to valuation:

(1) Asset-based models

These models attempt to value the assets that are being acquired as a result of the acquisition.

(2) Market-based models

These models use market data to value the acquisition.

(3) Cash-based models

These models are based on a discounted value of the future cash flows relating to an

acquisition.

An acquisition may potentially have an impact on both the financial and the business risk of the
acquirer. This impact needs to be incorporated into the analysis of the valuation of an
acquisition.

Asset–based models

Net asset value (NAV)

Asset-based methods use the statement of financial position as the starting point in the
valuation process.

This values a target company by comparing its assets to its liabilities, which gives an estimate
of the funds that would be available to the target's shareholders if it entered voluntary
liquidation. For an unquoted company, this value would need to at least be matched by a
bidder, and this value is often used as a starting point for negotiating the acquisition price.

The target company's net asset value may need to be adjusted if an exam questions tells you
that the realisable value of assets differs from their book value.

Drawbacks of NAV approach

This technique is sometimes used to estimate a minimum value for an unquoted company that
is in financial difficulties or is difficult to sell (if a company is listed then its minimum value is its
current share price).

This technique ignores:

(1) The value of future profit

(2) The value of intangibles

However, both of these drawbacks can be addressed.

Book value 'plus'

Because this valuation of a target company ignores the profit of the target company a premium
is normally negotiated, based either on a multiple of the firm's profits or an estimated value of
the company's intangible assets. This is called a 'book value plus' model.

Intangible assets

In many firms intangible assets are of enormous value; a company's knowledge base, its
network of contacts with suppliers and customers, and the trust associated with its brand
name are often significant sources of value.

Calculated Intangible Value (CIV) assesses whether a company is achieving an above-average

return on its tangible assets. This figure is then used in determining the present value
attributable to intangible assets.

CIV involves the following steps:

(1) Estimate the profit that would be expected from an entity's tangible asset base using an

industry average expected return.

(2) Calculate the present value of any excess profits that have been made in the recent past,
using the WACC as the discount factor.

Drawbacks of CIV approach

(a) It uses the average industry return on assets as a basis for computing excess returns; the
industry average may be distorted by extreme values.

(b) CIV assumes that past profitability is a sound basis for evaluating the current value of
intangibles – this will not be true if, for example, a brand has recently been weakened by a
corporate scandal or changes in legislation.

(c) CIV also assumes that there will be no growth in value of the excess profits being created
by intangible assets.

Replacement values

In a book value-plus valuation the replacement value of the assets may be more useful than the
book value, and may be provided in an examination question. The replacement value of the
assets of the acquisition target would quantify the cost of setting up the company from scratch
without an acquisition ie by acquiring the assets on the open market.

Lev's method for valuing intangibles

This method is a modification of the approach used in CIV and involves adjusting the valuation
to reflect that growth will not be zero (as assumed in the CIV approach).

This is similar to CIV, but this model then proposes a three-step discounting procedure:

(1) Discount the first five years at the firm's current rate of growth

(2) Discount the next five years at a declining rate that moves towards the industry average

(3) Discount after this at the industry average growth rate.

Lev (Ryan, 2007, p.408) argues that the discount rate used should be high to reflect the
uncertain nature of intangible assets. This contrasts with CIV which normally uses a weighted
average cost of capital.

Market-based models

A sensible starting point for valuing a listed company is the market value of its shares.

If the stock market is efficient the market price will reflect the market's assessment of the
company's future cash flows and risk (both business risk and financial risk).

It follows that the relationship between a company's share price and its earnings figure, ie its P/
E ratio, also indicates the market's assessment of a company or a sector's future cash flows
and risk (both business and financial risk).

P/E ratio

A P/E ratio can be applied to valuing a takeover target by taking the latest earnings of the
target and multiplying by an appropriate P/E ratio.

Problems with this method

(1) Choice of which P/E ratio to use

Care has to be taken that the P/E ratio used reflects the business and financial risk (ie capital
structure) of the company that is being valued. This is quite difficult to achieve in practice.

Also, the P/E ratio will normally be reduced if the company that is being valued is unlisted.
Listed companies have a higher value, mainly due to the greater ease in selling shares in a
listed company. The P/E ratio of an unlisted company's shares will be 30%–50% lower
compared to the P/E ratio of a similar public company.

(2) Earnings calculation

The earnings of the target company may need to be adjusted if it includes one-off items that
will tend not to recur, or if it is affected by directors' salaries which might be adjusted after a
takeover.

Historic earnings will not reflect the potential future synergies that may arise from an
acquisition. Earnings may need to be adjusted to reflect such synergies.

Finally, the latest earnings figures might have been manipulated upwards by the target
company if it has been looking to be bought by another company.

(3) Stock market efficiency

Behavioural finance (see Section 1) suggests that stock market prices may not be efficient
because they are affected by psychological factors, so P/E ratios may be distorted by swings
in market sentiment.

Using your judgement

In practice, using the P/E ratio approach may require you to make a number of judgements
concerning the growth prospects and risk of the company that is being valued and therefore
which P/E ratio is appropriate to use. There may be arguments for increasing the P/E ratio to
reflect expectations of higher growth or lower risk as a result of an acquisition (or for
decreasing the P/E ratio to reflect expectations of lower growth or higher risk as a result of an
acquisition). In the exam you should make and state your assumptions clearly, and you should
not worry about coming up with a precise valuation because, in reality, valuations are not a
precise science and are affected by bargaining skills, psychological factors and financial
pressures.

Post-acquisition P/E valuation

Where an acquisition affects the growth prospects of the bidding company too, the P/E ratio of
the bidding company will change. In this case, the P/E approach needs to be adapted.

Maximum to pay for an acquisition

The post-acquisition value of the group can be compared to the pre-acquisition value of the
bidding company (ie the acquirer); the difference gives the maximum that the company
should pay for the acquisition.

Calculation of value added by the acquisition

Cash-based models

The final set of valuation models are based on the concept of valuing a company using its
forecast cash flows discounted at a rate that reflects that company's business and financial
risk. These models are often seen as the most elegant and theoretically sound methods of
business valuation, and can be adapted to deal with acquisitions that change financial risk or
business risk.

Dividend basis

The simplest cash flow valuation model is the dividend valuation model (DVM).

This is based on the theory that an equilibrium price for any share is the future expected
stream of income from the share discounted at a suitable cost of capital.

The formula calculates the value of a share as the present value of a constantly growing future
dividend.

The anticipated dividends are based on existing management policies, so this technique is
most relevant to minority shareholders (who are not able to change these policies).

Estimating dividend growth

Other issues

When using the dividend valuation model to value an unlisted company it may be necessary to
use the beta of a similar listed company to help to calculate a Ke. This beta will need to be
ungeared and then regeared to reflect differences in gearing (see Chapter 6).

Drawbacks
(a) It is difficult to estimate future dividend growth.

(b) It creates zero values for zero dividend companies and negative values for high growth
companies (if g is greater than re ).

(c) It is inaccurate to assume that growth will be constant.

Non-constant growth

The DVM model can be adapted to value dividends that are forecast to go through two phases:

Earnings growth

Note that the techniques that have been covered for estimating dividend growth (historic
method and current reinvestment method) can also be used to evaluate forecasts of a
company's earnings growth.

Free cash flows and free cash flows to equity

Free cash flow (FCF): the cash available for payment to investors (shareholders and debt
holders), also called free cash flow to firm.

Free cash flow to equity (FCFE): the cash available for payment to shareholders, also called
dividend capacity.

This method can build in the extra cash flows (synergies) resulting from a change in
management control, and when the synergies are expected to be received. There are two
approaches which can be used.

Post-acquisition cash flow valuation

Where an acquisition affects the growth prospects or risk of the bidding company too, this
approach needs to be adapted. Where an acquisition alters the bidding firm's business risk
there is an impact on the existing value of the acquirer as a result of the change in risk, so the
following approach needs to be used.

Adjusted present value

Adjusted present value (APV) has been covered numerically in Chapter 6.

APV can also be used to value acquisitions that change the gearing of the bidding company.
One reason that this could happen is that the acquisition is a bid that is financed by borrowing
(see Chapter 10).

This technique values the enterprise (ie debt plus equity) and the amount of debt needs to be
subtracted in order to value the equity in the target company.

Valuing start-ups: Black–Scholes (BSOP) model

The BSOP model was introduced in Chapter 4; this can also be applied to company valuation
and the assessment of default risk, although in these contexts you will not have to perform any
calculations.

BSOP and company valuation

This approach is mainly useful for a start-up firm that is high risk and difficult to value using
normal techniques.

The value of a firm can be thought of in these terms:

Valuing start-ups

The valuation of start-ups presents a number of challenges for the methods that we have
considered so far due to their unique characteristics which are summarized below. These
effectively mean that traditional valuation techniques are not effective.

(a) Most start-ups typically have no track record

(b) Ongoing losses

(c) Few revenues, untested products

(d) Unknown market acceptance, unknown product demand

(e) Unknown competition

(f) Unknown cost structures, unknown implementation timing

(g) High development or infrastructure costs

(h) Inexperienced management

BSOP and default risk

The BSOP model can also be used to assess the probability of asset values falling to a level
that would trigger default. This can be assessed by looking at the past levels of volatility of a
firm's asset values and assessing the number of standard deviations that this fall would
represent.

Within the BSOP model, N(d2) depicts the probability that the call option will be in-the-money
(ie have intrinsic value for the equity holders).

If N(d2) depicts the probability that the company has not failed and the loan will not be in
default, then 1 – N(d2 ) depicts the probability of default.

The probability of default is used in the BSOP model to calculate the market value of debt.

If the present value of the repayments on the debt is less than the market value, this shows the
expected loss to the lender on holding the debt. If the expected loss and default risk are known
then the recoverability of the debt in the event of default can be estimated.

This section is not examinable numerically.

Option pricing can be used to explain why companies facing severe financial distress can still
have positive equity values. A company facing severe financial distress would presumably be
one where the equity holders' call option is well out-of-money ie has no intrinsic value.

However, as long as the debt on the option is not at expiry, then that call option will still have a
time value attached to it. Therefore, the positive equity value reflects the time value of the
option, even where the option is out-of-money, and this will diminish as the debt comes closer
to expiry. The time value indicates that even though the option is currently out-of-money, there
is a possibility that due to the volatility of asset values, by the time the debt reaches maturity,
the company will no longer face financial distress and will be able to meet its debt obligations.

Growth strategies

To achieve its growth objectives, a company has three strategies that it can use, including:

(a) Internal development (organic growth)

(b) Acquisitions/mergers

(c) Joint ventures

Different forms of expansion have already been identified and discussed in Chapter 5.

Here we briefly recap on this focusing mainly on acquisitions; note that these are general
points and may or may not be relevant to the issues facing a company in an exam question.

Advantages and disadvantages of acquisitions vs internal development

Advantages and disadvantages of acquisitions vs joint ventures

Acquisition targets

A company's strategic planning should give a focus for selecting an acquisition target.

The strategic plan might be to diversify, or to find new geographical markets, or to find firms
that have new skills/products/key technology, or simply to identify firms that are poorly
managed and to turn them around and sell them on at a higher price.

The criteria that should be used to assess whether a target is appropriate will depend on the
motive for the acquisition.

For example, if the strategic plan is to acquire and turn around companies that are undervalued
then the key criteria will be whether a target firm's share price is below the estimated value of
the company when acquired – which is true of companies which have assets that are not
exploited.

Having identified the general type of target, two areas of particular importance are:

(a) Are there potential synergies with the target

(b) Is there a likelihood of a good working relationship with the target

Synergies: extra benefits resulting from an acquisition either from higher cash inflows and/or
lower risk.

Types of synergy

(1) Revenue synergy

Higher revenues may be due to sharing customer contacts and distribution networks or
increased market power.

(2) Cost synergy

This may result from being able to negotiate better terms from suppliers, sharing production
facilities or sharing Head Office functions.

(3) Financial synergy

Examples include: a reduction in risk due to diversification (this assumes shareholders are not
already well diversified), a reduction in the tax paid by two firms combined (losses in one firm
reduce the tax paid by the other), or when a firm with excess cash acquires a firm with
promising projects but insufficient capital.

Working relationship

Possible issues that impede a good working relationship between the acquired company and
its new owner include language, culture and strategic values. These issues should be
examined as part of a due diligence investigation prior to a takeover being finalized.

Due diligence

Prior to takeover bid, investigations should be undertaken to assess the target, three types are
common:

(1) Legal due diligence: checks for any legal concerns, for example any pending litigation and
are there concerns about the costs of complying with the local regulatory environment.

(2) Financial due diligence: focuses on verifying the financial information provided (eg updated
financial forecasts).

(3) Commercial due diligence: considers for example an assessment of competitors and a
fuller analysis of the assumptions that lie behind the business plan.

Reasons for failure of acquisitions

Overvaluation has been discussed in the previous chapter. Other potential reasons for the
failure of acquisitions are discussed here.

To minimise these risks a firm should have a clear post-integration strategy. This should
include:

(a) Control of key factors – eg new capex approval centralised

(b) Reporting relationships – appoint new management and establish reporting lines quickly

(c) Objectives and plans – to reassure staff and customers

(d) Organisation structure – integrating business processes to maximise synergies

(e) Position audit of the acquired company – build understanding of the issues faced by the
target via regular online employee surveys and strategy discussion forums with front line
staff and managers.

Reverse takeovers

Reverse takeover: a situation where a smaller quoted company (S Co) takes over a larger
unquoted company (L Co) by a share-for-share exchange.

To acquire L Co, a large number of S Co shares will have to be issued to L Co's shareholders.

This will mean that L Co will hold the majority of shares and will therefore have control of
the company.

The company will then often be renamed, and it is normal for the larger company (L Co) to
impose its own name on the new entity.

Advantages and disadvantages of a reverse takeover vs an IPO

A reverse takeover is a route to a company obtaining a stock market listing. Compared to an

initial public offering (IPO), a reverse takeover has a number of potential advantages and
disadvantages:

Regulation of takeovers

Takeover regulation in the UK (and the US) is based on a market-based or shareholder- based
model and is designed to protect a wide and dispersed shareholder base.

In the UK and the US companies normally have wide share ownership so the emphasis is on
agency problems and the protection of the widely distributed shareholder base.

In Europe most large companies are not listed on a stock market, and are often dominated by a
single shareholder with more than 25% of the shares (often a corporate investor or the
founding family). Banks are powerful shareholders and generally have a seat on the boards of
large companies.

Regulations in Europe have been developed to control the power of these powerful stakeholder
groups, which is sometimes referred to as a stakeholder-based system.

European regulations on takeovers have generally in the past relied on legal regulations that
seek to protect a broader group of stakeholders, such as creditors, employees and the wider
national interest.

UK regulation – the City Code

This is a voluntary code that aims to protect the interests of shareholders during the bid
process. Although it is voluntary, any listed company not complying may have its membership
of the London Stock Exchange suspended. The details of this code do not have to be
memorized, but awareness of its existence and purpose is examinable.

EU Takeovers Directive

The Takeovers Directive was introduced by the EU in 2006 in order to achieve harmonisation
and convergence of the shareholder-based and stakeholder systems. In terms of approach, it
has mainly led to the convergence of the European system and the UK and US one, by
adopting many of the elements of the City Code. Its key points included:

(1) The mandatory bid rule

The aim of this rule is to protect minority shareholders by providing them with the opportunity
to exit the company at a fair price once the bidder has accumulated a certain percentage of the
shares. In the UK, this threshold is specified by the City Code for Takeovers and Mergers and is
at 30%.

The mandatory bid rule is based on the grounds that once the bidder obtains control it may
exploit its position at the expense of minority shareholders. This is why the mandatory bid rule
normally also specifies the price that is to be paid for the shares.

The bidder is normally required to offer to the remaining shareholders a price not lower than the
highest price for the shares already acquired during a specified period prior to the bid.

(2) The principle of equal treatment

In general terms, the principle of equal treatment requires the bidder to offer to minority
shareholders the same terms as those offered to earlier shareholders from whom the
controlling block was acquired.

(3) Squeeze-out rights

Squeeze-out rights give the bidder who has acquired a specific percentage of the equity

(usually 90%) the right to force minority shareholders to sell their shares.

The rule enables the bidder to acquire 100% of the equity once the threshold percentage has
been reached and eliminates potential problems that could be caused by minority
shareholders.

However, in two key areas the original wording of the European code was significantly diluted
in the final draft:

(1) Board neutrality and anti-takeover measures (Article 9)

Seeking to address the agency issue where management may be tempted to act in their own
interests at the expense of the interests of the shareholders, it was originally proposed that the
board would not be permitted to carry out post-bid aggressive defensive tactics (such as
selling the company's main assets, known as a 'crown jewels' defence, or entering into special
arrangements giving rights to existing shareholders to buy shares at a low price, known as
poison pill defence), without the prior authority of the shareholders.

However, this has become an optional provision for member countries – because there is the
argument that the shareholders may have limited experience so managers are better placed to
act in the shareholders' best interest.

(2) The break-through rule (Article 11)

The effect of the break-through rule is to enable a bidder with 75% of the capital carrying
voting rights to break through the company's multiple voting rights and exercise control as if
one-share-one-vote existed.

Again this has become an optional provision for member countries.

Regulation of large takeovers

It is likely that any acquisition that is likely to lead to a substantial lessening of competition will
be investigated by a country's competition authorities.

A detailed investigation often takes six months to complete and may result in a block to the bid
or a requirement that the acquiring company disposes of parts of the acquired business.

In the UK the Competition and Markets Authority may intervene to prevent mergers that cause
the creation of a company with a market share of above 25%, if it feels that there will be a
substantial lessening of competition.

Mergers fall within the exclusive jurisdiction of the European Commission (Competition) where,
following the merger, the following two tests are met.

(a) Worldwide revenue of more than €5 billion p.a.

(b) European Union revenue of more than €250 million p.a.

The European Commission will assess the merger in a similar way as the Competition and
Markets Authority in the UK, by considering the effect on competition in the market.

The merger will be blocked if the merged company results in such a dominant position in the
market that consumer choice and prices will be affected.

Defence against a takeover

Post-bid defences

Where a bid is not welcomed by the board of the target company, then the bid becomes a
hostile bid. Where the board feels that the takeover is not in the best interest of their
shareholders, they can consider launching a defensive strategy.

This will normally involve attacking the value created for shareholders by the bid and
sometimes this will extend to attacking the track record of the bidder.

A defence could also involve the following tactics:

Pre-bid defences

In order to deter takeover bids in the first place, the best defence is to have an efficiently run
company with no under-utilized assets. This will contribute to excellent relationships with
shareholders and will help to maximise a company's share price, which will help to deter
takeover bids.

However, subject to local regulations, schemes can also be designed to make any takeover
difficult, for example:

Poison pills
If a hostile bid is made, or the stake held by single shareholder rises above a certain key level
(eg 15% in the case of Yahoo) then a 'poison pill' within the target's capital structure is
triggered: eg new shares are issued to existing shareholders at a discount, or convertibles can
be exchanged into ordinary shares on favourable terms.

Poison pills are and by controversial because they hinder an active market for corporate
control giving directors the power to deter takeovers. They also put directors in a position to
enrich themselves, as they may ask to be compensated for consenting to a takeover.

Golden parachutes

These are significant payments made to board members when they leave. In many countries
these schemes are illegal/non-compliant with local codes (eg the City Code in the

Types of mergers

Mergers and acquisitions can be classified in terms of the company that is acquired or merged
with, as horizontal, vertical or conglomerate. Each type of merger represents a different way of
expansion with different benefits and risks.

Horizontal mergers

A horizontal merger is one in which one company acquires another company in the same line
of business. A horizontal merger happens between firms which were formerly competitors and
who produce products that are considered substitutes by their buyers. The main impact of a
horizontal merger is therefore to reduce competition in the market in which both firms operate.
These firms are also likely to purchase the same or substitute products in the input market. A
horizontal merger is said to achieve horizontal integration.

The impact on market power is one of the most important aspects of an acquisition. By
acquiring another firm, in a horizontal merger, the competition in the industry is reduced and
the company may be able to charge higher prices for its products. However, competition
regulation may prevent this type of acquisition. To the extent that both companies purchase for
the same suppliers, the merged company will have greater bargaining power when it deals with
its suppliers.

Vertical mergers

Vertical mergers are mergers between firms that operate at different stages of the same
production chain, or between firms that produce complementary goods, such as a newspaper

acquiring a paper manufacturer. Vertical mergers are either backward when the firm merges
with a supplier or forward when the firm merges with a customer.

Vertical mergers create the possibility of creating barriers to entry through vertical acquisitions
of production inputs.

Conglomerate mergers

Conglomerate mergers are mergers which are neither vertical nor horizontal. In a conglomerate
merger a company acquires another company in an different, possibly unrelated, line of
business.

Consequence of different % stakes

Normally, a potential offeror will wish to build a stake prior to making an offer. Any person can
acquire a stake of up to 29.9% in a listed or Alternative Investment Market company without
being subject to any timing restrictions. Some of the important share stakes (in the UK) and
their consequences are outlined below.

Regulatory authorities

Competition and Markets Authority

A UK company might have to consider whether its proposed takeover would be drawn to the
attention of the Competition and Markets Authority.

If a transaction is referred to the Competition and Markets Authority and the Authority finds that
it results in a substantial lessening of competition in the defined market, it will specify action to
remedy or prevent the adverse effects identified, or it may decide that the merger does not take
place (or, in the case of a completed merger, is reversed).

Any person aggrieved by a decision of the Competition and Markets Authority in connection
with a reference or possible reference may apply to the Competition Appeal Tribunal for a
review of that decision.

A number of tests may be used to decide whether there has been a substantial lessening of
competition (SLC). These normally include:

(a) The revenue test

No investigation will normally be conducted if the target's revenue is less than £70 million.

(b) The share of supply test

An investigation will not normally be conducted unless, following the merger, the combined

entity supplies 25%. The 25% share will be assessed by the commission.

(c) The SLC test

Even if the thresholds in (a) and (b) above are met, the Competition and Markets Authority will
only be involved if there has been an SLC in the market.

The European Union

Mergers fall within the exclusive jurisdiction of the European Union where, following the merger,
the following two tests are met:

(a) Worldwide revenue of more than €5 billion per annum

(b) European Union revenue of more than €250 million per annum

The European Union will assess the merger in a similar way as the Competition and Markets
Authority in the UK by considering the effect on competition in the market.

The merger will be blocked if the merged company results in a market oligopoly or results in
such a dominant position in the market that consumer choice and prices will be affected.

Summary of defensive tactics

Chapter # 10
Financial Acquisition
& Mergers
Method 1: Cash offer

The most common ways of paying for a target company's shares are by offering cash or paper
(normally shares).

Financing a cash offer

How to obtain the cash required to finance a cash offer is a gearing decision and has been
covered in earlier chapters – note that a cash offer/bid does not necessarily mean that any
extra borrowing takes place, although this will often be the case.

Method 2: Paper offer

Impact of a paper offer

The impact of paper (ie shares) being used to finance an acquisition can be assessed using the
same factors considered above.

Mixed offer

Because cash might be preferred by some shareholders (eg due to certainty) and paper by
others (eg wanting to share in anticipated gains from a takeover), it is not uncommon for an
acquisition to be financed by a mixture of cash and shares.

Evaluating an offer

In the exam, you may be asked to evaluate a given offer and/or to suggest an offer.

(1) Cash offer

A cash bid can simply be compared against the current market value of the target company or
against an estimated value of an acquisition using the techniques covered in Chapter 8 (these
techniques will help to form the basis for a suggested cash offer).

While a significant premium above the market price is often expected (20%–30% is not
uncommon), it is important (to the buyer) that the amount paid is not greater than the value that
will be generated from the target company under new ownership.

(2) Paper/mixed offer

How much a paper bid, or a bid that is partly financed by the issue of paper, is worth can be
assessed quickly by looking at the value of the shares of the bidding company before
acquisition.

However, a more accurate valuation would be based on the value of the shares post-
acquisition.

The value of shares post-acquisition will be a matter of concern for the both the bidding
company and the target company:

(1) The bidding company will not want to issue so many shares that its share price falls post
acquisition, and there may also be concerns about the effect of a paper bid on diluting the
control of existing shareholders.

(2) The target company will want to estimate the likely post-acquisition value of the shares to
assess the attractiveness of the takeover bid.

Having evaluated a paper bid, you may choose to suggest an increase or a decrease in the
number of shares offered.

The techniques for valuing a company post-acquisition have been covered in Chapter 8.

Note that post-acquisition values may also be required to evaluate a cash bid, but this is
especially likely to be tested in the context of paper bids which forms the context for the recap
of post-valuation techniques given here.

Post-acquisition value using earnings

Having obtained a post-acquisition valuation you may need to take one of the following steps:

(1) Deduct the cash element of the bid (if any) and then divide by the new number of shares in

issue to calculate a post-acquisition share price.

(To allow the bidding company to assess whether its share price will rise or fall, and to allow
the target company to estimate the likely post-acquisition value of the shares to assess the
attractiveness of the takeover bid.)

(2) Deduct the value of whole bid to see if value is created for the bidding company's
shareholders.

Post-acquisition value using cash flows

As before, having obtained a post-acquisition valuation you may need to take one of the
following steps:

(1) Deduct the cash element of the bid (if any) and then divide by the new number of shares in
issue to calculate a post-acquisition share price.

(2) Deduct the value of whole bid to see if value is created for the bidding company's
shareholders.

Impact of a given offer on the financial performance and position of the acquiring firm

Impact on earnings

You may also be asked to evaluate the impact of a given offer on earnings (profits after tax and
preference dividends) and key ratios such as EPS.

Impact on statement of financial position

The consolidated statement of financial position may need to be analyzed using ratio analysis.
Basic ratios have been covered earlier in the Workbook and will be returned to in Chapter 14.

The main issue to be aware of here is that the difference between the value of a take-over bid
and the net assets of the company being acquired is accounted for as 'goodwill' in the
consolidated statement of financial position.

Alternative forms of paper

Alternative forms of paper consideration, including bonds, loan notes and preference shares,
are not so commonly used, due to:

(1) Difficulties in establishing a rate of return that will be attractive to target shareholders

(2) The effects on the gearing levels of the acquiring company

(3) The change in the structure of the target shareholders' portfolios

(4) The securities being potentially less marketable, and possibly lacking voting rights

Issuing convertible loan notes will overcome some of these drawbacks, by offering the target
shareholders the option of partaking in the future profits of the company if they wish.

The use of other financing instruments is fairly rare, but convertible debt or convertible
preference shares allow the target shareholder the possibility of sharing the benefit of any gains
from the acquisition. More commonly, convertibles are issued by a company in order to raise
finance for a cash bid.

Other points about financing

Managing the re-financing of the target's debt

Many debt agreements carry a change of control clause which means that when a company
completes an acquisition it may well have to refinance the target company's debt. The
acquiring company will need to ensure that it has factored this into its financial planning. This
may require a short-term line of credit to act as a bridging loan while refinancing is being
arranged.

Earn-out arrangements

With any form of financing the acquirer can reduce risk by including deferred payments which
are linked to future performance targets – these are often referred to as earn-out arrangements.
This is also a method of keeping previous owner-managers motivated post-acquisition, as they
continue to benefit (often considerably) from good performance.

Effect of an offer on financial position and performance of the acquiring company

Effects on earnings

One obvious place to start is to assess how the merger will affect earnings and earnings per
share.

P/E ratios (price to earnings per share) can be used as a rough indicator for assessing the
impact on earnings. The higher the P/E ratio of the acquiring firm compared to the target
company, the greater the increase in EPS to the acquiring firm.

Dilution of EPS occurs when the P/E ratio paid for the target exceeds the P/E ratio of the
acquiring company.

Chapter # 11
The role of treasury
function
Treasury management

The Association of Corporate Treasurers' definition of treasury management is given below:

Treasury management: primarily involves the management of liquidity and risk, and also helps
a company to develop its long term financial strategy.

A treasury department is likely to focus on four key areas:

The role of the treasury function

This is the management of short-term funds to ensure that a company has access to the cash
that it needs in a cost-efficient manner (ie ensuring that a company is not holding unnecessarily
high levels of cash, or incurring high costs from needing to organise unforeseen short-term
borrowing). This is a key function of treasury management.

Netting

Netting involves identifying amounts owed between subsidiaries of a company in different

foreign currencies. All foreign currency transactions are converted to a single common
currency and netted- off. This reduces transaction fees and the time and cost of hedging inter-
company transactions.

Risk management

This involves understanding and quantifying the risks faced by a company, and deciding
whether or not to manage the risk. This is an important area and has been covered in Section 3
of Chapter 2.

For firms that are facing significant levels of interest rate risk or currency risk, risk management
is likely to be appropriate. Specific techniques of currency and interest rate risk management
are covered in the next two chapters.

However, some general risk measurement and management techniques relating to the Black–
Scholes options pricing model are introduced in Section 3 of this chapter.

Corporate finance

This is the examination of a company's investment strategies. For example, how are
investments appraised, and how are potential acquisitions valued? These areas have all been
covered in earlier chapters and are central to the maximisation of shareholder wealth.

Funding

This involves deciding on suitable forms of finance (and by implication the level of dividend
paid), and has been covered in earlier chapters.

Treasury organisation

It is the responsibility of the board of directors to ensure that a treasury department is

organised appropriately to meet the organisation's needs. This will involve making decisions
about the degree of centralisation of the treasury department, and whether it should be
organised as a profit centre or a cost centre.

Degree of centralisation

Advantages of centralisation
Within a centralised treasury department, the treasury department effectively acts as an in-
house bank serving the interests of the group. This has a number of advantages:

Treasury organisation

A treasury department might be managed either as a cost centre or as a profit centre.

It is important that the organisation of a treasury department reflects a company's attitude to

risk. If a company operates in a stable business environment it may be more likely to accept
certain risks than a company that operates in a less stable environment.

If a profit centre approach is being considered, the following issues should be addressed.

(a) Competence of staff

Local managers may not have sufficient expertise in the area of treasury management to carry
out speculative treasury operations competently. Mistakes in this specialised field may be
costly. It may only be appropriate to operate a larger centralised treasury as a profit centre, and
additional specialist staff demanding high salaries may need to be recruited.

(b) Controls
Adequate controls must be in place to prevent costly errors and overexposure to risks such as
foreign exchange risks. It is possible to enter into a very large foreign exchange deal over the
telephone.

(c) Information
A treasury team which trades in futures and options or in currencies is competing with other
traders employed by major financial institutions who may have better knowledge of the market
because of the large number of customers they deal with. In order to compete effectively, the
team needs to have detailed and up to date market information.

(d) Attitudes to risk

The more aggressive approach to risk taking which is characteristic of treasury professionals
may be difficult to reconcile with the more measured approach to risk which may prevail within
the board of directors. The recognition of treasury operations as profit-making activities may
not fit well with the main business operations of the company.

(e) Internal charges

If the department is to be a true profit centre, then market prices should be charged for its
services to other departments. It may be difficult to put realistic prices on some services, such
as arrangement of finance and general financial advice.

(f) Performance evaluation

Even with a profit centre approach, it may be difficult to measure the success of a treasury
team for the reason that successful treasury activities sometimes involve avoiding the incurring
of costs, for example when a currency devalues. For example, a treasury team which hedges a
future foreign currency receipt over a period when the domestic currency undergoes
devaluation may avoid a substantial loss for the company.

Other approaches

It is also possible to have a mixture of the two approaches, this might involve regional treasury
department

Managing risk – using options

One technique for managing risk involves the use of options. These will be applied to currency
and interest rate risk in later chapters, but are introduced here in the context of shares.

Managing the risk of a fall in share values

A treasury department may be responsible for managing a company's portfolio of investments.

The company will be faced with the risk that the value of these assets (eg shares) decreases.

Use of put options

Put options entitle the holder to sell the shares at a fixed price. Put options result in
compensation being received if share prices fall which allows investors to protect themselves
against a drop in the share price (note that this makes put options unsuitable as an incentive
scheme for senior management because it would be a reward for a falling share price).

When an investor buys an option they are setting up a long position.

Black–Scholes (BSOP) model

In Chapter 4 we introduced the Black–Scholes option pricing (BSOP) model which shows how
the price for call and put options is set and in Chapter 8 we saw the application of this model
to business valuation and default risk.

The BSOP model is built around a number of variables, often referred to as 'the greeks', which
each have implications for risk management. Of the variables discussed in the rest of Section
3, only 'delta' (Section 3.2) will be tested numerically.

Delta

Delta is N(–d1) for a put option (and N(d1) for a call option).

Delta measures how much an option's value changes as the underlying asset value

changes.

Values of delta
Hedge Ratio

Delta also defines the hedge ratio, ie the number of option contracts required to manage the
risk of the underlying assets.

Delta hedge: defines the number of options required.

For example the number of share options required = number of shares ÷ delta

Gamma

Gamma measures how much delta changes with the underlying asset value.

This indicates by how much the delta hedge needs to be adjusted as the underlying asset
value changes.

When the value of gamma is low (ie delta change is small as the asset value changes)

As we have seen, deltas can be near zero for a long put or call option which is deep out-of-the-
money, where the price of the option will be insensitive to changes in the price of the
underlying asset because a small change in the value of the asset will still mean that the option
is deep out-of-the- money.

Deltas can also be near –1 for a long put option which is deep in-the-money (or +1 for a long
call option which is deep in-the-money), where the price of the option and the value of the
underlying asset move mostly in line with each other and this will still be the case even if there
is a small move in the asset value.

When the value of gamma is high (ie delta change is high as the asset value changes)

When a long put option is at-the-money (which occurs when the exercise price is the same as
the market price) the delta is –0.5 (+0.5 for a call option) but also changes rapidly as the asset
price changes.

Therefore, the highest gamma values are when a call or put option is at-the-money.

Other 'greeks'

The variables used in the BSOP are often referred to as 'the greeks'. These are the factors
affecting option value. Other factors, or greeks, that affect option value are discussed briefly
here.

Theta (time)

Theta: the change in an option's price (specifically its time premium) over time.

An option's price has two components, its intrinsic value and its time premium. When it

expires, an option has no time premium.

Thus the time premium of an option diminishes over time towards zero and theta measures
how much value is lost over time, and therefore how much the option holder will lose through
retaining their options.

Vega (volatility)

Vega: measures the sensitivity of an option's price to a change in the implied volatility of the
underlying asset.

Vega is the change in value of an option that results from a one percentage point change in the
implied volatility of the underlying asset. If a dollar option has a vega of 0.2, its price will
increase by 20 cents for a 1% point increase in the volatility of the value of the dollar.

We have seen earlier that the Black–Scholes model is very dependent on accurately estimating
the volatility of the option price. Vega is a measure of the consequences of an incorrect
estimation.

Long-term options have larger vegas than short-term options. The longer the time period until
the option expires, the greater the potential variability of the underlying asset.

Rho (rate of interest)

Rho: measures the sensitivity of option prices to interest rate changes.

Generally, the interest rate is the least significant influence on change in price and, in

addition, interest rates tend to change slowly and in small amounts.

In Chapter 4 (Section 3.2) we discussed the positive impact of higher interest rate on the value
of call options. The sensitivity of option prices to changes in the interest rate is measured as
rho. An option's rho is the amount of change in value for a 1% change in the risk-free interest
rate.

Chapter # 12
Managing Currency
Risk
Currency quotations

Transaction risk

The transaction risk is the risk that changes in the exchange rate adversely affect the value of
foreign exchange transactions and how this risk can be managed or 'hedged'.

Spot rate and spreads

A spot rate is the rate available if buying or selling a currency immediately.

By offering a different exchange rate to exporters and importers, a bank can make a profit on
the spread (ie the difference). Exchange rates are therefore often quoted as a spread.

Internal methods

Simple techniques can be used within a company to eliminate some of the transaction risk it
faces.

Wherever possible, a company that expects to have receipts in a foreign currency will net this
off against payments in the same currency before looking to lock into hedging arrangements.
This is called matching.

Matching payments against receipts will result in a single, smaller amount of currency to be
hedged. This will be cheaper than hedging each transaction separately.

Forward contracts

A contract with a bank covering a specific amount of foreign currency (FX) for delivery on a
specific future date at an exchange rate agreed now.

Money market hedging

For exporters

(1) Fixed date agreements (only apply on a specific date)

(2) Rate quoted may be unattractive

Borrowing in the foreign currency allows an exporter to take their foreign currency revenue
now, at today's spot rate and thereby avoiding exchange rate risk. The foreign currency
revenue will be used to repay the loan when it is received.

For importers

Transferring an amount of money into an overseas bank account, at today's spot rate, that is
sufficient to repay the amount owed to the supplier in future allows an importer to avoid
exchange rate risk.

Currency options

Currency options: contracts giving the holder the right, but not the obligation, to buy (call) or
sell (put) a fixed amount of currency at a fixed rate in return for an upfront fee or premium.

Options are another derivative product.

Chapter # 13
Managing Interest
Rate Risk
Interest rate risk is faced by both borrowers and lenders. It is the risk that the interest rate will
move in such a way so as to cost a company, or an individual, money.

Note that a borrower will benefit from an interest rate fall and an investor (or lender) will benefit
from an interest rate increase.

From the perspective of a company borrowing money, interest rate risk can be managed by
'smoothing', ie using a prudent mix of fixed and floating rate finance. If the company is risk
averse or expects interest rates to rise, then the emphasis will be on using fixed rate finance.

If, however, a major loan (or investment) is being planned in the future, then the risk is harder to
manage; this is shown below:

This risk (for a borrower or an investor) can be managed by a variety of interest rate derivatives;
these techniques can achieve one of two outcomes.

Forward rate agreements (FRAs)

Forward rate agreement: a contract with a bank to receive or pay interest at a pre-determined
interest rate on a notional amount over a fixed period in the future.

Like a currency forward, an FRA effectively fixes the rate. Unlike a currency forward, the FRA is
a separate transaction, and is structured to create a fixed outcome by counterbalancing the
impact that interest rate movements have on the actual transaction (ie a loan or an investment).

Interest rate futures

Futures contracts were used in the previous chapter to hedge currency. The points made in
that chapter about the general features of futures including standardised dates and amounts,
margins and marking to market all apply to interest rate futures.

A key difference from currency futures is that interest rate futures have a standardised period of
three months. This means that a company that is intending to borrow for, say, a six-month term
and is worried about interest rates rising will only receive compensation from an interest rate
future as if it has borrowed for three months (the standard term of the future). As a result two
three-month contracts will be needed to cover a six-month loan.

Interest rate future: an agreement with an exchange to pay or receive interest at

a pre-determined rate on a standard notional amount over a fixed standard period (usually
three months) in the future.

Types of futures contract

A company with a cash surplus over a period of time in the future will be worried about interest
rates falling; a futures contract to receive interest is needed, this is a contract to buy (so called
because buying assets results in interest being received).

A company needing to borrow money in future will be worried about interest rates rising; this
requires a futures contract to pay interest, this is a contract to sell (borrowers would sell bonds,
which creates an obligation to pay interest).

Companies that will have a cash flow surplus require contracts to buy.

Companies which will borrow require contracts to sell.

Interest rate options

Exchange-traded interest rate options

The mechanics of exchange-traded interest options are not similar to exchange-traded

currency options that were covered in the previous chapter.

In fact exchange-traded interest rate options are the same as interest rate futures contracts
except that they only ever pay compensation, they never incur losses.

For this reason, exchange-traded interest rate options are often called 'options on futures'.

A key difference from interest rate futures is that exchange-traded interest options involve the

payment of a premium.

Exchange-traded interest rate option: an agreement with an exchange to pay or receive

interest at a pre-determined rate on a standard notional amount over a fixed standard period
(usually three months) in the future.

These are two types of option contract, calls and puts.

Put option: an option to pay interest at a pre-determined rate on a standard notional amount
over a fixed period in the future.

Call option: an option to receive interest at a pre-determined rate on a standard notional

amount over a fixed period in the future.

(1) Call option – a right to buy (receive interest)

(2) Put option – a right to sell (Pay interest)

Interest rate collars

(1) Only available in large contract sizes

(2) Can be expensive due to the requirement tonpay an up-front premium.

A company can write and sell options to raise revenue to reduce the expense of an exchange
traded interest rate options.

A combined strategy of buying and selling options is called a collar.

For a borrower a collar will involve buying a put option to cap the cost of borrowing and selling
a call option at a lower rate to establish a floor (the borrower will not benefit if interest rates fall
below this level).

If interest rates rise the borrower is protected by the cap.

If interest rates fall the borrower will benefit until the interest rate falls to the level of the floor. If
interest rates fall below this then the borrower will have to pay compensation to the purchaser
of the call option.

This is illustrated below.

For an investor a collar will involve buying a call option to establish a floor for the interest rate
and selling a put option at a higher rate to establish a cap (the investor will not benefit if interest
rates rise above this level).

If interest rates fall the investor is protected by the floor.

If interest rates rise the investor will benefit until the interest rate rises to the level of the cap. If
interest rates rise above this then the investor will have to pay compensation to the purchaser
of the put option.

Over-the-counter options

Options are also available directly from a bank. These are tailored to the precise loan size and
timing required by a company, but will be more expensive and cannot be sold on if not needed.

Swaps

A swap is where two counter parties agree to pay each other's interest payments. This may be
in the same currency (an interest rate swap) or in different currencies (a currency swap).

Interest rate swaps

Swaps enable a company to:

(a) Manage interest rate risk – for example, by swapping some of its existing variable rate
finance into fixed rate finance a company can protect itself against interest rate rises; this
may be cheaper than refinancing the original debt (which may involve redemption fees for
early repayment and issues costs on new debt).

(b) Reduce borrowing costs – by taking out a loan in a market where they have a
comparative interest rate advantage.

Usually a bank will organise the swap to remove the need for counter parties to find each other
and to remove default risk.

Valuing interest rate swaps

An interest rate swap can also be valued as the NPV of the net cash flows under the swap.

At the start of the swap the swap contract is designed to give an NPV of zero based on the
current FRA rates (remember a zero NPV means that a project is delivering exactly the return
required).

Currency swaps

Currency swaps enable a company to:

(a) Manage currency risk – by swapping some of its existing or new domestic debt into
foreign currency debt a company can match foreign currency cash inflows and assets to
costs/liabilities in the same currency.

(b) Reduce borrowing costs – by taking out a loan in a (domestic) market where they have a
comparative interest rate advantage.

Currency swaps are similar to interest rate swaps but normally involve the actual transfer of the
funds that have been borrowed (the initial capital is swapped at the start and then back at the
end to repay the original loans).

Swaptions

A 'swaption' is an option to enter into a swap in return for an up-front premium. For example, if
there was any uncertainty over the proposed acquisition in the previous Activity, then a
swaption could be used.

FOREX swaps

FOREX swap: a short-term swap made up of a spot transaction and a forward transaction
which allows a company to obtain foreign currency for a short time period (usually within a
week) and then to swap back into the domestic currency a short-time later at a known
(forward) rate.

A FOREX swap is useful for hedging because it allows companies to shift temporarily into or
out of one currency in exchange for a second currency without incurring the exchange rate risk
of holding an open position in the currency they temporarily hold.

Chapter # 14
Financial
Reconstruction
Financial reconstruction schemes to prevent business failure

A company might be on the brink of becoming insolvent due to a high interest burden or severe
cash flow problems in the short term, but may have plans that it believes hold out a good
promise of profits in the future.

In such a situation, the company might be able to attract fresh capital and to persuade its
creditors to accept some shares (or new debt) in the company as 'payment', and achieve a
reconstruction which allows the company to carry on in business.

Existing shareholders are likely to see a large dilution of their holding as reconstructions often
involve issuing many new shares to creditors.

Legal framework

In insolvency proceedings the proceeds from selling the assets are shared out to repay
creditors and investors in a predetermined rank:

(1) Creditors with a fixed charge on a specific asset

(2) Creditors with a floating charge on the company's assets in general or a class of assets

(3) Unsecured creditors

(4) Preference shareholders

(5) Ordinary shareholders

In addition there may be amounts due to other parties, such as tax authorities and employees.

The rank of these parties, in terms of order of repayment, will be specified in an exam question.

The proposed reconstruction must be agreed by all parties – classes of creditors should meet
separately, every class must vote in favour for the scheme to succeed.

Approach

Financial reconstruction schemes for value creation

Reconstruction schemes may also be undertaken by companies which are not in difficulties as
part of a strategy to create value for the owners of the company.

The management of a company can try to improve operations and increase the value of the
company, by:

(a) Returning cash to shareholders using a share repurchase scheme.

(b) A significant injection of further capital, either debt or equity, to fund investments or
acquisitions.

(c) A leveraged buy-out: where a publicly quoted company is acquired by a specially

established private company which funds the acquisition by substantial borrowing.

This is a mechanism for taking a company private which is sometimes seen as being desirable
because it avoid the costs of a listing and potentially allows a company to concentrate on the
long-term needs of the business rather than the short-term expectations of shareholders.

Debt covenants and forecasting

Debt covenants

Debt finance often involves 'covenants' – these are conditions that the borrower must comply
with and, if they do not, the loan can be considered to be in default and the bank can demand
repayment.

Positive covenants

These involve taking positive action to achieve an objective. This could involve achieving
certain levels for particular financial ratios eg gearing, interest cover. In addition, it may also
include the need to provide the bank with regular financial statements/forecasts, to maintain
assets used as security and to insure key assets and staff.

Negative covenants

These place restrictions on the borrower's behaviour.

For example, they may prevent borrowing from another lender, disposal of key assets, paying
dividends above a certain level, or making major investments.

Forecasting and ratio analysis

In any type of financial reconstruction care will need to be taken that debt covenants are not
breached. In order to assess whether a positive covenant relating to financing ratios has been
broken, you may be required to forecast a company's profits and statement of financial
position.

Ratio analysis has been covered in earlier chapters.

Forecast profit statement

It makes sense to start with the profit forecast. This will allow the following to be identified:

Forecast statement of financial position (SOFP)

Next, the SOFP can be forecast (which will be impacted by the profit forecast which will have
forecast the level of retained earnings).

The format of the SOFP is likely to be given in the exam question, and in any case a precise
pro- forma will not be required.

Leveraged buy-outs and taking a company private

In a leveraged buy-out (LBO) a publicly quoted company is acquired by a specially established

private company. The private company funds the acquisition by substantial borrowing.

Procedures for going private

A public company 'goes private' when a small group of individuals, possibly including existing
shareholders and/or managers and with or without support from a financial institution, buys all
the company's shares. This form of restructuring is relatively common in the US and may
involve the shares in the company ceasing to be listed on a stock exchange.

Advantages

(a) The costs of meeting listing requirements can be saved.

(b) The company is protected from volatility in share prices which financial problems may
create.

(c) The company will be less vulnerable to hostile takeover bids.

(d) Management can concentrate on the long-term needs of the business rather than the
short-term expectations of shareholders.

(e) It may be felt that the stock market is undervaluing the company.

Disadvantages

The main disadvantage with LBOs is that the company loses its ability to have its shares
publicly traded. If a share cannot be traded it may lose some of its value. However, one reason
for seeking private company status is that the company has had difficulties as a quoted
company, and the prices of its shares may be low anyway.

Chapter # 15
Business
Reorganization
Unbundling

Business reorganisation

Unbundling: involves restructuring a business by reorganising it into a number of separate

parts.

Reasons for unbundling

Types of unbundling
Divestment (sell-off)

The sale of a division to a third party will add value if the estimated sale price exceeds the
present value of lost cash flows (including economies of scale lost as a result of the sell-off).

A buyer may be prepared to pay an amount that is greater than the present value of the cash
flows of the division because under their ownership the division is worth more eg due to
synergies with the buyer's other business operations.

To value a division, a cost of capital that reflects the risk of the division will be required.

Management buy-out (MBO)

This is another form of sell-off but may be preferred to a divestment because:

1. It allows a division to be sold with the co-operation of divisional management, and a lower

risk of redundancies

2. It will be less likely to attract the attention of the competition authorities than a sale to
another company

As with a divestment, an MBO will add value if the estimated sale price exceeds the existing
present value of lost cash flows (including economies of scale lost as a result of the sell-off).

The management team may be prepared to pay an amount that is greater than the present
value of the cash flows of the division because under their ownership the division will be worth
more eg the division achieves better performance because of greater personal motivation,
quicker decision making and savings in overheads (eg head office costs).

To value a division, a cost of capital that reflects the risk of the division will be required.

Financing issues

Typically an MBO will be mainly financed by a mixture of equity (referred to as private equity as
the MBO will be unlisted), debt and mezzanine finance.

If an MBO is mainly financed (80%+) by debt, this may be referred to as a leveraged buy-out
(LBO) and has been discussed in the previous chapter (note that this term is also used to
describe any highly leveraged takeover, whether linked to an MBO or not).

The equity and mezzanine finance element will be mainly provided by a venture capital/private
equity firm, although venture capital investors will usually want to see that managers are
financially committed to the venture as well, so an element of the equity will be provided by
managers.

Venture capital/private equity finance

The type of finance offered by the private equity company will normally be in the form of an
injection of equity and mezzanine finance.

Mezzanine finance: finance that had some of the characteristics of both debt and equity.

Convertible debt and convertible preference shares are forms of mezzanine finance as they
have characteristics of both debt (eg a fixed return is expected) and also equity (the investor
can convert into ordinary shares if the venture is successful).

A private equity company that is concerned about the risk of an MBO will increase the
proportion of their investment provided as mezzanine finance (ie loans/convertibles etc).

Venture capital/private equity – other issues

In addition to providing finance, venture capitalists can also be a source of strategic advice and
business contacts.

Private equity/venture capital groups will normally expect to exit their investment either by a
flotation or sale to another firm. Much of the gain expected by the venture capitalist will be
through selling their interests and making a substantial capital gain.

In order to make sure that an MBO is on track to deliver this, the venture capitalist will set
demanding financial targets. Failure to hit targets set by the private equity provider/venture
capitalist can lead to extra shares being transferred to their ownership at no additional cost (an
equity ratchet), or the venture capitalist having the right to make new appointments to the
board.

Other forms of management buy-out

Management buy-in

A management buy-in is when a team of outside managers, as opposed to managers who are
already running the business, mount a takeover bid and then run the business themselves.

An MBI might occur when a business venture is running into trouble, and a group of outside
managers see an opportunity to take over the business and restore it to profitability.

Alternatively, research suggests that buy-ins often occur when the major shareholder of a small
family company wishes to retire.

Many features are common to MBOs and MBIs, including financing.

Buy-ins work best for companies where the existing managers are being replaced by managers
of much better quality. However, managers who come in from outside may take time to get
used to the company, and may encounter opposition from employees if they seek to introduce
significant changes.

Buy-in management buy-out

Sometimes the management team will be a combination of an MBO (ie existing management)
and new managers (with specialist skills that the existing management team do not have, eg
finance).

This is sometimes referred to as a buy-in management buy-out (BIMBO).

Demerger (spin-off)

A demerger is the opposite of a merger. It is the splitting up of a corporate body into two or
more separate and independent bodies, it does not raise finance.

The motives for a demerger are likely to be strategic. For example, the removal of a
conglomerate discount/possible takeover defence.

The aims of a demerger are to create a clearer management structure and to allow faster
decision making. A spin-off may facilitate a future merger or takeover.

A demerger risks losing synergies between different parts of the group. It is also an expensive
and time-consuming process. Assets and liabilities will have to be clearly segregated between
the demerged units.

To value a demerged operation, a cost of capital that reflects the risk of the division will be
required, this is discussed in the next section.

Valuations

To value a divestment, a MBO, or a demerged operation, a cost of capital that reflects the risk
of the division will be required. This means that a project-specific cost of capital will need to be
calculated.

This topic has already been covered in Chapter 6 where we looked at investments that change
business risk and also in Chapter 8 where business valuations have been considered.

We have seen that when a company is moving into a new business area it can use the beta of
a company in that sector (a comparable quoted company, or CQC) and ungear the equity beta
to establish the asset beta which measures the risk of the new business area. This approach
can also be applied in valuing a specific business unit that a company is planning to unbundle.

Alternatively you may be given the asset beta, or you may be told that a division represents a
given percentage of a company's value in which case you can calculate the asset beta of a
division from the asset beta of a company.

Demergers: advantages and disadvantages

Advantages of demergers

(a) The main advantage of a demerger is its greater operational efficiency and the greater
opportunity to realise value. A two-division company with one loss-making division and one
profit-making, fast-growing division may be better off splitting the two divisions. The
profitable division may acquire a valuation well in excess of its contribution to the merged
company.

(b) Even if both divisions are profit making, a demerger may still have benefits. Management
can focus on creating value for both companies individually and implementing a suitable
financial structure for each company. The full value of each company may then become
appropriate.

(c) Shareholders will continue to own both companies, which means that the diversification of
their portfolio will remain unchanged.

(d) The ability to raise extra finance, especially debt finance, to support new investments and
expansion may be reduced.

Disadvantages of demergers

(a) The demerger process may be expensive.

(b) Economies of scale may be lost, where the demerged parts of the business had operations
(and skills) in common to which economies of scale applied.

(c) The smaller companies which result from the demerger will have lower revenue, profits and
status than the group before the demerger.

(d) There may be higher overhead costs as a percentage of revenue, resulting from (b).

(e) The ability to raise extra finance, especially debt finance, to support new investments and
expansion may be reduced.

(f) Vulnerability to takeover may be increased. The impact on a firm's risk may be significant
when a substantial part of the company is spun off. The result may be a loss in shareholder
value if a relatively low beta element is unbundled.

Chapter # 16
Planning and trading
issues for
multinationals
International trade

Types of free trade agreement

Multinational companies will encounter a variety of different types of international trade

agreements.

These may provide protection to the company in the sense that competitors operating outside
these areas may find it difficult to enter the market, or may create problems if the company is
itself operating outside these areas and creates barriers to trade as they try to enter these
markets.

Free trade area and customs unions

This exists when there is no restriction on the movement of goods and services between
countries, but individual member countries impose their own restrictions on non-members – eg
North American Free Trade Agreement (NAFTA).

A customs union involves a free trade area between member countries and, in addition,
common external tariffs applying to imports from non-member countries (eg Mercosur in South
America).

Common and single markets

A common market encompasses the idea of a customs union but in addition there are moves
towards creating free markets in each of the factors of production (eg labour, capital) and a
move to standardise market regulations (eg safety rules).

Eventually a common market becomes a single market with no restriction of movement in each
of the factors of production and no regulatory differences (eg a citizen in the European Union
(EU) has the freedom to work in any other country of the EU).

Economic Union

A common/single market may eventually evolve into economic and monetary union which will
also involve a common Central Bank, a common interest rate and a single currency.

International institutions
The activities of multinationals will be impacted by a number of different international
institutions.

Planning issues (1) – dividend policy

Dividend capacity

Dividend capacity has been introduced in Chapters 1 and 8 as 'free cash flow to equity' – it is a
measure of what is available for payment as dividend after providing for capital expenditures to
maintain existing assets and to create new assets for future growth.

In a multinational context, an additional complication is that dividend may be paid by foreign

subsidiaries to the parent company, and in addition:

(1) Extra tax may be payable on the profits made by foreign subsidiary; and

(2) Withholding tax may be due on dividends paid by the foreign subsidiary.

Factors affecting dividend policy

General factors affecting dividend policy have already been covered in Chapter 1. For a
multinational, there are a few additional factors to consider.

Planning issues (2) – transfer pricing

General considerations

In deciding on their transfer pricing policies, multinationals take into account many factors:

Regulation

Encourage local decision-making that will also improve the profit of the company as a whole.

Preventing an unfair impact on performance.

Transfer pricing may be used to boost the profits of a subsidiary, to make it easier for it to
obtain funds in the host country.

Channelling profits out of high tax rate countries into lower ones.

Transfer pricing is a normal and legitimate activity. Transfer price manipulation, on the other
hand, exists when transfer prices are used to evade or avoid payment of taxes and tariffs.

The most common solution that tax authorities have adopted to reduce the probability of
transfer price manipulation is to develop particular transfer pricing regulations based on the
concept of the arm's length standard, which says that all MNC intra-firm activities should be
priced as if they took place between unrelated parties acting at arm's length in competitive
markets.

Arm's length standard: this means that intra-firm trade of multinationals should be priced as if
they took place between unrelated parties acting at arm's length in competitive markets.

The main method of establishing 'arm's length' transfer price is the comparable uncontrolled
price (CUP) method which looks for a comparable product to the transaction in question, either
in terms of a similar product being bought or sold by the multinational in a comparable
transaction with an unrelated party or a similar product being traded between two unrelated
parties.

Market-based transfer pricing

A market-based transfer price is likely to be acceptable to regulatory authorities, and (if there is
a clear market price) it will also reduce the likelihood of disputes between divisions over the
level of the transfer price.

In addition, if the supplying division is at full capacity then the revenue it loses as a result of an
internal transfer shows the true cost (revenue foregone) to the division of an internal transfer.

However, if a division would have to incur marketing costs to sell externally then the market
price should be adjusted to reflect the fact that an internal transfer would not incur this cost, so
the transfer price becomes lower (ie market price less marketing costs saved).

Planning issues (3) – structure

Branch or subsidiary

Firms that want to establish a definite presence in an overseas country may choose to
establish a branch rather than a subsidiary. In many instances a multinational will establish a
branch and utilise its initial losses against other profits, and then turn the branch into a
subsidiary when it starts making profits.

A subsidiary is a separate legal entity and gives the impression of a long-term commitment.
The parent company benefits from limited liability. The normal structure of many multinationals
consists of a parent company (a holding company) with subsidiaries in several countries. The
subsidiaries may be wholly owned or just partly owned.

Debt or equity

The method of financing a subsidiary will give some indication of the nature and length of time
of the investment that the parent company is prepared to make.

A sizeable equity investment (or long-term loans from the parent company to the subsidiary)
would indicate a long-term investment by the parent company.

Because subsidiaries may be operating with a guarantee from the parent company, higher
gearing structures may be possible. As we have seen in Chapters 5 and 6, higher gearing can
help to reduce tax and to manage risk.

In addition, local governments may directly or indirectly offer subsidised debt finance.

So it may be desirable for a subsidiary to operate with higher levels of debt, especially if it is
operating in a high tax regime.

Thin capitalisation

However, many countries have rules that disallow interest deductions above a certain level
when the entity is considered to be too highly geared. A company is said to be thinly
capitalised when its capital is made up of a much greater proportion than usual of debt than
equity.

Tax authorities may place a limit on the amount that a company can claim as a tax deduction
on interest (for example as a percentage of EBIT), or may judge that a subsidiary contains
artificially high gearing if its gearing level is higher than the group's gearing.

Local regulations

Where overseas equity is preferred, a listing on an overseas stock exchange may be

considered. If so, it will be important to conform to local regulations.

For example, the London Stock Exchange requires at least three years of audited published
accounts and for at least 25% of the company's shares to be in public hands. A prospectus
must be published containing a forecast of expected performance and future plans. The
company will also have to be introduced by a sponsoring firm and to comply with the local
corporate governance requirements (such as splitting the roles of Chairperson and CEO, and
maintaining independent audit, remuneration and nomination committees).

A company must also show that it has enough working capital for at least the next 12 months.

Agency issues

Agency relationships exist between the managers at the headquarters of multinational

corporations (principals) and the managers that run the subsidiaries of multinational
corporations (agents).

The agency relationships are created between the headquarters and subsidiaries of
multinational corporations because the interests of the managers at the headquarters who are
responsible for the performance of the whole organisation can be considerably different from
the interests of the managers who run the subsidiaries.

The incongruence of interests between a multinational's headquarters and subsidiaries can

arise not only due to concerns that can be seen in any parent-subsidiary relationship, but also
due to the fact that the multinational's headquarters and subsidiaries operate in different
cultures and have divergent backgrounds.

This can be managed by:

(1) The parent company ratifying key decisions taken by the subsidiary

(2) Managerial compensation packages tied in to the performance of the group

(3) High dividend payouts to reduce the funds available to local management

(4) High gearing increases the discipline on local management to manage cash flows
effectively

Developments in international markets

The credit crunch

A credit crunch is a crisis caused by banks being too nervous to lend money, even to each
other

Between 2007–08 turmoil hit the global financial markets causing the failure of a number of
high-profile financial institutions (eg Northern Rock in the UK, Lehman Brothers in the US). The
crisis was caused by a number of factors:

(1) Years of lax lending by banks inflated a huge debt bubble: people borrowed cheap money
and invested it in property. In the US, billions of dollars of 'Ninja' mortgages (no income, no
job) were sold to people with weak credit ratings (sub-prime borrowers).

(2) Massive trade surpluses in some countries (eg China) led to a flood of investment into
countries with deficits (notably the US) which contributed to the asset price bubble that
contributed to the credit crunch.

(3) The US banking sector packaged sub-prime home loans into mortgage-backed securities
known as collateralised debt obligations (CDOs). These were sold on to investment banks
as securities. The credit risk rating on these securities often reflected the selling bank's AA+
rating and not the real risk of default. When borrowers started to default on their loans, the
value of these investments plummeted, leading to huge losses by banks on a global scale.

(4) In the UK, many banks had invested large sums of money in these assets and had to write
off billions of pounds in losses. In addition some investment banks underwrote bond issues
without fully understanding the risk – and were left holding the credit risk as the bonds
defaulted. As banks' confidence was at an all-time low, they stopped lending to each other,
causing a massive liquidity problem – a credit crunch. With bank lending so low,
businesses were unable to obtain funding for investments, resulting in large reductions in
output.

Securitisation and tranching

Securitisation

Securitisation: the process of converting illiquid assets into marketable securities.

Securitisation involves banks transfer lending such as mortgages to 'special purpose

vehicles' (SPVs) which are then sold as collateralised debt obligations (CDOs). By securitising
the loans, the bank removes the risk attached to its future cash receipts and converts the loan
back into cash, which it can lend again.

Tranching

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

Each tranche of CDOs is securitised and 'priced' on issue to give the appropriate yield to the
investors. The 'investment grade' tranche will be the most highly priced, giving a low yield but
with low risk attached; this is sometimes referred to as a senior tranche. Typical investors of
senior tranches are insurance companies, pension funds and other risk-averse investors.

At the other end, the 'equity' tranche carries the bulk of the risk – it will be priced at a low level
but has a high potential (but very risky) yield. These junior tranches (or subordinated debt) are
higher risk, as they are not secured by specific assets. These tranches tend to be bought by
hedge funds and other investors looking for higher risk–return profiles.

Tensions in the Eurozone

After the euro came into circulation in 2002, there was a rapid fall in interest rates (due to low
interest rates in Germany, the dominant economy) which led to a rapid increase in consumer
spending.

German economic policy continued to focus on export-led growth. The accumulation of

surplus funds in Germany helped to finance excessive borrowing in Southern European
economies. This, combined with low interest rates, led to a sharp increase in the price of
assets such as houses and shares and thus reinforced a boom into a bubble.

Following the credit crunch of 2007–08, asset prices in Southern Europe tumbled. In a number
of European economies, it was the bursting of the house price bubble, not lax spending
policies by the government, that led to a recession. Government borrowing ballooned after the
2008 global financial crisis because, for example, governments have had to fund bank bailouts.

Parts of Southern Europe have since faced nasty recessions, because no-one wants to spend.
Companies and mortgage borrowers were too busy repaying their debts to spend more, and
governments were drastically cutting their spending back as well.

Dark pool trading systems

Since 2007, when legislation removed the monopoly status of European stock exchanges,
there has been a rapid growth in trading systems for shares, especially off-exchange venues
known as 'dark pools' where large orders are matched in private.

Dark pools allow large shareholdings to be disposed of without prices and order quantities
being revealed until after trades are completed. Traditionally, when an investor wished to buy or
sell securities on a stock market they would be publicly identifiable once the order to buy or
sell was made.

One impact of dark pools has been to reduce transaction fees and to improve the prices that
large institutional shareholders can obtain when they buy/sell shares.

However, because dark pools normally use information technology to keep the orders secret
until after they've been executed, there is a reduction in the availability of information and a
threat to the efficiency of the stock markets.

Money laundering

Money laundering: constitutes any financial transactions whose purpose is to conceal the
identity of the parties to the transaction.

One effect of the free movement of capital has been the growth in money laundering.

Money laundering is used by organised crime and terrorist organisations but it is also used in

order to avoid the payment of taxes or to distort accounting information.

Regulations differ across various countries but it is common for regulation to require customer
due diligence ie to take steps to check that new customers are who they say they are. An easy
way to do this is to ask for official identification. If customers are acting on behalf of a third
party, it is important to identify who the third party is.

Staff should be suitably trained and a specific member of staff should be nominated as the
person to whom any suspicious activities should be reported. Full documentation of anti-
money laundering policies and procedures should be kept. Regulations may require that
historic records including receipts, invoices and customer correspondence are kept.