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The role of the financial manager – lecture 1The financial manager Investment decisions  Financing decisions  Risk management decisionsThe Corporate Objective Shareholders own the residual rights to the company.  The corporate financial objective to maximise shareholder wealth. However, compani...

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The role of the financial manager – lecture 1 The financial manager   

Investment decisions Financing decisions Risk management decisions

The Corporate Objective  

Shareholders own the residual rights to the company. The corporate financial objective to maximise shareholder wealth. However, companies do have other objectives such as stakeholder objectives.

stakeholder

objective

shareholders

Maximise shareholder wealth

employees/managers

Job security/

suppliers Loan creditors customer

Availability or quality of goods and services.

government

Tax payables

 

Stakeholders are not always in agreement - there can be conflict between shareholders and employees/managers. Employees/managers may be given shares in the company, in order to align incentives.

Technology    

Automation: technology completes tasks or changes who is responsibility for them. Brokerage: mediates between buyers and sellers. Management: aids recruitment, management and organisation of workers. Digitalisation: turns physical goods and knowledge into data that can be captured.

Capital investment decisions – lecture 2 Capital investment decisions is "to give up cash now for the prospect of greater cash in the future". The total amount of cash in the project (undiscounted) is equal to the total accounting profit, although the cash flow and the profit flow each period is different.   

Relates to an investment that generally last more than one year. Also called capital budgeting. Reasons for investment: improve capacity or improvement to goods/services, minimise cost of production, sustainability development or even new technology that will improve some aspect of the company.

Automation Investment 



Technology may substitute for human labour; hence the capacity of workers may be reduced. However, it can also generate task, and this means no human capital is replaced but instead more work is generated, i.e. Image recognition. Technology may transfer responsibility to consumers, i.e. self-service tills.

Process for financial managers: 1. Business Case: prepare an outline of the opportunity arising. 2. Conduct early screening of opportunities in light of company strategy, using porter's five forces model. 3. Evaluate these opportunities, link to factors such as regulations, market concentration, global economy, organisation readiness and attitude of workers. 4. Conduct a sensitivity/scenario analysis. 5. Present business case to the Board for funding. 6. Review and Monitor. Methods used to evaluate the investment decisions Net present Value (NPV)    

This is the present value of expected future cash flows. Takes into account risk and time value of money by looking at the expected cash flows discounted at the opportunity cost of capital. Add up the NPV's across projects and +ve figure means to invest. Estimate expected cash flow This includes: o Taxes o All incremental effects o Cash flows that come after sales o Changes in working capital (stocks + debtors - creditor) o Salvage value of any assets



This excludes: o Sunk cost o Allocated overheads o Depreciation - unless for tax purpose o Debt interest Determine the cost of capital.

Estimating the net cash flows:   

Nominal cash flow: REAL CF x (1+ inflation rate). Do not include debt interest. Add back depreciation as it has been deducted from production cost.

Internal rate of return (IRR) Payback method Book rate of return (BRR) Profitability Index International Issues: Exchange Rates 

Exchange rate are generally floating, if we assume risk neutrality (no risk, assuming the rate of return on investment is just the investment plus interest rates) and zero barriers to trade and flow of capital; the exchange rate is caused by a number of factors, such as inflation and political uncertainty.

Spot rate: rates for immediate exchange of currency. Forward rate: rates available today for an exchange of currency at a specific date in the future, it can give an indication of whether a currency is expected to appreciate or depreciate. What causes exchange rates to move? The following relationships, assuming risk neutrality and zero barriers to trade and zero cost are all equal.

Interest Rate Parity The relative difference in interest rates equals the relative difference between forward and spot exchange rates. Interest rate differential = expected change in spot rate. Foreign rate of interest = Home rate of interest. Expectation theory Expected (spot rate) = Forward rate available today. Purchasing Power Parity The expected difference in inflation = expected change in the exchange rate Interest rates and inflation rates The differences in expected interest rates reflect difference in expected inflation rates. Don’t borrow in currencies that appear to charge low interest rates, as the low interest rates may reflect the facts that investors expect inflation to be low and the currency to appreciate. Usually, countries with the highest interest rates tend to have highest inflation rates following a positive correlation. What does all these theories and assumptions mean in terms of international investment opportunities?

Interest rate and exchange rate exposure may affect the choices of financial managers, especially if the company has debt/loans in different countries, international sales, production sourced internationally or customers from other countries. The exchange rate exposure can be divided into three areas: 1. Transaction - as a result of a specific transaction. 2. Economic - general/broader exposure. 3. Translation: through translation of financial statements, i.e. group accounts. To evaluate international investment opportunities, there are two methods that can be used to find the NPV of investment: 1. Using Foreign cost of capital: o o o

C n (1+0.12) Discount the foreign COC to give a foreign NPV: foreign after-tax cash flows - Co Multiple this NPV by the current spot rate - to find the NPV in the home currency.

Estimate the foreign after-tax cash flows:

2. Using Home cost of capital: o

Estimate the foreign after-tax cash flows

o

Translate these to the home currency using the forward rate: S (f : h)=

o

Discount this at the home COC:

1+ rF 1+rH

Other factors such as tax planning and political risk are also important when evaluating international investment decisions.

Risk management – lecture 3 How does risk arise?  

Systematic risk factors affect all firms to some extent. Unsystematic risk factors: risk that affects the firm itself and possibly its close competitors.

The financial managers must consider:  

The expected future cash flows and the risk associated with these cash flows. Risk means uncertainty. There are many risks within businesses and not all of them could or should be hedged. Some are unavoidable or difficult/expensive to hedge.

Risk management Natural hedge  Useful approach to take if it is possible to do so, given the cash flows of a business.  The benefits of a natural hedge are that it needs no active management and has zero cost implications.  Not exposed to counterparty risk. Insurance  Always possible but not always affordable.  Insurance companies tend to work slowly and the premiums to insure against risk such as FX movements or change in interest rates are likely to be very high. Hedging  Hedging with derivatives: forwards rate agreements, futures, options and swaps.  It is an approach taken by many companies if the size of the risk and the potential for loss is great enough to justify the time and effort involved in setting up, monitoring and transaction hedges. Interest rate risk  



Arises when there is a time lag between the current date and a future need to borrow or lend a sum of money. Most companies are exposed to interest rate risk, hedging these risks may be worthwhile. o Forwards, futures, options and swaps. FRAs are simply interest rate forwards, locking into a forward interest rate via a contract. It facilitates hedging by fixing the interest rate, based on a notional underlying amount.



OTC are products which tailor the needs of the individual company and these are offered by banks.

How FRAs work    



FRAs fixes the interest rates. If the actual interest rate is higher than the FRA rate the bank pays the company the difference. If the actual interest rate is lower than the FRA rate the company pays the bank the difference. Duration: '3-9' FRA starts in 3 months' time and ends in 9 months' time and therefore has a duration of 6 months. They are usually available for 12-month period. Usually needs to be at least £500,000 to borrow at an FRA rate.

Managing Interest rate risk: using future contracts The futures contract gives the rate of interest for a deposit starting at maturity for x months. The interest rate is a forward’s contract, but it is not OTC. Instead, it is traded on a recognised derivatives exchange and is therefore a standardized product with set maturity dates through the year and based on a standard notional amount of underlying borrowing or deposit. As it is a standardised product, they may not match the underlying value and/or dates of borrowing and lending. Hence, they do not provide a perfect hedge, the risk associated with this is called hedging risk. Hedging with futures contracts as a lender 1. Buy futures contract/s now at Time 0. o Choose the maturity of the futures contract date to match the date when funds become available. 2. Invest when funds available. * 3. Sell the futures contract at maturity to close out the futures position. The lenders are worried the interest rate will fall and so then the profit on the amount will fall. To ensure the contract/s make a profit when the interest rates falls - they need a future position. The price quote on the interest rate futures is based on the quote 100 - IR.  

100 basis points = 1% or 75 basis points is 0.75% 100 less price quote at the time of the contract is the IR for the deposit period (or otherwise known as the fixed IR for that period).

*investing amount on deposit x spot rate on that date (x% p.a.) x time period (x/12) As a borrower Go short - sell The borrower needs to sell IR futures in order to make a profit if the IR rises. This is so when the borrower buys them back it is cheaper even if the IR falls. For this to happen the price quote for the future will be falling. Duration mismatch This is when the actual period of lending or borrowing does not match the notional period of the futures contract (usually 3 months). So, the number of contracts need to be adjusted in proportion to the time period of the actual loan or deposit compared with 3 months. lenght of loan 3 months amount of loan∨deposit ¿

future contract ¿ ¿ Number of future contracts =

Managing Interest rate risk: with options A call option on interest rates will make money if the interest rates rise above the strike or exercise price of the option. So, a call option could hedge a future borrowing and the option does not need to be exercised. The difference between the futures and FRAs is that options have a non-refundable premium which would need to be paid and have the option on whether to exercise it. Hence the premium pays for the optionality. Managing Interest rate risk: with swaps Swaps involve borrowers swapping obligations: either one currency for another or floating for a fixed interest rate. Benefits: arrangement costs are usually less than the process of terminating a contract and taking out a new contract. It is usually available for longer periods than the shortterm periods of FRAs, futures and options. They are OTC products so they can be tailored to precise needs.

Cost: risk of counterparty risk (although less nowadays).

How it works?  

Each firm must borrow in the loan markets where it has the greatest advantage 'comparative advantage' - depending on the firm’s credit ratings. For example, a firm with a higher rating will borrow in the market where it has the greatest advantage and a firm with the worst rating will borrow in the market where it has the least disadvantage.

Through the process of comparative advantage, each party has gained relative to what their position would have been had they not entered into the swap. Say a company wants to borrow at a variable rate if had done so directly the rate would be the bank rate (not advantageous to them). Hence through the indirect route of borrowing fixed and swapping into variable they could possibly saved x basis points of interest cost. 1. Calculate the difference between the fixed and variable rates of each company to find the difference between the 'differences'. Usually assume the potential gain is split evenly unless stated. o Hence what they would have saved the potential gain through the indirect route. 

There are 3 potential cash flows in the swap transaction: o The original cash flow that they needed to change the terms for via the swap (initial borrowing for each party). o The other two transactions is where each party makes a swap and receives a cash flow. o Sometimes the bank will act as an intermediary for a fee.

1) Neither party gains nor loses if LIBOR stays the same. 2) If LIBOR falls/(rises), company that initially had the fixed rate loan will benefit/(lose)

and the other party will lose/(benefit).

Cost of capital – lecture 4 Weighted average cost of capital (WACC)

Accept project = return on invested capital > opportunity cost of capital. WACC = (wd)[kd(1-t)] + (wps)(kps) + (we)(ke) Kd is yield to maturity on existing/new debt before tax (investors return on debt) - Using interpolation. Kd (1-t) is after-tax cost of debt, where t is the marginal tax rate Kps is cost of preference share capital - Dividend/price at current trading Ke is cost of ordinary share capital - CAPM = ke = Rf + β (Rm – Rf) - Dividend discount model = ke = D1 + g / P0 - Bond yield plus risk premium Optimal capital budget

Marginal cost of capital: cost of an additional unit of capital.  This increases as the firm adds to the amount of capital raised in a given period.  It has an upwards sloping curve.

Growth rate 

Historical dividend growth – [n root of (dividend growth – dividend paid in previous years)] – 1.  Rb model = r x g = return on equity x proportion of profits retained (1- dividend payout ratio). Cost of capital for a project Sometimes the investment the company wants to undertake has different levels of systematic risk to the current ones, so a new cost of capital has to be identified. The method to do this is called pure play. Pure play method steps: 1. Identify the equity beta of a comparable company (or companies) that us a pure play in the industry. Beta of the pure play company should reflect: o The systematic risk inherent in that industry o The company’s gearing level 2. Un-level it to adjust for differences in debt/equity ratio – this is the asset beta. 1 beta of pure play o Asset (unlevered) beta = 1+ ( 1−t ) D E o Formula to convert an equity beta to an asset beta (by removing the leverage to create a beta suitable for an all-equity financed company). o D/E is debt to equity ratio of pure play company o t is marginal tax rate of pure play company 3. Re-lever it to reflect the debt/equity ratio of the subject company – this is the project (equity) beta. o Use the market value for debt and equity figures D o Company (project) beta = asset ( unlevered ) beta [1+ ( 1−t ) ] E o Use the subject company’s tax rate and debt to equity ratio o Use this value directly into the CAPM formula to derive a new cost of equity o Cost of equity for project = Rf + (beta of project x equity risk premium) o Sometimes CAPM calculations are difficult to estimate in developing markets so the solution is to add country risk premium (CPR) to market risk premium. o Ke = Rf + β (Rm – Rf + CRP)

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4. Use the project (equity) beta as the cost of equity for the project when calculating the project WACC.

Capital Structure – Lecture 5

Internal financing: largest source of financing and typically between 70-90% of total financing – companies usually reinvest profits and net cash flows in order to grow. 

No issue costs.

External financing: debt (bank loans, corporate bonds) or equity (ordinary stock) or hybrid securities (preferred stock, convertible debt).

Debt Interest on debt is tax-deductible Unpaid debt is a liability. 3) Debenture: med-long term debt. In

the UK it is secured (fixed charge) on assets. 4) Note: debt instrument with a maturity shorter than a bond – usually up to 10 years. 5) Bond: maturity longer than 10 years, some issued in perpetuity.

Equity Dividends are paid out of post-tax profits Power is greater than debt – voting rights and right to residual profits. Ordinary shareholder rights:      

Vote on important issues i.e. M&A Right to elect directors Right to receive variable dividends Appoints the auditors Vote on remuneration of directors Liquidation – last in order

Most require payment at maturity. Preferred stock or hybrid securities: treated as equity in SOFP but has debt properties. No voting rights, fixed dividends which are not tax-deductible. Seniority order: preference in position over other lenders should the issuer be in liquidation. Insolvency practitioner Fixed charge creditors – denture holders in the UK, mortgage providers and lessors Floating charge creditors – charge over general assets of the business that are not

otherwise secured by a fixed charge Preferential creditors – employees’ salaries Unsecured creditors – amounts owed to suppliers, unsecured debt providers, tax and VAT payables Subordinated creditors – right to a pay-out subordinated to other creditors Preference shareholders Ordinary shareholders Differentiating debt from equity: 

ROE: usually this value is higher for levered firms (debt) as there is a higher risk to receive such high returns on equity.  Tax paid for levered firms (debt) is usually less as there is interest charges deducted – tax relief on interest charges. Unlevered situation: There is a 1-1 relationship between EBIT and ROE change – a drop/rise in EBIT is mirrored by a drop/rise in ROE. Levered situation: due to fixed interest cost the impact on ROE is much greater – in the form of x times compared to 1x times for a firm with no debt: EBIT% change/ ROE % change. Modigliani and Miller theory of capital structure     

No taxes

Taxes

All parties can borrow and lend at the same Rf rate. There are no transaction costs. There is no information asymmetry. Investors are rational and risk-adverse There are no taxes. Proposition 1 Proposition 2 firm value is not affected by leverage. Leverage increases shareholder risk and return. VL = VU rs = r0 + (D / EL) (r0 - rD) Firm value increases with leverage.

Some of the increase in equity risk and return is offset by interest tax shield.

VL = VU + TC D rS = r0 + (D/EL)×(1-TC)×(r0 - rD)

rD is the interest rate (cost of debt) rs is the return on (levered) equity (cost of equity) r0 is the return on unlevered equity (cost of capital) D is the value of debt

EL is the value of levered equity

Here we can see the M&M model without taxes and the overall impact that there is on the firm’s WACC. If the WACC remains the same at all levels of leverage, the firm value ...