FM Flashcards
What are internally generated funds advantages and disadvantages?
Pro:
Readily available
Low cost
Immediate
No change in control
Cons:
May impact dividend policy or funds may not be available
Pros and cons of a rights issue
Pros:
-Usually at a discount so increases attractiveness as well as protecting against a share price drop
-Issue costs are lower than for a new issue and easier pricing as no wealth is shared with new investors
-No change in control
Cons:
Shareholders may not invest which can be particularly troublesome for unlisted companies
New issue pros and cons
Pro:
The finance is usually attained somewhere commonly through public offering
Cons:
Loss of control
Can have very high issue costs and needs approval from existing shareholders + pricing is difficult
Offer for sale vs direct offer/offer for subscription
Offer for sale is company a to issuing house to investing public
Direct offer is straight to public
What is underwriting
Service for a fixed fee to agree to purchase any shares not sold be a company (providing insurance incase of a failed issue)
Explain VC
Think dragons den
Usually expect a large shareholding and place on the board with the ability to advise management, mainly pays return in Cgt in 3-5 years
Failure to hit targets can lead to shares transferred to the VC at no extra cost (known as an equity ratchet)
Crowdfunding pros and cons
Think seedrs
Pros:
good for startups that don’t have trading history and provides business awareness to attract customers , can be quick
Cons:
Fee is payable to the site used and also legal/advisory costs as well as admin cost of dealing with requests for extra info
What is an initial coin offering (ICO)?
Similar to an IPO but payment is crypto and an investor receives a token which represents a share or entitlement to a product or service
Receive money through issuing a white paper
Basically crowdfunding with crypto (seedrs)
Recognised as securities therefore likely to meet regulatory criteria and be less popular
Pros and cons of term loans
Loan from a single lender (usually a bank) which has to be repaid with interest at fixed period including a final repayment date-think generic loan)
Pros:
Arrangement fees are small compared with issue costs of loan stocks
May have either fixed or floating interest charges and interest most likely attracts tax relief
Cons:
Usually secured on company assets so likely to rely on having a strong balance sheet
Pros and cons of loan stock (debentures)
Loan stock is a method of borrowing small amounts from many lenders certifying the value of the loan (always £100 but bond can be at premium or discount), coupon rate (interest rate paid as percentage of £100 nominal), interest payment dates (usually 6 months) for redeemable debentures-redemption value and date
Pros:
Can be unsecured
Loan stock can be sold so more attractive to investors due to flexibility
Flexible in that they can be redeemable or irredeemable and can be at a premium or discount
Can also be offered with conversion rights or warrants
Cons:
High issue costs and usually higher interest than a term loan
Convertible loan stock pros and cons
Convertible to equity
Pros:
Lower interest rates and potential to avoid redemption cash flow problems
Cons:
Entitlement of ordinary shares could dilute equity
Loan stock with warrants pros and cons
Entitle sub for ordinary shares at predetermined price at set future date
Pro:
Encourages individuals to invest in debt finance
Peer to peer lending pros
Pros :
Usually lower interest rates due to increased competition between lenders and usually quicker to arrange and more accesible for companies with low credit ratings
Green loan principle (GLP)
Based around 4 competencies:
Use of proceeds
Process for project evaluation and selection
Management proceeds
Reporting
What is the efficient market hypothesis
Wb behaviour finance?
Basically says market can be weak (slow reacting to new info and based on past share price movements), semi strong (reacting to public and past but not insider) and strong is everything and instantly moving
Market is at least weak but isn’t strong, but can’t just be weak and can’t just aimlessly follow patterns and stocks tend to account for new info public once available around 5-10mins
Conclusions are that shares are fairly priced so a purchase is a zero NPV transaction, that investors cannot consistently beat the market without insider info and managers should invest in positive NPV projects to undress shareholder wealth
Behaviour finance can cause market inefficiency due to:
Overconfidence and miscalc-investors overestimate ability’s and the accuracy of their forecasts and also tend to overestimate the likelihood of unusual events and underestimate the likelihood of common ones
Conservatism and cognitive dissonance-investors tend to be resistant to change and will continue to believe even with evidence of contrary
Availablity bias and narrow framing-investors pay attention to one fact more than they should and can lead to overreliance on this
Representativeness and extrapolation expectiation-investors have a tendency to assume history will repeat itself and also buy shares if price has risen and sell after prices have fallen
How to calculate the ex-issue or ex-rights price=
(MV of shares already in issue + proceeds from new share issue + project NPV*)/number of shares are issue
If no info on NPV provided assume =0
The theoretical value of a right=
The ex rights price-the exercise price of the right
This is if an existing shareholder does not want to take up the right to buy new shares then this can be sold at the theoretical value given above
Current vs money cash flows
Current exc inflation
Money is inc inflation
A 4-year project will generate sales of £1,000 per year in current terms but these are expected to experience inflation of 5%.
Costs in year 1 are expected to be £600 but will then inflate by 10%.
Tax is at 25%.
The real discount rate is expected to be 8%, but investors are expected to be suffering general inflation of 3%.
Required:
Calculate the NPV of the project.
Money discount rate is 1.08*1.03=11.24%
10001.05-600=450 less 25% tax=337
10001.05^2-6001.1=442 less 25% tax=331
10001.05^3-6001.1^2=432 less 25% tax=324
10001.05^4-600*1.1^3=417 less 25% tax=313
Discount at 11.24%=1009 NPV
How to use real @ effective method for accounting for inflation?
This method is a short cut for the money method. It can be used for perpetuities or
long annuities.
Cash flows are left in real terms.
A specific ‘effective’ discount rate is calculated for each given cash flow.
The effective rate is given by:
1 + effective rate = 1 + money rate/(1 + specific inflation rate)
Benefits of understanding environmental costs
Including these within the costing system will allow for better pricing decisions
Managing and controlling these costs may avoid fines and save money
Regulatory compliance
Environmental cost types
Conventional costs – the costs of using raw materials, utilities, capital goods
and supplies
Potentially hidden costs – these costs tend to be ‘hidden’ in general overheads
rather than separately classified
Contingent costs – costs to be incurred at a future date, due to their uncertainty
a prediction may be required using probabilities (Expected Values – chapter 3)
Image and relationship costs – costs incurred to improve corporate image.
Storm Ltd is evaluating project X, which gives expected net cash flows of
£20,000 per annum for the next three years expressed in current terms.
However, these are expected to rise by 10% per annum. The real cost of
capital is 8%, the general rate of inflation is 6%.
(a) Find the NPV of the cash flows by discounting the money cash
flows.
(b) Prove that the same NPV can be calculated using the effective
method.
T1 -20k1.1
T2-20k1.1
T3-20k*1.1
1.08*1.06=1.1448 ie 14.48% money rate
=NPV 55429
b) effective rate is money rate/inflation rate so
1.1448/1.1-1=4.07% —use this as discount factor then on 20k yo get NPV of 55460
NPV function =
NPV(discount rate, cell range)
NOTE!! The NPV function assumes the first cell is a cash flow in year 1. To calculate the final NPV the net cash flow in year 0 will need to be included to this result.
Finding optimum economic life of an asset formula:
The method can be summarised as follows:
1 For EACH possible economic life, calculate the NPV of a single asset cycle.
2 The NPV of each option is then converted into an ‘Equivalent Annual Cost’.
This is the equal annual cash flow (annuity) to which a series of uneven cash flows is equivalent in PV terms. It is calculated as:
Equivalent annual cost = (PV of costs/Annuity factor)
3. LOWEST EAC wins
Assumptions and limitations of replacement analysis. (3)
The technique assumes that:
the cost of the asset will not be subject to inflation
the operating efficiency of assets different ages will be similar – in practice, new technology and/or obsolescence will mean that regular
replacement is preferred
The asset will be replaced in perpetuity or at least into the foreseeable future – in practice, products and therefore the assets required for their production usually have a finite life cycle.
How to deal with capital rationing for infinitely divisible projects
If they are infidently divisible this means we can obtain part NPV for part investment, treat as limiting factor analysis
Projects should be ranked according to the NPV earned per £1 invested in the cash-restricted period.
Funds should then be applied to the projects in ranking order until they aregone.
How to deal with capital rationing for indivisble projects?
These are projects where you can either do the project or not to ahcieve 100% NPV or nothing,
Where projects cannot be done in part, the optimal combination can only be found by trial and error
What are other considerations aside from NPV in deciding on a project (4 options given)?
NPV analysis does not take account of the strategic value of a project.
A superior analysis would therefore be:
Worth of a project = Traditional NPV + Value of any associated
options
Options would include:
Follow on options-ie what a project could allow to do next each one project to porduce a product could allow production of another product in the future
Abandonment options- eg considering 2 porjects one requires low resale value fixed asset investment, the other land but has a lower NPV -although it does the land presents a good abadnoment option if decide against project
Timing options -E.g. A firm is looking at two projects. The first has to be started now; the second can be started at any point in the next five years.
Growth options-E.g. A firm is looking at two projects, one requires a full commitment now, the other allows it to start with a small capacity but to expand later on if the market conditions are right.
What are value drivers? What are the 7 main?
Factors that enhance the NPV of the expected future cash flows (known as value drivers).
Five that impact the size of the future cash flows:
– sales and growth in sales (maximise)
– margin (maximise)
– investment in fixed assets (minimise)
– investment in working capital (minimise)
– tax (minimise).
Two that impact their NPV:
– discount rate (minimise)
– length of time that detailed future plans are available for (maximise).
Investing overseas considerations for a project. (4)
-Market attractiveness
For example, GDP and forecast demand in the region.
-Competitive advantage
Do we have experience and understanding of this and/or similar markets?
-Political risk
Is political or government action likely to affect value. This might include:
– import quotas and/or tariffs
– legal restrictions on products
– restriction on foreign ownership
– enforced nationalisation.
-Cultural risk
Differences in culture and business behaviours in a foreign country.
risk vs uncertainty and investors.
– risk – quantifiable, where probabilities are known (e.g. a roulette wheel)
– uncertainty – unquantifiable – outcomes cannot be mathematically
predicted (most business decisions).
All investors view risk differently. However, we assume in FM that
investors are rational and risk averse.
Risk averse means that:
investors demand an increase in return for an increase in risk or
if two projects offer the same expected return, the one with the lower risk is preferred.
Even risk averse investors will have different attitudes to risk. Some will need greater levels of compensation than others for the same level of risk.
Methods of addressing uncertainty in business.(5)
-sensitivity analysis
-minimum payback period
-prudent estimates of cash flows
-assessment of best and worst outcomes
-higher discount rates.
Limitations of expected values
discrete outcomes
subjective probabilities
ignores risk
not a possible outcome, so less applicable to one-off projects.
What is a sensitivity?
Sensitivity = the % age change in an estimate that gives an NPV of nil.
How to calculate sensitivities on factors
affecting cash flows
E.g. price, volume, tax rate
What about when factoring in tax?
NPV of the whole project/NPV of the cash flows
affected by the change
Where corporation tax has to be considered, the principle is the same, but care must be taken to include the tax effect:
Sensitivity = NPV of the whole project/NPV of the cash flows affected net of tax
How to calc sensitivity for the discount rate?
Difference between
the cost of capital and
the IRR
How to calc sensitivity for the project life?
Discounted payback
Limitations of sensitivity analysis.(3)
assumes variables change independently of each other
does not assess the likelihood of a variable changing
does not identify a correct decision.
What combats sensitiviy analysis limitiation of only looking at one variable in isolation?
Monte carlo simulation, looks at many variables at once by using different factors in different quantiities thus producing a simulation environment (usually a probability distribution)
Simulation can also assist with environmental risk analysis by giving more information about the impact of environmental costs on new ventures.
However these can be time consuming without appropriate software or complex and can cost a lot, also requires assumptions which may be unreliable
predictive vs prescriptive analytics
predicitive eg decision trees or linear regression
prescriptive is the above combined with AI and algorithms to come up with solutions based on the data analysis
Different biases that exist in data analysis.(6)
-Selection bias – sample selection does not represent the population
-Observer bias – the researcher allows their assumptions to influence the observation
-Omitted variable bias – key data is not included in the analysis
-Cognitive bias – the presentation of data may be misleading
-Confirmation bias – people see data that confirms their beliefs and ignore other items
-Survivorship bias – the sample contains only items that survived a previous event, which misses a significant part of the picture by not analysing the failures.
Explain the portfolio effect
As long as the investments’ return profiles differ to at least some degree, then risk will be reduced.
Initial diversification will bring about substantial risk reduction as additional investments are added to the portfolio.
However, risk reduction slows and becomes insignificant once 15 – 20
investments have been combined. i.e. not all risk can be eliminated by diversification.
systematic vs non-systematic risk
The risk a shareholder faces is in large part due to the volatility of the company’s earnings. This volatility can occur because of:
Specific (or non-systematic) risk – company/industry specific factors.
Systematic risk – market wide factors such as the state of the economy.
Systematic risk will affect all companies in the same way (although to varying degrees). The specific non-systematic factors will impact each firm differently depending on their circumstances.
By diversifying, an investor can (almost) eliminate specific unsystematic risk, but cannot alter the systematic risk of the portfolio.
Implications of the diversification and portfolio effect.(2)
Because investors in listed companies
are ALREADY fully diversified, they
do not suffer specific risk. Therefore,
in estimating their required return they
ONLY need to be compensated for
SYSTEMATIC risk.
When directors of listed companies
are making strategic decisions, they
SHOULD NOT try to reduce risk for
their shareholders by diversification.
This is because the shareholders are
already diversified and therefore
cannot reduce their risk any further.
The capital asset pricing model (CAPM)
The CAPM is a way of estimating the rate of return that a fully
diversified equity shareholder would require from a particular
investment.
It does this by considering the level of systematic risk of the investment compared to average.
The CAPM line is given in the form of an equation:
Rj = Rf + ß (Rm – Rf)
where:
Rj = required return from an investment
Rf = risk free rate – assumed to be the rate on Treasury Bills
Rm = average return on the market
(Rm – Rf) = equity risk premium
ß = systematic risk of the investment compared to market and therefore amount of the premium needed.
Problems with the CAPM.(4)
Estimating Rm: In practise this is usually done using historic rather than expected future returns.
-Estimating Rf: Gilts are not risk free, and returns on gilts will vary with the term of the bond.
-Calculation of beta: Betas are calculated using statistical analysis of the difference between the market return and the return of a
particular share or industry. There is plenty of research to
show that this is too simplistic a way to estimate risk, and that
risk premiums are made up of multiple different factors rather
than just one single ‘market’ factor.
-In addition, it is important to remember that beta takes account of SYSTEMATIC risk only, and therefore assumes that shareholders are FULLY DIVERSIFIED.
Use of the CAPM equation.
The CAPM equation is commonly used to find the required return from a project in situations where the project has a different risk profile from the company’s current business operations.
Investors will also review these results to determine which shares to invest into. If returns from a company are currently higher than the CAPM return, then investors will be attracted to these shares. This is said to have a positive alpha value, where the alpha value is calculated as the difference between the current return and the
CAPM return.
Note: this is likely to be a short-term issue, as the additional attraction of these returns will cause the share price to increase and hence the returns will be more reflective of the CAPM return.
G plc. is an all equity company. The current average market return being paid on risky investments is 12%, compared with 5% on Treasury bills. G plc. has a beta of 1.2.
What is the return that would be required on projects by G plc?
Required return = Rf + ß (Rm – Rf)
Rj = 5 + 1.2 (12 – 5) = 13.4%
WACC formula what does it calculate?
(MVeKe + MVpKp + MVd*Kd)/(MVe+MVp+Mvd)
The average return required for investors, to be used as discount factor for project appraisal etc.
Return based on equity, pref or debt investor
Equity is a constant or gorwing revenue stream to pay the dividend, pref is fixed revenue stream, debt is fixed interest or repayment or interest in perpetuity for irredeemable debt
When is it appropriate to use WACC as a discount rate for a project? (3)
If the proportions of debt and equity (gearing) are NOT going to change over the life of the project. If the gearing changes, then the WACC itself will change – and another approach (the APV approach, described in Chapter 6) is used.
-If the level of risk is NOT going to change. The company’s current ke is dependent on the current level of risk the shareholders are suffering – which will depend on the type of business that the company is in. If the new project is in a different business sector to the existing operations, then the level of risk (and therefore the ke) may be different. In Chapter 6 we will see how the CAPM is used to calculate ke in this situation.
-If the finance is NOT project-specific. The WACC utilises several different types of finance in order to calculate an average. If we use only one method of finance to invest in the project, then an average is not required and we will need to use an alternative approach, such as APV (chapter 6).
Assumptions when using the dividend valuation model (4)
A perfect market is operating to ensure that the share price is the present value of the future dividends discounted at ke. (In practise this will only be true if the shares/debentures are listed).
Dividends are paid only once a year (and either have just been or are just about to be paid. (In practise, a company will often pay interim dividends). Dividend growth is expected to be reasonably constant and predictable (In practise dividends may be non-existent or at best erratic).
If using historic dividends to predict growth – then we are assuming that the past is a good guide to the future (If circumstances change – for example the company getting a listing, this may not be true).
If using the earnings retention model to predict growth we are assuming that both the rate of return and the retention rate will remain constant over time (again, this may not be true if circumstances change).
Some limitations of WACC. (2)
Ideally we should only be using permanent long term sources of finance in the calculation of WACC (equity, prefs, debentures, loans), but arguably, some companies use overdrafts, leasing and even trade creditors for finance over long periods of time. Although we would not conventionally include these as part of our WACC calculation, there is no doubt that they could affect the true cost of capital.
Calculating a WACC for a small, unquoted company is very difficult, because there are no market values to obtain accurate returns and the small size usually results in more expensive finance.
Ke formula:
(D0*(1+g))/P0 + g
eg
A company has just paid a dividend of 20p. The company expects dividends to grow at 7% in the future. The company’s current cost of equity is 12%. Calculate the market value of the share.
201+0.07/P0 +0.07=12% therefore
P0=(201.07)/(0.12-0.07)=428p=£4.28
P plc has just paid a dividend of 10p. Shareholders expect dividends to grow at 5% per annum. P plc’s current share price is £1.05 ex div.
Calculate the cost of equity of P plc.
Ke=D(1+g)/P0 + g
=10(1.05)/1.05 +0.05
=15%
What does the formula for Ke assume about P0.(1)
that is is the ex rights price (immediately following a dividend)
Therefore in exam if given cum div price need to adjust to get the ex div price by removing the dividend from the cum div price
Donaldson Press plc is about to pay a dividend of 15p. Shareholders expect dividends to grow at 6% per annum. Donaldson Press plc’s current share price is £1.25.
Calc Ke
15p*(1.06)/(125-15) + 0.06=20.5%
What are the two methods for estimating dividend growth?(2)
Historic method , using excel can be calc as:
g =POWER (most recent value/oldest value, 1/number of periods of growth) – 1
or g= (D0/Dn years ago)^1/n - 1
Gordons growth model : g=r*b r is ARR b is earnings retention rate
Gordons growth model formula: (3)
g= r*b
Where:
r is the ARR ie earnings/opening shareholders funds
b is earning retention rate ie retained profit for the year/earnings
What is a big assumption for Kp and Ke
A perfect market
How to calc Kp
D/P0 as they dont grow over time
eg
A company has 50,000 8% preference shares in issue, nominal value £1. The current ex-div market value is £1.20/share.
What is the cost of the preference shares?
Kp=D/P0=8/120=6.7%
basic assumption for Kd calc
That current price=Present value of the expected future income
discounted at the investor’s required return
holds true for debt as well as equity. However, the income stream from the investment depends on whether the debt is irredeemable or redeemable.
Note: if a price has been given as cum-interest or interest is ‘due to be paid shortly’ then the interest should be deducted from the market price to give the ex-interest price.
For irredeemable debt the assumption becomes:
price of debenture=Present value of the future interest stream
received in perpetuity discounted at the
investor’s required return
Formula for valuing a debenture. How do you adjust this for tax?
r=i/P0
where i is annual interest starting in one years time
r = debt holders’ required return, (known as the ‘yield’)
We therefore get Kd by factoring in tax shield that comes from debt finance therefore formula becomes
Kd=(i*(1-T))/P0
A company has irredeemable debt currently trading at £40 ex interest. The coupon rate is 5% and the rate of corporation tax is 25%. What is the cost of debt to the company?
Kd=i(1-T)/P0
5%(1-25%)/40=9.4%
Formula for calculating redeemable debentures
There isnt one!
Because the cash flows are not a simple perpetuity – there is no simple formula to calculate the NPV or the IRR for us.
Instead we have to go back to basics and calculate the NPV or the IRR
longhand.
Spreadsheet function to calculate the price of a debenture
=PV(investor’s required return, number of time periods, interest value, redemption value)
eg A company has in issue 12% redeemable debt with 5 years to redemption. Redemption will be at par. The investors require a gross yield of 10%. What is the market value of the debt?
=PV(0.1, 5, -12, 100)
To calculate the yield on redeemable debt we can use the spreadsheet function: (2)
=RATE (number of time periods, interest payment, market value, redemption value)
OR
=IRR(cash flows)
Both of these functions provide the same answer, which is the average return per year for the investment.
A company has in issue 6% redeemable debt with 5 years to redemption.
Redemption is at a 10% premium. The current market value of the debt is £80. Tax rate is 25%.
(a) What is the gross yield to the debt providers?
(b) What is the cost of debt to the company?
a)
Yield is rate= (5, 6, -80, 110)=13.3%
b)
Therefore Kd=I(1-T)/P0
=13.3%*(1-25%)=9.9%
Calculate the yield on a 4% five-year loan that pays interest every six months and is redeemable at par with a market value of £90.
=RATE (number of time periods, interest payment, market value, redemption value)
Where:
Number of time periods = 5 years × twice a year = 10
Interest payment= 4% × 6/12 = 2%
Market value = £90
Redemption value = £100
=RATE(10, 2, -90, 100) = 3.2%
This is a 6-month rate and needs to be converted to an annual rate:
Annual rate = 3.2% × 2 = 6.4%
A company has in issue 6% redeemable debt with 5 years to redemption. Redemption is at a 10% premium. The current market value of the debt is £80. Interest is paid every 6 months.
What is the gross yield to the debt providers?
6 month Yield =RATE(10,3,–80,110) = 6.5%
Number of periods has changed to 10 because interest is paid every 6 months
for a total of 5 years, giving 10 interest payments overall. The interest of 6%
is being paid in 2 intervals during the year – giving an interest payment of £3
per £100.
To convert this to an annual yield:
6.5% × 2 = 13%
Non tradeable debt (1)
Bank and other non-tradable fixed interest loans simply need to be adjusted for tax relief
Cost = interest rate × (1 – T)
What is organic growth and what are the advantages and disadvantages?(3)
Organic growth is achieved through internally generated projects
whether funded with retained earnings or new finance.
Pros:
Organic growth rather than acquisition:
– spreads costs
– no disruption.
Cons
– risk
– slower
– barriers.
Where do convertible debentures fall under costing calcs
Treat as redeemable debt with the following adjustment:
-compare the redemption value with the value of the conversion option
– select the higher of the two values as the amount to be received at tn
– find the internal rate of return of the cash flows.
What is acquisition and what are the pros/cons as a growth model?(2)
Businesses may combine to achieve:
– synergy
– risk reduction
– reduced competition
– vertical protection.
An acquisition may be considered successful if it increases shareholder wealth,
i.e. if:
– the additional cash flows exceed the cost of acquisition and/or
– overall risk reduction is achieved.
Disadvantages of growth by acquisition
Synergy is not automatic; it must be pursued
Restructuring costs following the acquisition may be significant
Buying company may end up paying more in terms of both price and fees than it
gains in synergistic benefits.
Business valuation technique factors.(6)
-How desperate is the seller to sell – do they have any other potential buyers?
-How desperate is the buyer to buy – do they have anything else to spend their money on?
-If the target company is listed, what is the existing share price?
-Is the consideration to be paid in cash or shares? (see below)
-Is the purchase of a controlling interest? (in which case a premium might be paid).
As well as practical factors such as:
-Are key employees or key clients likely to leave after the acquisition? (thus reducing the value of the target).
What are the main numerical approaches to business valuation?(2)
-Asset valuation ie NRV or replacement cost
-income based approaches ie dividend, earnings EBITDA cash flwo
Problems with asset based valuations.(2)
The value of intangibles not included on the balance sheet will be missed (for example the value of staff, client relationships, brand value etc.).
The specific valuation of digital assets is outside the scope of the Financial Management exam, but it is important to note that these assets can be very valuable and are not taken into account in the traditional asset based valuation.
How does dividend based valuation work and when is it often used?(3)
normally used on minority share interest
The value is simply the present value of the future expected dividend payments discounted at ke: rearrnage the formula for ke we get PV=(d*(1+g))/(ke-g)
can also use dividend/yield if have estimate for yield based on similar companies as a simplified version
Problems with dividend based valuation. (3)
Estimating future dividends
Finding similar listed companies
If ke is estimated by using the CAPM, or by looking at other quoted companies, then a private company valuation will need to be adjusted downwards to reflect the lack of marketability.
Earnings based approach for business valuation
This is commonly used to value controlling interests, as the investor can control dividend policy and could therefore extract all of the earnings from the company as dividends if they wanted to. There are two key methods for earnings based valuations and both are simply a multiple of the relevant earnings for an investor.
Problems with an earnings based approach. (4)
If earnings have been erratic, then the latest earnings figure may be misleading
Accounting policies can be used to manipulate earnings figures (although the EBITDA multiple attempts to reduce this manipulation)
Finding appropriately similar listed companies
A private company valuation will need to be adjusted downwards to reflect the lack of marketability
PE multiple valuation. (5)
Equity value = Earnings × PE ratio
Earnings are taken as profit after tax and preference dividends, but before ordinary dividends
The PE ratio is generally found by looking at the PE ratios of a range of similar listed companies
A high PE ratio implies a high level of investor confidence that earnings will grow strongly
A low PE ratio implies the opposite. Therefore, it is important to select a PE ratio from listed companies that have similar growth expectations to the target.
EBITDA multiple valuation. (5)
Enterprise value = EBITDA × EBITDA multiple
This valuation gives us the Enterprise value, rather than just the value of equity
-Enterprise value = market value of equity + preference shares + Minority interest + debt – cash and cash equivalents
And so, if we are looking for the market value of equity only, we need to deduct the market value of other types of finance and add back cash and cash equivalents.
-An EBITDA multiple indicates how long it would take for an acquisition to earn enough to pay off its cost and so a high valued company will have a high multiple
As with the PE multiple, in an exam question it is important to use a multiple that is not of the company you are valuing, otherwise it doesn’t give us a useful valuation.
Cash flow based approach to valuation. (4)
The value is calculated by estimating the post-tax operating cash flows of the target company to infinity and discounting at the investing companies WACC. (Normally a detailed cash flow forecast is done for the next few years and then a simplifying assumption is made about cash flows from that point to infinity).
Therefore, the value is calculated as:
PV of cash flows to infinity, discounted at WACC-MV of debt=equity
If the company holds any investments, then the value of these must be added separately.
This is theoretically the best approach, however it may be difficult to estimate the future cash flows and the relevant discount rate.
SVA valuation
One common way of estimating the cash flows to infinity is to use estimates of the seven value drivers of shareholder value analysis listed earlier.
The value drivers are estimated for the competitive advantage period (normally three or five years) and then an assumption is made about cash flows from that point to infinity.
As for normal cash flow valuation, the value calculated will be debt plus equity, therefore the value of debt must be deducted.
Valuation of start-ups and technology companies. (6)
Valuing start-ups and technology companies is complicated due to a number of challenges, such as no profits, unknown competition or the volume of digital assets.
Possible approaches
Asset method – This can be difficult to apply because the value of tangible assets may not be high. Value could be assessed by estimating how much it would cost an investor to create the assets of the company from scratch, including R&D etc.
Earnings method – There may be no earnings in the early years, or suitable PE ratio to apply. Therefore, this is not a suitable method.
Dividend method – It is unlikely that a dividend will be paid and so this method is not appropriate.
Market multiples – It is possible to use ratios based on other valuations of similar companies. However, it may be difficult to find a similar company, or the stock market may have over-valued that sector.
Discounted cash flow – This is likely to be the most valid approach. Different scenarios and cash flows could be modelled based on companies with a similar business model. Cash flows should be discounted at a risk adjusted discount rate.
Pros and cons of paying cash for business. (5)
Pros:
the buyer gets full control of the target as well as full entitlement to future profits
in addition, the seller may prefer this method, as they receive a certain, unconditional amount.
Disadvantages
the buyer will have to find the cash from somewhere
also, the seller’s expertise may be lost from the business as there is no motivation for them to stay to ensure the success of the new venture
capital gains tax liabilities arise immediately.
Pros and cons of paying for bid company shares. (4)
Advantages
no need to fund a cash payment
also, the seller is motivated to stay to work for the success of the combination
CGT effects are deferred.
Disadvantages
control is diluted and future profits will be shared with the seller.
Pros and cons for loan stock to pay for business. (2)
this has the advantages of a cash payment without the need to find immediate finance
the buyer will of course have to pay interest on the debt until it is redeemed.
Reasons for divestment (sale). (4)
raising cash
lack of fit
diseconomies of scale
cheaper than liquidation.
Methods of divestment. (3)
Once the decision to sell a subsidiary has been made, it may be sold to:
the existing management (an MBO) – this can be difficult to finance and often involves the use of junk bonds or mezzanine debt
an external management team (an MBI)
another established business (a trade sale).
What is a spin off? (4)
Where shares in a subsidiary company are ‘given’ to the shareholders of the parent in proportion to their shareholdings.
Thus a group of companies are split into two separately held entities. No cash changes hands.
Reasons for a spin off might include:
lack of fit
diseconomies of scale
forced division due to a competition commission ruling.
Reasons for a share repurchase. (5)
Reasons for a repurchase from shareholders in proportion to their holdings would be:
to reduce the level of equity and therefore increase gearing
to get unused funds back into the hands of the shareholders
to maintain EPS following divestment.
Reasons for a share repurchase from a single shareholder might be:
to provide an exit route for an investor
to take a listed company off the market and back into private ownership.
A debt for equity swap.(2)
Where creditors (normally banks or bond holders) give up their debt in return for an equity stake in the company.
This generally happens if a company is in trouble and is unable to pay the interest and/or repayment on its debt. The lenders COULD force the company into liquidation
– but that way, they might get nothing at all. By taking equity and allowing the company to continue, they might feel they stand a better chance of a decent return.
Often the shareholders will lose a significant amount of control as a result.
Liquidation. (3)
Where a company is wound up, and its assets passed out to its shareholders (although before any assets can be passed to shareholders, all creditors must be paid in full).
A company may be forced into liquidation by its creditors because it can’t pay its debts. In this situation, the shareholders are very unlikely to receive anything from the liquidation.
Alternatively, a solvent company may be put into liquidation simply because its shareholders wish to wind up the company and take their money.
What is a forward?
A forward is a binding agreement to buy or sell (or borrow or lend)
something in the future at a price agreed today.
It is a tailor-made agreement between two parties and therefore can be for any amount of any product at any point in time.
Because a forward is a tailor-made agreement between two parties, and requires the physical delivery of the goods (or money), it can be awkward to cancel if the need arises.
What are futures and how do they differ from forwards?
Futures are just forward contracts that have been standardised (in
terms of delivery date and quantity).
The contract which guarantees the price (known as the futures contract) is separated from the transaction itself, allowing the contracts to be easily traded.
B plc manufactures fruit juice in cartons for sale in supermarkets. On 1 June, it identifies that 1,000 litres of orange juice will be needed on 31 August.
The price on 1 June is £1,500 but the price of orange juice fluctuates such that the price on 31 August is uncertain.
On 1 June, a three-month orange juice futures contract for 1,000 litres is available for £1,600. The actual price of orange juice on 31 August is £1,700.
Show how futures could have been used by B plc to hedge the price risk associated with the orange juice.
Purchase for 1.6k futures contract, actual price is 1700 therefore save 100
What is marking to market?
When futures contracts are entered into, a deposit known as the initial margin must be made to the futures exchange. This deposit is refunded when the contract is closed out.
The initial margin should cover any potential losses from the first day’s trading. Any further losses must be covered by topping up this account, known as a variation margin. This process is known as marking to market.
What is an option? What about OTC options?
An option gives the right but not the obligation to buy or sell (or borrow or lend) a specific quantity of an item at a predetermined price (the exercise price) within a stated period (American-style) or on a fixed date
(European-style).
Options can therefore be:
exercised if the exercise price is better than the spot rate
abandoned if the exercise price is worse than the spot rate.
In order to be given the option, the buyer pays a fee (known as an option premium) to the writer of the option.
An option to buy something (or to lend money) is known as a call option.
The option to sell something (or to borrow money) is known as a put option.
OTC: Like a forward, this is a tailor-made agreement between two parties. It can be for any amount, or any date.
Call or put?
An option to buy something (or to lend money) is known as a call option.
The option to sell something (or to borrow money) is known as a put option.
What are traded options?
In a similar way to futures being a standardised version of forwards, the standardised version of an OTC option is known as a traded option.
As for futures, the options contract is separated from transaction itself allowing the contracts to be easily traded.
B plc manufactures fruit juice in cartons for sale in supermarkets. On 1 June it identifies that a quantity of orange juice will be needed on 31 August.
A call option on orange juice is identified with an exercise price of £1,600 and a premium of £30.
Show the position if the call option is purchased and the price of orange juice turns out to be:
(a) £1,700
(b) £1,550
a)
Premium of 30 always paid
1600 exercise price
on august a) price is 1700 which is higher therefore do exercise the option, total price is prem of £30 and £1600 for options=£1630
b) price is less therefore do not exercise the option, total paid is 1550+30 prem=£1580
Managing interest rate risk
The risks can be reduced in a number of ways: (5)
-pooling of assets and liabilities ie risks may be netted off where both assets and liabilities are subject to interest rate risk.
-forward rate agreements (FRAs)
- interest rate futures
- interest rate options
- interest rate swaps.
Reasons for an imperfect hedge
Futures and traded options are standardised products. They come in standard sizes with standard expiry dates.
This means that a hedge may not be perfectly efficient for two reasons: (2)
Rounding the number of contracts
If the transaction is not an exact number of contracts, then the number of contracts must be rounded to the nearest whole number. This will mean that an element of risk remains.
Closing out before the expiry date
If the transaction occurs (and the future is closed out) before its expiry date, the futures price may not exactly match the spot rate at the date it is closed out.
This difference (known as basis risk) will mean that the hedge is again, imperfect. (You will not need to calculate basis risk in the exam, but you may be asked to identify it or explain what it is.)
What is an FRA? (2)
An FRA is a commitment to an interest rate on a future loan - like a future, the contract which guarantees the interest rate is separate to
the underlying loan transaction
The working of an FRA
Imagine a company has a requirement to borrow money in the future. To offset the risk of an interest rate rise, the company enters into an FRA.
– The capital amount is borrowed and interest is paid on the loan in the normal way
– if the interest is greater than the agreed forward rate the bank supplying the FRA contract pays the difference to the company
– if the interest is less than the agreed forward rate the company pays the difference to the bank supplying the FRA.
The outcome
The company ends up suffering a fixed rate of interest.
FRA terminology (2)
‘5 – 8 FRA’ – An FRA on a notional three-month loan/deposit starting in five months’ time
‘An FRA priced at 3.2 – 2.6’ – would effectively fix borrowing cost at 3.2% or investment return at 2.6% - bank always wins!
‘Selling an FRA’ fixes the interest received on a deposit
‘Buying an FRA’ fixes the interest paid on a loan.
E plc’s financial projections show an expected cash deficit in two months’ time of £8m, which will last for approximately three months. It is now the 1st November 20X4. The treasurer is concerned that interest rates may rise before the 1st January 20X5.
The treasurer has identified a suitable FRA: a 2 – 5 FRA at 5.00 – 4.70.
Required:
Calculate the interest payable if, in two months’ time, the market rate is:
(a) 7%
(b) 4%
Need to buy FRA as need capital, so buy 2 - 5 FRA, as this is 5% as paying interest
5%*8m *3/12
a) if market rate becomes 7% then bank pays 2%*8m back to company *3/12
b) if goes to 4% then still pay 5% *3/12
pay a fixed rate, FRAs fix therefore protect against risk but also wont allow for benefiting from favourable movement
What are interest rate futures (IRFs). (2)
These operate in a very similar way to FRAs, however they are for
standardised amounts, starting on predetermined dates.
The working of an IRF:
Imagine a company intending to borrow money in the future. To offset the risk of an interest rate rise, futures contracts will be sold to guarantee the rate of borrowing.
– The capital amount is borrowed on the open market and interest is paid on the loan in the normal way
– If interest rates rise, the more expensive cost of borrowing is offset by a profit on the futures contract
– If rates fall, the fall in the cost of borrowing is offset by a loss on the
futures contract.
The outcome
The company ends up suffering a fixed rate of interest.
IRF terminology. (2)
100-i — Interest rate futures are quoted at ‘100 – the expected market reference rate’ as a percentage (i.e. 95.5 would imply an interest rate of 4.5%)
Selling a futures contract fixes the interest paid on borrowing
Buying a futures contract fixes the interest received on deposits.
A treasurer plans to borrow £1 million in June for a period of 3 months. They therefore sell two 3-month £500,000 sterling June IRFs at 95 each.
Show the impact of this hedge if interest rates on the expiry date are
6.5%.
5% as 100-i, selling as borrowing
if at exp it is 6.5% then essentially saved 1.5%3/121m=3750
so would pay 6.5%3/121m then deduct 3750 to get net cost
Calculating the number of contracts needed for IRFs
The number of contracts required must cover:
the size of the loan/deposit
the length of the loan/deposit.
Number of contracts = Loan or deposit amount/Contract size × Loan or deposit period in months/3 months
At the end of March, M plc decides to invest $3,000,000 in June for six months. The treasurer is concerned that interest rates will fall in the intervening period and notes that 3-month June dollar interest rate futures are trading at 94.5. A standard contract size is $1,000,000. On the 30 June, interest rates had fallen to 5%.
Show how many futures contracts are needed and how they could have been used to hedge M plc’s risk exposure.
3m/1m*6months/3 months =6 contracts required
Want to deposit so buying futures. at interest of 94.5 means 5.5% on deposit thus 3m6/125.5%=82.5k
rates fall to 5% therefore profit from buying 5.5% futures is 0.5%
would acc receive 5% initally thus 3m6/125.5% (thus 7500 loss)
However, when this will be netted off by the gain when the position is closed out by selling 6 June futures:
61m3/12*0.5% (ie by the profit/gain) oer futures contract.
What are interest rate options? WB otc?(4)
An interest rate option gives the buyer the right, but not the obligation, to borrow/lend at an agreed interest rate at a future date.
An interest rate guarantee is a term for an interest rate option which hedges the interest rate for a single period (less than one year).
These are also called short term interest rate caps (put option) or short term interest rate floors (call option).
Over the counter interest rate options:
These are tailor made agreements between two parties, that give the
party buying the option, the right but not the obligation to borrow (put option) or lend (call option) at a fixed rate.
Like all options, they require a premium to be paid up front, regardless of whether the option is exercised or not.
A company has tendered for a large contract in a few months’ time. If it wins the contract, it will have surplus cash of £10m which it will need to put on deposit for a 4-month period from 1 August.
It invests in an option to lend the £10m for 4 months at 5%. The option has a premium of 0.3%.
State whether the option will be exercised, and show the outcome of the hedge if on 1 August the spot rate is:
(i) 4%
(ii) 5%
(iii) 6%
i) pay premium of 0.3% regardless so : 0.3%4/1210m
if spot is 4% then this is worse than 5% therefore should exercise the option thus 5%4/1210m earned less 0.3% prem =net interest receieved
ii) 5% is the same so doesnt really matter if exercise or not as still have to pay premium and thus remove from 5%4/1210m interest earnt
iii) 6% hgihers therefore shouldnt exercise so 6%4/1210m less the 0.3%4/1210m premium paid
Traded interest rate options
These are in fact options on interest rate futures. They give the holder the right to buy (call option) or sell (put option) one futures contract on or before the expiry of the option at a specified price (known as the strike price).
The working of a traded interest rate option
Imagine a company is intending to borrow money in the future. To offset the risk of an interest rate rise, the company buys a put option (i.e. the right to sell) on a futures contract.
– The capital amount is borrowed on the open market and interest is paid on the loan in the normal way.
– If interest rates rise, the option is exercised, therefore the more expensive cost of borrowing is offset by a profit on the futures contract.
– If rates fall, the option is allowed to lapse and the company therefore benefits from a cheaper cost of borrowing.
The outcome
The company ends up with an interest rate no higher than the guaranteed maximum – but which could be lower if rates fall.
put or call, traded interest rate options?
The choice of put or call options depends on whether the company plans to borrow or
invest in the future:
intention to borrow – purchase put options
intention to invest – purchase call options.
What are the two components of option value?(4)
Intrinsic vallue and time value
intrinsic:
The difference between the exercise price of the option and the current market value of the product.
An option with intrinsic value is known as ‘in the money’ (that is, if it were to be exercised today, a profit would be made). An option which is out of the money has no intrinsic value.
For example, if a share has a market price of £5 then a call option of £4.50 would have an intrinsic value of 50p (£5 – £4.50).
time value:
The difference between the actual premium and the intrinsic value.
Time value of a call option increases with:
time to expiry
volatility of the underlying share
interest rates (since the present value of the exercise price decreases).
For example, if the above call option had a premium of 75p then 50p would be the intrinsic value leaving 25p as the time value.
Time value of a call option increases with: (3)
time to expiry
volatility of the underlying share
interest rates (since the present value of the exercise price decreases).
Forward/futures vs options (7)
Forward/future
Eliminates risk completely
No downside risk, but no upside potential
If the underlying transaction falls through, the business is re-exposed to risk.
Option
Downside risk is eliminated
Upside potential is retained
If the underlying transaction falls through, there is still no risk.
Therefore, more flexible than a forward; but
more expensive.
OTC vs standardised products. (4)
OTC
Can be for any amount and any date
Tend to be more expensive unless for large amounts.
Standardised
Only set dates and amounts, therefore may not provide a perfect hedge
Can be closed out easily if the underlying transaction falls through.
A company wishes to borrow £2.1m for 3 months at the end of June. The price of June 3-month interest rate futures (contract size £500,000) is currently 97.
Required:
(a) Show how the company would hedge its exposure as well as it
could using interest rate futures.
(b) Show the outcome of the hedge if the company borrowed the
money and closed out the hedge on 30 June, when the futures
price was 95 and the spot rate was 5%?
(c) Show how the outcome of the hedge would change if the company borrowed the money and closed out the hedge on the 20th June, at which point the futures price was 95 and the spot rate was 5.2%?
a) Wishes to borrow so need to purchase a put futures for 97 thus 3%
3%2m3/12 +5%3/12100k if you
4.2 contracts needed - imperfect hedge - just buy 4
b) 5% therefore as agreed to 3% would benefit from not having increased interest rate THUS 2% profit on hedge, however because its an imperfect hedge only covering 2m the other 100k is left unhedged thus suffers the 5% rate, the effective rate is therefore the 3%2m3/12+5%100k3/12=3.1%
c) Effective interest rate = 17,300/2,100,000 × 12/3 = 3.3%
note the difference here is due to the spot now being 5.2% not 5% as it wouldve been if closed out at expiry, the profit on the future would still be 2% as this was committed to ie 97 futures and in both cases futures price is then 95
In addition to the 100k of borrowing that was unhedged, this time there is further inefficiency. Basis risk of 0.2% (the difference between the spot rate and the futures price at the date the contract was closed out (5.2-5%) has increased the cost of borrowing.
What are basic swaps/basic vanilla swaps?
An agreement whereby two parties agree to swap a floating stream of interest payments for a fixed stream of interest payments and via versa.
There is no exchange of principal. The companies involved are termed ‘counter-parties’
The scenario
One company (A) will want to borrow at a fixed rate, but has been offered a relatively good deal on a variable loan.
Another company (B) will want to borrow at a variable rate, but has been offered a relatively good deal on a fixed rate loan.
Instead of the companies’ borrowing as they want to:
A will borrow at a variable rate and B will borrow at a fixed rate.
B will make a variable interest payment to A and A will make a fixed interest payment to B – thereby the companies effectively swap interest payments.
How to calculate vanilla swap payments?
In order to calculate the payments required from A to B and vice versa,
a 3 step process needs to be followed:
1 Establish the total benefit to be gained from the swap (the reduction in the total interest rate paid by doing the swap)
2 Establish the final rates that can be achieved by each party, by splitting the benefit between them (equally unless told otherwise)
3 Establish the payments between the parties that will achieve this result.
Main reason for swaps. (4)
Swaps can be used to hedge against an adverse movement in interest rates.
Say a company has a $200m floating loan and the treasurer believes that interest rates are likely to rise over the next five years. The treasurer could enter into a five-year swap with a counter party to swap into a fixed rate of interest for the next five years. From year six onwards, the company will once again pay a floating rate of interest.
A swap can be used to obtain cheaper finance. A swap should result in a company being able to borrow what it wants at a better rate under a swap arrangement, than borrowing it directly itself.
Swaps can run for up to 30 years – therefore preferable to futures for long term borrowing.
Transaction costs involved in a swap may be cheaper than costs involved in refinancing.
Disadvantages of swaps. (3)
Counterparty risk (the risk the counter party will default)
Market risk (the risk of an adverse movement in interest or exchange rates)
Transparency risk (the risk that the accounts may be misleading).
Company A wishes to raise £6m. They would prefer to issue fixed rate debt because they want certainty about their future interest payments.
They can borrow at 7% fixed or SONIA + 3% floating.
Company B also wishes to raise £6m, but wishes to pay interest at a floating rate, as it would like to be able to take advantage of any fall in interest rates. It can borrow for one year at a fixed rate of 4% or at a floating rate of 2% above SONIA.
Calculate the payments between parties and demonstrate the effective cost of borrowing for A and B. Assume savings are split equally and the variable leg of the swap is SONIA.
Note: SONIA (Sterling Overnight Index Average) is the effective
overnight interest rate paid by banks and represents a minimum variable rate in financial management exams.
Without swap
A goes for 7% fixed
B goes for 2% + SONIA
=9% + SONIA
With swap
A goes for 3% + SONIA
B goes for 4% fixed
=7% + SONIA
Therefore benefit is 2% which needs splitting equally between the companies
hence A must end up paying 6% (7% without swap less 1% benefit)
B must end up paying 1% + SONIA as less 1% benefit
if A takes 3% + SONIA
B takes 4% fixed
to get 6% B must pay SONIA and A must pay 3% to B to get to what they should have with 1% benefit
What are index futures?
An index future is a futures contract whose value depends on the value of the FTSE100 Index.
The working of an index future
Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will sell index futures.
Later on, the portfolio is sold on the open market and the futures position is closed out (the futures contracts are bought back).
If the market has fallen, the loss in value of the portfolio is offset by the profit on the futures contract.
If it has risen, the increased value of the portfolio is offset by a loss on the futures contract.
The outcome
Regardless of what happens to the FTSE100, the company receives a guaranteed value for its portfolio.
Index futures terminology
Index futures are quoted in ‘points’ (just like the stock market index).
The contract size is always equal to the futures price × £10 (i.e. if the futures price stands at 4,500 points, then each futures contract will cover a value of £45,000).
What are index options?
An index option is an option to buy (call) or sell (put) a notional
portfolio of shares whose value mirrors the FTSE Index.
The working of an index option
Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will buy put options on index futures.
Later on, the portfolio is sold on the open market.
If the market has fallen, the option will be exercised and the loss in value of the portfolio is offset by the profit on the futures contract.
If it has risen, the option is allowed to lapse and the company benefits from the increased value of the portfolio.
The outcome
The company ends up with a minimum price for its portfolio – but this could be higher if the stock market rises more than expected.
A company has a portfolio of shares, which tracks the FTSE 100 index that it needs to sell towards the end of June. The portfolio is currently worth £300,000 and the FTSE 100 Index stands at 5000 points. June index futures are currently trading at 5200.
Required:
(a) Show the impact of the company hedging its position using index
futures if the company sells its portfolio on 30 June, and at that
date:
– the FTSE 100 and the futures price stands at 5290 and
– the portfolio is worth £317,400.
(b) How would the position change if the company decided to sell its
portfolio on 20 June and at that date:
– the FTSE 100 stood at 4900
– the futures price at 4950 and
– the portfolio was worth £294,000.
a)
Sells its portfolio on 30th June when FTSE 100 and futures price is 5290
Therefore must sell index futures, needs to protect 300k thus 300k/52000=5.77 thus need 6 contracts rounded
if sell at 5200 futures contract and then futures price becomes 5290
There is an increase of 317400 for portfolio less
90610=5400 loss on futures contracts =£312,000
b) portfolio now 294,000
still have 5200 but now 4950 means 2500*6=15000 gain on portfolio
thus =309,000 net position.
What are index options?
An index option is an option to buy (call) or sell (put) a notional
portfolio of shares whose value mirrors the FTSE Index.
The working of an index option
Imagine a company has a portfolio of shares which it will need to sell in the future. To protect against a fall in the market, the company will buy put options on index futures.
Later on, the portfolio is sold on the open market.
If the market has fallen, the option will be exercised and the loss in value of the portfolio is offset by the profit on the futures contract.
If it has risen, the option is allowed to lapse and the company benefits from the increased value of the portfolio.
The outcome
The company ends up with a minimum price for its portfolio – but this could be higher if the stock market rises more than expected.
A company has a portfolio of shares that it needs to sell at the end of June.
The portfolio is currently worth £800,000 and the FTSE 100 Index stands at 5100 points.
The company wishes to protect against the FTSE Index falling by the date of sale.
Demonstrate the impact if the company hedges using index options and sells its portfolio on 30 June, at which point:
the FTSE 100 stands at 5180 and
the portfolio is worth £828,000.
wants to sell so need to get put options and june so prem is 146 (as at 5100 FTSE)
800k portfolio wants to protect , 800k/51k=16 contracts
in june at sale worth 828k then less prem of 1460*16 contracts if it then stands at FTSE 1580 it has fallen by 20 points therefore do not exercise option
sell price: 1500
buy price: 1580 hence loss
therefore net is £804,640
What is transaction risk?
Transaction risk is the risk that an exchange rate will change between
the transaction date and the subsequent settlement date i.e. it is the
gain or loss arising on conversion.
It arises primarily on imports and exports.
For example, a firm enters into a contract on 1 January to buy a piece of equipment from the US for $300,000. The invoice is to be settled on 31 March.
The exchange rate on 1st January is $1.6/£ therefore the firm expects the cost to be £187,500.
However, by 31st March, the pound may have – strengthened to $1.75/£ in which case the cost will have fallen to £171,429
or
– depreciated to $1.45/£ in which case the cost has risen to £206,897.
What is economic risk?
Economic risk is the variation in the value of the business (i.e. the
present value of future cash flows) due to unexpected changes in
exchange rates. It is the long-term version of transaction risk.
For an export company it could occur because:
– the home currency strengthens against the currency in which it trades
– a competitor’s home currency weakens against the currency in which it trades.
A favoured, but long term solution, is to diversify all aspects of the business internationally
A UK exporter sells one product in Europe on a cost plus basis.
The selling price is based on a UK price of £16 to cover costs and provide a profit margin.
The current exchange rate is €1.56/£
What would be the effect on the exporter’s business if sterling
strengthened to €1.71/£?
The product was previously selling at £16 × 1.56 = €24.96
After the movement in exchange rates the exporter has an unhappy choice:
Either they must
raise the price of the product to maintain their profits: £16 × 1.71 =
€27.36, but risk losing sales as the product is more expensive and less competitive, or
maintain the price to keep sales volume but risk eroding profit margins.
(€24.96 ÷ 1.71 = £14.60 sales revenue).
The exporter is facing economic risk.
What is translation risk?
Where the reported performance of an overseas subsidiary in homebased currency terms is distorted in consolidated financial statements because of a change in exchange rates.
Note: This is an accounting risk rather than a cash based one.
Quoted exchange rates
Banks dealing in foreign currency quote two prices (a ‘spread’) for an exchange rate:
a lower ‘offer’ price
a higher ‘bid’ price.
E.g. a dealer might quote a price for US$/£ of 1.4325 – 1.4330.
The lower rate, 1.4325, is the rate at which the dealer will sell the variable currency (US dollars) in exchange for the base currency (sterling).
The higher rate, 1.4330, is the rate at which the dealer will buy the variable currency (US dollars) in exchange for the base currency (sterling).
The bank will always trade at the rate that is more favourable to itself.
The US Dollar/Sterling rate is quoted as 1.4325 – 1.4330.
Company A wants to buy $100,000 in exchange for sterling.
Company B wants to sell $200,000 in exchange for sterling.
What rate will the bank offer?
Company A would get 1.4325 as it is lower
Company B would get 1.4330 as it is higher
100k/1.4325=69808, 100k/1.4330=69783 ie company A would have the lower rate as will need to pay more £ to get dollars
and b wants to sell dollars so use higher rate to get a smaller conversion to £
think always demoniator if you rearrange
How to reduce transactional risk?
-Invoice in home currency (however this transfers risk to the other party and may not be commercially acceptable)
-Leading and lagging:
If an exporter expects that the currency it is due to receive will depreciate over the next few months it may try to obtain payment immediately (i.e. leading).
This may be achieved by offering a discount for immediate payment.
If an importer expects that the currency it is due to pay will depreciate, it may attempt to delay payment (lagging).
This may be achieved by agreement or by exceeding credit terms.
NB: Strictly this is NOT hedging – it is speculation – betting on the exchange rate changing in your favour!
-Matching-When a company has receipts and payments in the same foreign currency due at the same time, it can simply match them against each other. It is then only necessary to deal on the forex markets for the unmatched portion of the total transactions.
-foreign currency bank accounts:
Where a firm has regular receipts and payments in the same currency, it may choose to operate a foreign currency bank account
This operates as a permanent matching process
The exposure to exchange risk is limited to the net balance on the account
Hedging financial risk with forward rates
Forward rates are quoted as a premium or a discount on the spot rate.
Discount more $ per £ therefore depreciated
Premium less $ per £ therefore appreciated
An arrangement fee may be required to access the forward contract
The current spot rate for US dollars against UK sterling is 1.4525 – 1.4535 $/£ and the one-month forward is 0.25 – 0.30 cents discount.
A UK exporter expects to receive $400,000 in one month.
If a forward contract is used, how much will be received in sterling?
Receive dollars and then converting to £, so higher rate as will get less £ therefore 1.4535, 0.25 cents discount
400,000
1.4535+0.003=1.4565
=£332,364
A money market hedge?
Instead of hedging currency exposure with a forward contract, a company could use the money markets to lend or borrow, and achieve a similar result.
Hedging a payment
buy the present value of foreign currency amount today at the spot rate:
– this is like the firm making an immediate and certain payment in sterling
– and may involve borrowing the funds to pay earlier than the settlement date
the foreign currency purchased is placed on deposit and accrues interest until the transaction date
the deposit is then used to make the foreign currency payment.
L plc must make a payment of US $450,000 in 3 months’ time. The company treasurer has determined the following:
Spot rate $1.7000 – $1.7040
3 months forward $1.6902 – $1.6944
6 months forward $1.6764 – $1.6809
Money market rates for three months, quoted per annum:
Borrowing Deposit US dollars 6.5% 5% Sterling 7.5% 6%
Decide whether a forward contract hedge or a money market hedge
should be undertaken.
Make payment of dollars in 3 months time so need to exchange £ for $, therefore need rate that will give least amount of $ per pound
using a forward 3 month:
$/£=1.6902 is lowest rate so use that
in 3 months time its actually 1.7 but agreed to forward so need to pay above rate regardless hence sterling payment is:
450k/1.6902=£266,240
using money market hedge:
now deposit rate 3 months
$444,444 «< 1+ 3/12*US 5% 450k$
Immediately convert at spot
1.7
£261437 »_space;» using sterling borrowing rate 7.5% convert > £266,338
forward is marginally cheaper
Hedging a receipt
If you are hedging a receipt, borrow the present value of the foreign currency amount today
– sell it at the spot rate
– this results in an immediate and certain receipt in sterling
– this can be invested until the date it was due
the foreign loan accrues interest until the transaction date
the loan is then repaid with the foreign currency receipt.
L plc is now expecting a receipt of US $900,000 in 6 months’ time. The company treasurer has determined the following:
Spot rate $1.7000 – $1.7040
3 months forward $1.6902 – $1.6944
6 months forward $1.6764 – $1.6809
Money market rates:
Borrowing Deposit
US dollars 6.5% 5%
Sterling 7.5% 6%
Decide whether a forward contract hedge or a money market hedge
should be undertaken.
Forward contract expecting 900k$ so using 6 month forward rate and will be converting into £ so $/£=1.6944 will give least amount of £:
900k/1.6809=£535427
Using money hedge:
Due to receive the $ so need £
now 6 months $871671 < loan US rate < 900k Convert at spot 1.704 511,544 <<<deposit sterling 6%<<< Buy $=526,890
The forward hedge is the recommended hedging strategy, but differences in the two methods would normally be very small. Note that the money market hedge gives rise to funds immediately.
Should you buy or sell futures contracts?
Whether to buy or sell futures contracts depends on whether the contract is denominated in sterling or the foreign currency.
The examiner will give you contracts denominated in sterling, therefore the decision will depend on what you will be doing with sterling.
If a company is going to be buying currency in the future, then it will be SELLING sterling. It therefore needs to SELL sterling contracts.
If a company is going to be selling currency in the future, then it will be BUYING sterling. It therefore needs to BUY sterling contracts
How does the number of contracts differ for futures contracts?
As usual, this will be the transaction amount divided by the contract size. However, when using sterling contracts, the contract size will be in £ but the transaction amount will be in currency. Therefore, you will need to convert the transaction amount into £ first (using the futures price).
Other points to remember with futures contracts?
If using sterling contracts, the futures prices will be given as currency per £ (e.g. $/£), therefore the profit or loss on the future will end up in the foreign currency and will need to be translated at the spot rate on the transaction date.
This will also be the case with the premium on an option (see below). Because a premium is paid up front, it must be translated at the current spot rate.
It is now May. An importer will need to pay €140,000 in September. The current spot rate is €1.47/£.
September currency futures are currently quoted at €1.4/£. The minimum contract size is £50,000.
By September, the spot rate has moved to €1.32/£ and futures are quoted at €1.32/£.
Show how futures could have been used to hedge the exchange risk
associated with the transaction.
140k/1.40=£100k now /50k=2 contracts
now it is 1.32 so buy 140k euros = £106060
Close out the future:
Sell price 1.4
Buy price 1.32
Profit 0.08 250k =8000 into £ /1.32=(6060)
=£100,000
Crypto and problems (2) and how to hedge the risk (1)
Cryptocurrency is a digital currency that uses cryptography to make sure payments are sent and received safely.
They can be useful for transactions involving foreign currency, as both parties can agree to settle the transaction with a cryptocurrency, such as Bitcoin (BTC) rather than using foreign currency hedging techniques.
However, this presents two key problems:
Exchangeability – can only exchange for a narrow range of major currencies.
Price volatility – cryptocurrency exchange rates are extremely volatile.
However, there are opportunities to hedge this risk.
Forward contracts are tailored to the individual and allow a business to hedge the value of a cryptocurrency in advance.
A spread of rates will be quoted in the exam and it is important to select the correct rate for the transaction. As with foreign currency rates, the bank will always offer the least attractive rate for the business
other methods too eg futures
Futures contracts and crypto. (3)
Bitcoin futures are standardised contracts (standard amounts and dates) that can be traded on an exchange, to protect against future changes in the value of Bitcoin.
Whether to buy or sell
For a payment in Bitcoin, the company is concerned the price of Bitcoin will rise and make the purchase of the required Bitcoin more expensive = BUY futures today.
For a receipt in Bitcoin, the company is concerned the Bitcoin price will fall and therefore receive less from exchanging Bitcoin = SELL futures today.
Number of contracts
Bitcoin futures are in a standardised size, such as 5 Bitcoin. The number of contracts will be the transaction divided by the standard size.
Nuts plc need to pay their supplier 20 Bitcoin (BTC) in 2 months’ time.
Current spot rate 1 Bitcoin = £8,300 – £8,400
Two-month forward rate 1 Bitcoin = £8,350 – £8,450
Show the outcome if Nuts plc use a forward contract to hedge the
cryptocurrency.
If use forward then will agree to 1 bitcoin=8450 as less bitcoin for £
Therefore need to pay £169k
It is now July. An exporter will receive 40 Bitcoin in September. The current spot rate is 1 Bitcoin = £8,300 – £8,400.
September currency futures are currently quoted at £8,275. The minimum contract size is 5 Bitcoin.
By September, the spot rate and futures price has moved to £7,500.
Show how futures could have been used to hedge the Bitcoin
associated with the transaction.
receive 40 bitcoin in september now july so 2 months
futures curretly quoted at 8275 and min contract size is 5 bitcoin
40/5=8 contracts
concerned value will fall so will SELL futures today @ 1 bitcoin=8275
Actual transaction sell 40 BTC @ 7500 = 300k
then close out the future to get :
futures price is now 7500 (ie buy price) but sold future for 8275 therefore profit of £7755 BTC8=£31000
net receipt = 331k
Purchasing power parity (PPP)
PPP claims that the rate of exchange between two currencies depends on the relative inflation rates within the respective countries.
PPP is based on ‘The Law of One Price’
In equilibrium, identical goods must cost the same regardless of the currency in which they are sold.
The country with the higher inflation will be subject to a depreciation of its currency.
To estimate the expected future spot rates, apply the following formula:
Current spot rate × (1 + inflf)/(1 + influk) = Future spot rate
where
– inflf = expected foreign currency inflation rate for the period
– influk = expected UK inflation rate for the period.
An item costs $3,000 in the US but £2,000 in the UK. The current spot rate is $1.50/£. Inflation over the next year is expected to be 5% in the US, but only 3% in the UK.
What is the spot rate expected to be in one year’s time?
1.5*1.05/1.03=1.5291
the law of one price means they must always cost the same therefore if you inflate each by their respective inflation the $ to £ prices must equal, so could also divide those by one another to get the same result
eg 3k1.05=3150 and 2k1.03= 2060 therefore 3150/2060 also gives 1.5291
Spot rates, forward rates and interest rate parity theory (IRPT)
Interest Rate Parity theory claims that the difference between the spot and the future exchange rates is equal to the differential between interest rates available in the two currencies.
This is used by banks to calculate the forward rate quoted on a currency.
The formula is:
Current spot rate × (1 + if)/(1 + iuk) = Forward rate
where:
if = foreign currency interest rate for the period
iuk = UK interest rate for the period
IRP holds true in practice. There are no bargain interest rates to be had on loans/deposits in one currency rather than another.
However, where a government imposes controls on currency trading, or otherwise intervenes in the currency markets, its effectiveness is limited.
The 12 months’ interest rate for US$ is currently 9.2% pa. In the UK it is at 7.12% pa. The current rate of exchange is $1.5/£
What forward rate will be quoted by a bank for exchange in a year’s
time?
1.5*1.092/1.0712=1.5291
IRPT states that an investor would receive the same as if they had invested in Uk goernment bonds therefore what you gain in extra interest you lose in adverse forex movement so £1.0712m will equal $1.638m thuse giving the above answer also of 1.5291
Currency options
Options give the right but not the obligation to buy or sell currency at
some point in the future at a predetermined rate.
A company can therefore:
exercise the option
let it lapse if:
– the spot rate is more favourable
– there is no longer a need to exchange currency.
The option therefore eliminates downside risk but allows participation in the upside.
The additional flexibility comes at a price – a premium must be paid to purchase an option whether or not it is ever used.
Once again, a company may buy a tailor made OTC option, or use traded currency options.
OTC currency options (buying or selling?)
OTC options are generally denominated in a foreign currency, so to decide whether you need a put or call, you need to consider what you will be doing with the foreign currency.
If the company is going to be BUYING currency in the future, then it will need to buy a CALL option.
If the company is going to be SELLING currency in the future, then it will need to buy a PUT option.
Sammy Ltd is tendering for a contract in Danish Krone.
If the contract is won, Sammy will be receiving Kr20m in March.
The finance director has been offered an OTC option by the bank on Danish Krone at an exercise price of Kr8.45/£.
A call option on Krone would cost 30p per Kr1,000 and a put option would cost 28p per Kr1,000.
Calculate the Sterling received if the company wins the contract and the exchange rate in March turns out to be Kr8.7/£.
receiving Kr and quoted in Kr therefore what are we doing with Krona? will be selling Krona to buy £
therefore purchase put option thus 28p per Kr1000 premium therefore 20m/1000*28p=£5600 premium
In march exchange rate turns out to be Kr8.7/£ as agreed to 8.45 exercise option as otherwie will lose out therefore 0.25Kr profit on option
Exercising the option Kr20/8.45= £2366864
Less premium (5600)
net receipt = £2361264
Traded currency options (buy or sell)
As for futures, the examiner will give you contracts denominated in
STERLING, therefore: if a company is going to be buying currency in
the future, then it will be SELLING sterling. It therefore, needs to buy
PUTS.
If a company is going to be selling currency in the future, then it will be BUYING sterling. It therefore needs to buy CALLS.
P plc is a UK-based import-export company. It has an invoice which it is due to pay on 30th June, in respect of $562,500.
The current spot rate ($/£) is 1.5190
The company wishes to hedge its exposure to foreign exchange risk using options with an exercise price of $1.5/£.
The following options are available. Contract size is £62,500. Premiums are given in cents/£.
Show the cash flows in respect of the payment if the spot rate ($/£) on 30 June is 1.4663.
It has an invoice due for $ therefore need to sell £ to buy $ to pay the invoice therefore need to purchase put options, due to pya in June so June put therefore using table at 1.5 strike price the June put premium is 6.7 cents per £
562500 at current spot is 370309.4/62500=5.92 contracts - round to 6 contracts
start with what you do without any hedging so 562500/1.4663=£383,618
option -convert at future spot
sell as put at $1.5/£
buy at spot in June $1.4663/£ profit of $0.0337/£ per contract662500=$12637.5 profit/1.4663=8619
premium (60.06762500) = ($25125)/1.519 convert at current spot = (£16540)
=£391,540 net cost
