AFM Notes by - Taha Popatia PDF
AFM Notes by - Taha Popatia PDF
AFM Notes by - Taha Popatia PDF
MANAGEMENT
NOTES
BY
TAHA POPATIA
Volume # 1
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Sequence of compiled notes
1. Roles and responsibilities of senior financial manager
2. Net Present Value
3. Internal rate of return
4. Real rate and Nominal rate
5. Modified Internal Rate of Return
6. Capital Rationing
7. Capital Investment monitoring system
8. Free cash flows
9. Acquisitions and mergers versus other growth strategies
10. Criteria for choosing an appropriate target for acquisition
11. Different types of Synergies with respect to mergers and acquisitions
12. Different forms of consideration to acquire a target company
13. Defences against a hostile takeover bids
14. Explanations for the high failure rate of acquisitions in enhancing shareholder value
15. Factors to consider when determining which source or sources of finance are chosen to finance
a possible cash bid
16. IPO and a reverse takeover
17. Keypoints from takeover directives
18. Management buy-out and Management buy-in
19. Maximum Consideration and Maximum Premium
20. Portfolio restructuring and organisational restructuring
21. Reverse takeover
22. Introduction to dividend policy
23. Competitive advantages a company may gain over its competitors (who only invest in domestic
projects) for investing in overseas projects
24. Market price system of transfer pricing
25. Forecasting Exchange rates
26. Criteria for credit rating
27. Impact of the fall in credit rating
28. Beta asset and Beta equity
29. Business risk and financial risk
30. Existing wacc and the risk adjusted wacc
31. Adjusted present value
32. Mezzanine facility
33. Macaulay's duration
34. Modified duration
35. Advantages and drawbacks of exchange traded option contracts compared with over-the-
counter options
36. Advantages and drawbacks of using currency swaps
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Sequence of compiled notes
37. Advantages of multilateral netting by a central treasury function
38. Benefits of centralised and decentralised treasury departments
39. Estimating the futures price at any specific date
40. Foreign exchange risk management - currency futures
41. Forward contracts compared with over-the-counter option - foreign currency
42. Interest rate swap
43. Lock in rates
44. Mark-to-market and margins for future
45. Staff in treasury department
46. Ticks
47. Why exchange traded derivatives may be used rather than over the counter derivatives to hedge
foreign currency risk
48. Project Value at Risk
49. Islamic Finance
50. Behavioural finance
51. Dark pool trading systems
52. International Monetary fund
53. Greeks
54. Types of real options
55. Why to incorporate real options value into net present value
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Roles and Responsibilities of senior financial manager BY TAHA POPATIA
The principal role is the maximisation of shareholders wealth.
Shareholders wealth can be maximised by 1. Increasing the value of the company 2. Providing
cash flow to shareholders via dividend.
In order to achieve the above objective a financial manager must take three types of decisions:
o Investment decisions: Identifying the best investment opportunities.
o Financing decisions: Deciding how to finance them.
o Dividend decision: Deciding how much dividend shall be paid.
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Net Present Value- AFM BY TAHA POPATIA
Net Present Value = Present Value of Cash Inflows – Present Value of Cash Outflows
Involves discounting the relevant cash flows for each year of the project using an appropriate
cost of capital
If the Net Present Value is positive, organisation may undertake the project
If the Net Present Value is negative, organisation may not undertake the project
The technique takes account of the time value of money
In case of real cash flows (In today’s prices), use the real rate
In case of money cash flows (Includes inflation), use the nominal rate
In questions involving specific inflation rates, nominal rate method is usually more reliables
It assumes that cash flows can be reinvested at the IRR over the life of the project. In contrast,
the NPV method assumes that cash flows can be reinvested at the cost of capital over the life of
the project
Method # 2
Example
Method # 1
Method # 2
Benefits
To Company
Free cash (WACC)
flows To Equity
(Ke)
Free cash flow to company / firm
When all free cash flows are discounted at WACC, we get total value of the company under consideration
Value of
the Value of Value of
company / the debts equity
firm
Free cash flows basic format (cash flows before transaction with owners)
Method # 1
Free cash flow to equity holders ( when discounted with cost of equity to present value = value of equity)
Revenue synergy
They are increases in total sales revenue following a merger or acquisition, by increasing
total combined market share.
It may arise in circumstances where the enlarged company is able to promote its brand
more effectively or when the company is able to bid for large contracts, such as to supply
goods to government, which the two smaller companies were previously unable to do so
due to their small size.
Cost synergy
They are reductions in total costs following a merger or acquisition.
Prime reason is economies of scale.
Also, duplicate departments may be dissolved. As one department is now able to fulfil
the needs for entire company.
Financial synergy
They are reductions in expenses such as finance cost.
Larger company may be able to borrow funds at a lower rate as it may be seen as a lower
credit risk company.
It may also arise when a firm with significant excess cash acquires a firm with great
projects but insufficient capital. The combination may create value.
Combined company may be able to enjoy the tax benefit which was previously not
possible with individual companies.
Cash
Share exchange
New shares are issued by the acquirer and exchanged with the shares in the target company.
Acquirer does not have to raise cash.
Target company shareholders become shareholders in the new company as well.
Overall share capital increases.
Gearing level decreases
There are a number of defensive measures that the management may take to fight a takeover bid.
Although there are various sources of finance such as rights issue, bank loan, mezzanine finance
or convertible loan notes there is no guarantee that they will necessarily be available.
The success of rights issue will depend on the willingness and ability of the director-shareholders
to subscribe.
Obtaining bank loan or mezzanine finance may be difficult if a company is highly geared.
Convertible debt issue may depend on the terms and how possible subscribers view the future
prospects of the company.
COST
DIRECTORS PREFERENCE
The choice will also be determined by board’s attitude to gearing, the board may feel that it has
reached, or exceeded, the gearing level which it would regard as desirable. If this is the case, the
board would have to use equity finance.
CONTROL
Implications of the different sources of finance for control of the company may also be
considered.
An issue of shares arising from the convertible debt would change the balance of shareholdings,
so the directors would have to decide how significant this would be.
Mezzanine finance may also offer conversion rights, but possibly under certain circumstances.
Bank loan will have no impact on share capital, but the bank may impose certain restrictions,
including restriction on the sale of assets, limitations of dividends, or requiring accounting
figures, liquidity and solvency ratios, not to go beyond certain levels.
MIX OF FINANCE
Conventional way to obtain listing where a company issues and offers shares to the public.
The company will have to follow the normal procedures and processes required by the stock
exchange regarding a new issue of shares and will comply with the regulatory requirements.
An IPO can cost between 3% to 5% of the capital being raised because it involves investment
banks, lawyers, and other experts.
A marketing campaign and issuing of prospectus are also needed to make the offering attractive
and ensure shares to the public do get sold.
The IPO process can typically take one or two years to complete due to hiring the experts, the
marketing process and the need to obtain a value for the shares.
Regulatory process and procedures of the stock exchange need to be complied with.
There is no guarantee that an IPO will be successful.
It times of uncertainty, economic downturn or recession, it may not attract the attention of
investors and a listing may not be obtained.
Due to the marketing effort involved with an IPO launch, it will probably have an investor
following, which a reverse takeover would not.
REVERSE TAKEOVER
Enables a company to obtain listing without going through the IPO process.
An active private company takes control and merges with a dormant public company. These
dormant public companies are called "shell corporations" because they rarely have assets or net
worth aside from the fact that they previously had gone through an IPO process.
Reverse takeover is cheaper, takes less time and ensures that a company will obtain listing on a
stock exchange.
The shell company may have potential liabilities which are not transparent at the outset, such as
potential litigation action.
A full due diligence of the listed company should be conducted before the reverse takeover
process is started.
Squeeze-out rights
This condition allows the bidder to force minority shareholders to sell their stake, at a fair price,
once the bidder has acquired a specified percentage of the target company’s equity.
The percentage varies from country to country.
The main purpose of this condition is to enable the acquirer to gain 100% stake of the target
company and prevent problems arising from minority shareholders at a later date.
It allows remaining shareholders to exit the company at a fair price once the bidder has
accumulated a certain number of shares.
The amount of shares accumulated before the rule applies varies between countries.
The bidder must offer the shares at the highest share price, as a minimum, which had been paid
by the bidder previously.
The main purpose for this condition is to ensure that the acquirer does not exploit their position
of power at the expense of minority shareholders.
Therefore,
Synergy created due to acquisition : Market value of new company – pre acquisition values of
target and acquirer = $900 – ($500 + $300) = $100 million.
Synergy represents the maximum benefit from the acquisition.
Maximum consideration
The maximum consideration that the acquiring company will be willing to pay to target company
shareholders can be calculated with keeping in mind that the maximum the acquirer will be
willing to pay will be the amount that does not make acquirer worse off than the position it had
before acquisition.
Above table demonstrates that the maximum to be paid should be $400 million. Any excess
above this amount will lead to a loss in wealth and hence this is the maximum that the acquiring
company shareholders will be willing to pay.
If acquirer pays maximum consideration, all synergy relevant benefits are transferred to the
target company shareholders.
Maximum premium
Maximum premium = All synergy benefits = Market value of company after acquisition
transaction – (Pre-acquisition value of both companies before acquisition transaction).
Maximum premium = Maximum consideration – Market value of target pre-acquisition.
Involves the acquisition of companies, or disposals of assets, business units and/or subsidiary
companies through divestment, demergers, spin-offs, MBOs and MBIs.
ORGANISATIONAL RESTRUCTURING
Involves changing the way a company is organised. This may involve changing the structure of
divisions in a business, business processes and other changes such as corporate governance.
The aim of either type of restructuring is to increase the performance and value of the business.
COMPANIES THAT MAY PAY LOW DIVIDEND COMPANIES THAT MAY PAY HIGH DIVIDEND
Young companies Stable and mature companies
Growing companies Companies without any growth
Companies having profitable investment opportunity
opportunities Companies who cannot foresee any
Companies who want to minimise the profitable investment opportunities
amount of debt in capital structure Companies able and willing to acquire debt
finance to support its capital structure
Different dividend policies include:
o Stable
o Constant payout
o Zero dividend
o Residual approach to dividends
Practical influences on dividend policy:
o Legal
o Level of cash flows
o Availability of other sources of finance
States that spot rates between two currencies will change over time in relation to the rate of
inflation in the countries from which the currencies originate.
Example:
Question
Current spot exchange rate is 1.30 dollars = 1 pound
Expected inflation rates are:
Year US UK
1 3% 1%
2 2% 4%
3 1% 3%
Required:
Work out the expected spot rate for the next three years in accordance with purchasing power parity
theory
States that it is possible to predict future spot exchange rates from differences in interest rates
between the currencies.
Example:
Question
Current spot exchange rate is 1.30 dollars = 1 pound
Expected interest rates are:
Year US UK
1 3% 1%
2 2% 4%
3 1% 3%
Required:
Work out the expected spot rate for the next three years in accordance with interest rate parity
theory
Formula: Future spot rate = Spot x (1+interest rate in US)/(1+interest rate in UK)
Year Computation
1 1.30 x (1+3%)/(1+1%) = 1.3257
2 1.3257 x (1+3%)/(1+1%) = 1.3520
3 1.3520 x (1+3%)/((1+1%) = 1.37877
Country
No issuer’s debt will be rated higher than the country of origin of the issuer.
Rating will also depend on company’s standing relative to other companies in the country.
Industry
The strength of the industry within the country, measured by the impact of economic forces,
cyclical nature of the industry, demand factors, etc.
Company’s position within the industry compared with competitors will also be assessed.
Management evaluation
Financial
Beta equity
Refers to the company’s ability to generate sufficient revenue to cover its operational expenses.
Arises from the type of business an organisation is involved in and relates to uncertainty about
the future and the organisation’s business prospects.
Financial risk
Refers to the risks relating to the structure of finance the organisation has.
The higher the gearing the higher the risk.
It is the risk that equity shareholders will receive very less or no returns.
Company’s existing WACC can be used a discount rate if both, business risk and financial risk are
likely to stay the same.
If a company is evaluating a project with business risk which is different from the existing
business risk of the company. Company can calculate a risk adjusted weighted average cost of
capital to reflect the different business risk.
Also, if the financial risk of the new investment is different due to change in the capital
structure, the change can be incorporated by recalculating the WACC using the new capital
structure weightings. This may be suitable when the change is insignificant or the new project
can be treated as a separate business with its own long term gearing.
ADJUSTED PRESENT VALUE = BASE CASE NET PRESENT VALUE + FINANCING IMPACT
Introduction
This method separates the investment element of the decision from the financing element.
This method is recommended when there are complex funding arrangements such as subsidised
loan from government or for projects which will have different business risks and different
financial risks from the existing operations of the company.
Financing impact includes costs of raising new equity to finance the project, the costs of
obtaining debt finance, tax relief on the interest etc.
As all cash flows are low risk cash flows they are discounted using either cost of debt or the risk
free rate.
It is the weighted average length of time to the receipt of a bond’s benefits (coupon and
redemption value) the weights being the present value of the benefits involved.
Captures both the time value of money and the whole of the cash flows.
It is useful in allowing bonds of different maturities and coupon rates to be compared.
In order to calculate the duration of a bond, the present value of the annual cash flows and the
price or value at which the bond are trading at need to be determined.
Duration = Sum of PV of cash flows multiplied by respective years / market price of bond.
Example
Example
Duration, on the other hand, assumes that the relationship between changes in interest rates
and the resultant bond is linear. Therefore duration will predict a lower price that the actual
price and for large changes in interest rates this difference can be significant
Exchange traded options are readily available on the financial markets, their price and contract
details are transparent, and there is no need to negotiate these.
Greater transparency and tight regulations can make exchange traded options less risky.
For these reasons, exchange traded options’ transaction costs can be lower.
The option buyer can sell (close) the options before expiry.
American style options can be exercised any time before expiry and most traded options are
American style options, whereas over-the-counter options tend to be European style options.
Disadvantages
The maturity date and contract sizes for exchange traded options are fixed, whereas over-the-
counter options can be tailored to the needs of parties buying and selling the options.
Exchange traded options tend to be of shorter terms, so if longer term options are needed, then
they would probably need to be over-the-counter.
A wide range of products (for example, a greater choice of currencies) is normally available in
over-the-counter options markets.
Advantages
Ideal for companies investing abroad, because it will involve payment of interest in the currency
in which company will receive income abroad.
Company will be able to obtain swap for the amount it requires and may be able to reverse the
swap by exchanging with the other counterparty. Other methods of hedging risk may be less
certain.
The cost of a swap may also be cheaper than other methods of hedging, such as options.
Disadvantages
The counterparty may default. Although the risk of default can be reduced by obtaining a bank
guarantee for the counterparty.
They are better able to match and judge the funding required with the need for asset purchases
for investment purposes on a local level.
They may be able to respond quicker when opportunities arise and so could be more effective
and efficient.
Decentralised treasury departments may make the subsidiary companies’ senior management
and directors, more empowered and have greater autonomy. This in turn may increase their
level of motivation, as they are more in control of their own future, resulting in better decisions
being made.
Question
Answer
1. Calculate difference between 1st October 2020 spot rate and December futures on 1st October
2020 (1.30-1.25 = 0.05). This difference is called the basis.
2. On the last day of December, the December futures price and the spot price will be exact equal
and hence the basis will be zero.
3. In exam questions we assume that the basis falls linearly to zero over the life of the future.
4. Basis on 31st November 2020 can be calculated as 0.05/3 x 1 = 0.017. This is because 0.05 will
reduce to 0 over three months or 0.05/3 per month reduction.
5. We know spot on 31st November 2020, so we put that value.
6. December futures value on 31st November 2020 is calculated as difference between Spot on 31st
November 2020 and the basis (1.35-0.017).
Notes
Since spot rates have gone up between 1st October 2020 and 31st November 2020, the futures
price will go up as well.
In real life the basis may not reduce linearly over the life of future and we call it basis risk.
DISADVANTAGES
Subject to counterparty risk, the risk that the other party to the arrangement may default on the
arrangement. If it is arranged through a bank, the bank can provide a guarantee that the swap
will be honoured.
If a company swaps into a fixed rate commitment, it cannot then change to commitment. This
means it cannot take advantage of favourable interest rate changes as it could if it used options.
As swaps are over-the-counter instruments, they cannot be easily traded or allowed to lapse if
they are not needed or become no longer advantageous. It is possible that a bank may allow a
reswapping arrangement to reverse a swap which is not required, but this will incur further
costs.
Answer
This is a real life scenario because in real life we are not aware of spot rate and future price on
1st march 2020.
1st March 2020 1st May 2020 30 June 2020
Spot Rate 1.50 xx X
December futures 1.20 xx X
Basis 0.30 0.1 0
Although we are unaware of what future price and spot rates will be on 1st May 2020, but we do
know that the difference between these two will be 0.1, the unexpired basis and also, spot rate
will be higher than the futures price. Also, both the spot rate and the futures price will come
closer to each other as basis reach 0 on 30th June 2020, in case of June futures.
Method # 1: Current futures price +/- unexpired basis = 1.20 + 0.10 = $ 1.30 / Pound. We use +/-
sign since over here future prices are less than the spot rate on 1st March 2020 so they will
increase.
Method # 2: Spot rate +/- expired basis = 1.50 – 0.20 = $ 1.30 / Pound.
We can use this predicted rate to in our exam questions for conversion. Do note that this is
again a predicted rate and furthermore it includes the converted amount as well as gain/loss on
future transaction.
Experienced staff is needed to establish overall guidelines and policies for treasury activities.
They will also have greater knowledge of law, accounting standards, and tax regulations which
can help the business avoid penalties and perhaps structure its dealings so that it can, for
example, minimise the level of tax paid.
If a company is planning a major acquisition, the treasury function can provide advice on the
structure of consideration and financing implications.
Senior staffs are also needed to manage the work of less experienced staff to prevent or
mitigate the effect of mistakes which may be costly.
Inexperienced
May be able to arrange borrowing if the lender has already been chosen or, for example,
arrange forward rate agreements to be used if they are prescribed.
May lead to sub-optimal decision making if judgement is required.
Poor decisions may result in opportunity costs, for example, not using the lender who gives the
best deal or being committed to a fixed forward rate agreement when an option would have
allowed the business to take advantage of favourable rate movements.
Question
Answer
Gain on futures deal: Contracts x contract size x (sell rate – buy rate).
Gain on futures deal: 4 contracts x Pound 50,000 x ($1.25-$1.2280) = $ 4,400.
Gain in terms of pounds: 4,400/1.235 = Pound 3,563.
Net payment = Pounds 202,429 – Pound 3,563 = Pound 198,866.
In the above example we can also use ticks to calculate the gain on future transaction.
Since each tick is: 0.0001. $1.25 - $1.2280 = $0.022 movement in above future price represents
movement of 220 ticks.
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Ticks- AFM BY TAHA POPATIA
We can calculate tick value per contract as well: Pound 50,000 x 0.0001 = $5. Tick value of $5
shows that if future price goes up by 1 tick there will be a gain on each contract of $5.
Gain on future deal of $ 4,400 as calculated in above example can also be calculated as:
Contracts x ticks x tick value
4 x 220 x 5 = $4,400.
Where k is determined by the probability level, is the standard deviation and N is the periods
over which we want to calculate the VAR.
VAR is based on normal distribution theory.
Note: students are not required to go into details of how formula is derived and all concepts behind
normal distribution
Question # 1
Answer # 1
Using normal distribution theory 99% confidence level requires VAR to be within 2.33 standard
deviations from the mean, based on a single tail measure.
Answer # 2
Question # 3
Project A B
Net present value $2,054,000 $2,293,000
Value at risk (over the project’s life)
95% confidence level $1,103,500 $1,471,000
90% confidence level $860,000 $1,147,000
Compare the two projects
Answer # 3
Murabaha
Ijara
Leasing.
The bank makes available to the customer the use of assets for a fixed period and price.
The bank remains the owner of the asset and incurs the risk of ownership.
This means that the bank is responsible for the major maintenance of the asset.
Customer pays lease rentals.
Ownership is transferred to the customer at the end of the term either by way of a gift deed or
selling the asset for nominal amount.
Mudaraba
Equity finance.
There are two parties in mudaraba, the provider of capital is called rab-ul-mal while the
management and work is responsibility of the other who is called mudarib.
Profits are shared according to a pre-agreed contract whereas the losses are solely attributable
to the provider of capital.
Rab-ul-mal is not involved in management and execution of decisions.
Musharaka
Venture capital.
Both the parties contribute capital to the business and participate in managing the business.
Profits are shared according to a pre-agreed contract whereas losses are shared according to
capital contribution ratio.
Organisation = mudareb. Finance provide = rab-ul-maal.
Sukuk
Salam
Forward contract.
Prohibited for certain assets.
Commodity is sold today for future delivery.
Cash is received immediately (today) from the financial institution.
Delivery arrangements such as quantity, quality and time of delivery are decided immediately.
The sale is generally at a discount so that financial institution can earn profit.
The financial institution may sell the contract to another buyer for profit.
Salam arrangements are prohibited for gold, silver and other money-type assets.
Istisna
Phased payments.
These are used for long term construction projects.
Subject matter is raw material which has the characteristics of being transformed.
The bank finances the project with the client paying an initial deposit, followed by installments
during the course of construction.
At the completion of the project, the asset is delivered to the client.
It considers the impact of psychological factors on financial decision making and attempts to
explain how decision makers take financial decisions in real life, and why their decisions might
not appear to be rational every time and, hence, have unpredictable consequences.
It seeks to examine the following assumptions of rational decision making by investors and
financial managers:
o Financial decision makers seek to maximise their utility and do so by trying to maximise
portfolio or company value.
o They take financial decisions based on analysis of relevant information.
o They analysis of financial information that they undertake is rational, objective and risk-
neutral.
INVESTORS
Maximisation of utility
Rational decision making: Investors aim to maximise long-term wealth and hence utility.
Behavioural factors may influence investors to take decisions that are not the best ones for
achieving maximum value:
o Preferences for companies that investors consider are acting with social responsibility.
o Avoid “sin stocks” .
o Some investors hold on to shares with prices that have fallen over time and are unlikely
to recover. They may do this because it will cause them psychological hurt to admit, that
their decision to invest was wrong. This is known as cognitive dissonance.
FINANCIAL MANAGERS
Maximisation of utility
Managers may pay more for a target company than rational, having an unrealistic opinion as to
their skills.
Just as previously explained in respect of investors, there may be confirmation bias, paying
attention to information that suggests that an acquisition will enhance value and ignoring
evidence that indicates that the target will not be a good buy.
GAMMA
THETA
Theta is a measure of the sensitivity of the option price to the remaining time to expiry of the
option. It is the change in options price (specifically its time premium) over time.
Option premium has two components intrinsic value and time value. Theta deals with time
value.
Theta measures how much value is lost over time. Usually expressed as an amount lost per day.
The nearer the expiration date, the higher the theta and the farther away the expiration date,
the lower the theta.
RHO
VEGA
Vega measures the change in value of an option that results from a 1% change in the volatility of
the underlying item
Long term options have larger vegas than short term options. The longer the time period until
the option expires, the more uncertainty there is about the expiry price.