Revision Notes

ACCA
Advanced Financial Management (AFM)
Exams from September 2023
ii Introduction ACCA AFM

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ACCA AFM Introduction iii

Contents
Page

1: Role of a senior financial adviser in the multinational organisation 1

1 The role and responsibility of senior financial executive/advisor 1

2 Financial strategy formulation 2
3 Ethical issues in financial management 7
4 Management of international trade and finance 9
5 Strategic business and financial planning for multinationals 13
6 Dividend policy in multinationals and transfer pricing 15
7 Islamic financing 15

2: Advanced investment appraisal 17

1 Capital investment monitoring process 17

2 Discounted cash flow techniques 18
3 International investment and financing decisions 21
4 Other aspects of investment appraisal 25
5 Techniques for dealing with risk 27

3: Cost of capital 29

1 Calculating a current WACC for a business 29

2 Use of WACC in investment appraisal 33
3 WACC and change in business risk 34
4 Impact of changing the capital structure (i.e. gearing or financial risk) 35
5 Credit risk measurement (credit ratings and credit spreads) 37
6 Investment appraisal and a change in gearing/risk: adjusted present value (APV) 40

4: Option pricing theory 43

1 Option pricing theory 43

2 Value of Real Options 45
3 Using Black-Scholes to determine loan default risk 45
4 Using Black-Scholes to value equity 46
5 Delta Hedging and the ‘Greeks’ 46

5: Treasury function and currency risk management 47

1 The role of the treasury function in multinationals 47

2 Foreign exchange risk 49
3 Internal hedging methods 50
4 External hedging methods – forward exchange contract 50
5 External hedging methods – money market hedge 51
6 External hedging methods – currency futures 52
7 Over the counter (OTC) currency options 54
8 Exchange traded currency options 55

6: Interest rate risk 57

1 Interest rate risk 57

2 Forward Rate Agreements (FRAs) 57
3 Interest rate futures 58
iv Introduction ACCA AFM

4 Exchange traded interest options 60

7: Valuation techniques 65

1 Valuation – general issues 65

2 Asset basis – minimum valuation 66
3 Earnings basis (P/E valuations) 66
4 Discounted cash flow valuations (free cash flow valuations) 68
5 Dividend yield basis 69
6 Dividend Valuation model (DVM) – useful for valuing minority interests 69

8: Mergers and acquisitions 71

1 Acquisitions and mergers versus other growth strategies 71

2 Regulatory framework and processes 76
3 Financing acquisitions and mergers 78

9: Corporate reconstruction and reorganisation 81

1 Financial reconstruction 81
2 Business reorganisation 83

Formulae sheets 85
 1

Role of a senior financial adviser

in the multinational organisation

1 The role and responsibility of senior financial executive/advisor

Main roles and responsibilities of the finance director are:
 Investment decision
 Financing decision
 Dividend decision
 Risk management
Directors should aim to increase shareholder wealth and maximise shareholder return.

FORMULA TO LEARN
(𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 + 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑖𝑖𝑖𝑖 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝)
𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇𝑇 𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎ℎ𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑠𝑠 ′ 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 (%) = × 100%
𝑆𝑆ℎ𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝
 2 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

1.1 Development of financial targets

What to do Examples
Set strategies to meet targets Supply chain efficiencies, managing brand and
reputation, market and product diversification
Use financial planning data to model allocation of Capital rationing, linear programming
resource options to plan for the most efficient use
of resources
Employ other financial targets to underpin main Restrictions on gearing, profit margin
targets
Manage conflicts with non-financial objectives Quality improvements, assisting local community
projects
Consider moral/ethical behaviour versus statutory Use of an ethical framework
requirements

2 Financial strategy formulation

2.1 Assessing corporate performance

Note
In AFM ratios tend to be used sparingly to focus on a few key aspects of a business’s performance. It
is more important to be able to calculate a few ratios and explain them well than it is to race through
20 ratios without demonstrating what they tell you about the business.
You need to learn how to calculate the ratios below.

2.1.1 Profitability ratios

PBIT
Return on Capital Employed (ROCE) = × 100%
TALCL

(where TALCL = Total Assets Less Current Liabilities)

Gross profit
Gross Profit margin = × 100%
Revenue
Operating profit
Operating Profit margin = × 100%
Revenue
Profit after Tax
Net Profit margin = Revenue
× 100%
Profit after Tax and pref dividends
Return on Equity = × 100%
Ordinary SC +Reserves
Revenue
Asset turnover =
TALCL

2.1.2 Liquidity ratios

Current assets
Current ratio =
Current liabilities
Current assets − inventories
Quick ratio (or acid test) =
Current liabilities
Cost of sales
Inventory turnover =
Inventories
Inventory
Inventory days = × 365 days
COS
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 3

Trade receivables
Receivables collection period = × 365 days
Credit turnover
Trade payables
Payables payment period = × 365 days
Credit purchases or COS

Note
The working capital cycle includes receivables, inventories and payables. It effectively represents the
time taken to purchase inventories, then sell them and collect the cash. The length of the cycle is
determined using the above ratios.

2.1.3 Gearing/debt ratios

The term ‘gearing’ refers to the extent to which a business is dependent on loans and preference
shares, as opposed to ordinary shares and reserves.
Gearing ratios indicate the degree of risk attached to the company and the sensitivity of earnings and
dividends to changes in profitability and activity level.
Long term debt
Gearing = Long term debt+Equity × 100%
PBIT
Interest cover = Interest payable

Note
Check in questions whether gearing is debt/equity rather than debt/(debt + equity), and whether the
definition is based on book values (balance sheet values) or market values.

2.1.4 Investor ratios

Profit available to ordinary shareholders
Earnings per share (EPS) =
No of shares
Dividend per share
Dividend yield = × 100%
Market share price
EPS
Dividend cover =
Dividend per share
Market share price Market capitalisation
P/ E ratio ∗ = EPS
or
PAT
Equity value
Share price =
No. of ordinary shares in issue

* An indicator of the stock market’s confidence in the shares of a company

Note
If a question asks you to assess the performance of the business in line with its objective to
maximise shareholder wealth, concentrate on investor measures (particularly dividend yield (vs.
market average if possible) and share price performance (% increases in share price relative to stock
market increases).
You might also compare the actual return (total shareholder return) with the return that would be
expected for the level of risk taken to see if sufficient return is being generated. The expected return
would be found by identifying the relevant beta factor for the business and then using CAPM to
estimate the return required for that level of systematic risk.
4 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

2.1.5 Earnings before interest, tax, depreciation and amortisation (EBITDA)

EBITDA is a fair measure to assess managers with if they have no control over financing or CAPEX.
It gives a profit measure that roughly approximates to the operating cash flow generated by the
business.

2.2 Sources of finance

Source of Finance Types Return Risk
Equity  Ordinary Shares Dividend plus capital High – 100% loss on
 Venture capital (high return/exit growth in share price insolvency
strategy) (Ke%)
 Business Angels (wealthy
individual, high risk/return)
 Private Equity (not traded)
Debt  Bank loan Interest (Kd%) Lower than equity
 Debentures finance as interest
 Lease Finance paid out before
– Finance leases dividend and debt
– Operating leases may be secured
 Domestic bonds
 Eurobonds
Hybrids (Debt and  Convertible Bonds/Debentures Low cash payments Generally higher risk
Equity)  Debt with warrants due to other than standard debt
 Preferences Shares incentives as unsecured

The annual cost to satisfy equity and debt investors via the payment of dividend and interest is known
as the company’s weighted average cost of capital (WACC).

2.2.1 Equity

Raising
equity
finance

Private
Rights issue Public issue placing

Existing
A company
shareholders are Initial public
Direct listing issues shares
invited to offer (IPO) to a select
purchase
group of
additional shares
institutional
in the company
Underwriters buy shares Existing shares are sold investors and
in a ratio to their
and sell them to the to the public (so there is not to the
existing holding.
public. Stringent stock no dilution of public.
market regulatory shareholdings). Quicker and
requirements must be Underwriters are not less costly
met. A dutch auction involved, which saves than public
may be used (the price is costs. However there is offer.
based on the highest no support, guarantee
price at which all shares or promotion of the
can be sold). sale.
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 5

2.3 Initial coin offerings (ICO) and security token offerings (STO)
A cryptocurrency is a digital or virtual currency.
 It is difficult to counterfeit as it uses cryptography for security.
An ICO is the cryptocurrency equivalent of an Initial Public Offering (IPO).
 ICOs are a simple and inexpensive way of funding new ideas, with low barriers to entry.
 The lack of regulation makes them high risk and open to scams, however.
A STO is similar to an ICO but is asset backed and regulated by the government. They are therefore
seen as lower risk than ICOs.

2.4 Dividend policy

Surplus funds
generated
from projects

Retain within Return to

business ? shareholders?

To fund
Share
future Dividends
buybacks
projects?

Factors affecting dividend Explanation

policy
Investment decision The level of business risk (βe) will determine the expectation of the dividend
level (Ke) – large, stable companies are more likely to be able to pay out a
stable cash dividend than new or small companies.
Financing decision Interest on debt must be paid before a dividend.
Investment opportunities Companies (focused on growth or with limited access to debt finance) may
prefer to reinvest retained profits.
Changes in financing Share repurchase agreements return cash to investors, reducing dividend
capacity.
New issues of debt or equity enable the funding of expansion programmes
without affecting shareholders’ dividend expectations.
Liquidity/retained Sufficient liquidity and distributable reserves are required.
reserves Recessionary fears/ poor liquidity may lead to lower dividends.
Clientele effect A policy inconsistent with what shareholders expect may lead them to sell
their holdings.
Some shareholders may prefer reinvestment and growth in the share price
(capital gains tax) rather than dividends (income tax).
Dividend signalling What does a dividend signal about likely future performance?
Available cash If not, a scrip dividend can be considered (additional shares as an alternative
to a cash dividend).
Retained cash Sufficient cash should be retained for existing/future projects.
Consistent/stable profits Dividend growth requires consistent/stable profits.
6 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

In the real world, investors dislike erratic dividends and so companies tend to use either of the
following policies:
 Growth year on year (either for total dividends or, more usually, dividend per share). Investors
often expect dividends to at least increase in line with general inflation or an industry growth
rate.
 Constant dividend pay-out percentage

Note
As a guideline for exam questions:

Small or young company Large or listed company

Zero / Low dividend High stable growing dividend
Use cash for reinvestment Borrow to expand
Zero or low debt Higher gearing (industry average)

2.5 Risk
It is important for a business to identify the types of risk it faces, prioritise these risks and have an
appropriate action plan for dealing with them, depending on the degree of severity.

Identify the types Prioritise the risks Mitigate the risks

• Information • TARA framework • Negotiation

• Operational/ business (severity and frequency) • Monitoring
• Reputational • High impact, high • Operational Hedging
• Non-systematic (specific) probability - TRANSFER • Financial Hedging
• Systematic • High impact, low • Diversification
probability - AVOID
• Political • Insurance
(100% hedge)
• Cultural • Joint ventures/partners
• Low impact, high
• Economic probability - REDUCE (< • Legal system
• Regulatory 100% hedge) • Supply chain
• Fiscal • Low impact, low
• Credit probability -
ACCEPT/MANAGE

2.6 Behavioural finance

Conventional financial theories generally rely on the assumption that investors act rationally, such
that:
 Decision makers aim to maximise the value of their portfolio or company.
 Decisions are based on a rational, objective and risk-neutral analysis of relevant information.
Behavioural finance, on the other hand, considers psychological factors can affect investors’ decision
making in the real world.
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 7

Psychological factor Detail

Investor over-confidence Making bad investments due to lack of knowledge and high self belief
Cognitive dissonance Clinging onto long-held beliefs and ignoring evidence to the contrary
Anchoring Using information that is not relevant but is readily available, to simplify
the decision-making process
Availability bias Placing too much significance on the latest piece of available information
and losing sight of the bigger picture
Representativeness Over-reaction to news based on previous trends
Narrow framing Concentrating too much on one piece of information
Miscalculation of Eg over-estimation of the probability of success of dotcom businesses in
probabilities the late 90’s
Ambiguity aversion Aversion to investing in new business areas
Positive feedback Assumption that rising shares will continue to rise and falling shares will
continue to fall or that rising shares will stop rising despite evidence to the
contrary (gambler’s fallacy)
Conservatism Under-reaction to good/bad news due to resistance to changing an opinion
Confirmation bias Focus more on the evidence that supports a current view

Note
In the exam it is likely that you would have to review the practicalities around a scenario to identify
whether there is any evidence that any of the above factors/biases have been evident in the decision
making.

3 Ethical issues in financial management

3.1 Defining an ethical dilemma
The following tests help evaluate the issue:
 Are the company’s actions truthful?
 Do a particular group of stakeholders benefit at the expense of other stakeholders?
 Are any stakeholders harmed by the company's actions?
 If the action entered the public domain, would it damage the company’s reputation?
Firms should follow best practice to protect its reputation, market share and profitability as opposed
to simply implementing minimum legal requirements. As a general rule, directors should endeavour to
ensure ethical behaviour takes precedence over the pursuit of profit in all circumstances.
Ethical behaviour is linked to non-financial objectives such as:

Area Examples of objectives

Employees Health and safety safeguards, compliance with employment law.
Local community Protection of the local environment and investment in local community
Customers Commitment to quality, safety and fair dealing.
Suppliers Commitment to fair dealing, not exploitative and timely settlement.
Research and development Transparent, not illegal.
Government/regulatory Payment of taxes and regulatory compliance.
authorities
8 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

3.2 Resolution of stakeholder conflict

The resolution of shareholder conflict is found by bringing about goal congruence between the
objectives of the two parties. Strategies for this include:
 Regular shareholder communication
 Performance related pay linked to longer-term successes
 Non-executive Directors
 Separation of roles and a Corporate Governance framework
 Compliance with Accounting standards/Audit reports

3.3 The ethical framework

Applying the following five step ethical framework to a situation ensures it applies the highest ethical
standards.

1. Ensure understanding

2. Compare against ethical principles

3. Perform risk assessment

4. Mitigation

5. 'Mirror test'
• Would disclosure by the press result in negative publicity/ financial loss
• If failed, the issue is likely to be unethical and needs to be resolved

3.4 Other ethical considerations

 Ideally, a company should publish a Code of Ethics, and there should be an Ethics Committee
independent of the executive board.
 Sustainability is a target of zero impact that a company’s activities has on the Earth’s resources
whilst balancing growth.
 Environmental risk is the potential damage to shareholder wealth resulting from any adverse
public reaction to company’s activities which adversely affect the environment.
 An increasing number of investors are looking to ensure that the companies they invest in are
responsible stewards of the environment, good corporate citizens, and are led by accountable
managers. As well as traditional financial criteria, organisations must therefore also consider
environmental, social and governance (ESG) criteria when making decisions.
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 9

 Green finance is a loan or investment that promotes environmentally-positive activities. It

includes:
– Green loans
– Sustainability-linked loans (SLLs)
– Green bonds
– Green funds
 The Environment Agency (EA) has three official roles:
– Action
– Advice
– Protection
 An environmental audit seeks to measure and report the environment impact of a company’s
policies.
 The triple bottom line approach allows the formulation of clear objectives on:
– Social justice
– Environmental quality
– Economic prosperity

4 Management of international trade and finance

4.1 Barriers to free trade
Free trade allows traders to act or transact without interference from government.
Multinational companies frequently encounter barriers to trade outside free trade zones (eg EU).
Examples include:
 Domestic subsidies
 Import duties and tariffs
 Trade quotas
 Trade embargoes
 Import legislation and form filling
Often, barriers can be negotiated around if benefits to the local population can be demonstrated. A
joint venture with local industry can often circumvent import legislation, but potential returns are
shared and it may be difficult to work with local partners.

4.2 Agreements encouraging free trade

Trade agreement Description
Free trade area No restrictions between members, each has own trade restrictions with non-
members.
Customs union No restrictions between members, common trade restrictions with countries
outside union.
Common market/ In addition to trade, free movement of labour and capital between member states.
economic community
Economic union In addition, harmonisation of social and economic policies (i.e. single currency).

Some examples include:

 European Union (EU)
 North American Free Trade Agreement (NAFTA)
 South Asia Free Trade Agreement (SAFTA)
10 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

Note
Use the media, internet and financial press to gain an understanding of any current issues affecting the
ability for companies to freely trade overseas.

4.3 How actions of the World Trade Organisation impact on a multinational

organisation
The World Trade Organisation (WTO):
 Seeks to promote and liberalise free trade between all countries
 Assists companies in identifying and reducing existing trade barriers
 Acts as an intermediary between companies and member states with the objective to resolve
trade disputes
 Administers trade agreements & monitors national trade policies
 Provides technical assistance & training for developing countries
 Co-operates with other international organisations

4.4 Roles of other organisations in promoting global trade

The role of national and international financial institutions is aimed at ensuring global stability and
setting out a platform for economic growth. Examples include:
Institution Objectives
Central Banks (e.g. Bank of Control over interest rates, money supply (physical currency and the
England, the Fed) availability of credit) often with a view to maintaining low inflation and
steady GDP growth.
Guaranteeing the convertibility of a currency to support confidence in global
trade.
Setting reserve ratios for commercial banks and acting as a lender of last
resort if necessary.
The International Monetary The IMF currently has 190 member countries and its main purpose is to
Fund (IMF) support the stability of the international monetary system. There are three
main ways in which it does this:
 Keeping track of the global economy and the economies of member
countries, highlighting possible risks to stability and advises on needed
policy adjustments.
 Providing loans to member countries that have actual or potential
balance of payments problems to assist in the rebuild of international
reserves, currency stabilisation, paying for imports and restoring
conditions for strong economic growth.
 Capacity development – helps countries to modernise their economic
policies and institutions and train their people with a view to the
economy then strengthening, growing and creating more jobs.
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 11

Institution Objectives
The World Bank The World Bank, partially funded by the IMF consists of two main
institutions:
The International Bank of Reconstruction and Development (IBRD)
The IBRD provides loans, guarantees, risk management products and
advisory services to middle-income and creditworthy low-income countries
as well as co-ordinating responses to regional and global challenges.
The International Development Association (IDA)
The IDA is overseen by 173 shareholder nations and its services complement
the role of the IBRD by seeking to help out the very poorest countries. It
aims to reduce poverty by providing zero to low-interest loans (called
‘credits’) and grants for programs that boost economic growth, reduce
inequalities and improve people’s living conditions.
IDA credits tend to be repayable over a 30-40 year period (including a 5-10
year grace period).
Focus is on supporting activities around primary education, health services,
clean water and sanitation, agriculture, infrastructure and business climate
improvements that will then allow progression towards equality, economic
growth, job creation, higher incomes and better living conditions.

4.5 Role of financial markets in the management of global debt

Note
Keep abreast of this area as the exam approaches as the roles of the international markets change
with circumstance and changes in the political environment.

Role Detail
Management of global debt Governments issue debt to fund tax shortfalls against public spending plans.
The rating agencies have a role in providing such debt with a rating (i.e.
AAA). The raising of capital requires willing investors and if investor’s
confidence is shaken by events then the ability to raise additional finance
diminishes. Recently, concerns over the national debt levels in Greece
resulted in rating agencies reducing its credit rating to ‘junk status’. Spain
and Portugal have endured difficulties in raising debt.
This has prompted Eurozone members and the IMF to support Greece with
110bn Euros in financial aid on the condition that it slashes public spending
and boosts its tax revenues. In this way the markets place limits on the
ability of governments to borrow.
The financial development As emerging economies liberalise their economic policies, this facilitates a
of emerging economies significant flow of international capital into the region and demand for
international debt capital. The creation of jobs and wealth creates a need for
domestic financial institutions which in turn provide credit facilitating further
economic growth. Deficiencies in financial reporting, insolvency law,
corporate governance and the likelihood of corruption remain obstacles.
The maintenance of global The rapid financial development of emerging economies has contributed to
financial stability financial instability. There is no single global financial regulator. The global
debt crisis in the late 20th century and the recent ‘credit crunch’ with the fall
of Lehman Brothers and the bail out of Bank of America, AIG and UK banks
such as RBS, cast doubt on the market’s ability to self-regulate and maintain
its own stability.
12 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

4.6 Developments in world financial markets

Development Detail
Securitisation The process of banks packaging existing loans and mortgages and selling the
future interest cash flows to investors.
Usually sold to a Special Purpose Vehicle (SPV), which might then package a
number of these securitised loans together and sell them to investors
(collateralised debt obligations (CDOs)).
On sale, the banks use the cash flows generated to offer further loans and
mortgages.
Credit crunch Caused by a lack of confidence in the banking industry fuelled by years of
liberal lending criteria and a rise in securitisation
Tranching (traunching) The structure of securitisation deals – senior tranches have priority in
interest distributions over junior tranches (which are more risky, and
therefore command a higher return)
Credit default swaps (CDS) Counterparty agreements which allow the transfer of third-party credit risk
to another party
Gained popularity in an unregulated market, when large financial
institutions were unaware of their credit risk exposure which then added to
the 2007 economic downturn
Dark pool trading Trading systems which allow:
 Market makers (traders) to trade without quoting prices publicly on the
exchange system
 Fund managers to buy/sell large orders anonymously to avoid
influencing the market price or to avoid the market price adjusting
before this significant volume of shares is traded
Problems include:
 Reduction in transparency and market efficiency which reduces
investor confidence and market liquidity
 Danger that the market under-estimates risk, precipitating events
which led to the last credit crunch
Money laundering FSA requires UK companies engaging in financial services to warn the
authorities if they suspect/discover that illegal transactions have taken place
and:
 Check the identity/source of funds for new customers
 Implement effective internal control to protect the business from
money laundering
 Keep full and up to date records
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 13

Note
Use the following list of questions and news websites and internet searches to gain a current picture
of market and macroeconomic developments.
 What is the current expectation of UK and global inflation rates?
 What is happening with regard to Oil and other commodity prices?
 What factors are currently affecting global market stability?
 What is the current expectation with regard to UK and global interest rates?
 Which large corporations are currently dealing with negative publicity and why?
 Is there evidence of any recent or proposed changes in market regulation?
 What are the recent trends in the equity and debt markets?
 Is there evidence of pressure groups affecting financial policy?
 Are there current examples of global tax planning using transfer pricing and group structures to
minimise tax?

5 Strategic business and financial planning for multinationals

5.1 Financial planning framework for multinationals
Components of a strategy to ensure objectives and Examples
competitive advantages are realised
How to finance an overseas subsidiary Equity vs. debt, joint venture, local debt, list on
local stock exchange
Risks related to overseas operations Political, cultural, foreign exchange
How to repatriate profit Restrictions on dividends, transfer pricing,
management charges/ royalties, interest on loans
How to minimise local taxes/ prevent double tax
Control Local vs. central management

5.2 UK listing requirements

Listing requirements include:
(1) Audited accounts for a three-year period
(2) A value of at least £700,000 at the time of listing
(3) Working capital for at least twelve months following listing
(4) A prospectus must be issued to potential shareholders (general business data, financial
forecasts, summary of business risks)
(5) Compliance with the UK corporate governance
– Separate chairman and CEO
– Half the board NED
– Independent nomination
– Remuneration and audit committees
– Excellent controls and financial systems
– ‘City Code’ and other UKLA disclosure rules
14 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

Other issues to consider include:

 Employment of a ‘sponsor’ if a company is unfamiliar with local listing rules
 Listing overseas, if overseas finance is required
– ‘Dual listing’ – a company lists on two recognised exchanges
– Benefits – widening the scope of potential investors, improving the liquidity of shares.
 Investment in local legal expertise

5.3 Eurocurrency markets

Eurocurrency is currency which is held or borrowed by individuals and institutions outside the country
of issue of that currency. For example, borrowing $ from a London bank are Eurodollars.

5.4 Obtaining a Eurobond

A Eurobond is a debenture issued outside the jurisdiction of the country in whose currency the bond is
denominated.

Bearer instruments (so can be traded) High issue costs (2% upward)
Interest is paid gross (so overseas investors avoid UK Exchange rate risk if no foreign currency assets
tax)
Hedging foreign exchange risk as a Eurobond
liability will match a foreign currency asset
Often cheaper than a foreign currency bank loan
Can be fixed or floating
Normally unsecured (but need excellent credit
rating)
Finance is quickly raised (as Eurobonds are easy to
place with institutional investors )
Using local finance can reduces forex risk and
political risk

5.5 Global risks

Examples of risks
Import quotas and tariffs Litigation risks
Unfamiliar legal standards (eg safety, quality) Cultural risks
Exchange control regulations Different views on business ethics
Dividend remittance restrictions Inflation, interest rate volatility
Transfer pricing, local taxation issues Poor financial infrastructure
Restrictions on local investment, Supply chain management issues
Employment quotas ‘Special’ taxes
Government instability Non-compliance with local corporate governance
regulations
ACCA AFM 1: Role of a senior financial adviser in a multinational organisation 15

5.6 Agency conflict

The potential conflict between management of an overseas subsidiary and the Board of Directors
should be managed through corporate governance mechanisms, performance appraisal, target setting,
and on-site visits.
Management compensation packages can be used to reduce agency costs by aligning the interests of
overseas executives with head office management and the ultimate interests of the shareholders.

6 Dividend policy in multinationals and transfer pricing

6.1 Factors affecting the dividend decision
As well as the factors set out in , multinationals should also consider:
 Double tax relief will limit the extra tax payable on overseas dividends to the difference
between the rate of tax overseas and the UK rate.
 Exchange controls reduce the ability of a company to pay dividends from an overseas subsidiary
and the value of the dividend reduces with the time value of money.
 If dividend remittance is restricted or dividends are highly taxed, alternatives to a dividend are:
– Setting a high transfer price on goods sold to an overseas subsidiary (high UK income) or
a low transfer price on goods bought from an overseas subsidiary (low UK cost)
– Management charges, royalties and interest on intercompany loans

6.2 Transfer pricing and impact on profit

Transfer pricing has the effect of moving pre-tax profits around the group but does not change the
total pre-tax profit. However as different countries have different tax rates, the transfer price can
influence the total amount of tax that is paid and so many companies will set their transfer prices to
minimise the total amount of tax they pay.

7 Islamic financing
7.1 Basic principles of Islamic financing
Interest and speculation are prohibited.
All parties involved in a transaction are allowed to make informed decisions without being misled or
cheated.
The parties are allowed to pursue personal economic gain but without entering into those transactions
that are forbidden (for example transactions involving alcohol and armaments).
In an Islamic bank, the money provided in the form of deposits is not loaned, but is instead channelled
into an underlying investment activity, which will earn profit. The depositor is rewarded by a share in
that profit, after a management fee is deducted by the bank.
16 1: Role of a senior financial adviser in a multinational organisation ACCA AFM

7.2 Fixed income modes of finance

• A form of trade credit or loan

• The bank takes actual constructive or physical ownership of the asset and then
Murabaha sells it to the ‘borrower’ or ‘buyer’ for a profit
• The buyer pays the bank over a set number of instalments

• The equivalent of lease finance (operating lease) - the use of the underlying asset
or service is transferred for consideration
Ijara • The bank lets the customer the use of assets or equipment for a fixed period and
price
• The lessor is responsible for the major maintenance of the underlying assets

• The equivalent of a bond

• Linked to an underlying asset
Sukuk
• Eg a sukuk holder will participate in the ownership of the company issuing the
sukuk and has a right to profits (but will equally bear their share of any losses)

• Like forward contracts (an asset/commodity is sold now for delivery at a future
date)
Salam
• The cash changes hands now (possibly at a discount) and in the contract the
quality, quantity and future date are clearly stipulated

• Often used in major construction (buildings, warehouses, shopping centres etc.).

• The financial institution finances the construction on behalf of a client
Istisna
• The client pays an initial deposit followed by pre-determined instalments, so that
no interest is paid on the 'loan'

7.3 Equity modes of finance

• A special kind of partnership

• One party provide 100% of the capital, the other its specialist knowledge to
invest the capital and manage the investment project
Mudaraba • Profits generated are shared between the parties according to a pre-agreed
ratio.
• Only the lender of the money has to take losses.
• Most closely aligned with equity finance

• Relationship between two or more parties that contribute capital to a business

• Most closely aligned with the concept of venture capital
Musharaka • All providers of capital are entitled to participate in management but are not
required to do so
• The profit is distributed in pre-agreed ratios, while the loss is borne in proportion
to respective capital contributions
 17

Advanced investment
appraisal

1 Capital investment monitoring process

Post
Collecting Strategic Financial Monitoring
Evaluation Authorisation completion
ideas screening analysis and control
evaluation
18 2: Advanced investment appraisal ACCA AFM

2 Discounted cash flow techniques

2.1 Net present value (NPV) investors required rate of return.
A company will accept a project with a positive NPV as it satisfies both the investor (it delivers the
required return), and the company (the +NPV can be used to fund further expansion). Consequently, a
+NPV avoids agency conflict.

Note
You must be able to deal with the complications shown in the diagram below and explained in this
chapter.

NPV

FUTURE COST OF
CASHFLOWS CAPITAL

Tax on operating
Relevant costs &
cashflows & tax Expected Working Inflation (real or
revenues (incl Inflation
saved on capital values Capital money rate)
terminal values)
allowances

2.2 Relevant costs

Relevant costs must pass three tests:
(1) Future
(2) Incremental
(3) Cash flow
Relevant costs include opportunity costs, but exclude sunk costs and depreciation.

2.3 Discounting (the time value of money)

Note
You must be able to discount (with confidence):
 Single future amounts back to the present (present value)
 Annuities
 Perpetuities
Use discounting tables where the discount rate is a whole number between 1% and 20%. For all other
discount rates use the formulae below.
ACCA AFM 2: Advanced investment appraisal 19

FORMULA GIVEN IN EXAM

𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 = (1 + 𝑟𝑟)−𝑛𝑛
1−(1+𝑟𝑟)−𝑛𝑛
𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴𝐴 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 =
𝑟𝑟

FORMULA TO LEARN
1
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 =
𝑟𝑟

2.4 Prof-forma NPV layout

Time
0 1 2 3 4 5
Revenue X X X X
Relevant costs (X) (X) (X) (X)
Incremental cash before tax X X X X
Taxation (X) (X) (X) (X)
Capital expenditure (X)
Scrap value X
Tax benefit of CAs X X X X
Working capital (X) (X) (X) (X) X
Net cash flows (X) X X X X X
Discount factors @ WACC X X X X X X
Present value (X) X X X X X

NPV = X

2.5 Corporation tax

Show two corporation tax cash flows in your workings.
(1) Corporation tax on operating cash flows: be careful of tax timings and follow the guidance in
the question (i.e. same year vs. one year in arrears).
(2) Capital allowances on capital expenditure: this is tax allowable depreciation. Follow the steps
below.

STEPS TO INCORPORATE CORPORATION TAX INTO DCF WORKINGS

Step 1: Calculate the amount of capital allowance claimed in each year using the % allowance
given.
Step 2: Calculate the tax saved by multiplying by the tax rate given.
Step 3: Be prepared to calculate the tax effect of any balancing charge or allowance which
crystallises when the asset is sold. The allowance or charge will be found by comparing
the sale proceeds to the tax written down value at date of disposal.
20 2: Advanced investment appraisal ACCA AFM

2.6 Terminal values

Note
If the Examiner tells you that, for example “… the cash flows from Year 4 onwards will continue at the
Year 3 level forever”, treat the cash flows as a perpetuity to estimate what they are worth as a lump
sum.

2.7 Working capital

STEPS TO INCORPORATE WORKING CAPITAL INTO DCF WORKINGS

Step 1: Include funds needed to provide working capital up front as a time 0 cash outflow.
Step 2: Each year from then include the incremental movement between the total requirement
in one year and the next.
Step 3: At the end of the project, show all amounts invested in working capital thus as a cash
inflow.

2.8 Inflation
(1) Real method (ignoring inflation)
Use real cash flows (ignore inflation).
Discount at a real discount rate.
(2) Money/Nominal method (including inflation)
Use nominal or money cash flows (apply inflation).
Discount at a nominal or money discount rate.
Fisher equation : (1 + nominal rate{i}) = (1 + real rate{r}) × (1 + general inflation rate{h})

FORMULA GIVEN IN EXAM

(1 + 𝑖𝑖) = (1 + 𝑟𝑟) × (1 + ℎ)

2.9 Capital allowances and tax exhaustion

 If a company generates a taxable profit lower than the project capital allowance, tax relief is
limited to the profit generated.
 If the company is making a loss, the capital allowance increases the taxable loss. It does not
generate a cash tax saving in the period and must be ignored from the investment appraisal
until it can be used.

2.10 Cash flow classification (for follow on calculations)

 Investment phase – these are the initial cash flows during which capital investment is made.
 Return phase – this is period from the commencement of operations to the end of the project
(or last cash flow, whichever is later).
ACCA AFM 2: Advanced investment appraisal 21

3 International investment and financing decisions

Companies invest overseas where the domestic market is saturated, where there is a product gap in an
overseas market and low competition or to secure a cheaper/more efficient/less volatile source of
supply.
However, investing overseas presents further political, cultural, credit and foreign exchange risks.

3.1 Understanding exchange risk

There are three components of exchange risk:
(1) Transaction risk
(2) Translation risk
(3) Economic risk

3.2 Effect of changes in exchange rates on NPV

As the domestic currency appreciates the value of any overseas income will fall and therefore the
overseas NPV will fall.

3.3 Predicting exchange rates

3.3.1 Purchasing power parity (PPP)
PPP claims that changes in exchange rates are caused by differences in the rate of inflation between
two countries i.e. relative purchasing power.

3.3.2 Interest rate parity (IRP)

Interest rate parity assumes differences in the interest rates will cause movement in the exchange rate
as demand for capital will be affected (savers attracted to high rate, borrowers attracted to low rates).

3.3.3 Formulae
Based on parity theory, we can predict a movement in the exchange rate based on expected inflation
rates or interest rates using the following formulae:

FORMULA GIVEN IN EXAM

(1+ℎ )
𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 → 𝑆𝑆1 = 𝑆𝑆0 × (1+ℎ 𝑐𝑐 )
𝑏𝑏

(1+𝑖𝑖 )
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝𝑝 → 𝐹𝐹0 = 𝑆𝑆0 × (1+𝑖𝑖 𝑐𝑐 )
𝑏𝑏

where S1 = exchange rate in 1 year

F0 = forward rate today (rate agreed today for future transaction)
S0 = exchange rate today (spot)
hc = inflation rate and ic = interest rate, in the counter (non-base) currency
hh = inflation rate and ib = interest rate, in the base currency

For clarification if there is an exchange rate of $1.4 to the £ ($/£ 1.4) then the £ is the base currency
and the $ the counter currency.
22 2: Advanced investment appraisal ACCA AFM

3.3.4 International Fisher Effect

This suggests that the relative difference in interest rates between two countries is the same as the
relative difference in inflation rates.
(1+𝑖𝑖𝑐𝑐 ) (1+ℎ𝑐𝑐 )
= (see below for definitions of (i) and (h))
(1+𝑖𝑖𝑏𝑏 ) (1+ℎ𝑏𝑏 )

3.3.5 Expectations Theory

This suggests that if the International Fisher Effect holds, the spot rate predicted by PPP will be the
same as the current forward rate calculated via IRP.

3.4 Overseas tax – double tax relief (DTR)

DTR is the tax credit given for any foreign tax paid on overseas profits.
The parent tax authority will charge the full tax liability on the taxed profit remitted to the parent
company, less overseas tax already paid.

3.5 Remittance restrictions and exchange controls

There are two effects of overseas regulatory regime either restricting the ability of the subsidiary in
the foreign country to remit dividends back to the parent company (remittance restrictions) or limiting
the amount of foreign exchange that can move between countries (exchange controls):
 Impact on cash flow
 Currency exposure
Policies that could be adopted to get cash back to the parent ‘above the line’ include:
 Transfer pricing
 Management charges
 Intercompany loans
 Royalty charges to the subsidiary

3.6 Overseas discount rate

FORMULA TO LEARN
(1 + 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 ) (1 + 𝑖𝑖𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 )
=
(1 + 𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊ℎ𝑜𝑜𝑜𝑜𝑜𝑜 ) (1 + 𝑖𝑖ℎ𝑜𝑜𝑜𝑜𝑜𝑜 )

If we assume also that the International Fisher effect holds then this WACC estimation can be made
using either interest rates or inflation rates.

3.7 Overseas NPV (assuming UK is home country)

STEPS TO CALCULATE OVERSEAS NPV – METHOD 1

Step 1: Forecast foreign currency cash flows.
Step 2: Forecast exchange rates and convert to £ cash flows.
Step 3: Discount at UK WACC.
ACCA AFM 2: Advanced investment appraisal 23

STEPS TO CALCULATE OVERSEAS NPV – METHOD 2

Step 1: Adjust UK WACC to overseas WACC.
Step 2: Discount foreign currency cash flows using overseas WACC and calculate the foreign
currency NPV.
Step 3: Using the spot rate, convert into a £ NPV.

3.7.1 Layout for larger questions

0 1 2 3 Notes
Revenue ($) X X X
Costs ($) (X) (X) (X)
Operating cash flow ($) X X X The taxable foreign cash flow
Tax (@ $ tax rate) (X) (X) (X) Tax timing as given in the question
CAPEX (X)
Resale/Terminal value X May need a perpetuity valuation
Tax saved on CAs X X X CAs may be called ‘Tax allowable
depreciation’
Working capital cash flow (X) (X)/X (X)/X X May be positive or negative
Net $ cash flow (X) X X X
Remittance restrictions (X) (X) X e.g. restrictions for 2 years
Cash flow to remit to (X) X X X
other country
Exchange rates X X X X Using PPP or IRP
£ remittance (X) X X X
Extra UK cash flows X/(X) X/(X) X/(X) Any UK specific costs/revenues
Extra UK tax on o/seas (X) (X) (X) DTR calculation necessary. Time
profits delay?
Net £ cash flow (X) X X X
£ discount factors X X X X Calculate cost of capital?
£ PV (X) X X X

£NPV X/(X)

An alternative layout up to Net $ cash flow identifies the taxable profit figure (useful if double tax
relief has to be calculated).
0 1 2 3 Notes
Revenue ($) X X X
Costs ($) (X) (X) (X)
Tax allowable depreciation (X) (X) (X)
Taxable profit ($) X X X The taxable foreign profit
Tax (@ $ tax rate) (X) (X) (X) May have a 1 year delay
Add back tax allowable X X X
depreciation
CAPEX (X)
Resale/Terminal value X May need a perpetuity valuation
Working capital cash flow (X) (X)/X (X)/X X May be positive or negative
Net $ cash flow (X) X X X
24 2: Advanced investment appraisal ACCA AFM

3.8 Why invest overseas?

 To locate where production is cheap and thus survive in a competitive global market.
 To take advantage of a favourable trading environment (e.g. tax).
 To create a new avenue to grow the business and potentially have a better chance to win global
contracts.
 To locate closer to major customer to speed delivery and reduce transport costs.
 To reduce reliance on a single economy.
 To allow matching of costs in another currency with revenues already being generating from
overseas trade.

3.9 Using overseas debt

3.9.1 International debt market
There are three reasons to finance an overseas investment using overseas debt finance:
(1) Reduction in transaction risk
(2) Reduction in translation risk
(3) Reduction in political risk.
However, often the cost of a UK company borrowing $ from an overseas bank is higher which may
offset the above benefits. Using the unregulated Euromarkets to borrow foreign currency may provide
a cheaper solution. Such loans are often unsecured and without covenants, but this facility is only
available to very large or listed companies with an excellent credit rating.

3.9.2 International bond market – Eurobonds

This is a debenture issued by a UK company, used to raise foreign currency debt capital, often
unsecured and carrying a low coupon rate.

3.9.3 International equity market – dual listing

A company may be listed on two recognised share exchanges in order to widen it exposure to
potential investors.
The share price will end up being approximately the same in both markets when exchange rates are
taken into account because traders will exploit arbitrage opportunities.
There are two principal disadvantages:
(1) Listing fees will be paid to two listing authorities.
(2) Increase in costs of compliance
ACCA AFM 2: Advanced investment appraisal 25

4 Other aspects of investment appraisal

4.1 Single period capital rationing
If an organisation does not have sufficient funds to undertake all positive NPV projects at one
particular point in time, and the investment projects are divisible, rank the projects by the Profitability
Index ((PI):

FORMULA TO LEARN
𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐ℎ 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓
𝑃𝑃𝑃𝑃 =
𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼𝐼 𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖𝑖

If the investment projects are non-divisible, this means that either the whole project is undertaken or
none of it is undertaken. Identify all possible combinations of whole projects that can be undertaken
and then select the combination with the greatest total NPV.
Capital rationing can be hard (no stakeholder is prepared to invest) or soft (has internally decided not
to raise more funds).

4.2 Multi-period capital rationing

If capital is rationed for more than one period, linear programming computer software can solve the
problem. You will not be expected to perform calculations as multi-period capital rationing is only
examinable through discussion..

4.3 Internal rate of return (IRR)

The IRR is the maximum % return given by a project assuming all returns are paid to investors (and
there is no surplus left for the company i.e. NPV = 0).
Companies should accept projects where the IRR > WACC.

FORMULA TO LEARN
𝑁𝑁𝑁𝑁𝑁𝑁
𝐿𝐿
𝐼𝐼𝐼𝐼𝐼𝐼 ≅ 𝐿𝐿 + 𝑁𝑁𝑁𝑁𝑁𝑁 −𝑁𝑁𝑁𝑁𝑁𝑁 × (𝐻𝐻 − 𝐿𝐿)
𝐿𝐿 𝐻𝐻

where:
L = low discount rate chosen
H = high discount rate chosen
NPVL = NPV at the low discount rate
NPVH = NPV at high discount rate
26 2: Advanced investment appraisal ACCA AFM

4.4 Relative merits of NPV over IRR

NPV provides a clear decision NPV is not particularly easyfor

i.e. accept if positive, reject if non-accountants to accept
negative (IRR is easier)
NPV always gives the correct It requires the exact cost of
decision funds to be known (IRR does
NPV always gives a single not)
answer (some projects have
more than one IRR)
NPV maximises shareholders’
wealth

4.5 The Modified Internal Rate of Return (MIRR)

The IRR is not a reliable measure for two reasons:
(1) If the annual cash flows change from net inflow to net outflows more than once then there will
be more than one IRR. Choosing the wrong IRR could result in:
Accepting projects which should be rejected – accept negative NPV
Rejecting projects which should be accepted – sacrifice positive NPV.
(2) The IRR% assumes project net cash inflows are reinvested by the company and will generate a
return of at least the IRR%. In reality, reinvestment must simply generate at least the WACC%,
which is lower (in other words surplus returns from projects would usually be used to pay
dividends or repay loans/interest).
The MIRR solves both of these problems:
(1) There is only ever one MIRR, therefore it can be relied upon as the maximum project return.
(2) MIRR assumes that any reinvestment generates only the minimum required return (WACC%)
and not the project maximum return (IRR%).

FORMULA GIVEN IN EXAM

1
𝑃𝑃𝑃𝑃𝑅𝑅 𝑛𝑛
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 = � � (1 + 𝑟𝑟𝑒𝑒 ) − 1
𝑃𝑃𝑃𝑃𝐼𝐼

where PVR = Present value of the return phase

PVI = Present value of the investment phase
re = Required return (normally the WACC)
n = the length of the project

The return margin is defined as the difference between the MIRR and the WACC.
ACCA AFM 2: Advanced investment appraisal 27

5 Techniques for dealing with risk

Expected
• Use probabilities to find a weighted average
values (EV)

• Estimate the % by which a variable would need to change by before a

Sensitivity decision is reversed (ie for the NPV to decrease to zero)
analysis • Higher the better
• For cashflow inputs, sensitivity = NPV of project/PV of cashflow input

Risk adjusted
discount • Use a higher WACC to ensure a higher return for additional risk
factor

• Calculate the time to recover the initial investment

Payback • Shorter the better
period • Assume cashflows happen evenly throughout the year
• Ignores subsequent returns

Discounted
• Discount project cash flows so early and later cash flows are compared
payback
on a like for like basis
period

5.1 Project duration (Macaulay duration)

This type of duration can be defined one of two ways:
(1) The average time it takes to recover the PV of the project if cash flows are discounted at the
cost of capital (WACC).
(2) The average time it takes for the project to recover the initial investment if the cash flows are
discounted at the IRR of the project.
The longer the duration, the more risky the project. It is particularly useful where comparing different
projects where a lower duration is preferred. It works by amplifying risk on later cash flows by
multiplying by a higher time factor.

FORMULA TO LEARN
∑(𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 × 𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = ∑ 𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

5.1.1 Modified duration

This represents a measure of how sensitive the PV of a project is to a change in the required yield.

FORMULA TO LEARN
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 = (1+𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟)

The higher the value of the modified duration, the higher the volatility of the PV relative to changes in
required yields.
28 2: Advanced investment appraisal ACCA AFM

5.2 Value At Risk (VAR)

VaR determines a worst-case scenario by predicting the change in the NPV/value of an asset that
would occur most (say, 95%) of the time. This means there is a small chance (say, 5%) that the change
is a drop in NPV greater than this amount.

FORMULAE TO LEARN
Value at Risk (for fixed period) = Z score based on the confidence level × standard deviation
Value at Risk (for n periods) = single period VaR ×√𝑛𝑛

At a confidence level of 95%, we use 45% from the normal distribution tables to arrive at a Z score 0f
1.645.

Frequency

5% 45%

1.645
worse better

In other words, per the diagram above there is only a 5% probability that the value would fall to below
1.645 standard deviations below the mean value. Another way of interpreting this is that there is a
95% probability that the outcome will be higher than 1.645 standard deviations below the mean.

Approach to questions
(1) Select level of confidence to work to (e.g. 95% as above or say 99%). This may be stated in the
question.
(2) Look up the Z score in the normal distribution tables for this confidence level. For 95% you will
be looking for the value 0.45 in the tables and for 99% it would be 0.49. The Z score can then be
read from the table giving 1.645 for 0.45 and 2.33 for 0.49.
(3) Use the Z score and the standard deviation (given in the question) to work out the lower limit of
the outcome.
For example, a 1-year project has an NPV of $5m and a standard deviation $400k. If working to a 95%
confidence level we can be 95% confident that the NPV would not be lower than $5m – (1.645 ×
$0.4m) = $4.342m.

5.3 Simulation (Monte Carlo simulation)

Simulation programs pick the values of inputs into an NPV calculation based on probabilities, record
the NPV and repeat this process thousands of times.
The results are then plotted on a normal distribution to show the possible spread of project returns.

Note
You are not required to calculate simulation values in AFM.
 29

Cost of capital

1 Calculating a current WACC for a business

1.1 Cost of Equity (Ke)
Ke is the annual return required by shareholders measured as a percentage.
It represents the annual cost to the company of paying out dividends and providing capital growth.
There are two methods to calculating Ke – using the DVM or using CAPM.

1.1.1 Calculating Ke using DVM

Calculation of Ke using the dividend valuation model (DVM)
Formula Rearranging the formula provided in the exam:
D0 (1+g)
re = +g
FORMULA GIVEN IN P0

where:
EXAM re = estimate of return shareholders require
P0 = today’s ex-div share price
D0 = current dividend
g = annual dividend growth rate (%)
Methods of estimating g (1) If more recent dividend patterns are expected to continue:

FORMULAE GIVEN 𝑛𝑛
𝑔𝑔 = �
𝐷𝐷0
−1
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 𝑛𝑛 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦 𝑎𝑎𝑎𝑎𝑎𝑎
IN EXAM
30 3: Cost of capital ACCA AFM

Calculation of Ke using the dividend valuation model (DVM)

(2) Earnings retention method:

g = bre
where:
b = the proportion of earnings retained expressed as a
decimal
re = (approximately) shareholders required, estimated using
the CAPM)
Assumptions Current share price is valued as the present value of all future
dividends
Constant dividend growth
Limitations The company must be listed and the quoted share price must not
change
The dividend growth rate must be constant – forever!!
The dividend just paid must be indicative of the future dividend

1.1.2 Calculating Ke using CAPM

A rational investor should build an efficient portfolio by not

putting all their eggs in one basket! (they should try to find
investments that are not well correlated with one another). In
other words investors should DIVERSIFY in order to reduce risk.

By diversifying the investor is able to largely eliminate what is

known as UNSYSTEMATIC RISK (that is the risk specific to
individual companies caused by their management structure,
technology, succeptibility to changing weather etc...)

Once the investor has diversified as much as they can they will
have a portfolio of investments that is only succeptible to
SYSTEMATIC RISK (that is risk due to general market factors
such as changes to interest rates, exchange rates, productivity
levels etc).

The systematic risk of an individual investment (i.e. the extent to

which an individual investments returns are affected by these
general market factors) is measured by a BETA FACTOR.

A beta factor for an individual investment gets inserted into the

CAPM formula to give a measure of the investors required return
to compensate them for systematic risk only (i.e. assuming they
are already fully diversified)
ACCA AFM 3: Cost of capital 31

Calculation of Ke using CAPM

Formula 𝑘𝑘𝑒𝑒 = 𝑟𝑟𝑓𝑓 + 𝛽𝛽𝑒𝑒 �𝑟𝑟𝑚𝑚 − 𝑟𝑟𝑓𝑓 �
where:
FORMULA GIVEN IN rf = risk free rate
EXAM rm = return on market portfolio
β = exposure to systematic risk
Assumptions Investors can invest and borrow at the risk free rate
Capital markets are perfect
Limitations Estimating Rm
Estimating 𝜷𝜷𝒆𝒆
Ignores then size of the company.
Can only be used when the investors are diversified.

1.1.3 Alpha values

This is the amount by which a share’s returns are currently above or below the required return for the
level of systematic risk. Over time, the alpha value tends towards zero.

1.2 Cost of Preference Shares (Kp)

FORMULA TO LEARN
𝐷𝐷0
𝐾𝐾𝑃𝑃 =
𝑃𝑃0

1.3 Cost of Debt (Kd)

Why is debt cheaper than equity from the company’s perspective?
 Debt is often secured.
 Debt is often temporary.
 Interest on debt finance at fixed, returns dividends can be highly volatile.
 If the company becomes insolvent, debt holders are more likely to recover their investment
than equity investors.
 Interest is tax deductible (tax shield), dividends are not.
32 3: Cost of capital ACCA AFM

1.3.1 Types of debt and their costs

Types of debt Description Kd
Irredeemable The amount borrowed is not 𝐼𝐼(1 − 𝑇𝑇)
𝐾𝐾𝑑𝑑 =
repaid to the investor so 𝑃𝑃0
FORMULA TO interest is paid in perpetuity
where
LEARN
Po = current ex-interest debt price

Bank kd = Interest rate × (1–T)

FORMULA TO
LEARN
Redeemable The amount borrowed is Find IRR of debt cashflows:
repaid at a fixed future date t0: MV
(maturity) and interest is paid t1-tn: Interest
every year until the debt
tn: Redemption value
matures (coupon).
For ease, consider only one debenture of
$100 nominal, costing $100 if purchased
when issued, or at the market price is
purchased later

Note
If an exam question gives a debt beta (βd), use CAPM to determine the return an investor would
require on that bond in compensation for that level of risk.

1.3.1 Comparing cost of debt from debt holders’ and company’s perspectives
Required return of debt holder Company’s cost of debt
Gross or net? Kd gross Kd net
Also known as…? Gross redemption yield or yield to
maturity
What about tax? Ignore corporation tax Include corporation tax

1.3.2 Features of debentures

Features of debentures (loans direct from investors) include:
 Can be called Corporate Bonds or Loan Stock.
 Issued in debt units of $100 (par value).
 Interest is called the Coupon Rate.
 Price is quoted as a percentage of $100, so a bond quoted at $95% is trading at a $5 discount,
whereas a bond quoted at $104% is trading at a $4 premium
 Can be irredeemable or redeemable
ACCA AFM 3: Cost of capital 33

 Convertible debentures – option at the maturity date to receive equity shares at a given
conversion rate instead of cash
– Firstly estimate the equivalent value of shares at the conversion date
– Then calculate the IRR as above, substituting the value of shares received for the
redemption value foregone if this is higher than the redemption value

1.4 The weighted average cost of capital (WACC)

The weighted average cost of capital represents the average cost to the company of paying dividends
to its shareholders and interest to its debt holders.

FORMULA GIVEN IN EXAM

Ve Vd
WACC = �V � Ke + �V � Kd (1–T)
e +Vd e +Vd

Where:
Ve = Total value of the equity (usually share price × no of shares or P/E of company ×
PAT)
Vd = Total value of the debt (e.g. nominal value × $105/$100, if each $100 bond is
priced at $105)
Ke = Equity cost of capital
Kd = Debt cost of capital
T = Corporation tax rate

Notes
The total equity and debt values can either be calculated using book values or market values, though
market values give a better indication of the current cost of capital.

1.4.1 Assumptions of WACC:

 Tax has been ignored in calculating Kd, however as tax has to be included when calculating the
cost of redeemable debt, it is much easier to always include tax when calculating the cost of
debt and then ignore it when using this WACC formula.
 The organisation only has two sources of finance, so if an organisation was financed with
ordinary shares, preference shares and debt the formula would look as follows:
Ve Vp Vd
WACC = �V � Ke + � V � Kp + � V � Kd (1–T)
e +Vp +Vd e +Vp +Vd e +Vp +Vd

2 Use of WACC in investment appraisal

The WACC (% p.a.) is the annual cost of finance. A new project must generate at least this return to
cover this cost. The WACC therefore becomes the minimum acceptable return on a project.
During investment appraisal, the process of discounting at the WACC% effectively deducts sufficient
cash to pay interest and dividends to investors in each year.
34 3: Cost of capital ACCA AFM

2.1 When can the WACC be used?

 If there is no change in business risk
 If there is no change in gearing
 If the project has the same risk as the company
 If the project is small relative to the size of the company
Where there is a change in risk or gearing, the WACC needs to be recalculated at the new gearing and
risk levels. This new WACC is used specifically for project appraisal and is called the marginal cost of
capital.

3 WACC and change in business risk

Risk facing ∴ β for geared ∴ Cost of equity in

shareholders in geared company (βe or equity geared company (ke )>
company > risk facing beta) > β for ungeared cost of equity in
shareholders in company (βa or asset ungeared company
ungeared company beta) (kei)

STEPS TO WORK OUT A WACC IF THERE IS A CHANGE IN BUSINESS RISK

Step 1: Find a listed company with the same risk as the proposed project (a proxy company)
and determine its βe and gearing level.
Step 2: Degear the proxy βe to determine the ungeared beta βa (asset beta).

FORMULA GIVEN IN EXAM

Ve Vd (𝟏𝟏−T)
βa = � β �+ � β �
(Ve +Vd (𝟏𝟏–T)) e (Ve +Vd (𝟏𝟏–T)) d

Step 3: Regear βa at OUR company’s gearing level.

𝑉𝑉𝑒𝑒 +𝑉𝑉𝑑𝑑 (1−𝑇𝑇)
𝛽𝛽𝑒𝑒 = � � 𝛽𝛽𝑎𝑎
𝑉𝑉𝑒𝑒

Step 4: Use CAPM to determine the new project-specific Ke.

Step 5: Find the project-specific WACC using this Ke.
Step 6: Use this new project-specific WACC to evaluate the new project.

Note
The debt beta measures the risk of the company’s debt, which we assume is zero unless the question
specifically says otherwise (which means that the company can borrow at the risk-free rate of return).

If Ke is given for a comparable quoted company, follow the same method using the following formula
to degear/regear, which links geared and ungeared costs of equity.
ACCA AFM 3: Cost of capital 35

FORMULA GIVEN IN EXAM

𝑉𝑉
𝐾𝐾𝑒𝑒 = 𝐾𝐾𝑒𝑒𝑖𝑖 + (1 − 𝑇𝑇)�𝐾𝐾𝑒𝑒𝑖𝑖 − 𝐾𝐾𝑑𝑑 � 𝑉𝑉𝑑𝑑
𝑒𝑒

4 Impact of changing the capital structure (i.e. gearing or financial risk)

Funding a project using equity finance will decrease gearing whereas using debt finance will increase
gearing.
We would expect the project to generate additional profits which increase EPS. Because of the added
benefit of tax relief on debt interest we would expect the increase in EPS to be higher where the
company uses debt finance.

4.1 Impact of changing capital structure on WACC

When debt is introduced into the financial structure there are two impacts:

Increase
the level
of debt

Debt is cheaper than Shareholders

equity (less risk to financial risk
the investor). increases (↑ Ke).
WACC ↓ WACC ↑

Suggests it Suggests it
would be a good would be a good
idea to use more idea to use less
debt debt

The question is which one of the above factors dominates

4.2 Traditional theory (on impact on WACC of changing the capital

structure)
Adding debt makes sense up to a certain gearing
level since it is cheaper (as less risky) and %
Ke
shareholders’ risks are not initially significantly
affected. WACC

Eventually, if gearing gets too high the cost of K ie Kd

debt and equity will rise such that WACC
eventually starts to rise.
Conclusion – There is an optimum WACC (lowest Gearing
point) where project and hence company value
will be maximised.
36 3: Cost of capital ACCA AFM

4.3 M&M (No TAX)

As the level of debt increases the benefits of
debt (cheaper than equity) is exactly offset by %
Ke
the fact that the cost of equity (Keg) increases,
such that overall the WACC remains constant.
WACC
The two forces above are therefore equal and K ie
opposite.
Kd
Conclusion – WACC is not affected by gearing.
Gearing
Financing has no impact on company value.

4.4 M&M (with TAX)

Debt finance is even cheaper due to the tax relief %

on the interest payments. The lower cost of debt Ke

outweighs the increasing Ke such that WACC falls

as gearing increases.
K ie
Conclusion – WACC reduces as debt levels WACC
increase.
Kd
Theoretically, companies should use as much Gearing
debt as possible to lower the WACC.

In reality, at higher gearing levels the WACC

tends to rise due to the costs of financial distress
(higher Ke due to risk, higher Kd as banks get
nervous).

M&M make a few fairly limiting assumptions including:

 Debt is always risk free (big assumption)
 Perfect capital markets (perfect information, rational risk averse investors)
 Individuals and companies can borrow and invest at the same rate

4.5 Financial distress

The costs of financial distress (ie the costs associated with providing assurances to banks, debt holders,
other creditors and customers that they will remain solvent) will increase the WACC at high levels of
gearing. Examples include:
 Direct financial distress costs – higher interest payments imposed by the bank (credit risk
premium)
 Indirect financial distress costs – loss of sales / lack of credit from suppliers
 Agency costs – restrictive covenants preventing further borrowing/certain types of investment
ACCA AFM 3: Cost of capital 37

4.6 Pecking order theory

Order in which firms will , in general, finance projects

(1) Internal funds (2) Debt finance (3) Equity finance

Lowest issue costs Highest issue costs

Note
Exam advice
Keep gearing low if: High gearing is fine if:
Small, young enterprise, Mature company
Volatile cash flows Stable cash flows
Tax benefits < financial distress costs Tax benefits > financial distress costs

4.7 Static trade-off theory

Companies in a static position will seek to achieve a target level of gearing by adjusting their current
gearing levels.

4.8 Other considerations

 Potential conflict is between shareholders and debt holders:
– Consider expansion funded by debt finance. If expansion is successful then the benefits
that arise will flow principally to the shareholders. If the expansion fails and the debt is
partially or wholly not repaid (loan default) then the shareholders will have limited their
exposure as they will only lose a maximum of their equity stake.
– The cost of debt will therefore rise as the probability of default rises. This will influence
the optimal capital structure as the benefits of new debt finance are balanced with the
higher cost.
 Impacts of high levels of gearing:
– Large dividends are paid to protect shareholders, at the expense of creditors (subject to
any restrictive loan covenants)
– Directors may invest in high-risk projects in order to generate potentially higher returns

5 Credit risk measurement (credit ratings and credit spreads)

A credit rating defines the financial strength of a borrower and helps the investor determine the risk
associated with the investment.
The bond rating will affect the gross yield that the issuer will need to deliver to investors; the stronger
the credit rating, the lower the interest rate.
38 3: Cost of capital ACCA AFM

5.1 Calculating a credit rating

The Kaplan-Urwitz model is used to calculate a credit rating and uses the following criteria:
– Firm size (F),
– Profitability (π, net income/total assets),
– Gearing (L, long term debt/total assets),
– Interest cover (C),
– Risk (σ, standard deviation/mean of the last five years of earnings) – likely to be given
– Risk due to debt status (S, if subordinated = 1 if not = 0).
The final score is converted into a credit rating using the Kaplan-Urwitz model
4.41 + 0.0014F + 6.4π – 2.56S – 2.72L + 0.006C – 0.53σ
If the score is >6.76 a rating of AAA is given, if >3.28 a rating of A is given and if > 1.57 a rating of BBB is
given.

5.2 Impact on WACC on change of credit rating

The cost of a bond (Kd gross) can be estimated by adding together the following two factors:
(1) The risk free rate
(2) The credit risk premium (or credit spread)

% yield
Yield curve
4.2

3.0

2 5 Years to maturity

The yield curve tends to be upwards sloping due to:

 Expectations theory
 Liquidity preference theory
 Market segmentation theory.
The credit risk premium is quoted and will be given in the exam as a yield spread in basis points
(100 points = 1%).
For example:
Maturity 1 yr 2 yr 3 yr 5 yr 7 yr 10 yr 30 yr
AAA rating 3 7 14 20 26 38 55
ACCA AFM 3: Cost of capital 39

5.3 Assessing the credit risk premium (spread)

The banks will use Value at Risk (VAR) to determine the potential probability of loan default and will
use it to determine the interest rate necessary to meet the banks minimum required return on its
investment (the loan). The rate over the risk free rate will determine the credit spread for this
company.

5.4 Use of Macaulay Duration and modified duration with bonds

STEPS TO DETERMINE THE CHANGE IN BOND PRICE GIVEN A CHANGE IN THE

GROSS YIELD
Step 1: Calculate the Macaulay Duration on the bond.

FORMULA TO LEARN
∑(𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟 ×𝑡𝑡𝑡𝑡𝑡𝑡𝑡𝑡)
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷 = ∑ 𝑃𝑃𝑃𝑃𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟

Step 2: Calculate Modified Duration.

FORMULA TO LEARN
𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷𝐷
𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 =
1+𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑟𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚 𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦𝑦

Step 3: Calculate the change in price.

∆ 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃 = −𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀𝑀 𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑𝑑 × ∆𝑌𝑌 × 𝐵𝐵𝐵𝐵𝐵𝐵𝐵𝐵 𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃𝑃
where ∆𝑌𝑌 = change in the investors required gross yield

5.5 Advanced aspects of bond pricing and bond yields

5.5.1 Bond valuation
Bond prices are estimated as the PV of future interest and capital payments (using the investors
required return or yield to maturity as the discount rate).

5.5.2 Calculating the yield to maturity

Yield to maturity can be worked out as an IRR calculation if the current MV of the bond and the
interest and capital repayments are known.
Bonds of the same risk class will carry different required returns (yields) if they have different terms to
maturity. This is due to the ‘term structure of interest rates’ that is represented by the SPOT yield
curve (or simply the yield curve).

5.5.2 Estimating the spot yield curve

There are a range of methods that can be used to estimate spot yield rates but the one that may be
seen in the AFM exam is one that uses the link between bonds of the same risk class but with different
maturities, demonstrated in the illustration below.
40 3: Cost of capital ACCA AFM

ILLUSTRATION

There are three government bonds all with a nominal and redemption value of $100 that pay interest
on an annual basis as follows:
Coupon rate Current price Maturity
Bond 1 5% $102 1 year
Bond 2 4% $101 2 years
Bond 3 3.5% $96 3 years

Starting with the bond with the shortest duration, the spot yield rates are worked out as follows:
Bond 1
102 = 105 × (1 + 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠1 )−1
105
∴ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠1 = − 1 = 0.0294 𝑜𝑜𝑜𝑜 𝟐𝟐. 𝟗𝟗𝟗𝟗%
102

Bond 2 (using information from bond 1)

101 = (4 x 1.0294-1) + (104 x {1+spot2}-2)
101 = 3.886 + 104 x (1+spot2)-2
97.114 = 104 x (1+spot2)-2
104
∴ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠2 = � − 1 = 0.0348 𝑜𝑜𝑜𝑜 𝟑𝟑. 𝟒𝟒𝟒𝟒%
97.114

Bond 3 (using information from bonds 1 & 2)

96 = 3.5 × 1.0294−1 + 3.5 × 1.0348−2 + 103.5 × (1 + 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠3 )−3
96 = 3.400 + 3.269 + 103.5 × (1 + 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠3 )−3
89.331 = 103.5 × (1 + 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠3 )−3
3 103.5
∴ 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠3 = � − 1 = 0.0503 𝑜𝑜𝑜𝑜 𝟓𝟓. 𝟎𝟎𝟎𝟎%
89.331

The annual spot yield curve is therefore:

Year 1 2.94%
Year 2 3.48%
Year 3 5.03%

6 Investment appraisal and a change in gearing/risk: adjusted present

value (APV)
From the M&M model with tax :
𝐌𝐌𝐌𝐌 𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠 𝐜𝐜𝐜𝐜 > 𝐌𝐌𝐌𝐌 𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮 𝐜𝐜𝐜𝐜
𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕 𝐨𝐨𝐨𝐨 𝐚𝐚 𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠𝐠 𝐟𝐟𝐟𝐟𝐟𝐟𝐟𝐟 = 𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕𝐕 𝐨𝐨𝐨𝐨 𝐭𝐭𝐭𝐭𝐭𝐭 𝐟𝐟𝐟𝐟𝐟𝐟𝐟𝐟 𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮𝐮 + 𝐏𝐏𝐏𝐏 𝐭𝐭𝐭𝐭𝐭𝐭 𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬 𝐟𝐟𝐟𝐟𝐟𝐟𝐟𝐟 𝐝𝐝𝐝𝐝𝐝𝐝𝐝𝐝 (𝐭𝐭𝐭𝐭𝐭𝐭 𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬𝐬)
This theory can be applied to investment appraisal, for projects with complex financing structures.
ACCA AFM 3: Cost of capital 41

Note
The layout below shows some of the more common items that have featured in previous exam
questions. You may have to adapt in the exam to any other specific financing ‘side effects’ that the
examiner may present you with.

$
Step 1 – Find the ‘base case’ NPV
NPV of project assuming all equity finance used (use Kei as discount rate*). X/(X)
Step 2 – PV of specific financing for the project
Add – PV of tax saved on any interest payments (using Kd pre-tax as discount rate) X
Add – PV interest saved on a subsidised loan (using Kd pre-tax as discount rate) X
Less – PV of any finance issue costs (X)
APV of project X

* To ‘degear’ or eliminate the effects of gearing (financial risk) from Ke, use one of the following
formulae (which we have already met in Section 3):

i i V
K e = K e + (1 − T )( K e − K ) d
d V
e
VE VD (𝟏𝟏 − T)
ΒA =� ΒE � + � Β �
(VE + VD (𝟏𝟏– T)) (VE + VD (𝟏𝟏– T)) D

The impact of of each Subjectivity of discount

financing aspect can be rate to use when
separately evaluated discounting the debt
Very structured approach related cash flows
Assumes sufficient profits
to be able to take
advantage of the interest
payments being tax
deductible
42 3: Cost of capital ACCA AFM
 43

Option pricing theory

1 Option pricing theory

⦁ Difference today (T0) between:
Intrinsic value of the
Pa (the current value of the asset ie share price) and
option premium (price)
Pe (the exercise price of the option ie option price)

⦁ Reflects the uncertainty surrounding the intrinsic value, given share prices can
rise/fall
Time value of the ⦁ Influenced by: r = risk free interest rate
option premium s = volatility (standard deviation) in the value of the asset.
t = time to expiry of the option (in years)

• An increase in volatility generally increases the value of the option since there is a
Volatility greater chance of the option becoming valuable

• A decrease in time to expiry generally decreases the value of the option as there is
Time to expiry less time for the option to become attractive

• A rise in interest rates increases the required return of the investor which generally
Interest rates increases the value of a call option (mainly because as interest rates increase, the
PV of the exercise price will reduce)
44 4: Option pricing theory ACCA AFM

1.1 The Black-Scholes Option Pricing Model

FORMULA GIVEN IN EXAM

Value of a CALL option
𝐶𝐶 = 𝑃𝑃𝑎𝑎 𝑁𝑁(𝑑𝑑1) − 𝑃𝑃𝑒𝑒 𝑁𝑁(𝑑𝑑2 )𝑒𝑒 −𝑟𝑟𝑟𝑟
where:
𝑃𝑃
ln � 𝑎𝑎�𝑃𝑃 � + (𝑟𝑟 + 0.5𝑠𝑠 2 )𝑡𝑡
𝑒𝑒
𝑑𝑑1 =
𝑠𝑠√𝑡𝑡
𝑑𝑑2 = 𝑑𝑑1 − 𝑠𝑠√𝑡𝑡

Value of a PUT option (Put Call Parity)

𝑃𝑃 = 𝐶𝐶 − 𝑃𝑃𝑎𝑎 + 𝑃𝑃𝑒𝑒 𝑒𝑒 −𝑟𝑟𝑟𝑟

Formula inputs
Pa = current share price
Pe = exercise price of a European call option (exercisable only at time ‘t’)
r = risk free rate of return per annum (as a decimal)
s = volatility per annum i.e. standard deviation of the project
t = time to expiry of option (in years)

STEPS TO CALCULATE THE VALUE OF A CALL OPTION

Step 1: Find the values for d1 and d2 per the above formulae
Step 2: Look the values up for d1 and d2 in the normal distribution tables to give values for N(d1) and
N(d2)
Step3 : Put these values for N(d1) and N(d2) into the call option formula to find the call option value

Limitations/drawbacks of Black Scholes include:

 Volatility of an asset is difficult to estimate and is unlikely to remain constant for the duration of
the option. In reality the standard deviation is based on judgement.
 The formulae assume that the options are ‘European’ so only exercisable on a fixed date; often
we use Black-Scholes to value ‘American’ style options, which are exercisable at any date to
maturity.
ACCA AFM 4: Option pricing theory 45

2 Value of Real Options

Real option theory seeks to identify value that may be created due to flexibility that might be available
around a project but which is not taken into consideration with the traditional NPV analysis.
The existence of real options can be classified as follows.
OPTION TO DELAY OPTION TO EXPAND OPTION TO ABANDON OPTION TO REDEPLOY
CALL (buy assets) CALL (buy assets) PUT (sell assets) PUT (sell assets)
Avoid loss by rejecting if Create technology, Avoiding future loss by Avoid loss by selling
economy worsens patent, brand, use stopping project selling assets from Project A and
Create extra wealth if elsewhere in the assets to a third party using the cash realised on
proceed when economy business Project B
improves
True NPV = value of True NPV = project NPV True NPV = project NPV + True NPV = project NPV +
the real option + value of the real value of the real option value of the real option
option

2.1 Using BSOP to value real options in a project

 Use the same principles as used to value simple European share options
 Identify carefully the five variables of the model from the information in the question (Pa, Pe, r,
s, t)
 Pa, usually the hardest to identify, is the current share price (ie PV of all future dividends) when
dealing with a simple share option and when dealing with a project it is usually the PV of the
future returns from the project.

3 Using Black-Scholes to determine loan default risk

 Underlying premise:
If value of assets > outstanding debt, then company exercises its option to repay its debt
If value of assets < outstanding debt, then the company defaults on its debt obligation
 Use Black-Scholes to calculate the probability that the value of assets falls below the value of
outstanding debt (ie the probability of default):
– Pa, the market value of assets
– Pe, the value of debt (loan default position)
– N(d2), probability that a call option will be exercised (i.e. loan is repaid)
– 1 – N(d2), the probability of default
 Example - if N(d2) is 0.8 or 80%, there is an 80% likelihood that the assets will be worth more
than the value of the debt and hence a 20% likelihood that the assets will be worth less than the
debt value and hence be in default.
 If the company is successful, shareholders enjoy all the upside - they exercise the option to
repay the loan and retain the company’s equity (effectively exercising the option to ‘buy’ the
shares).
 If the company defaults, shareholders enjoy very little downside risk (protected by the
company’s limited liability status)
46 4: Option pricing theory ACCA AFM

4 Using Black-Scholes to value equity

 Use the same approach as for determining loan default risk.
 The value of the option can be equated to the value of the equity.

5 Delta Hedging and the ‘Greeks’

Delta is measured as N(d1) and calculated using the BSOPM. Delta measures the change in option
value which would result from a change of $1 in the underlying asset price (e.g. share price).
An investor is able to eliminate the risk associated with their portfolio by creating a delta hedge. To do
this an investor who holds a number of shares would need to sell (write) call options on those shares
in a ratio given by the delta (hedge ratio). If this is done then the investor will be in a delta ‘neutral’
position whereby any gains or losses on the shares will be exactly balanced out by losses or gains on
the call options.
The number of options is determined by the ‘delta hedge’ as follows:

FORMULA TO LEARN
𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛𝑛 𝑜𝑜𝑜𝑜 𝑠𝑠ℎ𝑎𝑎𝑎𝑎𝑎𝑎𝑎𝑎 ℎ𝑒𝑒𝑒𝑒𝑒𝑒
𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁𝑁 𝑜𝑜𝑜𝑜 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐 𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜𝑜 𝑡𝑡𝑡𝑡 𝑠𝑠𝑠𝑠𝑠𝑠𝑠𝑠 (𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤𝑤) = �𝑁𝑁(𝑑𝑑1)

5.1 Gamma
 Measures how much Delta changes as the underlying asset value changes
 For example, if the gamma is 0.01, the delta should increase by a factor of 0.01 for each 1% rise
in the underlying asset value. This is useful for assisting the investor/trader in adjusting their
delta hedge periodically.
 A high gamma value suggests the delta value is quite volatile thus requiring regular adjustments
to the delta hedge.

5.2 The ‘Greeks’

Delta This is the change in the value of the option as the value of underlying asset changes.
Gamma This is the change in delta value as the value of the underlying asset changes.
Theta Measures the change in an option’s value over time, specifically how the ‘time premium’
element of the option premium changes over time. Generally, the option value falls as we
move toward maturity. It will often be quoted as an amount lost per day

Note
Applying BSOP in the CBE software
If the AFM CBE that you sit includes a question that involves BSOP model calculations, you will be
provided with a BSOP spreadsheet that is pre-programmed to do the calculations for you. You
simply need to enter the five key variables of the model in the spreadsheet and the results of the
BSOP model calculations are automatically provided. A video is available on FILearn that provides
a live demonstration of how to use the software.
 47

Treasury function and

currency risk management

1 The role of the treasury function in multinationals

1.1 The money market
The money market is simply a network of financial institutions willing to lend to each other and to
other companies which:
 Provides short-term (< 1 year) funds to companies (usually listed, with a good credit rating)
 Co-ordinates the issue of new government bonds (UK gilts) and targets specific investors, in
return for a fee
 Is an active market in the trade of export invoices/promises to pay
 Provides derivatives

1.2 Common money market instruments (three types)

Coupon bearing Detail
Certificates of deposit Issued by banks which entitle the bearer to fixed interest and principal for a
(CDs) specified time period
Can be traded as ‘bearer only’ providing liquidity for the investor
Eurocurrency deposits Interest-bearing loans or deposits agreed in a country where the contract
currency is deemed a foreign currency
Interest is referenced LIBOR in London i.e. 3M US LIBOR
48 5: Treasury function and currency risk management ACCA AFM

Discount instruments Detail

Treasury bills (Gilts) Government bonds issued to fund public sector services and deal with short
term shortfalls in tax receipts
Carry a zero coupon, the return being embedded as issued at a discount and
redeemed at face value.
Commercial paper (CP) Debentures which redeem in less than one year
Issued by large or listed companies with an excellent credit rating with a
minimum of £500,000
Embedded return as issued at a discount and redeemed at face value
Usually unsecured debt, with no restrictive covenants
Low issue costs and cash can be raised in less than one day
Bills of exchange (BoE) An export customer’s ‘promise to pay’ with a minimum of £75,000 and
maturity 60-180 days
Sold at a discount as non-interest bearing
Useful to the exporter where there are lengthy credit terms

Derivatives Detail
Futures contract A contract to buy and sell a standard quantity of a specified commodity at a
fixed future date at a price fixed today
Options contract An option to exercise a futures contract to buy (call)/sell (put) a standard
quantity of a specified commodity at a fixed future date at a price fixed today
Privilege of choice bears a cost (premium)

1.3 Treasury function

Advantages Advantages of decentralised Longer-term decisions to
(versus centralised) increase shareholder value
Use cash surpluses to provide Encourages subsidiaries to be Investment decision – additional
short-term finance to other financially independent +NPV projects will increase
subsidiaries, avoiding the cost of shareholder wealth.
external bank finance
Consolidate subsidiary Allows the rapid exploitation of Financing decision – financing
borrowing requirements into a emerging opportunities as the expansion and meeting the
single loan at a lower interest process of parent company target capital structure
rate due to economies of scale authorisation can lead to delay
and avoid multiple transaction
fees
Reduce risk by requiring Dividend decision – Reinvesting
subsidiaries to justify parent retained profits vs. meeting
financial support through the dividend expectations
provision of collateral, loan
covenants and business plans
Reduce foreign exchange risk Risk management – Manage
exposure through the natural currency and interest rate risks
hedging of currency assets and within acceptable limits
liabilities.
ACCA AFM 5: Treasury function and currency risk management 49

2 Foreign exchange risk

2.1 Quoted rates
In the UK exchange rates are shown per £, such as $1.5350 $/£. This means it will cost $1.5350 to buy
or sell £1.
Banks will quote a ‘spread’ of rates detailing the price which they will buy the fixed currency on the left
and sell the fixed currency on the right.
BUY SELL
$1.5250 : £1 – $1.5450 : £1
Bank: Buys £s low at $1.5250 Sells £s high at $1.5450 (bank earns $0.02 per £1)

Note
The Spread can be shown in questions in three ways:
 1.5250 – 1.5450 $/£
 $/£ 1.5350 +/ – 0.0100
 $/£ 1.5350 bid/offer spread 250-450
There are two ways to determine which rate to use:
Use the worse rate. Calculate the £ equivalent using both rates. The company will ALWAYS LOSE OUT
– receiving the lowest receivable OR paying the highest payable.
Apply buy/sell to the first symbol. For example, 1.5250 – 1.5750 $/£. The first symbol is $ so the
company can Buy $ at $1.5250 and Sell $ at $1.5750. The first symbol represents the variable
currency (here the $) and the second symbol the base currency (here the £) and the banks will sell the
company the variable currency at the low rate and buy from the company at the high rate.

2.1.1 Exchange cross rates

a/b = a/c × c/b
So, if a question gives you a $/yen rate and a yen/£ rate, the $/£ rate will be $/yen x yen/£

2.1.2 Use of ‘ticks’ for FX movements

 Exchange rates are often quoted to 4 decimal places (e.g. $/£ 1.2508 – 1.2554.
 The smallest movement in the rate is therefore $/£ 0.0001 (a ‘tick’)
 If the standard amount of the contract is £62,500, say, the smallest change in value of the
contract is:
$/£ 0.0001 × £62,500 = $6.25 (the ‘tick size’ or ‘tick value’)
50 5: Treasury function and currency risk management ACCA AFM

3 Internal hedging methods

Hedging Method How it works
Invoice currency Invoice in domestic currency
Match receipts and Hedge net foreign currency position via a foreign currency bank account
payments
Match assets and Fund high value foreign assets (generate revenues in foreign currency) with
liabilities foreign borrowing (interest payments are also in foreign currency
Lead on a payment to a foreign supplier if you fear strengthening foreign
Leading and lagging
currency, but lag on a payment if you believe it is weakening
Countertrade Request payment in goods
Involves a netting centre through which all intra-group transactions will be
Multilateral netting
settled (a single net settlement from each company)

4 External hedging methods – forward exchange contract

These are binding agreements to buy or sell an amount of one currency in the future for a set price in
another currency (agreed today).
 FX forwards are either quoted as discounts or premiums on the spot price
 Remember: ADDIS (add a discount, deduct a premium) – for example:
– The spot price is $1.2543 - $1.2594: £1
– The 3-month forward is trading at a discount of 0.06 cents – 0.14 cents
– The 3m forward rate is:
($1.2543 + 0.06/100) – ($1.2594 + 0.14/100) = $1.2549 - $1.2608
– Remember, when choosing the rate to use: the COMPANY ALWAYS LOSES OUT!
 If you are given a 3m and 6m forward rate in the exam but the transaction is happening in say
5m time then you simply interpolate a 5m rate (i.e., find the rate that is 2/3 of the way between
the 3m and 6m rates)

Locks in an exchange rate Rate quoted may be poor

(removes downside) Mandatory agreement and
Widely available, easy to difficult to reverse
arrange, bespoke Removes potential upside
No transaction fee (bank as future rate is fixed.
profit embedded in
increased spread).

 A synthetic agreement on foreign exchange (SAFE) is like a forward contract except no currency
exchanges hands, simply the profit or loss on a notional amount of currency is settled between
the parties.
ACCA AFM 5: Treasury function and currency risk management 51

5 External hedging methods – money market hedge

Instead of using forward exchange contracts, a company can achieve a similar result by:
 Borrowing and lending on money markets
 Using spot foreign exchange transactions
This will fix an effective forward exchange rate for the hedging company.
The below table summarises the approach needed to hedge $ transactions for a UK based company:
To hedge future payment in Dollars: To hedge future receipt in Dollars:
Need to create a matching future receipt in $ to Need to create a matching future payment in $ to net
net off and be left with a guaranteed £ payment off and be left with a guaranteed £ receipt.
Borrow in £ now (use UK borrowing rate) Borrow in $ now (use US borrowing rate)
Convert to $ at spot (use £ to $ rate) Convert to £ at spot (use $ to £ rate)
Deposit $, earn interest (use US lending rate) Deposit £, earn interest (use UK lending rate)
On payment date, settle payment out of $ deposit On receipt date, use receipt to pay back $ loan
account Withdraw £ from deposit
Pay back £ loan + interest.

Note
It is easiest to start the calculations at the end and work backwards.
Suppose a UK based company which has just bought some goods on three month credit from a US
supplier for $90,000.
The spot exchange rate is $1.9851-$1.9857:£1 and the money market interest rates are:
Borrow Deposit
One year Sterling interest rate 6.0% 5.7%
One year Dollar interest rate 8.3% 8.0%
Using a money market hedge:

£ Sterling Dollars
(3) (2)

Need to borrow £ today and Buy $ at spot Need to deposit enough today
use to buy $ at the spot rate $1.9851 : £1 to grow to $90k in 3 months
Now $88,235 $90,000
Borrow = £44,449 Deposit =$88,235
1.9851 3
�1+8%×12�

3 3
�1 + 6% × � �1 + 8% × �
12 12

In 3 months, the £44,449

liability grows to Need $90k on deposit to pay the
3 months 3 supplier
£44,449 × �1 + 6% × 12�

=£45,115
(4) (1)
The £45,115 payment represents an effective forward rate of $90,000 / £45,115 = $1.9949/£
52 5: Treasury function and currency risk management ACCA AFM

6 External hedging methods – currency futures

Note
Hedging using currency futures takes time to understand and practice before you will feel comfortable.

They are effectively standardised versions of forward contracts:

 They settle in March, June, September and December.
 They have a standard contract size.
 Buying a Sterling future is akin to agreeing to buy £ Sterling for a set price at a set future date.
 FX futures don’t lead to any currencies being exchanged, only a net gain or loss in the currency
in which the price is quoted.
An initial margin (and possibly a variation margin) are paid to the exchange to cover potential trading
losses.

6.1 Basis
 Difference between the spot price (price available today) and the futures price (price agreed
today for a transaction at a fixed future date)
 On the date the futures contract matures the basis will ALWAYS be zero (ie spot = futures price
on the maturity date)
 Usual assumption for exams is that the basis declines in a linear (straight line) fashion from the
setup date to the maturity date. Used in calculations to predict the futures price at settlement
date as follows:
Now Settlement date
Spot X X
Futures price Balance figure
X
price
Difference 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑡𝑡𝑡𝑡 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
X × = X
𝑁𝑁𝑁𝑁𝑁𝑁 𝑡𝑡𝑡𝑡 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚

Basis risk is that risk that the difference between the future and spot price will not move in this
predictable way and the hedge is less effective than expected. The price movement in the spot market
might not be matched by an equal movement in the price of the futures contract.

6.2 Steps to follow when hedging using futures

STEPS TO FOLLOW WHEN HEDGING WITH FUTURES

Step 1: Setup the hedge (what you need to do up front right now) eg UK company using £
futures to hedge a $ receipt
 Contract to BUY or SELL £ (the contract currency)? If receiving $ you will need contracts to BUY
£ with those $.
 Which date/price contract? Choose the first available maturity date AFTER the expected $
receipt. The price will be given for that date maturity.
 Tick size = $/£ 0.0001 × £62,500 = $6.25
$ receipt
 Number of contracts needed = futures price × std contract size
ACCA AFM 5: Treasury function and currency risk management 53

Note
The calculation of number of contracts above assumes that the receipt (or payment) will be in a
different currency to that of the futures contract denomination. This will usually be the case in
questions. If the receipt/payment is in the same currency as the futures contract then you simply
divide the receipt or payment by the standard contract size to find the number of contracts.

Step 2: Outcome of the hedge (on transaction date)

 Close out futures contract by contracting to SELL £ (since initial contract was to BUY £)
BUY £ @ opening price X
SELL £ @ closing price X
Gain/(loss) in ‘ticks’ X/(X)
Overall gain/(loss) in $ = no of ticks × tick size × no. of contracts $X

 On the spot market, convert the $ receipt (net of any gain/(loss) on the futures contract) into £
using the spot rate on the outcome/settlement date.

6.3 Lock-in rate

If you are not given any information about the futures or spot prices on the transaction date, estimate
the lock-in rate using one of the following approaches;

If spot rate > futures rate on setup date

• Lock-in rate = opening futures price + basis remaining on close out, or

• Lock-in rate = opening spot rate – movement in basis

If spot rate < futures rate on setup date

• Lock-in rate = opening futures price – basis remaining on close out, or

• Lock-in rate = opening spot rate + movement in basis

Note
In the AFM exam you may see the examiner presenting solutions in a number of different ways but as
long as you stick to a recognised approach to these questions you will get the marks.
Sometimes the examiner leaves it up to you to demonstrate the outcome of a hedging technique by
making up some future exchange rates/futures prices based on assumptions about basis. Just use
sensible estimates and show you can follow the correct steps and you will be rewarded.

6.4 Hedge efficiency

Hedge efficiency for futures contracts can be estimated as:
𝐺𝐺𝐺𝐺𝐺𝐺𝐺𝐺 𝑜𝑜𝑜𝑜 (𝑙𝑙𝑙𝑙𝑙𝑙𝑙𝑙) 𝑜𝑜𝑜𝑜 𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓𝑓 𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐𝑐
(𝐿𝐿𝐿𝐿𝐿𝐿𝐿𝐿)𝑜𝑜𝑜𝑜 𝑔𝑔𝑔𝑔𝑔𝑔𝑔𝑔 𝑜𝑜𝑜𝑜 𝑆𝑆𝑆𝑆𝑆𝑆𝑆𝑆 𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚𝑚
54 5: Treasury function and currency risk management ACCA AFM

6.5 Advantages and disadvantages

Available for settlement dates at the Not good for SME, as product
quarter end BUT can be closed out knowledge is vital and futures contracts
early are for large volumes of currency
No transaction fee Remove upside
Futures aim to fix a rate for future Initial and ariation margins are payable
transaction (removes downside) upfront and during the life of the future
Contracts are standardised so may not
be able to hedge your transaction
exactly
Basis risk may result in a hedge not
being 100% efficient

7 Over the counter (OTC) currency options

Key terms Definition
Premium The amount initially paid for the option
Put option A right to sell the underlying currency
Call option A right to buy the underlying currency
Intrinsic value Value of the option if exercised today
Strike price/exercise price The price you end up paying/receiving for the currency
In the money Options that would generate a profit if exercised today
At the money Options which have exercise price = current spot price
Out of the money Options that would generate a loss if exercised today

If option rate (strike price or exercise price) is preferred then exercise the option
Key features of OTCs:
 Can be purchased from a bank.
 European style options – can only be exercised on the maturity date
 American style options – can be exercised at any date up to the maturity date.
 Can be tailored to the company’s needs in terms of amount of currency protected and the
timing of the transaction.
 Premiums are quoted as a lump sum
Do we need a Put or Call? From a UK banks perspective:
 A CALL is required if we want an option to Buy the contract currency
 A PUT is required if we want an option to Sell the contract currency.
ACCA AFM 5: Treasury function and currency risk management 55

8 Exchange traded currency options

Key features of exchange traded currency options:
 Contract to buy or sell a standard among of foreign currency on a standard future date at a rate
agreed now (v OTC)
 Generally not available outside the US, and so £ is the foreign currency and contracts are
quoted to buy/sell in blocks of £31,250.
 Call option – a right to buy £ (or other contract currency)
 Put option – a right to sell £ (or other contract currency)
 Example – if a UK company using traded options on £ to hedge a $ receipt, would want to sell $
and buy £, and so would need to buy call option
 A premium is applicable:
– Quoted as a dollar price for each unit of foreign currency
– Paid when the contract is arranged.

STEPS FOR EXAM QUESTIONS

Step 1: Set up the hedge (now)
 PUT or CALL option? Think about what you are doing with the contract currency
 What contract date?
 What exercise (strike) price? Any instructions in question? Keep premium low?
 Number of contracts?
$ receipt
No of contracts = strike price × std contract size

 Tick value? $/£ 0.0001 × £31,250 = $3.125

 Premium to pay (in $, purchased at the spot rate)? Ticks × tick value × no of contracts
Step 2: Calculate the INTRINSIC VALUE of the option (on transaction date)
 For a PUT option, if strike price > spot price, the option does have an intrinsic value (in the
money)
 For a CALL option, if strike price < spot price, the option has an intrinsic value
Strike price X
SPOT price X
Intrinsic value in ‘ticks’ X or zero
Intrinsic value ($) = no of ticks x tick size x no. of contracts $X
 It is generally assumed that the option will be sold on this day for an amount equal to its
intrinsic value
Step 3: Calculate the net outcome (on transaction date)
The gain on the option sale calculated above is either added to a FX receipt OR deducted from a FX
payment with the net balance converted to/from £ at the SPOT rate on the transaction date.
£ receipt/payment on SPOT mkt X
Premium cost X/(X)
Net receipt/payment X
56 5: Treasury function and currency risk management ACCA AFM

Note
If you have a foreign currency RECEIPT that is being converted back into £ you will then need to
DEDUCT the premium cost, whereas, if you have a foreign currency PAYMENT where you are working
out the cost in £ you will need to ADD the premium cost.

Removes downside Premiums are

risk but retains expensive and are
upside payable
immediately
Limited number of
currencies available
 57

Interest rate risk

1 Interest rate risk

Interest rate risk can be managed by netting interest bearing assets with interest bearing liabilities
(netting) or using a mix of fixed and variable rate finance (smoothing) or hedging.
LIBOR (the London Inter-Bank Offer Rate) is a benchmark variable rate that is referenced by much
variable rate debt.

Note
Be careful in questions to pick up instances where you are told what premium over LIBOR a borrower
has to pay (credit risk premium) as the hedging instruments are generally based on LIBOR so you may
need to remember to add on the premium above LIBOR at the end of the question.

2 Forward Rate Agreements (FRAs)

FRA allow companies to fix, in advance, a future borrowing rate or a future deposit rate, based on a
notional amount, over a set time period.
 They are cash settled on the start date of the underlying loan/deposit.
 No amounts are actually lent/deposited as part of the FRA, the company still needs to borrow
from or deposit with a bank
 Borrowers buy an FRA, lenders sell an FRA
 Borrowers pay the FRA fixed rate and receive the spot rate (LIBOR) as one net settlement.
 Lenders receive the FRA fixed rate and pay LIBOR as one net settlement.
 5.75-5.70 means you can fix the borrow rate at 5.75, deposit rate at 5.7
58 6: Interest rate risk ACCA AFM

 Market terminology for a three-month £2m loan, starting in three months’ time and fixing the
cost at 4.5% per annum is £2m 3-6 FRA at 4.5%
– The interest rates which banks will be willing to set for FRAs will reflect their current
expectations of interest rate movements
– Should the interest rate rise and the cost of the loan exceeds 4.5%, the bank will pay out
the difference between the rate paid and 4.5% (so that the effective interest paid is fixed
at 4.5%).

STEPS FOR FRA

Step 1: Setup (now)
 Buy a FRA (if borrowing in the future)
Step 2: Outcome (on the day the borrowing (or deposit) starts)
 Net settlement on the FRA if borrowing = (Spot rate – FRA rate) × Nominal value × # months /12
 Borrow money from your bank at spot rate

Easy to arrange, widely The contract must be

available. Suitable for honoured, even if the
SMEs, no transaction company decides not to
fees borrow/deposit.
Bespoke to suit company Rate quoted may be
requirements. expensive compared with
the current loan rate.

3 Interest rate futures

Interest rate futures are contracts to borrow or deposit a standard amount on a standard future date
for a three-month period but at an interest rate agreed now.
 BUYING an interest rate futures contract is fixing a RECEIPT of interest on a deposit so
contracting to SELL IR futures is fixing a PAYMENT of interest on a borrowing.
 For a loan (borrower) the hedging strategy is Sell, then to close out you Buy
 For a deposit (lender) the hedging strategy is Buy, then to close out you Sell
 Futures are quoted at a price equal to (100 – annual yield). If the market is expecting interest
rates to be 2% in 3 months’ time, 3m IR futures will be quoted at a price of 98.
 Maturity mismatch - if a hedge is required for longer or shorter than the standard contract
length of three months:
loan amount loan period
– Number of contracts = std loan size (i.e.£500k) × 3 months

 Interest rates are normally quoted to two decimal places, so tick value would be 0.01% × £500k
× 3/12 = £12.50.
ACCA AFM 6: Interest rate risk 59

Note
If you get interest rates quoted to three decimal places you may need to adapt the calculation above
(i.e. 0.001% × £500k × 3/12 = £1.25 tick value), remembering that 0.01% = 0.0001.

Flexibility – a future can be Only for large companies as

‘closed out’ when no longer available in large contract
required. sizes (£500,000).
May get a better deal than a If bought at the LIFFE
FRA due to market efficiencies exchange, then Initial and
on the London International Variation margins are payable
Financial Futures and Options upfront and during the life of
Exchange (LIFFE). the future.

Note
The contract can be ‘nominal’ in that any gain or loss due to the movement in the interest rate is
settled in cash as opposed to the actual borrowing or lending of cash. Assume this is the case for
questions.

STEPS – ASSUMING THE COMPANY IS PROTECTING A FUTURE BORROWING

Step 1: Setup
 Contracts to BUY or SELL? (Sell if borrowing, BUY if depositing)
 Which date/price contract?
 Number of contracts?
 Tick value? Usually £12.50
Step 2: Outcome of hedge (on transaction date)
 Close out futures contract by contracting to BUY IR futures (since initial contract was to SELL IR
futures)
SELL @ opening price X
BUY @ closing price X
Gain/(loss) in ‘ticks’ X/(X)
Overall gain/(loss) in $ = no of ticks x tick size x no. of contracts £X
 On the SPOT market, borrow money from the bank at whatever the rate is on that day (SPOT
rate as adjusted for any credit risk premium).
60 6: Interest rate risk ACCA AFM

4 Exchange traded interest options

A traded interest rate option is the right, but not the obligation to BUY (CALL option) or SELL (PUT
option) an IR futures contract to borrow or deposit a standard amount (£500k) on a standard future
date for a three-month period but at an interest rate agreed now.
A premium is payable.
To hedge increasing rates on a loan (i.e. if you are borrowing):
 Use a Put option – a option to sell an IR futures contract (i.e. an option to fix an interest
payment)
 Known as a CAP on an interest payment (i.e. guarantees a ceiling or maximum interest
payment).
To hedge falling rates on a deposit:
 Use a Call option – an option to buy an IR futures contract (i.e. an option to fix an interest
receipt)
 Known as a FLOOR on an interest receipt (i.e. guarantees at least a certain minimum receipt of
interest)

Keep potential upside Premium cost, which is paid

Flexibility – an option does upfront and be expensive
not need to be exercised so Only for large companies as
do not exercise if not available in large contract
needed sizes (£500,000)
May get a better deal than a If bought at the LIFFE
FRA due to market Exchange, then Initial
efficiencies (LIFFE). Margin is required

4.1 Exam question approach

STEPS IN A QUESTION
Step 1: Setup the hedge (up front)
 PUT or CALL option? Borrowers need PUT options and depositors need CALL options.
 What contract date?
 What exercise (strike) price? Any instructions in question? Keep premium low?
 Number of contracts?
loan amount loan period
Number of contracts = ×
std loan size (i.e.£500k) 3 months

 Tick value? 0.01% × £500,000 × 3/12 = £12.50

 Premium to pay? Ticks × tick value × no of contracts
ACCA AFM 6: Interest rate risk 61

Step 2: Calculate the INTRINSIC VALUE of the option (on transaction date)
 Compare the strike price with the current price of the futures contracts.

Note
You may have to estimate the price of the futures contracts using assumptions about basis.
For a PUT option, if strike price > futures price, the option does have an intrinsic value (in the money)
For a CALL option, if strike price < futures price, the option has an intrinsic value

Strike price X
SPOT price of futures contracts X
Intrinsic value in ‘ticks’ X or zero
Intrinsic value ($) = no of ticks x tick size x no. of contracts £X

It is generally assumed that the option will be sold on this day for an amount equal to its intrinsic value

Step 3: Calculate the net outcome (on transaction date)

 The gain on the option sale calculated above is either added to an interest receipt OR deducted
from an interest payment.

Note
You may need to remember to add on any credit risk premium that is relevant at this point from the
company’s perspective.

Borrowing Deposit
Interest (payment)/receipt on SPOT mkt (X) X
Premium cost (X) (X)
Net interest (payment)/receipt (X) X

Note
In step 3 above the outcome for borrowing and depositing have both been shown to highlight the
importance of getting the positive and negative signs the correct way around, otherwise it is very easy
to make silly mistakes (e.g. adding together an income and expense item).
62 6: Interest rate risk ACCA AFM

4.2 Collars

Note
The table below will help you understand the process of creating a collar.
Trade Interest outcome Explanation
Purchase PUT Fixes maximum If IR increases you exercise option to cap interest payments
option payment
Purchase CALL Fixes minimum If IR goes down you exercise option to create a floor for interest
option receipt receipts
Sell (write) PUT Fixes maximum If IR increases the buyer of the option will exercise their option to
option receipt only pay you the capped amount (i.e. you will never receive more
than the cap from them)
Sell (write) Fixes minimum If IR goes down the buyer of the call option will exercise their right
CALL option payment to receive from you a minimum amount of interest at the floor rate
(i.e. you will never pay them less than this floor amount)

4.2.1 Loan collar

If you are borrowing money, the way to use traded options to create a collar is to simultaneously do
the following;
 Create CAP (maximum payment) – Purchase PUT options and PAY premium
 Create FLOOR (minimum payment) – Sell (write) CALL option and RECEIVE a premium.
Follow the same steps as you would do for a traded option question except that normally the number
of contracts working is not required since you will just be demonstrating the resulting interest rates
rather than the cash amount.

Note
An exam question may tell you which rates to set the CAP and the FLOOR at or the examiner may
leave it up to you to demonstrate with whatever figures are available. Be careful not to set a floor rate
above a cap rate!!

4.2.2 Deposit collar

If you are depositing money, the way to use traded options to create a collar is to simultaneously do
the following;
 Create FLOOR (minimum receipt) – Purchase CALL options and PAY premium
 Create CAP (maximum receipt) – Sell (write) PUT option and RECEIVE a premium.
ACCA AFM 6: Interest rate risk 63

4.3 Interest rate swaps

• To reduce the cost of borrowing (Kd)

Objectives that • To hedge(a variable interest commitment is swapped to fixed)
can be delivered • To take advantage of falling rates (a fixed interest commitment
is swapped to variable)

• A counterparty must want to borrow the same amount for the

same period.
Necessary
• A counterparty must want to achieve an opposing objective.
conditions
• One of the parties must have a stronger credit rating and
achieve competitive advantage in finance costs.

• Each party (A and B) pays the interest on its loan commitment

to the bank.
Cash flows to net • A pays variable rate interest (typically at LIBOR) to B, or vice
versa.
• B pays fixed rate interest to A, or vice versa.

STEPS TO IDENTIFY IF A SWAP MIGHT BE BENEFICIAL

Step 1: Establish whether a SWAP is potentially viable
 Set out the rates each company would pay (with no swap) and could pay (if they did the
opposite) and work out the total rate (add rates together) in each case.
 If the total of the rates they could pay is lower than the total they would pay with no swap then
a SWAP is going to be beneficial and you move to the next step. If they would be better off in
total with no SWAP then you stop here.
Step 2: Split the potential gain between the two parties
 Take the overall gain and deduct any bank fees that may be given in the question
 Split the balance between the two parties as instructed in the question
Step 3: Work out the effective rate for each party
 The effective rate for each party is found by deducting their share of the gain from the amount
they WOULD PAY with no swap.

Note
You may additionally be asked to demonstrate the different cash flows that would result to make the
overall SWAP work between the two parties and the intermediary bank.
64 6: Interest rate risk ACCA AFM

4.4 Currency swaps

A currency swap is an agreement in which two parties exchange the principal amount of a loan and the
interest in one currency for the principal and interest in another currency. There are 3 stages to a
currency swap:
(i) At the start of the swap the equivalent principal amounts are exchanged at the spot rate
(ii) During the term of the swap each party pays interest on the swapped principal amount.
This can be on either a ‘fixed for fixed’ basis or a ‘fixed for variable’ basis (in a similar way
to the interest rate swaps covered above)
(iii) At the end of the swap term the principal amounts are swapped back at either:
– The prevailing spot rate
– A pre-agreed rate such as the rate used in the original exchange. If the original rate
is used then this would eliminate transaction risk on the loan element.
A company can therefore access lower cost finance for a foreign project/investment whilst potentially
managing exchange risk on the principal amount.

4.5 FOREX swaps

In a forex swap, the parties agree to swap equivalent amounts of currency for a period and then re-
swap them at the end of the period at an agreed swap rate. The swap rate and amount of currency is
agreed between the parties in advance.
The forex swap will provide a potential hedge against exchange rate risk and may allow a company to
access capital in markets where it cannot directly borrow.
 65

Valuation techniques

1 Valuation – general issues

The problem of overvaluation can lead to a reduction in wealth for both the buyer (pays too much if
overvalued reducing shareholder wealth) and the seller(refuses to sell if overvalued rejecting potential
increase in wealth).
Future growth can be estimated using:
 Internal measures – Use past growth to predict future growth or the growth model, g = bre
(seen earlier)
 External measures – Estimate a realistic company growth against published industry/economy
growth rates, competitor growth rates, and market research
There are generally considered to be three main groups of valuation techniques:
 Asset based
 Earnings based
 Cash flow based
66 7: Valuation techniques ACCA AFM

2 Asset basis – minimum valuation

Net assets value = Non-current assets + Net current assets – Long-term liabilities = Total assets – Total
liabilities
Book values Realisable values Replacement cost
Easy to Give a better indication of price in a sell off or asset stripping Maybe more appropriate
determine, but situation if trying to duplicate an
may be stated Ignores the economic benefits that could be delivered from existing business.
at historic cost future trade (ie pre-goodwill valuation) May give a better
Realisable values would need to be known and may be lower reflection of a maximum
than market values. price a buyer might
Might give a minimum price a seller of a business would consider paying for a
accept. business.

2.1 Calculated intangible value (CIV)

The CIV method provides a quick rough of the value of intangibles by finding the difference between a
company’s profits and the expected return on their tangible assets, which is deemed to be due to the
company’s intangible assets.

STEPS TO VALUE INTANGIBLES

Step 1: Estimate average excess return expected on tangible assets
$000
Actual return/profit (PBT) A
Average industry return with our tangible assets (industry ROA % × our y/e tangible assets) (B)
Excess pre-tax return attributable to intangible factors (value spread) C

Step 2: Estimate pv of excess return by valuing it as a perpetuity using the company’s cost of
capital
1
PV=Excess return (C) × (1 - tax rate) ×
r

Step 3: Estimate total value of business

Total value of business = Value of tangible assets + CIV value of the intangibles

Note
You may need to simply follow any instructions given in the exam question if the examiner chooses to
use different figures (i.e. use a different profit figure such as operating profit or a different assets
figure). It is a bit of a rough and ready calculation/estimate.

3 Earnings basis (P/E valuations)

3.1 Using P/E ratios in valuations
If we are given the earnings for a company and a suitable PE ratio to use, then:
 Total market value of equity = P/E ratio × current earnings
where earnings = PAT less preference dividends
 The value of one share = P/E ratio × EPS
ACCA AFM 7: Valuation techniques 67

3.2 P/E valuation scenarios

Valuing an unquoted company Valuing a company undergoing change

• Earnings × PE ratio of a similar quoted • Apply existing PE ratio to new expected

company in the same sector earnings
• Adjust the PE ratio used to reflect • Ensure earnings are sustainable ie adjust
differences between the two companies for any one-off factors (eg restructuring
eg growth, quoted v unquoted costs)
• Adjust for being unquoted - down by
20% to 40%

3.3 Advantages and disadvantage

Quick to calculate Adjustments may be

Considers future potential necessary to the P/E and
earnings figure.
Useful for valuing unquoted
companies Calculations are based on
profits rather than cash flows
Good for valuing a controlling
interest Which P/E to use in a takeover
situation (target co, predator
co’s or an average)?

3.4 Earnings yield approach

Earnings
MV of all shares =
Earnings yield
EPS
Value of one share=
Earnings yield

or
EPS
Share price =
Shareholders′ required return

Note
The same caveats (adjusting the valuation, using a suitable earnings yield, using sustainable
earnings) that applied to the PE ratio method also apply here. You would need to be able to find the
earnings yield of a quoted company if you were trying to value an unquoted one.
68 7: Valuation techniques ACCA AFM

4 Discounted cash flow valuations (free cash flow valuations)

Note
This approach is commonly used in the AFM exam.

4.1 Calculating free cash flows (FCF)

Free cash flow approximation $
Operating profit (PBIT) X
Add: depreciation X
Less: tax (X)
Operating cash flow X
Incremental NCA spend (X)
Incremental w/cap spend (X)
Replacement NCA spend (X)
FREE CASH FLOW (to the firm) X
Interest (X)
Debt repayments (X)
Cash in from new debt X
FREE CASH FLOW TO EQUITY (FCFTE) - Dividend capacity X

4.2 Valuing free cash flows

Free Cash Flow valuation Free Cash Flow to equity valuation
(1) Estimate Free Cash Flow (1) Estimate Free Cash Flow to Equity
(remember to deduct interest post tax)
(2) Discount at WACC (2) Discount at the cost of equity, Ke
(3) PV = Vd + Ve (3) PV= Value of equity Ve (i.e. market cap)
(4) Less: Value of debt Vd
(5) Value of equity Ve

4.3 Different time horizons and growth rates

𝐹𝐹𝐹𝐹𝐹𝐹 (1+𝑔𝑔) 𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹𝐹(1+𝑔𝑔)
 Infinite timeframe, use market value = or =
(𝑊𝑊𝑊𝑊𝑊𝑊𝑊𝑊−𝑔𝑔) (𝐾𝐾𝐾𝐾−𝑔𝑔)

 Finite timeframe, constant cash flows can be valued using annuity factors
 Generally, as the growth rate increases, the value will increase.
ACCA AFM 7: Valuation techniques 69

4.4 Advantages and disadvantages

Considers future Future cash flows will be

potential of the business estimates only especially
Can be used to value any if they have been derived
busienss from profit figures
Consirers the time value Requires a cost of capital
of money to be estimated

5 Dividend yield basis

Total dividend Divi per share
The dividend yield for a company = or
Market capitalisation Share price
total dividend
MV of all shares =
dividend yield

dividend per share

Value of one share =
dividend yield

Note
Dividend yields are only available for quoted companies.
If valuing a non-listed company you will have to use the dividend yield of a similar listed company
and scaling down your valuation (similar idea to P/E adjustments in the P/E valuation

6 Dividend Valuation model (DVM) – useful for valuing minority

interests
D0 (1 + g)
P0 =
(re − g)
where
P0 = share price
D0 = current dividend paid
re = cost of equity
g = estimated dividend growth rate (using historic dividend growth or g = rb)
70 7: Valuation techniques ACCA AFM

Bases valuation on future Difficult to estimate future

dividend stream (important for dividend growth and the cost
many investors) of equity
Useful for valuing minority Inaccurate to assume that
shareholdings growth will be constant to
infinity
Inappropriate for companies
which do not pay a dividend
and reinvest retained profits.

Note
The principles of this model can still be applied even if growth is not constant from year 1. You may
need to work out the PV of future dividends where the dividends are not constant for a few years and
then become constant at a later date.
 71

Mergers and acquisitions

1 Acquisitions and mergers versus other growth strategies

1.1 Evaluating growth objectives
To achieve its growth objectives, a company has three strategies that it can use:
Strategy Advantages Disadvantages
Internal or Organic growth A company can use its existing Failure to develop a competitive
talent pool to expand whilst product or launch successfully.
controlling its costs and growth A competitor enters the market and
rate. claims advantage.
Acquisitions / Mergers Instant access to, for example, new It may cost a premium over organic
markets, technology , customers, growth.
supply chains or economies of scale It may pay too much.
which might be difficult for the It requires significant finance
company to otherwise obtain. (acquisition).
Could be cheaper than organic Dilution of control (merger).
growth if high set up/infrastructure
The company does not get what it
costs, or inexperienced.
thinks it has bought.
Joint Ventures Where competitors have a mutual Commercially sensitive information
goal and are able to share the risks, is shared which can then be
costs and rewards of new products. exploited by the competitors.
Particularly useful where the R&D The risk/return ratio is unfairly
costs are prohibitively expensive. weighted in the favour of the
Can reduce political risk when competitor.
investing overseas.
72 8: Mergers and acquisitions ACCA AFM

1.2 Synergy
Often a Bidder will have to pay a premium to the current fair value to persuade shareholders of the
Target to sell.
The creation of synergy on acquisition provides the increase in wealth required by the Bidder. Synergy
is additional wealth which is only created as a result of the combination of two companies i.e.
𝑴𝑴𝑴𝑴𝑨𝑨+𝑩𝑩 = 𝑴𝑴𝑴𝑴𝑨𝑨 + 𝑴𝑴𝑴𝑴𝑩𝑩 + 𝑷𝑷𝑷𝑷 𝒐𝒐𝒐𝒐 𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔𝒔
Synergy can be classified into three areas:
(a) Sales synergy eg increase volumes (improved market reach, product visibility, technology)
(b) Cost synergy eg access to new economies of scale due to increased company size
(c) Financial synergy eg reduction in WACC due to perceived reduction in risk.

1.3 Criteria for choosing suitable acquisition targets

Every acquisition should be evaluated against a series of strategic objectives set out by the board of
directors such as:
 Strategic aims
 Diversification
 Tax savings
 Increase in debt capacity
 Disposal of cash surplus
 Underperforming company
 Access to key technology

1.4 Risks of acquisition

An acquisition strategy will fail if expected synergies fail to materialise. This may happen for the
following reasons.
Risk Explanation
Agency theory An over dominant director seeking status may ‘empire-build’ rather than build
shareholder wealth.
Pay too much A change in economic conditions might reduce the net benefits purchased.
Cultures clash/post Failure to define a new ‘shared culture’ can lead to standoff between groups of
integration strategy employees and significantly impact on effectiveness of the new group and morale.
Loss of talent Key staff may decide to leave rather than face the uncertainty of the new structure.
Customer/supplier Customers are lost because they fear post-acquisition quality and delivery problems
uncertainty and may anticipate an increase in price. The supply chain fear potential liquidity
issues and reduce quantity and credit terms.
Due diligence errors Unexpected issues, costs and liabilities arise as the due diligence process failed to
accurately identify all costs, contingencies, assets, staff skills, capacity, data etc.
Pre-emptive theory An acquisition is hastily pursued out of fear that a competitor will gain large cost
savings or synergies from horizontal integration.

1.5 Post-integration strategy

This will address all the key risks above and will ensure:
 All due diligence is completed.
 A new shared vision, mission with goals and corporate values are communicated
ACCA AFM 8: Mergers and acquisitions 73

 An operational structure is implemented aimed at realising planned synergies.

 Staff surplus to requirements are made redundant. This removes uncertainty.
 Key positions and reporting lines are clear and communicated; control of key resources/capital
expenditure is clearly delegated.
 A new marketing/advertising campaign is delivered; key customer and supplier relationships
are protected.
A position audit is performed once the new group is trading to identify further risks/potential gains.

1.6 Alternative ways of obtaining a stock market listing

1.6.1 Reverse takeovers
An RTO is usually the acquisition of a larger unquoted target company by a smaller quoted company
through a share-for-share exchange.
Typically, a large number of shares in the smaller quoted company will be issued to the shareholders
of the larger unquoted one such that the shareholders in the larger unquoted company will have
control of the quoted company.
 This enables the private company to obtain a listing without going through a lengthy Initial
Public Offer (IPO) process.
 The name of the smaller quoted company will typically be changed to that of the larger
unquoted company and will be run by the management team of the larger unquoted company.

They can be completed much more Private acquirer company management

quickly than conventional IPO, may lack experience of dealing with the
saving time and money. stock markets and requirements of being
After the reverse takeover, the a listed company.
shareholders should benefit from They may be viewed as a poor man’s IPO
the advantages of a stock market with less regulation/scrutiny applied to
listing (eg the shares are more them than an IPO, and so market interest
marketable, the company’s profit is in the newly-listed company may be
raised). limited.
They are less susceptible to market No new finance is raised with a reverse
conditions than an IPW, as the deal takeover.
is between the shareholders of the There is still significant amounts of
two companies only. regulation (suspension of share
trading, mandatory offer).

1.6.2 Special purpose acquisition companies (SPAC)

A SPAC is essentially a shell company set up by investors with the sole purpose of raising money
through an IPO to eventually acquire another company.
74 8: Mergers and acquisitions ACCA AFM

1.7 Estimating post acquisition values

1.7.1 Separate synergy valuation
MVA+B = MVA + MVB + PV of synergies
The MVA and MVB can be calculated as:
 Share price × number of shares, OR
 P/E ratio × existing earnings (PAT), OR
 PV of future cash flows
This is a convenient method if synergies:
 Are one off
 Have a finite life
 Will last for the foreseeable future (perpetuity valuation).

1.7.2 P/E valuation of combined earnings

In general, use:
MVA+B = P/E ratio × Combined sustainable earnings
 If the companies are in the same industry, use the predator’s P/E ratio (this is referred to as
‘bootstrapping’):
MVA+B = buyer's PE ratio × combined earnings
 Alternatively, a combination of the P/E ratios of the two businesses can be used.
 Combined sustainable earnings (e.g. PATA + PATB) may include any synergies that are expected
to last forever (e.g. “savings in salaries for the foreseeable future”).
 Sometimes specific synergies are not mentioned and they are effectively built into the
valuation via the P/E ratio used.

1.7.3 PV of future combined free cash flows

An accurate (but lengthy and complicated) approach is to use:
MVA+B = PV of future combined free cash flows
You may need to make an estimate of an appropriate cost of capital (the WACC of the buyer, or the
seller or a combined WACC?).
The type of valuation (Type 1, 2 or 3) will determine the appropriate Ke or WACC.
Type Description of acquisition How to determine Ke or WACC
Type 1 Acquisitions that do not When valuing own company, use existing gearing/beta’s to
change financial or business generate appropriate discount rate
risk
Type 2 Acquisitions that change Often if borrowing to fund acquisition:
financial risk only  Degear and regear beta or Ke to determine appropriate
discount rates
 Use APV
ACCA AFM 8: Mergers and acquisitions 75

Type Description of acquisition How to determine Ke or WACC

Type 3 Acquisitions that change When diversifying or using a comparable quoted company to
business risk or business determine risk.
and financial risk (1) Find buyer βe, target βe (or use comparable quoted
company) βe and degear to βa. Degear by division if each
has a different risk
(2) Find weighted average βa based on proportions of
buyer/seller/division
(3) Regear at the new group gearing level to find group βe
(4) Use group βe and CAPM to find group Ke
(5) Find new WACC and use to value FCF’s (Group cash flows +
synergy)
(6) Deduct Vd to find Ve combined group
(7) Compare with value of bidder to find maximum price
If you recall, we determined the maximum price the bidder should pay was based on the following:

𝑴𝑴𝑴𝑴𝑴𝑴 𝒕𝒕𝒕𝒕 𝒑𝒑𝒑𝒑𝒑𝒑 𝒇𝒇𝒇𝒇𝒇𝒇 𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕𝒕 𝑩𝑩 = 𝑴𝑴𝑴𝑴𝑨𝑨+𝑩𝑩 − 𝑴𝑴𝑴𝑴𝑨𝑨

There may be non-trading one-off cash flows such as pension and share option liabilities and sales of
surplus assets which the valuation will require adjusting for.

1.8 Quantifying the gains for the shareholders

1.8.1 Cash offer
The gain to the target company shareholders will simply be:
 Purchase consideration – current MV of shares
The gain to the predator company shareholders will be represented by:
 Total synergies – gain to target shareholders

1.8.2 Share based acquisition

The gains will depend on the the choice of price for the target company’s shares (which we assume to
be somewhere between the standalone value of the target company and the value of the target
company plus synergies) and hence the share exchange.
MV Before MV After Change in wealth
$m $m
A X ? ?
B Y ? ?
X+Y X+Y+synergies

To determine the gains for each set of shareholders, the new share price of the combined company
must be calculated.

1.9 Valuing high cost/high growth start-up companies

To value a company which is currently delivering a net loss and negative free cash flows use:
FCF Valuation = PV Inflows at high growth rate – PV outflows at low growth rate.

1.10 Valuing loss-making companies

Forecasting sustainable future earnings and/or future cash flows can be difficult when an organisation
is currently loss-making. An asset-based approach is most commonly used in such circumstances.
76 8: Mergers and acquisitions ACCA AFM

2 Regulatory framework and processes

2.1 The City Code
The City Code on Takeovers and Mergers is a voluntary set of principles governing takeovers and
mergers of UK companies. It is issued and administered by the Takeover Panel (the Panel), an
independent body of representatives from UK financial institutions with key members appointed by
the Bank of England.
Directors of both bidding and target companies may aim to manipulate the bid process to their
advantage.
The Panel can block a company from making a bid for a listed company if it feels the rules have not
been followed. Furthermore, any listed company not complying with the code may have the
membership of the London Stock Exchange suspended. Unlisted companies are encouraged to follow
the guidance.

2.1.1 Benefits of the City Code include

 The City Code sets out procedures which ensure the highest standard of conduct which
companies and directors must follow during the bid.
 It determines procedures governing the access to information.
 It sets out a time limit for making a formal bid declaration following market rumours/approach
to purchase. This removes share price uncertainty.
 It can prevent a company from repeatedly bidding and withdrawing offers which would
otherwise prevent a company from pursuing its own trade without distraction.
 It ensures shareholder approval is required for any sale of the business.

2.1.2 Timeline for a takeover offer

-28 • Announcement of intention to bid

days

• Last day for all shareholders to received offer document

0 days

14 • Last day for target company to issue defence document

days

21 • Earliest day for the offer to close

days

42 • Last date for offeror to revise its offer

days

95 • Last day for paying offer consideration

days
ACCA AFM 8: Mergers and acquisitions 77

2.1.3 The Competition and Markets Authority CMA)

The CMA legally intervenes to prevent a merger that creates a combined market share of above 25%
(either nationally or locally).
 The principle behind this legislation is the protection of the consumer who can be exploited on
price if there is a lack of competition.
 Certain industries whose monopoly power cannot be curbed by this legislation (for example,
water, gas and electricity) are subject to price regulation by Government agencies.

2.1.4 Examples of takeover regulation

In the exam you will not be expected to have specific knowledge about a country’s regulatory
framework but there are a few general regulations that are seen around many countries’ markets.

The mandatory bid condition

This allows remaining shareholders to exit the company at a fair price once the bidder has
accumulated a certain number of shares. The amount of shares accumulated before the rule applies
varies between countries. The bidder must offer the shares at the highest share price, as a minimum,
which has been paid by the bidder previously. The main purpose for this condition is to ensure that the
acquirer does not exploit their position of power at the expense of minority shareholders.

The principle of equal treatment

This stipulates that all shareholder groups must be offered the same terms, and that no shareholder
group’s terms are more or less favourable than another group’s terms. The main purpose of this
condition is to ensure that minority shareholders are offered the same level of benefits, as the
previous shareholders from whom the controlling stake in the target company was obtained.

Squeeze-out rights
This allows the bidder to force minority shareholders to sell their stake, at a fair price, once the bidder
has acquired a specific percentage of the target company’s equity. The percentage varies between
countries but typically ranges between 80% and 95% (90% in the UK). The main purpose of this
condition is to enable the acquirer to gain a 100% stake of the target company and prevent problems
arising from minority shareholders at a later date.

2.1.5 Directors’ ethical duties

Where the Board feels that a takeover is in the best interests of the shareholders:
 They should issue a recommendation to shareholders to accept the bid.
 Usually 50% of shareholders must vote to accept the bid for the sale to proceed.
Where the Board feels that a takeover is not in their shareholders’ best interests:
 They have fourteen days from receiving the formal offer to issue a defence document to the
shareholders.

2.1.6 Defence strategies

Pre-emptive strategies can reduce the attractiveness of a company from a potential bidder.
Pre-emptive strategy How to reduce the company’s attractiveness
Golden parachute Increase bonus or redundancy/pensions terms for directors/employees
Poison Pill Create share options/deferred shares which convert to equity on
acquisition or sell new shares to existing shareholders at a very low price
78 8: Mergers and acquisitions ACCA AFM

Pre-emptive strategy How to reduce the company’s attractiveness

White Knight Seek an alliance with, or sell to, another company to strengthen the
company's position
Crown Jewels Sell off attractive assets/part of the business
Revaluation of assets May increase the offer price required
Re-forecasting May increase the offer price required
Reverse takeover (Pacman Mount a counter-bid for the attacking company
defence~)
Litigation or regulatory Seek investigation by the Panel or CMA which will cause delay
defence
Pre offer defence strategy Focus on wealth creation (dividend policy meets the shareholders’
expectations and that the market is kept informed of positive
developments (market efficiency)

Note
Employment of any of these defences is unethical if not in the best interests of the shareholders.
Directors have a duty to put aside their personal goals of remuneration and continued service if
shareholders can get a better deal from a sale or merger.
After the bid has been made the directors can still defend the bid, but they must still act in the best
interests of all of the shareholders rather than considering their own position.

3 Financing acquisitions and mergers

3.1 Cash based acquisitions
An acquisition results in 100% control being transferred to the acquiring company. Cash bids are often
offered at a premium to market price (20% as an approximate guide).
A cash offer can be funded from:

Retained • Requires surplus cash

earnings • May involve divestment of assets

• Debentures - can signal intention to bid to market

• Banks loan - can avoid signalling, can be short term prior to bond issue
Debt finance
• Eurobond for overseas acquisition
• May require security; amount may be prohibitive

• Convertible bonds and warrants

Mezzanine • Venture capital/private equity
finance • Maybe the only route for companies excluded from traditional bond
markets
ACCA AFM 8: Mergers and acquisitions 79

3.2 Paper based mergers

A merger (or paper bid) is the exchange of shares in the target company for new shares in the bidding
company. This results in control being shared between both sets of directors and shareholders.
As no cash changes hands this is attractive to companies without access to cash or debt; furthermore
target shareholders will receive shares as opposed to cash thereby delaying capital gains tax.
A deal could be mixed, meaning a combination of shares and cash. This provides target shareholders
with the certainty of some cash and the potential for higher dividends.
The most appropriate offer is often the one which maximises the increase in shareholder wealth.

3.3 Investor considerations between cash or paper

Bidder Target

• Dilution of EPS • Exit investment - cash

• Cost of finance • Need for future income
• Impact on gearing • Taxation impact
• Authorised share capital • Share price of bidder
• Impact on culture
80 8: Mergers and acquisitions ACCA AFM
 81

Corporate reconstruction
and reorganisation

1 Financial reconstruction
1.1 Causes of financial distress
 Asset management failure eg failure to invest in appropriate technology
 Poor working capital management
 Liability management failure eg poor control of interest rate risk and currency risk
 Adverse movements in market demand
 Capital management failure eg inappropriate funding methods.
 Failure to control costs
 Failure to maximise revenues
Ratios might provide warning signals for issues noted above.

1.2 Financial reconstruction schemes

Following efforts to reduce trading expenditure, restructuring a company is a more radical and
permanent strategy to improve future trading prospects.
Restructuring plans can include:
 The closure of unprofitable divisions and unnecessary departments
 A redundancy programme and elimination non-value adding overheads
 A reduction in expensive R&D, marketing and IT projects
 A refinancing of short/medium term debt to longer term debt
82 9: Corporate reconstruction and reorganisation ACCA AFM

 A conversion of debt to equity (lower interest payments but dilution of control of existing
shareholders)
 A cash call to investors, new debt or equity finance

1.2.1 UK insolvency legislation – agreement of creditors

 Each class of creditors should meet and vote whether they agree with the terms of the
scheme.
 Every class of creditor must vote yes for the scheme to succeed.
 For a scheme to be acceptable, each class of creditors must agree it is in a better position
financially compared to the position on liquidation of the company.

1.3 Steps on financial reconstruction

Assess the Assess the Discuss whether Determine

1

4
financial position financial position you believe each whether the
of each group of of each group of group of company will be
creditor on creditor after the creditors will economically
liquidation terms of agree to the viable and have
(restating assets reconstruction scheme. sufficient
to realisable scheme have working capital
value). been following the
implemented scheme.

1.4 Order of settlement on liquidation

On liquidation, the assets of the business are converted into cash and this is then distributed to
creditors in the following order in compliance with UK legislation.

Settlement of liquidation fees

1

Amounts due to fixed charge holders – named property offered as loan security
2

3 Amounts due to preference creditors (set out in the question)

Amounts due to floating charge holders – all other assets offered as loan security
4

Unsecured creditors
5

Preference share capital – restricted to nominal value only

6

Ordinary share capital – restricted to nominal value only

7

If available cash does not cover a particular class of creditor in full then a pro-rata payout (cents per $1
debt) is paid in settlement.
ACCA AFM 9: Corporate reconstruction and reorganisation 83

2 Business reorganisation
2.1 Types of reorganisation

• Raise cash – to fund a more profitable ventures or reduce financial risk

Sell off • Strategic review – dispose of a non-core subsidiary/product which is
(divestment) underperforming or absorbing a disproportionate amount of management time
• Take-over defence – pre-emptive measure against takeover rumours

• A company spins off some business it owns into a completely separate company
• No cash is raised
Demerger
• Management of demerged companies can concentrate on their core business
• Market can value each part of the business fairly, increasing shareholder value

• The business ceases to exist

Liquidation
• Sale of the assets is deemed the best way of returning any value to the investors

• Sale of the shares of the company to the public to be traded on a stock exchange.
Initial public • Advantages – some realisation of cash for investors, major shareholders usually
offering (IPO) maintain control and it can offer a high potential return
• Disadvantages – a costly process with an uncertain outcome

• The business concept is sold to others to replicate

Franchise • Usually an upfront cash receipt with an ongoing franchise fe.
• The arrangements are often legally very complicated

• Managers (from inside or outside the organisation) buy out the business/ part of it
Management • Can be attractive for the managers (own and run their own business, potential equity
buyout (MBO) gains) and the company (dispose of non-core operations, raises cash, it may be
quicker than a sale to a third party)

2.2 MBO in more detail

2.2.1 Financing an MBO

Typically, the MBO team want a decent % of the equity but can only personally afford a small fraction
of the amount payable. An approximate financing structure might therefore be
Management team 1-5%
Banks – Senior (secured) debt and subordinated (less secured) debt 30-40%
Banks/Investors – Mezzanine debt (unsecured, higher interest rate, shorter term) 20-30%
possibly with equity warrants
Venture capital 20-30%

2.2.2 The venture capitalist

 Typically looks to invest in businesses with high potential growth where the management have
a proven track record.
 May require in the region of 25%-30% average annual return (generally seen as dividends +
capital gain), some sort of board presence and decision-making input plus a clear exit plan for a
three-to seven-year timescale.
84 9: Corporate reconstruction and reorganisation ACCA AFM

 Exit plan – flotation, sale to third party, sale of shares to the management team or sale to
institutional investors.
 May agree a ‘ratchet system’ to incentivise the management team to deliver
 85

Formulae sheets
86 Formulae sheets ACCA AFM

Modigliani and Miller Proposition 2 (with tax)

V
Ke = Kie + (1 − T)(K ie − Kd ) d
V e

The Capital Asset Pricing Model

E(ri) = Rf + βi (E(rm) – Rf)

The asset beta formula

Vd (1 – T)
βa = βe + βd
( + (1 – T)) ( Ve + Vd (1 – T))

The Growth Model

(1 + g)
Po =
( – g)

Gordon’s growth approximation

g = bre

The weighted average cost of capital

WACC = Ke + Kd (1 – T)
+ +

The Fisher formula

(1 + i) = (1 + r)(1 + h)

Purchasing power parity and interest rate parity

(1 + ) (1 + )
S1 = S0 × F0 = S0 ×
(1 + ) (1 + )
ACCA AFM Formulae sheets 87

Modified Internal Rate of Return

1
PVR n
MIRR = � PV � (1 + re ) − 1
I

The Black-Scholes option pricing model

C = Pa N(d1 ) − Pe N(d2 )e−rt

Where:

ln (Pa /Pe ) + (r + 0.5s2 )t

d1 =
s√t

d2 = d1 − s√t

The Put Call Parity relationship

P = C − Pa + Pe e−rt
88 Formulae sheets ACCA AFM

Present Value Table

Present value of 1 i.e. (1 + r)–n

Where r = discount rate

n = number of periods until payment

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 0.826 2
3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 0.751 3
4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 0.683 4
5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 0.621 5

6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 0.564 6
7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 0.513 7
8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 0.467 8
9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 0.424 9
10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 0.386 10

11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 0.350 11
12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 0.319 12
13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 0.290 13
14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 0.263 14
15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 0.239 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.694 2
3 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.579 3
4 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.482 4
5 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.402 5

6 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.335 6
7 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.279 7
8 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.233 8
9 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.194 9
10 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.162 10

11 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.135 11
12 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.112 12
13 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.093 13
14 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.078 14
15 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.065 15
ACCA AFM Formulae sheets 89

Annuity Table

1−(1+r)−n
Present value of an annuity of 1 i.e.
r
Where r = discount rate
n = number of periods

Discount rate (r)

Periods
(n) 1% 2% 3% 4% 5% 6% 7% 8% 9% 10%

1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 0.909 1
2 1.970 1.942 1.913 1.886 1.859 1.833 1.808 1.783 1.759 1.736 2
3 2.941 2.884 2.829 2.775 2.723 2.673 2.624 2.577 2.531 2.487 3
4 3.902 3.808 3.717 3.630 3.546 3.465 3.387 3.312 3.240 3.170 4
5 4.853 4.713 4.580 4.452 4.329 4.212 4.100 3.993 3.890 3.791 5

6 5.795 5.601 5.417 5.242 5.076 4.917 4.767 4.623 4.486 4.355 6
7 6.728 6.472 6.230 6.002 5.786 5.582 5.389 5.206 5.033 4.868 7
8 7.652 7.325 7.020 6.733 6.463 6.210 5.971 5.747 5.535 5.335 8
9 8.566 8.162 7.786 7.435 7.108 6.802 6.515 6.247 5.995 5.759 9
10 9.471 8.983 8.530 8.111 7.722 7.360 7.024 6.710 6.418 6.145 10

11 10.37 9.787 9.253 8.760 8.306 7.887 7.499 7.139 6.805 6.495 11
12 11.26 10.58 9.954 9.385 8.863 8.384 7.943 7.536 7.161 6.814 12
13 12.13 11.35 10.63 9.986 9.394 8.853 8.358 7.904 7.487 7.103 13
14 13.00 12.11 11.30 10.56 9.899 9.295 8.745 8.244 7.786 7.367 14
15 13.87 12.85 11.94 11.12 10.38 9.712 9.108 8.559 8.061 7.606 15

(n) 11% 12% 13% 14% 15% 16% 17% 18% 19% 20%

1 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.833 1
2 1.713 1.690 1.668 1.647 1.626 1.605 1.585 1.566 1.547 1.528 2
3 2.444 2.402 2.361 2.322 2.283 2.246 2.210 2.174 2.140 2.106 3
4 3.102 3.037 2.974 2.914 2.855 2.798 2.743 2.690 2.639 2.589 4
5 3.696 3.605 3.517 3.433 3.352 3.274 3.199 3.127 3.058 2.991 5

6 4.231 4.111 3.998 3.889 3.784 3.685 3.589 3.498 3.410 3.326 6
7 4.712 4.564 4.423 4.288 4.160 4.039 3.922 3.812 3.706 3.605 7
8 5.146 4.968 4.799 4.639 4.487 4.344 4.207 4.078 3.954 3.837 8
9 5.537 5.328 5.132 4.946 4.772 4.607 4.451 4.303 4.163 4.031 9
10 5.889 5.650 5.426 5.216 5.019 4.833 4.659 4.494 4.339 4.192 10

11 6.207 5.938 5.687 5.453 5.234 5.029 4.836 4.656 4.486 4.327 11
12 6.492 6.194 5.918 5.660 5.421 5.197 4.988 4.793 4.611 4.439 12
13 6.750 6.424 6.122 5.842 5.583 5.342 5.118 4.910 4.715 4.533 13
14 6.982 6.628 6.302 6.002 5.724 5.468 5.229 5.008 4.802 4.611 14
15 7.191 6.811 6.462 6.142 5.847 5.575 5.324 5.092 4.876 4.675 15
90 Formulae sheets ACCA AFM

Standard normal distribution table

0.00 0.01 0.02 0.03 0.04 0.05 0.06 0.07 0.08 0.09
0.0 0.0000 0.0040 0.0080 0.0120 0.0160 0.0199 0.0239 0.0279 0.0319 0.0359
0.1 0.0398 0.0438 0.0478 0.0517 0.0557 0.0596 0.0636 0.0675 0.0714 0.0753
0.2 0.0793 0.0832 0.0871 0.0910 0.0948 0.0987 0.1026 0.1064 0.1103 0.1141
0.3 0.1179 0.1217 0.1255 0.1293 0.1331 0.1368 0.1406 0.1443 0.1480 0.1517
0.4 0.1554 0.1591 0.1628 0.1664 0.1700 0.1736 0.1772 0.1808 0.1844 0.1879

0.5 0.1915 0.1950 0.1985 0.2019 0.2054 0.2088 0.2123 0.2157 0.2190 0.2224
0.6 0.2257 0.2291 0.2324 0.2357 0.2389 0.2422 0.2454 0.2486 0.2517 0.2549
0.7 0.2580 0.2611 0.2642 0.2673 0.2704 0.2734 0.2764 0.2794 0.2823 0.2852
0.8 0.2881 0.2910 0.2939 0.2967 0.2995 0.3023 0.3051 0.3078 0.3106 0.3133
0.9 0.3159 0.3186 0.3212 0.3238 0.3264 0.3289 0.3315 0.3340 0.3365 0.3389

1.0 0.3413 0.3438 0.3461 0.3485 0.3508 0.3531 0.3554 0.3577 0.3599 0.3621
1.1 0.3643 0.3665 0.3686 0.3708 0.3729 0.3749 0.3770 0.3790 0.3810 0.3830
1.2 0.3849 0.3869 0.3888 0.3907 0.3925 0.3944 0.3962 0.3980 0.3997 0.4015
1.3 0.4032 0.4049 0.4066 0.4082 0.4099 0.4115 0.4131 0.4147 0.4162 0.4177
1.4 0.4192 0.4207 0.4222 0.4236 0.4251 0.4265 0.4279 0.4292 0.4306 0.4319

1.5 0.4332 0.4345 0.4357 0.4370 0.4382 0.4394 0.4406 0.4418 0.4429 0.4441
1.6 0.4452 0.4463 0.4474 0.4484 0.4495 0.4505 0.4515 0.4525 0.4535 0.4545
1.7 0.4554 0.4564 0.4573 0.4582 0.4591 0.4599 0.4608 0.4616 0.4625 0.4633
1.8 0.4641 0.4649 0.4656 0.4664 0.4671 0.4678 0.4686 0.4693 0.4699 0.4706
1.9 0.4713 0.4719 0.4726 0.4732 0.4738 0.4744 0.4750 0.4756 0.4761 0.4767

2.0 0.4772 0.4778 0.4783 0.4788 0.4793 0.4798 0.4803 0.4808 0.4812 0.4817
2.1 0.4821 0.4826 0.4830 0.4834 0.4838 0.4842 0.4846 0.4850 0.4854 0.4857
2.2 0.4861 0.4864 0.4868 0.4871 0.4875 0.4878 0.4881 0.4884 0.4887 0.4890
2.3 0.4893 0.4896 0.4898 0.4901 0.4904 0.4906 0.4909 0.4911 0.4913 0.4916
2.4 0.4918 0.4920 0.4922 0.4925 0.4927 0.4929 0.4931 0.4932 0.4934 0.4936

2.5 0.4938 0.4940 0.4941 0.4943 0.4945 0.4946 0.4948 0.4949 0.4951 0.4952
2.6 0.4953 0.4955 0.4956 0.4957 0.4959 0.4960 0.4961 0.4962 0.4963 0.4964
2.7 0.4965 0.4966 0.4967 0.4968 0.4969 0.4970 0.4971 0.4972 0.4973 0.4974
2.8 0.4974 0.4975 0.4976 0.4977 0.4977 0.4978 0.4979 0.4979 0.4980 0.4981
2.9 0.4981 0.4982 0.4982 0.4983 0.4984 0.4984 0.4985 0.4985 0.4986 0.4986

3.0 0.4987 0.4987 0.4987 0.4988 0.4988 0.4989 0.4989 0.4989 0.4990 0.4990

This table can be used to calculate N(d), the cumulative normal distribution functions needed for the
Black-Scholes model of option pricing. If 𝑑𝑑1 > 0, add 0.5 to the relevant number above. If 𝑑𝑑1 < 0,
subtract the relevant number above from 0.5.