AFM - Short notes PDF

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AFM - Short notes...

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ACCA – AFM

ADVANCED FINANCIAL MANAGEMENT

STUDY NOTES

Contents Sr. #

TOPIC

Page #

1.

Investment Appraisal

01

2.

Net Present Value (NPV)

07

3.

Investment Appraisal in Capital Rationing Situation

14

4.

Weighted Average Cost of Capital (WACC)

24

5.

CAPM

35

6.

Mergers and Acquisitions

59

7.

Business Valuation

70

8.

Gain and Losses on Acquisition

80

9.

Corporate Restructuring

87

10.

Foreign Currency risk Management

11.

Option Contract

107

12.

Option on Interest Rate Future

114

13.

Limitations and Assumptions

139

14.

Reverse Takeovers – an Explanation

159

15.

Reverse Takeovers – the Potential Drawbacks

162

16.

Islamic Finance

164

17.

Expected Values, Decision Trees and Combined probabilities

179

93

Study Notes

Advanced Financial Management - AFM

INVESTMENT APPRAISAL Decision Making

Short term

Long term

Capital expenditure: Capital expenditure is expenditure which results in the acquisition of non-current assets or an improvement in their earning capacity. It is not charged as an expense in the income statement; the expenditure appears as a noncurrent asset in the Statement of financial position. Revenue expenditure: Charged to the income statement and is expenditure which is incurred. (i) For the purpose of the trade of the business this includes expenditure classified as selling and distribution, administration expenses and finance charges. (ii) To maintain the existing earning capacity of non-current asset. Investment Appraisal:A detailed evaluation of projects or investments viability and its effects on shareholders wealth is called investment appraisal. Relevant Cash flows in Investment Appraisal Relevant cash flows are those cash flows which are: • Directly related with the project. • •

Incremental Future cash flows

Any cash flows or cost incurred in the past, or any committed cost which will be incurred regardless of whether the investment is undertaken or not is a non-relevant cash flows e.g. sunk cost, Allocated/General fixed overheads etc. The other cash flows, which should be considered as Relevant Cash flows, are as follow: • Opportunity Cost: • Tax: • Residual value: • Infra-structure Costs: • Marketing Costs: • Human resource costs: Assumptions of Timing of Cash flows  If Cash flows arise during the period, then it is assumed as it arises at the end of that period.  If cash flow arises at the start of the period then it is assumed as if it arises at the end of the preceding period  Period ‘0’ is not a period, instead it represents start of period ‘1’.

pg. 1 of 186

Study Notes

Advanced Financial Management - AFM

Time Value of Money Sum of money received today has more worth than same sum of money received in future because of these reasons. • Inflation • Opportunity to reinvest •

Risk and uncertainty

Simple interest 1. 1000 x 10% = $100 2. 1000 x 10% = $100 3. 1000 x 10% = $100 Cash flows are not reinvested each year Compound interest 1. 1000 x 10% = 100 + 1000 = 1100 2. 1100 x 10% = 110 + 1100 = 1210 3. 1210 x 10% = 121 + 1210 = 1331 Cash flows are reinvested each year resulting in higher principal that increases the interest amount. We can also calculate the future amounts using this formula FV = PV (1+r)n FV= future value= 1331 PV= Present Value= 1000 1331 = 1000 x (1+10%) 3 Discounting Where r = cost of capital = WACC = required rate of return PV = FV (1+r)-n

Assumption: All cash flows are reinvested in the same project or any other at a given rate of return (cost of capital). Year 1 2 3

Cash flows 1000 2000 3000

pg. 2 of 186

Df@12% 0.893 0.797 0.712

PV 892.9 1594.39 2135

Study Notes

Advanced Financial Management - AFM

Consistent Cash flows If Cash flows arises in a series of equal cash flows then it is called Consistent Cash flows. These are of two Types: Annuity: If Consistent cash flow for a certain Period. e.g Y1-5 or Y3-7 Perpetuity: If Consistent cash flow for infinite period e.g. Y1-∞ or Y3-∞

Present Values of Consistent Cash flows The Annuity Factor =

𝟏−(1 + r)-n 𝒓

The Perpetuity Factor =

𝟏

𝒓

Annuity If Cash flows Start from Period 1.

Perpetuity

Annual Cash flow X Annuity Factor e.g. Y1-5 $10,000 at Disc. Rate of 10% $10,000 X 3.791(from annuity table) =$37,910 If Cash flows Start from Period 0.

Annual Cash flow X Perpetuity Factor e.g. Y1-∞ $10,000 at Disc. Rate of 10% $10,000 X (1/10%) = $100,000

Annual Cash flow X (Annuity Factor + 1) e.g. Y0-5 $10,000 at Disc. Rate of 10% $10,000 X (3.791+1) =$47,910

Annual Cash flow X (Perpetuity Factor + 1) e.g. Y0-∞ $10,000 at Disc. Rate of 10% $10,000 X ((1/10%)+1) = $110,000

If Cash flows Start from Subsequent Period e.g. Year 3. Annual Cash flow X Annuity Factor of No. of periods Annual Cash flow X Perpetuity Factor X Discount factor of X Discount factor of preceding period from Start preceding period from Start e.g. Y4-8 $10,000 at Disc. Rate of 10% $10,000 X 3.791 X 0.751 =$28,470 e.g. Y4-∞ $10,000 at Disc. Rate of 10% $10,000 X (1/10%) X 0.751 = $75,100 Perpetuities with growth: • Cash flow with constant growth. • Unlimited time period. • Growth starts from year 1 1. Single growth model: PV = Cash flow (1+ g) COC – g 2.

Multi growth model: 1 2 Cash flow CF1 CF2 D.F @ 10%

pg. 3 of 186

0.909

0.826

3 CF3 0.751

4 CF4 0.683

5-∞ CF4 x (1+g) COC -g x 0.683

Study Notes

Advanced Financial Management - AFM

Example: Cash flow in Year 1 is 1000 it will increase with a growth of 5% for next 4 years then at a constant growth of 2% for foreseeable future COC 10% .Calculate PV? 1 2 3 4 5 5-∞ Cash flow 1000 1080 1166 1260 1360 1360 x (1+0.02) 0.10 -0.02 D.F @ 10% 0.909 0.826 0.751 0.683 0.621 x 0.621 PV 909 892 875.67 860.58 844.56 10768.14 PV = 15154 Annuity with growth: You will receive $100 Cash flows for 5 years and cash flows will grow at a rate of 5% starting from year 1 and discount factor of 10%. Calculate PV. Years Cash flows@ 5 % growth Df@10% PV

1 105 0.909 95.45

2 110.25 0.826 90.86

3 115.76 0.751 86.94

4 121.55 0.683 83.02

5 127.63 0.621 79.26

435.53

1 +𝑔

OR PV PV =100 x [

1− ( −𝑟 )^𝑛 1 ] [ 𝑟 −𝑔 1 +0. 05 1− ( −0 )^5 1

.1

0 .1−0.05

=constant CF x (1+0.05)

(1+g)

= 435

]

Investment Appraisal Techniques  Payback Period  Net Present Value NPV  Internal Rate of Return (IRR)  Discounted Payback Period  Modified Internal Rate of Return (MIRR)  Duration  Adjusted Present Value (APV) Payback period method: Definition:The time period, in which initial investment is recovered, known as payback period. The number of years for the cash out lay to be matched by cash inflows.

pg. 4 of 186

Study Notes

Advanced Financial Management - AFM

Formula:For constant (Even) cash flows: Payback period = Initial investment Annual inflows For Uneven cash flows: Draw a cumulative cash flow column, then calculate project payback period. Answer should be compared with the target payback period of the business.

Decision rule:- Feasibility Decision: If payback period is less than target payback period then ACCEPT the project. If payback period is more than target payback period then REJECT the project. Comparison Decision: Project with minimum payback period should be preferred. Advantages of payback period:• It is simple to calculate and easy to understand. • Payback period method can also be used as a basic screening device at the first stage for short list projects. • It considers cash flows rather than accounting profits, that’s why chances of manipulation are very low. • Payback period method indirectly avoids risk as it gives favor to those investments which have short payback periods. This method helps the company to grow, minimize risk and maximize liquidity. • In the situation of capital rationing, it can be used to identify the projects which generate additional cash for investment quickly. Disadvantages of payback period:• It does not consider the time value of money. • It does not consider the whole life of project cash flows. It might be possible that it will favor the projects, giving high cash inflows in the starting years only and giving very low cash inflows in the remaining years. • There is no specific criteria or rule which can justify that company’s target payback period is measured accurately that why it is difficult to measure target payback period. • It may lead to excessive investment in short term projects. • It does not consider the risk and uncertainty in the projects. Uncertainty of cash inflows can deteriorate the results. • It does not focus on shareholders wealth maximization.

Discounted Payback period Definition:  The time period in which initial investment is recovered in terms of present value is known as discounted payback period  It is same as simple payback period. The only difference is that the discounted cash flows are used instead of simple cash flows for calculation.

pg. 5 of 186

Study Notes

Advanced Financial Management - AFM

Decision Rule  Feasibility Decision: If payback period is less than target payback period then ACCEPT the project. If payback period is more than target payback period then REJECT the project. Comparison Decision : Project with minimum payback period should be preferred. Years Cash flows D.F @ 10% Present Values 0 (500000) 1.000 (500000) 1 300,000 0.909 272,700 2 200,000 0.826 165,200 3 200,000 0.751 150,200 4 600,000 0.683 409,800 

Discounted Payback 

Cumulative Values (500000) (227300) (62100)

= 2 years + (62.100/ 150,200 x 12)

= 2 years and 5 months It takes into account the time value of money and timings of cash flows.

pg. 6 of 186

Study Notes

Advanced Financial Management - AFM

NET PRESENT VALUE (NPV) Formula to calculate NPV:NPV=PV of cash inflows - PV of cash outflows. Decision Rule:If NPV of the project is positive, accept the project If NPV of the project is negative, reject the project. Advantages of Net Present Value: Net Present Value method takes into account the time value of money and this is giving a better picture of the projects viability. • It considers the whole life of the project because all cash flows relating to the project life is incorporated in its calculations. • It gives an indication about the increase or decrease in the wealth of shareholders. Its decisions rule is consistent with the objective of maximization of shareholders wealth. • It focuses on cash flows rather than accounting profit, so it takes into account the relevancy and irrelevancy of cash flows. • It can also be used for projects with non-conventional cash flows. • It gives a better ranking of mutually exclusive projects. • It assumes that cash flows are reinvested at the company’s cost of capital. • NPV is technically more superior method to IRR because of its less rigid assumptions. Disadvantages’ of Net Present Value: • It involves complex calculations as compared to other techniques. • Managers feel it difficult to explain the calculations of Net Present Value method. • It does not take into account the risk and uncertainty of estimates and scarcity of resources. • Cost of capital used in NPV calculation is difficult to calculate and gets subjective when we incorporate risk and uncertainty within companies cost of capital.

pg. 7 of 186

Study Notes

Years

Advanced Financial Management - AFM

0

1

2

3

4

Sales

X

X

X

X

Variable Cost

(X)

(X)

(X)

(X)

Incremental Fixed Cost

(X)

(X)

(X)

(X)

Operating Cash flows

X

X

X

X

Tax Expense

(X)

(X)

(X)

(X)

Tax Savings on Capital Allowances

X

X

X

X

(X)

(X)

(X)

X

Change in Working Capital

(X)

Initial Investment

(X)

Scrap Value

X

Net Cash flows

(X)

X

X

X

X

Discount Factor

X

X

X

X

X

Present Values

(X)

X

X

X

X

Net Present Value

X

Capital Allowances • Straight line basis • Reducing balance basis Straight Line Basis 

Formula 1 Capital Allowance = Investment Cost – Scrap Value Useful Life



Formula 2 (Investment Cost – Scrap Value) x %age of allowance



Tax Savings on Capital Allowances Capital Allowance x Tax rate

Reducing Balance basis Example Initial Investment = 2000 Capital Allowances = 25% reducing balance Useful life = 4 years, Tax rate = 30% (payable in same year), Scrap Value = 500

pg. 8 of 186

Study Notes

Years

Advanced Financial Management - AFM

Written Down Value

Capital Allowances @ 25%

Tax Savings @ 30%

Timing

1

2000

500

150

1

2

1500

375

113

2

3

1125

281

84

3

4

844-500

344

103

4

In the last year: • If the written down value > the scrap value we calculate balancing allowance. • If the written down value < the scrap value we calculate balancing charge. • If the scrap value is after tax, we calculate capital allowance rather than balancing allowance or balancing charge. INFLATION Real rate of return/cost of capital Real rate of interest reflects the rate of return that would be required in the absence of inflation. Money rate of return/cost of capital Money or nominal rate of return is rate that will be required in presence of inflation. Relationship between real and nominal rates of interest (Fisher formula) (1 + m) = (1 + r) (1 + i) Where i= rate of inflation/RPI rate of interest)

r = real rate of interest

m = nominal (money

Money cash flows are those cash flows in which the effect of specific inflation has been adjusted. Real cash flows are those cash flows which have not been adjusted for inflation.

pg. 9 of 186

Study Notes

Advanced Financial Management - AFM

Methods to be used in Investment Appraisal

If General inflation rate is given

If Specific inflation rates are given

If General inflation rate is

If Specific inflation rate is

Money

Real Method

Money

Inflate all Cash flows with general inflation rate. Discount these cash flows with

Do not inflate Cash flows. Discount all Cash flows with real discount

Inflate each variable cash flow with its specific inflation rate. Discount with money cost of capital (calculated through real rate and general inflation rate.

preferred Method

Nominal Cashflow = Real cashflows ( 1+ i)n Sometimes Examiners gives the value in year 1 terms instead of current prices terms then Nominal Cashflow = Real cashflows ( 1+ i)n-1 Working capital change

pg. 10 of 186

Study Notes

Advanced Financial Management - AFM

Step 1

Calculate working capital requirement one year in advance e.g. working capital is 10% of sales at the start of each year Step 2

Calculate incremental working capital by taking change of each year working capital and in last year of project (not in ongoing business) there will be an assumption that all working capital will be recovered.

Sensitivity Analysis   

It assess how responsive is the project’s Net Present Value to the changes in a given variable. It considers each variable in isolation. Formula to calculate sensitivity of a particular variable:Sensitivity =

• • •

Net present value % After-tax Present value of particular variable It indicates which variables may impact most upon the net present value (critical variables) and the extent to which those variables may change before the investment results in a negative NPV. It assesses how responsive is the project’s Net Present Value to the changes in a given variable. It indicates which variables may impact most upon the net present value (critical variables) and the extent to which those variables may change before the investment results in a negative NPV. Sensitivity analysis

Selling price sensitivity

Variable cost sensitivity

Fixed cost sensitivity

Contribution/Sales volume sensitivity

pg. 11 of 186

Study Notes

Advanced Financial Management - AFM

Scarp value sensitivity

Initial investment sensitivity (without tax) Initial investment sensitivity (with tax)

Cost of capital sensitivity: • Calculate IRR of the project and compare it with the cost of capital. • If cost of capital increases to IRR, NPV will be zero. Project life sensitivity: • Calculate discounted payback period and compare it with the total project life. • If total life reduces to the level of discounted payback period, NPV will be zero. Advantages • This is not a complicated theory to understand. • Information will be presented to management in a form, which facilitates subjective judgment to decide the likelihood of the various possible outcomes considered. • Indicates just how critical are some of the forecast which are considered to be uncertain, those areas then can be carefully monitored. Disadvantages • It assumes that changes to variables can be made independently or in isolation. However it’s unrealistic as they are often interdependent. • It only identifies how far a variable needs to change; it does not look at the probability of such a change. • It is not an optimizing technique. It provides information on the basis of which decision can be made. • Critical factors may be those over which managers have no control. Simulation Sensitivity analysis considered the effect of changing one variable at a time. Monte Carlo simulation improves on this by looking at the impact of many variables changing at the same time. Using mathematical modeling it produce a distribution of the possible outcomes from the project. Steps in Sim...