1) Investment Appraisal

IRR
-It is a cost of capital that gives NPV zero
Usefulness
● IRR is very useful for people having limited financial management knowledge
Weakness
● IRR works on reinvestment assumption and it assumes that cash flows will be
reinvested in the same project at IRR.
● IRR cannot be used in case of mutually exclusive projects.
● In case of non conventional cash flows which means there will be multiple IRR and is
therefore not useful
● IRR has a scaling problem,e.g NPV would be rising,investment would be high but
IRR low,hence scaling problem.

If IRR>cost of capital , the project should be accepted

IRR=a+[A/A-B] x (b-a)

MIRR
-It is a cost of capital that gives NPV zero
-If MIRR>cost of capital, then opt for the project.
Usefulness
● MIRR and NPV both assume that cash flows are being reinvested in the same
project at cost of capital.
● MIRR does not have a scaling problem.
● MIRR and NPV can be used in case of mutually exclusive projects
● In case of non standard pattern of future free cash flows there will be only one MIRR
Weakness
● Defining investment phase and return phase is problematic
● In non standard pattern future free cash flows we have to modify the MIRR

MIRR= [PVR/PVI]^1/n x (1+re) -1

PVR=Present value of return phase
PVI= present value of investment phase
n=The year of last cash flow from the project
re= rate of reinvestment (if not mentioned in question then assume re=cost of capital)

Capital rationing
● It is when a company is lacking funds.Ideally a company must undertake all projects
with positive net present value, but at times due to capital rationing a company may
not be able to do so.
● There are two types of capital rationing
Soft capital rationing:
-Lack of funds due to internal policies of the organisation
-Reasons: putting a limit on the capital budget or project should only be financed
through retained earnings.
- Management wants to avoid dilution of control by issuing new shares
 -Management may be unwilling to issue additional capital if it will lead to a dilution of
earnings per share.
Hard capital rationing
-Lack of funds due to external reasons
-Costs associated with making small issues of capital may be too great
-For e.g financial crunch in the market or weak lending power of the banks or poor
credit rating.

CIMS:
Reasons
● It monitors how an investment project is progressing once the system has been
implemented.
● It considers the possibility of both internal and external risks,which may affect the
project.
● The system will set a plan on how the project should proceed.
● It then ensures that the project is progressing according to the plan and budget.
● It also sets up contingency plans for dealing with the identified risks.

Benefits:
● It ensures that the project is completed on time.
● It acts as a communication device between managers managing the project and
the monitoring team
● CIMS identifies risk, so that department will be proactive towards it rather than
reactive which can help them reduce costs.

Why is APV better than NPV?

● APV separates out investment cash flows and financing cash flows, which will help
the management to see which part of the project generates more value.
● APV discounts the investment cash flows with cost of equity as discount factor and
financing cash flows with a different discount factor, which is not the case in NPV
where an average risk assessed discount factor is used
● In APV subsidised interest rate is used in calculations which is not the case in NPV
● NPV does not incorporate PV of transaction cost which is borne by the company,
while APV shows this.

2) Mergers and Acquisitions:

Benefits of Acquisition/Mergers over Organic growth:

● The buyer may have limited potential for growth prior to acquisition,however after
acquisition it may grow quickly
● In case of acquiring a business of the same line of activity as the buyer itself trades
in,the competition of that industry will get relaxed.
● After acquisition, a bigger group of companies will come out which will help them in
obtaining finance easily.
● The top management of both companies can be combined and a new team can be
created leading to success resulting in gaining a competitive advantage.
● When two firms merge,it will result in bulk purchases which will lead to economies of
scale, hence resulting in cost saving
 ● The acquirer company can strip the assets of the acquired company which will
improve the cash flow position of the combined company.

Criterias for choosing an appropriate target for acquisition

● Aims and objectives of acquirer: This criteria talks about the long term goals of
acquirer company ,whether they want to expand in a new product range or they want
to go deep in their existing product range market
● Tax saving: The target company may have excess carried forward losses and the
acquirer may be interested in acquiring such companies as this will result in tax
savings.
● Access to better technology: The acquirer may want to acquire the target company
which has better access to technology, which will result in significant advancement
for the acquirer.
● Opportunity and availability: An opportunity to acquire a particular company may
arise,and the acquiring company might decide to take the opportunity while it is
available.

What is synergy? Types of synergies.

There are three types of synergies:
● Revenue Based Synergy:
–Combined company’s revenue will be more than the total revenue of the individual
companies.
–By increase in market share:If the two companies merged will be of the same
industry,competition will get relaxed ,therefore market share will increase thus
resulting in increase in selling price,which will result in overall increase in revenue.
● Cost Based Synergy:
–Combined company’s total cost will be lower than the total cost of individual
companies.
–By merging, there will be elimination of duplicate roles,due to which wages and
salaries will reduce which will result in cost saving.
–By sale of surplus assets, there will be cash inflow for the business which will help
the cash flow status for the combined company.
● Financial Based Synergy:
–Combined company’s will be able to raise finance more easily compared to when
individual companies try to raise funds.
–If a combined company goes to a bank for a loan they will easily provide it at a
lower interest rate because combined company would assumed to be a bigger group
which are often assumed to be safer compared to when an individual company would
have requested for it
–By merging, it is also possible to raise finance within the group

Different forms of considerations to acquire a company:

● Debt: One of the sources of finance is debt. Debt is a cheaper source of finance but
knowing that a cheaper source does not mean that it is the best one. When you raise
funds through debt you will have to pay interest which will result in tax savings.Debt
finance sends positive signal to the stock exchange. However, raising funds through
 debt finance will result in change in capital structure i.e debt to equity ratio. Also it will
result in change in weighted average cost of capital of combined and therefore
change in value of combined company.
● Equity: Equity is an expensive source of finance but note that an expensive source
does not mean that it is not the best one. Raising funds through equity sends a
negative signal to the stock exchange and this source of finance will also dilute the
current shareholders holding. This method will also change the post acquisition
gearing of the company,which will result in change in weighted average cost of
capital and change in value of combined companies value.

Defences against hostile takeover bid:

● Golden Parachute: A large payment or financial compensation guaranteed to a

target company’s executives if they should be dismissed as a result of merger. Due to
this, no investor company would want to acquire the target company.
● Poison pill: An attempt to make the target company unattractive for the bidding
company,normally by giving right shares to existing shareholders at a very low price.
This would reduce the market value of the target company,hence the investor
company losing its interest.
● White knights: Inviting a third party company to make an acceptable counter offer
for the target company facing hostile takeover. Constant counter offers may make
investor company unwilling to acquire.
● Crown jewels: It is a defence strategy in which the target company sells off its most
attractive looking assets to a friendly third party company,consequently the hostile
bidder is less attracted to the company's assets. Note that the target company buys
back the valuable assets from the friendly third party company after the clouds of
take over ends.
● Pacman Defence: It is an aggressive strategy in which the company threatened with
a hostile takeover turns the tables by acquiring the investor company.This tactic
appears to suggest that target company’s management is in favour of the merger
taking place but they disagree about which company should be in control.
● Litigation Defence: The target company tries to seek government intervention. In
order for this strategy to be effective, the target company would have to prove that
this acquisition is against the public interest.

Why do mergers fail?

● The acquired company may not have the product range or industrial position, which
the acquirer had anticipated.
● The working culture of the acquirer company may be different from the working
culture of the acquired company.
● The acquirer may have paid too much bid premium and after the acquisition may
have realised that it was overpaid
● Sometimes some mergers fail because of the overestimation of synergies
● The acquirer company may have acquired the target company just so that the
competitor does not buy it, hence, an unplanned acquisition

KEY POINTS FROM TAKEOVER DIRECTIVE:

 1) Mandatory bid rule:
● This is designed to protect minority shareholders,where the acquiring company has
control over the target company
● It provides minority shareholders with an opportunity to sell their shares and exit the
target company at a fair share price.
● The main purpose of this rule is to ensure that the acquirer does not exploit their
position of power at expense of minority shareholders

2) Principal of equal treatment:

● This is designed to protect minority shareholders,where the acquiring company has
control over the target company
● It requires the acquiring company to offer the same terms to minority shareholders as
were offered to earlier shareholders from whom the controlling interest was taken

3) Squeeze out rights:

● This condition allows the bidder to force the minority shareholders to sell their shares
at a fair price,once the bidder has acquired a specified % of the target company’s
equity.
● The main purpose of this condition is to enable the acquirer to gain 100% shares of
the target company and prevent problems arising from minority shareholders at a
later date.

3) Black Scholes Option Pricing Model

Assumptions of BSOP:
● It assumes that the market is perfect i.e. BOD and shareholders have the same
information.
● BSOP assumes that risk free rate is constant ,however it may not be the case if
options expiry is long
● BSOP assumes volatility stays constant throughout life of project, however it may not
be the case in long term
● BSOP gives predictive values not conclusive values.
● BSOP assumes that company will not pay any dividend till the expiry of options
● BSOP assumes that real options are contractual agreements which have to be
fulfilled.
● BSOP is assumed to find out value of European style options not the value of real
options

The Greeks:
● Gamma(Change in Pa)= A high Gamma value indicates that the delta value is quite
volatile. Due to this it is hard to maintain a delta hedge , since the volatile delta value
will be constantly changing. Therefore,Gamma is a measure of how easy risk
management will be.
● Rho(risk free rate of return)= Rho measures the sensitivity of the option value to
changes in risk free rate of return. A high Rho value will have a positive impact on the
call option, but will have a negative impact on the put option. Also longer term options
will have a larger Rho value than short term options because the more time there is
to expiry of options the more significant is the change in risk free rate.
 ● Vega(Volatility)= It measures the change in option value caused by 1% change in
volatility. It measures the consequences of an incorrect estimation of volatility. Longer
term options have a higher vega value than short term options because the more
time there is to expiry of options the more significant is the change in volatility.
● Theta(Time)=Theta measures how much value is lost over time.An option price has
two components ,intrinsic value and time value.However when option expires, time
value becomes zero.

BSOP with Investment appraisal:

● Option to Delay(CALL)=
–Pa: PVR (PV of return phase)
–Pe: Investment that can be delayed
–r: Risk free rate
–S: Volatility
–t: Time to delay
● Option to Expand(CALL)=
–Pa: Additional PV of return phase
–Pe: Additional investment
–r: risk free rate
–S: Volatility
–t: time to expanding
● Option to Early Exit(PUT)=
–Pa: PV of NCF after offer’s time(t)
–Pe: Offer’s price
–r: risk free rate
–S: Volatility
–t: time to early exit

Delta of CALL option= N(d1)

Delta of PUT option=N(-d1)
Default risk of company= 1-N(d2)

VaR(Value at risk)
● VaR is a certain confidence level that loss won't exceed a certain amount,
maximum confidence which VaR can give is 99%
● VaR= Standard deviation x confidence level value x SQRT(t)
● E.g if VaR for annual basis and standard deviation is monthly then it will be
SQRT(12)
● If VaR over 5 years(project life) and standard deviation is annual then
SQRT(5)
● Confidence level 95 value= 1.645 99 value = 2.33

Incorporating real options in NPV

E.g:
$m Project: U V W X Y Z

PV of expected inflows 50 50 50 50 50 50

Initial investment required 45 47 53 54 56 56

NPV 5 3 -3 -4 -6 -6

● Traditional NPV is usually calculated using pre-planned figures which are budgeted
by the management according to their expertise and knowledge.
● Although it is believed that traditional NPV is superior amongst all other investment
appraisal techniques,the problem with traditional NPV is that it does not incorporate
sudden changes which may affect the budgeted position of the company.
● This weakness stated above is countered by the introduction of real options,which
will convert traditional NPV into strategic NPV and that can be called a superior
method amongst other investment appraisal techniques.

● Based on the above table,according to traditional NPV projects U and V would be

accepted with a total NPV of $8m. It will increase shareholders' wealth, while the
other projects will be rejected.
● Now for instance we have to opt between project U and project X immediately
because none of these two can be delayed. It is obvious that Project U will be opted
with a traditional NPV of 5m compared to project X,whose NPV is -4m. The overall
knowledge of this part is that a positive traditional NPV always tends to increase
shareholders wealth.
● Keeping the above example intact all the other projects except U and X can be
delayed, this is where real options occur.

Project V W Y Z

Volatility(Std 0.2 0.1 0.3 0.2

deviation)

Delay 3 1 3 2
period(yrs)

Option 12.2 1.8 11 5.5

value($m)

Traditional 3 -3 -6 -6
NPV

Strategic NPV 15.2 -1.2 5 -0.5

● In the above table we have calculated the strategic NPV using the real option to
delay,to see the strategic value of projects V,W,Y,Z. Just randomly looking at the
 table we can see that the strategic NPV will be greater than the traditional NPV of
8m.
Project V:
● This project looks very promising. It already had a positive traditional NPV and with
the incorporation of real options, the strategic NPV has gone up to $15.2m.
● It can be interpreted that opting project V right now will not give a good enough value
compared to opting Project V in a time period of 3 years in which it will give a
promising value.
● In short, project V can increase shareholders value if opted today but it will give a
further increase in shareholders wealth if opted in 3 years.
● However, real options are also estimates , it is possible that in a time span of 3 years
the company may not be able to opt project V due to competitors action or it might
not be attractive in 3 years time
Project W
● This project does not look promising at all. It has a negative traditional NPV, and
even with incorporation of real options its strategic NPV is also negative.
● Project W has a low volatility,which means that in a delay period of 1 year the
chances of cash flow changes are only 0.1. That's why this project does not have a
very high option value.
● This project is not worth exercising at all, opting now or with a real option to delay will
not increase shareholders wealth.
Project Y:
● Despite having a negative traditional NPV of -6m this project provides a positive
strategic NPV of 5m. This is because the real option to delay is 3 years and the
volatility is high which also explains the reason for a positive strategic value.
● Opting this project right now would not be beneficial for shareholders wealth, but
opting this project in a time span of 3 years will increase shareholders wealth.
Project Z:
● This project is similar to Project Y but is less promising. It currently has the same
negative traditional NPV as project Y, but with a lower volatility and delay period and
hence, lower option value.
● This project seems unworthy to be opted,but it is safe to assume that it will not
always be unworthy. It is true that even after a delay of two years this project would
not be worth it but giving it some more time may turn out to be beneficial to
shareholders. But it is certainly useful if shareholders are willing to invest in a long
term project.

FOREX

Hedging techniques:
1) Netting: We match the transactions in the same currency and time period, and net
off, the conclusive amount will be hedged. We do not hedge matching transactions
separately as this will increase hedging cost.
2) Forward Exchange Contract: Banks offer Forward rate and once accepted it will be
a binding agreement. It is a derivative.
3) Money Market Hedge: It is a non derivative technique.
a) MMH (Payments)
Step 1: Amount to be deposited = e.g $1000/1+i%xn/12=900
 i%= foreign currency deposit rate.
Step 2: Amount to be borrowed = 900/ or x according to spot buying rate=500
Step 3: Interest payment= 600 x i% xn/12= 12

i%= Local currency borrowing rate.

b) MMH (Receipts)
Step 1: Amount to be borrowed= e.g $1000/ 1+i%xn/12=980

i% =Foreign currency borrowing rate

Step 2: Amount to be deposited =940 / or x by spot selling rate=870

Step 3: Interest received= 870 x i%xn/12= 32

i%=Local currency deposit rate

4) Lead payment hedge: It is a non derivative technique and is payment in advance.

5) Multilateral Netting:
● Step 1: All transactions should be translated to Principal Co.’s currency(usually
parent company). Transactions can be payments or receipts
● Step 2: We will perform netting.
-All transactions whether payments or receipts will be converted to Principal currency
using Mid market rate= (Spot buying rate + Spot selling rate)/2
-A huge amount is netted off amongst itself due to multilateral netting.
-This arrangement also saves hedging costs.
-One drawback of multilateral netting is that some of the governments may not allow
this and some may allow this. Those who do not allow it focus on mainly increasing
banks revenue, while those who do allow this focus on bringing new businesses in
the economy.

6) Currency future contracts:

Step 1: Date of contract

Step 2: Hedging strategy

If Payment and contract currency in foreign currency then: BUY NOW SELL LATER
If Payment in foreign currency and contract currency is local then: SELL NOW BUY LATER
If Receipt and contract currency in foreign then: SELL NOW BUY LATER
If Receipt in foreign and contract in local currency then: BUY NOW SELL LATER

Step 3: Future estimated rate

From 2 future prices we will have to find an estimated rate using the forward exchange
contract for till the payment date.
Then calculate the Final receipt or payment which will be used in step 4.

Step 4: No. of contracts

If the amount is in foreign currency then convert to local then divide for no. of contracts.
Under/ Over hedge should be written if occurs.
 7) Currency Options:

Step 1: Date of contract

Step 2: Hedging strategy

If Payment and contract currency in foreign currency then: BUY CALL OPTION
If Payment in foreign currency and contract currency is local then: BUY PUT OPTION
If Receipt and contract currency in foreign then:BUY PUT OPTION
If Receipt in foreign and contract in local currency then:BUY CALL OPTION.

Step 3: Select exercise price

If indirect quote receipts then exercise price + premium(divide by 100) and then choose
lower effective rate.
If indirect quote payments then exercise price - premium(divide by 100) and then
choose higher effective rate.
If direct quote receipts then exercise price - premium(divide by 100) and then choose
higher effective rate.
If direct quote payments then exercise price + premium(divide by 100) and then choose
lower effective rate.

Step 4: No. of contracts.

Here underhedge is a rule. Koi bhi answer aye contracts ka e.g 47.8 it will become 47.

Step 5: i)Hedge receipt

Basic receipt( No. of contracts x contract size) xx
L: Premium paid
(contract size x no. contracts x premium)
(Answer ko spot buying rate se convert to local) (xx)
A:Underhedge amount to be hedged by FRH
(Basic receipts x exercise price= already hedged) (xx)
(Then Total amount - already hedged= not hedged)
(Then not hedged divide or multiply by forward
selling rate)

Net receipts xx

ii) Hedge Payments

Basic receipt( No. of contracts x contract size) xx
L: Premium paid
(contract size x no. contracts x premium)
(Answer ko spot buying rate se convert to local) (xx)
A:Underhedge amount to be hedged by FRH
(Basic payments x exercise price= already hedged) (xx)
(Then Total amount - already hedged= not hedged)
(Then not hedged divide or multiply by forward
Buying rate)

Net payments xx
8) Interest rate futures:

Step 1: Which contract?

Step 2: Hedging strategy

Borrowing= SELL NOW BUY LATER
Lending= BUY NOW SELL LATER.

Step 3: No. of Contracts

(Borrowed amount/contract size) x (Time period of borrowing/3)

Step 4: Basis risk

(Difference between today's spot price: 100- LIBOR and future price of selected contract=
Total basis risk)
We need to find unused basis for next step: total basis/total months x unused month(contract
close ke bad wale extra months) E.G 1.5 basis is for 6 months and unused months are 2 so
unused basis = 1.5 / 6 x 2

Step 5: To calculate future close out price (BY BOTH WAYS ONLY IF MENTIONED
OTHERWISE GO WITH THE ONE WHERE THERE WILL BE RISK)
When LIBOR INC. BY 5% When LIBOR DEC BY 5%
Spot price Spot price
100-LIBOR+5% 100-LIBOR-5%
L: Unused basis L: Unused basis
From above From above
Future price Future price

Step 6: Outcomes of hedge when LIBOR INC.and DEC.

Actual interest payment
(amount x LIBOR+INC x n/12)
L: Gain on futures
(Gain x 100xno. Of contracts x tick value)
OR
A: Loss on futures same way
Net interest payment

Step 7: Effective interest rate

Net interest payment/ total amount x12/time period of borrowing x 100

9) Interest options:

Step 1:Which contract?

Step 2: Hedging strategy

Borrowing= BUY PUT OPTION
Lending=BUY CALL OPTION

Step 3: Select Exercise price

Borrowing= Ceiling %+ premium%=Annual cost so select LOWER ONE

Lending=Floor % - Premium %= Annual return so select HIGHER ONE

Step 4: No. of contracts.

(Borrowed amount/contract size) x (Time period of borrowing/3)

Step 5: Compare exercise price with future close out price

-When LIBOR INC.
Exercise price if borrowing put if lending call xx
Future close out price from futures xx
If gain exercise(Borrowing me uper wala zyada hona chahiye aur
lending me neeche wala zyada hona chahiye )
Gain on options
(gainx 100 x tick value x no. of contracts)
Premium paid
(premium x 100 xtick value x contracts)
Actual interest payment/receipt from futures
Net interest

Step 6: Effective rate

10) Collar hedge

Step 1: Hedging strategy

Borrower= BUY PUT OPTION(Premium pay) SELL CALL OPTION(Premium receive)
Lender= BUY CALL OPTION(Premium pay) SELL PUT OPTION(Premium receive)

Step 2: Exercise price

Put ki sabse kum wali hogi aur
Call ki zyada wali

Step 3: Net premium

Premium paid-Premium received x 100 x tick value x contracts

Step 4: If LIBOR INC.

Then assume you are exercising put that is
Exercise price PUT xx
Future close out price xx
If gain exercise if loss lapse

● Currency Swap Part 1:

Situations in which other hedging instruments are not available, we use currency
swap.
In currency swap exchange rate gets fixed for a longer period of time,which means
there won't be fluctuations in the exchange rate
Currency swap is a binding agreement which may also cause loss.
Advantages:
 -Hedging is possible for a longer period
-Useful in countries with a volatile exchange rate

● Interest rate swap:

It is operated by the bank.
In interest rate swap, one company will have a better credit rating than another
company.
Step 1: First calculate the benefit and then divide it accordingly, if nothing mentioned
divide equally.
Step 2: The company with a better credit rating will choose either fixed or floating
according to the greater benefit being received. For e.g A chooses fixed rate due to
higher benefit then B will have to choose floating rate.

ALtd BLtd
Actual B.C -fixed rate -Floating rate
Altd pays Bltd -Floating rate +Floating rate
Bltd pays Altd
(Fixed-benefit) rem fixed rate -remaining fixed rate
B.C before bank fee Libor + means additional pay
And minus means less pay
L: Bank fee (xx) (xx)
Overall B.C XX XX

● Currency Swap part 2

No company will have a complete advantage over another.
Steps are the same as interest rate swap.

● FRA Article:

Year Annual spot yield curve Annual forward rates

1 3.5% -

2 4.6% 5.71%

3 5.4% 7.02%

4 6.1% 8.23%

5 6.3% 7.1%

Then for finding fixed rate:

For e.g borrow amount is 100million repayable in 5 yrs.
Bank offers a swap variable interest rate with fixed rate and returns will be received at yield
rates less 50 basis points.

Company expects interest receipt from bank

Step 1: Y1 (3.5%-0.5%) x 100=3m
 Y2 (5.71%-0.5%) x 100=5.21m
Y3 (7.02%-0.5%) x100=6.52m
Y4 (8.23%-0.5%) x 100=7.53m
Y5 (7.1%-0.5%) x 100=6.6m

Step 2:
After this, Fixed interest company will pay bank
(3m-R) X 1.035^-1+ (5.21m-R) X 1.046^-2+(6.52m-R) X1.054^-3+(7.53m-R)
X1.061^-4+(6.6m-R) X 1.063^-5=0
After solving this you get
5.68m=R
Then 5.68/amount of borrow(100) x 100= 5.68%

● Margin deposit with article:

Margin deposit is linked with only currency or interest rate futures.
–If a company decides to use currency or interest futures then the initial margin will
have to be deposited in the currency which you are hedging.
–If that currency is not our currency then buy the amount at spot rate and deposit it.
–Initial deposit will be based on the number of contracts.
–This deposit is not our cost, it just stays with the brokerage house as a security.
–Practically, the date when futures are bought and the transaction date have a lot of
fluctuations so if a company deposited initial margin and due to fluctuations the initial
deposit falls below the maintenance level, the company will receive a margin call in
which the company will be asked to pay extra till maintenance level this amount is
called variation in margin. If the company does not have enough to deposit then the
number of contracts will be based on the reduced deposit amount, and then all the
future gain and loss will be based on these contracts. If our reduced deposit level is
greater than the maintenance level then the excess may be withdrawn by the
company.
The company will receive a negligible amount of interest from the amount of margin
deposit kept at the brokerage house hence not shown in calculations.

Advantages & disadvantages of traded option contracts compared to OTC

options

Advantages:
● Exchange traded options are easily available, because it is a standardised
product available in a standardised market, which is not the case in OTC
options.
● Greater transparency and tighter regulations make exchange traded options
less risky
● Exchange traded options transaction costs are lower.
● The exchange traded option buyer can close the option before expiry,
because they are available in the standardised market, this is not the case in
OTC options since it is custom made, it will be hard to find people willing to
buy an OTC option.
 Disadvantages:
● The maturity date and contract sizes for exchange traded options are fixed,whereas
OTC options can be tailored according to the requirement of the party.
● Exchange traded options tend to be short term, so if longer term options are needed,
it would be available in the OTC market.
● A wide range of products are available in the OTC options market, which may not be
the case in standardised markets.

Advantages and Disadvantages of currency swap

Advantages:
● It is ideal for companies investing abroad, because it will involve payment of interest
in the currency in which country will receive income abroad.
● This method of currency swap is cheaper than other hedging instruments.
● Excluding credit risk premium, the company will hedge its full amount using currency
swap which is not the case in other hedging instruments.

Disadvantage:
● The counterparty may default, although companies may get banks to guarantee for
counterparty

Advantages of multilateral netting by a central treasury function

● A central treasury department helps in coordinating the information about inter

group balances
● The multilateral netting arrangements should make cash flow forecasting easier in
the group
● There will be a smaller number of transactions in multilateral netting compared to
other hedging techniques,this also means multilateral netting will have lower
transaction costs.
● In multilateral netting there will be less loss on interest due to money being in transit

Forward contracts compared with over the counter options

● In forward contracts there is no upfront premium payment, which is not the case in
OTC options as there will be a non refundable premium payment in OTC options
● Forward contract gives us guaranteed net payable or receivable at the end of
hedging, but in case of OTC options it will only show net payable or receivable if
option is exercised.
● Forward contract is a binding agreement which means it will have to be fulfilled.
However OTC options give us the right to buy or sell which means it can be lapsed if
it is not beneficial.

Interest rate swap advantages and disadvantages

Advantages
● Swaps are usually facilitated by banks that make it an OTC product which means
they can be arranged in any size and for whatever time period it is required.
 ● Transaction costs in interest rate swap are often lower than other interest rate
hedging techniques.
● In case of swapping a floating rate of interest with fixed rate of interest, it will help the
company in budgeting finance costs

Disadvantages:
● In case, a company swaps into fixed rate commitment they will have to fulfil the
commitment which means they cannot enjoy favourable movements in interest rate
changes.
● In case of interest rate swap, bank fees will also have to be paid.
● In case the interest rate swap is not facilitated by the bank, there is a risk that
counterparty may default. If banks facilitate the interest rate swap, then the bank
takes the guarantee that both parties will honour the agreement

Benefits of centralised and decentralised treasury departments

Benefits of centralised treasury department/ Drawbacks of decentralised treasury

department:
● A centralised treasury department may make rational decisions for the benefit of
business as a whole, whereas, decentralised treasury will lead to dysfunctional
behaviour.
● A centralised treasury department will have access to experts which a small
decentralised treasury department may not have.
● If a centralised treasury department takes a loan for the whole organisation, it will be
able to negotiate at lower interest rates which won't be the case if decentralised
treasury departments submit for loans.
● A centralised treasury department avoids the need to have multiple bank accounts
and it reduces transaction cost and bank charges.

Benefits of decentralised treasury department/ Drawbacks of centralised treasury

department:
● A decentralised treasury department will be able to respond quicker to opportunities
available, so it will be more efficient and effective.
● The need for cash and further investments will be judged better by a decentralised
treasury department rather than a centralised treasury department

Management Buyout/Management Buy In

MBO means to purchase all or part of business by the company’s own management
MBI means purchase of all or part of a business by a team of third party company’s
management.

Advantages of MBO/ Disadvantages of MBI

● As company’s own managers are purchasing the business, there will be less likely
chances of making existing employees redundant which will save redundancy costs.
● As the company's own management is buying the business, they will know the true
value of the business inside out.
 ● Trading relationships will be created between the seller company and the new
company created after the MBO, which means the seller company may get business
from the new company formed.

Disadvantages of MBO/ Advantages of MBI

● Since the existing management is buying the company, there will be less chances of
innovation i.e. no fresh blood will be injected into the company.
● The new company based on existing management may not have the expertise to run
the company.

INTRODUCTION TO DIVIDEND POLICY

Market price system of transfer pricing
. Dark pool trading systems
International Monetary fund

Reverse takeovers:
–An RTO involves a smaller quoted company taking over a larger unquoted company by
a share for share exchange.
–In order to acquire the larger unquoted company a large no. of shares in the quoted
company will have to be issued to the shareholders of the larger unquoted company.
–Hence, after the takeover the current shareholders in the larger unquoted company will
hold majority of the shares in the quoted company and will therefore have control of the
quoted company.

Benefits of Reverse takeover/ Drawbacks of IPO:

● Access to capital markets: As a listed company, more finance is likely to be available
and cost of finance is likely to be lower than if the company was unquoted.
● Higher company valuation: As the shares in the company will now be listed potential
investors will see the investment to be less risky as now the company will have to
abide by rules and regulations. As a result , investors are likely to attribute a higher
value to shares.
● Speed: An IPO can take between one to two years to complete whereas an RTO can
be completed in as little as 30 days.
● Cost: Just as an IPO is a time consuming process, it is also an expensive one due to
the amount of paperwork required. An RTO will usually, but not always cost less.

Drawbacks of RTO/ Benefits of IPO:

● Reputation: Companies that get listed through RTO will always be considered
inferior to companies getting listed through IPO. The reason for this are past trends
because companies getting listed through RTO are rarely successful.
● Cost: While RTO is usually cheaper than IPO, there are still significant direct and
indirect costs which the company may not have anticipated. For e.g regulatory
costs,acquisition costs etc
● Risk: Compared to IPO ,RTO is done with a lower level of scrutiny and in a hassle
,therefore there may be inherent risk and liabilities may stay hidden and
unanticipated problems may remain hidden.
 ● Lack of expertise: A company achieving a listing through RTO may not have the
expertise to deal with all the regulations and procedures that a listed company may
comply with.

Asset securitisation/Toxic assets:

The bank may give loans to the general public for them to invest for e.g in a housing scheme
etc.The bank is on the ideology that the receivables will pay them back and if they do not
pay them back, they will still have the ownership of whatever the general public has invested
in, so they can sell it to get their money back.
However, loans given by the banks will be long term, for e.g repayment in 10 years, so these
unpaid receivables will now become toxic assets/ illiquid assets for the banks which
means they cannot be easily converted into cash.
Now, to counter these illiquid assets, the bank will create a special purpose vehicle(SPV)
and the SPV will issue its bonds to other banks to raise cash.
The cash raised by SPV will be used to buy toxic receivables from the bank. In short the
bank gets cash, while SPV gets ownership of receivables and the underlying asset and SPV
will repay its bondholders as soon as they receive money from their receivables within the
repayment period. This illiquid to liquid conversion is called Asset securitisation.
The bonds issued by the SPV is called Collateralized Debt Obligations (CDO’s)
The problem here is that other banks may not be ready to become bondholders of the SPV,
this is because CDO’s are not marked to the market which means it's a lot more riskier.
To counter the above problem the banks introduced Tranches, which are layers of risk and
returns.
Tranches:
Tranche 1(Equity tranche)
In equity tranche, all those debtors will be included from whom the chances of recovery is
very low.
Fewer investors will be interested in equity tranche because the risk is high and the return is
not guaranteed.
This tranche is cheaper than the other two tranches.
Tranche 2(Mezzanine tranche)
The investors investing in mezzanine tranche will get a fixed return
The risk mezzanine tranche will be lower than Equity tranche but will be higher than senior
tranche.
The cost of mezzanine tranche is higher than equity tranche but lower than senior tranche.
Tranche 3(AAA or Senior tranche)
It is the most expensive tranche
The risk in the senior tranche is less than the other two tranches but the return is fixed by
less than mezzanine tranche.

In case of repayment, tranche 3 will be paid first followed by tranche 2 and tranche 1 will be
paid in the end.

- Loan Note A
- Loan Note B
- Total cost
- Uske baad Total Return- Total Cost jou ayega wo equity tranche kelye return hay
 Bond valuation:

Bond price= coupon x (1+r n)^-n +coupon x (1+r n)^-n……….+redemption x (1+r

n)^-n

Dividend policies are established to maximise the wealth of shareholders.

There are three types of dividend policies:
1) Residual policy= If spare cash is available at the year end, the company should pay
a dividend to its shareholders. Every year the company might have different amounts
of spare cash available and sometimes spare cash may not be available at all, so this
creates uncertainty of whether a dividend will be received or not. Shareholders do not
prefer this method

2) Pattern= This policy suggests that the company should be consistent with dividend
payments. In this we treat our shareholders as debt holders which means we pay
fixed dividends and maintain the same payout ratio. Due to its
consistency,shareholders prefer this method.

3) Irrelevancy(M&M)= This policy suggests that dividends are irrelevant. It believes that
payment or non-payment of dividend will keep the shareholders indifferent because
they believe companies should retain the money for reinvestment.By investing in
positive NPV projects, share price will increase and so shareholders can sell their
shares and enjoy the benefit of increase in share price, This is also called Dividend
manufacturing.

● Clientele effect: It means expectation of shareholders from the company about

dividends due to past trends of the company of dividend payments.
● Signalling effect: If a company gives dividend to its shareholders it will signal to the
stock market about the company being successful and keeping its shareholders
happy, which in turn will increase share price.
● Dividend cover: It shows how many times an organisation can make repeated
dividend payments.

Alternatives to cash dividends:

1) Scrip dividends: Instead of receiving cash dividends, shareholders will receive
dividends in the form of extra shares. This will allow shareholders to sell those shares
and enjoy the gain. This issue of shares will increase equity of the company and EPS
will be diluted.Issue of shares will result in further dividend payments in future.
2) Shares buy back: If a company has one off cash available , they can buy back their
own shares at Po and cancel them which will reduce the dilution of shares, there will
be less pressure on the board in the future to pay dividends and this method is
allowable under company law. Gearing may increase due to Ve decreasing.

Maximum dividend capacity/Payable= Calculated using FCFE of 1 year.

Behavioural finance article:

Introduction:
 This tells us about psychological factors that affect financial decision making
and explains how and why decision makers make a financial decision which may
be sometimes very good while at times can be irrational and can have negative
consequences.

1) Investors
Now we have to talk about what are rational decisions and how do behavioural
factors affect those rational decisions
a) Maximisation of utility:
Investors aim to maximise long term wealth and their utility.
Behavioural factors that may influence that may not be best in achieving
maximisation of wealth:
-Investors want to maximise long term wealth but only wants to invest in companies
with social responsibility
-Investors want to maximise long term wealth but prefers to avoid those companies
who are operating in industries which they regard as unethical(sin stocks)
-Some investors hold on to shares with prices that have fallen overtime and are
unlikely to recover. They do this because it will psychologically hurt them to admit
that their decision to invest was wrong. This is known as cognitive dissonance.

b) Analysis of relevant information:

An investor will make a rational decision by analysing the future prospect of the
company.
Behavioural factors that may influence in decision making:
-Investors may use information that is not relevant but is readily available,possibly to
simplify the decision making process. This is known as anchoring.
-Investors might sell their shares on the ground that the shares have gained value
long enough and they believe that now their value will start to fall, probably because
they do not want to get greedy.Although analysis suggests that prices will continue to
rise. This is known as the gambler's fallacy.
-Investors buy or sell shares in a company just because many other investors have
already done so, it gives social conformity. This is called Herd instinct.
-Some investors don't base their decisions on analysis but make them on their own
instincts , which sometimes turns out to be a poor decision. These are known as
noise traders.
c) Rational, objective and risk neutral analysis:
An investor will make a decision after an analysis of information currently present.
Behavioural factors that may influence the decision:
-An investor makes a decision according to information that confirms the investors
ideology but ignores evidence that casts doubt on those decisions. This is known as
confirmation bias.

2) Finance Managers:
a) Maximisation of utility
A finance manager will want to maximise the shareholders wealth in long term
How will this rational decision be affected by behavioural factors?
- Finance manager may want to think about his own success first rather than the
company's overall success. This is known as agency problem
 -The finance managers are unwilling to let someone else have what they have been
trying to acquire. This is known as loss aversion bias.
b) Analysis of relevant information:
A finance manager will make a decision based on future prospects about a company
i.e company valuation and so on
How will this rational thinking be affected by behavioural factors?
-A finance manager may pay investors money in a loss making company but has so
much confidence that they can turn the tables of the loss making company into a
profitable company. Due to this sometimes they keep paying more to mitigate the
loss making company’s losses. This is known as entrapment.
c) Rational,objective and risk neutral analysis:
A finance manager will make a decision after an analysis of information currently
present.
Behavioural factors that may influence the decision:
-Finance manager makes a decision according to information that confirms the
managers ideology but ignores evidence that casts doubt on those decisions. This is
known as confirmation bias.

Cross rates:

Step 1: We will try to cancel out the common currency

Step 2: If the common currency is cancelling out after we convert the division sign to
multiplication then we will divide in cross direction uper by neeche if it is an indirect quote.
OR
If direct quote is coming then divide in cross direction but neeche wala divide by uper wala
Step 3: If the common currency is cancelling out by multiplication then we will multiply uper
by neeche wala not in cross.

Islamic finance:

Fixed income modes:

1) Murabaha: It is a form of trade loan. In a normal loan bank will give the loan by
keeping one of the assets as security. In murabaha, the bank will take actual
ownership of the asset you want to buy using the loan and then they will sell it to you
at a profit. The payment can be done over a set of instalments, no penalties or
additional markup can be added by the bank.
2) Ijara: It is the equivalent of lease finance. Under this the bank will make an asset
available to use for the customer for a fixed period at a fixed price. The purpose/use
of this leased asset must be specified in the Ijarah contract. The Lessor(bank) will be
responsible for major maintenance of the leased asset. The lessee is responsible
for maintaining the asset in the proper manner.
3) Sukuk: It is like an Islamic bond. In traditional bonds companies issue bonds to
bondholders in return for cash and then pay them interest over the period. In Sukuk,
Islamic bonds are linked to the underlying asset such that the sukuk holder is a
partial owner of the assets and profit is linked to the performance of that asset. But
in case of loss sukuk holders will equally share any losses.

Equity modes:
 1) Mudaraba: It is a kind of partnership, where one partner solely invests in the
commercial enterprise while the other partner is responsible for the management of
that commercial enterprise. The one investing is known as Rab ul mal and the one
responsible for the management is known as Mudarib. Profit generated is distributed
according to pre agreed ratios whereas the losses will be borne by the Rab ul mal.
2) Musharaka: It is like a joint venture. Two or more parties contribute capital to the
business and divide profits. All investors are entitled to participate in the
management but are not required to do so. The profit is distributed by partners in pre
agreed ratios and losses are borne strictly on the basis of capital invested.

Criteria for credit rating agency:

Criteria a credit rating agency considers when assessing credit rating of a company:
1) Industry risk: Credit rating agencies will first investigate the industry company
operates in, either slum or boom they will consider the duration it continues
till. They will compare companies performance with industry averages to see
the position of the company in that industry.
2) Financial flexibility: It means how easily a firm can raise finance, the easier it
is the better the credit rating would be. They will also see if the company has
enough cash to run its day to day operations.
3) Evaluation of company’s management: They will see the qualifications,
experience and the success of past and existing projects of the management
to see if they are capable enough for the company to earn a good credit
rating.

To: BOD of xxx co

From:
Subject : xxx project
Date: xx/xx/xxxx

Introduction:
This report carries out information related to financial acceptability of investment in the
assembly plant in Yilandwe ,assumptions made in evaluating the financial acceptability, risk
and issues which Lmoni company should consider before making the final decision. At the
end a reasoned recommendation will also be provided.
i) Evaluation-
The appendix 1 shows the forecast cash flows of investment in Yilandwe project at a project
specific discount rate of 12%. The NPV is forecasted to be $147342. A positive NPV always
implies that a project should be accepted as it increases shareholders wealth.
ii) Assumptions, Risks and issues-
Assumptions:
One of the assumptions while calculating forecasted cash flows was that:
Working capital at year 0 will be funded externally, any further increase during the four year
project will be funded internally.
Another assumption is that tax rates in Yilandwe over the four year project will remain
constant throughout.
It is also assumed that spot rates used in NPV are forecasted using purchasing power parity.
It is further assumed that the inflation rates in three countries Yilandwe, USA and Europe will
remain the same as they are estimated with no further changes.
Also the project specific cost of capital of 12% is also an assumed figure because there are
many estimates while calculating risk adjusted cost of capital like taking proxy company Beta
Asset and considering it as company’s own Beta asset.
It is assumed that all the estimates of sales revenue, costs, royalty payments, initial
investment,working capital etc are accurate.
Issues:
-Sensitivity analysis= As already stated there are a large number of assumptions. A change
in the value of key variables(sales, variable cost, fixed cost) might have an adverse impact
on NPV. This is why sensitivity analysis should be carried on all key variables before making
a decision
-Real options= While evaluating the financial acceptability, BSOP real options were
completely ignored. It may be highly possible that there may be an option to delay which
might give a strategic NPV of more than what it is now, option to expand, option to early exit,
option to redeploy all might have given a better NPV compared to NPV calculated in
Appendix 1.
Risks: Political, economic, cultural,ethical.
Reasoned recommendation:
The proposal based on above risks ,assumptions, issues and forecasted NPV should be
accepted as a positive NPV always tends to increase shareholders wealth.