F3 Passcards CIMA BPP 2015

CIMA Passcards New
Strategic Paper F3 syllabus

Financial Strategy 2015
Passcards for exams
in 2015
CMF3PC15.indd 1 14/07/2014 12:46

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Strategic Paper F3
Financial Strategy
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First edition July 2014 The contents of this book are intended as a guide and not
ISBN 9781 4727 1403 9 professional advice. Although every effort has been made to
e ISBN 9781 4727 2058 0 ensure that the contents of this book are correct at the time of
going to press, BPP Learning Media makes no warranty that
British Library Cataloguing-in-Publication Data the information in this book is accurate or complete and accept
A catalogue record for this book is available from the no liability for any loss or damage suffered by any person
British Library acting or refraining from acting as a result of the material in
Published by Printed in the United Kingdom this book.
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Preface Contents
Welcome to BPP Learning Media’s CIMA Passcards for F3: Financial Strategy.
They focus on your exam and save you time.
They incorporate diagrams to kickstart your memory.
They follow the overall structure of the BPP Learning Media Study Texts, but BPP Learning Media’s CIMA
Passcards are not just a condensed book. Each card has been separately designed for clear presentation.
Topics are self contained and can be grasped visually.
CIMA Passcards are still just the right size for pockets, briefcases and bags.
Run through the Passcards as often as you can during your final revision period. The day before the exam, try
to go through the Passcards again! You will then be well on your way to passing your exams.
Good luck!
Page iii
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Preface Contents
Page Page
1 Strategic financial objectives 1 8 Equity finance 73
2 Strategic financial management 7 9 Capital structure 83
3 Reporting issues 25 10 Strategic implications of acquisitions 95
4 Dividend policy 39 11 Introduction to valuation techniques 103
5 Long-term debt finance 45 12 Advanced valuation techniques 113
6 Managing the debt profile 57 13 Post acquisition issues 117
7 Leasing 69
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1: Strategic financial objectives
Strategic financial objectives

Satisfy requirements of
interested parties and
stakeholders
Not for profit organisation – Maximisation of shareholder wealth –
value for money total shareholder return
Other non-financial
objectives
Impact of changes in
Contrast vs profit
Other financial objectives underlying economic &
maximisation
business variables
Strategic financial Stakeholders Not-for-profit

objectives organisations
Maximisation of shareholder wealth

is assumed to be the main objective of a profit-making entity. Share price goes up.
Measured using EPS, ROCE, DPS Other financial targets Non financial objectives
Level of gearing Quality measures

Profit retentions Customer-based measures
Operating profitability Employee welfare
Conflicts Cash generation Society welfare
Value added Innovation measures
Short-term v long-term
Multiple targets Balanced scorecard approach

Stakeholders Share price

are those persons and organisations that have an measures shareholder attitude to:
interest in the strategy of the organisation The future – influenced by investment decisions
Risk – influenced by financing decisions
Managers
Internal Cash – influenced by dividend decisions
Employees
Shareholders
Bankers
Connected
Customers
Suppliers
Government
External Pressure groups
Local communities
Page 3 1: Strategic financial objectives


Agency problem Goal congruence

Managers acting as agents for is the state which leads individuals to take actions which are
shareholders may not act in best in their self-interest and also in the best interest of the entity.
interests of shareholders.
achieved by
Corporate governance Incentive schemes

Actions
The system by which
organisations are directed Performance related
Maximise short-term profits to pay
and controlled
trigger bonuses Share options
Boost their own pay and perks Rewarding managers
Avoid debt finance to avoid careful with shares
cash management

Not-for-profit organisations (NFPOs)

have a primary objective to provide a quality service within a value for money framework.
Value for money Objective setting for NFPOs
Economy – purchase of inputs of appropriate Who are the main stakeholders?

quality at minimum cost
Which are the most important objectives?
Efficiency – use of these inputs to maximise How will achievement of objectives be
output measured?
Effectiveness – use of these inputs to achieve
goals
Page 5 1: Strategic financial objectives

Notes
2: Strategic financial management
Strategic financial management –

creating a financial strategy
Influences on financial
strategy
Investment decision Financing decision Dividend decision
Affected by taxation and

Affected by regulation other regulations
Performance analysis and
Inter-relates with financing forecasting Inter-relates with financing
and dividend decisions and investment decisions
Short-term finance Financing requirements Long-term finance

Financial management Influences on Taxation and Performance Forecasting

decisions financial strategy international influences analysis
Identify investment Long-term capital structure Affects views of company’s

opportunities Short-term working capital long-term prospects and
Evaluate them management market value of shares
Decide on optimal Profitability v liquidity Payment of dividend
allocation of scarce funds reduces amount of retained
Source? Cost? Risk? earnings for investment
New project? Takeover?
Merger? Sell-off? How much? When?
The three decisions are integrated


Lack of funding Need to keep

investors happy
Business strategy Taxation

Influences
Regulatory bodies Economic factors

Foreign exchange risk
Entities which trade internationally Political risk

Geographical separation
have extra constraints
Litigation
Page 9 2: Strategic financial management


Legislation
Eg Companies Acts, Health and Safety, employment law
Regulatory bodies
Competition regulation Corporate governance

Industry regulators impose price and
The system by which companies
profit controls where market is not
are directed and controlled.
competitive.
Competition authorities protect
competition and regulate takeovers.
Effects of inflation Effects of exchange rate increases

↑ costs of production ↑ costs of exports
↓ costs of imports
↑ selling prices
↑ interest rates to dampen demand
↓ foreign exchange rates (through purchasing
power parity)
↓ demand (through higher prices/uncertainty)
Business and exchange rates

Businesses want certainty, but also an exchange rate that means that they are competitive. Exchange rate
uncertainty can lead to businesses financing investments abroad by borrowing in the same currency.


Reasons why interest rates differ Effects of interest rate increase

Risk
Need to make profit on re-lending Market value of interest-bearing securities falls
Duration of lending Return expected from shares rises
Size of loan Price of shares falls
Different types of financial asset Companies reduce total debt finance
Companies raise new debt finance by short-
term borrowing/debt at variable interest rate
Companies with surplus cash switch into
interest-bearing securities
Nominal and real rates of interest Required return on capital investments rises
1 + nominal rate of interest – 1

Real rate of interest = ______________________
1 + rate of inflation

International influences Taxation influences

Issues of trading abroad: Domestic
Risk of higher costs due to adverse Payment of tax needs to be factored into cash flow
foreign exchange movements forecasts, impacts working capital
Political issues – eg sanctions and Tax relief eg on interest payments on debt finance; capital
embargoes (political trade restrictions) allowances (tax deprecation) on equipment and machinery
Geographical separation of a parent International
company from its subsidiaries, language Dividend policy in multinationals influenced by differing tax
and cultural differences may cause rules and tax rates of countries within the group
issues of group management control
Tax havens – countries with lenient tax rules or low tax
Litigation varies in different countries and rates, designed to attract foreign investment, eg Ireland.
can affect products sold in these Large multinationals often set up subsidiaries in tax
countries havens to reduce tax
Companies could face being taxed twice on overseas
profits unless double taxation agreement is in place
between the home and overseas country


Remember!
Only calculate relevant ratios Profitability
Understand the needs of the user Liquidity
Debt
Shareholders’ investment
Make meaningful comments applied to the scenario
Is comparable information available?

Understand the limitations Is information up-to-date?
Could information have been manipulated?
What other information should be looked at?
Dividends Dividend yield

Returns to shareholders EPS
Capital gains from increases in market value P/E ratio
Profitability
ROCE = Profit margin × Asset turnover
PBIT Revenue
= ×
Revenue Capital employed
Liquidity
Receivables Inventory Accounts payable
Current ratio Quick ratio Cash cycle
collection period turnover period
You must know these by now!

Gearing
Debt ratios
Interest cover


Purpose of forecasting
Analysis of financing
Setting shareholder expectations Performance evaluation
requirements
1 Statement of comprehensive income

↓ retained earnings affect statement of financial position
2 Statement of financial position
↓ movement in assets and liabilities determines cash flow
3 Cash flow forecast
Any clear format can be used for a cash flow forecast but you need to be quick.
Financing Short-term The treasury

requirements financial strategy function
Easing cash flow problems Investing surplus cash

considerations
Postponing capital expenditure

Accelerating cash inflows Liquidity
Selling non-essential assets Profitability
Longer credit Safety
Rescheduling loan repayments
Reducing dividend payments
Ratio analysis can be used to analyse the impact of different types of financing on the
potential achievement of objectives. Eg target EPS.


Conservative approach
High levels of working capital
High financing cost
Reduced risk of system breakdown
Possible inventory obsolescence and lack of flexibility to customer
demand
Level of working capital Moderate approach

Aggressive approach
Low levels of working capital
Aim to increase profitability by reducing financing cost
Increased risk of system breakdown and loss of goodwill
Easier with modern manufacturing techniques
Working capital financing

Short-term finance is usually cheaper than long-term finance.
In A (conservative) all
permanent and some
Assets
fluctuating current assets
($) A
Fluctuating financed out of long-term
current assets sources; may be surplus cash
for investment.
C
B In B (aggressive) all fluctuating
Permanent and some permanent current
current assets assets financed out of short-
term sources, possible liquidity
problems.
Non-current assets
In C long-term funds finance
permanent assets, short-term
0 Time
funds non-permanent assets.

Overtrading
happens when a business tries to do too much too quickly with too little long-term capital.
Multinational working capital management

Symptoms of overtrading issues
Rapid increase in turnover

Longer distances involved
Rapid increase in volume of current assets
More parties involved
Only a small increase in proprietors’ capital
Political risk
Increase in short-term credit finance eg overdraft
Exchange rate fluctuations
Dramatic change in liquidity ratios
Managing inventory is more complex

Treasury management
is the corporate handling of all financial matters, the generation of funds for business, the management of
currencies and cash flows and the strategies, policies and procedures of corporate finance.
TREASURY
Corporate Liquidity Funding Currency Corporate
financial management management management finance
objectives
Working capital Policies Exposure Share capital
Policies Banking relationships Sources Futures Listings
Aims Cash transmission Types Options Project finance
Strategies Cash investment Security Security Joint ventures
Systems Interest rates Regulations Mergers
Risk Dividends
Tax

If a company has a large number of subsidiaries or divisions, does it centralise treasury functions (and have
central department acting as group banker) or allow each subsidiary to carry out its own treasury functions?
Centralised treasury management Decentralised treasury management
Avoids surplus/deficits mix Diversified finance sources match local assets

Bulk cash flows and lower bank charges Greater autonomy for subsidiaries and divisions
More short-term investment opportunities More responsive to local needs especially
Foreign currency risk decreased by matching worldwide
Employ experts
Smaller total precautionary balance
Can be profit centre focusing on efficiency and
cost minimisation
Better control framework
Common technology
Cost centre or profit centre?

Main incentive is to keep costs
within budgeted spending
Cost Profit Useful if high level of foreign
exchange transactions (hedging
targets. centre centre or not hedging) or wish to make
speculative profits.
Staff Controls Information Attitudes Internal Performance

competence to risk charges evaluation
Expertise Prevention of Must be Consistent with Fair market May be in loss
required over exposure up-to-date company’s price may be avoidance
High overall difficult to set rather than
salaries? position? profit making

Notes
3: Reporting issues
Reporting issues
Need to inform stakeholders of

financial risks Limitations of financial statements
Financial statements do not inform

Disclosure of stakeholders of other risks and
Hedging non-financial information
financial instruments
Non-financial information conveyed

through optional reporting
Management Environmental Integrated

Sustainability Social responsibility
commentary reporting reporting
Hedging Financial Management Sustainability Environmental

instruments commentary reporting
Hedging [IAS 39]

Hedge accounting is mandatory where a transaction qualifies
as a hedge (all three criteria met):
Designated at inception as a hedge
‘Highly effective’
Hedge effectiveness can be reliably measured
IAS 39 identifies three types of hedges which determines their accounting treatment.
Type Hedges against Accounting treatment
Fair value hedge Changes in fair value of a recognised asset or Gain or loss on instrument is recognised in the
liability or an unrecognised firm commitment* (or P/L
portion of either) that could affect profit or loss Gain or loss on hedged item also recognised in
P/L (and adjusts the carrying value of hedged
item)
Cash flow hedge Exposure to variability in cash flows attributable to Gain or loss on effective portion of instrument is
a risk associated with a recognised asset or liability recognised in other comprehensive income (and
that could affect profit or loss recognised in P/L when asset or liability affects
profit or loss, eg by interest income)
Gain or loss on ineffective portion is recognised
in P/L
Hedge of net Variability in value of the net investment in a As for cash flow hedge
investment in a foreign operation or monetary items accounted for
foreign operation as part of that net investment
*IAS 39 allows the hedge of a foreign currency firm commitment to be accounted for as a cash flow hedge.
Page 27 3: Reporting issues

The main disclosures required are:
Statement of financial position Statement of profit or loss and other

comprehensive income
Carrying amount of financial assets and
liabilities by IFRS 9 category Net gains/losses by IFRS 9 category
Reasons for any reclassification between fair
value and amortised cost Interest income/expense
Details of assets and exposure to risk where Impairment losses by class of financial asset
transfers of assets have taken place
Carrying amount of financial assets pledged as
collateral
Allowance for credit losses
Multiple embedded derivatives
Defaults and breaches
Hedge accounting Fair value
Description of hedge By class

Methods and assumptions
Description of financial instruments designated
as hedging instruments
Risk
Nature of risks being hedged
Qualitative disclosure: management’s
Cash flow hedges: when cash flows will occur objectives, policies and processes for
managing those risks
FV hedges: gains or losses on hedged item
and hedging instrument Quantitative disclosure:
– Extent of exposure to risk
Ineffectiveness recognised in profit or loss
– Credit risk
– Liquidity risk
– Market risk


General purpose financial reports do not and cannot provide all of the information that existing and potential investors,
lenders and other creditors need. Those users need to consider pertinent information from other sources, for example,
general economic conditions and expectations, political events and political climate, and industry and company
outlooks. (Conceptual Framework)
Purpose Principles
Interpret financial statements in the context of Should supplement and complement the
the entity’s operating environment financial statements
Assess what management views as the most Should be from the management’s perspective
important issues
Should have an orientation towards the future
Assess the strategies adopted by the entity Should be
and their likelihood of success
– Understandable
– Relevant
– Balanced
– Comparable over time

Pressure is mounting for companies to minimise any negative impact on society and the environment from their
actions - ie to take sustainability into account in their actions
Long-term
Multi-stakeholder GRI general standard disclosures
International 1 Strategy and Analysis
2 Organisational Profile
3 Identified Material Aspects and Boundaries
Global Reporting Initiative (GRI) provides 4 Stakeholder engagement
guidelines on optional Sustainability 5 Report Profile
Reporting (mandatory for certain types
6 Governance
of companies in the EU)
7 Ethics and integrity
GRI specific standard disclosures
1 Disclosures on management approach
An increasing number of
companies follow GRI 2 Indicators
guidelines eg Shell, BA


Environmental accounting
Environmental issues are likely to have a growing impact on business in the future due to forthcoming
legislation, consumer pressure and so on.
What is environmental accounting?

Recognising and seeking to mitigate the negative environmental effects of conventional accounting practice
Separately identifying environmentally related costs and revenues within the conventional accounting
systems
Taking active steps to set up initiatives in order to amerliorate existing environmental effects of conventional
accounting practice
Devising new forms of financial and non-financial accounting systems, information systems and control
systems to encourage more environmentally benign management decisions
What is environmental reporting? – continued Impact on financial statements

Developing new forms of performance No disclosure requirements under IFRS relating to
measurement, reporting and appraisal for both environmental issues at present. Some companies
internal and external purposes adopt voluntary disclosures (descriptive and
unquantified) in the following areas.
Identifying, examining and seeking to rectify areas
on which conventional (financial criteria) and Contingent liabilities
environmental criteria are in conflict Exceptional charges
Experimenting with ways in which sustainability Operating and Financial Review comments
may be assessed and incorporated into Profit and capital expenditure forecasts
organisational orthodoxy
IAS 37 Provisions, contingent liabilities and contingent
assets addresses environmental liabilties (including
site restoration costs).

Social Human resource Integrated

responsibility accounting reporting
Should social responsibility come at the expense of profit?
Against For
It’s shareholders’ money Property rights are not the only rights
The business of business is making money; it’s Businesses get government support
for governments to impose the law; raise taxes Externalities – businesses often don't pay the
Society, not business, is the best judge of moral costs they impose on others
priorities and social welfare Businesses are not just economic machines but
It’s patronising to a workforce, whose lives might social institutions
become controlled by the company Shareholders rarely exercise power
Society is not just a market place
Social responsibility is good PR
Social responsibility pre-empts legislation

Basic principle Implications
Employees are assets People are a resource

Competitive advantage is gained by Organisation must protect its
effective use of people investment
Deterioration in attitudes is a cost to
the company
Human asset accounting was developed, later broadened into intellectual assets.


Integrated reporting is concerned with conveying a wider message on organisational performance. It is

fundamentally concerned with reporting the value created by the organisation's resources.
Rise of integrated reporting

Traditional corporate reporting is said to only tell part of the story. Stakeholders are increasingly interested in
understanding how management use the organisation's resources to create value.
Value creation
The International Integrated Reporting Council introduced the Integrated Reporting Framework. The framework defines
resources as 'capitals'.
Capitals are used to assess value creation. The framework classifies capitals as being:
Manufactured
Intellectual Capital Financial
Capital Capital
Integrated
Reporting Capitals
Human Natural
Capital Capital
Social
Capital


Interaction of capitals
An increase in one capital may result in a decrease in another.
Example
Paying for a staff training programme may increase human capital (eg improve
staff skills), but reduce financial capital as the costs of the training programme
will lead to a reduction in the company's financial reserves (eg money).
Integrated reporting does not involve attaching monetary values to every part of an organisation's operations.
Value creation can be measured by the use of qualitative and quantitative performance measures.
Example
Customer satisfaction can be measured by comparing
the number of customers retained year on year.
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4: Dividend policy
Maximisation of
shareholder wealth
Investment Financing
decision decision Dividend decision
Dividend policy should strike a balance

between amount of earnings to
retain and payout as dividends
Examples of dividend policy
Theories of dividend policy
Alternatives to cash dividends

Dividend Theories of Alternatives to

policy dividend policy cash dividends
Sufficient funds available Investors want dividend/capital gains

Law on distributable profits Preferred gearing level
Loan agreements
Dividend policy Other sources of finance
Funds for asset replacement Consistency
How much earnings to retain Avoid large falls/rises
Retain earnings Pay dividends
No payment to finance providers Signal of good prospects

Enables directors to invest without asking for
Ensures share price stability
approval by finance providers
Avoids new share issue and change of control Shareholders want regular income
and issue costs
Constant payout ratio Can create volatile dividend movements

Stable growth Set at a level that signals the company’s growth prospects
Residual policy Only pay a dividend after all attractive projects have been funded
Mature companies Young companies
Page 41 4: Dividend policy


Modigliani and Miller theory of dividend irrelevance

Shareholders are indifferent between dividends and capital gains, and the value of a company is determined
soley by the earning power of its assets and investments.
Traditional view
Price of a share depends on the mix of dividends, given shareholders' required rate of retu
Assumes
No tax
No transaction costs In reality shareholders do seem to care about dividend policy.
All relevant information available

Scrip issue Scrip dividend

is the issue of new shares in proportion to existing is a dividend in the form of new shares.
holdings, reducing equity reserves. It is also known Preserves cash position
as a bonus issue. May enhance borrowing capacity
Share re-purchase (share buyback)

Share re-purchase can be from distributable profits or new issue proceeds. A private company can purchase its
own shares out of capital.
Benefits Disadvantages
Use for surplus cash Determination of purchase price
Increase in earnings per share No better use of funds
Increase in gearing Tax disadvantage for shareholders
Prevention of takeover
Page 43 4: Dividend policy
Notes
5: Long-term debt finance
Maximisation of
shareholder wealth
Debt finance
Choice of debt finance
Short-term finance Cost of debt

Long-term debt
finance
Issued through private

Issued through
placement to institutional
capital markets
investors
Bonds
Procedures for Choice of debt Short and Long-term Convertibles and

issuing debt finance finance medium-term finance debt finance warrants
Capital markets
are markets for trading in long-term financial instruments, equities and
bonds. They enable organisations to raise new finance and investors to
realise investments. Principal UK markets are the Stock Exchange and
Alternative Investment Market.
Private placement
Placing means arranging for most of an issue of securities to be bought
by a small number of institutional investors. It is cheaper than issuing
securities through capital markets.

Choice of debt finance affected by:
Availability
Credit rating
Amount
Duration
Fixed or floating rate
Security and covenants
Page 47 5: Long-term debt finance


Term loans Mezzanine finance
Easy and quick to negotiate and arrange Unsecured loans

Flexible repayment schedules Rank after secured debt but ahead of equity in
a liquidation
Useful for small entities
Bridging finance eg in management buyout
Bank won’t withdraw at short notice (unlike
overdraft) Higher risk than bank loan so higher rate of
interest
Creditworthiness Commercial Paper

Purpose Unsecured corporate debt
Amount Maturity up to 270 days
Repayment Higher risk → higher reward Only issued to large organisations with good
Time period credit ratings
Security Another commercial paper issue can be issued
when one matures

Bonds Redemption
have a nominal value, the debt owed by the is the repayment of bonds.
company, and interest is paid on this amount.
Value of redeemable debt =
(Interest earnings × Annuity factor) +
Deep discount bonds (Redemption value × DCF factor)
are issued at a large discount to the nominal value.

Value of irredeemable debt (with tax)
Zero coupon bonds P0 = ______
i (1 – t)
kdnet
are issued at a discount, with no interest paid on
them.
i (1 – t) is annual interest after tax
kdnet is after tax cost of debt


Yield to maturity
is the effective yield on a redeemable bond and is effectively the IRR of the cash flows (redemption yield).
Advantages of debt Disadvantages of debt
Interest tax-deductible Interest must be paid each year
Can offer security Funds required for redemption or repayment
Rank above shares in liquidation Increased financial risk for ordinary

shareholders
Issue costs lower than for shares
Shareholders may demand higher return
No change in control
Articles or covenants may restrict borrowing
Lenders don’t participate in profits

Convertibles
are a hybrid of debt and equity. They can be converted to ordinary shares at some future date.
Conversion value = Conversion ratio x market price per ordinary share
Conversion premium = Current market value – current conversion value
Advantages of convertibles Disadvantages of convertibles
Sweetener for debt Issuer loses out if market price of shares is

above conversion price
Lower interest than straight debt
Debt may have to be repaid
Conversion rights substitute for other lender
Borrowers reluctant to invest due to lower yield
conditions
Shareholders may demand higher return
Issue costs not required on conversion
No extra funds if conversion takes place


Warrants
are rights given by a company to an investor allowing him to subscribe for new shares at a future date at a
fixed, pre-determined exercise price.
Advantages of warrants Disadvantages of warrants
Sweetener for debt When exercised they will result in diluted

share capital
Do not themselves involve payment of interest
or dividends May be exercised when no need for new
capital
Lower interest than straight debt
Company has less control over exercise of
Can generate additional equity funds in the warrants than share capital
future
International Small and Cost of capital Cost of debt

debt finance medium-sized entities
Euromarkets
are markets in Eurocurrencies and Eurobonds (International bonds). Eurocurrencies are deposits with banks
outside of the country of origin of the funds. Eurobonds are bonds sold outside of the country in whose
currency the bond is denominated.
Unsecured, no Unregulated markets Cheap debt finance that

covenants. organised by can be traded and wide pool
merchant banks. of investors share risk.
Used by large companies with Popular source of

excellent credit ratings to finance used to manage
borrow in any foreign currency. foreign currency risk.


Small and medium-sized entities (SMEs) Funding gap

High failure rate so hard to raise
have three main characteristics: external finance
Unquoted Few shareholders so hard to
Ownership restricted to a few individuals raise internal finance
Not micro-businesses that exist to employ Maturity gap
just owner
Hard to obtain medium
Financing problems term loans due to
mismatching of
maturity of assets and
liabilities.
Inadequate security
making banks reluctant to lend.

The cost of capital

is the rate of return that the enterprise must pay to satisfy the providers of funds and it reflects the riskiness
of providing funds.
Risk free rate of return Return required from a completely risk free
+ investment eg yield on government securities
Premium for business risk Increase in required rate of return due to uncertainty
about future and business prospects
+
Premium for financial risk Danger of high debt levels, variability of equity returns
COST OF CAPITAL


After tax cost of irredeemable debt capital Cost of redeemable debt

kdnet = ______
i (1– t) Year Cash flow DFa PVa DFb PVb
P0
0 Market value 1 (X) 1 (X)
where kdnet is the after-tax cost of the debt capital 1 – n Interest less tax X X X X
i is the annual interest payment n Redemption valueX X X X
P0 is the current market price of the debt Kd = a + NPVa (b – a)
capital ex-interest NPVa – NPVb
t is the rate of tax
6: Managing the debt profile
Maximisation of
shareholder wealth
Managing the
debt profile
Refinancing risk Interest rate risk Currency risk
Mitigated through use of Mitigated through use of

Mitigated by spreading debts derivatives eg interest rate derivatives eg currency
to mature at different times options, futures and swaps options,futures and swaps
Managing the Managing Managing

debt profile interest rate risk currency risk
Currency risk
is the risk of higher costs from
adverse exchange rate movements.
Refinancing risk Interest rate risk

is the risk of being unable to Risks of debt is the risk of higher costs from
refinance or repay existing debts -
mitigated by spreading debts to
finance include increases in interest rates.
mature at different times.


Internal methods
Matching Smoothing
is where assets and liabilities with a common is where a company keeps a balance between its
interest rate are matched. Used by banks. fixed rate and floating rate borrowing.
External methods
1 Forward rate agreements
hedge interest rate risk by fixing the rate on the future borrowing.
Page 59 6: Managing the debt profile


2 Interest rate futures 4 Interest rate option

Hedge against interest rate movements. The terms, Grants the buyer the right to deal at an agreed interest
amounts and periods are standardised. rate at a future maturity date.
If a company needs to hedge borrowing, purchase
The futures prices will vary with changes in put options.
interest rates
If a company needs to hedge lending, purchase call
Outlay to buy futures is less than buying the options.
financial instrument Interest rate cap sets an interest rate ceiling.
Interest rate floor sets lower limit to interest rates.
3 Interest rate swaps Which instruments to use?

Consider:
are agreements where parties exchange interest Cost
rate commitments. Flexibility
Expectations
Ability to benefit from favourable interest rate movements
Interest rate swaps Uses of interest rate swaps
are agreements where parties exchange interest Switching from paying one type of interest to another
commitments. In simplest form, two parties swap Raising less expensive loans
interest with different characteristics. Each party Securing better deposit rates
borrows in market in which it has comparative Managing interest rate risk
advantage. Avoiding charges for loan termination
Example Complications
Company A Company B
Interest paid on loan (9%) (LIBOR + 1%) Bank commission costs
A pays to B (LIBOR + 1%) LIBOR + 1% One company having better
B pays to A 9%
__________ 9%
_________ credit rating in both relevant
LIBOR +
__________ 1% (9%)
_________ markets – should borrow in
Companies may decide to use a swap rather than terminating their comparative advantage
original loans, because costs of termination and taking out a new loan market but must want
may be too high. If LIBOR is at 8%, neither party will gain nor lose. Any interest in other market
rate other than 8% will result in gain/loss.


Spot rate Remember!

is the exchange rate currently offered on a particular currency.
Company sells base currency LOW
Forward rate buys base currency HIGH
is an exchange rate set for currencies to be exchanged at a For example, if UK company is buying and selling
specified future date. pounds, selling (offer) price may be 1.45 $/£,
buying (bid) price may be 1.47 $/£.
Economic risk
is the risk that the present value of a company’s future
cash flows might be reduced by adverse exchange rate
Translation exposure
movements.
is the risk that the organisation will make
Transaction risk exchange losses when the accounting results of
its foreign branches or subsidiaries are translated
is the risk of adverse exchange rate movements between into the home currency.
the date the price is agreed and the date cash is
received/paid, arising during normal international trade.
Internal methods include: Matching

Creating $ costs
Currency of invoice Leading

Invoice foreign $ Revenue Accelerating
customers in their receipts/payments
currency
Netting Lagging
Against $ costs from Delaying
other divisions payments/receipts


Forward exchange contract
A firm and binding contract between a bank and its customer

For the purchase/sale of a specified quantity of a stated foreign currency
At a rate fixed at the time the contract is made
For performance at a future time agreed when contract is made
Currency futures
are standardised contracts for the sale or purchase at a set future date of a set quantity of currency.
Currency options
are the right to buy (call) or sell (put) a foreign currency at a specific exchange rate at a future date.
Advantages Disadvantages
Simple Fixed date agreements

Available for many currencies Rate quoted may be unattractive
Normally available for more than a year ahead Only available in large contract sizes
Flexible dates ie a September futures can be Deposit needs to be topped up on a daily basis if
used on any day up to the end of September the contract is incurring losses
Flexible dates (like a future) Only available in large contract sizes
Allow a company to take advantage of favourable Expensive
movements in exchange rates. Options are the
only form of hedging that does this
Useful for uncertain transactions, can be sold if
needed


Currency swaps Risks of swaps
In a currency (or ‘cross-currency’) swap,

Credit risk
equivalent amounts of currency and interest cash
(Counterparty defaults)
flows are swapped for a period. However the original
borrower remains liable to the lender (counter party Position or market risk
risk). A cross-currency swap is an interest rate swap (Unfavourable market movements)
with cash flows in different currencies.
Sovereign risk
(Political disturbances in other countries)
Advantages of currency swaps
Flexibility – any size and reversible Spread risk
Can gain access to debt in other currencies (For banks which combine swap and hedge)
Restructuring currency base of liabilities Transparency risk
Conversion of fixed to/from floating rate debt (Accounts are misleading)
Absorbing excess liquidity
Cheaper borrowing
Obtaining funds blocked by exchange controls
Example
Edward Ltd wishes to borrow US dollars to Gordon borrows US $ and Edward borrows £.
finance an investment in the USA. Edward’s
1
The two companies then swap funds at the
treasurer is concerned about the high current spot rate.
interest rates the company faces because it
is not well-known in the USA. Edward Ltd 2 Edward pays Gordon the annual interest cost on
the $ loan. Gordon pays Edward the annual
should make an arrangement with an
interest cost on the £ loan.
American company, Gordon Inc, attempting
to borrow sterling in the UK money 3 At the end of the period, the two companies
markets. swap back the principal amounts at the spot
rates/predetermined rates.

Notes
7: Leasing
Maximisation of
shareholder wealth
The lease or buy decision

for an asset involves a
Leasing
financing decision which
interacts with the investment
decision to buy the asset
Common source of finance
Operating lease
Finance lease
Sale and leaseback
Lease or buy decision

Leasing as a Lease or buy

source of finance decisions
Leasing
is a commonly used source of debt finance. It is a contract between the lessor and lessee for hire of a
specific asset.
Can be compared with other forms of debt Lessor receives Lessee has possession and
finance (ie borrowing to purchase asset) lease payments and ownership of asset on payment of
using DCF techniques. owns the asset. specified rentals over a period.
Expected life of an asset
Start End
Operating lease – short-term rental Finance lease – long-term rental

Operating leases Finance leases
Lessor bears most of risk and rewards Lessee bears most of risks and rewards
Lessor responsible for servicing and Lessee responsible for servicing and
maintenance maintenance
Period of lease short, less than useful economic Primary period of lease for asset’s useful
life of asset economic life, secondary (low-rent) period
Asset not shown on lessee’s statement of afterwards
financial poition Asset shown on lessee’s statement of financial
position
Advantages of leasing Sale and leaseback

Supplier paid in full is when a business agrees to sell one
Lessor receives (taxable) income and tax depreciation of its assets to a financial institution and
Help lessee’s cash flow leases it back.
Cheaper than bank loan?
Page 71 7: Leasing
Leasing as a Lease or buy

source of finance decisions
Steps in lease or buy decision for tax-paying organisation

1 Calculate the costs of leasing (lease payments, lost capital allowances, lost scrap revenue)
2 Calculate the benefits of leasing (saved outlay on purchase, tax on lease payments)
3 Discount at the post-tax cost of debt
4 Calculate the NPV (if positive, lease is cheaper than post-tax cost of loan)
An alternative method is to evaluate the NPV of the cost of the loan and the NPV of the lease separately and
choose the cheapest option.
The position of the lessor
The cashflows will be mirror images of the lessee’s position. The lessor will receive capital allowances and
pay tax on lease payments.
8: Equity finance
Maximisation of
shareholder wealth
Equity finance
· Issued through capital

Cost of equity
markets
· Companies need to obtain
a stock market listing
(floatation)
· Methods of floatation
Capital Asset Pricing Model

Dividend valuation model
(CAPM)
New issues of shares Rights issues
Theoretical ex-rights
price (TERP)
Yield adjusted
ex-rights price
Capital markets Rights issues Share prices Dividend valuation CAPM

model
Obtain
Long-term Capital Primary markets → raise new finance
listing
finance markets Secondary markets → buy and sell shares on stock
(flotation) market
Why seek a stock market listing?
Disadvantages of obtaining
listing
Access to wider pool of equity finance
Loss of control Higher public profile
Vulnerability to takeover
Higher investor confidence due to greater scrutiny
More scrutiny
Greater restrictions on directors Allows owners to realise some of their investment
Compliance costs Allows use of share issues for incentive schemes
Pressure for short-term profits and takeovers
Initial public offer (IPO) Placing

The company sells shares to the public at large. Offer Placing means arranging for most of an issue to be
for sale by tender means allotting shares at the bought by a small number of institutional investors. It
highest price they will be taken up. is cheaper than an offer for sale.
Costs of share issues Pricing share issues
Underwriting costs Price of similar companies

Stock Exchange listing fees Current market conditions
Issuing house, solicitors, auditors, public Future trading prospects
relation fees Premium on launch
Printing and distribution costs Price growth after launch
Advertising Higher price means fewer shares and less
earnings dilution
Page 75 8: Equity finance


model
Venture capital Private equity

is risk capital normally provided in return for an raise funds from investors and use the money to
equity stake. buy companies which are then run privately.
Very high growth Very significant

potential amounts
Exit strategy is sale or flotation 3 to 5 years later.
Very high returns
Preference shares
carry a fixed rate of dividends but they will not be paid if no profits. Not tax-deductible unlike debt interest.

model
Rights issue Offer price will be Advantages of rights issue

lower than current
is an offer to existing shareholders market price
enabling them to buy new shares.
Lower issue costs than offer for sale
Shareholders acquire shares at
discount
Relative voting rights unaffected
Value of rights
Theoretical ex-rights price – issue price
N
Theoretical ex-rights price (TERP) example

4 shares @ $2.00 8.00 9.50
TERP = = $1.90
1_ share @ $1.50 1.50
____ 5
5__ 9.50
____
____


model
Fundamental theory of share values Chartists

states that the value of a share will be the present attempt to predict share prices by assuming that
value of future expected dividends, discounted at past price patterns will be repeated.
shareholders’ cost of capital.
In practice share prices are affected by day to day

fluctuations reflecting:
Random walk theory
Supply and demand in particular period is consistent with fundamental theory, based on
Investor confidence the idea of intrinsic value which alters as new
Market interest rate movements information becomes available.
Capital markets Rights issues Share prices Dividend CAPM

valuation model
Cost of equity if constant dividends paid Estimating growth rate

d Exam formula Use formula (Gordon’s growth model):
ke =
P0
g = bR
where P0 is price at time 0
d is dividend where R is yield on new investments (ARR is often used)
k e is cost of equity or preference capital b is proportion of earnings retained
Or historic growth:
Dividend growth model
g = n dividend in year x –1
d0 (1 + g) d1
ke = +g= +g dividend in year x – n
P0 P0
where n is the number of years’ growth
where d0 is dividend at time 0 year x is the final year’s dividend
d1 is dividend at time 1
g is dividend growth rate

Capital markets Rights issues Share prices Dividend CAPM

valuation model
Non-constant growth
Adaptation of dividend model with more than one growth rate
Phase 1 (e.g. next 2 years) Phase 2 (e.g. next 3 onwards)

growth is forcast at an unusually high growth returns to a constant rate
(or low) rate
Use an NPV approach to calculate the PV Use the formula to assess the NPV of the constant growth phase,
of the dividends for the finite time period however the time periods need to be adapted e.g.
d1 d3
P0 = is adapted to P1 =
Ke − g K3 − g
Then the value given by the formula needs to be discounted back

to a present value (here using a T2 discount rate).

model
The capital asset pricing model (CAPM)

can be used to calculate the cost of equity and incorporate risk.
Beta factor (ββ)
Unsystematic risk Systematic risk measures the systematic risk of
a security relative to the market.
Specific to the Due to variations in It is the average fall in the return
company market activity on a share each time there is a
Can be reduced or Cannot be 1% fall in the stock market as a
eliminated by diversified away whole.
diversification
Increasing risk
Beta < 1.0 Beta = 1.0 Beta > 1.0
Share < average risk Share = average risk Share > average risk
Ke < average Ke = average Ke > average


model
The CAPM formula Problems with CAPM
ke = Rf + (Rm – Rf) β
Assumptions unrealistic?
where ke(ri) is cost of equity capital/expected equity Zero insolvency costs

return Investment market efficient
Rf is risk-free rate of return
Investors hold well-diversified portfolios’
Rm is return from market
β is beta factor of security Perfect capital market
Required estimates difficult to make
Market risk premium Excess return
Risk-free rate (govt. securities’ rates vary with
is the extra return required from a share to
lending terms)
compensate for its risk compared with average
market risk. β factors difficult to calculate
9: Capital structure
Maximisation of
shareholder wealth
Capital structure
decision
Tax savings
Financial risk and financial
distress costs
Thin capitalisation
Capital structure theories

The capital Effect on ratios Weighted average Theories of Project specific Thin
structure decision cost of capital capital structure cost of capital capitalisation
Capital structure
Refers to the way in which an organisation is financed.
Advantages of debt finance Disadvantages of debt finance
Cheaper than equity as interest is tax Interest has to be paid no matter what profit is
deductible made
More attractive to investors as secured Direct financial distress costs eg cost of
against assets liquidation
Indirect financial distress costs eg loss of sales
Issue costs are lower than shares
Agency costs ie managers reluctant to invest if
Acts as discipline on management as careful gearing already high
control of working capital needed
Need money for debt redemption
No immediate dilution in EPS or DPS Increased financial risks for shareholders who
No immediate change in structure of control may want higher returns
Financial risk Shareholders’ investment
Gearing ratio Interest cover EPS Dividend yield

P/E Dividend
cover
Prior charge capital MPS

Profit before interest and tax DPS
Equity (including EPS
Interest payable MPS
reserves) EPS
Earnings after tax DPS
Number of ord. shares
Page 85 9: Capital structure

WACC = ke
[ ]
V +V
E
V
E
D
+ kd (1 – t)
[ ]
V +V
E
V
D
ke is cost of equity VE is market value of equity

kd is cost of debt VD is market value of debt
Use market values rather than book values unless market values unavailable (unquoted company)
Assumptions of WACC Problems with WACC
Project small relative to company and has New investments may have different business
same business risk as company risk
WACC reflects company’s long-term future New finance may change capital structure and
capital structure and costs perceived financial risk
New investments financed by new funds Cost of floating rate capital not easy to
Cost of capital reflects marginal cost calculate
Level of gearing
Low High
Young company Mature company

Volatile cash flows Stable cash flow
Tax benefits < financial distress costs Tax benefits > financial distress costs
Is there an optimal capital structure?
Traditional theory Modigliani and Miller
There is an optimal capital mix at which the weighted The weighted average cost of capital is
average cost of capital is minimised. Shareholders not influenced by changes in capital
demand increased returns to compensate for greater structure. The benefits of issuing debt are
risk as gearing rises. At high gearing debtholders also counterbalanced by the increased cost of
require higher returns. equity.

Traditional theory
ke
Cost of
capital ke is the cost of equity in the
geared company
WACC
kd is the cost of debt
kd WACC is the weighted average cost

of capital
Po is the optimal capital structure

where WACC is lowest
0 Po Level of gearing
Assumptions
All earnings paid out as dividends
Earnings and business risk constant
No issue costs
Tax ignored
M&M – ignoring taxation M&M – with corporate taxation
Cost of Cost of
capital capital
Ke Ke
WACC
WACC
Kd Kd
Gearing Gearing

M & M formulae
The value of a geared company is equal to the value of an equivalent ungeared company plus the
value of the tax shield.
Vg = Vu + TB
The cost of equity will increase when the relative value of debt compared to equity increases.
Vd
Keg = Keu + (Keu – Kd) (1 – T)
Ve
WACC is reduced when gearing increases.

Kadj = Keu (1 – tL)
The lower a company’s WACC, the higher the NPV of its future cash flows and the higher its market
value.
Cost of capital
Calculate using
WACC Marginal cost of capital (using CAPM)
Projects must be small relative to company Project has a different business risk
Same financial risk from existing capital Finance used to fund investment changes capital
structure structure
Project has same business risk as company Use geared betas

Calculating a marginal cost of capital

1 Find a company’s beta in the new business area and strip out the impact of their debt levels from the beta
VE VD (1− t)
βu = β g + βd
VE + VD (1− t) VE + VD (1− t)
2 Regear the beta for your company’s debt
VD (1 − t)
β g = βu + (βu − β d )
VE
3 Use this project-specific geared beta and CAPM to calculate an appropriate cost of capital
Thin capitalisation
Describes companies with a significantly higher proportion

of debt finance to equity finance
Occurs in many group companies - easier to obtain debt
finance from other group companies than third party lenders
Used for tax avoidance - interest payments on debt finance
can be deducted from taxable profits in most countries
Certain tax authorities have anti-avoidance legislation that
places limits on the amount of interest that can be tax
deductible

Notes
10: Strategic implications of acquisitions
Maximisation of
shareholder wealth
Strategic implications
of acquisitions
Mergers and takeovers
Resistance by the
Synergies Tax issues
target company
Regulation:
Competition
authorities
Regulation:
City Code
Impact of mergers
and takeovers
on stakeholders
Mergers and Taxation Regulation

takeovers
Operating Acquisition of Asset Earnings

economies management Diversification backing quality
Reasons for mergers and acquisitions
Finance/ Cheaper Tax Defensive Strategic

liquidity growth merger opportunities
Factors in a takeover decision
Cost of acquisition? Form of purchase consideration?

Reaction of predator’s shareholders? Accounting implications?
Reaction of target’s shareholders? Future policy (eg dividends, staff)?
TAKEOVER STRATEGY ACQUIRE

Growth prospects limited Younger company with higher growth rate
Potential to sell other products to existing Company with complementary product range
customers
Operating at maximum capacity Company making similar products operating below capacity
Under-utilising management Company needing better management
Greater control over supplies or customers Company giving access to customer/supplier
Lacking key clients in targeted sector Company with right customer profile
Improve statement of financial position Company enhancing EPS
Increase market share Important competitor
Widen capability Key talents and/or technology
Page 97 10: Strategic implications of acquisitions


takeovers
Approval of predator’s shareholders Resistance by target company

Approval may be required under Stock Exchange Unwillingness to sell
rules, or because market price of shares will fall if Cash offer not satisfactory
shareholders are unhappy with the value of the Shares offered in exchange being unattractive
takeover. No post-acquisition advantages
Opposition of employees
Possible objections Defensive tactics
Reduction in EPS Persuading shareholders offer is poor

Target in risky industry Advertising campaign
Target facing liquidation White knight/poison-pill
Reduction in overall net asset backing Counterbid for predator
Management buy-out
Synergy
Revenue synergy exists when the acquisition will Sources of financial synergy
result in higher revenues, higher return on equity or
a longer period of growth for the acquiring company.
Diversification Tax benefits
Revenue synergies arise from: Use of cash slack Debt capacity
(a) Increased market power
(b) Marketing synergies
(c) Strategic synergies
Cost synergy results from economies of scale. As

scale increases, marginal cost falls and this will be
manifested in greater operating margins for the
combined entity.


takeovers
Taxation impact on mergers and acquisitions
Some countries allow past losses of acquired subsidiary to be

offset against present profits of parent company, but some eg
UK prevent this
Cross border acquisitions
– Local taxes such as withholding taxes on interest, dividends
and royalties need to be taken into account – impact is
reduced if double taxation agreement (DTA) is in place
– Companies can exploit differing tax rules and tax rates by
merging with an overseas company and re-incorporating in
a low tax regime

takeovers
City Code Competition authorities

is a UK code which companies are expected to may act against mergers not felt to be in the
follow during a takeover or merger. Administered public interest, by rejecting them outright or
by UK’s Takeover Panel. An example of good laying down conditions.
practice.
General principles
All offeree's shareholders treated similarly

Shareholders given sufficient time and information to make decision
Board of offeree company must not deny shareholders opportunity to decide on merits of the bid
False markets must not be created
Offeror must only announce bid after ensuring they can fulfil consideration of bid
Offeree company must not be hindered in conduct of its affairs

Notes
11: Introduction to valuation techniques
Maximisation of
shareholder wealth
Valuation techniques
Discounted
Dividend
Net assets future Earnings
valuation
valuation cash flows valuations
model
valuation
Valuation of
Shareholder
intangible assets
value
and intellectual
analysis
capital
Asset Earnings Dividend Cash flow Efficient market Intellectual

valuation valuation valuation valuation hypothesis capital
Net assets valuation method Uses
Net tangible assets As measure of security in a share valuation

Value of shares =
No of shares
As measure of comparison in scheme of
merger
Possible bases of valuation As floor value in business that is up for sale
Problems
Historic Replacement Realisable Need for professional valuation

basis basis basis Realisation of assets
(unlikely to (asset used (asset sold/ Contingent liabilities
be realistic) on on-going business Market for assets
basis) broken up)

Price-earnings ratio Have to decide suitable P/E ratio.

Factors to consider:
Market value Industry Asset backing and liquidity
P/E ratio =
EPS Status Nature of assets
Market value = EPS × P/E ratio Marketability Gearing
Shareholders
Shows the
current profitability
Shows the market’s view of Earnings yield valuation model
the growth prospects/risk of
of the company a company
EPS
Earnings yield = × 100%
May be affected by Which P/E ratio to use? market price per share
one-off transactions Adjust downwards if Earnings
valuing an unquoted Market value =
company Earnings yield
Page 105 11: Introduction to valuation techniques


Dividend valuation model Assumptions
d0 (1+ g) Dividends from new projects of same risk type

P0 =
(k e – g) as existing operations
No increase in cost of capital
Where P0 is price at time 0 Perfect information
d0 is dividend (paid now) Shareholders have same marginal capital cost
ke is cost of equity Ignore tax and issue expenses
g is dividend growth rate
Problems
d1
P0 =
(k e – g) Companies that don’t pay dividends don’t have
zero values
d1 is dividend in one year’s time Need enough profitable projects to maintain
[= d0 (1 + g)] dividends
Generally more relevant for small shareholders. Dividend policy likely to change on takeover

Discounted cash flows method Shareholder value analysis

Value investment using expected after-tax cash Analysis focuses on key decisions affecting value
flows of investment and appropriate cost of capital. and risk. Decisions depend on value drivers (eg
profit margin, working capital, required return).
Free cash flow
Value of company is sum of future free cash flows.
Problems
= Revenues
– Operating costs Difficult to select appropriate cost of capital
+ Depreciation
– Debt repayments and lease obligations Unreliable estimates of future cash flows
– Working capital increases
Not best method for minority interests who lack
– Taxes
influence on cash flows
– Replacement capital expenditure


Summary of valuation techniques

Maximum value (under new management)
NPV/SVA
– includes expected synergies
– discount free cash flows at target’s WACC
P/E method
– adjust P/E
– P/E × EPS
Fair value (under existing management)
Dividend valuation – use target’s growth rate
Minimum value
Assets basis

The efficient market hypothesis (EMH) Weak-form efficiency suggests prices reflect all
relevant information about past price movements
is the theory that the stock market reacts and their implications.
immediately to all the information that is available.
Semi strong-form efficiency suggests prices are
also influenced by publicly available knowledge.
Strong-form efficiency suggests prices are also

Features influenced by inside information.
Prices reflect all relevant Implications

information
No individual dominates The share price of a company is the best basis for a takeover bid
market A company should concentrate on maximising NPV of investments
Transaction costs insignificant There is no point in attempting to mislead the market


Intellectual capital is knowledge that can be used to create value.
Human resources Intellectual assets Intellectual property

Skills Drawing Legally protected assets
Experience Computer program Patents
Knowledge Data collection Copyrights
Market-to-book values Calculated intangible value

Value of firm’s intellectual capital Calculates market value of intangible assets on
= Market value of firm – tangible assets book value the basis of company’s return on tangible assets
over industry’s average return on tangible assets.
Tobin’s q
Market capitalisation (share price × no of shares) : Replacement cost of assets
Calculated intangible values

1 Calculate average pre-tax earnings and average year end tangible asset values over the time period.
2 Divide earnings by average assets to get the return on assets.
Multiply the industry average return on asset % by the entity’s average tangible assets value. Subtract
3 this from entity’s pre-tax earnings to calculate excess return.
4 Subtract tax from excess return to give after-tax premium attributable to intangible assets.
5 Calculate NPV of premium by dividing by entity’s cost of capital.
The reliability of the various methods used to value shares may be affected by the level of market efficiency.
In a semi-strong market, the share price is the best basis for a takeover bid. Only pay more for synergies.

Notes
12: Advanced valuation techniques
Maximisation of
shareholder wealth
Valuation techniques
Valuation issues
Valuation of unquoted
Choice of discount rate
companies
Valuation Choice of Valuation of

issues discount rate unquoted companies
Overseas aquisitions
Cash flows of overseas target need to be adjusted
to account for:
forecasted changes in currency
local taxes, eg withholding tax (reduced if
double taxation agreement (DTA) in place)
Grants Sensitivity analysis

Value of assets or earnings may Valuation Need to examine sensitivity of
need to be adjusted for the affect of
government grants.
Issues changes of assumptions that would
cause NPV to fall to zero.

Cost of equity Weighted average cost of capital
Suitable to use as a discount rate for post-tax and Suitable to use as a discount rate for post-tax but
post-interest cash flows to obtain value of equity pre-interest cash flows since these represent
Capital asset pricing model earnings available to all providers of finance
Dividend valuation model Value of equity determined by subtracting value of
debt
Risk-adjusted WACC
Cost of capital of comparative company can be used as benchmark

However if comparative company has different systematic risk, project specific or risk adjusted cost of capital
should be used (see Chapter 9)
Risk-adjusted cost of capital method can also be used for specific division of a company with different
systematic risk
Page 115 12: Advanced valuation techniques


Valuing unquoted companies

1 Find the beta of a similar quoted company
and ungear the beta
VE
βu = βg
VE + VD (1 – t)
2 Regear using unquoted company’s gearing

and calculate ke geared
VD (1 − t)
β g = βu + (βu − β d )
VE
3 Use this ke geared to calculate value of
company using dividend valuation model
d 0 (1 + g)
P0 =
ke – g
13: Post-acquisition issues
Maximisation of
shareholder wealth
Mergers and
acquisitions
Financing – cash or paper bids Exit strategies
Post-merger issues
Valuation pre and

Problems with integration
post acquisition
Payment Valuation of mergers Post-acquisition Exit strategies

methods and takeovers integration
Purchase consideration
Cash Paper
How to obtain the cash is a gearing decision Shares exchanged

Target’s shareholders liable to tax on capital Predator’s share capital increases leading to
gain dilution of EPS and control
Does not dilute control of predator Difficult to assess post merger value and need
shareholders to retain value of shares
A large debt issue will signal takeover and may No need to increase gearing
increase target’s share price
If the takeover is to be by a share exchange, it may fail if predator’s shares fall in value or target’s rise.
Payment methods Valuation of mergers Post-acquisition Exit strategies

and takeovers integration
Effect on EPS Valuation using post-merger flows

If target company’s shares are bought at a higher P/E Use dividends or cash flows of merged company as
ratio than predator’s shares, then predator company’s basis for valuation.
shareholders will suffer a fall in EPS.
Estimate initial dividends of combined company
If target company’s shares are valued at lower P/E + dividend growth rate
ratio, predator company’s shares will benefit from rise
Estimate new cost of capital
in EPS.
Calculate value of combined company
A dilution of earnings on an acquisition may be
accepted in certain circumstances, such as earnings Compare with value of acquiror: excess is
growth, superior quality of target’s earnings, or increase value of target
in asset backing.
A single dividend policy will also be needed, that will
satisfy both sets of shareholders.
Page 119 13: Post-acquisition issues


Drucker’s golden rules

Failure of mergers
(1) Within a year appropriate new Management should be put in place
and takeovers
(2) Add value to target (ie set targets and communicate to customers)
(3) Show Respect to the products, management and track record of target
(4) Develop a Common core of unity (eg take action to ensure systems Poor strategic plan
compatibility)
(5) Develop strategies for Holding onto the key staff (loyalty bonuses) Over-optimism
= MARCH Inflexibility of integration
Jones’ integration sequence methods
Poor man management
Step 1. Communicate initial reporting relationships
Step 2. Achieve rapid control of key factors Cultural differences
Step 3. Resource audit Lack of knowledge of target
Step 4. Re-define corporate objectives Poor management in target
Step 5. Revise organisational structure

A divestment is disposal of part of its activities by an entity.
Demerger Disadvantages of demergers
is the splitting up of a corporate body into two or Loss of economies of scale

more separate bodies, to ensure share prices Ability to raise extra finance reduced
reflect the true value of underlying operations. Vulnerability to takeover increased
Reasons for sell-offs

Sell-off
is the sale of part of a company to a third party, Strategic restructuring
generally for cash. Sell off loss-making part
Protect rest of business from takeover
Cash shortage
Reduction of business risk
Sale at profit
Page 121 13: Post-acquisition issues


Management buy-outs (MBOs) Benefits
is the purchase of all or part of a business by its Best offer price available is from MBO
managers. The managers generally need financial
When group has decided to sell subsidiary,
backers (venture capital) who will want an equity stake.
best way of maximising management co-
operation
Problems Sale can be arranged quickly
Selling organisation more likely to retain
Lack of financial experience beneficial links with sold segment
Tax and legal complications Won’t be blocked by competition authorities
Changing work practices May be viewed more positively by employees
Inadequate cash flow
Board representation by finance suppliers
Loss of employees/suppliers/customers
Notes

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Strategic Paper F3 syllabus

CMF3PC15.indd 1 14/07/2014 12:46

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1: Strategic financial objectives

Strategic financial objectives

Strategic financial Stakeholders Not-for-profit

Maximisation of shareholder wealth

Level of gearing Quality measures

Strategic financial Stakeholders Not-for-profit

Stakeholders Share price

Page 3 1: Strategic financial objectives

Strategic financial Stakeholders Not-for-profit

Agency problem Goal congruence

Corporate governance Incentive schemes

Strategic financial Stakeholders Not-for-profit

Not-for-profit organisations (NFPOs)

Value for money Objective setting for NFPOs

Economy – purchase of inputs of appropriate Who are the main stakeholders?

Page 5 1: Strategic financial objectives

2: Strategic financial management

Strategic financial management –

Maximisation of shareholder wealth

Investment decision Financing decision Dividend decision

Affected by taxation and

Short-term finance Financing requirements Long-term finance

Financial management Influences on Taxation and Performance Forecasting

Maximisation of shareholder wealth

Investment decision Financing decision Dividend decision

Identify investment Long-term capital structure Affects views of company’s

The three decisions are integrated

Financial management Influences on Taxation and Performance Forecasting

Lack of funding Need to keep

Business strategy Taxation

Regulatory bodies Economic factors

Entities which trade internationally Political risk

Page 9 2: Strategic financial management

Financial management Influences on Taxation and Performance Forecasting

Competition regulation Corporate governance

Effects of inflation Effects of exchange rate increases

Business and exchange rates

Page 11 2: Strategic financial management

Financial management Influences on Taxation and Performance Forecasting

Reasons why interest rates differ Effects of interest rate increase

1 + nominal rate of interest – 1

Financial management Influences on Taxation and Performance Forecasting

International influences Taxation influences

Page 13 2: Strategic financial management

Financial management Influences on Taxation and Performance Forecasting

Is comparable information available?

Dividends Dividend yield

You must know these by now!

Page 15 2: Strategic financial management

Financial management Influences on Taxation and Performance Forecasting

1 Statement of comprehensive income

Financing Short-term The treasury

Easing cash flow problems Investing surplus cash