ACA Financial Management

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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
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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
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Money rate of inflation
(1+ money rate) =

(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)
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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
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Shareholder Value Analysis drivers
Sales growth (+)
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
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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
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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
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TERP
(MV of old shares + Proceeds + Project NPV)/

(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
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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
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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
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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
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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
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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)
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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
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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
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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
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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)
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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
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Asset based approaches to valuation
Net realisable value

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
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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
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Earnings based approaches to valuation
PE Ratio

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
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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
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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
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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
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Pros and Cons of acquisition with shares
Pr: no cash, seller can stay, deferred CGT

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
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Who buys puts and who buys calls an IR option?
Borrowers buy put options

Depositors buy call options
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Number of IR contracts
Amount borrowed / size

*

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
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Number of Index Contracts
Value of portfolio /

(F/S price * £10)
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Premium/Profit/Loss on Index contracts
(Premium/Change in points)
*
£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
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FX Forwards premiums and discounts
Add a Discount

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
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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
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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
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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
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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
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Number of Fx contracts
Transaction in £ / Contract in £

(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
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Premium on fx option
prem* contract size * number of contracts

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
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Forward rate equation
spot 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
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Profit/Loss on a futures hedge
Price now - price later = profit/ loss

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
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OTC versus Standardised Products
- expense
- over/under hedging
-trading on open market
-availability
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Options versus obligations
-upside potential
- 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

Card 3

Front

Money rate of inflation

Back

Preview of the front of card 3

Card 4

Front

Rate of inflation used to discount cash flows

Back

Preview of the front of card 4

Card 5

Front

Equivalent Annual Cost =

Back

Preview of the front of card 5
View more cards

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