ACCA P4 Advanced Financial Management

Sample Study Note

For exams in June2014

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 Lesco Group Limited, April 2015 All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, or transmitted, in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without the prior written permission of Lesco Group Limited.

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Sample Note Content:

Main study note content [Total Pages: 218] ...................................................... 4 Product Summary .......................................................................................... 5 Live online note sample plan ........................................................................... 6 Live online course timetable: ........................................................................... 7 Free cash flow ............................................................................................. 11 Adjusted Present Value(APV) ......................................................................... 17 Business Valuation ....................................................................................... 31

Please note:
This is just the sample study note extracted from the main study note in your tuition study [This tuition study note is consistent in basic/super/gold package]. There would be more chapters in the main study note covering the whole ACCA syllabus. You can also take a look at the content within the main study note below:

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Main study note content [Total Pages: 218] Chapter1 Financial Crisis & Corporate Governance -Why financial crisis -corporate governance

Chapter 2 Accounting Equation: Assets=liability+Equity Sessoin1 Assets -session1.1 Domestic investment appraisal -session1.2International investment appraisal -session1.3Business Valuation -session1.4Risk Management

Session2 Liability+Equity -session2.1 Financing decision -session2.2 Dividend Policy Decision

Chapter 3 How to grow and save your business? -session3.1 International Trade -session3.2 Mergers & Acquisitions -session3.3 Business Reorganization and Reconstruction

Chapter4 Other current issues

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Product Summary
content Basic package Super package Gold Package Oxford Brookes BSc in Applied Accounting

ACCA HD quality super tuition videos

ACCA HD quality super revision videos

Last minute revision ACCA Live online tuition(4sessions) ACCA Live online revision(14hours) ACCA Mock exams(with tutor mark) ACCA Tutor support ACCA Electronic study note ACCA Student online forum Pass Guarantee ACCA Final revision mock exam paper ACCA Super Live online session (2030hours) ACCA Super Live online revision (Super 3 days) ACCA 1V1 Career Advice ACCA Extra exam techniques demonstration Live online mentoring

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Live online note sample plan

Live online tuition note plan for June2014 P4 Exam

[Only for super / gold package (there would be a unique plan for gold package)]

Live sessions: [2 hours/session---live online + recorded after class]:

Live session1 topic: Investment appraisal Summary

Live session2 topic: Financing decision + Business Valuation Summary

Live session3: Risk Management Summary

Live session4: overall summary of knowledge in P4 exam

Live revision note for June2014 P4 exam: [will be available since mid April 2014]: Live revision1+2: [There would be a separate live revision note detailing all past exam questions with answers to go through]

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Live online course timetable: Live session/revision for F4-P7

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*Please Note: This Timetable may be subjected to future changes. Kindly check regularly for any possible updates.

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Domestic investment appraisal

The idea behind this is to use techniques to evaluate whether the investment proposal is worthwile.

Techniques would be classified between:

Non-discounting techniques
Payback period

Discounting techniques
Net present value(NPV)

Other decisions
Asset replacement Capital rationing
Lease or buy decision

Free cash flow Risks&Uncertainty

Sensitivity analysis
Monte Carlo simulation Value at risk

Option pricing model

Real option Black-Scholes option pricing model
Accounting rate of return(ARR/ROCE/ROI) Adjusted present value Internal rate of return(IRR) Discounted payback period Duration/ Macaulay Duration method Modified internal rate of return(MIRR)

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Free cash flow

Free cash flow to firm is cash flow from operations+ interest expense cash flow from investing activities.

Free cash flow to equity is free cash flow-interest expense(net of tax)-net debt borrowing.

Once we have calculated the free cash flow to equity we can then establish the dividend cover based on free cash flow to equity. We have learnt how to calculate dividend cover where we take PAT/Dividend paid. But before PAT is profit and its subject to manipulation by management so we can use a cash flow approach to do this.

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There are 2 ways to calculate free cash flow to equity:

Direct method: PAT Adjustment for non cash item Adjustment for changes in working capital -cash flow from investing activities Adjustment for net debt borrowing Free cash flow to equity x x x x x x

Indirect method: Free cash flow -interest paid(net of tax)-because in free cash flow we have subtracted the whole taxes Adjustment for net debt borrowing Free cash flow to equity x x x x

Free cash flow needs to be assessed not in a single period because sometimes company would spend money into expanding the business in the current year so the current years free cash flow would be low but it does benefit the company for the long term.

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Example Human Ltd

The following statement of profit or loss relates to Human Ltd. $m Sales Cost of sales Gross profit Operating expense PBIT Interest PBT Tax@20% PAT 90 (30) 60 (20) 40 (10) 30 (6) 24

During the year loan repayments are expected to amount to $20 million. Issue of new debt is $69m.

Deprecation charge is $30 million and capital expenditure is $10 million.

Human ltd bought $3 inventory during the year.

Human Ltd ha 100m shares in issue and DPS is $0.03.

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Required: 1, calculate free cash flow to firm 2, calculate free cash flow to equity 3, calculate dividend cover using free cash flow to equity method.

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Answer:

1, FCF to firm:

PBIT Tax at 20% on PBIT

40 (8) 32

Depreciation Working capital Capital expenditure FCF to firm

30 (3) (10) 49

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2, FCF to equity:

Indirect method: FCF to firm -interest net of tax(10x(1-20%)) Adjustment to net debt borrowing (69-20) FCFTE 90 49 (8) 49

Direct method: PAT Adjustment to non cash item Depreciation Adjustment to working capital CAPEX Adjustment to net debt borrowing (69-20) FCFTE 90 (3) (10) 49 24 30

3, dividend cover: = FCFTE Dividend value = 90 100mX0.03 =30times

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Adjusted Present Value(APV)

APV is used when you are appraising a project where its financial risk is changed.

We have looked at NPV calculation and we use WACC(weighted average cost of capital) to discount cash flow.

WACC has incorporated debt and equity element and one of the arguments for this is future sales, costs incurred have nothing to do with financing but instead they are something to do with operations.

So thats why we developed APV to separate business option from financing.

APV is used when you are appraising a project where its financial risk is changed.

This means we use cost of equity(ungeared) to discount the basic cash flow including revenue & expenses because they are something to do with business not finance.

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We can then establish present value of finance effect including issue cost, tax saving on interest and subsidy as well and for these items we use risk free rate/cost of debt to discount because APV doesnt specify which discount rate we should choose and you can argue that eg, for tax saving on interest we have no idea when tax rate may change and as a result we can use Rf or Kd to discount the cash flow. Here notice you can either use Rf or Kd to discount cash flow and whichever you use your examiner would give you a mark in the exam(although your answer may be different from examiners and thats totally acceptable).

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Calculation:

APV=

Base case NPV

PV of Finance Effect
Issue costs Tax savings on interest Subsidy

Only include relevant cash flow from operations

Discount factor would only include BR(Keu)

But when Co is geared(2approach to separate (Keu))

M&M preposition
2 cost of equity
Keg=Keu+(Keu-Kd)D(1-T) E

Beta Geared Ungeared

3 WACC

WACC(g)=WACC(ungeared)(1-Dt ) (Keu) D+E

1, ungeared

a= e [ E ] E+D(1-T)

2,CAPM

Keu=rf+a(Rm-Rf)

Keu=rf+a(Rm-Rf)

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PV of finance effect calculation:

Issue costs: 1, % X amounts raised(not amounts required) 2, net off with tax saving 3, discount them

Tax saved on interest: 1, interest expense 2, multiply by tax rate 3, discount it

Subsidy: 1, PV of tax shield on interest 2, PV of subsidy(amounts saved net of tax because save interest=save expense so increase in tax )

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Base Case NPV Example1:

Company A is an equity finance company with Ke=10%.

Company B is considering a project that would cost $100,000 to be financed 50% by equity (ke= 21.6%) and 50% by debt (kd(pre-tax) =12%).

Required: Calculate Keu for company A and company B.

Answer:

Company A: Keu=10%

Company B:
Keg=Keu+(Keu-Kd)D(1-T) E

21.6% =Keu +(Keu-12%) X 50X(1-30%) 50 Keu=17.6%

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Base Case NPV Example2:

Company has the following market value of finance:

Value of debt is $6m. Value of equity is $11.8m. Companys current WACC is 19.7%. Tax rate is 30%.

Required: Calculate Keu for company.

Answer:
WACC(g)=WACC(ungeared)(1- Dt ) (Keu) D+E

19.7% =WACC (ungeared) X 1- 6X30% 6+11.8 WACC(ungeared) (Keu)=21.9%

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Base Case NPV Example3:

Company diversifies its business by entering into the mining industry.

The companys equity beta is 0.85, and its financial gearing is 60% equity, 40% debt by market value.

The average equity beta in the mining industry is 1.2, and average gearing 50% equity, 50% debt by market value.

Tax rate is 30%.

The risk free rate is 5.5% per annum and the market return 12% per annum.

Required: Calculate Keu.

Answer:
1, ungeared

a= e [ E ] E+D(1-T)

a=1.2 x 50 50+50X(1-30%) =0.71

2,CAPM

Keu=rf+a(Rm-Rf)

Keu=5.5%+0.71X12 %=10%

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Base Case NPV Example4:

Company has an equity beta of 0.85 and asset beta of 0.5. Rf=5% Rm=10%

Required: Calculate Keu.

Answer: Keu= Rf+a(Rm-Rf) =5%+0.5x(10%-5%) =0.075

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Example: (JOJO Ltd) (issue cost)

CAPEX required: $20m

How to raise $20m: from a 1 for 3 rights issue at a price of 2 per share.

Right issue cost: 5%.

Rf: 10%.

Required: Calculate issue cost to be incorporated into APV calculation where: 1, issue cost is not a tax allowable expense 2, issue cost is a tax allowable expense and tax is paid 1 year in arrears while tax rate is 30%.

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Answer: 1, Amounts raised issue costs = amounts required

100%

5%

95% 20m

20/0.95 =21.05 21.05-20=1.05 21.05X5%

DF@yr 0= 1.05X1=1.05

APV= base case NPV - 1.05

2, Issue cost = 1.05 (1)

DF@10% yr0 yr1 1

PV (1.05) 0.909 (0.73) 0.32

Tax saved: 30%X1.05 =0.315

APV= base case NPV - 0.73

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Example: TT Ltd (tax saving on interest)

CAPEX required: $10m.

How to raise $10m: use a 5 year bank loan(year1-5) and interest expense is 10%.

Tax is paid 1 year in arrears at 30%.

Rf=10%. Required: Calculate tax saving on interest to be incorporated into APV calculation.

Answer: 1, interest 10%X$10m=$1m. 2, tax saved: 30% X$1m= $0.3m 3, discount it: 1 year in arrears based on year 1-5

$0.3X AF(YR2-6) @10% $0.3XAF1-6 XDF(yr 1-5)@10% =0.3X 1/0.1 X(1-1/1.1^5)X0.909 =0.3X3.791X0.909 =1.03

So APV=base case NPV + 1.03

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Example: SS ltd

CAPEX required=$20m

Company would normally borrow at 8%

Government has offered a loan at 6%(which is lower than market rate)

Risk free rate=5%

Project is for 5years

Tax rate is at 30% paid in the current year.

Required: Calculate subsidy to be incorporated into APV calculation.

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Answer:

1, PV of tax shield on interest $20m X6%X30% XAF@5%(1-5yr) = 1.56 4.33

2, PV of subsidy Subsidy %= 8%-6% =2% Total subsidy p.a.= 2% X$20m=0.4

PV of subsidy(net off tax) 0.4X(1-30%)XAF@5% 5yrs =1.21

APV=base case NPV +1.56+1.21

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Comment of APV

1, Difficult to choose an appropriate discount rate for side effect, ie, tax shield.

2, when establish the discount rate for base case NPV, ie, Keu, the beta factor is based on M&M assumptions.

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Business Valuation

In this session we are going to look at how to value a business.

Session overview:

1. 2. 3. 4. 5.

Reasons to value a business Types of valuation methods Payment methods Defense Regulation regarding takeover

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Reasons to value a business

The 1st question is why do we need to value a business?

Well, the reasons being: We want to acquire another company so we need to determine how much we are going to pay for them.

For listed companies you would notice they have their own share price then we can take it multiply by number of shares giving us total market capitalization then why do we still need to value them?

The reason is because we are in a semi market hypothesis so the share price quoted may not include insider information then we need to do extra calculation to verify whether that share price is the value of the company.

Other reason includes eg, why we need to value the company would be company may want to go listed onto the stock exchange then how would you determine your share price? Of course you need to value it first then divide by the number of shares and hence you can get share price you are going to quote.

Or we would like to merge another company(Co1+Co2=Co1) or acquire another company in order to make it become a subsidiary, eg, creating synergies(1+1>2) so we need to understand how much its worth before we purchase it.

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Types of valuation methods

The 2nd question being how we can value a business?

There are three types of valuation including type1, type2 and type3.

Type 1 acquisition means after acquiring this company the existing business risk and financial risk would not change.

Type 2 acquisition means after acquiring this company the existing business risk would not change but financial risk changes.

Type 3 acquisition means after acquiring this company both business risk and financial risk change.

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Type 1 acquisition

We are going to use book value approach, market based approach and cash flow based approach to value the business.

1. Book value approach The simple idea is to look at total equity within statement of financial position BUT that figure doesnt include up to date information like:

Replacement cost: cost of setting up the same business now. Net realizable value: value to sell something now. Potential intangible assets: slogan, brand name etc. And we need to subtract goodwill in the valuation process as well.

After weve looked the above things we need to consider how to value an intangible asset.

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Example: Hum ltd

Hum has the following elements within its FS: $ Non-current assets: PP&E Goodwill Other intangible assets 100 30 20

Current assets: Inventory Receivable 10 15

Total equity

150

Total liability Note:

25

The property, plant and equipment have a replacement value of $50. 30% of the inventory are no longer required by Hum ltd and they can only be sold to customers for $2. Required: Calculate the valuation for Hum Ltd based on its net asset method.

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Answer:

$ Non-current assets: PP&E Goodwill Other intangible assets 50 30 20

Current assets: Inventory Receivable 10-3+2=9 15

Total equity

150

Total liability

25

Asset excluding goodwill - liability =39(net assets) 50-30+20+9+15 -25

After weve looked at how to value a business using net assets approach then we can start thinking about how to value its intangible assets because we know that an asset can be recognized in its FS if its identifiable (price agreed between two parties) but for company name, slogan, relationship with customers, they are not identifiable and how can we come up with a value for those items?

And for goodwill(the excess we paid for the reputation, slogan and relationship of company) maybe thats not worth this value and how can we value this as well?

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We use:

CIV approach(calculating intangible value) Market to book value The simple idea behind CIV approach is we compare: Average operating profit Average assets base With industry figure and the excess amount would be due to the value of intangible assets.

The simple idea behind market to book value approach is to compare: Book value of equity with market value of equity(share priceXnumber of shares) And the excess amount would be due to the value of intangible assets

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Example: Independence Ltd(CIV)

Average profit before interest and tax of Independence Ltd is $66.2. Average assets of Independence Ltd are $230. Average Pre-tax return on asset in the industry is 20%. Tax rate is 30%. Cost of capital is 11%.

Required: Calculate the value of intangible assets using CIV approach.

Answer:

Return on asset of Independence Ltd is 66.2 =29% 230

Excess return=ROA of independence industry average =29%-20%=9%

Intangible asset value before tax=9%X230=21

Value of intangible asset after tax=21X(1-30%) =134 11%

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Example MB plc

At the year end the book value of total equity of MB ltd is $200m. Share price as at the year end is $20 and there are 20m shares in issue.

Required: Calculate the value of intangible assets.

Answer: MV=$20X20m=$400m BV =$200m(include any possible replacement cost/NRV is necessary)

So the value of intangible assets=MV-BV=$200m.

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2. Market based approach Under market based approach we are going to use

P/E ratio Dividend yield model to value a business.

After looking at the above techniques we can start thinking about why valuing high growth company is very difficult?

Well firstly most of these companies are loss making and hence using P/EXloss per share to value them becoming market price? Well this is difficult.

Secondly maybe these companies dont have much cash to pay to shareholders and hence when using dividend valuation model to value a company because Do=0 so Price of company=0?

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P/E ratio

This is useful when value a business for majority shareholders.

Share value=

earnings

P/E acquirer

Target company

There are some limitations when using this method:

1, for earnings for target company, are you going to use the average earnings over 5years? 3years? Or are you going to use current year earnings?

2, for P/E ratio, if the target company is a listed company then P/E can be obtained from share market but what if the target company is not listed? So you may need to adjust the P/E using your own experience, expertise or you can take a company in the similar industry to adjust it.

Heres a very simple example to show how it works:

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Example: Pipi Ltd

Sisi plc wants to acquire Pipi ltd and profit after tax of Pipi ltd is $300 whilst P/E ratio of a company in a similar industry with Pipi is 6. And P/E of Sisi plc is 8.

Required: What is the value of Pipi Ltd?

Answer: Share value=P/E Sisi plc X earnings=8X$300=$2,400

Pipi Ltd

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Dividend yield basis

Dividend yield= Share price

DPS

X100

This is one of the ways to maximize shareholders wealth and for listed companies this can be taken out from stock market.

This is often greater than interest rate because if this is not the case, from shareholders perspective why bother taking additional risks to invest money in shares but instead they can put their money directly into banks and enjoy a higher return.

We use this method to value a business normally unlisted but we can reasonable estimate the dividend per share of that company.

So share price of target company =

DPS(target Co)

Dividend yield (similar listed Co)

Example: Don ltd Gun plc wants to acquire an unlisted company called Don ltd. Don has 10m shares in issue and expects to pay out a total dividend of $300,000. Dividend yield of a company in the same industry of Don Ltd is 2%.

Required: Calculate share price of Don Ltd using dividend yield basis.

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Answer:

share price of target company =

DPS(Don Co)

Dividend yield (similar listed Co)

= $300,000/10m 2%

=$1.5/share

Maybe we can further adjust $1.5/share by reducing it by 30% because its unlisted companies? But this is based on industry experience and expertise.(just a guess work)

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3. cash flow based approach dividend valuation model(dividend growth model) free cash flow method Economic value added(EVA)

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Dividend valuation (growth) model

Here we are focusing on perpetuity whereby we are going to take future dividend(cash element) discounted at ungeared cost of equity.

In simple terms this is the PV of future dividend at cost of equity ungeared. Note: this is future dividend not current dividend.

This is useful when value a business whereby shareholders hold a minority stake because they tend to prefer dividend rather than capital gain.

Future dividend would remain constant or would grow.

If its constant then Po= D Ke

If its with growth then Po= Do(1+g) Ke -g Notice: 1. Po is ex dividend because we need to consider the net effect after paying out dividend to shareholders and forms ke to our company. 2. g is dividend growth rate not earnings growth rate. 3. If examiner tells you to value a business using DVM cum dividend then you need to take Po + g.

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Comment: Advantage: Its useful when valuing a company for minority shareholders.

Disadvantage: When calculate growth rate etc using CAPM then disadvantages associated with CAPM would also apply.

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Example: DIDI plc (DVM Model)

1, DIDI plc expects to pay a constant annual dividend of 45c per share and the market expects a rate of return of 15%.

2, DIDI plc expects to pay dividend of 30c next year and dividend growth rate is 5% whilst earnings growth rate is 10%. Ungeared cost of equity is 10%.

3, DIDI plc expects to pay dividend of 30c next year and dividend growth rate is 5% and the market expects a rate of return of 15% and what is the cum dividend value of share?

4, Current dividend of DIDI plc is 30c and dividend growth rate is 5%. Risk free rate is 5% and market rate of return is 10% and beta is 1.3.

5, DIDI plc expects to pay dividend of 30c next year. Ungeared cost of equity is 10%. Dividend in 4years ago was 20c per share and now is 25c per share.

6, DIDI plc expects to pay dividend of 30c next year. Ungeared cost of equity is 10%. DIDI plc has an accounting rate of return of 11% and pays out 35% of its profit after tax as dividend each year.

7, DIDI plc has a DPS of 30c and has just paid out whilst dividend growth is expected to be 10% in the next 2 years and 5% in year 3. DIDI plc estimates a 3% growth of dividend till perpetuity after year3. Ungeared cost of equity is 5%.

Required: Using DVM calculate share value of DIDI plc.

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Answer: 1, Po=$0.45 =$3/share 15%

2, Po=

$0.3

=$6/share

10%-5%

3,Po+Dividend =

$0.3

+$0.3=$3.3/share

15%-5%

4, Po=

$0.3X(1+5%)

= $4.85/share

5%+1.3X(10%-5%) -5%

5, g=(current dividend Dividend 4 yrs ago

)^1/4 -1 =(25/20) ^1/4 -1 =5.7%

Po=

$0.3

=$6.98/share

10%-5.7%

6, g=11%X(1-35%)=7%(Gordons growth method)

Po=

$0.3

=$10/share

10%-7%

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7, Years 1 2 3 Dividend 30X(1+10%) =33 30X(1+10%)^2=36 36X(1+5%)=38 DF @5% 0.952 0.907 0.864 PV 31c 33c 33c $0.97

Year4 dividend into perpetuity=38x(1+3%)=$20/share 5%-3%

X year3 discount factor

0.864

Year 3value

$17/share

So total share value=$0.91+$17=$17.91/share

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Free cash flow Basis

This is again perpetuity approach to discount future free cash flow at discount factor.

Therere 2 free cash flow from the previous study:

Free cash flow to firm (cash available to debt and equity holders) Free cash flow to equity(cash available to equity holders) If theres no grow of cash flow we can use:

PV= FCFo -value of debt WACC

PV=FCFTE Ke

If theres cash flow growth then we can use DVM model like:

PV= FCFo(1+g) -value of debt WACC-g

PV=FCFTE(1+g) Ke -g Notice: g is cash flow growth rate or you can use inflation rate as well.
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Example Nente Co(June2012 Q1)(adjusted) Free cash flow of Nente Co is $1,180. Free cash flow in 3 years ago was $970 and now is $1,230. Its expected that growth rate will reduce to 25% of the original rate for the foreseeable future. Weighted average cost of capital is 11%.

Value of debt from statement of financial position is 6,500.

Number of shares of Nente Co is 2,400shares.

Required: Using free cash flow to firm approach calculate current value of a Nente Co share.

Answer:

PV= FCFo(1+g) -value of debt WACC-g =1,180X(1+0.0206) -6,500 0.11-0.0206 =$13,471-$6,500 =$6,971

Share price=$6,971/2,400shares =$2.9/share

g=(1230/970)^1/3 =0.0823 X25%=0.0206

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Economic Value Added(EVA) Free cash flow approach just looks at valuation of a company as at a point in time, ie, discounting future cash flow to the present value and if the company has spent money into buying non-current tangible and intangible assets then the total cash flow would decrease and hence value of the firm and share would decrease as well. But for economic value added method we are going to focus on a period rather than just a point in time. We are going to take profit-cost associated with finance and make LOTS OF adjustments(in the real life there are more than 160 adjustments we need to make).

Calculation

EVA=

net operating profit after tax Operating profit(1-T%) Or PAT + int net of tax

-(WACC X capital employed)

NOPAT: Operating profit(before tax) -Operating profitXCT% Normal operating profit after tax Adjustments:
Non cash items-depre/amotisation Research expenses Training costs Interest expense net of tax Operating leases

X (X) X

X X X X X X

Net operating profit after tax

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Capital employed:

long term debt+total equity *

*there are lots of adjustments in the real life but in the p4 exam your examiner tends not to complicate these issues but in p5 you can expect some other adjustments to be made like capitalized operating leases etc.

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Example: EVA plc The statement of profit or loss for EVA plc is as follows: 2013-2014($m) Sales Other Expenses Training costs research costs Interest expense PBT Tax expense @30% Profit after tax 80 (10) (10) (10) (10) 40 (10) 30

The statement of financial position of EVA plc is as follows as at 2014: 2014($m) Total Assets 100

Equity Ordinary shares($1 par value) Retained earnings Total equity Long term liabilities-traded debts Current liabilities Total equity and liabilities WACC is 5%. Required: Using EVA to value the EVA plc and the value of EVA plc share. 30 20 50 40 10 100

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Answer:

Operating profit -Operating profitXCT%(40X30%) Normal operating profit after tax Adjustments:
Research expenses Training costs Int net of tax(10X0.7)

40 (12) 28

10 10 7 55

Net operating profit after tax

Capital employed=LTD+equity=40+50=90

EVA=net operating profit after tax-(WACC%Xcapital employed) =55-(5%X90) = 50.5 (40)

-value of debt

Total value of firm 10.5m Number of shares 30m Share price $0.35/share

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