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ACCA Paper F9

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Title: ACCA Paper F9


1
ACCA Paper F9 Financial Management
  • Taught Course
  • June 2010 Exams

2
Tutor Contact Details
  • Doug Haste
  • 01794 341515
  • douglashaste_at_bpp.com

3
ACCA Paper F9 Financial Management
  • Day 3 recap

4
Give 4 advantages of debt finance
Advantages of debt finance
Debt is a cheap source of finance
The use of debt is a signal of confidence
The use of debt is a discipline on management
The use of debt avoids dilution of earnings per share
5
Give 4 practical influences on the level of debt
  • Lifecycle
  • Operational gearing
  • Stability of revenue
  • Security

6
How should gearing change over a firms lifecycle?
Low gearing
High gearing
Young company (SME)
Mature company
7
What is this used for what are its drawbacks?
Ke d1 g po
8
What is this used for what do the terms mean?
Risk of this share
E(r) Rf ß (E(Rm) Rf)
Risk free rate
Market premium for risk of holding shares
9
When is this used to calculate the cost of debt?
Kd i po
(1- t)
Formula not given
10
When is this used to calculate the cost of debt?
Time cash flows 0 market value 1-n interest
(post tax) n redemption
IRR approach
11
What do the weightings stand for here?
WACC Ve Ke Vd Kd (1-T)
VeVd VeVd
of total finance that is equity
of total finance that is debt
12
MM theory (with tax)what does this say about
using debt?
Cost of capital
WACC
Gearing
13
What are the key assumptions of MM?
Capital market imperfections
Direct financial distress costs
Indirect financial distress costs
Agency costs
14
How should a firm calculate a marginal cost of
capital?
  • 1. Find a quoted company in that business

2. Adjust their beta to reflect differences in
gearing
3. Use re-geared beta to calculate an appropriate
cost of capital
15
ACCA Paper F9 Financial Management
  • Day 4

16
Syllabus overview
  • Section A - Financial Management function
  • Section B - Financial management environment
  • Section C - Working capital management
  • Section D Investment appraisal techniques
  • Section E Sources of business finance
  • Section F Cost of capital

Section G - Business valuations
17
Chapter 17
  • Business valuations

18
Syllabus Guide Detailed Outcomes
  • Identify and discuss reasons for valuing
    businesses and financial assets.
  • Identify information requirements for valuation
    and discuss the limitations of different types of
    information
  • Apply asset-based valuation models, including net
    book value (balance sheet basis), net realisable
    value basis, and net replacement cost basis.
  • Apply income-based valuation models, including
    price/earnings methods and earnings yield method
  • Apply cash-based valuation models, including
    dividend valuation/growth model and discounted
    cash flow basis.
  • Apply appropriate valuation methods to
    irredeemable debt, redeemable debt, convertible
    debt and preference shares.

19
Exam Context
  • This chapter is the title of a whole section
    (section G) within the syllabus this clearly
    highlights its importance. It has been examined
    in Q1 of the December 2007 exam which required
    the valuation of shares (11 marks) and a
    convertible bond (6 marks), and in June 2008 (Q2)
    for 7 marks. In December 2008, bond valuation was
    tested for 4 marks (Q4b) and share valuation was
    tested for 14 marks (Q1 b,c,d). In June 2009
    (Q1b) share valuation was examined for 6 marks
    and in December 2009 (Q2cii) 3 marks were
    available for the calculation of a share price
    using the dividend growth model. Business
    valuation can be combined with other areas of the
    syllabus such as cost of capital in Q2 December
    2009.

20
Qualification Context
  • The detailed practicalities of financing and
    managing the process of acquiring another company
    are covered in P4 Advanced Financial Management.

21
Business Context
  • Acquisitions are a key investment decision,
    because of the outlay involved eg in 2000
    GlaxoWellcome acquired SmithKline Beecham for
    38,600m . If a business pays too much for a
    target it can seriously harm their shareholders
    wealth. This often happens.

22
Overview business valuations
Maximisation of shareholder wealth
Investment decision
Avoid over-paying for acquisitions
23
Reasons for business valuations
  • In making a bid for another company, it is
    important for the buyer to create a range of
    values within which a buyer would be prepared to
    negotiate. When deciding to float or sell the
    company again the seller must create a range of
    values within which to negotiate.

24
Range of values
Maximum value
  • Earnings / cash flows under new ownership
  • Dividends under existing management
  • Assets basis

Minimum value
25
Assets basis
  • If a business is difficult to sell, its owners
    may be prepared to accept a minimum bid that
    matched the value that they get from a
    liquidation. There are 2 ways of assessing this
  • Balance sheet value - but the book value of
    assets will differ from their market value
  • Realisable value - better, but harder to
    calculate.

26
Lecture example 1
  • Groady plc
  • Required
  • Calculate the balance sheet valuation of
    Bergerbo in m (total value is often called
    market capitalisation).

27
Answer to lecture example 1
  • Asset Value
  • 62.8m debt of 33.1 29.7m
  • but we have no information about the
    industry, the nature of the assets or any
    intangible values.

28
Range of values
Maximum value
  • Assets basis

Minimum value
29
Value per share
Value per share P0
Where d0 dividend paid now Ke cost of
equity of the target g growth rate in
dividends
30
Lecture example 2
  • Groady plc wants to acquire an Italian company,
    Bergerbo SpA, continued.
  • Required
  • Calculate a dividend valuation for Bergerbo,
    assuming
  • no dividend growth
  • 3 pa dividend growth

31
Answer to lecture example 2
  1. P 2/.076 26.3m
  2. P 2.06/0/046 44.8m

32
Disadvantages
  1. It is difficult to estimating future dividend
    growth
  2. It is inaccurate to assume that growth will be
    constant
  3. It creates zero values for zero dividend
    companies.
  4. It creates negative values for high growth
    companies, if g gt Ke

33
Range of values
Maximum value
  • Dividends under existing ownership

Minimum value
34
Range of values
Maximum value
  • Cash flows under new ownership

Minimum value
35
Range of values
Maximum value
  • Earnings under new ownership

Minimum value
36
Earnings basis
Market value P/E x earnings
Current profitability
Growth prospects
37
Lecture example 3
Groady plc wants to acquire an Italian company,
Bergerbo SpA, continued. Bergerbo SpA summarised
income statement for the year ending 31 December
20X3
  • Required
  • Calculate possible total share values for
    Bergerbo, using the P/E method
  • Construct a range of share prices within which
    Groady plc will be prepared to negotiate

38
Answer to lecture example 3a
P/E valuation
Industry average 19.5 x 2.6 50.70m
Bootstrapping 21.2 x 2.6 55.12m The
latter may be the value attached to the earnings
by Groady since both companies are in the same
industry and under the management of Groady,
Bergerbos activities may perform as well as
Groadys.
39
Answer to lecture example 3b
Range of values (normally)
55.12m earnings 44.8 divi valn 44.7 market
price (the strongest indicator of the companys
current value) Min 29.7m assets.
40
Earnings basis - drawbacks
Market value P/E x earnings
One-off transactions?
Which P/E? Adjust downwards ?
41
Earnings yield
Market value earnings / E/P
Same as P/E method
42
Earnings yield
Earnings yield EPS
Market price per share
Market value Earnings Earnings
yield
43
Valuation of other securities
  • Discounted cash flow techniques can be used to
    value irredeemable debt, redeemable debt,
    convertible debt and preference shares.

44
Chapter summary
  • In making a bid for another company, it is
    important for the buyer to create a range of
    values within which a buyer would be prepared to
    negotiate. When deciding to float or sell the
    company again the seller must value the shares
    and create a range of values within which to
    negotiate.

45
Summary
Maximum value
  • Earnings / cash flows under new ownership
  • Dividends under existing ownership
  • Assets basis

Minimum value
46
Chapter 18
  • Market efficiency

47
Syllabus Guide Detailed Outcomes
  • Distinguish between and discuss weak form
    efficiency, semi-strong form efficiency and
    strong form efficiency
  • Discuss practical valuation considerations of
    shares and businesses, including
  • Describe the significance of investor speculation
    and the explanations of investor decisions
    offered by behavioural finance.
  1. marketability and liquidity of shares
  2. availability and sources of information
  3. market imperfections and pricing anomalies
  4. market capitalisation

48
Exam Context
  • This brief chapter is mainly home study, and is
    not likely to form a major part of an exam
    question in December 2007 Q1 it was examined for
    8 marks, and in June 2008 (Q2d) it was examined
    for 5 marks.

49
Qualification Context
  • The detailed practicalities of business
    valuations are also covered in P4 Advanced
    Financial Management.

50
Business Context
  • Inion, a Finnish medical devices company, chose
    to list on the London Stock Exchange rather than
    the Helsinki Stock Exchange because it felt that
    it would be more accurately priced on the London
    market.

51
Overview market efficiency
Maximisation of shareholder wealth
Investment decision
Business valuations guided by stock market
valuation
52
The efficient markets hypothesis
Share price
612p
560p
24 Sept 2007
25 Sept 2007
53
Semi-strong form
Most studies support the view that the London
Stock Exchange is semi-strong form efficient. If
true, then the implications of this are that
  1. the share price of a company is the best basis
    for a takeover bid, a company should only pay
    more than the market price if there are
    synergies.
  2. the directors should take the correct investment
    / financing / risk management decisions make
    this information public (press release, annual
    accounts).

54
Syllabus overview
  • Section A - Financial Management function
  • Section B - Financial management environment
  • Section C - Working capital management
  • Section D Investment appraisal techniques
  • Section E Sources of business finance
  • Section F Cost of capital
  • Section G Business valuations

Section H - Risk management
55
Chapter 19
  • Foreign currency risk

56
Syllabus Guide Detailed Outcomes
  • Describe and discuss different types of foreign
    exchange risk translation risk, transaction
    risk, economic risk.
  • Describe the causes of exchange rate
    fluctuations, including
  1. balance of payments
  2. purchasing power parity theory
  3. interest rate parity theory
  4. four-way equivalence

57
Syllabus Guide Detailed Outcomes contd
  • Forecast exchange rates using purchasing power
    parity theory and interest rate parity theory.
  • Discuss and apply traditional and basic methods
    of foreign currency risk management, including
    currency of invoice, netting and matching,
    leading lagging, forward exchange contracts,
    money market hedging, asset liability
    management
  • Compare and evaluate traditional methods of
    foreign currency risk management
  • Identify the main types of foreign currency
    derivatives used to hedge foreign currency risk
    and explain how they are used in hedging.

58
Exam Context
  • This chapter was tested for 25 marks in the pilot
    paper, for 8 marks in Q4d of the December 2007
    exam, and for 14 marks in December 2008 (Q4c,d).
    It was combined with a calculation of a
    theoretical ex-rights price and ratio
    calculations in Q3 December 2009.

59
Qualification Context
  • Derivatives are a major topic in P4 Advanced
    Financial Management.

60
Business Context
  • In 2005 VW made 1.2 billion of currency losses,
    mainly due to the effect of a weak dollar on the
    value of their revenue.

61
Currency movements in 2008 euro vs
1.41 / Dec 07
-28
1.02 / Dec 08
62
Currency movements in 2008 - vs
2.07 / Dec 07
-28
1.50 / Dec 08
63
Lecture example 1
  • During 2003, the value of the increased by
    20 against the from 1.5/ to 1.8/.
  • Required
  • Calculate the impact of this on a UK exporter due
    to receive 180,000 from a US customer
  • Calculate the impact of this on a UK importer due
    to pay 180,000 to a US supplier

64
Answer to lecture example 1
180,000 / 1.5 120,000 expected 180,000 /
1.8 100,000 received Losses 20,000 UK
exporters lose when the gets stronger
(a)
(b)
180,000 / 1.5 120,000 expected 180,000 /
1.8 100,000 paid Gains 20,000 UK
importers gain when the gets stronger
65
strong
weak
UK importers suffer because the is strong and
their costs are in s
UK exporters suffer because the is weak and
their revenue is in s
66
Terminology
/ 1.9615 /- 0.0003
UK exporter
UK importer
Buys s Pays a high price
Sells s Receives low price
67
Lecture example 2
  • Exchange rates on January 30th 2007 were /
    1.9615 /- 0.0003.
  • Required
  • Calculate the receipts from a 1m sale to a US
    customer
  • Calculate the cost of paying an invoice of 1m.

68
Answer to lecture example 2
  1. 1m / 1.9618 509,736
  2. 1m / 1.9612 509,892

69
Managing transaction riskinternal methods
Matching
Invoice in s
Leading
revenue
Lagging
Netting
70
Terminology
/ 1.9615 /- 0.0003
UK exporter
UK importer
Buys s Pays a high price
Sells s Receives low price
71
Forward contracts
Normally given as 1.9606 /- 0.0006 or
  • Spot rate given 1.9612 1.9618
  • Subtract premium 0.0012 - 0.0006

Forward rates 1.9600 1.9612
72
Lecture example 3
  • Spot exchange rates on January 30th 20X7 are
    / 1.9615 /- 0.0003 and forward rates are
    /1.9605 /- 0.0007.
  • Required
  • Calculate the receipts from a 1m sale to a US
    customer, due to be received in 3 months time if
    forward rates are used.
  • Calculate the cost of paying an invoice of 1m in
    3 months time, if forward rates are used.

73
Answer to lecture example 3
  1. 1m / 1.9612 509,892
  2. 1m / 1.9598 510,256

74
Ad/DisAd
Advantages of forward rates Disadvantages of forward rates
Simple Fixed date agreements
Low or zero up-front costs Rate quoted may be unattractive
Available for many currencies
Normally available for more than a year ahead
75
Money market hedge - exporter
Expect revenue in 3 months time
Borrow in s today
76
Money market hedge 5 steps (exporter)


now
3. Take out loan
4. s today
1. Receive s
3 mths
5. Compare to a forward
2. Repay loan
This determines the size of the loan
77
Money market hedge - importer
Expect costs in 3 months time
deposit today
78
Money market hedge 5 steps (importer)


now
3. deposit
4. Withdraw s
1. Pay s
3 mths
5. Compare to a forward
2. Using on deposit
Determines the size of the deposit today
79
Derivatives futures
3 months
Now
  • Receive s
  • use spot rate

2. Contract to buy - futures market
4. Compensation if ex rate moves against you
3. Pay a deposit
Standard contract sizes
4. Or losses if ex rate moves in your
favour
5. Fixed outcome
80
Lecture example 4
  • Three month interest rates on January 30th 20X7
    are as follows

Required Calculate the receipts from a 1m sale
to a US customer, due to be received in 3 months
time if money market hedging is used compare to
a forward contract (example 3a).
81
Answer to lecture example 4
82
Lecture example 5
  • Three month interest rates on January 30th 20X7
    are as follows

Required Calculate the cost of an invoice for
1m payable in 3 months time if money market
hedging is used compare to the result from a
forward contract (lecture example 3b).
83
Answer to lecture example 5
84
Ad/DisAd
  • Advantages of money market hedging
  • Disadvantages

May be cheaper if an exporter with a cash flow
deficit or an importer with a cash flow surplus
More time consuming than a forward contract and
normally no cheaper
85
Lecture example 6
  • Fidden is a medium sized European company with
    export and import trade with the USA. The
    following transactions are due within the next
    six months
  • Required
  • Calculate the net receipts and payments in euros
    that Fidden might expect for both its three and
    six month transactions if the company hedges
    foreign exchange risk on
  • the forward foreign exchange market
  • the money market.

86
Answer to lecture example 6
(a)
(b) Money market hedge
87
Derivatives options
3 months
Now
  • Receive s

2. Contract to buy - call option
4. Use if ex rate moves against you
3. Pay a premium
4. Or use spot rate if it moves in your
favour
5. Worst case known
88
Ad/DisAd
  • Advantages of futures
  • Disadvantages of futures

Flexible dates ie a September futures can be used
on any day up to the end of September
Only available in large contract sizes
Deposit needs to be topped up on a daily basis if
the contract is incurring losses
89
Big Mac Index Purchasing Power Parity
Do exchange rates even out the prices of Big Mac
meals worldwide?
90
Forecasting exchange rate movements
  • Balance of payments
  • Inflation
  • Interest rates

91
Lecture example 7
  • The / exchange rate in January 2007 was 1.5
    inflation in Europe was 2.1 and 2.7 in the UK
  • Required
  • Forecast the / exchange rate for the next 3
    years and comment on the implications.

92
Answer to lecture example 7
(a)
Spot 1.5 X 1.021/1.027 1.49 in 1 year 1.49 X
1.021/1.027 1.48 in 2 years 1.48 X 1.021/1.027
1.47 in 3 years
(b)
Europe may become an easier place to export to
a more expensive to buy imports from.
93
Lecture example 8
The / exchange rate in January 2007 was 0.6667
inflation in Europe was 2.1 and 2.7 in the UK.
A company is considering taking out a 1 year 10m
bank loan in euros at 6 or in at 6.6
Required Advise the company whether to take
advantage of lower interest rates in Europe.
94
Answer to lecture example 8
UK loan costs 10m x 1.066 to repay 10.66m
Euro loan of 10m / 0.6667 15m x 1.06
15.9m x 0.6705 forward rate (see below)
10.66m Forward in 1 year 0.666 x 1.066/1.06
(note euros are the base currency) 0.6705 in 1
year There is not a risk free advantage from
using the cheaper euro loan.
95
Four way equivalence
96
Chapter summary
Section Topic Summary
1 Types of risk and terminology The main categories of risk are translation risk, economic risk and transaction risk. Exchange rates are normally given as a spread, the company will always be offered the worst rate.
2 Internal methods Internal hedging techniques include leading lagging, netting and invoicing in the local currency also see chapter 5 - managing foreign currency receivables and payables.
3 Forward contracts Fixes the exchange rate on a specific amount of money at a specific date in the future very popular
4 Money market hedging A short term loan or investment in a foreign currency to hedge risk.
97
Chapter summary contd
Section Topic Summary
5 Derivatives Currency futures fix the rate in the future on a standard amount of money. Currency options allow a company to use a worst case (option) rate, but the company can also use the spot rate if this is better.
6 Other risk Translation risk and economic risk both require a firm to forecast exchange rates it is unwise to have assets/ cash inflows in a currency that may weaken.
7 Forecasting There are a number of factors that influence exchange rates over the long term, including the balance of payments, inflation and interest rates
98
Chapter 20
  • Interest rate risk

99
Syllabus Guide Detailed Outcomes
  • Describe and discuss different types of interest
    rate risk gap exposure, basis risk.
  • Describe the causes of interest rate
    fluctuations, including structure of interest
    rates and yield curves, expectations theory,
    liquidity preference theory, market segmentation.
  • Discuss and apply traditional and basic methods
    of interest rate risk management, including
    matching and smoothing, forward rate agreements
    and asset liability management.
  • Identify the main types of interest rate
    derivatives used to hedge interest rate risk and
    explain how they are used in hedging.

100
Exam Context
  • Discussion of interest rate hedging was tested in
    December 2008 for 7 marks (Q2a). Q2b in December
    2009 asked for a discussion of why different
    bonds might have different costs of debt for 6
    marks. This was actually looking for a discussion
    of why interest rates vary.

101
Qualification Context
  • Derivatives are a major topic in P4 Advanced
    Financial Management.

102
Business Context
  • In 2005, City Lofts, a leading apartment
    developer announced that it had purchased
    interest rate options to cap the risk of higher
    interest rates on 45m of its debt portfolio
    until 2007.

103
Interest rate risk
Types of risk

Higher costs on existing loans Higher costs on
planned loans Basis risk Gap exposure
104
Interest rate movements in 2008 UK
Interest rate
Months during 2008
105
The yield curve
yield
Normal yield curve
Years
106
  • Expectations theory
  • Liquidity preference theory
  • (c) Market segmentation theory

107
Managing interest rate risk
Now plan a loan in 3 months time
In 3 months time -take out in loan
Rates may have risen
108
Lecture example 1
Frantic plc is planning to take out a 6- month
loan of 5m in 3 months' time. It is concerned
about the base rate (LIBOR) rising above its
current level of 4.75. Frantic has been
offered a 3-9 FRA at 5. Frantic can borrow at
approximately 1 above the base rate.
  • Required
  • Advise Frantic of the likely outcome if in 3
    months' time the base rate is 5.5
  • Advise Frantic of the likely outcome if in 3
    months' time the base rate is 4.5. Solution

109
Answer to lecture example 1
(a)
Bank pays compensation of 0.5 to Frantic
Frantic borrows at the best rate available eg
5.5 1 6.5 Net costs 6
(b)
Frantic pays bank compensation of 0.5 Frantic
borrows at the best rate available eg 4.5 1
5.5 Net costs 6
110
Ad/DisAd
Advantages of forward rates Disadvantages of forward rates
Simple Fixed date agreements
Low or zero up-front costs Rate quoted may be unattractive
Normally available for more than a year ahead Lose out if interest rates fall
111
Managing interest rate risk - FRAs
Now plan a loan in 3 months time
Take out in loan in 3 months time
Fix the rate today
112
Managing interest rate risk - FRAs
5m 3-9 FRA at 5
Size of loan
Start end month
Base rate guaranteed
113
Derivatives futures
3 months
Now
  1. Expect to take out loan

2. Contract to pay - futures market
4. Compensation if increases
3. Pay a deposit
Standard contract sizes
4. Or losses if falls
5. Fixed outcome
114
Derivatives options
3 months
Now
  1. Expect to take out loan

2. Contract to pay - put option
4. Compensation if moves against you
3. Pay a premium
4. Or use favourable rate
5. Worst case known
115
Chapter summary
Section Topic Summary
1 Types of risk This chapter is mainly concerned with managing the cost of loans that are being planned in the near future.
2 Interest rate fluctuations The yield curve is a useful indicator of the markets expectations of interest rates. If interest rate rises look likely it is particularly important to manage interest rate risk.
3 Internal methods Internal techniques for managing interest rate risk include Smoothing Matching
116
Chapter summary contd
Section Topic Summary
5 Forward rate agreements Fixes the rate of interest on a short term loan being planned in the near future.
6 Derivatives Interest rate futures fix the rate in the future on a standard amount of money. Interest rate options allow a company to use a worst case (option) rate. Swaps allow a company to convert the nature of a loan (fixed/variable) and/or the currency of a loan.
117
End of day 4 - what to do now
  • Reinforce todays learning
  • Further develop question skills

Checkpoint Guidance in your Course Companion
Course notes review
Question practice
Course Exam 2 in 10 working days
Slide 634
118
End of day 4 - Three Steps to Success
Slide 635
119
Closing talk moving from learning to revision
  • Must keep working!
  • Need to quickly become comfortable with key
    knowledge
  • Must be capable of attempting exam standard
    questions by start of revision courses
  • Revisit checkpoint guidance as necessary
  • Remember Course Exam 2
  • Revision courses and mock days
  • Tutor still available for help with queries
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