FM

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  • Created by: ziggy007
  • Created on: 03-12-21 20:23
Sensitivity Formula
Variable = NPV/PV Variable
CoC = (IRR-CoC)/CoC
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Profitability Index
NPV/Initial Investment
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EAC
NPV/Annuity factor for project life
Choose lowest EAC
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ARR
Average annual profit/average investment
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Payback Period Advantages
Simple
Screening tool
Liquidity
Focus on near term cashflows
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Payback Period Disadvantages
Ignores time value
Only considers CFs to payback date
Encourages short termism
No clear decision rule
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ARR/ROCE Advantages
Simple
Entire project life
Reflects investor views
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ARR/ROCE Disadvantages
Ignores time value
Based on profits, not CFs
Doesn't consider length of project
No clear decision rule
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NPV Advantages
Considers time value
Shows shareholder wealth creation
Allows for risk
Clear decision
Entire project
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NPV Disadvantages
Requires CoC to be estimated into future
Time consuming and can be misunderstood
No liquidity consideration
Assumes can reinvest at CoC
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IRR Advantages
Considers time value
Does not require exact cost of funds
Easy to interpret
Looks at entire project
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IRR Disadvantages
Ignores size of investment required and total CFs
Can give conflicting answer to NPV when evaluating mutually exclusive projects of different length/size
Assumes can reinvest at IRR
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Non-Financial Factors
Compliance
Staff morale
Suppliers and customers
Reputation
Sustainability
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Inflation Formula
(1+nominal)=(1+real)*(1 +inflation)
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Adjusting for risk and uncertainty
Expected values (risk)
Sensitivity analysis (uncertainty)
Simulation (risk)
Adjusted discount rate (risk/uncertainty) - use higher to be more conservative
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SVA
Working cap investment
Cash flow life
Sales growth rate
NCA investment
Operating margin
Tax rate
CoC

Competitive advantage period + Residual Period (perpetuity)
Discount at WACC for MV debt + MV equity
Deduct MV debt for value of equity
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Real Options
Follow-on = future products
Abandonment = exit early
Timing = delay to wait for favourable conditions
Growth = dip toe in the water and grow
Flexibility = change suppliers/materials if cheaper options
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Investing Overseas - Political Risks
Quotas
Tariffs
Non trade barriers
Restrictions
Nationalisation
Min shareholding
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Mitigating Political Risks
Negotiations
Insurance
Production strategies
Management Structure
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Debt v Pref shares v Ordinary shares
Security on liquidation
Returns
Capital return
Tax impact
Control
Risk/Reward
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Sources of equity finance
Rights issue - TERP
Public Offer - offer for sale (issue house - expensive) v offer for subscription (public)
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Issue costs pecking order
1 - RE
2 - Rights issue
3 - New issue
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Sources of Debt
Irredeemable
Redeemable
Convertible
Loan stock with warrants
International money markets (eurocurrency from banks, international bonds by companies)
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Loan Documentation
Reps and warranties - legality and financial condition
Guarantees - from guarantor
Covenants - Providing info, negative pledges, financial covenants, restrictions
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Dividend policy - Residual theory
Divs only paid out after all + NPV projects financed. Remaining cash paid as div. This maximises shareholder wealth

Clientele effect = invest for div policy - may divest if no div

Uncertainty = cash more certain that future divs
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Irrelevancy theory (M&M)
Companies always invest in + NPV
If can't fund by RE will raise
If so SHs get smaller share but compensated for larger dividend after
If div too low, can sell shares for higher capital value

Signalling = div reductions bad
Agency = want cash now as worri
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Alternatives to cash dividend
Scrip dividends (free shares)
Share repurchase
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Cost of equity
CAPM
DVM
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Growth rate
Annualised
OR
Gordon growth model = g = rb
r = PAT/opening SH funds
b = % retained
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CAPM: Pros and Cons
Pros:
Directly links risks and returns
Can be used when share price unknown
Cons:
Assumes SHs diversified
Assumes all inputs constant
Assumes can borrow and deposit at r
Assumes all systematic risks can be grouped into one measure, Beta
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DVM: Pros and Cons
Pros:
Calculates Ke based on market data (share price)

Cons:
Constant div growth assumed and unrealistic
Identifying ex div share price difficult
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Cost of debt: Pref Shares
Do/Po
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Cost of debt: Irredeemable
Interest(1-T)/Po
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Cost of debt: Bank Debt
Interest rate*(1-T)
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Cost of debt: Redeemable
PV of cash flows to find IRR
*(1-T) for cost of redeemable debt
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Cost of debt: Convertible
PV of cash flows
Final value higher of redemption value and future MV of shares
*(1-T) for cost of convertible debt
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WACC
(MVs*Ks)/MVs
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Using current WACC?
If project has same business risk as existing
If no change to long term cap structure
Relatively small project (small impact of NPV on MV equity)
Not using project specific finance
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Why debt is cheaper
Secured
More certain returns
Possibly redeemable
First to be paid if liquidated
Tax shield
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Capital Structure: Traditional
Debt is good to start and WACC falls
As keeps risking cost of equity rises faster and cost of debt also starts to rise

Thus there exists an optimal point where WACC = minimum
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Capital Structure - M&M 1958 - No Tax
If assumption of no tax, then total payments same for equivalent companies with or without debt

Thus, comparable companies also have same MV and hence same WACC

No optimal cap structure

WACC same at all levels of gearing
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Capital Structure - M&M 1963 - With Tax
Tax benefit of paying interest = total payments to investors higher for equivalent company with debt

Therefore higher debt = higher MV and thus lower WACC

Gear up as much as possible to minimise WACC
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Capital Structure - Practical Considerations
Bankruptcy risk and costs
Tax exhaustion
Agency Costs
Availability of finance
Issue costs
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Types of Risk and impact on WACC
Business Risk - specific and systematic - variability in PBIT
Specific Risk - company specific. May be diversified away

Systematic Risk - Macro factors such as FX and interest rates. Impacted by business sector and operational gearing. Measured by Beta.
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Financial Risk
Additional exposure to systematic risk (variability in PAT) due to financial gearing and associated interest payments
Interest represents additional fixed payment even in profits low, making it easier to make losses if sales volume drops

Causes geared be
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WACC - Business risk change
De-gear proxy beta

Re-gear our beta

CAPM for Ke

Use for new WACC calc
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CAPM Alternatives
APT (numerous systematic factors, not just beta fits all)
Fama and French (Size, Value and Momentum)

Bond-Yield-Plus (on top of yield from bonds in company)

Fundamental Beta (adjusted for nature of operations, operational gearing, financial gearing)
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Market Efficiency
Weak
Semi-Strong
Strong
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Behavioural Finance
Overconfidence
Representativeness (overreaction)
Narrow framing (rely on one piece of info)
Miscalculation of probs
Positive feedback (will continue to rise)
Conservatism (under-react to good, overreact to bad)
Availability bias (using only latest info)
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Method of Payment
Cash

Shares

Loan stock
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Organic Growth
Pros:
Costs spread
Less disruption

Cons:
More risky
May be too slow
Barriers to entry
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Acquisition
Pros:
Synergies
Reduction of specific risk
Integration - H and V

Cons:
Overpayment
Poor fit
Agency problem
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Methods of Divestment
MBO
MBI
Spin off (demerger)
Trade sale
Liquidation
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Reasons to divest
Avoid conglomerate discount
Bad fit with other ops
Business too time intensive
Poor results
Need for liquidity
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Agency Problems
Takeovers
Time Horizon
Risk
Debt

Mitigate:
Reward schemes, corp governance, audits
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Writing a business plan
Exec summary
History/Background
Mission statement
prods and services
Markets
Resources and ops
Financials, risk and return
Action plan
Appendices
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Hedging Share Prices
Stock Index Futures
Sell futures now and buy in x months
Fall in portfolio hedged by gain on futures
Traded via exchange
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Stock Index Futures Pros and Cons
Pros:
Protects downside risk
Can close out anytime

Cons:
Standardised contracts
Basis risk (spot vs futures)
Removes upside
Must post margin
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Share Options
Pay a premium
Option to buy (call) or sell (put) set number of shares
American = anytime exercise
European = only exercise on expiry

Premium quoted in pence per share
Can be either bespoke or traded (standardised)
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Share Options Pros and Cons
Pros:
Protects from downside risk and can benefit from upside

Cons:
Expensive
If standardised may be under/over hedged
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Stock Index Options
Same for share options, but based on level of index
Contractual notional = strike level * £10

Premiums are points per contract
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Stock Index Options Pros and Cons
Pros:
Protects from downside risk and can benefit from upside

Cons:
Expensive
If standardised may be under/over hedged
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Option Terminology
For calls and puts

In the money
At the money
Out the money
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Option Valuation
Value of option = premium payable

Intrinsic value = value of exercising now
Time premium = difference between total value and intrinsic value
Impacted by:
Time to expiry
Volatility of underlying
General level of interest rates
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Interest Rates
FRAs
Interest Rate Futures
Traded Options
Interest Rate Swaps
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FRAs
OTC contract which fixes effective interest

Borrowers buy FRAs
Lenders sell FRAs

3-6 = start in 3 months lasting 3 months

Bank pays/receives difference of Forward to spot on settlement
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FRAs Pros and Cons
Pros:
Hedges downside risk
Tailored to investor (no over/under hedging)

Cons:
Usually only available on loans >£500k
Usually only for < 1 year
Removes upside
Difficult to exit e.g if date/size of borrowing changes
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Interest Rate Futures
Similar to FRAs, but standardises

Borrowers (pay interest) sell futures now and buy in x months to hedge against rates rising

Lenders (receive interest) buy futures now and sell in x months to hedge against rates falling
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Interest Rate Futures Pros and Cons
Pros:
Hedges downside risk
Cal close out anytime and thus more flexible than FRAs
Cons:
Standardised = over/under hedge
Basis risk (spot v futures price)
Removes upside
Must post margin
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Traded Interest Rate Options
Borrowers use puts = option to sell (hedges rates rising)
Lenders use calls = option to buy (hedges rates falling)

Premiums quoted in annual % - Pro-Rate!!
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Traded Interest Rate Options Pros and Cons
Pros:
Protects v downside and allows benefit of upside

Cons:
Expensive
May be under/over hedged if standardised
Basis risk
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Interest Rate Swaps
OTC agreement where counter-parties agree to swap their interest commitments

One pays fixed and receives floating

One pays floating and receives fixed

Difference between differences = calculate total benefit (diffs between fixed and diffs between varia
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Interest Rate Swaps Pros and Cons
Pros:
Can either provide fixed or floating interest
Can be longer term than other methods
Can be used to achieve lower costs for both parties

Cons:
Lose upside potential if paying fixed
If paying floating risk of rates rising
Risk of counter-party defaul
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FX Quotations
We always lose out!

Add discount
Subtract Premium
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Types of FX Risk
Transaction Risk: changes in FX before settlement

Economic Risk: Long term business exposure to foreign country currency

Translation Risk: Danger of business generating accounting losses when translating sub results
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How to hedge economic risk
Move production overseas

Consider economic risk when making decisions e.g. which markets to enter, products to launch

Respond to FX rates by changing prices
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Additional risks of trading overseas
Physical risk: e.g. stolen in transit

Credit risk: chance of customer default and impact on liquidity

Trade risk: e.g. customer cancelling whilst goods in transit
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FX Hedging
Forward Contracts
Currency Futures
Currency Options
Money Market Hedging
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Forward Contracts
Linked to interest rate party

Locks in sale/purchase of currency at set price

Add discount
Deduct premium
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Forward contracts Pros and Cons
Pros:
Locks in price, hedging downside
Tailored to investor

Cons:
Removes upside
Difficult to unwind hedge if not needed
Counter-party risk
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Currency Futures
Similar to forward but standardised contract. Need to calculate number of contracts

Receipt in x months = buy futures now and sell in x months to hedge against FX rising
Payment in x months = sell futures now and buy in x months to hedge FX falling

Gain
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Currency Futures Pros and Cons
Pros:
Hedges downside
Can close out position anytime

Cons:
Standardised contracts under/over hedging
Basis risk
Removes upside
Must post margin
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Currency Options
Pay premium now
Can be standardised or OTC

If hedging $ receipt (will need to buy £), use a call option for option to buy at set FX.

If hedging $ payment (need to sell £), use a put option for option to sell at set FX
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Currency Options Pros and Cons
Pros:
Protects downside risk and allows benefit of upside

Cons:
Expensive premium
If traded may under/over hedge on contracts
If traded, not available in all currencies
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Money Market Hedge - Hedging future payment in $
Create $ asset now = lending $ now
value to lend = lending rate back x months
Convert to £ at spot and borrow £
On payment date, settle GBP loan and interest
Settle $ payment out of USD deposit account
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Money Market Hedge - Hedging future receipt in $
Create $ Liability Now = Borrow $ now
Value to borrow = borrowing rate back x months
Convert to £ at spot
Deposit in UK bank
On receipt date, use receipt to pay back $ loan
withdraw £ from deposit
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MMH Pros and Cons
Pros:
Locks in price, hedging downside
Tailored to investor

Cons:
Loses upside
Difficult to unwind hedge (no secondary market)
Unlikely to be cheaper than forward and greater admin and expertise needed
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Hedge Efficiency
Gain/Loss on hedging instrument /
Gain/loss on hedged item
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IRP
Difference between current spot and current forward rate should equal difference between interest rates in each country
Fo = So * ((1+foreign interest)/(1+local interest))

Investor indifferent between buying $ using forward contract
OR
Borrowing £ to b
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PPP
Difference between current spot and expected future spot should equal difference between inflation rates in each country
S1 = So * ((1+foreign inflation/1+local inflation)

Investor indifferent between buying goods in £
OR
Converting money to $ and buyin
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IRP Assumptions
Spot price represents equilibrium price (supply=demand)
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PPP Problems
Inflation rates are estimates
PPP works better in long run
Can be hampered by government intervention
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Other cards in this set

Card 2

Front

Profitability Index

Back

NPV/Initial Investment

Card 3

Front

EAC

Back

Preview of the front of card 3

Card 4

Front

ARR

Back

Preview of the front of card 4

Card 5

Front

Payback Period Advantages

Back

Preview of the front of card 5
View more cards

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