FINANCIAL MANAGEMENT - SYNOPSIS Investment Appraisal

1.1 Accounting Rate of Return ARR = Average annual profit Depreciation Average Investment in the Project Limitations 1. Numerator & denominator are highly subjective i.e. manipulation is possible by way of accounting policy eg: Depreciation methods. 2. It fails to recognize the timings of profit. 3. It does not represent actual tangible profit. 1.2 Payback Period

Simple Payback Period: It is the time period taken by a project to generate cash flows equal to the initial capital outflow (investment) of the project. Factor of the year: Advantages 1. It considers cash flows which can be objectively measured i.e. independent of accounting policy. 2. It talks about timing of cash flows. Limitations 1. It fails to consider the timing of cash flows with in the payback period. (Two projects may have the same simple payback period but one may return more of its investment in initial years than the other.) 2. It ignores profitability. 1.3 Net Present Value Inflow required Total Inflow of the year

(Positive) Net present value is the present value of the surplus that would be obtained from the project over & above the companys investment in the project & return at the required rate.

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Years Investment Recoupment PV factor @ 10% PV of cash flows NPV Inflow Less: Capital Less: Required Return @10% Net Surplus PV of Surplus 1.5 Cash flow Determination Dos & Donts Donts / Should not Include / Exclusions Non cash items / depreciation / provisions / amortization. Irrelevant costs / sunk costs / allocation of costs. Financing costs / financing cash flows (inflows & outflows). 0 1 (100) 115 1 0.909 (100) 104.54 4.54 115 (100) (10) 5 4.54

Dos / Should include / Inclusions Tax impact. 1.6 Tax gain / tax loss / tax depreciation. Relevant costs & opportunity costs. Inflation effects. Working capital changes.

Working Capital changes are used to translate the profit figures into cash flows.

Years 0 2 3 Working capital 1is always recovered at the Salesend of the project 25 30 25 Cost unless told otherwise(20) (22) (28) of sales Profit 5 8 7 Working Capital (20) (2) (6) 28 Cash Flows (20) 3 2 35 flows)

1.7

Inflation:

(Uninflated

cash

flows are real cash flows) (Inflated / money cash flows are nominal cash

Nominal cash flows are discounted at nominal rates & vice versa. If multiple inflation rates for cost components are given than all variables are inflated with the corresponding inflation rates & the general inflation rate is used to calculate the Inflation Adjusted Discount Rate. ( 1 + i ) ( 1 + r ) = (1 + n )

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FINANCIAL MANAGEMENT - SYNOPSIS

where i : inflation rate r : real discount rate n : nominal discount rate 1.8 Multiple Discount Rates Period Wise 3 6% (1.04)(1.05)(1.06)

Years 0 1 2 Discount Rates 4% 5% PV Factor - (1.04) (1.04)(1.05) 1.9 Tax

Tax payments & tax gain/loss are always nominal cash flows (as they have inflation element built in them because they are calculated from profit figure which are themselves nominal) hence they are never inflated to account for the delay in payments. Similar for Tax depreciation. However, if all the figures are real figures & we are provided with the real discount rate, then we must deflate them to arrive at the real cash flows. 1.10
1-

Formulae Simple Annuity P = R 1- (1 + i ) -n

i

2-

Annuity Due

P = R + R 1- (1 + i ) i or P = R 1- (1 + i ) i

-n

This formula tells the PV of the installments before the first installment (at Time 0)

-n

(1+i)

3-

R (1 + i ) i

n-1

This formula tells the Future Value of the installments as at the end of the last cash flow (At time of the last installment)

For Annuity Due n (periods) need to be adjusted accordingly. Note: If tax is payable in the same year than gross taxable cash flows shall be taken. Tax on taxable profits shall be calculated separately & shown in subsequent years. Impact of tax depreciation, tax gain / loss on disposal shall be added or deducted to reach actual cash flows.

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FINANCIAL MANAGEMENT - SYNOPSIS

1.11

Net terminal Value

Net Terminal Value is the cash surplus remaining at the end of the project after taking into account repayment of capital / initial cost & return of capital at the required rate. NTV when discounted at the required rate would give the NPV of the project with the underlying assumption that any surplus (arising at the end of each year) would earn interest at the required rate /same rate. Only because of the aforesaid assumption the relationship between NPV & NTV remains true. 1.12 Sensitivity Analysis

It is one method of analyzing the risks surrounding capital expenditure project & enables an assessment to be made of how responsive the project NPV is to changes in the variables used to calculate that NPV. i Selling Price NPV / Present Value of Sales (Net of Tax) ii Sales Volume NPV / Present Value of Contribution Margin (Net of Tax) iii Variable Cost NPV / Present Value of Variable Cost (Net of Tax) iv Fixed Cost NPV / Present Value of Fixed Cost (Net of Tax) v Cost / Initial Investment NPV / Present Value of investment (Net of Tax) vi Discount Rate (WACC IRR) IRR vii Project Life (Total Life Discounted payback period) Total Life 1.13 Capital Rationing Capital Rationing: A situation in which the company has a limited amount of capital to invest in potential projects such that the different possible investments need to be compared with one another in order to allocate the limited capital available Soft Capital Rationing Hard Capital Rationing : Due to internal factors : Due to external factors

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FINANCIAL MANAGEMENT - SYNOPSIS

Capital Rationing

Single Period

Multiple Periods & Divisible Projects non mutually exclusive (independent)

Divisible Projects & non mutually exclusive (independent) Rating of Projects using Profitability Index NPV / Capital Investment or Postponibility Index Loss on Postponement Capital Investment NPV - NPV (1 year disc) Capital Investment Surplus can be invested

Indivisible Projects & / or mutually exclusive

Use absolute NPVs

Linear Programming using Simplex / graphic method

Surplus cannot be invested

Investment Opportunities at discount rate No further requirements as the NPV of surplus cash is zero

No further steps Investment Opportunities at different rates

Higher Rate Positive NPV of Surplus cash shall added to absolute NPV

Higher Rate Negative NPV of Surplus cash shall deducted to absolute NPV

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1.14 Lease or Buying Decision

1. Financing cash flows: A company faces two types of decisions -i- Acquisition Decisions Whether to acquire or not (discounted using WACC) -ii-Financing Decisions Whether to Lease or Buy (Post Tax Incremental Interest / Borrowing Rate) While appraising an acquisition decision, the company uses the after tax cost of capital / required return to discount the cash flows. This cost of capital is in fact the IRR of the mode of financing being used. Hence the PV of all the cash flows would be zero & would not be considered in acquisition decisions. However, if cost of capital & IRR of loan are different, than The only cash flows that are considered are those that are the financing cash flows would need to be considered. effected by the choice of decisions / method of financing. 2. In making lease / borrow decisions (leases point of view) the incremental borrowing rate shall be used for calculating the lease based NPV & IRR for lease shall not be used. 3. When lease rentals are being paid in advance at start of the year, the than tax impact shall be taken form start of year 2. This is because of the fact that the tax benefit of the first rental paid at Year 0 would be materialized in year 1 & tax benefit shall be taken in year 2, iff tax is paid in arrears.

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Financing Decisions Lease / Borrow

When WACC & Incremental Borrowing rate are same

When WACC & Incremental Borrowing rate are not same

Tax is payable in same year -i- Calculate Lease based NPV -ii- Borrowing decision NPV would be equal to acquisition decisions NPV

Tax is payable in arrears -i- Calculate Lease based NPV -ii- Add NPV of Financing Cash flows to acquisition decision NPV

Tax is payable in same year -i- Calculate Lease based NPV -ii- Compute borrowing decision NPV using acquisition decision cash flow discounted at post tax incremental borrowing rate -iii- compare the two

Tax is payable in arrears -i- Calculate Lease based NPV -ii- Borrowing decision NPV to be computed incorporating financing Cash Flows discounted at post tax incremental borrowing rate -iii- compare the two

-iii- compare the two -iii- compare the two

4. Tax saving on tax depreciation would be allowed in accordance with timing of tax payment. If tax is ignored, than no such tax benefit would be allowed. 5. Cash Flows during the Year: Normally it is an implied assumption that cash flows occur evenly through out the year, hence are shown at end of the year. However, if is stated that cash flows occur semi/bi annually that equivalent discount rate is ( 1 + i ) n = ( 1 + e i ) en Where; en: number of installments in a year 1.15 Internal Rate of Return (IRR)
IRR = a + (b-a) A A-B

The IRR for a given stream of conventional cash flows is calculated as

Where;

a: smaller discount rate where NPV is positive b: larger discount rate where NPV is negative A: Positive NPV B: Negative NPV

IRR 2/3 of ARR

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Conventional cash flow are those cash flows in which outflow occurs initially & inflow occurs subsequently throughout the project life Cash Year Year 0 Year 1 Year 2 Flow (1,000,000) (1,000,000) (1,000,000) 100,000 92,593 89,286 1,000,000 925,926 892,857 Present Values 18,519 (17,857) IRR = 8% + (12% - 8%) x 18,519 [18,519 (17,857)] IRR = 10.036% IRR technique assumes that if there is any surplus cash, it will be invested at the Project IRR; unlike NPV which assumes that surplus cash is invested at WACC . Modified IRR is calculated with the assumption that the re - investment of surplus cash would be made at the required rate of return 1.16 International Investment Appraisal Discounted at 8% 12%

1. All the same rules apply as stated above (for normal cash flow) with the following additions. 2. We make separate cash flows for LCY & FCY post tax; convert the FCY bottom lines into LCY using the Interest Rate Parity / Inflation Rate Parity. 3. We must never knock off Royalty Income & Royalty Expense because changes in tax rates may allow for differing tax benefits. 4. If stated that Full Bi Lateral Tax Treaty Exists than no further computation is required for tax Otherwise we must convert FCY to Rs & add to Rs Cash flow If stated that higher tax rates apply $ @ 35% No further work is required Rs @ 25% $ @ 25% We must further Tax $ by Rs @ 35% 10 % & add to Rs. cash flow

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FINANCIAL MANAGEMENT - SYNOPSIS

Cost of Capital
A return that the company must earn to satisfy the providers of funds & it reflects the riskiness of providing funds. Elements of cost of capital: Risk Free Rate of Return Business Risk Premium Financial Risk Premium 2.1 Weighted Average Cost of Capital (WACC) Determination

Cost of Equity It is calculated assuming that the MV of shares is durectly related to the expected future dividends

Cost of Debt A

E = Div (to sale) + Sale Price Ke

Dividend Valuation Model Without Growth = Do / Ke Without Growth = Do (1+g) ( Ke g) Ke is always post tax, since dividend is paid from PAT. Dividend stream starts from D1 & Do is not included that is why E (Market value of equity) is always Post Dividend. Note:S = P (1+g)n g=rxb r: return earned on reinvested profit b: retention rate

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A

Irredeemable debt or Redeemable at current market rates Kd D D = = = T / De Kd / I I (1 - t) Kd

Redeemable debt or Redeemable Other than at current market rates Fixed Rate Debt Kd is the IRR which equates current MV with the PV of future interest receivables plus the PV of redemption amount Variable / Floating Rate Debt Kd is the cost of an equivalent fixed interest debt with similar term to maturity in a firm of similar commitment Convertible Loan Stock Kd is the IRR which equates Do with the PV of -i- future interest receivables -ii- future conversion value Running Finance Kd is the IRR which equates Do with the PV of -i- future interest receivables -ii- future conversion value

WACC = Ke x E + Kd1 x D1 +Kd2 x D2+ E+ D1 + D2+ 1. WACC is based on Ex dividend & Ex Interest Market Values of equity & debt components respectively. 2. The after tax Kd of an irredeemable debt can be computed by multiplying the Pre tax Kd with (1-t).

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Post Tax Kd D (MV of debt) is given (Redeemable Debt) D (MV of debt) is not given Calculate D (MV) form the holders point of view by discounting the gross interest payments (based on coupon rates) & redemption amount at pre tax Kd (without tax) Calculate the IRR which equates D with PV of coupon interest payments (net of tax) & PV of redemption amount 3. It has been agreed that if interest accrued on a debt would not be paid for some time, then such accrued interest would form part of MV of debt. 4. There is no tax benefit of interest payment on preference shares hence gross interest payments are calculated & Kd is automatically post tax 5. When WACC may be used for Project Appraisal. Project is small relative to the size of the company (Does not alter Business Risk or Financial Risk; D: E ratio). WACC denotes existing long term future cost of capital of the company. Finance of the project can be easily obtained through issue of new debt or capital. WACC is equal to the marginal cast cost of capital = Additional Required Return Additional Investment 2.2 Definitions Coupon Interest Rate / Coupon Rate: Rate at which the interest is actually paid to the borrower by the holder Face Value / Nominal Value: Reference value used for calculation of coupon interest rate. Issue Value: Value at which debt / security is initially issued to the borrower. Page 11 of 50

(Pre tax Kd is irrelevant) Calculate the IRR which equates D with PV of interest payments (net of tax) & PV of redemption amount

FINANCIAL MANAGEMENT - SYNOPSIS

Redemption Value: Value / amount to be paid by the borrower to the holder. on maturity / redemption of the debt security. Redemption value > face value: redemption at premium Redemption value < face value: discount at premium Redemption value = face value: redemption at par Market Value: Value at which the security can be actively traded in the market currently. Purchase Yield: Rate at which when all future cash flows are discounted at the time of purchase of security their PV equals the purchase price; IRR when all cash flows are plotted against purchase value; does not change. Market Yield: Rate at which when all future cash flows are discounted their PV equals the market value of debt; IRR when all cash flows are plotted against market value. It changes. When securities are redeemed at par Example E:40m D:20m WACC: 17% The company wishes to invest in a project that would cost Rs 6m & would give NPV of Rs 3m at the existing WACC. The business risk of the project is similar to the existing operation of the company. Please compute how the project may be financed thorough debt & Equity? Ke: Kd: 21% 9% Return > market rate ; traded at premium Return < market rate ; traded at discount Return = market rate ; traded at par

MV before project E 40 D 20

Finance NPV MV after 4 2 3 project 47 22 Financial Risk ( D:E

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60 MV before project E D 40 20 60 6 3 9 (3) (3) 6 3 69 Ratio) changes MV after

Finance NPV Increase through

financing project 3 46 Financial Risk 3 23 ( D:E Ratio) 6 69 remains same

We distribute both the cost & NPV in D: E ratio. It has been concluded that in order to keep the financial risk or gearing constant, the project must be financed in such a way so that revised gearing ratio (D:E) remains unchanged. The entire NPV belongs to the equity holders of the company as the debt holders usually get a fixed return 6. The following shortcuts may be used when: Earnings are constant. Debt is irredeemable / redeemable at Market value. All earnings are paid out as dividend. Tax is payable in same year. = PBIT E+D WACC (Post Tax) = PBIT(1 t) E+D
WACC (pre tax) = PBIT E+D WACC (post tax) = PBIT (1-t) E+D

WACC (Pre tax)

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WACC

Financial Risk (Impact of Changes in Financial risk on discount rates

Financial Risk

Traditional Theory

MM Theory

Risk Adjusted WACC

APV

Impact of Changes in Financial Risk on WACC Determination 2.3 Traditional Theory of Gearing Kd remains constant as gearing level rises upto a level after which it increases Ke rises as gearing level Initially as the gearing level rises, WACC falls due to cheaper debt (KD is always lower than Ke). However if it continues to increase the increase in Ke would become insignificant & WACC should start increasing 2.4 MM Theory (Modigliani & Miller)

MM Theory without Taxation Gearing levels of companies have no effect on WACC. WACC remains same when business risk remains same as the WACC formula shown below does not bear any relationship to the D: E ratio. As WACCu = WACCg Therefore; PBIT Company A Total MV Company A PBITs. For an ungeared company WACCu = Keu PBIT Company B Total MV Company B

This also means that Market values of two companies are in proportion to their

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MM Theory with Taxation A geared company would have a lower WACC & greater Market Value as compared to an ungeared company, as the tax shield on debt would increase the market value of geared company. WACCg < WACCu MVg > MV u MVg = MV u (Based on PBIT) + debt related tax benefits The Market values of geared & ungeared companies are proportional because of same Distributional Potential. In the aforementioned formulae it is assumed that the sane & prudent management of a company to maximize the market value of the company will keep on rolling over the debt till infinity therefore debt related tax benefits are discounted using the perpetuity technique as follows: Debt related tax benefits PV Factor PV:
WACC = Keg = E+D Keu + (Keu - Kd) D ( 1 - t) E

: R x D x Kd x t : Kd :D x t

Ke x E+ Kd(1-t) x D

The above shows that Keg > Keu as a geared company the shareholders always bear a financial risk & therefore demand & Financial Risk Premium

WACC g = Keu 1 -

Dt E+D

Note: If the question asks to determine the MV of a geared company the same may be done by computing the MV of the company in its ungeared status then adding D x t to determine the MVg NOTE: The MM theory is based on the assumption that Debt is available to all borrowers at the same rate.

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2.5 Arbitrage Gain: Gain made without incurring additional risk / maintaining risk profile same Investor Moving From Ungeared to Geared Company Divest form ungeared company Invest in equity & debt of the geared company in D:E ratio ( D = Dt) Ignore personal taxation The gearing ratio of the geared company will be calculated after adjustment of Dt in the debt portion of the geared company Geared to Ungeared Company Divest form geared company Incur personal borrowing to keep the financial risk same Ignore personal taxation

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FINANCIAL MANAGEMENT - SYNOPSIS Portfolio Theory

Portfolio theory demonstrates that it is possible to reduce the portfolio risk without a consequential decrease in portfolio return. 3.1 Expected Return: Probability x Return PxR 3.2 Portfolio Return: Portfolio return is the weighted average of all probable future returns from the security. Portfolio Return Rp = RA XA + RB XB The portfolio return depends upon: 3.3 Individual expected return RA & RB Respective weightages XA & Xb Portfolio Risk: Portfolio risk is the Standard Deviation of the returns of the

security

Portfolio Risk depends on: Individual risk () Respective weightages (xA) Relationship b/w return on the asset; measured by the correlation coefficient

If returns are directly related it causes greater impact on portfolio risk p There are always certain factors which affect all companies irrespective of correlation coefficient e.g.: Tax effects i.e. why even when correlation coefficient is zero, portfolio risk is not nullified.

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An in efficient portfolio is one where return increase is not accompanied by increase in risk. 3.4 Capital Asset Pricing Model 1. This model is used to calculate the required return of a security / minimum return of a security / Project return ( R ) or the company (Ke) 2. It assumes a liner relationship between risk & return 3. In portfolio theory the total risk of a security is considered However in CAPM model only the systematic risk is considered on the grounds that the investor may reduce or completely eliminate the unsystematic risk by way of diversification

Note:
= 1 For Market i.e. Return moves with market

3.5

is defined as follows: It is the ratio of systematic risk of a security with risk of market portfolio or

It denotes change in return of a security resulting form a %age change in market return

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When market shows a Bullish Trend (Goes Up) we should invest in securities with > 1 (so that market rises by 1% we may earn more than 1%) When market shows a Bearish Trend (Goes Down) we should invest in securities with < 1 (so that market falls by 1% we may loose less than 1%) For Risk free securities =0 =0

RA = RF For securities with Risk = Market Risk =1 sys = market RA = RM For securities with > 1 sys > market RA > RM For securities with < 1 sys < market RA < RM 3.6 Value = Actual Return - CAPM Return If = Positive (+ve) Actual MV < CAPM MV Undervalued Actual Return > CAPM Return Should invest / hold

If = Negative (-ve) Actual MV > CAPM MV Overvalued Actual Return < CAPM Return Should not invest / divest

values are temporary values as arbitrage gain opportunities / speculation will over a long period of time cause securities to offer the same return as that offered by a market portfolio (become inline with market).

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For projects with similar investment requirements & expected returns than the project with lowest should be selected 3.7 Portfolio : It is the weighted average of the individual of the securities comprising the portfolio. p = a + b + c 3.8 Limitations: This model is good only for a single year investment decision making. There is not always a linear relationship between risk & return. Neither market portfolio nor Market return may always be a true benchmark. Total risk is not considered only unsystematic portion is given weightages. At any give time there may be multiple risk free rates in the market. Shareholders risk attitude is difficult to judge. Forecasting return & correlating between them is very subjective. This model can only be used for securities which bear a correlationship with market.
p = sys A = AM x A sys Market sys Market

Because if

= 0, = 0 & RA = R

which is not true

As per the CAPM model an investor should demand return only against the systematic return of the risk, as the unsystematic portion of risk may be eliminated by diversification. (A well diversified market portfolio / market bears only systematic risk),however, an investor may not always be in a position to diversify & consequently will demand return against unsystematic risk he bears , an element this model has failed to consider.

3.9

Application of MM Theory

Without Tax

WACCg = WACCu Keg > Keu With Tax WACCg < WACCu Keg > Keu If these relationships do not hold there are opportunities for arbitrage gain as MV of any one company will be in disequilibrium 3.10 MM Theory & CAPM Page 20 of 50

FINANCIAL MANAGEMENT - SYNOPSIS

WACCg = Ke x E + Kd x (1-t) x D E +D

a represents Business risk only e represents Business risk & Financial Risk both Therefore, all companies in Same industry similar business risk = a Company B 40 % debt < e = a Company C 70 % Debt < e

Should have the same A a Company A All equity e As per CAPM R

= Rf + (Rm Rf) Ke = Rf + (Rm Rf) e Kd = Rf + (Rm Rf) d

Never use a & d to calculate Kd & WACC; the CAPM model is for equity only

Therefore, a geared = a ungeared (for both with & without tax) and a = e
a = e x E + d x D(1-t) E + D( 1 - t )

Since debt is virtually risk free d = 0

a = e x E E + D( 1 - t )

Impact of Changes in Business Risk on WACC 3.11 Adjusted Present Value However, when Adjusted Present Value (APV) is an extension of MM theory with taxation APV & NPV give the same result when the gearing level remains same financial risk changes NPV method requires the calculation of Risk adjusted WACC APV method is superior & facilitates the calculation of a revised NPV by making certain adjustments to Base Case NPV Step 1: Identify the business risk of the project i.e. a of the industry to which the project relates. This a is also the e of an ungeared company in the same industry. a = e u Page 21 of 50

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Step 2 : Using this e u , calculate the Ke u using the CAPM equation as follows: Keu = Rf + (Rm Rf) eu Alternatively this may be calculated using MM theory equation, if the D/E ratio of the industry or any company in the industry is available; Keg = ( Keu Kd) D (1 t) E Step 3 . Discount the project cash flows with the Keu calculated above to arrive at the Base Case NPV Step 4: Make the following adjustments to allow for effects of method of financing Base Case NPV Adjustments (Using Kd pre tax ) PV of tax saving of interest on debt (Utilized & spare debt capacity) PV of issue cost PV of tax saving on issue cost (if tax allowable) PV of interest saving on subsidized borrowing (Using Rf as benchmark) Adjusted Present Value the APV method may not always be equal because of the following reasons: In the conventional method NPV is calculated by discounted all the relevant cash flows with WACCg, hence all the aforementioned adjustments are incorporated into WACCg determination with the exception of spare debt capacity & subsidized debt which can only be incorporated here. 3.12 Risk Adjusted WACC the current a, if project involves diversification determine the a 2. Identify financial risk (D:E) ratio of the project. In absence of project specific (D:E) ratio we assume that the project will be financed form the exiting pool of funds therefore the existing D:E ration of the company may be used. 3. Using a & D:E of the new project calculate e.
a = e : e x E + d x D (1-t) E + D( 1 - t ) Risk adjusted e

xx xx xx xx xx xx

It is important to note that the NPV calculated using both the conventional method &

1. Identify the business risk of the project , if similar to existing operations use

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4. Using CAPM determine Risk adjusted Ke as follows:
K e u = Rf + ( R
m

f )

5. Using Risk Adjusted Ke, determine the risk adjusted WACC as follows:

The tax rate above is the same as used to calculate in e (in 3 above) The WACC so computed is the appropriate discount rate of the project 3.13 Discount Rate for Project Appraisal

1. No Changes in Financial or Business Risk Current WACC may be used as discount rate Questions are likely to be focused on how the project is to be financed to keep the WACC constant Cost of project & increase in earning (equity) will be given. Calculate revised MV by dividing increased earning with WACC & compare with old MV to calculate NPV Amount of debt = Amount of equity = D x D+E Total Increase in MV or PV of inflows

E x PV of inflows - NPV D+E

Calculate revised PAT & divide by new Ke to determine revised MV of Equity Accept or reject projects based on NPV 2. Business Risk changes / Financial Risk may or may not change 2.1. Adjusted Present Value (APV) 2.2. Risk adjusted WACC (WACC) 3. Financial Risk Changes & Business risk remains the same 3.1. Traditional Theory Since traditional theory is not based on any formulae increase / decrease in Ke & Kd will be provided (due to gearing changes) 3.2. MM Theory 3.2.1. MM Theory Without taxation Cost of project, increase in earning & mode of financing are available. Current WACC will be given .Since MM theory without tax assumes no changes in WACC due to gearing the inflows are discounted at the existing WACC to Page 23 of 50

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calculate the MV of the company. Deduct MV of debt to obtain revised MV of E Accept / reject based on NPV. Revised Ke may also be calculated by dividing total revised earning after interest after by new MV 3.2.2. MM Theory With taxation Existing MV of D & E will be given with the tax rates After project company WACC changes depending upon the mode of financing but it cannot be calculated now, since revised MV of E & Ke are unknown The MV of a geared company is MVg = MVu +Dt The existing Ke will be calculated by dividing current earnings after tax (ignoring debt interest) with MVu By undertaking project Ke u will not change since only BR is effect on all ungeared/equity company. This Keu will be used to discount the revised earnings after tax) ignoring interest) to calculate revised MV of ungeared company from which old MVu is deducted to achieve change in MV To this amount (debt used in current project financing) is added to calculate MV of geared company.

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FINANCIAL MANAGEMENT - SYNOPSIS Dividend Policy

The primary objective of a dividend policy of a company is to maximize shareholder wealth which depends on both the current dividends & capital gain. The major reasons for using retained earnings to finance new investments rather than to pay higher dividends & then borrow or raise more equity to finance the projects are as follows: Using funds from retained earnings means that the project can be undertaken without the involvement of either the shareholders or any outsider. It saves issue cost which would have been incurred if new equity had been issued. It avoids the possibility of change in control of the entity , a risk that usually follows issue of equity. 4.1 Theory of Relevance / Residual Theory of Dividend Distribution

Only that portion of the divisible profits should be distributed which cannot be invested in projects yielding a positive return r > Ke Here; r: return earned on reinvested profits We only invest in projects where WACC > IRR Scenario I Company pays out all profits as dividend E (ex dividend) E (cum dividend) Scenario II Payout Ratio = 40% Retention Dividend = 60% = 4 8 (0.4 x 12) = 12 / 0 .1 = 120 = 120 + 12= 132

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Scenario II (a) b = 60% r = 12% g=bxr = 0.6 x 0.12 = 7.2 % E = Do ( 1 + g) Ke g E = 4.8 ( 1 + 7.2%) 10% 7.2% E = 184 E (cum div) = 184 + 4.8 = 188.8 Higher Than Before Scenario II (b) b = 60% r = 8% g=bxr = 0.6 x 0.08 = 4.8 % E = Do ( 1 + g) Ke g E = 4.8 ( 1 + 4.8 %) 10% 4.8% E = 97 E (cum div) = 97 + 4.8 = 101.8 Lower Than Before Scenario II (c) b = 60% r = 10% g=bxr = 0 6 x 0 10 =6% E = Do ( 1 + g) Ke g E = 4.8 ( 1 + 6 %) 10%6% E = 127.2 E (cum div) = 127.2 + 4.8 = 132 Same As Before

Note: Bonus Dividend is only Capitalization of profit, hence is not real dividend 4.2 Theory of Irrelevance / MM Theory of Dividend Distribution

Shareholder is indifferent of dividend policy, although +ve NPV increase shareholder wealth, hence the company should borrow & invest funds in +ve NPV generating projects to increase Shareholder wealth 4.3 Practical Aspects Signaling Effects: dividends declared by a company serve as a signal to the shareholders of the financial performance & future prospects It is important to maintain a constant stream Cliental Effect: A shareholder makes gain in two ways -Dividend -Capital Gain We know that: High dividend low capital gain Low dividend high capital gain Corporate Capital gain taxable Dividend exempt/NTR Individual Capital gain exempt Dividend taxable Page 26 of 50

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The company can influence its cliental by way of its dividend policy, it can lead to the following advantages: Attracts high profile clients Resist takeovers if there are large corporate entities who have invested for long term strategic purposes rather than for short term profit making 4.4 Definitions A scrip dividend is a dividend payment which takes the form of new share instead of cash, it converts profit reserves into issued share capital. A scrip or bonus issue (also referred to as capitalization issue) involves the issue of new shares to existing shareholders in proportion to their existing holdings.

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FINANCIAL MANAGEMENT - SYNOPSIS Share Valuation Techniques

5.1 Reasons 1. To determine share prices upon first public issue. 2. To determine the share prices of unquoted companies. 3. To determine the share price upon bulk sale & purchase of shares (to incorporate the premium for control transfer). Techniques 5.2 Asset Based Valuation Techniques Book value of net assets Number of shares Book value basis = Pros 1) The information used is verified by the auditors of the company. Cons 1) Book value does not represents the fair value , the information used is subject to manipulation by the company; such as by way of accounting policy Market value basis = Pros 1) Removes the inconstancies if the book value model. 2) As per the technique, the value determined represents the minimum / floor price that the company should accept, as the amount represents the value that the company will receive if all the assets are disposed off immediately. Cons 1) Market values do not represents the fair value 2) the information used is not subject to verification by the company auditors 3) The resulting value may not be equal to the floor price , as in the event of immediate sale of all the assets of the company , one receives FSV (Forced Sale Value) which is less than the market price. Note We ignore the flowing in the asset based valuation techniques Fictious asset (goodwill, deferred tax assets) Page 28 of 50 Market value of net assets Number of shares

FINANCIAL MANAGEMENT - SYNOPSIS

5.3 Intangibles without a market value Earning Based Valuation 1.1. Constant Dividend E = Do Ke 1.2. Dividend growing at constant rate E = Do (1 + g) Ke g 1.3. Irregular Dividends (Discount each value / dividend by Ke individually) Pros 1) The method is suitable for minority shareholder who has invested in the company for the sake of dividends only. 2) The method is based on cash flows which can be objectively measured. Cons 1) Not suitable for majority shareholders who have invested for strategic reasons hence are therefore interested in the earning potential. 2. Earning Valuation 2.1. Constant Earning E = Earning / Ke 2.2. Earnings growing at constant rate E = Earning (1 + g) Ke g 2.3. Irregular Earnings (Discount each value / dividend by Ke individually) Pros 1) Removes the inconstancies of dividend model; useful for large transactions Cons

1. Dividend Valuation

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FINANCIAL MANAGEMENT - SYNOPSIS

1) The information is subjective (It is not appropriate / correct to discount earnings, we should only discount cash flows). Note Dividend Yield = D / MV Earning Yield Earning / MV Therefore Dividend Yield & Market Yield = Ke. 5.4 P/E Ratio (Earning Based) 2/3rds of Comparable P/E ratio of similar quoted company x EPS of the target company Quoted Higher P/E x Future Expected EPS = Prospective Price

A listed company must have the same size, products & risk 5.5 Super Profit xxx xxx / (xxx) xxx xxx xxx 100 10% 10 14 4 6
= A e g In u v ra e d stry P fit ro A e g In u v ra e d stry R tu e rn

Net Assets Super profit / (loss) Net assets value Number of shares Value per share Net Assets Average Industry Return Average Income / Year Actual Income Super Profit Years
A e g In u try v ra e d s R tu e rn

5.6

Cash Flow Basis 1) Free cash flows represents the cash that is freely available from operating activities of the company

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2) We treat the company as a project, plot similar cash flows for the whole company (Ignoring financing cash flows), then the PV = NPV is the value of the company 3) We call them free cash flows to distinguish them form the cash flow statements made for financial statements. 4) When FCFE are discounted we get the MV of the company. 5) Any capital expenditure not related to the operating activities of the business. 6) Free cash flows represents the cash that is freely available from operating activities of the company 7) We treat the company as a project, plot similar cash flows for the whole company (Ignoring financing cash flows), then the PV = NPV is the value of the company 8) We call them free cash flows to distinguish them form the cash flow statements made for financial statements. 9) When FCFE are discounted we get the MV of the company. 10) Any capital expenditure not related to the operating activities of the business. PV of FCFC PV of FCFE E+D (D) D xxx (xxx) xxx (xxx) (xxx) (xxx) xxx (xxx) xxx xxx xxx xxx xxx (xxx) (xxx) (xxx) xxx xxx Page 31 of 50

Free Cash Flows to Company (FCF) Revenue Less: Operating Expenses Earning Before Interest & Tax , Depreciation & Amortization Less: Depreciation Amortization Earning Before Interest & Tax Less: Tax (Excluding Tax Saving Of Interest On Debt Net Income Add: Depreciation Amortization Cash Flows (Post Tax From Operations) Less: Capital Expenditure Working Capital Changes Free Cash Flows To The Company (Discounted using WACC) Net profit after tax

FINANCIAL MANAGEMENT - SYNOPSIS

Add : Interest Less: Tax saving on interest Net operating profit after tax Add : Non cash Items (Depreciation / Amortization) Add/Less: Working capital adjustments Less: Capital Expenditure Related to operations Free Cash Flows To The Company (Discounted using WACC) Free Cash Flows to Equity (FCFE) Free Cash Flows To Company Less: Interest Expenses Add Tax Saving On Interest Expense Less: Preferred Dividend (On Preference Shares) Add: Proceeds Of New Debt Issued Less: Principal Repayment Of Debt Free Cash Flows To Equity (Discounted Using Ke) Net profit after tax Add : Non cash Items (Depreciation / Amortization) Add/Less: Working capital adjustments Less: Capital Expenditure Related to operations Less: Debt/ Preference shares repayment Add: New issue of debt / preference shares Free Cash Flows to Equity Notes: 1. When stated that Current dividend will be reduced Share Value Share Value = PV of existing inflows + PV of project inflows Number of shares + PV of project inflows New Number of shares xxx (xxx) xxx (xxx) (xxx) (xxx) xxx xxx xxx xxx/(xxx) (xxx) (xxx) xxx xxx xxx (xxx) xxx xxx xxx/(xxx) (xxx) xxx

2. When stated that Bonus shares 1 for every 10 = PV of existing inflows

3. When stated that new public issue & the entire benefit goes to the existing shareholders Share Value for new PV of existing inflows + NPV of project = public issue Original number of shares

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FINANCIAL MANAGEMENT - SYNOPSIS Mergers, Acquisitions & Corporate Reorganizations

Motive for mergers / acquisitions The motive for many mergers & acquisitions is to create incremental value through the existence of synergy, when two entities are combined. Synergy means hat the value of the combined entity is greater than the value of the component parts 6.1 Reasons of synergy

Operating Synergy arises from Improved productivity / cost cutting as a result of merger. Increased market share. Increased efficient use of resources / cash rich companies.

Financial Synergy arises from Diversification reduces the risk of the companys cash flows hence effecting the WACC of the company. Reduced viability & return might improve the companys credit rating increasing the debt capacity. Uses of tax shields / losses previously unutilized.

Horizontal Merger Purchase of competitors Vertical Merger Purchase of suppliers / customers

Note: Mergers are within the same industry, diversification is used to diversify outside the industry or to acquire a competitor 6.2 Valuation of A Target Comparable P/E ratios: Since the similar / comparative companies may not be of the same size, structure , risk, growth rate or activity subjective adjustments (60% - 80%) may be required (Quoted companies have higher PE ratios)

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Note: PE ratio is based on historical accounting information & hence does not consider the impact of merger / acquisition, future cash flows / synergies 6.3 Dividend Valuation Model (As in WACC) PV of operating Cash Flows Super profit Asset Based (Book Value / Fair Value)

Exchange Ratios & Payment Methods

After calculating the appropriate target value, value need to be assigned to the shares of the acquires & the acquire Cash purchases: Advisable when surplus cash is available. Target Shareholders may prefer it provides a precise consideration, however cash payment may lead to CVT (capital value tax). Preference Shares / Debt. Share Exchange: Continuation of ownership as part of successful bidder Precise post acquisition value of the bid may not be determinable. Mezzanine Financing: Cash + Short to medium term loan, unsecured higher interest rate with options to exchange for shares after takeover. Called Mezzanine as it lies between Debt & Equity. Effects: Predator Company 6.4 Dilution of EPS Gearing is effected Transfer of control Target Company Taxation Continued stake in business Gearing may change depending on bid price

Impact on predators Market Price & EPS xx (xx) xx

Value of merged Company Current value of predator Maximum Price of target

Minimum price of an unlisted company will be the current market price or realizable value of Net Assets if unutilized Page 34 of 50

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Target Company P/E Higher Lower Note: Bootstrapping The process of buying a company with higher EPS to boost ones own EPS. Ignoring any synergy effects the immediate effect is expected to be a movement in the overall P/E ratio to the weighted average (by earnings) of the P/E of the component parts P/E of Predator x Earning of Predator + P/E of Target x Earning of Target Earning of Predator + Earning of Target If the predator has acquired the target shares at a premium the above ratio will fall & hence MV will fall However, if the old P/E of the predator is assumed to be unchanged, this will increase the MV of the predator Any PV of incremental benefit adding to the MV the combined entity will be discounted using the discount rate of the combined entity Dividend Policy: After merger a single dividend policy is followed, usually that of the Predator prevails 6.5 Defensive Tactics Against a Bid Combined EPS Falls Rises

If the bid has not been made Target Company may establish Poison Pills such as granting the right to alternative shareholders to purchase its shares at a deep discount rate, dispose key activities (Crown Jewels) to make itself less attractive. The company may introduce Golden Parachutes for key staff (expensive service contracts that come in effect if the jobs are lost) It can ensure that the press /media & shareholders are fully aware of financial strengths, future strategies so that the companys value / worth is known If the bid has been made Launch an advertising campaign against the bid to persuade shareholders that the predator is financially stable. Page 35 of 50

FINANCIAL MANAGEMENT - SYNOPSIS

6.6 Releasing future forecasts to support the argument that the company is undervalued. Counter Bid. Finding a White Knight, a preferred alterative bidder who will make a welcome bid. Reasons for failures of Mergers 6.7 Strategic plan fails to produce the desired benefits Over optimization about future market conditions, & operating strategies Poor Integration / Management

Corporate Reorganization 1) Determine the companys current realizable value (assuming that it goes for liquidation) & calculate the entitlement of different creditors (Banks, trade creditors, debenture holders, preference shareholders etc ) Any preferential charge on assets should be given the due consideration proceeds of assets of the company If a lender has a floating charge on the assets his debt should be repaid first form the sale Incase of fixed charge over a specific asset preferential payments apples only in respect of proceeds of that asset. 2) Evaluate the reconstruction scheme Consider the inflows & outflows of the scheme. Make a reconstruction account & credit debit all amounts written off should ideally become Zero). 3) Prepare a post scheme P/L account after deducting revised interest cost , tax & determine the shares of the stakeholders in it as a percentage of their current investments. 4) Prepare a post scheme balance sheet to see if the assets are sufficient to pay off the debts. 6.8 Divestments Demerger Sell off (It

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FINANCIAL MANAGEMENT - SYNOPSIS

Spin offs (a new company is created whose share are owned by the shareholders of the original company) MBO (Management Buy Out) MBI (Management Buy In) Take Over by outside employees

All the above are a way to restructure a company. It may be done to dismantle a corporate enterprise in order to focus upon a core component, to react to a change in the strategic focus of the company or to sell off unwanted assets. They may result in reverse synergy where the separate components of the business are worth more than the sum of the combined entity. A. De merger /Sell off / Spin Off Calculate value of the components using DCF techniques. Compare the post merger values of components with the current market value of original company before merger to calculate the benefits of reverse synergy. B. Management Buy Out / In Calculate value of the company Funding of the buy out / in may be made through the following o Personal funds secured by new directors to show personal commitment o Specialist venture capital organizations o Mezzanine Financing o Deferred payments o Bank Loans

Interest Rate Exposure

8.1 Yield Curve: Represents term structure if interest rates

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X axis: Period of loan Y axis: Interest rate Normal upward sloping yield curve: Downward sloping yield curve: Short

Long tern loan yields higher interest than term rates are higher than long term short term loans because of greater risk & rates. This occurs when n interest rates because funds are locked up for longer time are expected to fall. Since borrowers period would not want to get locked in long term expensive debts. Demand for short term debts will increase & therefore interest rate will fall.

8.2

Interest Rate Gap 1. Negative Gap: Interest sensitive liabilities > interest sensitive assets Company will loose if interest rates fall by maturity 2. Positive Gap: Interest sensitive assets > interest sensitive liabilities Company will gain loose if interest rates fall by maturity

8.3

Hedging strategies 1. Forward rate agreement 2. Interest rate future 3. Interest rate options or guarantees(including interest rate gap) 4. Interest rate SWAP

8.4

Interest Rate Future

Futures are priced as 92.5% or 9250 means interest rate 7.5% Page 38 of 50

FINANCIAL MANAGEMENT - SYNOPSIS

1. What contract Assuming in Jan 1 a loan is due for rollover in 3 months for a further period of 3 months for a further period of six months, 3 month interest rate future are available expiring on March, June & September March Contract is relevant. 2. What type Interest rate expected to risesell future buysell future 3. How many contracts Even though the choice of expiry date would depend on rollover date, period to be hedged shall be loan period & not the rollover period. Exposure x Loan period period of standard contract

Standard Contract value 4. Calculate tick size

For 3 month contract/ i.e. standard contract period of 3 month 0.01/100 x 3/12 x standard contract size. 5. Calculate closing future price 6. Hedge Efficiency : Profit in spot/future Loss in spot/future 7. Optimal Hedge Ratio: Future Exposure Underlying exposure

(SD of change in price of underlying instrument (SD of change in price of future contract

: Correlation coefficient between changes in price of underlying instrument & future contract 8.5 Interest Rate Options

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1. Choose contract date: The contract should expire after rollover date so that it may be closed out or exercised. 2. Type of contract 2.3.1. Borrowing is to be hedged against rising interest rate Buy put options. 2.3.2. Lending is to be hedged falling against rising interest rate Buy call options. 3. 4. Strike price Number of contracts Exposure x Loan period period of standard contract

Standard Contract value 6. Closing of Contracts 6.3 6.4

5. Tick size (same as in interest rate futures) If contract expires after rollover date they may be sold / exercised (Only in American style option) / sold in future wallet If contract expires on rollover date they may be allowed to lapse or exercised & sold at spot to realize gain Gain in 6.3 > 6.4 because time value will be reflected in option price 8.6 Interest Rate Collar

A collar effectively fixes a cap / floor on interest rate 1. Borrowing is to be hedged against rising interest rate Buy put option Sell call option

Reduce the premium 2. Lending is to be hedged against falling interest rate 8.7 Buy call option Sell put option Interest Rate SWAP 1. Preferences must be different

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2. With preference cost must be higher 3. Borrow opposite to needs 4. Bank arrangement fees is added 5. Divide benefits Example Actual Borrowing Opposite to preference SWAP Swapster to German Client German client to Swapster SWAP arrangement fee Net cost desired after SWAP If KIBOR is 5% then Company A will receive: 5% -8.625% = -3.625% Company B will pay: 3.625% Swapster to German Client German client to Swapster Swapster German 5% (5%) (8.625%) 8.625% (3.625%) 3.625% If asked the net position; after incorporating the actual variable debt rate, then the company for whom the bottom lines results in negative will receive and vice versa Swapster FR: 9% LIBOR (8.625%) 0.15% LIBOR +0.525% German VR: LIBOR + 1.5% (LIBOR) 8.625% 0.15% 10.275%

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FINANCIAL MANAGEMENT - SYNOPSIS Costs of Financing

9.1. 9.2. 9.3. 9.4 Under Hedging Approach Under Conservative Approach Under Trade Off Effective Cost Cost of permanent financing + Cost of seasonal financing Cost of maximum financing for long term Cost of short term financing + Cost of long term financing Mark Up Rate 100-profit free compensating balance

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FINANCIAL MANAGEMENT - SYNOPSIS Net Open Position

Per currency and the overall position limit has been fixed at ten percent of the capital base in Pakistan of each authorized dealer. The open position is firstly measured separately for each foreign currency in which the bank is performing transactions or has assets of liabilities. The open position in a single currency is the sum of: (a) The spot position and (b) The off-balance sheet position The following steps should be followed when computing the Foreign Exchange Exposure: 1 1. The net position in each currency is calculated by adding together the net spot position and net-off balance sheet position for each currency separately. For example, a spot deposit liability (Foreign Currency Account) matched by an SBP contract (an off-balance sheet asset) would translate to a zero net open foreign exchange position. 2 2. Once the exposure has been determined in each individual currency, the second step is to measure the banks overall exposure to foreign exchange risk. (using the absolute values for each currency whether it be overbought sales> purchase, or over sold purchase > sales) Conversion of the net open position in each currency into the equivalent amount of domestic currency is done by using spot exchange rates. The forward transactions will be revalued at relevant forward rates instead of spot rates. This means that the banks will have to revalue on daily basis each individual outstanding forward transaction by taking the forward rate for the remaining tenor of the contract.

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FINANCIAL MANAGEMENT - SYNOPSIS Forex

Direct Quote Rs / FCY The amount of domestic currency Selling Rate > Used in which is equal to one unit of foreign Buying Rate Pakistan currency FCY / Rs The amount of foreign currency which Buying Rate > Used in UK is equal to one unit of foreign Selling Rate currency.

Indirect Quote

Spread / Margin 60 Offer / selling Rate 11.2 Types of Exposure to Currency Risk flows 2. Transaction Exposure: Extent to which a given exchange rate movement will effect the local currency 3. Translation /Accounting Exposure: Possibility that book value of shareholders funds may change as a result of change in exchange rates 11.3 Relative Purchasing Power Parity (PPP) 58 Buying / Bid Rate

1. Economic / Operating Exposure: Total FCY exposure, it relates to future cash

Sf 1 + inflation rate (Foreign) = So 1 + inflation rate (Domestic) Where; Sf: Spot Exchange Rate at the start of the period (in FC per unit of DC) So: Spot Exchange Rate at the end of the period (in FC per unit of DC) expected spot rate at the end of the period Note: The above formula may be used when the exchange rates are quoted as FC/DC (indirect quote). When direct quotes are provided use Domestic currency will be placed in the numerator and FC will be placed in the denominator.

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Please note that the inflation rates and the exchange rates must be of the same periods e.g. 3month spot rate: 3 month inflation rate. 11.4 International Fisher Relation (IFR)

(1 + nominal interest rate) = (1 + real interest rate) (1 + inflation rate) 1 + nominal interest rate (Foreign) 1 + nominal interest rate (Domestic) = 1 + inflation rate (Foreign) 1 + inflation rate (Domestic)

Please note that the inflation rates and the exchange rates must be of the same periods e.g. 3month spot rate: 3 month inflation rate. 11.5 Uncovered Interest Rate Parity

Sf 1 + nominal interest rate (Foreign) = So 1 + nominal interest rate (Domestic) Where; Sf: Spot Exchange Rate at the start of the period (in FC per unit of DC) So: Spot Exchange Rate at the end of the period (in FC per unit of DC) expected spot rate at the end of the period Note: The above formula may be used when the exchange rates are quoted as FC/DC (indirect quote). When direct quotes are provided use Domestic currency will be placed in the numerator and FC will be placed in the denominator. Please note that the inflation rates and the exchange rates must be of the same periods e.g. 3month spot rate: 3 month inflation rate. 11.6 Covered Interest Rate Parity

F 1 + nominal interest rate (Foreign) = So 1 + nominal interest rate (Domestic) Where; Sf: Spot Exchange Rate at the start of the period (in FC per unit of DC) So: Spot Exchange Rate at the end of the period (in FC per unit of DC) expected spot rate at the end of the period Please note that the inflation rates and the exchange rates must be of the same periods e.g. 3month spot rate: 3 month inflation rate. 11.8 Hedging Strategies

1. Invoice in home currency Page 45 of 50

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2. Matching of receipts & payments 3. Matching of long term assets an d liabilities 4. Leads & logs (Lead payments: Making Payments in advance) (Lag payments: Delaying payments beyond their due dates) 5. Netting (Netting is the process in which credit balances are set off against debit balances such that only the reduced net amounts are paid by actual currency flows) 6. Money Market hedge 7. Forwards 8. Futures 9. Options 10. Swaps 11.8 Money Market Hedge

We borrow & invest such FCY today that after the required time period
Principal + Mark up = Desired Amount

Future Receipt in Foreign Future Payment in Foreign Currency Currency Borrow FC such that Purchase & deposit FC such that Total expected receipt in future currency Total expected payment in future = Amount to be borrowed + interest on the currency = Amount to be deposited borrowed amount + interest on the deposited amount Covert the above into LC at spot Covert the above into LC at spot Invest in LC amount in a deposit till the Borrow in LC and convert it into receipt arrives FCY to make the above deposit Actual receipt in LC is the amount of LC Actual cost in LC is the amount of deposit + interest earned on it LC borrowed + interest paid on it Effective rate is Effective rate is LC converted at spot + Interest received LC borrowed at spot + Interest received FC receipt FC receipt The transaction rate (final) will always be the same as calculated through Purchase power / Interest Rate parity techniques

11.9

Forward Exchange Contract

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FINANCIAL MANAGEMENT - SYNOPSIS

Inflow : Sell FCY Banks Buying Rate Outflow: Buying FCY Banks Selling Rate Closure of Forward Contract Before Expiration By entering into offsetting position (opposite transaction) at the spot market By negotiation( Paying the price differential contract) of the forward At Expiration By entering opposite transaction at the spot market

A forward exchange contract is a) An immediately firm & binding contract b) For the purchase of a specified quantity of FCY c) At a specified rate (fixed at the time of contract) d) For performance at a future date 11.9 SWAPS

1. Make cash flows in both the currencies (including SWAP for part b) 2. Convert FCY at applicable rates (may have to use Interest / Inflation Rate Parity techniques) 3. Discount & compare the NPVs 11.10 Foreign Currency Futures 1. Choose the contract, expiry date of the contract must be subsequent to the underlying exposure (in case multiple contracts are available choose the most nearer one) 2. Choose contract type (buy / sell) US company expects receipts in Sell future US company expects to make payment in Buy future

3. Calculate Number of contracts (always round up) Amount to be hedged Page 47 of 50

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Standard Size 4. Estimate closing future price (Using Basis) Basis may remain the same or decline evenly over time future price 5. Hedge Efficiency: Profit in Spot / future Loss in Spot / future Note: Futures are always closed by opposite transaction in the future market (for the same date that is why Basis understanding / computation is necessary 6. Do not forget initial margin Notes on Futures: 1. Future market is a market for purchase & sale of items in market in future via contracts with standard quantity & standard maturity dates. 2. The price of a future contract fluctuates in line with the price in the spot market. 3. Future contract can be closed out at any time before the maturity dates, x number of future contact can be closed by selling x number of future contracts. 4. Future contracts may or may not result in a perfect hedge because of the following two reasons The standard quantity available via a future contract may not exactly match the required quantity in spot market. The movement in spot price may not equate the movement in future price. This is referred to as BASIS RISK On the settlement date Spot price always equates

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11.11

Futures Standard quantity Traded on exchange Time maturity May be closed out at any time before maturity on exchange Requires initial deposit Does not give a perfect hedge Premium & Discount

Forwards Tailor made quantity Party specific Time specific Close out with specific party on specific date No initial deposit Gives a perfect hedge

Direct Quote Spot xx Premium xx Future / Forward xx Spot Discount Future / Forward

Direct Quote Spot xx Premium (xx) Future / Forward xx xx xx xx

xx Spot (xx) Discount xx Future / Forward

Direct Quote Premium is added Discount is reduced Indirect Quote Premium is reduced Discount is added 11.12 Foreign Currency Options 1. Choose the contract date 2. Choose contract type (Putsell, Call buy) 3. Calculate Number of contracts (always round up)
Amount to be hedged Standard size

4. Premium (Payable in advance or on close out Incase payment is to be made upfront we must consider financing cost) Notes Premium is sunk cost hence it is irrelevant for decision making purposes When you have an option (and not an obligation) to buy you are the holder of a call option When you have an option (and not an obligation) to sell you are the holder of a put option Page 49 of 50

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In the money option When an option is feasible Out the money When exercising an option is not feasible

Call Option In the money Exercise Price < Spot Price Out the Money Exercise Price > Spot Price Put Option In the money Exercise Price > Spot Price Out the Money Exercise Price < Spot Price

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