Advance Financial Management

Core Areas
• Advance WACC
• Advance Investment Appraisal
• BSOP (Black Scholes Option pricing theory)
• Advance risk management
• Merger & Acquisition
Non-Core Areas
• Dark pool trading
• Securitization
• Islamic finance
• Austerity measure (Cost cutting methods)
• Ratio analysis
• Green finance
• Environmental social and govt issues (ESG)

COST OF CAPITAL
The cost companies bear to raise finance is called the cost of capital.
WACC = Weighted average cost of capital
WACC = Ke+Kd+Kb+Kp
Ke = Cost of Equity
Kd = Cost of Debt
Kb = Cost of Bank Loan
Kp = Cost of Preference shares

In question, if asked to calculate the WACC refer to the balance sheet to understand the mode of finance used to raise the finance.

Cost Of Preference shares

The cost of a preference share is the return paid to preference shareholders.

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𝑃𝑑
𝐾𝑝 = 𝑃0
Pd = Preference dividend per share
Po = Current market price per share

Q1- A Ltd has 8% of the preference share at a par value of $1 and a market price of $ .80 per share.

Kp = .08/.80 = 10%

Q2- The market price of the preference share is $8 B Ltd has a 9% preference share at a par value of $ 50.

Kp = (50*.09)/8 = 56.25%

Cost of Bank Loan

Always given in the question
Kb = Interest(1-t)

Cost of Debt
It is the cost paid to debt holders.

Types of Debts

- Irredeemable debt
- Redeemable Debt
- Convertible debt

I. Irredeemable Debt

Kd = I / Po

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I= Interest
Po = Market value of debenture

Q8 – A Ltd has 8% irredeemable debentures at a par value of $100. The market price of debenture is $ 40 Tax rate is 30%. Calculate the cost of debt and the
after-tax cost of debt.

Kd = 8/40 = 20%

Kd after tax = 20% * (1-.30) = 14%

Q6 - B Ltd has 6% irredeemable debentures at a par value of $50. The market price of debenture is $ 90 Tax rate is 30%. Calculate the cost of debt and the
after-tax cost of debt.

Kd = 3/90 = 3.33%

Kd after-tax = 3.33% * (1-.30) = 2.33%

II. Redeemable Debt - Kd = IRR

IRR = Lower Rate + (NPV Lower Rate /(NPV of Lower rate - NPV of higher rate)) x (Higher rate – Lower Rate)

Q1 - A Ltd has 8% debentures which will be redeemed at par in 4 years, The Market price of the debenture is $98 taxable at 30%.
Year 0 1-3 4 NPV
MV (98.00) 5.60 105.60
Discount Factor 6% 1.00 2.673 0.79
(98.00) 14.97 83.65 0.61
(98.00) 5.60 105.60
Discount Factor 8% 1.00 2.577 0.74
(98.00) 14.43 77.62 (5.95)
IRR = 6% + (0.61 / (0.61 – (-5.95)) x 8%-6% = 6.19%

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Q2 - A Ltd has 9% at par value of $100 to be redeemed after 5 years at par, the tax rate is 30% Market value of the debenture is $102

Year 0 1-4 5 NPV

MV (102.00)
After-Tax Inflows 6.30 6.30
Redemption 100.00
Net Cashflows (102.00) 6.30 106.30
Discount Factor 4% 1.0000 3.6299 0.8219
Discounted CF (102.00) 22.87 87.37 8.24

Discount Factor 6% 1.0000 3.4651 0.7473

Discounted CF (102.00) 21.83 79.43 (0.74)

IRR = 4% + (8.24 / (8.24 – (-13.42)) x (6%-4%) = 5.84%

III. Convertible Debts – Kd = IRR

Q1- A Ltd has 7% debentures which will be redeemed at par after 6 years and can be converted into 10 ordinary shares. Share price at that time will be $11 /
Share. Tax Rate 30%. The market price of the debenture is $105
- Redemption Value 100 - Conversion Value $110 = (11*10) Conversion option is attractable for the lender
Year 0 1-5 6 NPV
MV (105.00)
After-Tax Inflows 4.90 4.90
Conversion 110.00
Net Cashflows (105.00) 4.90 114.90
Discount Factor 4% 1.0000 4.4518 0.7903
Discounted CF (105.00) 21.81 90.81 7.62

Discount Factor 6% 1.0000 4.2124 0.7050

Discounted CF (105.00) 20.64 81.00 (3.36)

IRR = 4% + (7.62 / (7.62 – (-3.36)) x (6%-4%) = 5.39%

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Q2 - A Ltd has 4% debentures which will be redeemed at par after 4 years, debentures can also be converted into 12 ordinary shares price of $ 8 each after
4 years. The tax rate is 30% Market value of debt is $96
- Redemption Value 100 - Conversion Value $96 = (12*8) Redemption option is attractable for the lender

Year 0 1-3 4 NPV

MV (96.00)
After-Tax Inflows 2.80 2.80
Conversion 100.00
Net Cashflows (96.00) 2.80 102.80
Discount Factor 3% 1.0000 2.8286 0.8885
Discounted CF (96.00) 7.92 91.34 3.26

Discount Factor 6% 1.0000 2.6730 0.7921

Discounted CF (96.00) 7.48 81.43 (7.09)

IRR = 3% + (3.26 / (3.26 – (-7.09)) x (6%-3%) = 3.94%

IV. Corporate Bonds (Spread base bonds)

Kd = Rf + Spread
Rf = Risk-free rate of return
Spread = Premium

Q1- The rate on 5 years bond is 3% XYZ Ltd an AAA rate company has some bonds in issue

Q2 - The rate on the 7-year bond is 11% PUR Ltd a BB rate company has some bonds in issue

Q3- The rate on a 13-year bond is 15% ABC Ltd a BB rate company has some bonds in issue
Q4- A 4-year Govt bond has the rate of 5% XYZ Ltd an AA rated co has some bonds in issue.

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Cost of Equity

Return paid to ordinary shareholders

I. Dividend Valuation Model (DVM)

𝑫𝒐(𝟏+𝒈)
Ke = +𝒈
𝑷𝒐

Do = Latest Dividend
Po = Market value of shares
G = Dividend growth

Past dividend model G= ((Latest dividend / Earliest dividend)^1/n)-1

N= Number of dividend growth (Total Years – 1)
Gordons retention method G= BR
b = retention rate = 1- (DPS/EPS)
r = Return on equity

Q 1 – share price $10, Dividend per share is $0.50, Growth rate 10%
Ke = ((.50*1.10)/10)+.10 =15.50%

Q2- share price $200, Dividend per share is $0.10, Growth rate 15%
Ke = ((10*1.15)/200)+.15 =20.75%

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II. Capital Asset pricing model (CAPM)

A better model than the DVM as it incorporates risk.

Types of risk
- Systematic risk – Risk arises due to the state of the economy and can’t be diversified.
- Unsystematic risk – unique risk for a particular industry and can be mitigated by diversification.
Beta incorporates the unsystematic risk. Most of the time due to the capital rationing situation.

Ke = rf + Risk premium
Ke = rf + βe (Rm - Rf)
Risk premium = (Rm - Rf)

Assets = Capital + Liabilities

Assets = Equity + Debts
Beta Asset = Beta equity + Beta debt
βa = (βe x (E/(E+D(1-t))+ (βd x D(1-t)/E+D(1-t))

Note = Beta asset will always be given in question, beta of debt will also be provided if not assume it zero
Q1 – The following balance sheet extracts are given :

Ordinary shares $ 0.50 share = 10,000

Debentures 10% = 15,000
Share price is $3 per share
The tax rate is 30%
Βa = 1.50 and debts are traded @ $110

Βa= βe (E/E+D(1-t)+ βd (D(1-t)/(E+D(1-t)

1.50 = βe (60,000/(60000+((15000*110/100)*.70)+0
Be = 1.50/.839 = 1.78

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Q2 – The following balance sheet extracts are given :

Ordinary shares $ 0.20 share = $20,000

Debentures 15% = 30,000
Share price is $.80 per share
The tax rate is 30%
Βa = 1.80 and Bd = .90, debts are traded @ $120, Return on govt bond is 12% market return is 15%, Find Ke

Βa= βe (E/E+D(1-t)+ βd (D(1-t)/(E+D(1-t)

1.80 = βe (80000/(80000+((30000*120/100)*.70)+.90 ((30000*120/100)*.70)/(80000+((30000*120/100)*.70)
1.80=Be x .76 + 0.21
1.80-.21 = Be X.76
Be = 1.59/.76 = 2.09

Ke = 12% + 2.09 (15-12) = 18.27%

Q3 – A Co’s debt to equity ratio by market value is 1:2, Rf is 11% & market rate is 12% Be is 1.20. The company is thinking of entering a new line of business.
It has collected the data of a leading company in a new industry whose debt-to-equity ratio is 2:5 and Be is 1.15. the tax rate is 30%
Find Ke in the normal scenario and the diversification scenario.

Ke = 11% + 1.20 (12-11) = 12.20%

Ba of a proxy company
Ba = 1.15 (5/ (5+(2*.70) = 0.89
0.89 = Be (2/ (2+(1*.70))
Be = 1.202
Ke = 11% + 1.202 (12-11) = 12.202%
The investor return has increased due to an increase in the risk.

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Q4- A Co’s balance sheet extracts:
Share capital ($0.30 / Share) = $3,000
15% Debentures = $6,000
Co equity beta is 1.30, the market value of the share is $4, Market value of debentures is 125. The company is thinking of entering a new line of business. It
has collected the data of a leading company in a new industry.
Share capital ($0.50 / Share) = $4,000
12% Debentures = $12,000
The market value of the share is $2, and debts are traded at 105. Be is .80. The risk-free rate is 12% and the market risk premium is 15%.

Ke = 12% + 1.30 (15-12) = 15.90%

Proxy Be = .80
Un-gear the proxy to find the Ba.
Ba = .80 (16000/(16000+(12600*.70)) = .516
Re-gear the proxy Ba using its gearing to find the new Be.
.516 = Be ((3000/.30*4)/(40000+(6000*125/100*0.7)
.516=Be x .883
Be = .516 /.883 = .584

Ke = 12% + .584 (15-12) = 13.752%

V. Miller and Modigliani Theory

- In the case of diversification, we have to ungear the proxy beat and regear using our gearing ratio which requires the Beta. If the beta is not given,
we use the MM equation to find the Ke.

Keg = Keug + (1-t) {Keug – Kd)x D/E}

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Q1 – A co has a D/E ratio of 1:2, Risk risk-free rate is 11%, a market return is 13%, co has Be of 1.50. It is thinking of entering into a new industry, a competi-
tor in the industry has D/E 2:3 and Be is 1.20. Tax rate is 30%. Find the revised Ke.

Proxy beta
Ba = 1.20 x (3/(3+(2*.70)=.81

Re-gear the proxy beta using your gearing

0.81 = Be (2/ (2+(1*.70)
0.81 = Be x .71
Be = 0.81/0.71 = 1.14
Ke = 11% + 1.14(13%-11%)= 13.28%

Q2 – A co has a D/E ratio of 2:5, Risk risk-free rate is 10%, a market return is 12%, cost of debt is 5%. It is thinking of entering a new line of business, a com-
petitor in the industry has D/E 1:3 and Ke of 16%. Tax rate is 30%. Find the Ke if co enters the new business.

Find the Keug using the proxy data

Keg = Keug + (1-t) {Keug – Kd)x D/E}
16%=Keug +(1-.30){Keug-5%)X1/3}
16%=Keug + .70 {Keug -5%} x .333
16%=Keug + (.70Keug – 3.5% ) x .333
16%=Keug + .2331Keug – 1.16%
16%+1.16% = 1.2331Keug
Keug=13.91%
Regear the proxy ung Ke using the own company data
Keg= 13.91%+(1-.30)(13.91%-5%)x 2/5
Keg = 13.91%+2.49% = 16.40%

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Q3 – The following data relates to ABC Ltd
S capital ($0.2) / Share = $2000
10% Debentures = $3000
Co has a beta of 1.60, a Tax rate of 30%, a share price is $3 per share, and bonds are traded @ $ 110. Co plans to enter into a new line of business and it has
found a company in the same business with the following data
S capital ($0.5) / Share = $1000
12% Debentures = $2000
The share price of this company is $2 and debts are traded at 120, The Be of the company is 1.40 find the Ke of ABC enters into a new line.
Find the Ba of the proxy co
Rf = 10%, Rm = 15%
Ba = 1.40 ((1000/.50*2)/(4000+(2000*120/100*.70)
Ba=.985
Regear the Ba of Proxy using its company gearing ratio
Ba=Be ((2000/.20*3)/(30000+(3000*110/100*.70)
.985=Be*.928
Be=.985/.928=1.06
Ke= 10%+ 1.06(15-10)
Ke=15.30%

Q4. The following data relates to ABC Ltd

S capital ($0.5) / Share = $10,000
13% Debentures = $6000
Tax rate of 30%, share price is $ 6 per share, and bonds are traded @ $ 150. Co plans to enter a new line of business and it has found a company in the same
business with the cost of equity of 18% and, the cost of debt of 6%. Share price of $ 4 and has bonds worth $8000 traded at $120. The total issued shares
are 10,000. Find Ke

Keg= Keug + (Keug-Kd)(1-t)D/E

18%=Keug+ (Keug-6%)(1-.30)(9600/40000)
18%=Keug+ (.70Keug-4.20%).24
18%=Keug+.168Keug-1.008%

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1.168Keug = 18%+1.008
Keug= 16.27%

Keg=Keug + (1-t)(Keug-Kd)(D/E)
Keg=16.27+(1-.30)(16.27-6)(9000/120000)
Keg=16.27+.539 = 16.80%

Q5- Stetson is a passenger airline having debt to an equity ratio of 1:1, At wishes to diversify into the parcel business and has founded a company named co
x in the parcel sector Be of Co x is 1.18 & Ke is 18.40 of Co x, debt to equity of Co X is 1:4 risk-free rate is 4% market rate is 12.50% tax rate is 30%, cost of
debts is 5%. Find Ke under the beta model and MM Tax model.

Ungear to Be of Proxy co
Ba = 1.18 (4 / (4+(1*.70) + (0)(1*.70/4+(1*.70))
Ba=1.004
1.004=Be(1/1.70)+0
Be=1.71
Ke = 4% + 1.71(12.50-4) = 18.53%

Keg= Keug + (1-t)(Keug-Kd)(D/E)

18.40=Keug+.70(Keug-5)(1/4)
18.40=Keug+.70(.25Keug-1.25)
18.40=Keug+.175Keug-.875
1.175Keug = 19.275
Keug = 16.44%

Keg= 16.44%+(1-.3)(16.44-5)(1/1)
Keg=16.44%+8.00=24.44%

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WACC = (Ke x Ve/(Ve+Vd+Vb+Vp) + (Kd(1-t) x Vd/(Ve+Vd+Vb+Vp) + (Kb x Vb/(Ve+Vd+Vb+Vp) + (Kp x Vp/(Ve+Vd+Vb+Vp)

Question - Backwood

Ve = 225/.50*3.76 = $1,692 m
Vd = 75*120/100 = $ 90 m
Vb = $135 m

Kb = 7%
Kd= 9%

Ke
Rf = 7.75%
Rm = Risk premium – Rf = 14.5-7.75 = 7%
Un gear Proxy beta using the proxy data
Ba = Be (60/(60+40*.70) + Bd (40/(60+40*.70)
Ba=1.5(.68)+0
Ba= 1.023
Re gera using the own data
1.023=Be(1692/(1692+(225*.70)+0
Be=1.12
Ke = 7.75 + (1.12*6.75) = 15.31%

WACC = 15.31% (1692/(1692+225) + 7%(135/(1692+225) + 9%(90/(1692+225)

WACC = 13.51%+.49%+.42% = 14.42%

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Question – Allegro Technologies Co (ATC):

WACC = Ke + Kb
WACC = 15.06 (375/(375+156)+4.80(156/(375+156)
WACC = 10.63%+1.41% = 12.04%

Ve = 52/.50*3.50 = $ 364m
Vb = $156
Kb = 6%.8 = 4.80%

Proxy data
Ve = 125*3 = $375 m
Vd = 92*1.02 = $93.84m
Ba= 1.80 (375/(375+93.84*.80)+0
Ba=1.50
Re-gear using own equity
1.50 = Be (364/(364+156*.80)
Be=2.01
Ke= 3% + 2.01*6%
Ke=15.06%

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WACC in case of change in capital structure
Sometimes capital structure is proportionate of debt and equity changes in a company. In such cases, we again have to un-gear and re-gear. This will be done
through the beta approach CAPM. However, if betas are not given then Un-gear and re-gear through the MM model. Rules of ungear and re-gear will remain
the same in both models.
1- CAPM
o Un-gear the Be to find the Ba
o Regear the Ba to find the Be
2- MM Theory with Tax
o Un-gear to find the Keug
o Re-gear to find the Keg
In Un-gear use the old capital structure and in Re-gear use the new capital structure.

Q1- A Co has a Be of 1.50, its capital structure is 60% equity and 40% debt. Risk free rate is 10% market return is 13%. Co is thinking of changing its capital
structure to 50:50 E/D. find the current Ke and Ke after tax.
Ba=1.50 (60/(60+40*.70) + 0
Ba= 1.02
1.02=Be(50/(50+50*.70)+0
Be=1.734
Current Ke = 10%+1.5(13-10) = 14.50%
Revised Ke =10%+1.734(13-10) = 15.2%

Q2- A Co Ke of 13% and Kd of 6%, it has a capital structure of 70:30 E:D, It is thinking of changing the capital structure of 60:40 E: D. Tax rate 30%.
Find Ke following the new capital structure.
Un-gear using the old structure
Keg = Keug + (1-t)(Keug-Kd)(D/E)
13% = Keug+(1-.30)(Keug-6)(30/70)
13% = Keug+.70(.428Keug-2.57)
13%=Keug+.299Keug-1.799
1.299Keug=13+1.799
Keug=11.39%

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Re-gear using the new gearing ratio
Keg=Keug+(1-t)(Keug-Kd)(D/E)
Keg=11.39%+.70(11.39-6)(40/60)
Keg=13.90%

Summary – Un-gear and Re-gear will be needed in the change in capital structures as well as diversification

Diversification Capital structure change

CAPM – Un-gear Be and find Ba using the proxy data CAPM – Un-gear Be and find Ba using the old structure
Re-gear Ba of proxy to find Be using the own gearing Re-gear Ba to find Be using the new capital structure
MM Theory – find Ve-Un-geared using the Proxy Data MM Theory – find Ve-Un-geared using the Old capital structure
Re-gear the Proxy Ve-un-geared using your data Re-gear the Ve-un-geared using the new capital structure

Question – A co has the capital structure as follows

Share capital ($.50/Share) $10000
10% Debentures $8000
The share price is $ 2 per share and debentures are traded at $120, the Tax rate is 30% and Be is 1.50. The company is thinking of paying off its 30% debt,
however, this will not impact the share price and bonds.
The company is also thinking of diversifying its operations and has identified a competitor whose Be is 1.20 and is financed 50:50 E/D.
If risk free rate is 8% and the market return is 11% Find
- Current Ke
- Ke After diversification
- Ke after capital structure changes

Ke = 8% + 1.50(11-8) = 12.50%

Ve = (10000/.50)*2=40000
Vd=9600
Vd after change = 9600*.70 = 6720

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Ke after diversification
Ungear the proxy Be to find Ba
Ba = 1.20 (50/(50+(50*.70)+0 = 0.705

Regear the proxy beta using your gearing

.70 = Be (40000/46720)
Be=.82
Ke = 8% + .82(11-8) = 10.46%

Ke After capital structure changes

Ungear the Be using the existing capital structure

Ba=1.50(40000/(40000+9600*.70)+0
Ba=1.28
Regear the Ba using the new capital structure
1.28 = Be(40000/(40000+(6720*.70))
1.28=.89Be
Be=1.43

Ke = 8% + 1.43(11-8) = 12.29%

Example – A co is currently involved in the construction business as well as the automobile business and has the following capital structure:-

Ordinary shares ($ 0.30/Share) = $3000

10% Debentures = $5000

Share price is $2/share and bonds are traded at $120. Equity beta is 1.50, tax rate is 30%. The company is planning to close the automobile business, the
construction business accounts for 60% of revenue & automobile business 40% of revenue. The asset beta of an automobile company is 0.60. the risk-free
rate is 10%, the market return is 13%, bond share spread is 1%, find the current WACC and WACC after closing the automobile business.

Answer

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Current Ve (3000/.30) *2 = $20000
Current Vd (5000*1.20) = $6000
Current WACC
Ke = 10% + 1.50(13-10) = 14.50%
Kd(1-t) = Rf + spread = (10%+1%) *.70= 7.70%
WACC = 14.50%(20000/26000) + 7.7%(6000/26000) = 11.15%+1.77% = 12.92%
WACC after closing the automobile business
Find the asset beta of the construction business =
Ke = 10% + 2.01(13-10) = 16.03%
Kd(1-t) = Rf + spread = (10%+1%) *.70= 7.70%

Ba = 1.50 (20000/ (20000+(6000*.70)+0 = 1.23

Asset beta = asset beta of construction division * Asset beta of the automobile division
1.24 =Bac (.60) + .60(.40)
Asset beta of construction division = (1.24-.24) / .60 = 1.67
1.67 = Be (20000/24200) +0 = 2.01
WACC = 16.03%(20000/26000) + 7.7%(6000/26000) = 12.33%+1.77% = 14.10%

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Past exam Question Morda Co
WACC = Ke (Ve / (Ve+Vd) + Kd(Vd/(Vd+Ve))

Ve = 50000/.40*2.88 = $360000
Vd = = $120000*104.26/100 = 125112
Ke = 3.80% + 1.20(7%) = 12.20%
Kd = 3.8%+.90%=(4.70%*.80) = 3.76%
WACC = 12.20% (360000/(360000+125112) + 3.76%(125112/(360000+125112)
=9.08%+.96% = 10.04%

First Director proposal

- Sell of the repair and maintenance business
- Payoff the 80% debt from the sales proceeds
- Size of bespoke division 70%, size of repair & Maintenance division 30%

Ve = 50000/.40*2.88 = $360000*.70 = 252000

Vd = 120000*108/100*.20= $25920
Ke = 3.80% + 1.12(7%) = 11.64%
Kd = 3.8%+.60%=(4.40%*.80)=3.52%
WACC = 11.64% (360000/(360000+25920) + 3.52%(25920/(360000+25920)
=10.85%+0.23% = 11.08%

Calculate the Beta asset of the whole business

Ba = Be (360000/(360000+125112*.80)
Ba=.94
Ba = Bac + Bam
.94 = Bac (.70) +(.65*.30)
Bac = 1.06
Calculate the beta equity using the new capital structure

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Ba = Be (360000/(360000+(25920*.80)
1.06 = Be(.91)
Be = 1.12

Second director proposal

- borrow 70 m debt to acquire the non-current assets

Ve = 50000/.40*2.88 = $360000
Vdo = $120000*100.96/100 = $120828
Vdn = $70000*100.69/100=$70,483
Ke = 3.80% + 1.21(7%) = 12.27%
Kd = 3.8%+.90%=(6.20%*.80) = 4.96%
Kd = 3.8%+2.40=(6.20%*.80) = 4.96%
WACC = 12.27% (360000/(360000+191311) + 4.96%(70483/(551311) + 4.96%(120828/551311)
=8.01%+0.63% + 1.08% = 9.72%

Past Exam Coden Co

WACC before the implementation of the proposal

Ke = 4% + 1.1(6%) = 10.6%
Kd = 4% + .90 = 4.90*.80 = 3.92%
Ve = 42,614
Vd = 42228

WACC = 10.6%(42614/(42614+42228) + 3.92% ( 42228/(42614+42228)

= 5.32% + 1.95% = 7.27%

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WACC After implementation of the proposal

Ke = 4% + 0.94(6%) = 9.64%
Kd = 4% + .60 = 4.60*.80 = 3.68%
Ve = 42,614
Vd = 42228* 0.30= 12668

WACC = 9.64%(42614/(42614+12668) + 3.68% ( 12668/(42614+12668)

= 7.43% + .84% = 8.27%

Calculate the asset beta of Hotel Coden co

Ba = Be ( 42614*(42614 + (42228*.8) = 1.10(.557) = 0.61

Find the beta asset of the Hotel industry

Ba= Bah + Bap
0.61 = Bah(.60) + (.40*.40)
Bah = 0.75
Calculate the revised Be
Ba = Be (42614/(42614+(12668*.80)
.75=Be(.80)
Be=0.94

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Theory - Many people argue that introducing debt in company capital structure will reduce the WACC as debt is a cheaper source of finance
however there are some theories on this topic.

1- Traditional theory of WACC

WACC will fall by introducing the debt initially but will start increasing as the debt increases from a certain level called the optimal point.
2- Modigliani and miller no Tax
WACC will fall by introducing the debt but the demand of equity holders will rise which will offset the impact of debts (cheaper source).so doesn’t
matter company should invest through WACC or not.
3- Modigliani and Miller with Tax
WACC will fall by introducing the debt, but the demand of equity holders will rise which will offset the impact of debts (cheaper source). But since
debt also gives tax savings so increase in Ke will not exactly offset the benefit of cheaper debt and WACC will fall. So the company should keep 100%
gearing.
4- Packing Order theory
Funds should be raised in the following order
- Internally generated funds
- Debt
- Equity
Note
- Beta assets will always be given in question, beta of debt will also be provided if not assumed it zero.
- Use the Cost of debt after tax in the beta equation.
- The cost of debt used in beta calculation was after tax so in the calculation of WACC the debt will considered before tax as the tax impact has been
already incorporated in the calculation of Beta.
- MV of bonds = IRR before tax basis because the tax rate incorporated in the cost of bonds

Summary – Un-gear and Re-gear will be needed in the change in capital structures as well as diversification

Diversification Capital structure change

CAPM – Un-gear Be and find Ba using the proxy data CAPM – Un-gear Be and find Ba using the old structure
Re-gear Ba of proxy to find Be using the own gearing Re-gear Ba to find Be using the new capital structure
MM Theory – find Ve-Un-geared using the Proxy Data MM Theory – find Ve-Un-geared using the Old capital structure
Re-gear the Proxy Ve-un-geared using your data Re-gear the Ve-un-geared using the new capital structure

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INVESTMENT APPRAISAL
Investment appraisal is based on two areas

Domestic Appraisal Oversees or International Appraisal

Foreign Direct Investment (FDI)
Major areas to understand.
- Mutual Tax Treaty
- Quotes
- Parity theory
- Capital allowances.
- Working capital

Mutual Tax Treaty

Case 1
If the tax rate in the USA is 20% and in the UK is 20% and a double tax treaty is not available, we have to pay 20% tax in the UK and 20% tax in the USA.
Case 2
If the tax rate in the USA is 20% and in the UK is 20% and a double tax treaty exists, we have to pay 20% tax in the UK but no tax will be paid in the USA.
Case 3
If the tax rate in the USA is 25% and in the UK is 20% and a double tax treaty exists, we have to pay 20% tax in the UK and 5% tax in the USA.
Case
If the tax rate in the USA is 15% and in the UK is 20% and a double tax treaty exists, we have to pay 20% tax in the UK and no refund is available in the USA.

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Quotes
- Direct Quote
- Indirect Quote
Indirect Quote
(Foreign Currency / Local Currency)
Divide to convert
Low Rate = Buying
High Rate =Selling

Direct Quote
(Local Currency / Foreign Currency)
Multiply to convert
Lower rate = selling
Higher rate= Buying

Parity Theories
Purchase Power Parity theory – S1 = So( 1+Hc/1+Hb)
S1 = Expected spot rate or forward rate
So = Current spot rate
Hc = Inflation rate in country 1
Hb = Inflation rate in country 2

Interest rate Parity theory – Fo = So (1+ic/1+Ib)

Fo = Expected spot rate or forward rate
So = Current spot rate
Ic = Interest rate in country 1
Ib = Interest rate in country 2
Country 1 = the country of numerator currency
Country 2 = the country of the enumerator

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Example. 1
The current spot rate is 4AED / $
The interest rate in the USA is 10%
Interest rate in UAE is 8%
Find the one-year forward rate
So = 4 * (1.08/1.10) = AED 3.92/$

Example. 2
The current spot rate is 1.3 € / £
The interest rate in Europe is 8%
The interest rate in the UK is 5%
Requirement # 1 Find one year forward rate
Fo = 1.30 * (1.08/1.05) = 1.33 € / £

Requirement # 2 Find 6 months forward rate

Fo = 1.30 * (1+(.08/2)/(1+(.05/2)) = 1.319 € / £

Requirement # 3 Find a 3-month interest rate

Fo = 1.30 * (1+(.08/4)/(1+(.05/4)) = 1.309 € / £

Losses Carry forward

People usually want to pay tax on profits but usually expect to get Tax refunds on losses. However, this doesn’t happen instead there is a concept of losses
carried forward

Working Capital
Example 1
Cash required for the day-to-day operations
The following revenues are available.
Year 1 2 3 4
Sales 5000 6000 8000 12000
Working capital required each year is 10% of the revenue and it must be placed at the start of the year to which sales relate.

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Answer
Year 0 1 2 3 4
Working Capital Requirement 500 600 800 1200 0
Working capital -500 -100 -200 -400 1200

Example 2
Cash required for the day-to-day operations
The following revenues are available.
Year 1 2 3 4 5
Sales 1000 1500 1800 2000 3000
Working capital required each year is 20% of the revenue and it must be placed at the start of year 2.
Answer
Year 1 2 3 4 5 5
Working Capital Requirement 200 300 360 400 600
Working capital -200 -100 -60 -40 -200 600
Example 3
Cash required for the day-to-day operations
The following revenues are available.
Year 1 2 3 4
Sales 6000 8000 6000 15000
Working capital required each year is 10% of the revenue and it must be placed at the start of the year to which sales relate.
Answer
Year 0 1 2 3 4
Working Capital Requirement 600 800 700 1500 0
Working capital -600 -200 100 -800 1500

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Capital Allowance
Capital allowances are tax-allowable depreciations that are tested under a straight line and reducing balance method.

Example 1

Investment $5000, life 5 Years, tax rate 30% same year, scrap value $500. Capital allowance method straight line.

Year 1 2 3 4 5
Capital Allowance 900 900 900 900 900
Tax Savings @ 30% 270 270 270 270 270

Example 2

Investment $10000, life 4 Years, tax rate 30% same year, scrap value $1000. Capital allowance method straight line.

Year 1 2 3 4 5
Capital Allowance 2250 2250 2250 2250
Tax Savings @ 30% 675 675 675 675

Example 3

Investment $5000, life 4 Years, tax rate 30% same year, scrap value $500. Capital allowance reducing balance @ 25%.

Year 0 1 2 3 4
Capital Allowance 5000 1250 937.5 703.125 1,609.38
Tax Savings @ 30% 375 281.25 210.9375 482.81

Duration (Also called Macavlays Duration)

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It is the advance form of the payable period (Weighted average payable period). It tells how much period outflow at year zero will be recovered.

Step 1 – find the present value of the return phase

Step 2– find the weighted average PV
Step 3 -Divided step 1 by step 2

Sensitivity Analysis
Tells a company by how much % a variable should change to make the NPV zero

Sensitivity analysis on sales = (NPV/PV of sales) *100

Sensitivity analysis on Variable cost = (NPV/PV of [Link]) *100
Sensitivity analysis on Cost of capital = (IRR-Cost of capital /cost of capital ) *100
Sensitivity analysis on Fixed Cost = (NPV/PV of F.C) *100
Sensitivity analysis on Sales volume = (NPV/PV of Contribution) *100

Methods of entry into new market

Foreign Direct Investment (FDI)

Benefits of FDI
- Trade and technology secrets remain with co
- Intellectual capital remains with co
- Employee motivation as they get a chance to work abroad
Drawbacks of FDI

- FDI is very costly compared to licensing

- FDI is inflexible in case of backing off
- FDI is more risky
International Investment Appraisal additional steps

- Additional Tax

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- Redundancy/loss contribution after tax
- Royalty Income
- Remittance block-out
- Internal Profits

Internal Rate of Return(IRR)

IRR = Lower rate + (NPV of lower rate /(NPV of Lower rate – NPV of higher rate)) X (Higher rate – Lower rate)

Modified Internal Rate of Return(MIRR)

MIRR = ((NPV of return phase/NPV of Investment phase) ^(1/n)*(1+r))-1

Question - Bromwich Inc, Donegal plc: Allegro Technologies Co (ATC):, Fernhurst Co., Yilandwe, Grant Co., Partsea Plc:

Yilandwe
Report
To. Board of Directors
From: Senior Consultant
Date: xx/xx/xx
Subject: Yilandwe Project feasibility
Introduction: This report evaluates the financial acceptability of the investment in the assembly plant in Yilandwe. It then discusses the assumptions risks
and issues that Imoni should consider before making a financial decision. It then provides a reasoned recommendation on whether Imoni should invest in
the assembly plant or not.
(i) Evaluation of financial acceptability
Appendix 1 shows the evaluation of financial acceptability through the NPV approach
(ii) Assumptions made together with the risk and rewards which Imoni co should consider before making the final decision.
- It is assumed that the project will last for 4 years however it may continue after 4 years

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- It is assumed that the tax rate will remain constant however the tax rate may vary due to govt policies or economic conditions
- It is assumed that the forecast exchange rate will be based on the inflation rate however they can be based on the interest rate.
- It is assumed that the construction of the plant can be done very quickly and production can start immediately however it can be delayed.
- It is assumed that royalty and transfer price will be negotiated with the govt which will be successful.
- The cost of capital for the discounting of the cash flow is considered at 12% but no detailed working have been provided.
Risks that Imoni can face due to FDI.
- Imoni will face political risk due to investment in Yilandwe as the Govt is not popular in rural areas it is only popular in urban areas so any change in
govt will affect our investment.
- Imoni co will face social risk in Yilandwe as the plant is being built on a school that will be shut down with the aspiration to be built in another place.
- Imoni will face cultural risks as the working style in Yilandwe can be different from the USA.
- Imoni will face the exchange rate risk which is based on inflation so any change in inflation will affect the exchange rate which will directly impact
the remitted cash flows.
- Imoni will face legal risk as the current govt has imposed strong monetary and fiscal controls already and perhaps imposed the new regulations as
well. E.g. remittance block out.
- Imoni co will face environmental risk as the construction of a new plant could impact the rural environment and can have an impact on the living
standard of the residents.
The issue that Imoni should consider before making the final decision.
- Imoni Co should consider the legal and licensing requirements.
- Imoni company will be investing in the new country so they should consider the means of finance availability in the new country.
- Imoni company is investing in a country where the people living in the area are not well educated so they perhaps will have to employ the outsiders
which could be costly.
(iii) Reasoned recommendation on whether Imoni should invest in the assembly plant in Yilandwe.
Considering the financial side the Project is giving a good return in the form of NPV so the project should ideally be accepted however they should Consider
the other non-financial factors as well before making the final decision.

Grant Co
Report
To: Board of Directors

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From
Date XX/XX/XX
Subject: Feasibility Study of Production in Home Country or FDI
Introduction:
This report evaluates the feasibility of investing in Grant co a foreign subsidiary in Indonesia or continuing the production in the local market. It also high-
lights the assumption made to calculate the NPV. It further gives the

Capital Rationing In Investment Appraisal

Capital rationing is a situation in which a company has a range of investment opportunities, and all seem profitable but the amount of cash is limited.
Reasons/Causes of capital rationing.
- Soft capital rationing. Due to internal factors. External parties are willing to lend but management doesn’t want due to the following reasons. Fear
of dilution of control, fear of interest cost.
- Hard capital rationing. Due to external factors. The company wants to raise finance but the external parties are not willing to give finance as they –
consider us risky or they don’t have finance due to the recession.
If the rationing is for one period, it is called single-period capital rationing. If the rationing is for successive periods it is called multi-period capital rationing.

Single-period capital rationing.

- shortage of material/labour.
Dealing approach: Optimal plan, best combination of projects
Types of projects:
- Divisible projects – can be taken proportionately.
Multi-period capital rationing.
- shortage of material/labor.

1- Indivisible projects – cannot be considered in parts either to accept or reject. There is no solution available in the world for indivisible projects these
are dealt with, with the rough trial and error method.
Find the probability index = (NPV / Investment)

Mutual exclusive projects are projects that cannot be undertaken together.

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Example 1:
Three projects are under consideration.
Only $65000 is available and the projects are divisible.
Requirement: find the best combination of the projects which will maximize the NPV.

Project Investment NPV Probability Index Ranking To be invested

A 30000 4500 4500/30000=0.15 C 20000
B 20000 6000 6000/20000=0.30 A 20000
C 25000 5000 5000/25000=0.20 B 25000
NPV = 6000+5000+3000 = 14000
Example 2
Three projects are under consideration.
Only $90000 is available and the projects are indivisible.
Requirement: find the best combination of the projects which will maximize the NPV.

Project Investment NPV Combinations Investment Combine NPV

A 40000 14000 A+B 90000 30000
B 50000 16000 B+C 80000 31000
C 30000 15000 A+C 70000 29000

The company should invest in projects B & C and the remaining 10000 should be invested somewhere else.

Example 3
Four projects are under consideration.
Only $100000 is available and the projects are divisible.
Requirement: find the best combination of the projects which will maximize the NPV.
Project Investment NPV Probability Index Ranking To be invested
W 30000 3000 3000/30000=0.10 D XXXXX

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X 40000 12000 12000/40000=0.30 B 40000
Y 25000 10000 10000/25000=0.40 A 25000
Z 35000 7000 7000/35000=0.20 C 35000
NPV = 12000+10000+7000=29000

Example 4
Four projects are under consideration.
Only $80000 is available and the projects are indivisible.
Requirement: find the best combination of the projects which will maximize the NPV.
Project Investment NPV Combinations Investment Combine NPV
W 30000 4000 W+X+Y 65000 9100
X 25000 3800 X+Y+Z 55000 7800
Y 10000 1300 W+X+Z 75000 10500
Z 20000 2700 W+Y+Z 60000 8000
The company should invest in projects W, X & Z and the remaining 5000 should be invested somewhere else.

Example 5
Five projects are under consideration. Only $10,000,000 is available and the projects are indivisible.
Project Investment NPV
A 2500000 1000000
B 2200000 1550000
C 2600000 1350000
D 1900000 1500000
E 5000000 400000
Requirement: find the best combination of the projects which will maximize the NPV.
- All projects are divisible.
- All projects are in-divisible.
- All projects are divisible, but B & D are mutually exclusive.
- All projects are in-divisible, but B & D are mutually exclusive.

All projects are divisible.

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Project Investment NPV Probability Index $ Ranking To be invested
000
A 2500000 1000000 1000/2500=0.40 E XXXXXX
B 2200000 1550000 1550/2200=0.704 C 2200000
C 2600000 1350000 1350/2600=0.519 D 900000
D 1900000 1500000 1500/1900=0.789 B 1900000
E 5000000 4000000 4000/5000=0.80 A 5000000
NPV = 4000000+1500000+1550000+467307 = 7,517,307
All projects are in-divisible
Project Investment NPV Combinations Investment Combine NPV
A 2500000 1000000 A+B+C+D 9200000 5400000
B 2200000 1550000 A+B+E 9700000 6550000
C 2600000 1350000 A+D+E 9400000 6500000
D 1900000 1500000 B+C+E 9800000 6900000
E 5000000 4000000 B+D+E 9100000 7050000
C+D+E 9500000 6850000
The company should invest in projects B, D & E and the remaining 900000 should be invested somewhere else.

All projects are divisible, but B & D are mutually exclusive.

Project Investment NPV Probability Index $ Ranking To be invested
000
A 2500000 1000000 1000/2500=0.40 E 500000
B 2200000 1550000 1550/2200=0.704 C XXXXXX
C 2600000 1350000 1350/2600=0.519 D 2600000
D 1900000 1500000 1500/1900=0.789 B 1900000
E 5000000 4000000 4000/5000=0.80 A 5000000
NPV = 4000000+1500000+1350000+200000 = 7,050,000
All projects are in-divisible, but B & D are mutually exclusive.
Project Investment NPV Combinations Investment Combine NPV
A 2500000 1000000 A+B+C+D 9200000 5400000
B 2200000 1550000 A+B+E 9700000 6550000

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C 2600000 1350000 A+D+E 9400000 6500000
D 1900000 1500000 B+C+E 9800000 6900000
E 5000000 4000000 B+D+E 9100000 7050000
C+D+E 9500000 6850000

The company should invest in projects B, C & E and the remaining 200000 should be invested somewhere else.
Question - Slow Fashions Ltd:

Multi-period capital rationing

Shortage for more than one period.

1- Find the objective function.
2- Establish constraints.
3- Establish non-negative constraints.

Example 1
Example
Year Project A cash flows Project B cash flows Funds availability
0 (10000) (20000) 20000
1 (20000) (10000) 25000
2 (30000)
3 100000 60000

1- Establish the objective function.

The company's object is to maximize the Profits

Maximize = 22140A + 15970B

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NPV of Project A
Year 0 1 2 3
Cash flows (10,000) (20,000) (30,000) 100,000
Discount Factor 10% 1.000 0.909 0.826 0.751
PV (10,000) (18,182) (24,793) 75,131
NPV 22,156

NPV of Project B
Year 0 1 2 3
Cash flows (20,000) (10,000) - 60,000
Discount Factor 10% 1.000 0.909 0.826 0.751
PV (20,000) (9,091) - 45,079
NPV 15,988

2- Establish constraints

10000A + 20000B ≤ 20000

20000A + 10000B ≤ 25000
30000A + 0B ≤ 20000

3- Establish non-negativity constraints

≥ A, B ≤
Question - Arbore Co:
Adjusted present value (APV)

APV is the adjusted form of NPV or simply NPV with some adjustments.
Format
Financing side
Base case NPV of the Present value of financing cash flows. XXXX

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PV of tax savings from the Interest payments xxxxx
PV of interest savings on subsidized loan xxxxx
PV of Tax loss due to interest savings (xxxx)
PV of issuance cost of equity and debt (xxxx)
PV of tax savings on equity and debt issuance cost xxxxx
Increase in debt capacity due to the investment xxxxx

APV (Adjusted Present Value of NPV) XXXX/(XXXX)

Adjusted present value (APV):

APV is an adjusted form of NPV or an NPV with some adjustments
When to use APV:
(If anyone conditions is there)
1. When financing is required for a project and a major portion of finance is required via debt
2. When the interest rate offered on a loan is subsidized
3. When there are issues cost of debt or equity
Note: APV can be used as an expansion or well-diversification
Assumption of APV:
1. While calculating the base case NPV project is 100% equity financed so WACC is Ke
2. While calculating NPV of financing cash flow project is 100% debt financed so WACC is Kd (if Kd is missing use Rf)
3. When expansion of activities is there use Co’s Beta assets as beta equity to find Ke
4. When diversifying do ungeared from proxy data (CAPM or MM + tax) but no regearing is done
Use ungearing data to find Ke (use proxy’s beta asset as our beta equity in CAPM and use proxy’s Ke(ug) as our Ke in MM + tax)
Questions: The Problem, Fubuki Co, Burung Co:, Tramont Co:

Fubuki Co.

Discuss the appropriateness of the method used and any assumption made during the calculation

- While calculating the base case NPV the Ke is used as the discount factor
- while calculating the PV of financing CF discount factor use is Kd
- In diversification only ungearing is done and not regearing

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appropriateness of the method.

- APV is an appropriate method compared to NPV as it gives the true picture, NPV gives the wrong picture as it ignores some key cash flows like tax
benefits on interest payment, it ignores the interest saving on subsidized loans, and issues costs. Since the issue cost is an outflow and tax benefits are an
inflow ignoring them will result in incorrect NPV therefore using NPV in this case is inappropriate and APV is preferred as it incorporates all remaining cash
flow which NPV ignores.

Tramont Co:

To: Board of Directors Of Tramont Co

From:
Date: xx/xx/xxxx
Subject: Feasibility study of Investment in Gambala.
Introduction:
This report evaluates whether the trimount should cease the operation from the USA and undertake the project in Gambala or not, it also emphasizes the
potential changes in Govt of Gambala and Other business factors Tramont should consider before undertaking the project.

(i) Evaluate whether Tramont Co should undertake the project in Gambala

A detailed calculation has been done in the appendix which that the project is giving a positive APV hence the project should be accepted.
(ii) Discusses the potential change in government and other business factors that Tramont Co
Govt changes:
The current govt has provided a subsidized loan to G co which will be reviewed and in case of a rise in interest rates, the profits will reduce. If the new party
forms the govt they perhaps increase the taxes as mentioned in the scenarios which could also hit the profits. There is a treaty between both countries
about the tax if they cancel then G co should have to bear an additional tax of 20% considering the the current tax rates.
The current Govt has facilitated by providing the tax relief on carry forward losses which could be taken by the new govt so the additional tax will come.

Other business factors.

Tramont should consider whether the FDI is a suitable option or the licensing is possible.
T co should consider any legal requirement for establishing the co in the Gambala.
Gambala Co should consider the cultural impact of investing the gambala and whether they will be able to fit in the culture.
Gambala co should consider social issues like intellectual capital availability in gambala.

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BSOP (Black Scholes Option pricing theory)
Right to buy or sell the commodities/Shares at a prespecified rate at a pre-specified time.

In the regular market, the share purchase is a bit risky as it can be loss-making as a result of price fluctuation
In the options market, the option holder buys a right to purchase the share at a certain amount in the future by an option premium and can choose either to
purchase or forgo the deal.
The option premium the holder pays is calculated through the BSOP.

Important terms:
1. Share option: means the right to buy or right to sell shares at a fixed price
2. Call option: right to buy
3. Put option: right to sell
4. Exercise price/strike price: price at which share will be bought or sold
5. Expiry Date: The date in the future on which options can be exercised
Note: European options can be exercised only at the expiry date but American-style options can exercised at
expiry date as well as before
The Black Scholes model (BSOP) is only for European-style options.

Option value = Intrinsic value + time value

Intrinsic Price = Current share – Exercise price
Time Value = period to exercise the option
Markets in Option

1- Traded Market – Standardized options

2- OTC market (Over the counter market) – tailor-made option (customer specific)
Assumptions of BSOP
1- BSOP option assumes that options are European style option
2- BSOP assumes no dividend will be paid during the life of the option
3- The BSOP option assumes that no transaction cost or tax will be applicable
4- Share price follows normal distribution and is constantly traded.

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Call Option
Pa = Current share price
Pe = Exercise Price
R = Risk-free rate
S = Standard deviation
T = Time to expiry in years
C = call option value
P = Put option value
E = 2.7183

Standard deviation = √r

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Five steps model.
Step 1 – Find Pa, Pe, R, S and T
Step 2 – find e^-rt
Step 3 – find d1 and d2
Step 4 – find Nd1 and Nd2
Step 5 – find the call and put value

Example: 1
Current Share price: $95
Exercise price: $100
Risk-free rate 8%
Time to expiry 3 months
Standard deviation 30%
Required: value of call and put option
Solution: Spreadsheet notes

Options in investment appraisal

In investment appraisal some times a company have different options

1- The option to delay (start a project a bit later) is called a call option
Pe is the initial investment
Pa is the present value of returns from initial investment
2- Option to expand (Invest more funds) Call Option
Pe is the additional investment
Pa is the present value of returns from the additional investment
3- Option to early exit (Take money from the competitors or govt) (Put Option)
Pe is the Govt or competitor offer
Pa is the present value of opportunity cost
4- Option to redeploy (more funds somewhere else)
Not examines

Questions: ALASKA SALVAGE: CATHLYNN: Mehgam:, DIGUNDER:, Furlion Co:

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Protectionist measures:
1- High tax on import to make the foreign product less attractive to boost up the local industry.

Strategic NPV:
(NPV without option +NPV With Option)

if the option can be exercised at any point during the time it is called the American option which is resolved through binominal option theory.

The Greeks in BSOP

Gamma, vega , rho and theta:
Delta measures the sensitivity of the option value to changes in the value of the underlying asset Sensitivities to other factors in the Black Sholes formula
are denoted by other Greek letters as follows:
Gamma – measures the rate of change of delta as the underlying asset’s price changes
Vega – measures the change in option value caused by a 1% change in the volatility (i.e. by a 1% change in the standard deviation expressed as a decimal).
Rho – measures the sensitivity of the option value to changes in the risk-free rate of interest.
Theta – measures the rate of decline in the value of the option caused by the passage of time
More details on the Greek
Collectively, delta, gamma, vega rho, and theta are known as “the Greeks” The importance of the delta value has been illustrated above i.e. it is useful when
setting up a delta hedge. The importance of the other Greeks is explained below.
Gamma
A high gamma value indicates that the delta value is quite volatile This means that it will be quite difficult for an option writer to maintain a delta hedge
since the volatile delta value will require the option writer to be constantly changing the number of options written Therefore gamma is a measure of how
easy risk management will be.
Vega
It is very important for the Black-Sholes model that the share price volatility is estimated accurately. An incorrect estimate of volatility can change the op-
tion value dramatically. Therefore, vega is a measure of the consequences of an incorrect estimation. Longer-term options have larger vegas than short-
term options, because the more time there is until the expiry of the option, the more significant a change in volatility is.
Rho
Interest rates tend to change slowly and by small amounts, so the impact of interest rates on option prices (measured by rho) is generally not particularly
significant However, note that rho is positive for call options (an increase in interest rates leads to an increase in option price) but negative for puts (an in-
crease in interest rates leads to a decrease in option price) Also, longer term options have larger rhos than short term options because the more there is
until expiry of the option, the more significant a change in interest rates is.

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Theta
An option price has two components, the intrinsic value and the time value, however, when the option expires, the time premium reduces to zero, there-
fore, theta measures how much value is lost over time. Theta is usually expressed as an amount lost per day (e.g. theta could be -$0.06, indicating that 6
cents of value is lost per day. Theta usually increases as the expiry date approaches
Delta

Delta = No of shares/Nd1

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ADVANCE RISK MANAGEMETN
Types of risks
1- Currency risk management
2- Interest rate risk management

Currency Risk Management

Risk that currency rate will go up if we have to make payment in future or risk the currency rate will fall if we have to received in the future.

Payment in future
Techniques to deal/Hedge/Minimize currency risk

Internal methods

1- Leading / Laging in payment

2- Invoice in local currency
3- Netting off
4- Matching Receipts and payment

External Methods

1- Forward exchange contracts

2- Money market hedge
3- Currency future
4- Currency Options
5- Currency swaps

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Types of currency risks

I- Transaction risk
Risk of loss on any transaction i.e. Buying (Imports), Selling (Exports)
II- Translation risk
Risk of loss when F/S of a company translated from one currency to another currency. Usually occur when company has involved in foreign in-
vestment.
III- Economic risk
It is extreme form of transaction risk i.e risk of loss on both imports and exports.

Forward exchange Contracts (Rate Fixation contracts)

A co-contract to buy/sell currency in the future at a specific date at a specified rate.

Example 1
We are in Pakistan and have to make a payment in three months $1000. Rates $/PKR
Spot rate 0.011 - 0.012
1 Month forward rate 0.01 - .0115
3 months forward rate 0.009 - 0.011
How much PKR will be involved under forward contracts
=1000/.009 = 111,111 PKR

Example 2
We are in USA and must pay £ 5000 after 4 months rates are $/£
Spot rate 1.20 - 1.30
4 Month forward rate 1.22 - 1.34
6 months forward rate 1.25 - 1.36
How much $ will be involved under forward contracts
= 5000*1.34 = $6700

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Example 3
We are in Thailand and will receive $ 4000 after 6 months rates are $/THB
Spot rate 36.00 - 36.50
3 Month forward rate 35.50 - 36.20
6 months forward rate 35.40 - 36.10
How much THB will be involved under forward contracts
= 4000/36.10 = 110

Example 4
We are in UAE and will pay SAR 6000 after 2 months rates are SAR/AED
Spot rate 1.10 - 1.15
1 Month forward rate 1.08 - 1.14
2 months forward rate 1.06 - 1.13
3 months forward rate 1.05 - 1.12

How much THB will be involved under forward contracts

= 6000/1.06 = 5660.37

Example 5
We are in PAK and must receive 600000 Omani riyal after 3 months PKR/OMR.
Spot rate 350 - 355
1 Month forward rate 352 - 356
3 months forward rate 353 - 357

How much PKR will be involved in hedging under forward contracts

= 60000*353= 211800000

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Money Market hedge

Payment
I- Deposit the foreign currency using the foreign currency deposit rate (Payment / 1+ FC deposit rate)
II- Calculate the amount required in home currency using the current spot rate
III- Borrow the home currency in home country

Example 1
We are in Pakistan and must pay $ 2000 after three months, spot rate is
$/PKR 0.011625 - 0.01168
Company can borrow PKR at 8% per annum and deposit PKR at 7% per annum. At can borrow $ at 9% per annum and deposit $ 6% per annum.
Deposit the amount in foreign currency using the foreign currency deposit rate = 2000/1+(.06/4) = $1970 =
Borrow the equivalent amount in home currency = 1970/.011625 = 169462
Close the local currency account at maturity date using the local currency borrowing rate = 169462* (1+.08/4) = 172851

Example 2
We are in Pakistan and must pay £ 5000 after 6 month Spot rate is £/PKR .01145 - 0.01148. co can borrow at 10% and deposit at 9% per annum. It can
borrow PKR at 8% per annum and deposit PKR at 7% per annum.

Deposit in foreign currency =5000/(1+.09/2) = 4784

Borrow the foreign currency in home market = 4784/.01145 = PKR 417,816
Total Payment in Six months in local currency = 417816 * 1.08/1 = 434,528

Example 3
We are in USA and must Malaysian Ringgit 5000 after 4 month Spot rate is MYR/$ 5 - 5.20. company can borrow ringgit @ 8% and de-
posit @ 6%. It can borrow $ @ 4% and deposit @ 3% per annum.
Deposit the foreign currency = 5000/(1+.06/3) = 4902
Amount to borrow = 4902/5= $981
Payment after 4 month = 981* (1+ .04/3) = $994

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Receipts
I- Borrow the money from foreign bank using the foreign currency borrowing rate (Receipts / (1+ FC Borrowing rate)
II- Calculate the amount required in home currency using the current spot rate
III- Deposit the money using the home country deposit rate

Example 1
We are Pakistan and will receive $ 2000 after 6 months at spot rate $/PKR 0.011-0.012, company can borrow at 8% per annum deposit @ 6%. It can
borrow PKR @ 7% and deposit @ 5% per annum.
1- Borrow the foreign currency 2000/1.04 = 1923
2- Calculate the present value using the current spot = 1923/.012 = 160,250
3- Deposit the amount In local currency = 160250*(1+(.05/2) = 164,256.

Example 2
We are in UK and will receive $20000 after 3 months at spot rate $/£ 1.12-1.14, company can borrow n£ at 12% per annum deposit @ 10%. It can bor-
row $ @ 8% and deposit @ 7% per annum.
1- Borrow the foreign currency 20000/1+(.08/4) = 19607
2- Calculate the present value using the current spot = 19607/1.14 = 17199
3- Deposit the amount In local currency = 17199*(1+(.10/4) = $ 17,628

Netting
Involves off setting transactions to minimize currency risk
Bilateral netting – Two group companies involve
Multilateral netting – Several group companies are involved

Multilateral netting Approach

Step 1 – Convert all intercompany balances to one currency
Step 2 – Draw a transaction matrix
Advantages of Netting off
i- Netting of result in no of transactions being minimized which will lead to time being saved
ii- Netting of will reduce exposure especially if there are border controls

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iii- Netting of help to reduce the transactions cost and taxes
iv- Netting off reduce the currency risk exposure due to the difference of buying and selling rates
Disadvantages of Netting off
i- Some jurisdictions do not allow netting to take place
ii- May result in loss of rebates

Currency Futures
Futures are same as forward contracts i.e. company contracts to buy/sell currency in future at specific date at agreed rate. However there are some differ-
ences:
i- Future contracts are for a standardize amount
ii- Futures are tradeable
iii- Settlement of future can be done before
Deriving a futures hedge:
i- Find the future lock in rate/ predicted rate
ii- Calculate the expected receipt/ payment using this future lock in rate
iii- Find the number of contracts
Currency Options
Options are the same as forward exchange contracts i.e. company contract to buy currency in future at specific date at agreed price. However there are
some differences.
i- Options give a right not an obligation to buy or sell a currency
ii- The company can exercise the option if it is beneficial or let it lapse if it is loss making by paying the option premium.
iii- An option which gives the right to buy currency is call option & option that give right to sell currency is put option
Deriving an option hedge: (Decide call or put)
For Payments:
i- Total payments = Expected payments in our local currency using ex price+ un hedged payments +premium payable
ii- Expected Payments= no of contracts x contract size
iii- No of contracts = (expected payments in Foreign currency/exercise price ) /Contract size
iv- Premium payable =no of contract x contract size x premium amount
v- Un hedge payments=exp payment in F.C – (no of contract x contract size x Ex price)
For Receipts:
i- Total receipt= expected receipts using ex price in our currency + unhedged receipt– premium payable

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ii- Expected Receipts =No of contracts x contract size
iii- No of contracts = (Expected receipts in foreign currency/exercise price) / Contract Size
iv- Premium payable=No of contract x contract size x premium amount (Premium needs to be converted in local currency using spot rate as premi-
um has to be paid immediately in option contract)
v- Un hedge receipts =Expected Receipts in foreign currency - (no of contracts x contracts size x exercise price)
vi- Un hedge receipt needs to be converted into local currency using Fwd. rate as under hedged amount is hedged using fwd. ex contracts

Answer Structure

The information given in the question allows us to manage foreign exchange exposure through the forward rate contract, future or options.
A four-month forward rate was used since payment/Receipts were after 4 months and using the forward contract answer was. ______
In the future a four-month lock-in rate was derived assuming the difference in rate moves proportionally w.r.t time using future the answer was---- this is
worth better than the forward rate contracts.
Options are always better because they give a right not an obligation and co can exercise it if it is beneficial and let it lapse if it is loss-making. however, a
premium needs to be paid for this using option the answer is ____ at the exercise price of____ and____at the exercise price of___.This is worse than the
future and forward mainly due to the high premium payment. hence the recommended strategy is.

Why Govt Don't Allow

i- Netting off reduces the number of transactions due to which govt losses the taxes and transactions fees.
ii- Govt feels that the netting of leads to the money laundering and taxes evasion
Why Govt allow
i- Govt thinks that the majority transactions will rout through us so it will give ease to the investor of doing development.
ii- maximum transactions will route through us business will increase.
Advantages of netting off
i- Reduce the currency exposure due to fluctuates in exchange rates
ii- Reduce the transaction fee due to decrease in number of transactions.

MULTIDROP (JUN 10), Casasophia Co:, Cocoa-Mocha-Chai (CMC) Co:, Kenduri Co: Nutourne Co:, Lirio Co,

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Currency Swaps
Swap is basically an exchange

Example
A project costing 5 million will generate 20 million pesos in year 1, 10 million in year 2 expected rate in year 1 is 5 pesos/£ and 4 pesos/£ in year two. A local-
ly govt has offered to swap the inflows at a fixed rate of 4.50 pesos/£. Discount rate is 10% find NPV if
i- SWAP take place
ii- Swap doesn’t take place.
Answer
i-
0 1 2
Investment £ (5.00) 0 0
Cashflows Pesos 0 20 10
Cashflows £ (5.00) 4 2.5
Discount Factor 10% 1 0.909 0.826
-
PV 5.00 3.64 2.07
NPV 0.70
ii-
0 1 2
Investment £ (5.00)
Cashflows Pesos 20 10
Cashflows £ (5.00) 4.44 2.22
Discount Factor 10% 1 0.909 0.826
-
PV 5.00 4.04 1.84
NPV 0.88

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Derivatives
Over the counter Exchange Traded
Customize contracts Standardized contracts
Any amount Standardized contract size
Available in any currency Available in major currencies
Settlement at any date Settlement date (March/June/Sep/Dec)
No initial margin required Initial margin required
The lower limit of the margin called Maintenance margin. In
case of loss on maintenance margin the broker will give a
margin call to reinstate the limit which is called variation
margin.
Gain or loss settled on maturity Gain or loss settled on daily basis using the mark to market
approach
High risk of default No risk of default
Counter party is another importer Counter party is clearing house
Forward contract Future contract

Forward exchange contracts

Advantages Disadvantages
Very simple to step If currency moves in you Favor you miss gains
Inexpensive to maintain May be time consuming
Lock in rate for the future receipts to reduce risk

Money market hedge

Advantages Disadvantages
Highly feasible when fund exchange contracts are not availa- More complicated to organise than the forward contracts
ble
Reduce risk exposure by involving banks Time-consuming than forward exchange contracts.

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Currency Futures
Advantages Disadvantages
Standardized make it easier for offeror Not available of any amount, only in lots
Costs are very low Restricted to professional traders
The potential of profit without delay

Currency Options
Advantages Disadvantages
They are very cheap to trade Unlimited risk for seller
Risk is limited to the premium for buyer Complex in working
Not legally binding

Currency SWAPS
Advantages Disadvantages
A company can enter into a SWAP at any time during life of The process of setting up an option is time-consuming and
the transaction complex
Offers insurance against risk associated with one currency They are prone to risk as one party can default

Types of Markets
i- Exchange-traded markets
Transactions are complete through a centralized source. One party act as a mediator between buyer and seller. Specific number of transaction will take
place every day via a centralized system. E.g. NYSE, PSX
Advantage:
- Strict security
- No compliance issue
- Reduce chances of fraud
- Due to regulators delivery is guaranteed
- Less chances of price manipulation
ii- Over-the-counter markets

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There is no regulator, there are mainly mediators who compete to link buyers & sellers so there is no centralized source for the traders and sellers
Advantage:
- no intermediary costs
- no bureaucratic process.

Interest Rate Risk Management

Risk that interest will increase if we have to borrow money in future or will fall if we have to deposit in the future.

Techniques to deal with the interest rate risk

- Forward rate agreement

- Interest rate future
- Interest rate options
- Interest rate SWAP
- Interest collars

Forward rate agreements

Contract of rate fixing where co contract to borrow/Deposit money in future at specific date at specific rate.
FRA (Fwd rate agreement):
Format:
Actual return/ Cost of borrowing /deposit xxx
(Amount x rate of interest actual x time period / 12)
Add/Less: Benefit/Loss due to FRA x/(x)
(Difference in the rates x amount x time period/ 12)
Net cost/ return xxx

Example 1
Assume it is 1st Dec ABC ltd will be receiving 2 million on 1st Feb which will be invested with the bank till 1st May a bank has offered the following FRA rates.

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3-5 5.00% - 5.50%
2-5 5.20% - 5.60%
2-7 5.50% - 5.80%
3-7 5.90% - 6.00 %
Co currently has opportunity to invest fund at inter bank rate less 10 basis point and inter bank rates currently 5%.

Outcome of the FRA if interest rate increase or decrease by 1%

Case of deposit, Toady date 1st Dec, Deposit date 1st Feb
Period: 3 months
Interest Increase By 1% Interest Decrease By 1%
Actual return on deposit 29500 19500
Gain Loss on deposit -3500 6500
Net cost / return 26000 26000

Example 2
Assume it is 1st June ABC ltd need to borrow 10 million on 1st Sep and will repay loan on 1st Dec a bank has offered the following FRA rates.
3-6 4.00% - 4.80%
3-9 4.200% - 4.90%
6-9 4.30% - 4.95%
Co currently has opportunity to borrow the fund at inter bank rate plus 20 basis point and inter bank rates currently 4%.
Outcome of the FRA if interest rate increases or decrease by 1.20%
Case of Borrow, Toady date 1st June, borrow date 1st Nov Feb
Period: 3 months
Interest Increase By 1.20% Interest Decrease By 1.20%
Actual Cost of borrowing 135000 75000
Gain Loss on borrowing -15000 45000
Net cost / return 120000 120000

Interest rate Futures:

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Strategy
Borrowing ----- sell now buy later
Deposit ------- buy now sell later
Logic: Future is quoted as 95(means 100 is spot price & 5 is interest rate). In borrowing we fear interest rate may rise so future will become cheaper in long
term so sell now buy late at cheaper rate. In deposit we fear interest rate will fall so future will be expensive so buy now sell later)

Format :
1) Find no of contracts as follows (Borrow/ deposit amount x time period of borrowing /deposit) Contract size 3m (fixed)
2) Find basis risk (spot price – libor) less future price (given)
3) Find unused basis (basis risk x Extra months)/Total months Commented [MU1]: Count from today date till the future
4) Find future close out price (in both cases) (spot – libor ) less unused basis if declining trend in basis risk (Spot – libor) add unused basis if rising trend in contract date , difference between the borrowing or deposit
basis risk date and contract date
5) Find tick size if not given in question (Contract size x 1/10000 x 3m/12m)
NOTE: 0.01/ means 1 ticks 0.02/ means 2 ticks 0.1/ means 10 tick’s 1% means 100 ticks
6) Find outcome of hedge in case of libor increase/decrease Actual cost or return of borrowing/ deposit x (Amount x Interest rate x time period /12)
Add/less: gain or loss on futures x/(x) (Difference in Futures contract price & future lock in rate) x ( spot rate x no. of contracts x tick size ) Net benefit/ cost
x
7) Find effective interest rate Net cost/return x 12 months Borrowed/ deposit amount time period of borrowing /deposit

Interest rate options:

In case of borrowing ------ put option
In case of deposit --------- call option
(In borrowing sell now buy later so put option)
(In deposit buy now sell later so call option)
FORMAT:
Case 1 Case 2 (Libor dec) (libor Inc)
1) Exercise price of option XX
2) Future close-out price (from future) XX
3) Exercise yes/no yes/no
4) gain in basis points if yes XX
5) Total gain (gain in basis pts x no of contract x tick size X/(x) X/(x)

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6) Actual cost of borrowing or actual return on dep from future XX
7) Premium payable X/(x) X/(x)
(Premium rate x spot x no of cost x tick size) Net return/ net borrowing cost X X
8) Effective Interest rate XX
Note for No5 & No.7: Gain will be added if this deposit case & deducted if borrowing case Premium payable will be added if borrowing case & deducted if
deposit case

Interest rate Swaps:

Objective. Co one wants a floating rate loan and company two want a fixed rate loan .

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Under swap. Co 2 contacts company one and requests that co one take fixed rate loan and we (co.2) will take floating rate loan and then we will swap our
loans with any benefits of swap being shared in 60% to co 1 & 40% to co 2.

Questions: Awan Co., Alecto Co:, Armstrong Group:, FNDC PLC:, Dalkon Co:, Keshi Co:

Collar Options:
Interest rate COLLARS:
Technique of making COLLAR
Step 1: Opt for put Option (at low strike price) and call option (at high strike price) simultaneously
Step 2: Compare ex price of call & put option with future close out price to find gain/loss, with premium being differential of both premiums

Right to sell = Put option

Right to buy = call option
Borrowing = sell now buy later = put option
Deposit = buy now sell later = call option

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MERGER & ACQUISITION
Pre-Acquisition Valuations
In this situation, the aim is to establish a value for a business’s equity capital. There are several
methods that can be used here:
• Latest price on the stock market
• Net asset valuation
• Price-earning model
• Dividend valuation approaches
• Net assets and CIV
1- Latest Share Price:
The value of the entity is simply;
No of issued equity shares x Current price (Po) per share
The weaknesses of this method are:
o The company may not have a listing
o The price is based on trading not on selling a controlling interest in the company.

2- Net Asset Valuation:

A business is worth just the value of its net Assets
To establish the net assets: Total Assets – (Total Liabilities + Preference Shares)
The net asset value equals the Ve and can be based on:
a) Book Values
b) Net realizable Value (NRV)
c) Replacement Cost
It is useful for:
a) “Seller” to set minimum value of the company (NRV)
b) Companies with lots of tangible high-value assets such as a property Investment Company
The major weaknesses are:
a) Not include non-tangible assets
b) Excludes what all assets generate future:
i) Dividends
ii) Profits
iii) Cash flows

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3- Price – Earnings Model: (Market value per share / Earning per share)
A business is worth a multiple of its profits and so
Ve = Sustainable PAT x Suitable P/E or
Po = Sustainable EPS x Suitable P/E
To find the sustainable PAT – there may be adjustments to the latest reported reports for non-reoccurring items (post-tax)
The suitable P/E ratio is taken from a proxy-listed company or the Industry average. This value may have to be ARBITARILY adjusted to make it fit the busi-
ness under consideration. For example, it is common to REDUCE the listed company's P/E ratio by 30% when applying this to a non-listed entity.
The concerns with this method are:
o Finding a proxy Co P/E
o Adjustments are arbitrary
o Sustainable profits needs forecasting adjustments.

4- Dividend Valuation Model:

The company is worth the present value of its future dividends discounted at the cost of equity. If there is a constant future growth rate in dividends then
the calculation can be summarized via:
If the growth is constant

Otherwise, Market value = PV of all future dividends discounted at Ke

Issues to note:
o Growth may not be constant forever
o Where do we get “g” from?
o CAPM may be needed to find Ke.
o Often better to value a small shareholding

5- Free Cash Flow Valuation:

Business is worth the discounted value of the its future free cash flows.
There are two Approaches
a) FCF co-discounted at the Co WACC. This gives V entity.
b) FCF equity discounted at Ke. This gives V equity.

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Preparing a schedule of forecast FCF Is very important.

FCF co FCF e
Revenue xxx xxx
Cash Costs (xxx) (xxx)
PBIT (xxx) (xxx)
Interest - (xxx)
Taxable Profit xxx xxx
Taxation (xxx) (xxx)
Add: TAD xxx xxx
Less: Investment In NCA (xxx) (xxx)
Less: Investment In Working Capital (xxx) (xxx)
FCF FCF co FCF e
Discount Rate Co WACC Ke
V entity
(Vd)
Valuation Ve Ve

Questions: STANZIAL INC:, Borgonni and Venitra, Sigra Co:, Pursuit Co:, Makonis Co:

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Post-Acquisition Valuations:

i. Bootstrapping:: When the BUYER (B) has a higher P/E ratio than the SELLER (S) the bootstrapping method can be used

Latest PAT of Co B
Latest PAT of Co S
Add: Post Tax Synergistic Profit benefits
Combined PAT
P/E ratio of Co B X P/E

POST Acquisition VALUE OF Co B + Co S

ii. Add together Method: here, the pre-acquisition values of Co B and Co S are added together. In addition, the PV of synergies are brought in.

Pre- Acquisition Value Co B

Pre- Acquisition Value Co S

- Add: PV of Synergistic Benefits xxx

TOTAL Co B + Co S

iii. Free Cash Flows -forecast free cash flows of the combined company are prepared. These are discounted at the NEW combined company WACC
to ascertain the value of the entity. The new value of debt is deducted to arrive at the value of the equity.

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iv. Cash Offer
Current share price xxx
Cash Offer xxx
%gains xxx

v. Share for share offer

Current share price xxx
Combined co share price xxx
% gain xxx

vi. Bond offer

Current share price xxx
Market value of bond xxx
%gain xxx

The factors should be considered before accepting or rejecting the offer

- Buyer may increase bid in future

- Economic condition are improving so keep running over may better
- They should consider the cash offer perhaps beneficial
- Rates are based on the forecast which could be wrong
- Negotiation for the better offer like one for one share.

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THEORY
1- Money laundering
2- Free trade areas
3- World trade organization
4- Initial coins offer
It is similar to IPO but in IPO the share are quoted on stock market where as in the ICO the digital currency are publish.
5- IMF
It provide the fund to govt to manage there balance of payment.
6- World bank
It provide the soft loans to under developed countries
7- Bank of international settlement
World bank of all the central banks
8- The FED, the fed is the central bank of united state
9- European central bank – the ECB is responsible is the bank maintaining the monetary policy all the member countries of European union.
10- Islamic Finance
Islamic finance is the sharia compliant finance, which mean what ever is outlined in hold Quran and Ahadees should be implemented.
Under Islamic finance the Reba (interest) is strictly forbidden
In Islamic finance sharia compliant instrument have been given
i- Murabaha – is an agreement to purchase the raw material. In the agreement Islamic bank will buy the raw material on your behalf and will sell you on profit on instillment.
ii- Ijara. Is the arrangement similar to the mortgage loan, like loan to buy car
iii- Mudarabah. -
iv- Musharika - partnership
v- Sukuk. – Islamic bonds
vi- Salam – advance payment
vii- Istisna – project financing
11- Austerity measure – reduction of defence budget, travelling ban on govt officials, allowance reduction
12- Dark pool Trading – In the stock market live trading if a person shows a willingness to buy a big chunk of shares as soon as he will put his offer the other holders will hold the share
with the hope of something better happening and as a resuld the main person either not get the shares or he will have pay extra amount. To overcome this issue investor will ask the
broker if someone is selling shares which can fulfil his need and meet him privately and the ownership of share transfer without knowing by the stock exchange.

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