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Below are some questions and answers relating to paper P9 Management Accounting Financial Strategy from past events.
Question
Please can you tell me the difference between an asset beta and an equity beta, and their respective roles in ungearing and re-gearing companies?Answer
An asset beta-value is a measure of the systematic risk of any asset, whether that be a share, a bond, a portfolio of shares (perhaps in a unit trust or other similar vehicle), or a project. An equity beta is the beta-value for a particular share.
The point of ungearing and regearing the beta values of companies is as follows. If you need to calculate a discount rate to use to evaluate (using an NPV calculation) a project or investment that has a significantly different risk profile (i.e. beta) than existing business, this is how you do it:
i) estimate the systematic risk of the project's operating cash flows by comparing it with published betas of companies operating within that industry
ii) adjust these beta values to allow for the company's level of gearing:
- ungear the published beta
- regear the ungeared beta using the company's own gearing ratio
This gives you a project-specific geared beta
iii) Take this project-specific beta and use the CAPM formula as usual to estimate a project specific cost of equity, and hence a project specific cost of capital (by weighting this with the company's own cost of debt)
All the examiner is looking for is for you to follow the steps above in a nice, methodical fashion. I suggest you use brief titles/descriptions to indicate what you are doing at each step, and label your workings fully.
Look in the 2008 P9 Study System, pp. 181-185 for a full discussion of this.
Question
Bootstrapping, what does it mean?
Answer
'Bootstrapping' is the process of buying a company with a higher earnings per share ratio than that of your own, so as to boost your own EPS.
Take a look at this example:
Big plc is considering buying out Small plc by offering two Big shares for each Small:
Big plc shares = 3,800,000
Small plc shares = 200,000
Annual earnings Big = £1,140,000
Annual earnings Small = £100,000
EPS Big = 30p per share
EPS Small = 50p per share
Assuming there is no synergistic effect from the acquisition, and no earnings growth occurs, look what happens post acquisition:
New co shares = (3,800,000 + (2x100,000)) = 4,000,000
New co earnings = (£1,140,000 + £100,000) = £1,240,000
New co EPS = (£1,240,000 / 4,000,000) = 31p per share
Big has attempted to improve its market standing by boosting its EPS, but rather than doing this in the 'right' way (i.e. increasing earnings by investing in projects with positive NPVs), it has 'bootstrapped' itself through the acquisition of a target with higher EPS than its own.
Question
There was some confusion in my taught course about how to treat a foreign asset at the balance sheet date when a foreign liability has been taken out to hedge the risk - should this be restated? Does IAS 39 provide guidance on when not to restate assets?
Answer
IAS 39 requires foreign currency hedge effectiveness to be assessed both prospectively and retrospectively. To qualify for hedge accounting at the inception of a hedge and, at a minimum, at each reporting date, the changes in the fair value or cash flows of the hedged item attributable to the hedged risk must be expected to be highly effective in offsetting the changes in the fair value or cash flows of the hedging instrument on a prospective basis, and on a retrospective basis where actual results are within a range of 80% to 125%. All hedge ineffectiveness is recognised immediately in the income statement (including ineffectiveness within the 80% to 125% window). Therefore the value of the asset should be restated if there has been a big enough movement in the exchange rate between the date of recognition of the asset and the balance sheet date so as to render the hedge ineffective.
Question
When do we use Adjusted Net Present Value? How do you use it? How do we use it in practical life?
Answer
What is it?
NPV is used to appraise investment decisions. It uses the cost of capital for a company for the discount factor, since this is the opportunity cost of the capital required to fund the project.
However, by investing in a project, this can itself have an effect on the cost of capital of the firm. Adjusted present value recognises this by taking into account the side-effects of financing the project into the project's NPV.
How do we use it?
A simple illustration:
A project's NPV is £20m. However, the project is considered socially desirable and so qualifies for a tax-free local authority grant of £2m.
APV = NPV + side-effect of financing
= £20m + £2m
= £22m.
Tax benefits of debt financing, and issue costs of debt/equity would also be examples of possible side-effects.
Use in practical life
The model tends to mainly be used where side-effects are material in relation to the overall capital costs of the project.
Question
In advanced capital budgeting techniques we have to convert from real rates to nominal rates using inflation factor? My question is if I directly use real rates and want to use discount rate also at real rate then I will get NPV at real rate , if so how can I convert it into
nominal rate. Is it possible, if so how?
Answer
You have to discount real cash flows at a real discount factor, or nominal cash flows at a nominal discount factor. You cannot discount real cash flows at a nominal discount factor, or vice versa - this would not be comparing like-with-like.
If you are given real (inflated) cash flows with a nominal discount factor, you have to either deflate the cashflows, or adjust the discount factor using the formula
(1+n) = (1+r)x(1+i)
where n is nominal rate, r is real rate, and i is inflation rate.
Question
What type of investments can be evaluated by using MIRR? Why do companies issue irredeemable debts and is there some companies that issue such debt in the UK?
Answer
Modified IRR is used to get around the problem of multiple IRR's (which of course make evaluation of different sources of finance impossible).
Multiple IRR's mean there are more than one discount rate at which the NPV of a project is zero, This can happen when project cashflows reverse during the lifetime of a project - for example, if there is an initial outflow (buy the asset), before then several cash inflows (as the asset generates sales), before another major outflow (e.g. the asset is refurbished, or perhaps upon scrapping the asset there are significant environmental cleanup costs).
Modified IRR - get rid of multiple IRR's by assuming only one cash outflow at the start of the project (hence you get a single MIRR to use for your decision-making). All cashflows are assumed to be reinvested at the cost of capital to give a single cash inflow at the end of the project's life.
Compound each period's cashflow to the end of the project, and use this to find the MIRR.
Consider:
A project has an initial investment of £20000, and then has annual cash inflows of £6500, £7750, £5750, £4750, and a final cash outflow of £300 at the end of its fifth year. The WACC of the company is 8%.
If the project has a life of 5 years, then the compound factor for the first year is (1 + 0.08)^4, i.e. 1.3605, that of the second year is (1 + 0.08)^3, i.e. 1.2597, etc.
Year Cash flow 8% compound factor £
1 6500 1.3605 8843
2 7750 1.2597 9763
3 5750 1.1664 6707
4 4750 1.0800 5130
5 (300) 1.0000 (300)
------------
30143
To find IRR, divide the £20000 investment into the £30143 figure you've calculated, then look in the 'n=5' row of the PV table.
20000
--------- = 0.6635, suggesting an MIRR of approximately 8.5%.
30143
Irredemable debt is used for annuities such as pensions etc. Yes, companies in the UK issue both irredemable and redeemable debt. In an exam question the examiner will make it clear which kind of debt is being evaluated.
Question
What is the difference between cost of capital and cost of equity. Please let me know when cost of equity is calculated as follows ke= d/po and keg=keu+(D+E)(keu-kd)?
Answer
'Cost of capital' is a weighted average of the return expected by providers of all sources of long-term finance within the business (therefore both equity and debt)
'Cost of equity' is a weighted average of the return expected by providers of equity long-term finance only within the business.
The first equation can be used where we assume a constant rate of dividends to perpetuity, and ignores taxation. This is a good equation to use for an ungeared company.
The second equation allows you to work out the cost of equity for a geared company - therefore when there is a mixture of debt and equity finance on the balance sheet.
Question
If a company has a high P/E ratio (much higher than the industry ratio), does it indicate anything about this particular company? Can i come to a conclusion taking only the P/E ratio alone into consideration?
Answer
If the P/E ratio is higher than the industry average, this means that the market prefers to invest in this company rather than one of its rivals.
All companies in the 'industry average' bracket can be assumed to share a broadly similar external environment, and so have broadly similar opportunities and threats within that environment. A higher P/E ratio for company X than average (assuming a perfectly competitive market) indicates that the market believes that X is capable of exploiting those opportunities and/or defending against those threats than their rivals - hence the value of that company's shares is higher than the market average suggests is should be.
This could be based on a particularly successful management team, or on a gearing ratio or other measurement that indicates the risk profile of the company is more acceptable to the market than that of the industry average (i.e. risk-adjusted investor returns from that company are expected to be higher than those of their rivals).
Question
In a mergers and acquisitions question, the target company rejects the share exchange given in the question and it asks us to recommend a suitable share exchange ratio. Can you please tell me how I can calculate this ratio?
Answer
What you need to do is look at the value of the share of the post-ac company.
(AT) for the target company (T) implied by the offer made by the aquirer (A). The only rational reason for T rejecting the offer is either that they have been offered less than the value of the holding they currently have (unlikely but possible), or that they feel that the share of the synergy generated by the turnover offered by A is too small.
You need to calculate the ratio at which T's shareholders would be indifferent to the merger (this is the minimum they would accept) - this is the ratio of TA at which their offer is equal to the market value of their current holding. Next work out the ratio at which all synergy generated by the merger is all given to to T's shareholders (this is the maximum ratio that would be acceptable for A) - the synergy is the difference between the value of TA, and the pre-ac values of T and A added together. This gives you the possible 'range' of ratios that can rationally be offered.
If the ratio rejected is below the minimum then you can argue that they have rejected since they lose value by accepting the deal. If the ratio rejected is within the range, then they either believe that the share of the synergy offered to them is insufficient, or they believe the synergy anticipated by A is unrealistic. Either way, any offer better than that rejected, yet still within the range established above, can sensibly be selected and justified to the examiner.
Question
Can you please explain to me why the EPS will drop in the predator company if it takes over a company with a higher P/E ratio? I can’t get my head around it as some material I have read seems to contradict itself.
Answer
The EPS may fall due to the new shares that may be issued to pay for the take over if it is to be financed via a share exchange i.e. there are more shares in circulation and therefore a dilution in EPS. However, this dilution in EPS may be short-lived as synergies are gained from the takeover/merger.
Question
What does redeemable and unredeemable debt mean and when is it applicable?
Answer
Redeemable debt is when the initial debt amount is paid back along with the interest payable; to calculate the cost of debt you need to use an IRR calculation. Irredeemable debt is when the principal sum is not repaid and only interest payments are paid on the debt; here the cost of debt is calculated as Kd post tax = Kd.(1-t).
Question
What guidance can you give if I have obtained a wide range of business valuations, say, an upper limit of double the lower limit. The Berliner method appears very arbitrary and other 'solutions' seem to have no really solid foundation either. If I am in the position of Predator should I bid low and risk rejection, or go in high, guaranteeing acceptance but risk paying too much?
Answer
This area of Business Valuations can be confusing and the questions you are asking are perfectly logical.
Traditionally, in a question of this nature you are given little direction as to what the question is really looking for. Therefore you need an approach to tackle this type of question.
Where I would start is to decide what type of valuation is required. Is the company being bought for acquisition or is it being bought to be asset stripped?
The next thing to do is decide on your method of valuation. There are four main methods:
- Asset Based Valuation (Using Balance Sheet)
- Price Earnings Method (using the P/E ratio)
- Discounted Cash Flow (i.e. discounting the future cash flows of the company)
- Dividend Valuation Model (DVM)
In a question, there is normally enough information to calculate valuations using at least three of the above methods. The Berliner method you have mentioned is not as 'mainstream' as the above four and normally not that widely used in the exam questions.
You will find that these methods can give varying values for the business. This is OK. What the examiner is looking for is not an exact answer but your ability to apply a number of differing methods. Business valuations is not an exact science and some students struggle with this. Ultimately a business is worth what someone is willing to pay for it and I would make this point in the exam.
When giving a conclusion to the question you can state that the valuation will be between two figures i.e. the highest and lowest figure, but you must take into account the reason for acquisition.
