ACA Financial Management
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- Created by: Abi Woodrow
- Created on: 06-12-21 14:05
Reasons why NPV is theoretically superior
1. Time Value of Money
2. Absolute measure of return
3. Cashflows, not profits
4. Considers entire life of a project
2. Absolute measure of return
3. Cashflows, not profits
4. Considers entire life of a project
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Cash flows to ignore in NPV
Sunk costs
Committed costs
allocated and apportioned costs
non-cash items
book values
finance costs
Committed costs
allocated and apportioned costs
non-cash items
book values
finance costs
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Money rate of inflation
(1+ money rate) =
(1+real)*(1+general)
(1+real)*(1+general)
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Rate of inflation used to discount cash flows
money rate
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Equivalent Annual Cost =
EAC =
(PV of costs/
Annuity factor)
(PV of costs/
Annuity factor)
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Assumptions behind replacement analysis
cost of operation not subject to inflation
operating efficiency of assets are similar
asset will be replaced in perpetuity
operating efficiency of assets are similar
asset will be replaced in perpetuity
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Shareholder Value Analysis drivers
Sales growth (+)
Length of time (+)
Operating margin (+)
Working capital investment (-)
Cost of capital (-)
Asset investment (-)
Tax (-)
Length of time (+)
Operating margin (+)
Working capital investment (-)
Cost of capital (-)
Asset investment (-)
Tax (-)
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4 Real Options
Follow on
Abandon
Timing
Growth
Abandon
Timing
Growth
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Sensitivity to cash flows
NPV of project / NPV of CF after tax
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Sensitivity to discount rate
Difference between the cost of capital and the IRR
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Sensitivity to project live
Discounted payback
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Limitations of sensitivity analysis
Assumes variables change independently
Does not assess likelihood
Does not identify a correct decision
Does not assess likelihood
Does not identify a correct decision
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Definition of CAPM
A way of estimating the rate of return that a fully diversified equity shareholder would require from a particular investment by comparing the level of systematic risk compared to average
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Problems with CAPM
Estimating Rm using historic data
Estimating Rf using gilts which arent risk free
Betas are calculated using statistical analysis which is too simplistic
Assumes fully diversified shareholders
Estimating Rf using gilts which arent risk free
Betas are calculated using statistical analysis which is too simplistic
Assumes fully diversified shareholders
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TERP
(MV of old shares + Proceeds + Project NPV)/
(Number of shares in issue afterwards)
(Number of shares in issue afterwards)
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Theoretical value of a right
TERP - exercise price
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Methods of Green Finance
- Green loans
- sustainability linked loans
- green bonds
- green funds
- sustainability linked loans
- green bonds
- green funds
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Efficient Market Hypothesis
Share prices incorporate all information about a company if strong. If semi-strong, then shares are fairly priced, managers improve wealth by investing in positive NPV projects, and investors need insider information to beat the market
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Behavioural Finance
Overconfidence and miscalculation of probability
Conservatism and cognitive dissonance
Availability bias and narrow framing
Representativeness and extrapolative expectation
Conservatism and cognitive dissonance
Availability bias and narrow framing
Representativeness and extrapolative expectation
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WACC definition
The rate of return a company needs to achieve on projects to satisfy investors
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Historic Dividend Growth model g =
((D0/Dn)^(1/n))-1
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Cost of preference shares
d/mv (ex-div)
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Gordon growth model g =
r*b
ARR*retention rate
ARR*retention rate
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r =
PAT/Opening Capital Employed
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b =
(EPS-D0)/EPS
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Cost of Irredeemable debentures
(1-T)*(I/P0)
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How to treat convertible debentures
compare redemption value with conversion option (i.e. par or share price)
select higher of the two values as achieved at tn
find the IRR
select higher of the two values as achieved at tn
find the IRR
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3 WACC assumptions
1- gearing isnt going to change
2- level of risk isn't going to change
3- finance is not project specific
2- level of risk isn't going to change
3- finance is not project specific
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4 DVM assumptions
1- perfect market is operating
2- dividends paid once a year
3- past is a good guide for future
4- rate of return and retention rate remain constant (if using GG)
2- dividends paid once a year
3- past is a good guide for future
4- rate of return and retention rate remain constant (if using GG)
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2 Impacts on WACC as gearing increases
1- Decreases from debt being cheaper and tax deductible interest payments
2- Increases from return to shareholders becoming more varied
2- Increases from return to shareholders becoming more varied
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Traditional theory of gearing
There is a optimal level of gearing whereby cheap debt has pushed WACC down but no threat of bankruptcy or volatility
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No Tax Gearing Theory of M&M
The WACC is unaffected by changes in gearing as the costs are exactly offset and shareholders are rational
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With Tax Gearing Theory of M&M
Gearing up reduces the WACC and optimal structure is 99.9% gearing
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Practical problems with high levels of gearing
Bankruptcy risk
Tax Exhaustion
Agency costs
Assets used for security
Loan covenants
interest cover
Tax Exhaustion
Agency costs
Assets used for security
Loan covenants
interest cover
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Stages to find the Ke for a new project
1. degear a beta from a geared company (find Ba)
2. adjust the Ba with the company gearing levels (find Be)
3. Calculate Ke using CAPM
2. adjust the Ba with the company gearing levels (find Be)
3. Calculate Ke using CAPM
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APV method
Find the Ke with no gearing and use to find NPV of CFs
Add the PV of tax shield discounted using pre-tax Kd
APV = base cost + PV of tax shield (theoretical debt capacity)
Add the PV of tax shield discounted using pre-tax Kd
APV = base cost + PV of tax shield (theoretical debt capacity)
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Traditional Dividend Policy Theory
A consistent dividend stream is better
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M&M Dividend Policy Theory
Consistency of dividends are irrelevant as shareholders will want higher long term profitability and will sell shares if they need income.
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Real world dividend policy impact
Signalling: reductions signal bad news
Clientele effect: tax difference and transaction costs mean shareholders wont sell shares
Pecking order: firms prefer retained profits, rights issues, and then a new issue
Clientele effect: tax difference and transaction costs mean shareholders wont sell shares
Pecking order: firms prefer retained profits, rights issues, and then a new issue
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Asset based approaches to valuation
Net realisable value
Replacement cost
Replacement cost
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problems with asset based approaches to valuation
doesn't include intangibles or future cash flows
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Income based approaches to valuation
Dividends, Earnings, Cash flows
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Dividend based approaches to valuation
Present value of future expected dividends
Dividend Yield
Dividend Yield
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Present value of future expected dividends
PV = d1*(1/(Ke-g))
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Dividend Yield
Price = Dividend/Yield
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Problems with Dividend based approaches to valuation
Estimating future dividends
Finding similar companies
Need to adjust for non-listed marketability
Finding similar companies
Need to adjust for non-listed marketability
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Earnings based approaches to valuation
PE Ratio
EBITDA Multiple
EBITDA Multiple
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Problems with earnings based approaches to valuation
erratic earnings
accounting policies can manipulate multiples
private companies need to be discounted
accounting policies can manipulate multiples
private companies need to be discounted
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Equity value from PE Ratio
Earnings (PAT but before o. dividends) * PE Ratio
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Equity value from EBITDA multiple
Enterprise value = MV Equity + preference shares + Minority interest + debt - cash and cash equivalents
EBITDA multiple = EV/EBITDA
EBITDA multiple = EV/EBITDA
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Cash Flow based approaches to valuation
Cash flows, SVA
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CF valuations
PV of discounted cash flows - MV of debt
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SVA valuation
Use estimates of the 7 drivers
Make an assumption about terminal value
Deduct debt
Make an assumption about terminal value
Deduct debt
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Pros and Cons of acquisition with cash
Pr: buyers get full control, unconditional and certain amount
Co: Will need to find cash, seller could leave, capital gains tax
Co: Will need to find cash, seller could leave, capital gains tax
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Pros and Cons of acquisition with shares
Pr: no cash, seller can stay, deferred CGT
Co: control is diluted
Co: control is diluted
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Define a Forward
Tailor made, binding obligation to sell/buy at a fixed rate
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Define a Negotiated Option (OTC)
Tailor made right to buy/sell something at a point in the future at a price fixed today
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Define a Future (IRF)
Standardised, traded contract bought/sold now then sold/bought later at a gain or loss
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Define a Traded Option
standardised right to buy (call) or sell (put) something at a point in the future at a price fixed today
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Who buys and who sells a IRF?
Borrowers sell futures contracts
Depositors buy futures contracts
Depositors buy futures contracts
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Who buys puts and who buys calls an IR option?
Borrowers buy put options
Depositors buy call options
Depositors buy call options
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Number of IR contracts
Amount borrowed / size
*
period of borrowing/3 months
*
period of borrowing/3 months
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IR Option premium
Given % * 500k * (3/12) * Contracts
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How to hedge portfolio risk
Sell futures contracts
or
buy put options
or
buy put options
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Number of Index Contracts
Value of portfolio /
(F/S price * £10)
(F/S price * £10)
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Premium/Profit/Loss on Index contracts
(Premium/Change in points)
*
£10
*
number of contracts
*
£10
*
number of contracts
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Call option
Option to buy shares later
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Put option
option to sell shares later
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In the Money
Exercising today would give a profit
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Intrinsic Value
Difference between exercise price and market value (0 if no profit)
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Time Value
Premium - Intrinsic Value
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3 Components of Time Value
Time to Expiry
Volatility
Interest rate
Volatility
Interest rate
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FX Forwards premiums and discounts
Add a Discount
Deduct a Premium
Deduct a Premium
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How to MMH a $ receipt
1. Borrow $ at US rate
2. Sell £ for $ at spot rate
3. Deposit the £ at UK rate
4. Use receipt to pay back borrowing
2. Sell £ for $ at spot rate
3. Deposit the £ at UK rate
4. Use receipt to pay back borrowing
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How to MMH a $ payment
1. Borrow £ at UK rate
2. Sell £ for $ at spot rate
3. Deposit at US rate
4. Use $ to pay
2. Sell £ for $ at spot rate
3. Deposit at US rate
4. Use $ to pay
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Who buys and who sells a £ Future on a $ payment/receipt?
Sell £ futures for a payment
Buy £ futures for a receipt
Buy £ futures for a receipt
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Who buys put and who buys call £ options on a $ payment/receipt?
Buy £ Put options for a payment
Buy £ Call options for a receipt
Buy £ Call options for a receipt
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Who buys put and who buys call $ options on a $ payment/receipt?
Buy $ Call options for a payment
Buy $ Put options for a receipt
Buy $ Put options for a receipt
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Number of Fx contracts
Transaction in £ / Contract in £
(converted at futures price or strike price)
(converted at futures price or strike price)
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Profit or Loss on fx future
gain/loss * contract size * number of contracts
convert at future rate
convert at future rate
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Premium on fx option
prem* contract size * number of contracts
convert at future rate
convert at future rate
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How to hedge with BTC futures
Buy BTC futures for a BTC payment
Sell BTF futures for a BTC receipt
Sell BTF futures for a BTC receipt
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Forward rate equation
spot rate *
(1.OS interest/inflation rate)/
(1.UK interest/inflation rate)
(1.OS interest/inflation rate)/
(1.UK interest/inflation rate)
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Risks when trading overseas
Currency: Economic, Transaction, Translation
Other: physical, trade, liquidity, credit
Other: physical, trade, liquidity, credit
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Profit/Loss on a futures hedge
Price now - price later = profit/ loss
combine with underlying transaction
combine with underlying transaction
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profit/loss on options hedge
Price now - price later = profit/ loss
compare with underlying transaction
add premium
compare with underlying transaction
add premium
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OTC versus Standardised Products
- expense
- over/under hedging
-trading on open market
-availability
- over/under hedging
-trading on open market
-availability
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Options versus obligations
-upside potential
- elimination of risk
- transaction falling through
- expense
- elimination of risk
- transaction falling through
- expense
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Other cards in this set
Card 2
Front
Cash flows to ignore in NPV
Back
Sunk costs
Committed costs
allocated and apportioned costs
non-cash items
book values
finance costs
Committed costs
allocated and apportioned costs
non-cash items
book values
finance costs
Card 3
Front
Money rate of inflation
Back
Card 4
Front
Rate of inflation used to discount cash flows
Back
Card 5
Front
Equivalent Annual Cost =
Back
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