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ACCA P4 Key Point Notes June 2010
ACCA P4 Key Point Notes June 2010
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ACCA
P4
Advanced Financial Management
Key Point
Notes
June 2010
These notes are not intended to cover the whole syllabus, but target key examinable areas.
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ACCA P4 Advanced Financial Management Key Point Notes June 2010
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Index
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Exam Technique
First 15 minutes
Read the questions carefully
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General
Numerical Questions
State formula
Show method
Explain as you go
Written Questions
Check format – report / essay/ listed points
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Tips
These will be posted on my website sometime in late May
2010.
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Key facts
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Positives
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Chapter One
Cost of Capital
1 Weighted Average Cost of Capital (WACC)
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We= Ve or (1-Wd)
Ve+Vd
Wd= Vd or (1-We)
Ve+Vd
re=Ke=Cost Of Equity
rd(1-t)=Kd(1-t)=Cost of Debt
Ke or re =Rf +βe(Rm-Rf)
re=Do(1+g) +g
Po
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Example
g= n√ (Do) -1
Dn
n=Increments of growth
Dn=Oldest DPS given
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g= 3√(0.32) -1
0.24
g= 0.10
Example
g= 0.12 x 0.70=0.084
g= 0.14 x 0.70=0.098
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Kd(1-t)=Interest % x (1-t)
Example
Kd(1-t)=11x(1-0.30)=7.7%
Kd(1-t)=Ints x (1-t)
Po
Example
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Time $
To Po (X) Take two guesses
T1-Tn Ints X(1-t) X like 10% and 1%
Tn Capital X and do an IRR
Repayment
Example
Time $ 10% PV 1% PV
To Po (105) 1.0 (105) 1.0 (105)
T1-Tn Ints 7.50 X(1- 3.791 19.90 4.853 25.48
X(1-t) 0.30)
T5 CR 100 0.621 62.10 0.951 95.10
(23) 15.58
Kd(1-t)=1 +
15.58 X (10-1)=4.63%
(15.58+23)
3.6 Quick assumption that the examiner might indicate is
that
Kd(1-t)=RF X (1-t)
OR
Kd(1-t)=Yield X (1-t)
OR
Example:
(1+r)-n = 1
(1+r)n
$7 + $7 + $107
(1+0.0525) (1+0.0525) (1+0.0525)3
1 2
=$6.65+$6.32+£91.77
= $104.74
The Vd is
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4 Degearing/Regearing βeta
Example
t= 30% βd=NIL
βa = 4 X 1.95
4+1(1-0.30)
= 4 X 1.95
4.7
= 1.66
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1.66 = 2 X βe
2+1(1-0.30)
1.66 = 2 X βe
2.7
Example
Hence,
= 1.38
β a= Ve X βe
Ve+Vd(1-t)
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1.38= 0.68 X βe
0.68+0.32 (1-0.30)
1.38= 0.68 X βe
0.904
Ke=Rf+(Rm-Rf) βe
Ke =5+ (9)1.83
= 21.47%
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Chapter Two
2 Practical Issues
Vd:Ve
a) Yield<Ke
b) Gearing causes Ke to rise –Financial Risk
Key Points:-
Ve+Vd
Key points:-
Vg=Vu+VDT
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Example
Vg=Vu+VDT
= $545m
Split Vd=$150m
Ve=$395m
= 13.86%
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Loan sizes are larger than one bank can take on its
own.
Banks may be based in different countries –mixed
lending package.
Low transaction costs.
Disadvantages
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Solution:-
b) Current Vd
WD=0.25
W D = Vd
Ve+Vd
Ve=$1.2billion
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0.25= Vd
1.2+Vd
0.25(1.2+Vd)=Vd
0.30+0.25 Vd=Vd
0.30=0.75 Vd
Vd=0.30 =$0.4billion
0.75
Revised Vd
$4 + $4 + $104
1.044 1.0442 1.0443
=$3.83+$3.67+$91.40=$98.90
Therefore, existing debt’s new Vd=
Therefore, Vd=$395.60+$400=$795.60million.
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=3.64%
Pros Cons
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Chapter Three
Dividend Policy
1 Introduction
2 Theories
2.1 Residual – If spare cash exists at the end of the year pay
dividend.
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3 Practical Considerations
Availability of cash
What dividends do S/H want (clientele effect)?
Signalling effect –payment of dividends indicates a
healthy company
Retaining cash is a key source of finance.
Dividend growth should be greater than inflation
Tax impact upon S/H
Effect the dividend will have on dividend
cover(EPS/DPS)
Number of investment opportunities will restrict
dividend payments.
Risk-paying now is safer than promising to pay next
year
Is the dividend within the company law regulations?
4.1.2 This will allow the S/H to sell extra shares for cash and
the gain will be subject to CGT.
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4.2.1 If the board has “one off” period of excess cash, they
could consider a share buy back.
4.2.2 Considerations:-
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Chapter Four
How lenders set their
interest rates?
1 Credit Risk
Therefore,
σa = σm x √ T
σa = 10% x √12months
= 34.64% annually
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$1,200,000 = 1.732
$692,800
Value of the
asset
$0.8m $2m
Lies 1.732 σ σ =$692,800
Away from $2m
0.4582+0.50=0.9582
Type of Asset
Covenants on disposing the asset
If (say) only 75% of the debt can be recovered and LIBOR is
6%.What premium above LIBOR should the bank set?
i.e
$800,000=
“Note: 0.0418=1-0.9582”
800,000=723,170(1+i) +23,660(1+i)
800,000=723,170+23,660+746,830 i
(800,000-723,170-23,660) = 0.0712
746,830
$800,000=
800,000 = 719,775+23,549+743,324i
i = 0.0762
i.e = 7.62%
3 Problems
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Chapter Five
Advanced Investment
Appraisal
1 Net Present Value of Free Cash Flows (FCF)
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1.2 Proforma
Time
$’000 T0 T1 T2 T3 T4
Revenue(inc - X X X -
Inflation)
Costs(inc - (X) (X) (X) -
Inflation)
Operating Cash - X X X -
flows
Tax @ (1year - - (X) (X) (X)
delay)
Capex&Scrap (X) - - X
Value
Tax savings on - - X X X
TAD
Asset - (X) (X) (X) -
replacement
spending
Working Capital (X) (X) (X) X -
Free Cash Flows (X) X X X (X)
Cost of Capital% 1.0 X X X (X)
PV (X) X X X (X)
NPV $XXX
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1.4 Inflation
eg Real CF3=$600
= 7%pa
h = inflation
r = real cost of capital
i = money cost of capital
eg r = 10% h=5%
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1+i = 1.155
i =0.155 or 15.5%
1.5 Taxation
$’000 T1 T2 T3
Operating 200 300 -
Cash Flows
Tax 30%(say - (60) (90)
1year delay)
eg Capex will take place over the first year and be finished
by the end of the year. Cost $6.2m.TAD is 50%.First year
allowance followed by straight line allowances for a further
three years. Tax is 30 %( no time delay).
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Another Example
T0=1/Jan/09
T0 CAPEX $1000K
T5 Scrap $200K
$’000 T0 T1 T2 T3 T4 T5 T6
Capex & (1000) - - - - 200 -
Scrap
T.A.D(w1) - - 75 56.25 42.19 31.64 34.92
(w1)
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eg
$’000 T0 T1 T2 T3
WC needed - 100 170 300
Relevant (100) (70) (130) 300
Cash Flows
$’000 T0 T1 T2 T3 T4-Tperp
Cash (1000) 200 400 300 350pa
Flows
10% 1.0 0.909 .826 .751 1 X 0.751
0.10
*
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Therefore,
$’000 T0 T1 T2 T3 T4-Tperp
Cash (1000) 200 400 300 350
Flows
10% 1.0 0.909 0.826 0.751 9.388
*
* 1 X 0.751
r-g
1 X 0.751=9.388
(0.10-0.02)
2 IRR
2.1 The Internal Rate of Return is the cost of the capital that
gives an NPV of NIL
2.2 Example
NPV @10%=$300K
NPV @20%=($160K)
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IRR=
= 16.52%
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Example
Jon inc (USA company) has a project in the UK. Cash flows
have been computed already as:-
Time £’000
T0 1,000
T3 scrap 100
T1 operating flows 500
T2 operating flows 600
T3 operating flows 400
UK 20%
USA 30%
with a one year delay
USA=5%pa UK=3%pa
Solution
Notes:-
USA=Home, UK=Foreign
S0=$1.50/£ or £0.67/$
Spot Rates via PPP:-
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Time £/$
S0 0.67
S1 0.67 X 1.03 = 0.66
1.05
S2 0.66 X 1.03 = 0.65
1.05
S3 0.65 X 1.03 = 0.63
1.05
S4 0.63 X 1.03 = 0.62
1.05
£’000 T0 T1 T2 T3 T4
Operating - 500 600 400 -
Flows
TAD - (300) (300) (300) -
(1000-100)
3
Taxable - 200 300 100 -
“Profit”
Tax@20% - - (40) (60) (20)
Add back - 300 300 300 -
TAD(not
cash flow)
- 500 560 340 (20)
Capex&Scrap (1000) - - 100 -
£’000 (1000) 500 560 440 (20)
Spot Rates £0.67 £0.66 £0.65 £0.63 £0.62
$’000 (1493) 758 862 698 (32)
USA Tax(w1) - - (30) (46) (16)
FCF (1493) 758 832 652 (48)
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T1 Taxable Profit=£200
Additional Tax=10% X £200=£20
Converted @ T1 spot =£20/£0.66
=$30
Paid at T2!!!
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Chapter Six
Adjusted Present Value
1 When to use it
2 Method
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APV
$m
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a) βa = Ve X βe
Ve+Vd(1-t)
= 7500 X 1.40
7500+2500(1-0.30)
= 1.14
b) Keu=RF+ (Rm-RF)βa
Keu=5.0+ (3.5)1.14
= 9%
Note:-
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$m T0 T1 T2 T3 T4 T5 T6
Revenue - 680 900 900 750 320 -
Direct Costs - (408) (540) (540) (450) (192) -
Lost Cont’n - (150) (150) - - - -
Operating - 122 210 360 300 128 -
Cashfows
Tax at 30 % - - (37) (63) (108) (90) (38)
Capex&Scrap (800) - - - - 40 -
Tax Saved - - 120 48 29 17 14
on Capital
Allowances
(w)
FCF (800) 122 293 345 221 95 (24)
9% 1.0 .917 .842 .772 .708 .650 .596
PV (800) 112 247 266 156 62 (14)
Assumptions:-
Indirect costs are not incremental
Design costs are sunk therefore ignored.
(w)
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5.40+1.80=7.2%
$m
Base Case NPV 29
Issue Costs (16.33)
PV of Tax Savings 67.06
$79.73m
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3 Subsidised Loans
i.e
Ints pa not paid less tax not saved all discounted at the
yield.
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Chapter Seven
1.2 IRR is the cost of capital that causes the NPV to be nil.
It’s decision rule
1.4 MIRR is a measure that gives an NPV of nil but will lead
to a project decision rule consistent with NPV.
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2 Computing MIRR
Time $’000
T0 (1000)
T1 400 Return phase
T2 600 of the project
T3 300
Cost of Capital=10%
Time $ 10% PV
T0 (1000) 1.0 (1000)
T1 400 0.909 363.6 *
T2 600 0.826 495.6
T3 300 0.751 225.3
84.5
* PV of Return Phase=$1084.50
Formula given
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(1/3)
MIRR= {1084.50} (1+0.10)-1
1000
= 0.1301. i.e 13.01%
Alternative Method:
Time $’000
T1 400 X 1.102= 484
T2 600 X 1.10 = 660
T3 300 X 1.0 = 300
1444
T0 (1000)
T3 1444
1444 =1000
3
(1+MIRR)
MIRR = 3√(1444) -1
1000
0.1303 OR 13.03%
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PVI=972.7
PVR =985.9
Therefore,
3.1 Both NPV and MIRR assume cash flows from a project
are reinvested at re.This may not be the case.
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Chapter Eight
Capital Rationing
1 The Problem
PI= NPV
Cash outlay in critical period
3 Multiperiod-Divisible Projects
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Example
Project Cash 0 1 2 3
Flows at
time:
$000 $000 $000 $000
A -10 -20 +10 +20
B -10 -10 +30 +6
C -5 +2 +2 +2
Solution
1) Symbols
2) Objective
Z= D0+ D1 + D2 + D3
1.10 1.102 1.103
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3) Constraints
10a +10b+5c+D0=20,000
20a+10b+D1=5000+2c
D2=10a+30b+2c
D3=20a+6b+2c
Dn≥0
0≤ a, b, c, ≤1
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Chapter Nine
2 Transaction Exposure
2.1 Change in the value of the spot rate over the short
term causing a cash gain or loss.
3 SPOT Rates
(Bid) (Offer)
$1.5000 - $1.5555 / £
Reciprocal and
cross over!!!!! £0.6429 - £0.6667 / $
(Bid) (Offer)
4 Internal Hedges
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4.4 Netting
5 External Hedges
“Fix the rate today that will apply on a set future date”
Technique: -
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Technique
Home Abroad
Today’s Spot
Today £ Answer FX
X 1 + ints foreign
1+ints home
Future Date
£ Answer FX
FX
Technique: -
2. Setup – Today
Net FX Transaction
Futures Rate
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Technique: -
2. Set up today
1. Cheapest premium or
2. Nearest to spot or
3. Best possible rate
No. of contracts
Transaction Number
Strike Rate
Summary
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Pros Cons
Forward Market
Fixed Rate, certainty Inflexible/contract
Easy Lose out on the upside
Cheap Must ensure FX receipts
Tailored arrive
MMH
Convert today Complicated
Cheap May not apply for FX
Tailored receipt
Flexible
Futures
Effectively fix rate Complicated
No cost Small loss
Small gain Need cash for margin
No tailoring
Options
Best hedge – cover Complicated
d/s risk only No tailoring
Flexibility Expensive
Lots of choice
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7. SWAPS
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Solution
£m 0 1
Without swap
Buy 100m pesos @20 (5.0)
Sell 200m pesos @40 5.0
Interest on sterling loan (5 (0.5)
x 10%)
(5.0) 4.5
£m 0 1
With forex swap
Buy 100m pesos @20 (5.0)
Swap 100m pesos back 5.0
@20
Sell 100m pesos @40 2.5
Interest on sterling loan (5 (0.5)
x 10%)
(5.0) 7.0
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Chapter Ten
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FRA 3-9 @ 4% pa
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Contract sizes
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Purchased from
a merchant bank for
a fee Covers the adverse
of interest rate
changes but at a
cost!!!
Contract that caps
the future interest
rate for a set
period
IRG 3-9 @ 4% pa
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NB Collars
4 SWAPS
4.2 Example
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%
A (Fixed)+B (Float)
10+LIBOR+2 =LIBOR +12
A(Float)+B (Fixed)
LIBOR+1+B =LIBOR+14
Difference 2%
12 (w1)
10 LIBOR+2
A PAY LIBOR
B PAY 12
4.4 Problems
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Solution
1) Timeline
(w1) Basis of 0.12 [12 Basis points] will fall to nil by 31st
March. On the 1st March one month from three is still
remaining. Hence,
1/3 x 0.12=0.04
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(ii) Options
No of contracts – as above 80
Premium Payable
= £16,800
LIBOR LIBOR
5.00% 7.00%
£ £
Premium Paid (16,800) (16,800)
Interest paid-see Futures (550,000) (750,000)
above
Compare Cap vs Mar Futures
Interest Rate
6.00% vs 5.04% -
6.00% vs 7.04%
Therefore, Use the option and 104,000
receive
(7.04-6.00) X 80 X £12.50
0.01
Total Cost (566,800) (662,800)
Effective Annual% 5.67% 6.63%
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= 6.15%
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Chapter Eleven
Valuation of Options
+Value at Risk
1 Valuation of Options
1.1 An option gives the holder the right, but not the
obligation to buy or sell a share at a fixed price on a
specified future date.
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1.1 The above five factors have been built into the Black-
Scholes formula to find the value at time 0 of a
European call option. (c).
All three formulae are given in the tables but you must
know what the symbols stand for.
Symbols:
Pa=share price
Example
1) Find d1 and d2
d1=In (100/95)+(0.10+0.5X0.52)0.25
0.5√0.25
d1=0.051+0.056
0.25
d1=0.43
d2=0.43-0.25=0.18
2) N (d1) =0.50+0.1664=0.6664
N (d2) =0.50+0.0714=0.5714
3) Find e-rt
e-0.025=0.975
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Hence,
=$13.71
p =$13.71-$100+$95 X 0.975
= $6.34
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2 ‘The Greeks’
2.1
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3.1 Formulae
where
FO=Forward Rate
X=Exercise Rate
R=Domestic interest rate.
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3.3 Example
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Solution
1) Find d1&d2
2
d1=ln (28/24)+(0.05+0.5x0.25)2
0.25 X √2
= 0.154+0.1625
0.35
= 0.90
d2= 0.90-0.35=0.55
2) N(d1)=0.50+0.0159=0.8159
N(d2)=0.50+0.2088=0.7088
3) e-rt
rt=0.05 x 2=0.10
e-0.10=0.9048
Hence c=
$4m+$7.45m
=$11.45m
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Example
At 95%,what is VaR?
45% 50%
$50m
s=$4.85m
$ 50m-(1.65 X $4.85m) =$42m
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Chapter Twelve
1.2.2 The Net Asset value equals the Ve and can be based
on:-
a) Book Values
b) Net Realisable Value(NRV)
c) Replacement cost
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OR
Po = Do(1+g)
(Ke-g)
1.3.4 Finding g
a) Past Growth model
eg:
Year DPS
2006 $0.45
2007 $0.49
2008 $0.52
2009 $0.54
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g= 3√ (0.54)-1
(0.45)
g=0.063
g=bre
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1.5.2 Establish:-
1.5.4 Example
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Ve= FCF0(1+g)
(re-g)
T1 $420m
T2 $490m
T3 $510m
Time
$m T1 T2 T3 T4-F.Ever
FCF 420 490 510 510(1.03)
1/1.0792 1/1.07922 1/1.07923 16.171*
PV 389 421 406 8,495
Ve=$9,711m
* 1 X 1 = 16.171
3
(0.0792-0.03) (1.0792)
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Approach:-
$ ‘000
Value Spread X
r =Cost of Capital
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4) Value of Equity is
Method
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$
Normalised earnings X
Less
Return on financial/monetary (X)
assets(Rf X monetary assets
employed)
Less
Return on physical /tangible (X)
assets(Average industry return
on tangibles X tangible assets
employed)
Earnings driven by intangible X
assets
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Predator Target
No of Equity shares X X
in Issue
PAT X X
EPS X X
Pre acquisition Po X X
P/E Ratio X X
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a) Using Bootstrap
$000
Predator PAT X
Target PAT X
Total PAT X
Predator Preacquisition Ve X
Target Preacquisition Ve X
Ve *
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Predator
a) Po risen?
b) EPS risen?
Target
Per Share $
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a) Cash
b) Shares
c) Loan Stock
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Chapter Thirteen
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1.8 Example
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Retained earnings 22
Additional information:
Required
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1.9 Solution
= 10.75%
NOPAT:-
£m
PAT 32
Add: Non – cash Expenses 15
47
Add: Post tax ints 3.25
(5m X 0.65)
£50.25
= £38.64m
Quick Example
BB Plc
2003 Ve = £25m
2004 Ve = £40m
Rights issue in 2004 = £5m
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Quick Example
CC Plc
WACC = 14%
Vd = £2.5m
1
SVA = £1.5m x 0.14 - £2.5m = £8.21m
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Chapter Fourteen
Corporate Reconstruction
and Reorganisation
1 Causes of Corporate Failure
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4 Financial Reconstructions
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Chapter Fifteen
Ethical Issues
2 Preparation
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