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ACCA APPROVED CONTENT PROVIDER
ACCA PasscardsPaper P4Advanced Financial Management
Passcards for exams up to June 2015
ACP4PC14.indd 1 30/05/2014 10:47
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Professional Paper P4Advanced Financial Management
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First edition 2007, Eighth edition June 2014ISBN 9781 4727 1132 8
e ISBN 9781 4727 1188 5
British Library Cataloguing-in-Publication DataA catalogue record for this book is available from the
British Library
Your learning materials, published by BPP LearningMedia Ltd, are printed on paper obtained from traceablesustainable sources.
Published byBPP Learning Media LtdBPP House, Aldine Place142-144 Uxbridge RoadLondon W12 8AA
www.bpp.com/learningmedia
Printed in the UK by RICOH UK Limited
Unit 2Wells PlaceMersthamRH1 3LG
All rights reserved. No part of this publication may bereproduced, stored in a retrieval system or transmitted, inany form or by any means, electronic, mechanical,photocopying, recording or otherwise, without the priorwritten permission of BPP Learning Media.
BPP Learning Media Ltd
2014
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Page iii
ContentsPreface
Welcome to BPP Learning Medias ACCA Passcards for Professional Paper P4 Advanced FinancialManagement. They focus on your exam and save you time. They incorporate diagrams to kickstart your memory. They follow the overall structure of BPP Learning Medias Study Texts, but BPP Learning Medias ACCA
Passcards are not just a condensed book. Each card has been separately designed for clear presentation.Topics are self contained and can be grasped visually.
ACCA Passcards are still just the right size for pockets, briefcases and bags.Run through the Passcards as often as you can during your final revision period. The day before the exam, tryto go through the Passcards again! You will then be well on your way to passing your exams.
Good luck!
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ContentsPreface
Page1 The role and responsibility of senior
financial executive 12 Financial strategy formulation 73a Conflicting stakeholder interests 173b Ethical issues in financial management 233c Environmental issues 254 Trading and planning in a multinational
environment 315 DCF 416 Application of option pricing theory in
investment decisions 477a Impact of financing and APV method 517b Valuation and free cash flows 658 International investment decisions 73
Page9 Acquisitions and mergers vs growth 8110 Valuation for acquisitions and mergers 8711 Regulatory framework and processes 9912 Financing mergers and acquisitions 1051314 Reconstruction and reorganisation 11115 The treasury function in multinationals 11916 Hedging forex risk 12317 Hedging interest rate risk 13518 Dividend policy in multinationals and
transfer pricing 14319 Recent developments 149
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1: The role and responsibilityof senior financial executive
Topic List
Financial management
Financial planning
Senior financial executives are required to make crucialdecisions, including those related to investment,distribution and retention.
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Financialmanagement
Financialplanning
Financial objectivesThe prime financial objective is to maximise the market value of the companys shares. Primary targets are profits and dividend growth. Other targetsmay be the level of gearing, profit retentions, operatingprofitability and shareholder value indicators.
Risk and incertainty Profit manipulation Sacrifice of future profits? Dividend policy
Why profit maximisation is not asufficient objecture
Non-financial objectivesNon-financial objectives do not negate financialobjectives, but they do mean that the primaryfinancial objectives may be modified. They takeaccount of ethical considerations.
Employee welfare Management welfare Societys welfare Service provision Responsibilities towards customers/suppliers
Examples
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1: The role and responsibility of senior financial executivePage 3
Investment decisions include: New projects Takeovers Mergers Sell-off/DivestmentThe financial manager must: Identify decisions Evaluate them Decide optimal fund allocation
Financial decisions include: Long-term capital structureNeed to determine source, costand risk of long-term finance. Short-term working capital
managementBalance between profitability andliquidity is crucial.
Dividend decisions may affectviews of the companys long-termprospects, and thus the sharesmarket values.Payment of dividends limits theamount of retained earningsavailable for re-investment.
Investment decisions
Financing decisions
Dividend decisions
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Financialplanning
Financialmanagement
The formulation, evaluation and selection ofstrategies to prepare a long-term plan of action toattain objectives. Strategic decisions should besuitable, feasible and acceptable.
Long-term direction Matching activities to environment/resources
Key elements of financial planning
Planning involves a long horizon, uncertainties andcontingency plans.
Consideration of which assets are essential andhow easily assets can be sold.
Long-term investment and short-term cash flow Surplus cash How finance raised Profitable
Strategic analysis means analysing theorganisation in its environment, its resources,competences, mission and objectives.
Strategic choice involves generating and evaluatingstrategic options and selecting strategy.
Strategic planning
Strategic cash flow management
Strategic fund management
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1: The role and responsibility of senior financial executivePage 5
Strategic
Tactical
InvestmentSelection of products/marketsTarget profitsPurchase of major non-currentassetsOther non-current assetpurchasesEfficient/effective resourceusagePricing
DividendGrowth v dividend payout
Scrip v cash dividends
FinancingDebt/equity mix
Lease v buy
Tactical planning and controlConflict may arise between strategic planning (needto invest in more expensive machinery, research anddevelopment) and tactical planning (cost control).
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Johnson and Scholes separate power groups into 'internal coalitions' and 'external stakeholder groups'.Stakeholder goals
Shareholders Providers of risk capital, aim to maximisewealth
Suppliers To be paid full amount by date agreed,and continue relationship (so may acceptlater payment)
Long-term lenders
To receive payments of interest andcapital by due date
Employees To maximise salaries and benefits; alsoprefer continuity in employment
Government Political objectives such as sustainedeconomic growth and high employment
Management Maximising their own rewards
Financialplanning
Financialmanagement
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2: Financial strategy formulation
Topic List
Assessing corporate performance
Financial strategy
Arbitrage
Risk and risk management
Formulating the correct financial strategy is crucial forbusiness success. The four main areas of financialstrategy are capital structure policy, dividend policy, riskmanagement and capital investment monitoring.
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Financialstrategy
Risk and riskmanagement
ArbitrageAssessing corporateperformance
Debt and gearing Debt ratio (Total debts: Assets) Gearing (Proportion of debt in long-term capital) Interest cover Cash flow ratio (Cash inflow: Total debts)
Liquidity ratios Current ratio Inventory turnover Receivables days
Acid test ratio Payables days Return on capital employed
Profit margin Asset turnover
Profitability and return
Dividend yield Interest yield Earnings per share Dividend cover Price/earnings ratio
Stock market ratios
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2: Financial strategy formulationPage 9
Comparisons with companiesin different industries
Investors aiming for diversifiedportfolios need to know differences between industrial sectors.
Sales growth Profit growth ROCE P/E ratios Dividend yields
Comparisons with other companies in same industry
These can put improvements onprevious years into perspective ifother companies are doing better,and provide further evidence ofeffect of general trends.
Growth rates Retained profits Non-current asset levels
Comparisons with previous years
% growth in profit % growth in revenue Changes in gearing ratio Changes in current/quick ratios Changes in inventory/
receivables turnover Changes in EPS, market price,
dividendRemember however Inflation can make figures
misleading Results in rest of
industry/environment, or economic changes
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Financialstrategy
Risk and riskmanagement
ArbitrageAssessing corporateperformance
Economic Value Added (EVATM)EVATM = NOPAT (cost of capital capital employed)
Add: Cumulative goodwill written off Cumulative depreciation written off NBV of intangibles Provisions
Adjustments to capital employed
Add: Interest on debt Goodwill written off Accounting depreciation Increases in provisions Net capitalised intangibles
Adjustments to NOPAT
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2: Financial strategy formulationPage 11
Shares Ownership stake Equity (full voting rights) Preference (prior right to dividends) All companies can use rights issues Listed companies can use offer for sale/placing
Debt/Bonds Fixed or floating rate Zero coupon (no interest) Convertible Bank loans Security over property may be required
When comparing different sources of finance, forexample different categories of debt, the followingfactors will generally be important:
Cost Flexibility Commitments Uses Speed/availability Certainty of raising amounts Time period available
Comparison of finance sources
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Financialstrategy
Risk and riskmanagement
ArbitrageAssessing corporateperformance
Costs Income to investors Tax Effect on control
Practicalities in issuing new shares Theoretical valuation models, eg Capital Asset
Pricing Model (CAPM) or Arbitrage PricingTheory (APT)
Bond-yield-plus-premium approach: adds ajudgmental risk premium to the interest rate onthe firms own long-term debt
Market-implied estimates using discounted cashflow (DCF) approach (based on an assumptionon the growth rate of earnings of the company)
Estimating cost of equity
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Financialstrategy
Risk and riskmanagement
ArbitrageAssessing corporateperformance
2: Financial strategy formulation
Pecking order Retained earnings Debt Equity
Whether lenders are prepared to lend (security) Availability of stock market funds Future trends Restrictions in loan agreements Maturity of current debt
Feasibility of capital structure
Risk attitudes Loss of control by directors Excessive costs Too heavy commitments
Acceptability of capital structure
Company financial position/ stability of earnings Need for a number of sources Time period of assets matched with funds Change in risk-return Cost and flexibility Tax relief Minimisation of cost of capital
Suitability of capital structure
Page 13
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Financialstrategy
Risk and riskmanagement
ArbitrageAssessing corporateperformance
Dividend policyDividend decisions determine the amount of, andthe way in which, a companys profits are distributedto its shareholders.
Cash Shares (stock) Share repurchases
Ways of paying dividends
Residual theory Target payout ratio Dividends as signals Taxes Agency theory
Theories of why dividends are paid
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ArbitrageFinancialstrategy
Risk and riskmanagement
Assessing corporateperformance
2: Financial strategy formulationPage 15
CAPM exam formula Arbitrage pricing theoryThe theory assumes that the return on each securityis based on a number of independent factors.
E (rj) is expected return on security
B1 is sensitivity to changes in Factor 1
F1 is difference between Factor 1 actual andexpected valuese is a random term
Factor analysisAnalysis used to determine factors to which securityreturns are sensitive. Research indicates: Unanticipated inflation Changes in industrial production levels Changes in risk premiums on bonds Unanticipated changes in interest rate term
structure
r = E(rj) + B1F1 + B2F2 ... + e
E(ri) = Rf + i(E(rm) Rf)
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Risk and riskmanagement
Financialstrategy
ArbitrageAssessing corporateperformance
Overriding reason for managing risk is to maximiseshareholder value.
Systematic and unsystematic Business Financial Political Economic Fiscal Regulatory Operational Reputational
Types of risk Risk management
The process of minimising the likelihood of a riskoccurring or the impact of that risk if it does occur.
Risk mitigation
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3a: Conflicting stakeholder interests
Topic List
Stakeholders
Corporate governance
Governance of a modern corporation can give rise toconflicts between the various stakeholders of the firm.
Be prepared to answer questions on key concepts suchas agency theory or goal congruence, or developmentsin corporate governance.
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Corporategovernance
Stakeholders
Separation of ownership and management: ordinary(equity) shareholders are owners of the company, butthe company is managed by its board of directors.
Central source of stakeholder conflict: differencebetween the interests of managers and those of owners.
Transaction costs economicsThe transaction costs economics theorypostulates that the governance structure of acorporation is determined by transaction costs.
Short-termism Sales objective (instead of shareholder value) Overpriced acquisitions Resistance to takeovers Relationships with stakeholders may be difficult
Sources of stakeholder conflictThe transactions costs include search andinformation costs, bargaining costs and policingand enforcement costs.
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Corporategovernance
Stakeholders
3a: Conflicting stakeholder interestsPage 19
Agency theory Goal congruenceProposes that, whilst individual team members actin their own self-interest, individual well-beingdepends on the well-being of other individuals andon the performance of the team.
Is accordance between the objectives of agentsacting within an organisation and the objectives ofthe organisation as a whole.
Corporations are set of contracts between principals(suppliers of finance) and agents (management).
The agency problem
Management incentives may enhance congruence:
Profit-related pay Rights to subscribe at reduced price Executive share-option plans
BUT management may adopt creative accounting.Sound corporate governance is another approach.
If managers dont have significant shareholdings,what stops them under-performing and over-rewarding themselves?
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Corporategovernance
Stakeholders
UK Corporate Governance Code
Executive directors
Limits on service contracts,emoluments decided byremuneration committeeand fully disclosed
DIRECTORS responsible forcorporate governance
AUDITORS provide external assurance
OTHER USERS(employees, creditors)
FINANCIAL REPORTINGSYSTEM links SHAREHOLDERS
Meet regularly Matters refer to board Division of responsibilities Committees audit, nomination,
remuneration
Board of directors
Majority independent No business/financial links Dont participate in options Appointed for specified term
Non executive directors
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3a: Conflicting stakeholder interestsPage 21
The Higgs Report stresses the importance of the board including a balance of executive and non-executivedirectors such that no individual or small group can dominate decision-making. The report also lays down criteria for establishing the independence of non-executive directors, and stresses the need to separate theroles of Chairman and Chief Executive.
Audit committee of non-executive directors Consider need for internal audit function Accounts contain corporate governance statement Directors review and report on internal controls
Accountability and audit
20 working days notice Separate resolutions on separate issues All committees answer questions
Annual general meeting
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Corporategovernance
Stakeholders
Stock market is less open, morelinks with banks than in UK.Policy boards (long-term)Functional boards (executive)Monocratic boards (symbolic)
In Germany, banks have longer-term role, may have equity stake.Separate supervisory board hasworkers and shareholdersrepresentatives.
The US system is based oncontrol by legislation, regulation,more rules on directors dutiesthan in UK. Major creditors areoften on boards.
USA
Management culture
By means of Stock Exchangeregulation, stringent reportingrequirements, tightened bySarbanes-Oxley.
JapanFlexible approach to governance,low level of regulation. Allstakeholders collaborate.
EuropeBy means of tax law. Also two-tierboard system to protect shareholderinterests.
Management culture comprises views on management and methods of doing business. Multinationals may haveparticular problems imposing the parent companys culture overseas eg American practices in Europe.
International comparisons
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Ethics have become increasingly important in formulatingfinancial strategies. Financial managers must rememberto build ethical considerations into the decision-makingprocess.
3b: Ethical issues in financial management
Topic List
Ethical aspects
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Ethical aspects
Businessethics
Marketing
Market behaviour Dominant position, treatment ofsuppliers and customers
Social and cultural impact
Product development Animal testing, sensitivity toculture of different countriesand markets
Human resourcemanagement Minimum wage, discrimination
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3c: Environmental issues
Topic List
Business practice
Regulation
You could be asked to discuss how the financial managerneeds to take into account environmental issues whenformulating corporate policy.
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RegulationBusinesspractice
Green issues and business practice
Sustainabilityrefers to the concept of balancing growth withenvironmental, social and economic concerns.
Companys environmental policy may include reduction/management of risk to thebusiness, motivating staff and enhancement ofcorporate reputation.
Environmental reportingMany companies produce an external report for externalstakeholders, covering: How business activity impacts on environment An environmental objective (eg use of 100%
recyclable materials within x years) The company's approach to achieving and
monitoring these objectives An assessment of its success towards achieving
the objectives An independent verification of claims made
Direct environmental impacts on business eg: Changes affecting costs or resource
availability Impact on demand Effect on power balances between competitors
in a marketIndirect environmental impacts: eg, legislativechange; pressure from customers or staff as aconsequence of concern over environmentalproblems.
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3c: Environmental issuesPage 27
Economic
Environmental Social
Triple bottom line reporting: a quantitativesummary of a companys economic,environmental and social performance over theprevious year.
Triple bottom line proxy indicators Economic impact Gross operating surplus Dependence on imports Stimulus to domestic economy by purchasing
locally produced goods and servicesSocial impact Organisations tax contribution EmploymentEnvironmental impact Ecological footprint Emissions to soil, water and air Water and energy use
Triple bottom line decision making
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RegulationBusinesspractice
Financialcapital
Manufacturedcapital
Intellectualcapital
Humancapital
Social andrelationship
capital
Naturalcapital
Integrated reporting
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3: Environmental issuesPage 29
Principles of integrated reportingIntegrated reports should be based on a number ofprinciples:
Strategic focus and future orientation Connectivity of information Stakeholder responsiveness Materiality Conciseness Reliability and completeness Consistency and comparability
Integrated thinking involves consideration of the interrelationships between operating and financialunits and the capitals the business uses.
Organisational overview and external environment Governance structure and value creation Business model Opportunities and risks Strategy and resource allocation Performance achievement of strategic objectives
and impact on capitals Basis of preparation and presentation
Contents of integrated report
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RegulationBusinesspractice
Carbon trading
UNFCCC
allows companies which emit less than their allowance tosell the right to emit CO2 to another company.
obliged signatories to reduce total greenhouse gas emissionsby 2012, compared to 1990 levels. EU15 reduction target: 8%.
1997 Kyoto Protocol to the UNFCCC
Mission: to protect or enhance environment,so as to promote the objective of achievingsustainable development.
Environment Agency
is an audit that seeks to assess theenvironmental impact of a company's policies.
Environmental audit
The auditor will check whether the companysenvironmental policy: Satisfies key stakeholder criteria Meets legal requirements Complies with British Standards or other
local regulations
United Nations Framework Convention on Climate Changeagreements: To develop programs to slow climate change To share technology and cooperate to reduce greenhouse
gas emissions To develop a greenhouse gas inventory listing national
sources and sinks
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4: Trading and planning in a multinational environment
Topic List
Trade
Institutions
International financial markets
Global financial stability
Multinationals strategy
Risk
The growth of international trade brings benefits andrisks for the corporation. The globalisation of internationalmarkets facilitates the flow of funds to emerging marketsbut may create instability.
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
International tradeWorld output of goods and services is increased ifcountries specialise in the production ofgoods/services in which they have a comparativeadvantage and trade to obtain other goods andservices.
Comparative advantage Countries specialising in what they produce, evenif they are less efficient (in absolute terms) inproduction of all types of good, is the comparativeadvantage justification of free trade, withoutprotectionism or trade barriers.
Product differentiation barriers Absolute cost barriers Economy of scale barriers The level of fixed costs Legal/patent barriers
Barriers to market entry
Tariffs or customs duties Import quotas Embargoes Hidden subsidies Import restrictions Restrictive bureaucratic procedures Currency devaluations
Protectionist measures
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4: Trading and planning in a multinational environmentPage 33
European UnionThe EU combines a free trade area with a customs union (mobility of factors of production).
Mutually beneficial trade may be reduced There may be retaliation Economic growth prospects may be damaged Political ill-will may be created
Whats wrong with trade protection
To combat imports of cheap goods To counter dumping Infant industries might need special treatment Declining industries might need special
treatment Protection might reduce a trade deficit
Why protect trade?
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
World Trade Organisation andInternational Monetary Fund
Reduce existing barriers to free trade Eliminate discrimination in
international trade (in eg tariffs andsubsidies)
Prevent growth of protection bygetting member countries to consultwith others first
Act as a forum for assisting free trade,and offering a disputes settlementprocess
Establish rules and guidelines tomake world trade more predictable
WTO aims
Promote international monetary co-operation, andestablish code of conduct for international payments
Provide financial support to countries with temporarybalance of payments deficits
Provide for orderly growth of international liquidity
IMF aims
World Bank (IBRD)supplements private finance and lends money on a commercialbasis for capital projects, usually direct to governments orgovernment agencies.
BISBank for International Settlements: the banker for central banks.Promotes co-operation between central banks Provides facilities for international co-operation
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
4: Trading and planning in a multinational environmentPage 35
Loss of national control over economic policy The need to compensate for weaker economies Confusion in transition to EMU Lower confidence arising from loss of national
pride
Arguments against EMU
Economic policy stability Facilitation of trade Lower interest rates Preservation of the Citys position
Arguments for EMU
To stabilise exchange rates between membercountries
To promote economic convergence in Europe To develop European Economic and Monetary
Union (EMU)
European Monetary System (EMS)Purposes
Globalisation of financial markets has contributed tofinancial instability, despite facilitating the transfer offunds to emerging markets.
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
The global debt crisis arose as governments in lessdeveloped countries (LDCs) took on levels of debtthat were above their ability to finance.
Deflationary policies damage profitability Devaluation of currency Reduction in imports by developing countries Increased reliance on host countries for
funding
Negative impacts on multinational firms
Restructure or rescheduled debt Economic reforms to improve balance of trade Lending governments write off some of the debts Convert some debt into equity
Resolving the global debt crisis
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
4: Trading and planning in a multinational environmentPage 37
Market seeking
Raw material seeking
Production efficiencyseeking
Knowledge seeking
Political safety seeking
Economies of scale
Managerial andmarketing expertise
Technology
Financial economies
Differentiated products
Strategic reasons for FDI
Joint ventures industrial co-operation(contractual) or joint-equity
Licensing agreements Management contracts Subsidiary Branches
Ways to establish an interest abroad
Management contracts: a firm agrees to sellmanagement skills sometimes used in combinationwith licensing. Can serve as a means of obtainingfunds from subsidiaries, where other remittancerestrictions apply.
Many multinationals use a combination of methodsfor servicing international markets.
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
Multinationals financial planning
Blocked funds
Control systems
Multinational companies need to develop a financial planningframework to ensure that the strategic objectives andcompetitive advantages are realised. Such a financial planningframework will include ways of raising capital and risks relatedto overseas operations and the repatriation of profits.
A company raising funds from localequity markets must comply with thelisting requirements of the local exchange.
Multinationals can counter exchangecontrols by management charges orroyalties.
Large and complex companies may beorganised as a heterarchy, an organicstructure with significant local control.
Local finance costs, and any available subsidies Tax systems of the countries (best group structure may
be affected by tax systems) Any restrictions on dividend remittances Possible flexibility in repayments arising from the
parent/subsidiary relationship
Finance for overseas investment depends on:
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
4: Trading and planning in a multinational environmentPage 39
Government stability Political and business ethics Economic stability/inflation Degree of international
indebtedness Financial infrastructure
Level of import restrictions Remittance restrictions Assets seized Special taxes and regulations
on overseas investors, orinvestment incentives
Factors in assessing political risk
Negotiations with host government Insurance (eg ECGD) Production strategies Contacts with customers Financial management eg borrowing funds locally Management structure eg joint ventures
Dealing with political risk
Litigation riskscan generally be reduced by keeping abreastof changes, acting as a good corporate citizenand lobbying.
Cultural risksshould be taken into account when decidingwhere to sell abroad, and how much tocentralise activities.
Environmentally sensitive
Environmentally insensitive
Adaptation necessary
Fashion clothes Convenience foods
Standardisation possible
Industrial and agricultural products World market products, eg jeans
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RiskMultinationalsstrategy
Global financialstability
Internationalfinancial markets
InstitutionsTrade
Agency issues Solutions to agency problems inmultinationalsAgency relationships exist between the CEOs of
conglomerates (the principals) and the strategicbusiness unit (SBU) managers that report to theseCEOs (agents).
Multiple mechanisms may be needed, working inunison. Eg: Board of directors: separate ratification and
monitoring of managerial decisions frominitiation to implementation.
Executive incentive systems can reduceagency costs and align the interests ofmanagers and shareholders by making topexecutives pay contingent on the value theycreate for the shareholders.
The interests of the individual SBU managers maybe incongruent not only with the interests of theCEOs, but also with those of the other SBUmanagers.
Each SBU manager may try to make sure his orher unit gets access to critical resources andachieves the best performance at the expense ofthe performance of other SBUs and the wholeorganisation.
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5: DCF
Topic List
NPVs
Internal rate of return
In this chapter, we discuss the evaluation of projects usingthe Net Present Value (NPV) method and the Internal Rateof Return.
The NPV method is extended to include inflation andspecific price variation, taxation and the assessment offiscal risk and multi-period capital rationing.
We also look at the potential internal rate of return toassess a project's return margin and its vulnerability tocompetitive action.
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Internalrate of return
NPVs
Net present value (NPV)The sum of the discounted cash flows less theinitial investment.
Decision criterionInvest in a project if its net present value is positiveie when NPV > 0Do not invest in a project if its net present value iszero or negative, ie when NPV 0
Real and nominal discount factorsWhat nominal rate (i) should be used for discountingcash flows, if the real rate is r and the rate of inflation h?
The net effect of inflationon the NPV of a projectwill depend on threeinflation rates: the ratesfor revenues, costs, andthe discount factor.
Corporate taxes Value added taxes
Other local taxes Capex tax
allowances
Tax effects on NPV
(l + i) = (1 + r)(1 + h)
(the Fisher equation,given in exam)
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Capital rationingCapital rationing problem exists when there are insufficient funds to finance all available profitableprojects.
5: DCF Page 43
Case IFractional investment allowed: rank thealternatives according to the ratio of NPV to initialinvestment or the benefit cost ratio.
Case IIFractional investment not allowed: a moresystematic approach may be needed to find the NPV-maximising combination of entire projects subject tothe investment constraint. This is provided by themathematical technique of integer programming.
The Monte Carlo method
Project Value at Risk
amounts to adopting a particular probabilitydistribution for the uncertain (random) variables thataffect the NPV and then using simulations togenerate values of the random variables.
is the minimum amount by which the value of aninvestment or portfolio will fall over a given period oftime at a given level of probability.
The multi-period capital rationing problem can beformulated as an integer programming problem.
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Internalrate of return
NPVs
IRRThe discount rate at which NPV equals zero.
The IRR calculation also produces the breakeven costof capital and allows calculation of the margin of safety.
If the cash flows change signs then the IRR may notbe unique: this is the multiple IRR problem.
With mutually exclusive projects, the decisiondepends not on the IRR but on the cost of capitalbeing used. Decision criteria using IRR
A project will be selected as long as the IRRis not less than the cost of capital.
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5: DCFPage 45
Modified IRR (MIRR)
Calculate the present value of the return phase(the phase of the project with cash inflows).
Calculate the present value of the investmentphase (the phase with cash outflows).
Calculate MIRR using the following formula:
This formula is given in the exam.
MIRR is the IRR which would result without theassumption that project proceeds are reinvested atthe IRR rate.
Re-investment rateThe NPV method assumes that cash flows can bereinvested at the cost of capital over the life of theproject.
Selection of investments based on the higher IRRassumes that cash flows can be reinvested at theIRR over the life of the project.The IRR assumption is unlikely to be valid and sothe NPV method is likely to be superior. The betterreinvestment rate assumption will be the cost ofcapital used for the NPV method.
Decision criterionIf MIRR is greater than the required rate of return:ACCEPTIf MIRR is lower than the required rate of return:REJECT
1
2
31n
(1+ re) 1MIRR =PVRPV1
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Notes
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6: Application of option pricing theory in investment decisions
Topic List
Options concepts
Real options
Option valuation techniques can be applied to capitalbudgeting exercises in which a project is coupled with aput or call option. For example, the firm may have theoption to abandon a project during its life. This amountsto a put option on the remaining cash flows associatedwith the project. Ignoring the value of these real options(as in standard discounted cash flow techniques) canlead to incorrect investment evaluation decisions.
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Realoptions
Optionsconcepts
OptionsAn option is a contract that gives one party the option toenter into a transaction either at a specific time in the futureor within a specific future period at a price that is agreedwhen the contract is issued.
The buyer of a call option acquires the right, but not theobligation, to buy the underlying at a fixed price.
The buyer of a put option acquires the right, but not theobligation, to sell the underlying shares at a fixed price.
In the money option: intrinsic value is +veAt the money option: intrinsic value is zero
Out of the money option: intrinsic value is ve
The higher the exercise price, the lowerthe probability that the call will be in themoney.
As the current price of the underlyingasset goes up, the higher theprobability that the call will be in themoney.
Both a call and put will increase inprice as the underlying asset becomesmore volatile.
Both calls and puts will benefit fromincreased time to expiration.
The higher the interest rate, the lowerthe present value of the exercise price.
Determinants of option values
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Realoptions
Optionsconcepts
6: Application of option pricing theory in investment decisionsPage 49
Real optionsStrategic options known as real options arisingfrom a project can increase the project value. They areignored in standard DCF analysis, which computes asingle present value.
Option to delay
Option to expand
When a firm has exclusive rights to a project or product for aspecific period, it can delay taking this project or product untila later date. For a project not selected today on NPV or IRRgrounds, the rights to the project can still have value.
is when firms invest in projects allowing further investmentslater, or entry into new markets, possibly making the NPV +ve.The initial investment may be seen as the premium to acquirethe option to expand.
Option to abandon
Option to redeployis when company can use its productive assets foractivities other than the original one. The switch willhappen if the PV of cash flows from the newactivity will exceed costs of switching.
Black-Scholes valuationIn applying Black-Scholes valuation techniques toreal options, simulation methods are typically usedto overcome the problem of estimating volatility.
is if the firm has the option to cease a projectduring its life. Abandonment is effectively theexercising of a put option. The option to abandon isa special case of an option to redeploy.
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Realoptions
Optionsconcepts
Exercise price (Pe) Price of underlying asset (Pa) Volatility of underlying asset (s) Time to expiration (t) Interest rate (r) Intrinsic and time value
Determinants of option values
Real options are highly examinable.
Black-Scholes formulae
These formulae are given in the exam.
Put option
rt2e1a )eN(dP)N(dPC
=
ts
)t0.5s(rPP
Ind
2
e
a
1
++
=
tsdd 12 =
rtea ePPP
C +=
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7a: Impact of financing and APV method
Topic List
Sources of finance
Duration
Credit risk
Modigliani & Miller
Other theories
APV approach
The cost of capital is the rate of return required by investorsin order to supply their funds to the company. It is also therate of return a company must earn in a project in order tomaintain its market value. There are two forms of capital to afirm, equity and debt, and each supplier of capital requires areturn which is determined by the risks each type of investorfaces.
The overall cost of capital to the firm is the weightedaverage of the cost of equity and the cost of debt.
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Sources of finance
Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
Equity Venture capital
Business angels
Short-term/long-term
debt
Leasefinance
Hybrids
Assetsecuritisation
Islamicfinance
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7a: Impact of financing and APV methodPage 53
Islamic financetransaction
Similar to Features
Murabaha Trade credit/loan Pre-arranged mark up for convenience of later payment, no interest
Musharaka Venture capital Profit share per contract, no dividends, losses per capital contribution,both parties participate
Mudaraba Equity Profit share per contract, no dividends, losses borne by capitalprovider, organisation runs business
Ijara Leasing Whatever the other features, lessor remains asset owner and incursrisks of ownership
Sukuk Bonds Underlying tangible asset in which holder shares may be asset-based(sale/leaseback) or asset-backed (securitisation)
Salam Forward contract Commodity sold for future delivery, cash received at discount fromfinancial institution, payments received in advance
Istisna Phased payments Project funding, initial payment and then instalments from businessundertaking the project
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
Cost of equity
CAPM
Cost of irredeemable debt
WACC
Cost of redeemable debtIRR calculation, including amount payable onredemption
ke =
g = br
d0 (1 + g)
P0kd =
i(1 T)P0
g is growth rate of dividendsb is proportion of profits retainedr is rate of return on investments
e de de d d e
V VWACC = k k 1 T
V V V V
E(ri) = Rf + i(E(rm) Rf)
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7a: Impact of financing and APV methodPage 55
Beta factors of portfolios Difficulties in determining excess return Difficulties in determining risk-free rate Errors in statistical analysis used to calculate
betas Difficulties in forecasting companies with low
P/E ratios Assumption that costs are zero Assumption that investment market is efficient Assumption that portfolios are well-diversified
Limitations of CAPM
Portfolio of all stockmarket securities
Beta factor 1
Portfolio of risk-freesecurities
Beta factor 0
Investors portfolio Beta factor weightedaverage of individualbeta factors
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
Geared betasmay be used to obtain an appropriate requiredreturn when an investment has differing businessand finance risks from the existing business.
Difficult to identify firms with identical operatingcharacteristics
Estimate of beta factors not wholly accurate Assumes that cost of debt is risk-free Does not include growth opportunities Differences in cost structures and size will
affect beta values between firms
Weaknesses in the formula
Exam formula
where
a = asset (or ungeared) beta
e = equity (or geared) beta
d = beta factor of debt in the geared company
Vd = market value of debt in the geared company
Ve = market value of equity capital in the geared company
T = rate of corporate tax
a e dVe
(Ve + Vd(1 T))Vd(1 T)
(Ve + Vd(1 T))= +
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
7a: Impact of financing and APV methodPage 57
Duration (Macaulay duration)The weighted average length of time to the receiptof a bonds benefits (coupon and redemption value).The weights are the present values of the benefitsinvolved.
Calculating duration
Longer-dated bonds have longer durations Lower-coupon bonds will have longer
durations Lower yields will give longer durations
Properties of duration
Modified durationModified duration =
Modified duration shares the same properties asMacaulay duration.
1
2
3
Multiply PV of cash flows for each time periodby the time period and add together.
Add the PV of cash flows in each periodtogether.
Divide the result of step 1 by the result of step 2.
yieldredemptiongross 1durationMacaulay
+
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
Credit migration
Credit risk (or default risk)is the risk for a lender that theborrower may default on interestpayments and/or repayment ofprincipal.
Credit risk for an individual loan orbond is measured by estimating: Probability of default
typically, using information onborrower and assigning a creditrating (eg Standard & Poors,Moodys, Fitch)
Recovery rate the fraction offace value of an obligationrecoverable once the borrowerhas defaulted
is the change in the credit rating after a bond is issued.
Standard & Poors MoodysAAA Aaa Highest quality, lowest default risk
AA Aa High quality
A A Upper medium grade quality
BBB Baa Medium grade quality
BB Ba Lower medium grade quality
B B Speculative
CCC Caa Poor quality (high default risk)
CC Ca Highly speculative
C C Lowest grade quality
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7a: Impact of financing and APV methodPage 59
Credit rating of company Maturity of debt Risk-free rate at appropriate maturity Corporate tax rate
Determinants of cost of debt capital Option pricing models to assess default risk
is the premium required by an investor in acorporate bond to compensate for the credit risk ofthe bond.Yield on corporate bond = risk free rate + creditspread
Credit spread
The equity of a company can be seen as a calloption on the assets of the company with an exerciseprice equal to the outstanding debt.
Expected losses are a put option on the assets ofthe firm with an exercise price equal to the value ofthe outstanding debt.
From the Black-Scholes formula, the probability ofdefault depends on three factors: The debt/asset ratio The volatility of the company assets The maturity of debtCost of debt capital = (1 tax rate)(risk free rate
credit spread)
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
External credit enhancement
Internal credit enhancement Excess spreadOver-collateralisation
Letters of creditSurety bonds
Cash collateral accounts
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
7a: Impact of financing and APV methodPage 61
MM theory (no tax)The use of debt would only transfer morerisk to the shareholders, therefore will notreduce the WACC.
MM theory (with tax)Debt actually saves tax (due to tax reliefon interest payments) therefore firmsshould only use debt finance.
where ke = cost of equity in a geared companyke = cost of equity in an ungeared companyVd, Ve = market values of debt and equitykd = pre-tax cost of debt
This formula is given in the exam.
MM and cost of equity
e
dd
ie
iee V
V)kT)(k(1kk +=
i
Too risky in reality to have high levels of gearing Assumes perfect capital markets Does not consider bankruptcy risks, tax exhaustion,
agency costs and increased borrowing costs as risk rises
Limitations of MM theory
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
Static trade-off theoryA firm in a static position will adjust their gearing levelsto achieve a target level of gearing.
Agency theoryThe optimal capital structure will occur where thebenefits of the debt received by the shareholdersmatches the costs of debt imposed on theshareholders.
Problems with financial distress costs
Higher cost of capital Loss of sales Downsizing High staff turnover
Indirect financialdistress
Legal and admincosts associated withbankruptcy
Direct financialdistress
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7a: Impact of financing and APV methodPage 63
is, unlike the MM models, based on the ideaof information asymmetry: investors have alower level of information about the companythan its directors do. As a result, shareholdersuse directors' actions as a signal to indicatewhat directors believe about the companywith their superior information.
Pecking order theory Predictions To finance new investment, firms prefer internal
finance to external finance.
If retained earnings differ from investment outlays,the firm adjusts its cash balances or marketablesecurities first, before either taking on more debt orincreasing its target payout rate.
Internal finance is at the top, and equity is at thebottom, of the pecking order. A single optimal debt-equity ratio does not exist: a result similar to theMM model with no taxes.
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Sources offinance
Creditrisk
Othertheories
Duration APVapproach
Modigliani& Miller
Adjusted present value (APV) approachThe adjusted present value (APV) method ofvaluation is based on the Modigliani Miller modelwith taxation.
We assume that the primary benefit of borrowing isthe tax benefit and that the most significant cost ofborrowing is the added risk of bankruptcy.
Steps in applying APV 1
3
2
Calculate the NPV as if the project was financed entirely by equity (use ke)
Add the PV of the tax saved as a result of thedebt used to finance the project (use kd)
Subtract the cost of issuing new finance
i
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7b:Valuation and free cash flows
Topic List
Yield curve and bond values
Free cash flows
Equity valuation
This chapter mainly focuses on the use of free cashflows and their use for valuation puposes.
It also briefly considers using the yield curve for bondvalues and recaps equity valuation methods from PaperF9 financial management.
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The yield curve can be used to estimate bond value by splitting, say a four year bond into four separatebonds. Each bond can then be discounted by using the rates from the yield curve.
The total of the discounted cash flows represents the issue price.
An IRR style calculation can be used to calculate the yield to maturity.
In general:
Equityvaluation
Free cash flows
Yield curve andbond values
n1
valueRedemptionn1
Coupon21
Coupon1
CouponPrice)()()()( nn21 riririri +
++
+++
++
=
Using the yield curve
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Equityvaluation
Free cash flows
Yield curve andbond values
7b: Valuation and free cash flowsPage 67
Free cash flow (FCF)Free Cash Flow = Earnings before Interest(FCF) and Taxes (EBIT)
less Tax on EBIT
plus Non cash charges (eg depreciation)
less Capital expenditures
less Net working capital increases
plus Net working capital decreases
plus Salvage value received
Forecasting FCFConstant growth
where FCF0 is the free cash flow at beginning n is the number of years
Differing growth rates
n0 g)(1FCFFCF +=
Forecast each element of FCF separately usingappropriate rate.
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Equityvaluation
Free cash flows
Yield curve andbond values
Forecasting dividend capacity
Direct method of calculating FCFE Indirect method
The dividend capacity of a firm is measured by itsfree cash flow to equity (FCFE).
Net income (EBIT net interest tax paid)
Add depreciation
Less total net investment
Add net debt issued
Add net equity issued
Free cash flow
Less (Net interest + net debt paid)
Add Tax benefit from debt(net interest tax rate)
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7b: Valuation and free cash flowsPage 69
Firm valuation using FCF Terminal values and company valuationValue of the firm is the sum of the discounted freecash flows over the appropriate time horizon.
Value of the firm is the present value over theforecast period + terminal value of cash flowsbeyond the forecast period.
Assuming constant growth, use the Gordon model:
gkg)(1FCF
PV 00 +
=
where g = growth ratek = cost of capital
Calculate value of equity (present value ofFCFE discounted at the cost of equity).
Calculate value of debt.
Value = value of equity + value of debt
1
23
Firm valuation using FCFE
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Equityvaluation
Free cash flows
Yield curve andbond values
Possible bases of valuation
Range of valuesMax Value the cashflows or earnings under
new ownership.Value the dividends under the existingmanagement.
Min Value the assets.
Historic basis
(unlikely to be realistic)
Replacementbasis
(asset used on ongoing
basis)
Realisablebasis
(asset sold/business
broken up)
Uses of net asset valuation method As measure of security in a share valuation As measure of comparison in scheme of
merger As floor value in business that is up for sale
Need for professional valuation Realisation of assets Contingent liabilities Market for assets
Problems in valuation
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7b: Valuation and free cash flowsPage 71
Price-earnings ratioP/E ratio =
Market value = EPS P/E ratioEPS
valueMarket
Have to decide suitable P/E ratio.Factors to consider: Industry Status Marketability Shareholders Asset backing and liquidity Nature of assets Gearing
Earnings yield valuation modelMarket value =
yield EarningsEarningsMay be affected by
one-off transactionsWhich P/E ratio to use?
Adjust downwards ifvaluing an unquoted
company
Shows the current profitability
of the company
Shows the markets view ofthe growth prospects/risk of
a company
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Equityvaluation
Free cash flows
Yield curve andbond values
Dividend valuation model
Discounted cash flow methodValue investment using expected after-tax cash flowsof investment and appropriate cost of capitalWhere D0 is dividend in current year
g is dividend growth rate
Where P0 is price at time 0D is dividend (constant)ke is cost of equity
gkD
Pe
00 )g1( +=
ekD
P0 = Based on expected future income Can be used to value minority stake Growth rate difficult to estimate Dividend policy may change Companies that dont pay dividends dont have
zero values
Features
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8: International investment decisions
Topic List
NPV and international projects
Exchange controls
Exchange rate risks
Capital structure
Companies that undertake overseas projects are subjectto exchange rate risks as well as other risks such asexchange controls, taxation and political action.
Capital budgeting methods for multinational companiescan incorporate these additional complexities in thedecision-making process.
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NPVs for international projects
Capitalstructure
Exchangerate risks
Exchangecontrols
NPV andinternational projects
Purchasing power parity
International Fisher effect
Absolute purchasing parity theory: prices of products in differentcountries will be the same when expressed in the same currency.Alternative purchasing power parity relationship: changes inexchange rates are due to differences in the expected inflation ratesbetween countries.
Alternative methods for calculatingthe NPV from a overseas project:
Convert project cash flows intosterling and discount at sterlingdiscount rate to calculate NPVin sterling terms.
Discount cash flows in hostcountry's currency from projectat adjusted discount rate forthat currency and then convertresulting NPV at spot exchangerate.This equation is given in the exam.
In the absence of trade or capital flows restrictions, real interest ratesin different countries will be expected to be the same. Differences ininterest rates reflect differences in inflation rates.
b
c
b
c
h1
h1
i1
i1
+
+
+
+=
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8: International investment decisionsPage 75
Effect of exchange rates on NPVWhen there is a devaluation of sterling relative to aforeign currency, the sterling value of cash flowsincreases and NPV increases. The oppositehappens when the domestic currency appreciates.
Impact of transaction costsTransaction costs are incurred when companiesinvest abroad due to currency conversion or otheradministrative expenses. These should also betaken into account.
Effect on exportsWhen a multinational company sets up a subsidiaryin another country in which it already exports, therelevant cash flows (and NPV) for evaluation of theproject should account for loss of export earnings inthe particular country.
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Capitalstructure
Exchangerate risks
Exchangecontrols
NPV andinternational projects
SubsidiesThe benefit from concessionary loans should be included in the NPV calculation as the difference between therepayment when borrowing under market conditions and the repayment under the concessionary loan.
Low tax on foreign investment or sales incomeearned by resident companies
Low withholding tax on dividends paid to theparent
Stable government and currency
Adequate financial services support facilities
Tax haven characteristics
Host country Corporate taxes Investment allowances Withholding taxes
Home country Double taxation relief Foreign tax credits
Taxes in international context
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Capitalstructure
Exchangerate risks
Exchangecontrols
NPV andinternational projects
8: International investment decisionsPage 77
Exchange controls Strategies
For an overseas project, we include only theproportion of cash flows that are expected to berepatriated in the NPV calculation.
Types
Rationing supply of foreign exchange.Payments abroad in foreign currency arerestricted, preventing firms from buying as muchas they want from abroad.
Restricting types of transaction for whichpayments abroad are allowed, eg suspending orbanning payment of dividends to foreignshareholders, such as parent companies inmultinationals: blocked funds problem.
Multinational company strategies to overcomeexchange controls:
Transfer pricing, where the parent companysells goods or services to the subsidiary andobtains payment.
Royalty payments adjustments, when a parentcompany grants a subsidiary the right to makegoods protected by patents.
Loans by the parent company to the subsidiary:setting interest rate at appropriate level.
Management charges levied by the parentcompany for costs incurred in the managementof international operations.
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Capitalstructure
Exchangerate risks
Exchangecontrols
NPV andinternational projects
Translation exposureis the risk that the organisation will make exchangelosses when the accounting results of its foreignbranches or subsidiaries are translated.
Translation losses can arise from restating the bookvalue of a foreign subsidiarys assets at theexchange rate on the statement of financial positiondate only important if changes arise from loss ofeconomic value.
Economic exposureis the risk that the present value of a companysfuture cash flows might be reduced by adverseexchange rate movements.
Economic exposure: Can be longer-term (continuous currency
depreciation)
Can arise even without trade overseas (effects ofpound strengthening)
Transaction exposureis the risk of adverse exchange rate movementsbetween the date the price is agreed and the datecash is received/paid, arising during normalinternational trade.
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Capitalstructure
Exchangerate risks
Exchangecontrols
NPV andinternational projects
8: International investment decisionsPage 79
Finance costs Taxation systems Restrictions on dividend remittances Flexibility in repayments Reduction in systematic risk Access to foreign capital Agency costs
Choice of financeOverseas subsidiariesParent company needs to consider a number ofissues when setting up an overseas subsidiary:
Amount of equity capital Whether parent owns 100% of equity Profit retention by subsidiary Amount of subsidiarys debt Amount of subsidiarys working capital Whether subsidiary should obtain local listing
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Capitalstructure
Exchangerate risks
Exchangecontrols
NPV andinternational projects
Availability. Domestic financial markets, exceptlarger countries and the Euro zone, generallylack the depth and liquidity to accommodatelarge or long-maturity debt issues.
Lower cost of borrowing. In Eurobondmarkets interest rates are normally lower thanborrowing rates in national markets.
Lower issue costs. Cost of debt issuance isnormally lower than the cost of debt issue indomestic markets.
Advantages of international borrowingInternational borrowing options(1) Borrow in the same currency as the inflows from
the project
(2) Borrow in a currency other than the currency ofthe inflows, with a hedge in place
(3) Borrow in a currency other than the currency ofthe inflows, without hedging the currency risk
Option (3) exposes the company to exchangerate risk which can substantially change theprofitability of a project.
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9: Acquisitions and mergers vs growth
Topic List
Acquisitions and mergers
Shareholder value issues
Firms may decide to increase the scale of theiroperations through a strategy of internal organic growthby investing money to purchase or create assets andproduct lines internally.
Alternatively, companies may decide to grow by buyingother companies in the market, thus acquiring ready-made tangible and intangible assets and product lines.
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Shareholdervalue issues
Acquisitionsand mergers
Operating economies
Managementof acquisition
Diversification Asset backing Earningsquality
Finance/liquidity
Internal expansioncosts
Tax Defensivemerger
Economicefficiency
Mergers and acquisitions
Cost of acquisition Form of purchase consideration Reaction of predators shareholders Accounting implications Reaction of targets shareholders Future policy (eg dividends, staff)
Factors in a takeover
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9: Acquisitions and mergers vs growthPage 83
SupplierAim: control ofsupply chain
Firm
Customer/distributorAim: control of
distribution
Two firms operate indifferent industries
Aim: diversification
BACKWARD MERGER
FORWARD MERGER
CONGLOMERATE MERGER
VERTICAL MERGER
Two merging firmsproduce similar products
in the same industryAim: increase market
power
HORIZONTAL MERGER
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Shareholdervalue issues
Acquisitionsand mergers
Takeover strategy AcquireGrowth prospects limited
Potential to sell other products to existingcustomers
Operating at maximum capacity
Under-utilising management
Greater control over supplies or customers
Lacking key clients in targeted sector
Improve statement of financial position
Increase market share
Widen capability
Younger company with higher growth rate
Company with complementary product range
Company making similar products operating below capacity
Company needing better management
Company giving access to customer/supplier
Company with right customer profile
Company enhancing EPS
Important competitor
Key talents and/or technology
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Shareholdervalue issues
Acquisitionsand mergers
9: Acquisitions and mergers vs growthPage 85
SynergyRevenue synergy exists when the acquisition willresult in higher revenues, higher return on equity ora longer period of growth for the acquiring company.
Revenue synergies arise from:(a) Increased market power(b) Marketing synergies(c) Strategic synergies
Cost synergy results from economies of scale. Asscale increases, marginal cost falls and this will bemanifested in greater operating margins for thecombined entity.
Diversification Use of cash slack
Tax benefits Debt capacity
Sources of financial synergy
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Shareholdervalue issues
Acquisitionsand mergers
Failures to enhance shareholder valueWhy do many acquisitions fail to enhance shareholder value?
Agency theory: takeovers may be motivated by self-interestedacquirer management wanting:
Diversification of management's own portfolio Use of free cash flow to increase size of the firm Acquisitions that increase firm's dependence on management
Value is transferred from shareholders to managers of acquiring firm.
Hubris hypothesis: bidding company bids too much becausemanagers of acquiring firms suffer from hubris, excessive pride andarrogance.
Market irrationality argument: whena companys shares seem overvalued,management may exchange them foran acquiree firm: merger. The lack ofsynergies or better management maylead to a failing merger.
Preemptive theory: several firms maycompete for opportunity to merge withtarget to achieve cost savings. Winningfirm could improve market position andgain market share. It can be rational forthe first firm to pre-empt a merger withits own takeover attempt.
Window dressing: where companiesare acquired to present a better short-term financial picture.
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10: Valuation for acquisitions and mergers
Topic List
Valuation issues
Type I
Type II
Type III
High-growth start-ups
Intangible assets
There are different methods for predicting earningsgrowth for a company, using external and internalmeasures. An acquisition potentially affects the risk ofthe acquiring company and its cost of capital.
First, we consider the overvaluation problem: theproblem that when a company acquires anothercompany, it often pays more than the companys currentmarket value.
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Valuationissues
Intangibleassets
High-growthstart-ups
Type IIIType IIType I
The overvaluation problemis paying more than the current market value, toacquire a company.
During an acquisition, there is typically a fall inthe price of the bidder and an increase in theprice of the target.
The overvaluation problem may arise asmiscalculation of potential synergies oroverestimation of ability of acquiring firm'smanagement to improve performance.
Both errors will lead to a higher price thancurrent market value.
Estimating earnings growthGordon constant growth model:
PV =
Three ways to estimate g:
Historical estimates: extrapolate past values Rely on analysts forecasts Use the companys return on equity and
retention rate of earnings (g = ROE retentionrate)
g)(kg(1FCF0 )+
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10: Valuation for acquisitions and mergersPage 89
Acquisitions and acquirers risk
Business risk of combined entityThe risk associated with the unique circumstancesof the combined company. Affected by the betas ofthe individual entities (target and predator) and thebeta of the resulting synergy.
Asset betaThe weighted average of the betas of the target,predator and synergy of the combined entity.
Geared equity betaCalculate value of debt (net of tax). Divide byvalue of equity.
Multiply the above by difference between betaof combined entity and beta of debt.
Add the above to the beta of the combinedentity.
1
2
3
Acquisition Affectsfinancial risk?
Affectsbusiness risk?
Type 1 N N
Type 2 Y N
Type 3 Y Y
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Intangibleassets
Valuationissues
High-growthstart-ups
Type IIIType IIType I
Type I valuationsMethods to value company:(1) Book value-plus models(2) Market-relative models(3) Cash flow models, including EVATM, MVA
Market-relative models (P/E ratio) P/E ratio =
so market value per share = EPS P/E ratioEPS
valueMarket
Total Asset ValueLess Long-term and short-term payablesEquals Company's Net Asset Value
Book value-plus modelsUse the statement of financial position as startingpoint.
Book value of net assets is also 'equity shareholders'funds': the owners' stake in the company.
Decide suitable P/E ratio and multiply by EPS: anearnings-based valuation.EPS could be historical EPS or prospective futureEPS. For a given EPS, a higher P/E ratio will resultin a higher price.
High P/E ratio may indicate: Optimistic expectations Security of earnings Status
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Q Ratio is the market value of company assets (MV)divided by replacement cost of the assets (RC).
Points to note RC of capital is difficult to estimate, so is proxied
by the book value of capital. The equity Q ie Qeis approximated as:
Qe =
If Q 1, management has increased the value ofcontributed capital.
capitalEquity equity of value MarketQ =
Equity version of Q:
Qe = debt Total RCdebt of value MarketMV
RCMV
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Calculate WACC from cost of equity (K ) and costof debt (K ).
WACC =
where
T is the tax rate
is the value of the debt
is the value of equity
Discount free cash flow at WACC to obtain value offirm.
Calculate equity value.
Equity Value = Value of the firm Value of debt
Intangibleassets
Valuationissues
High-growthstart-ups
Type IIIType IIType I
Calculate Free Cash Flow.
FCF = EARNINGS BEFORE INTEREST AND TAXES (EBIT)
Less: TAX ON EBIT
Plus: NON-CASH CHARGES
Less: CAPITAL EXPENDITURES
Less: NET WORKING CAPITAL INCREASES
Plus: SALVAGE VALUES RECEIVED
Plus: NET WORKING CAPITAL DECREASES
Forecast FCF and Terminal Value.
Free cash flow model1
4
3
2
5
eV++
+
d
dd
ed
ee V
VKT)(1
)V(VV
K
e
d
dV
eV
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EVA approachEVA = NOPAT WACC Capital Employed
Or, EVA = (ROIC WACC) Capital Employedwhere NOPAT = Net Operating Profits After Taxes
ROIC= Return on Invested CapitalWACC = Weighted average cost of capital
Value of firm = Value of invested capital + sum of discounted EVA
(Subtract value of debt from value of company to getvalue of equity.)
Market value added approachshows how much management has added to thevalue of capital contributed by the capital providers.
MVA = Market Value of Debt + Market Value ofEquity Book Value of Equity
MVA related to EVA: MVA is simply PV of futureEVAs of the company.
If the market value and book value of debt are thesame, MVA measures the difference between themarket value of common stock and equity capital ofthe firm.
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Intangibleassets
Valuationissues
High-growthstart-ups
Type IIIType IIType I
Type II valuations: APVAcquisition is valued by discounting Free CashFlows by ungeared cost of equity, then adding PVof tax shield.
APV calculation steps
APV = Initial Investment + Value of acquired companyif all-equity financed + PV of Debt Tax ShieldsIf APV is +ve, acquisition should be undertaken.
Calculate FCF (as previously).
Forecast FCFs and Terminal Value.
Ungeared beta of firm is calculated from geared beta:
1
7
6
5
4
3
2
Discount free cash flow at ungeared cost ofequity to obtain NPV of ungeared firm or project.
Calculate interest tax shields.
Discount interest tax shields at pre-tax cost ofdebt to obtain PV of interest tax shields.
APV = NPV OF UNGEARED FIRM OR PROJECT
Plus: PV OF INTEREST TAX SHIELDSPlus: EXCESS CASH AND MARKETABLE
SECURITIESLess: MARKET VALUE OF CONTINGENT
LIABILITIES= MARKET VALUE OF FIRM
Less: MARKET VALUE OF DEBT= MARKET VALUE OF EQUITYE
DT)(11
GU
+=
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Intangibleassets
Valuationissues
High-growthstart-ups
Type IIIType IIType I
10: Valuation for acquisitions and mergersPage 95
Type III iterative valuations1
87
65
4
32
A problem with WACCIf WACC weights are not consistent withthe values derived, the valuation isinternally inconsistent.Then, we use an iterative procedure: Go back and re-compute the beta
using a revised set of weights closer tothe weights derived from the valuation.
The process is repeated until assumedweights and weights calculated areapproximately equal.
Estimate value of acquiring company before acquisition.
Estimate value of acquired company before acquisition.
Estimate value of synergies.
Estimate beta coefficients for equity of acquiring andacquired company, using CAPM.
Estimate asset beta for each company.
Calculate asset beta for combined entity.
Calculate geared beta of the combined firm.
Calculate WACC for combined entity.
Use WACC derived in step 8 to discount cashflows of combined entity post-acquisition.
Value of equity: difference between thevalue of the firm and the value of debt.9
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High-growthstart-ups
Intangibleassets
Valuationissues
Type IIIType IIType I
Valuation of high-growth start-ups
Steps in valuation
Valuation methods
Discounted Cash FlowsWith constant growth model:
V =
Since FCF = Revenue Costs = R C, value of company:
V = g r
C R
g r
FCF
Typical characteristics of start-ups: few revenues,untested products, unknown product demand,high development/ infrastructure costs.
Identify drivers (eg market potential, resourcesof the business, management team)Period of projection needs to be long-termForecasting growthGrowth in earnings (g) = b ROICFor most high growth start-ups, b = 1 and soledeterminant of growth is the return on investedcapital (ROIC), estimated from industryprojections or evaluation of management,marketing strengths, and investment. Probabilistic valuation methods can be used.
Asset-based method not appropriate: most investment of astart-up is in people, marketing and /or intellectual rights thatare treated as expenses rather than capital.Market-based methods also present problems: difficult tofind comparable companies; usually no earnings to calculateP/E ratios (but price-to-revenue ratios may help).
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Intangibleassets
Valuationissues
High-growthstart-ups
Type IIIType IIType I
10: Valuation for acquisitions and mergersPage 97
Intangible assetsDiffer from tangible assets as they do not havephysical substance.
Goodwill Brands Patents
Customer loyalty Research and
development
Examples of intangible assets
Measuring intangible assetsMarket-to-book value measures intangible assetsas the difference between book value of tangibleassets and market value of the firm.
Tobins q =
Used to compare intangible assets of firms in sameindustry serving the same markets and with similartangible non-current assets.
Calculated intangible values (CIV) calculates anexcess return on tangible assets, which is used todetermine the proportion of return attributable tointangible assets.
assets of cost tReplacemen
firmof tioncapitalisaMarket
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Intangibleassets
Valuationissues
High-growthstart-ups
Type IIIType IIType I
Levs knowledge earnings method separatesearnings deemed to come from intangible assets,which are then capitalised.
Relief from royalties Premium profits Capitalisation of earnings Comparison with market transactions
Methods of valuing intangible assets
Valuing product patents as options.
Identify value of underlying asset (basedon expected cash flows).
Identify standard deviation of cash flows.
Identify exercise price of the option.
Identify expiry date of the option.
Identify cost of delay (the greater thedelay, the lower the value of cash flows).
1
2
3
5
4
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11: Regulatory framework and processes
Topic List
Global issues
UK and EU regulation
Defensive tactics
The agency problem can have a significant impact onmergers and acquisitions. Takeover regulation is a keydevice in protecting the interests of all stakeholders.
Different models of regulation have been used in the UKand in continental Europe. EU level regulation seeks tocreate convergence in takeover regulation.
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Defensivetactics
UK and EUregulation
Globalissues
Agency problemThe agency problem and the issues arising fromthe separation of ownership and control havepotential impact on mergers and acquisitions.
Potential conflicts of interest Protection of minority shareholders. Transfers
of control may turn existing majority shareholdersof the target into minority shareholders.
Target company management measures to prevent the takeover, which could run againststakeholder interests.
Takeover regulationTakeover regulation can: Protect the interests of minority shareholders
and other stakeholders Ensure a well-functioning market for corporate
control
Two models of regulation UK/US/Commonwealth countries: market-based
model case law-based, promotes protection ofshareholder rights especially
Continental Europe: 'block-holder' or stakeholdersystem codified or civil law-based, seeking toprotect a broader group of stakeholders: creditors,employees, national interest
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Defensivetactics
UK and EUregulation
Globalissues
11: Regulatory framework and processesPage 101
UK takeover regulationMergers and acquisitions in the UK subject to:
City Code Companies Act Financial Services and Markets Act 2000 Criminal Justice Act 1993 (insider dealing provisions)
City CodeThe City Code on Takeovers and Mergers:
Originally voluntary code for takeovers/mergers ofUK companies now has statutory basis
Administered by the Takeover Panel
Similar treatment for all shareholders Sufficient time and information for
informed decision Directors must act in interests of whole
company Avoid false markets in shares Offer only made if it can be fully
implemented Offeree company not distracted for
excessive time by offer for it
City Code Principles
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Defensivetactics
UK and EUregulation
Globalissues
Competition and Markets AuthorityThe Competition and Markets Authority (CMA) can accept orreject proposed merger, or lay down certain conditions, ifthere would be a substantial lessening of competition.
Substantial lessening of competition tests: Turnover test (70m min. for investigation by CMA) Share of supply test (25%)
European UnionMergers fall within jurisdiction of the EU (which will evaluateit, like the CMA in UK) where, following the merger:
(a) Worldwide turnover of more than 5bn per annum(b) EU turnover of more than 250m per annum
EU Takeovers DirectiveEffective from May 2006 to converge market-based and stakeholder systems.
Takeovers Directive principles Mandatory-bid rule: required at 30%
holding, in UK Equal treatment of shareholders Squeeze-out rule and sell-out rights: in
UK, 90% shareholder buys all shares Principle of board neutrality Break-through rule: bidder able to set
aside multiple voting rights (but countriescan opt out of this)
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% Consequence of share stake levelsAny Company may enquire on ultimate ownership under s793 CA 2006.
3% Beneficial interests must be disclosed to company Disclosure and Transparency Rules.
10% Shareholders controlling 10%+ of voting rights may requisition company to serve s793 notices.Notifiable interests rules become operative for institutional investors and non-beneficial stakes.
30% City Code definition of effective control. Takeover offer becomes compulsory.
50%+ CA 2006 definition of control (At this level, holder can pass ordinary resolutions.)Point at which full offer can be declared unconditional with regard to acceptances.
75% Major control boundary: holder able to pass special resolutions.
90% Minorities may be able to force majority to buy out their stake. Equally, majority may be able torequire minority to sell out.
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Defensivetactics
UK and EUregulation
Globalissues
Defensive tactic ExplanationGolden parachutes Compensation payments made to eliminated top-management of target
firm.
Poison pill Attempt to make firm unattractive to takeover, eg by giving existingshareholders right to buy shares cheaply.
White knights and white squires Inviting a firm that would rescue the target from the unwanted bidder. Awhite squire does not take control of the target.
Crown jewels Selling firms valuable assets or arranging sale and leaseback, to makefirm less attractive as target.
Pacman defence Mounting a counter-bid for the attacker.Litigation or regulatory defence Inviting investigation by regulatory authorities or Courts.
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12: Financing mergers and acquisitions
Topic List
Financing methods
Effects of offer
Questions on the subjects discussed in this chapter maybe regularly set in the compulsory section of this paper.Questions could involve calculations.
A bidding firm might finance an acquisition either by cashor by a share offer or a combination of the two. Weconsider how a financial offer can be evaluated in termsof the impact on the acquiring company and criteria foracceptance or rejection.
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Effectsof offer
Financingmethods
Methods of financing mergers Funding cash offersMethods of financing a cash offer: Retained earnings common when a firm acquires a
smaller firm Sale of assets Issue of shares, using cash to buy target firm's shares Debt issue but, issuing bonds will alert th