Step 4. Calculate the option price (for a call option)
4.9 Raising capital in the world’s financial markets
Multinational companies might be able to raise capital in different financial markets around the world, should they wish to do so. To be able to raise capital in any financial market, a company must meet the legal, regulatory and compliance requirements that apply in that particular market.
Legal requirements
There are certain legal requirements that must be met before a company can raise capital from investors on a stock market. In the UK for example, companies cannot raise capital from the general investing public unless they have the status of a public limited company.
Regulatory requirements
There are also regulatory requirements that have to be met. These include regulations relating to obtaining official permission to raise capital in the form of shares or bonds, and issuing a prospectus to potential investors. Having obtained approval from the regulatory authorities, the shares or bonds must be accepted for trading by a stock exchange.
Compliance requirements
Having issued shares or bonds, the company must then continue to comply with continuing obligations (rules) of the regulatory authorities and the stock market.
These include rules relating to the regular provision of information about the company to the stock market (such as profit warnings and trading updates).
To meet the regulatory and compliance requirements for issuing shares or bonds on a stock market, a company might have to commit considerable time and money. The burden is greater for shares than for bonds. This is because bonds are often traded
‘privately’ between professional and institutional investors whereas shares are
The process of raising capital by issuing shares in a stock market
Although the detailed rules vary between countries, the broad nature of the rules for issuing shares in a stock market are fairly similar in most countries with a large stock market. There is a two-stage process of acceptance before the shares can be issued.
The company and its shares must be approved by a regulatory authority for the country’s stock markets. In the UK, this involves getting the shares accepted on to an ‘Official List’ by the Listing Authority, which is a department of the financial markets regulator (the Financial Services Authority), or by a similar listing authority in any other EEA country of Europe. Obtaining a listing for the shares includes an approval process for a draft prospectus for the share issue.
Companies whose shares have been accepted on to the Official List are called
‘listed companies’. In the US, approval must be obtained from the US stock markets regulator, the Securities and Exchange Commission or SEC.
The company must also apply to the country’s stock exchange for the shares to be accepted for trading on the stock market operated by the exchange. In the UK, for example, companies apply to the London Stock Exchange for the new shares to be admitted to trading on the exchange. Similarly, in the US, a company might apply for its shares to be traded on the New York Stock Exchange or NASDAQ.
When the shares have been issued and are trading on the stock market, the company must comply with continuing regulations of both the financial markets regulator and the stock exchange. In the UK for example, listed companies must comply with the Listing Rules and the Disclosure and Transparency Rules of the financial markets regulator, and must also comply with the Admission and Disclosure Standards of the London Stock Exchange which require for example that securities must be eligible for electronic settlement.
Some multinational companies obtain listings for their shares in two or more countries. For example a company in Germany might obtain a listing in Germany and its shares might be traded on the German stock market. In addition, the company might obtain a listing for its shares in the USA or in the UK.
International companies might obtain a listing for their shares in a major international stock market such as London, in addition to their own country. In recent years, several major companies in countries such as Russia and Kazakhstan have sought a listing in the UK. The advantage of a London listing for these companies is that they gain access to global investment capital: it is much easier to raise capital by issuing shares in the UK than in countries with financial markets that are much less developed.
Raising capital by issuing bonds
In recent years, multinational companies have often preferred to raise capital by issuing bonds rather than shares. Debt capital has been much cheaper than equity, and institutional investors have been willing to invest in large quantities of bonds.
If a multinational company wants to raise capital in the international markets, it might prefer to consider the possibility of issuing bonds in a national bond market rather than consider the possibility of a share issue.
Paper P4
Advanced Financial Management
Q & A
Practice questions
Contents
Page The role and responsibilities of financial
managers
1 Corporate social responsibility 446
2 Corporate governance 446
3 Dividends and retentions 446
4 Financial plan 446
Capital investment appraisal
5 DCF exercises 448
6 DCF and tax 448
7 Free cash flow 449
Investing: portfolio theory and the CAPM
8 Two-asset portfolio 449
9 Risk and return 450
10 Coefficient of variation 450
11 Capital market line 451
12 Obtaining a beta factor 451
Cost of capital
13 WACC 452
14 Optimal WACC 452
15 Change in gearing 453
16 Geared beta 453
Other aspects of capital expenditure appraisal
17 APV method 453
18 Adjusted present value 454
29 More APV 455
International investment and financing decisions 20 Cash flows from a foreign project 456
21 Foreign investment 456
Valuations. Mergers and acquisitions
22 Valuation 457
23 Valuation of bonds 457
24 Annuities and bond prices 458
25 EVA 458
26 MM, gearing and company valuation 458
27 Acquisition 459
28 Takeover 459
Foreign exchange risk and currency risk management
29 Interest rate parity 461
30 Foreign exchange 459
31 Money market hedge 462
Interest rate risk. Hedging with FRAs and swaps
32 FRA 462
33 Swap 462
34 Credit arbitrage (1) 463
35 Credit arbitrage (2) 463
36 Currency swap 463
Futures and hedging with futures
37 Currency futures 464
38 More currency futures 465
40 Imperfect hedge and basis 465
41 Currency hedge 466
42 Hedging with STIRs 466
43 More hedging with STIRs 467
44 FRAs and futures 468
Options and hedging with options
45 Traded equity options 469
46 Currency options 469
47 Interest rate hedge 470
Option pricing and delta hedging
48 Black-Scholes 470
49 Put-call parity 471
50 Delta hedge 471
51 Bonus scheme 471
52 Delta neutral 472
1 Corporate social responsibility
(a) What are the main issues that might be covered by a company’s policy on corporate social responsibility?
(b) What types of company are most likely to face CSR risks?
(c) What is the nature of CSR risk?
2 Corporate governance
(a) What is the main purpose of statutory or voluntary codes of corporate governance?
(b) What are the main problems or issues that a code of corporate governance might be expected to cover?
3 Dividends and retentions
The directors of an all-equity company are considering the company’s policy on dividends and retentions. The cost of capital is 9% and the company is able to invest in new capital projects that will earn this return. The company’s shares are quoted and traded on a major stock market.
In the year just ended, the earnings per share were $2.00 per share. The company pays a dividend annually, and is about to pay a dividend for the year just ended on the basis of its selected dividend and retentions policy.
Required
Suggest what the company’s share price might be if the directors select a policy of paying annual dividends that are equal to:
(a) 25% of earnings (b) 50% of earnings (c) 70% of earnings.
4 Financial plan
The board of directors of NNW have asked for a four-year financial plan to be prepared for Year 5 to Year 8. They have approved the following assumptions for the plan:
(1) Sales growth will be at the rate of 6% each year into the foreseeable future.
(2) Cash operating costs will be 70% of sales.
(3) Investment in new plant and equipment is expected to grow in line with the growth in sales, and the net book value of plant and equipment will grow at the same rate.
(4) Tax-allowable depreciation will grow in line with the growth in sales.
(5) Inventory, receivables, cash and trade payables will also increase at the same rate as the growth in sales.
(6) There will be no change in long-term borrowing. Interest on the bank
overdraft will be payable at 7%. The interest charge for bank overdraft in the income statement each year should be calculated on the opening bank overdraft at the beginning of the year.
(7) Tax on company profits will be 30%.
(8) The company policy is to pay dividends as a constant percentage amount of earnings. This policy will not change.
(9) The cost of equity capital has been estimated as 12%.
The income statement of NNW for the year to 31st December Year 4 is as follows:
$ million
Sales 1,800
Cash operating costs (1,260)
EBITDA 540 Tax allowable depreciation (160)
Earnings before interest 380
Interest (78)
Profit before tax 302
Tax at 30% (91)
Profit after tax 211
Dividends (135)
Retained profit 76
The balance sheet of NNW as at the end of Year 4 is as follows:
$ m $ m
Plant and equipment 2,020
Current assets
Inventory 520 Receivables 640 Cash 30
1,190
Total assets 3,210
Share capital (shares of $0.05 each) 450
Reserves 1,200
1,650
Long term loan at 8% 800
Trade payables 450
Bank overdraft 310
3,210
Required
(a) Prepare a financial plan for Years 5 to 8, showing the profit after tax,
dividends, retained profits for each year and a summary balance sheet as at the end of each year.
(b) Calculate the expected free cash flow in each year of the financial plan.
(c) Comment briefly on the financial plan.
(d) Use the dividend growth model to estimate a market value per share as at the end of Year 8 (the end of the financial planning period). State any assumptions that you make in your estimate.
5 DCF exercises
(a) Calculate the NPV of an investment with the following estimated cash flows, assuming a cost of capital of 8%:
Years Annual cash flow
$ 0 (3,000,000)
1 – 4 500,000
5 – 8 400,000
9 – 10 300,000
11 onwards in perpetuity (per year) 100,000
(b) The cash flows for an investment project have been estimated at current prices, as follows:
Year Equipment Revenue Running costs
$ $ $
0 (900,000)
1 800,000 (400,000)
2 800,000 (400,000)
3 600,000 (350,000)
4 200,000 400,000 (300,000)
It is expected that the cash flows will differ because of inflation. The annual rates of inflation are expected to be:
Equipment value: 4% per year
Revenue: 3% per year
Running costs: 5% per year.
The cost of capital is 12%
Required
(i) Calculate the NPV of the project ignoring inflation.
(ii) Calculate the NPV of the project allowing for inflation.
6 DCF and tax
A company is considering whether or not to invest in a four-year investment project. The project will require the purchase of equipment costing $800,000. This will have an estimated residual value of $200,000 at the end of Year 4. The equipment will be depreciated by the straight-line method.
The profits before interest and tax from the project are expected to be $250,000 each year. Tax is payable at 30% one year in arrears.
The equipment will qualify for capital allowances (tax depreciation allowances) of 25% each year, using the reducing balance method. The first claim for an allowance would be made against Year 0 profits.
The after-tax cost of capital is 15%.
Required
Calculate the NPV of the project.
7 Free cash flow
A company expects to make profits before interest and tax next year of $3 million.
Other budgeted information is as follows:
$ Interest charges 400,000 Taxation 600,000 Dividend payments 1,200,000 Depreciation charges 550,000 Increase in working capital 150,000 Capital expenditure:
Asset replacement expenditure 1,000,000 Discretionary expenditure 700,000 Required
Calculated the expected amount of free cash flow next year.
8 Two-asset portfolio
An investor is planning to invest in two securities, Security X and Security Y. The expected return from each security will depend on the state of the economy, as follows:
State of the
economy Probability
Return from Security X
Return from Security Y
% %
Strong 0.25 15 20
Fair 0.60 10 8
Weak 0.15 2 (6)
Required
(a) Calculate the mean and standard deviation of the expected return from Security X.
(b) Calculate the mean and standard deviation of the expected return from Security Y.
(c) Calculate the covariance of the returns from Security X and Security Y. The formula for a covariance is:
Covx,y= Σr x( −x ) (y−y )
(d) Calculate the correlation coefficient for returns from Security X and Security Y, for a portfolio consisting of 50% of the funds invested in Security X and 50% of the funds invested in Security Y. The formula for correlation coefficient is:
ρx,y=Covx,y σx xσy where:
σx = the standard deviation of returns from Security X
σy = the standard deviation of returns from Security Y Comment on the correlation coefficient.
(e) Calculate expected return, the variance and standard deviation of a portfolio consisting of 50% of the funds invested in Security X and 50% of the funds invested in Security Y. The formula for correlation coefficient is:
a2(Variance X)2 + (1 – a)2(Variance Y)2 + 2a(1 – a) Covx,y
where:
a = the proportion of the portfolio invested in Security X (1 – a) = the proportion of the portfolio invested in Security Y Variance X = the variance of the returns from Security X Variance Y = the variance of the returns from Security Y
(f) Calculate expected return, the variance and standard deviation of a portfolio consisting of 80% of the funds invested in Security X and 20% of the funds invested in Security Y.
9 Risk and return
A divisional manager’s attitude to investing in new projects is affected by his attitude to risk. He is prepared to invest in a project that is more risky, provided that it offers a higher expected return.
He is currently considering four mutually exclusive projects, for which the estimated returns and risk are as follows:
Project Estimated project NPV Risk (σ) Project 1 80% chance of + $4 million, 20% chance of + $2 million 0.80 Project 2 70% chance of + $5 million, 30% chance of + $1.5 million 1.60 Project 3 60% chance of + $6 million, 40% chance of + $1 million Not yet calculated Project 4 50% chance of + $8 million, 50% chance of – $1 million Not yet calculated Required
(a) Calculate the risk with Project 3 and Project 4.
(b) Suggest which of the four projects the divisional manager will select.
10 Coefficient of variation
A multinational company is planning to invest in two developing countries, and it will invest equal amounts of capital in each country. It is looking at returns and risk
The company is particularly concerned about the political risk in each country, and the threat of political risk to its expected returns. A firm of management consultants has produced the following statistical estimates of expected returns ad political risk in each of the countries.
Country
Expected investment return (%)
Political risk (%)
Country A 16 25
Country B 22 36
Country C 30 45
The expected return from investing in any of the three countries is independent of the returns that would be obtained from the other countries.
Required
(a) Calculate the risk, return and coefficient of variation of the following three investment portfolios:
(i) 50% in Country A, 50% in Country B (ii) 50% in Country A, 50% in Country C (iii) 50% in Country B, 50% in Country C (b) Comment on the results.
11 Capital market line
The risk-free rate of return is 3%. The return on the market portfolio is 9%.
Suggest how an investor should create a portfolio to provide a return of 7% with minimum risk.
12 Obtaining a beta factor
A beta factor will be estimated for Security Y from the following data.
Month
Returns from the market portfolio
Returns from Security Y
% %
1 + 2 + 3
2 – 1 – 2
3 – 2 – 2
4 + 3 + 5
EV of monthly return + 0.5 + 1.0
Required
(a) Use this data to calculate:
(i) the standard deviation of the monthly return from the market portfolio and
(ii) the standard deviation of the monthly return from Security Y.
(b) Calculate the correlation coefficient for the market returns and the returns from Security Y. This is calculated as:
ρm,y=Covm,y σm xσy where:
σm = the standard deviation of returns from the market portfolio
σy = the standard deviation of returns from Security Y The formula for the covariance is:
Covx,y= Σ(x−x ) (y−y )
(c) Use this data to calculate the beta factor for Security Y. You can use either of the following formulas.
β =Covm,y Varm Alternatively β =ρm,y xσy
σm