Key Points from Past Papers for last

minute revision
By Taha Popatia
June 2010 to December 2016
(Also includes one page bullets for
Islamic finance and Greeks to learn)

Available at
Commerce Book Point – 0300-9226612 / www.cbpbook.com
(Free Delivery at your doorstep, All ACCA/CA/ICMAP/PIPFA Books available)
For queries, suggestions and comments
ARTT Business School – 02134523176
Students must use this booklet while attempting past papers the book will help
them learn key points and hence obtain good marks in exam by reproducing the
bullet points. The purpose of the booklet is to facilitate in learning key points.
Although reasonable efforts have been put to make the book free from majority
of the errors, nevertheless absolute assurance is never possible due to inherent
limitations in the process of compilation, interpretation and presentations
therefore I will not be responsible for any errors found, if you find anything
missing or some error in these notes please contact me at
taha_popatia@hotmail.com.
 ACCA p4 2010 past papers summary
By Taha Popatia
June 2010

Question # 1

Uncertainties associated with the project

 The timing and the level of capital expenditure over the investment phase of the project.
 The operating surpluses from the project and their timing.
 The timing and amount of closure costs.
 The discount rate.

Real Options

 There may be a range of real options attaching to a project of this type 1. The option to delay 2. The
option to expand or contract capacity 3. The option to withdraw early or extend the operating life of the
project. Each of these will add value to the firm by helping eliminate the downside exposure and focusing
the expected value calculation on the upside of the possible distribution of outcomes.

Simulations

 The assessment of the volatility (or standard deviation) of the net present value of a project entails the
simulation of the financial model using estimates of the distributions of the key input parameters and an
assessment of the correlations between variables. Given the shape of the input distributions, simulation
employs random numbers to select specimen value for each variable in order to estimate a trail value for
the project NPV. This is repeated a large number of times until a distribution of net present values
emerge.
 Monte Carlo Simulation is a method of probability analysis done by running a number of variables
through a model in order to determine the different outcomes.
 Decision makes are able to determine number of possibilities and probability of occurrences.

Question # 2

BSOP model for valuation of company

 Using BSOP model in company valuation rests upon the idea that equity is a call option.
 BSOP model can be helpful in circumstances where the conventional methods of valuation do not reflect
the risks fully or where they cannot be used.
 Five variables which are input to the BSOP model: Value of the underlying asset, the exercise price, the
time to expiry, the volatility of the underlying asset value and the risk-free rate of return.

Question # 3

Securitization - risks

 Correlation risk. Timing and liquidity risk. Default and collateral risk.

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Question # 4

Disposal of a division

 How any joint assets might be sold.

 Any regulatory issues need to be clarified.
 Potential buyers will need to be sought through open tender or through intermediary.
 Once a potential buyer has been found, access should be given so that they can conduct their own due
diligence.

Question # 5

Netting arrangements with the global business and trading partners

 Number of currency transactions can be minimized, saving transaction cost and focusing the transaction
risk onto a smaller set of transactions that can be more effectively hedged.
 Some jurisdictions do not allow netting arrangements, and there may be taxation and other cross border
issues to resolve. There will be costs in establishing the netting agreement and where third parties are
involved this may lead to re-invoicing or in some cases re-contracting.

December 2010

Question # 1

Cease trading / corporate restructuring / management buy out

 If management buyout is taken shareholders will receive premium on the share price.
 Shareholders need to weigh up whether they would like to possibly benefit from the future company
prospects (not evident at the moment) or whether they would like to sell their shares for premium.
 If the restructuring is considered as opposed to liquidation, then clearly a significant benefit to the
management and directors is that they would retain their employment, unless the new shareholder
owners decide to terminate some of their contracts.
 The management buy-out may influence different classes of managers and directors very differently. For
those who participate in buy-out, the calculations suggest a clear gain for them. For those not
participating in the buy-out, it is likely that they will lose their employment.

Question # 2

Adjusted Present Value

 Calculate project NPV with ungeared cost of equity.

 Add less financing side effects. – issue cost for issuing the debt, + annual tax relief x annuity factor for the
life of the project discounted using debt yield rate or normal borrowing rate for the company + subsidy
benefits (savings due to cheaper loan) discounted at debt yield rate or normal borrowing rate for the
company.
 The adjusted present value can be used where the impact of using the debt financing is significant.
 Here the impact of each of the financing side effects from debt is shown separately rather than being
imputed into the weighted average cost of capital.

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 The project is initially evaluated by only taking into account the business risk element of the new venture.
 Assumptions: H company’s ungeared cost of equity is used because it is assumed that this represents the
business risk attributable to the new line of business. The ungeared cost of equity is calculated on the
assumption that Modigliani and miller proposition 2 applies. Feasibility study is ignored as a past cost. It
is assumed that the five-year debt yield is equivalent to the risk-free rate. It is assumed that all cash flows
occur at the end of the year unless otherwise specified.

Question # 3

 The number of put contracts to purchase depends on the hedge ratio, which in turn depends on the delta
of the option. This measures the change in the options price over the change in the price of the share and
therefore helps determine how many option contracts are needed to protect against a fall in the share
price.
 If market is efficient – where information is known and securities are priced correctly, holding well
diversified portfolio will eliminate or significantly reduce the unsystematic risk. Companies will not
increase shareholders value by hedging in such cases because there will be no further reduction in
unsystematic risk. Shareholders would not gain from risk management or hedging.
 Hedging or the management of risk may result in increase in shareholders’ value if market imperfections
exist, and in these situations reducing the volatility of a company’s earnings will result in higher cash
inflows.
 Purchasing OTC put options from the bank – premium needs to be paid. Benefit: protects against
downside movement whilst still benefiting from positive movements in the share price. Options bring
risks with them – delta is not stable and the rate of change in an option is measured by the gamma. The
option value also changes as time to expiry reduces (measured by theta) and as volatility of the
underlying asset changes (measured by vega).

Question # 4

How to manage dividend shortfall

 Borrow the shortfall amount needed through increased overdraft facilities.

 Postpone the current projects if that option is available.
 Ask the subsidiary company to remit higher proportion of their profits as dividends.

Question # 5

Benefits/Disadvantages of Joint venture

 Benefits of joint venture: sharing of risks, possible lower running costs and the partner’s existing
experience of local market and lower capital investment costs.
 Disadvantages of joint venture: loss of reputation, product quality and staffing, government restrictions,
cultural differences, managerial issues, contractual issues and loss of tax concessions.
 Easier access to local capital market so that long term currency exposure is reduced.
 Reputation of the company if it goes into joint venture.
 Government restrictions – visa issuance for staff and repatriation of funds.
 Cultural differences from expatriate staff and local staff should be reduced.

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 Manager’s actions may be restricted in the case of joint ventures because the opinions of both the
partners need to be taken into account.
 Sensitivity analysis of different projections and an assessment of the likelihood of their occurrence.

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 ACCA p4 2011 past papers summary
By Taha Popatia
June 2011

Question # 1

Assumptions and limitations of free cash flows to firm method

 Assumptions – growth rate in next few years, perpetual growth rate after few years, additional
investment in assets, stable tax rates, discount rates.
 No information has been provided about pre- and post-acquisition costs.
 Type 3 acquisition – both the business and financial risk of the acquiring company changes as a result of
the acquisition.
 When the cost of capital of the combined company changes, it causes the value of the company to
change causing the proportion of market value of equity and market value of debt to change, and thus
change the cost of capital. Therefore, changes in the market value of the company and cost of capital are
interrelated. To resolve this problem, an iterative procedure needs to be adopted where the beta and the
cost of capital are recalculated to take account of the changes in the capital structure, and then the
company is revalued. This procedure is repeated until the assumed capital structure is closely aligned to
the capital structure that has been recalculated. This process is normally done using a spread sheet
package such as excel.
 If cash reserves are paid to shareholders. The company may become less attractive to prospective
bidders but it is important to take into account the fact about how the shareholders will view this.
 Further if entire cash is paid back and after that we have to acquire a certain company we may need to
borrow a lot of debt which will increase our gearing and make up an unreasonable debt structure. The
increased gearing may have significant implications and may result in increased restrictive covenants.

Question # 2

Currency forward future and options

 Forward contracts are not traded on a formal exchange and therefore default risk exists.
 Future contracts require margin payments and are marked-to-market on a daily basis, although any gain
is not realized until the contracts are closed out.
 Option buyer can let the option lapse if the rates move favourably. Hence options have an unlimited
upside but a limited downside. However, a premium is payable for this benefit.

Purchasing Power Parity

 According to PPP, future spot currency rates will change in proportion to the inflation level differentials
between two countries.
 Local bank may default over swap deal.

Question # 3

Macaulay duration

 In order to calculate duration, the present value of cash flows and the price at which the bonds are
trading at need to be determined.
 To compute (PV of Y1 x 1 + PV of Y2 x 2 …) / PV of all cash flows.

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How useful duration is as a measure of the sensitivity of a bond price to changes in interest rates

 The sensitivity of bond prices to changes in interest rates is dependent on their redemption dates. Bonds
which are due to be redeemed at a later date are more price-sensitive to interest rate changes, and
therefore are riskier.
 Duration measures the average time it takes for a bond to pay its coupons and principal and therefore
measures the redemption period of a bond.
 Duration can be used to assess the change in the value of a bond when interest rates change using the
following formula: Change in price = (-D x change in interest rate x Price) / (1+i). Where p is the price of
the bond, d is the duration and i is the redemption yield.
 Duration, assumes that the relationship between changes in interest rates and the resultant bond is
linear. Therefore, duration will predict a lower price than the actual price and for large changes in
interest rates this difference can be significant.

Question # 4

Option to delay – call option

 Pa or current price is the present value of projects positive cash flows discounted to current day.
 Pe or exercise price is paid later.
 Option to delay the decision gives the managers opportunity to monitor and respond to changing
circumstances before committing to the project.
 The option pricing formula requires numerous assumptions to be made about the variables.
 The option to delay the decision may not be the only option within the project.

Question # 5

Foreign Investment factors

 Main aim of directors should be to maximize the shareholders’ value.

 Directors should also try to minimize the negative consequences resulting from the implementation of
the project, taking into account the company’s responsibility to its stakeholders.
 Directors must take into account the projects impact on company’s reputation.
 Consider financial impact of investment NPV and real options and company’s reputation.
 For a new product, it is likely that the uncertainty and risk to income flows will be significant.
 If directors are given share options, they may take unnecessary risk since they would benefit from
increase in share prices but not lose if the share price falls.
 Due diligence procedures for the project need to be undertaken before the decision is made.
 Assess the likelihood of competitors and alternative products which may affect the future sales of the
product.
 The adequacy of the expertise and infrastructure required by the company needs to be assessed.
 The livelihood of the affected locals needs to be considered as well as the impact on the wildlife and the
environment.
 Priority to jobs for locals may be given to gain their support.

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 ACCA p4 2011 past papers summary
By Taha Popatia
December 2011

Question # 1

Adjusted present value

 Base case net present value + adjustments.

 Assumptions: In adjusted present value calculations, the tax shield benefit is normally related to the debt
capacity of the investment, not the actual amount of debt finance used.
 It has been that many of the input variables, such as for example the tax and capital allowances rates, the
various costs and prices, units produced and sold and the rate of inflation are accurate and will change as
stated over the four years’ period. In reality any of these estimates could be subject to change to a
greater or lesser degree and it would be appropriate to conduct uncertainty assessments like sensitivity
analysis to assess the impact of the changes to the initial predictions.

Foreign investment

 The new government may not allow remittances every year.

 Consider possibility of follow on projects and the real options should be included in analysis.
 The amount of experience a company has in international ventures must be considered.
 Company must develop strategy to deal with cultural differences.
 Impact on own reputation due to redundancies in local operations.
 Company must communicate its strategy of shut off of local operations to its employees and possibly
other stakeholders clearly so as to retain its reputation.

Question # 2

Advantages / Disadvantage of hedging using interest rate collar instead of options

 Lower cost. A collar involves simultaneous purchase and sale of both call and put options at different
exercise prices.
 The main disadvantage is that whereas with the hedge using the options the buyer can get full benefit of
any upside movement, with the collar the benefit is limited or capped as well.

Basis risk

 Basis risk occurs when the basis does not diminish at a constant rate. In this case, if a future contract is
held until it matures then there is no basis risk because at maturity the derivative price will equal the
underlying asset’s price. However, if a contract is closed out before maturity there is no guarantee that
the price of the futures contract will equal the predicted price based on basis at that date.

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Question # 3

Criteria used by credit agencies for establishing a company’s credit rating

 INDUSTRY RISK – measures the resilience of the company’s industrial sector to changes in the economy.
Factors – how successful the firms in the industry operate under differing economic outcomes. How the
demand shifts in the industry as the economy changes.
 EARNING PROTECTION – measures how well the company will be able to maintain or protect its earnings
in changing circumstances. Factors – Diversity of customer base. Profit margins and return on capital
employed.
 FINANCIAL FLEXIBILITY – measures how easily the company is able to raise the finance it needs to pursue
its investment goals. Factors – Relationships with finance providers example banks. Debt covenants
 EVALUATION OF THE COMPANY’S MANAGEMENT – how well the managers are managing and planning
for the future of the company. Factors – The company’s planning and control policies, Management
succession planning and qualification and experience of the managers.

Question # 4

Management but out

 Management buy-out costs may be less as compared to other forms of disposal.

 There may be less resistance from the managers and employees, making the process smoother and
easier to accomplish.
 It may be able to get a better price for the company. The current management and employees possibly
have the best knowledge of the company and are able to make it successful. Therefore, they may be
willing to pay more for it.
 It may increase company’s reputation among its internal stakeholders such as the management and
employees. It may also increase its reputation with external stakeholders and the markets if it manages
the disposal successfully and efficiently.

Breach of debt to equity ratio

 Pay lower dividend.

 Negotiate less onerous terms with the bank.
 Pay more loan each year from cash reserves to reduce debt amount.

Question # 5

Triple bottom line reporting

 A triple bottom line (TBL) report provides a quantitative summary of a corporation’s performance in
terms of its economic or financial impact, it’s impact on environmental quality and its impact on social
performance.
 A corporation’s sustainable development is about how these three factors can grow and be combined so
that a corporation is building a reputation as being a good citizen.

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 Each factor can be assessed or measured using a number of proxies. Economic impact – operating profits
and dependence on imports. Social impact – working conditions and ethical investments and fair pay.
Environmental factors – ecological footprint, emissions to air.
 Focusing on and reporting the company’s environmental and social impact may build and enhance its
reputation. Increasing reputation may increase the long-term revenue of the company.
 Consideration and improvement of working standards and consulting employees as of this process, when
assessing social factors, may help in retaining and attracting high performing, high calibre employees.
 Improvement of due diligence procedures as part of the economic factor assessment may help limit
direct legal cost and indirect costs incurred in maintaining stakeholder relationships.
 Monitoring and reporting on the performance of employees and managers as part of the assessment of
economic and social factors may help identify areas where work can be done more effectively and
efficiently.

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 ACCA p4 2012 past papers summary
By Taha Popatia
June 2012

Question # 1

Free cash flows to firm and option to delay

 Free Cash Flow to Firm = PBIT + Non-cash flows – cash investments – tax.
 Option to delay is a call option.
 Pa is the present value of future positive cash flows only.
 Pe is the initial cost of project without discounting.
 Calculate normal NPV and after that calculate option value and then add both.
 Cash offer for purchase prevents dilution of shareholdings
 Assumptions: In a FCFTF method growth rate cost of capital and time period are all estimates or
assumptions. For the takeover offer value of synergy savings and pe ratio are both assumptions.
 For real option calculation, it is assumed that the option variables will not change during the period
under consideration
 The value of the option is based on the possibility that the option will only be exercised at the end of the
two years, although it seems that the decision can be made any time within the two years.

Report format

Report to the board of directors

Impact of the takeover proposal from mjie co and production rights of the follow on product

Main body

Report compiled by:

Date:

Appendices

Question # 2

Asset securitization

 Asset securitization will be taking the future incomes from leases and converting them into assets.
 These assets will be converted into bonds now and future lease incomes will be used to pay coupon
interest on these bonds. The company will immediately receive money from the sale of asset today.
 Division of pooled leased assets into tranches is possible. The higher rated tranches would carry less risk
and have less return compared to lower rated tranches.
 If default occurs the income of the lower tranches is reduced first.
 Securitization is an expense process involving management costs, legal fees and ongoing administration
costs.

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Question # 3

Swap of interest payments

 Spot rate for year 1 and forward rate for other years.
 The reason the equivalent fixed rate of 3.7625% is less than the 3.8% four-year yield curve rate, is
because the 3.8% rate reflects the zero-coupon rate with only one payment made in year four.

Raising equity to pay off loan

 As the proportion of debt increases, the level of financial distress increases and with it the associated
costs.
 On the other hand, interest payments are tax deductible.
 Reducing the debt would result in a higher credit rating for the company and reduce the scale of
restrictive covenants.
 The process of changing financial structure can be expensive – costs of undertaking the issue.
 The impact of rights issue on current share price needs to be considered.

Question # 4

Cost of capital calculation – IRR AND MIRR – Value at risk

 Calculate asset beta of ELFU company from equity beta of the company. Calculate asset beta for other
services from equity beta for other services. Now use weighted average method to calculate asset beta of
component services.
 IRR assumes positive cash flows are reinvested at IRR. MIRR assumes that positive cash flows are
reinvested at the cost of capital.
 To calculate MIRR take all cash inflows to last future date and use s=p(1+i) ^n
 99% confidence level requires the value at risk to be within 2.33 standard deviations from the mean,
based on a single tail measure. (starting from left to right in a normal distribution graph leave first 1% this
will be at negative 2.33 and right side is of negative 2.33 is 99%)
 Annual value at risk = standard deviation into 2.33(for 99%) = 800,000 x 2.33 = 1,864,000
 Five years’ value at risk = standard deviation into 2.33(99%) into square root of 5 (5 is the number of
years. = 800,000 x 2.33 x √5 = 4,168,000.
 The figure mean that ELFU can be 99% confident that the cash flows will not fall by more than 1,864,000
in any one year and 4,168,000 in total over five years from the average returns.
 Therefore, the company can be 99% certain that the return will be Rs. 336,000 or more every year
(average annual return less 1,864,000) and Rs. 6,832,000 or more in total over the five year period
(2,200,000 x 5 – 4,168,000).
 There is a 1% chance that the returns will be less than 336,000 each year or 6,832,000 over the five-year
period.

Question # 5

Risk and issues when setting up a subsidiary abroad

 Risk of loss of reputation if move results in local redundancies.

 How the subsidiary and its products will be seen by local people.
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 The composition of the board of directors and the large proportion of the subsidiary’s equity held by
minority shareholders may create agency issues and risks.
 Government may impose taxes or impose restrictions on the subsidiary.
 Cultural issues and communication barriers.
 Risks such as foreign exchange exposure, product health and safety compliance, employee health and
safety regulations may need to be considered and assessed.
 Suggestions for mitigation of risks and issues: Sensitivity and probability analysis, analysis of real options.
 Effective market communication to develop customer perception about product.
 Negotiations with the local government must be undertaken regularly to gain benefits such as lower tax
rates.
 Economic analysis must be conducted to work out possibilities of rise in interest rate or forex exposure.

Dark pool trading

 Dark pool trading systems allow share orders to be placed and matched without the traders’ interest
being declared publicly on the normal stock exchange.
 Trade is only declared publicly after it has been agreed.
 Large volume trades which use dark pool trading systems prevent signals reaching the markets in order
to minimise large fluctuations in the share price or the markets moving against them.
 Arguments against DPTS suggest that because most of the individuals who use markets to trade equity
shares are not aware of the trade, transparency is reduced.

Dec 2012

Question # 1

Discussing assumption that market value of equity will remain unchanged after the implementation of the
proposal

 It is unlikely that the market value of equity would remain unchanged because of the changes in business
and financial risk and change in growth rate of free cash flows.
 The market value of equity is used to estimate the equity beta and the cost of equity of the business after
the implementation of the proposal. But the market value of the equity is dependent on the cost of
equity, which is in turn, dependent on the equity beta. Therefore, neither the cost of equity nor the
market value of equity is independent of each other and they both will change as a result of the change
in business strategy.

Demerger

 Demerger: Involves the company splitting into two parts (or more), with each part becoming a separate,
independent company. The shareholders would then hold shares in each separate independent
company.
 Benefits/Drawbacks of Demerger: Management can create unique financial structure suitable for each
company separately. The full value of each company would become apparent as a result. Strong
communication. Demerger may be an expensive process and result in decline of the company’s overall
value.

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 Shareholders may have invested in the company specifically for its risk profile and selling the properties
may imbalance their portfolios. With the demerger, the portfolio diversification remains unchanged.

Question # 2

Transaction, Translation and Economic exposure

 Transaction exposure: exposure to receipts in future. The receipts may change due to unfavourable
exchange rate movements.
 Translation exposure: translation of financial statements.
 Economic exposure: The risk that exchange rate movements might reduce the international
competitiveness of a company. It is the risk that present value of a company’s future cash flows might be
reduced by adverse exchange rate movements.
 Hedging strategies: leading and lagging, maintaining a foreign currency account, money market hedge.
 Hedging translation risk may not be necessary. Translation of currency is an accounting entry.
 Translation losses may be viewed negatively by equity holders and impact trend analysis.
 To hedge translation risk match assets with liabilities.
 Economic exposure is long term. Difficult to manage. Ver few derivatives offered for such long period.
Ways to avoid such exposure: locating production in countries with favourable exchange rates and
cheaper raw material and labour inputs or setting up a subsidiary abroad to create a natural hedge.

Question # 3

Acquisition

 Squeeze out rights: The bidder can force minority shareholders to sell their shares. Limits are very high
around 90%.
 Minority shareholders may also require acquirer to purchase their own shares, known as sell-out rights.
 The principle of equal treatment requires that all shareholders should be treated equally. The bidder
must offer to minority shareholders the same terms as those offered to other shareholders.

Question # 4

Capital rationing

 Soft capital rationing: setting internal limits on capital available for each department possibly due to
capital budget limits placed by the company on the amounts it wants to borrow or can borrow. In the
latter case, the company faces limited access to capital from external sources, for example, because of
restrictions in bank lending, costs related to the issue of new capital and lending to the company being
perceived as too risky. This is known as hard capital rationing and can lead to soft capital rationing.
 A capital investment monitoring system monitors how an investment project is progressing once it has
been implemented. Setting up plan and budget of how the project should proceed. Considers internal
and external risks which may affect the project. Ensures that the project progresses according to the plan
and budget.

Question # 5

Role of IMF

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 The role of the IMF is to oversee the global financial systems, in particular to stabilize international
exchange rates, help countries to achieve balance of payments and facilitate in the country’s
development through influencing the economic policies of the country in question.
 IMF may also offer temporary loans to countries.
 IMF often requires countries to adopt strict austerity measures such as reducing public spending and
increased taxation as conditions of the loan.

Reducing quality related costs

 Some inspections would be reduced this may result in defective units.

 The warranty costs may outweigh the savings made.

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 ACCA p4 2013 past papers summary
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June 2013

Question # 1

Ungeared cost of equity

 Ungeared cost of equity represents the return shareholders would require if company was financed
entirely by equity and had no debt. The return would compensate them for the business risk undertaken
by the company. This rate can be used as cost of capital if the company doesn’t issue any debt and faces
no financial risk.
 Assumptions: future growth rate, profit margins. The basis of estimating the future growth rates and
profit margins on past performance may not be accurate.
 Cost of capital is estimated on the assumption that the competitor and our company’s business risk is
same.

Reasons for public listing

 Reasons for public listing: gaining a higher reputation by being listed on a regulated stock exchange,
being able to raise funds more easily in the future, listing will help existing shareholders to sell their
equity stake and gain from the value of the organisation.
 Being listed will result in additional listing costs and annual costs related to additional reporting
requirements.

Shares issued at discount

 Shares are issued at a discount to ensure that all of them are subscribed.

Question # 2

Different types of synergy

 An acquisition creates synergy benefits when the value of the combined entity is more than the sum of
the two companies’ values.
 Synergy types – Revenue synergy: Results in higher revenue and a longer period when the company is
able to maintain competitive advantage. Cost synergy: Results mainly from reducing duplication of
functions and related costs and from taking advantage from economies of scale. Financial synergy:
Results from financing aspects such as transfer of funds between group companies to where it can be
utilised best or from increasing debt capacity.
 Financial synergy may arise when one company has ideas and capability to develop innovative products
and the other company has sufficient finance available such as slack cash.
 Cost synergy may arise from the larger company being able to negotiate better terms and lower costs
from their suppliers. And there may be duplication of functional areas such as research and development
and head office which could be reduced and costs saved.
 Revenue synergy may arise when one company’s management can help market another company’s
product more effectively by using their sales and marketing talents resulting in higher revenues and
longer competitive advantage.

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Question # 3

Multilateral netting

 Multilateral netting involves minimising the number of transactions taking place through each country’s
banks. This would limit the fees that these banks would receive for undertaking the transactions and
therefore governments who do not allow multilateral netting want to maximise the fees their local banks
receive.
 On the other hand, some countries allow multilateral netting in the belief that this would make
companies more willing to operate from those countries and any bank fees lost would be more than
compensated by the extra business these companies bring in to the country.

Gamma

 Gamma measures the rate of change of delta of an option. When the long call option is at the money the
delta is 0.5 but also changes rapidly. Hence the gamma is highest for a long call option which is at the
money. The gamma is also higher when the option is close to expiry.

Question # 4

Dividend, financing and investment policy

 High growth companies generally pay no dividend since cash flows are invested in profit earning projects.
The shareholder clientele in such companies expect to be rewarded by growth in equity value.
 Capital structure theory would suggest that because of the benefit of the tax shield on interest payments,
companies should have a mix of equity and debt in their capital structure.
 The pecking order proposition would suggest that companies tend to use internally generated funds
before going to markets to raise debt capital initially and finally equity capital.
 Since limni company operates in a rapidly changing industry, it probably faces significant business risk
and therefore cannot afford to undertake high financial risk.
 Risk management theory suggests that managing the volatility of cash flows enables a company to plan
investment strategy better.
 Change in dividend payment policy may change the company’s current clientele and this may cause share
price fluctuation.

Share buy back

 Share buyback benefits: helps control transaction costs and manage tax liabilities. Shareholder has an
option whether to sell shares back to company or not. In this way, the can manage the amount the
receive in cash. Dividend has no such option. Reduction in share capital increases eps too and increase
share prices.

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December 2013

Question # 1

The World Trade Organisation and the possible benefits and drawbacks

 The World Trade Organisation’s main aims are to reduce the barrier to international trade. It does this by
seeking to prevent protectionist measures such as tariffs, quotas and other import restrictions. It also
acts as a forum for negotiation and offering settlement processes to resolve disputes between countries.
 Normally countries retaliate against each other when they impose protectionist measures. A reduction in
these may allow a country to benefit from increased trade and economic growth.
 Possible drawbacks of reducing protectionist measures mainly revolve around the need to protect certain
industries.

Real options (put) – option to abandon

 Pa is present value of underlying asset this is the sum of the present values of the cash flows foregone. Pe
is price offered.
 Real option: offer to sell the project is an abandonment option, a put option value is calculated.
 Assumed all figures relating to variables such as revenues, costs, taxation, initial investments and their
recovery, inflation figures and cost of capital are accurate. There is considerable uncertainty surrounding
the accuracy of these, and in addition to the assessments of value conducted, sensitivity analysis and
scenario analysis are probably needed to assess the impact of these uncertainty.
 It is assumed that future exchange rates will reflect the differential in inflation rates between two
countries.
 It is assumed that short dated treasury bills are equivalent to the risk-free rate of return required by the
BSOP model.
 The BSOP model makes several assumptions such as perfect markets, constant interest rates and
lognormal distribution of asset prices. It also assumes that volatility can be assessed and stays constant
throughout the life of the project and that the underlying asset can be traded.

Foreign investment factors

 Investing in foreign country may result in political risks. For example, government, may impose a limit to
the amount of remittances which can be made to the parent company.
 The physical infrastructure such as railways, roads and shipping channels are maintained in good repair.
 Fiscal risks: Imposition of new taxes and limits on expenses allowable for taxation purposes do not
change.
 Employee health, safety law, employment law and any legal restrictions around land ownership.
 Risks related to differences in cultures between two countries.

Question # 2

FRA / Forward and options for interest

 The FRA rates offer from bank gives higher return however the company faces a credit risk with over the
counter products like the FRA, where voblaka bank may default on any money owing to Awan Co.

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Delta and Hedge ratio

 The delta value measures the extent to which the value of a derivative instrument, such as an option,
changes as the value of its underlying asset changes.
 For example, a delta of 0.8 would mean that a company would need to purchase 1.25 option contracts
(1/0.8) to hedge against a rise in price of an underlying asset of that contract size, known as the hedge
ratio.
 The option delta is equal to N(d1) from the black scholes option pricing formula. This means that delta is
constantly changing when the volatility of time to expiry change.
 Therefore even when the delta and hedge ratio are used to determine the number of option contracts
needed, this number needs to be updated periodically to reflect the new delta.

Question # 3

Acquisition of another company (FCFTC method)

 Equity beta and therefore the risk of the combined company is greater than the original company
previously.
 Assumptions: growth of cash flows in perpetuity. Calculation of combined company’s asset beta when
based on weighted average market values is based on good evidence or not.
 Assumed that the figures such as growth rates, tax rates, free cash flows, risk free return, risk premium
and so on are accurate and do not change in the future.
 In all these circumstances, it may be appropriate to undertake sensitivity analysis to determine how
changes in the variables would impact on the value of the combined company.

Question # 4

Demerger

 A demerger would involve splitting a single company into two separate companies which would then be
operating independently of each other. The equity holders would continue to have an equity stake in
both companies.
 With the demerger, since the equity holders retain an equity stake in both companies, the benefit of
diversification is retained.

Mudarabah and Musharaka

 In a mudaraba contract profit will be shared in a pre-agreed profit sharing ratio between bank and
customer. Losses will be borne by bank. Bank will not be involved in executive decision making process.
Banks role will be similar to equity holder.
 In a musharaka profits will be shared according to a pre agreed arrangement and losses shared according
to the capital or other asset and services contributed by parties. In a musharaka bank can take the role of
an active partner and participate in the executive decision making process.
 Finance provider may prefer Musharaka contract because it may be of the opinion that it needs to be
involved with the project and monitor performance closely due to the inherent risk and uncertainty of
the venture and also to ensure that the revenues, expenditures and time schedules are maintained
within initially agreed parameters.

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June 2014

Question # 1

Future contract

 We are worried that us$ will strengthen and therefore the chf1 = $1.0659 will shift to chf1=$1.02 may be.
Therefore, go short, that is sell at the moment and buy at a cheaper rate later.

Duration

 Modified duration and Macaulay duration are different. The steps are for MAC duration.
 McCauley’s duration is the weighted average length of time to the receipt of a bond’s benefits (coupon
and redemption value), the weights being the present value of the benefits involved.
 Step 1 Add the present value of the cash flows in each time period together.
 Step 2 Multiply the present value of cash flows for each time period by the time period and add
 together.
 Step 3 Divide the result of step 2 by the result of step 1
 Modified duration is a measure of the sensitivity of the price of a bond to a change in interest rates.
 Modified duration = Macaulay duration / (1 + GRY). (GRY is gross redemption yield).
 Change in bond price = -modified duration x change in yield x current price of the bond.
 Longer dated bonds will have higher modified durations – that is, bonds which are due to be redeemed at
a later date are more price- sensitive to changes in interest rates and are therefore riskier.
 For example, modified duration of 2.42 means that the value of the bond will change by 2.42 times the
change in interest rates multiplied by the original value of the bond or loan.
 The relationship is only an approximation because duration assumes that the relationship between the
change in interest rates and the corresponding change in the value of the bond or loan is linear. In fact,
the relationship is in the form of a curve.

Question # 2

APV – Adjusted Present Value

 For Adjusted present value calculations use asset beta and calculate all equity financed discount rate. Use
it for NPV working. After than adjust for financing side effects.
 In calculated the present value of tax shield and annual subsidy benefits the annuity factor used is based
on 4% to reflect the normal borrowing/default risk of the company.
 Interest is not normally included in the net present value calculations.
 When different cash flows are subject to different rates of inflation of inflation, applying a real rate to
non-inflated amounts would not give an accurate answer.
 The impact of the working capital requirement is included in the estimate as, although all the working
capital is recovered at the end of the project, the flows of working capital are subject to different
discount rates when their present values are calculated.
 APV approach: The value of the project is initially assessed considering only the business risk involved in
undertaking the project. The discount rate used is based on asset beta which measures the business risk
of that company only. The impact of debt financing and subsidy benefits are then considered. In this way,

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company can assess the value created from its investments activity and then additional value created
from the manner in which the project is financed.
 It is assumed that working capital required will form part of the funds borrowed but that the subsequent
working capital requirements will be available from the funds generated by the project. The validity of
this assumption needs to be assessed since working capital requirements at the start of years 2 and 3 are
substantial.
 It is assumed that the other company’s asset beta represents the business risk of the current project
under consideration which may not be the case.

Question # 3

Organic growth and growth by acquiring companies

 Acquisition: quicker and less costly. Horizontal acquisitions help eliminate key competitors and enable it
to take advantage of economies of scale. Vertical acquisitions help to secure supply chain and maximise
returns from its value chain.
 Organic growth: takes long time, expensive and may result in little competitive advantage being
established due to the time taken. Also, organic growth in new area would need managers to gain
knowledge and expertise of an area and function, which they are not currently familiar with.

Actions to be taken for successful acquisition

 For successful acquisition perform proper due diligence of benefits. Have sufficient data and information
to enable a thorough and sufficient analysis.
 Assess the sources of synergy properly.
 Post-acquisition audit must be performed after each acquisition and reasons for failed acquisitions listed
and considered before any further acquisition.
 Company must determine the maximum premium it is willing to pay and not go beyond that figure.
 Company must ensure that it has proper procedures to integrate the staff and systems of the target
company effectively.

The maximum premium payable for acquisition

 The maximum premium payable is equal to the maximum additional benefits created from the
acquisition of target with no increase in value of shareholders of acquirer.

Question # 4

Net present value and real options

 Conventional investment decision (example NPV) it is assumed that once a decision is made it has to be
taken immediately and carried till conclusion.
 When there is uncertainty with regard to the investment decision and where a company has flexibility in
its decision making, valuing projects using options can be particularly useful.
 Option pricing useful when: company does not have to make a decision on now or never basis, where
decision can be abandoned, opportunity for further expansion as a result of original decision.
 The initial exploration rights may give company the opportunity to delay the decision of whether to
undertake the extraction of oil and gas at a later date.

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 Assumptions of BSOP model 1. The underlying asset operates in a perfect market. 2. Risk free rate is
assumed to be known and remains constant which may not be the case where the time it takes for the
option to expire may be long. 3. Volatility can be assessed and stays constant throughout the life of the
project 4. Underlying asset can be traded freely.

Equity as call option

 Equity can be regarded as purchasing a call option by the equity holders on the value of the company,
because they will possess a residual claim on the assets of the company. The face value of the debt is
exercise price and the repayment term of debt as the time to expiry of the option.
 If at expiry the value of the company is greater than the face value of the debt, then the option is in the
money. V > F, E = V- F. Otherwise if F > V, then the option is out of the money and E=0.
 Debt can be regarded as the debt holders writing a put option on the company’s assets, where the
premium is the receipt of interest when it falls due and the capital redemption.
 Companies facing severe financial distress may still have positive equity values, the equity holders call
option may be well out-of-money and therefore no intrinsic value however the call option may still have
a time value until debt is not at expiry.
 According to BSOP model the value of an option is dependent on five variables 1. The value of the
underlying asset, the exercise price, the risk-free rate of interest, the implied volatility of the underlying
asset and the time to expiry of the option.
 Vega: determines the sensitivity of an option’s value to a change in the implied volatility of the
underlying asset.

December 2014

Question # 1

Risk diversification

 Risk diversification: like individuals holding well-diversified portfolios, a company with a number of
subsidiaries in different sectors could reduce its exposure to unsystematic risk. Risk diversification also
reduces volatility of cash flows.
 Argument against this is that since individual investors can undertake risk diversification themselves
quickly and cheaply there is no need for companies to do so.
 If EU feels that certain acquisition will give monopolistic powers to a company it may not allow the
company to acquire another company.
 Report to the board of directors, ABC company
Proposed acquisition of XYZ company
--------------------------------
Assumptions
------------------------------
Concluding comments
----------------------------
Report compiled by:
Date:
Appendices

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Appendix 1: ABCDEF

Question # 2

Centralisation / Decentralisation of treasury department

 Centralised department should be able to evaluate the financing requirements of the company as a
whole, it may be able to negotiate better rates when borrowing in bulk.
 Experts and resources within one location could reduce duplication costs.
 It could transfer resources from subsidiaries which have spare cash resources to ones which need them.
 Decentralising may be beneficial in several ways to for example each subsidiary company may be better
placed to take local regulations, custom and practice into consideration. Giving subsidiary companies
more autonomy on how they undertake their own fund management may result in increased motivation
and effort from the subsidiary’s senior management and thereby increase future income.

Salam contracts

 Salam contracts: payment for the commodity is made at the start of the contract. The buyer and seller of
the commodity know the price, the quality and the quantity of the commodity and the date of future
delivery with certainty.
 On the other hand, future contracts are marked to market daily and this could lead to uncertainty in the
amounts received and paid every day. (Islamic principles stipulate the need to avoid uncertainty and
speculation).

Question # 3

Aims of a free trade area and benefits of operating within the EU

 A free trade area like the European union aims to remove barriers to trade and allow freedom of
movement of production resources such as capital and labour.
 EU has an overarching common legal structure across all member countries and erects common external
barriers to trade against countries which are not member states.
 Companies outside EU may find it difficult to enter EU market due to barriers to trade.
 Companies within EU may be able to compete on equal terms with rivals. Companies outside EU market
may find it difficult to enter EU market. The company may also be able to access any grants which are
available to companies based within the EU.

IRR, MIRR and Value at risk

 IRR assumes that returns are reinvested at IRR, whereas modified internal rate of return assumes that
they are reinvested at the cost of capital.
 Cost of capital is a better assumption as this is the minimum return required by investors in the company.
 The value at risk provides an indication of the potential riskiness of a project.
 VAR – single tail test.
 95% five years’ present value VAR = k x sd x square root n = 400,000 x 1.645 x 5^0.5 = 1,471,000
 90% five years’ present value VAR = k x sd x square root n = 400,000 x 1.282 x 5^0.5 = 1,147,000

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 A company can be 95% confident that the present value will not fall by more than 1,471,000 over its life.
Hence the project will still produce a positive net present value. However, there is a 5% chance that the
loss could be greater than 1,471,000.

Possible legal risks and mitigation strategies

 Countries may have different legal regulations on food preparation, quality and packaging. The company
needs to ensure that the promotional material on the packaging complies with the regulations in relation
to what is acceptable in each country.
 Mitigation strategies: research of the countries’ current laws and regulations to ensure compliance.
Investigate the extent to which it may face difficulty in overcoming quota restrictions. Strict contracts
between company and agent who transport the food. Include all financial impact of above matters in
financial analysis. These extra costs may mean that the project is no longer viable.

Question # 4

Economic Value Added (EVA)

 Advantages and drawbacks of using economic value added – The cost of capital indicates the minimum
value which is required by the investors of a company and therefore any positive economics profit
greater than the cost of capital times the capital employed should result in an increase in value for the
investors. EVA captures performance into a single figure whereas ratios on the other hand will require
various different targets to be set.
 EVA = Net operating profit after tax – WACC x book value of capital employed.
 EVA is an annual measure and therefore it is relatively easy to manipulate. Short term projects with early
redemption but low yields may be chosen to the detriment of longer term, high yield projects which may
not show immediate high returns.
 For EVA Net operating profit = operating profit add depreciation less economic depreciation add non-
cash expenses less taxation excluding finance cost.

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June 2015

Question # 1

Direct investment or licensing the company

 Direct foreign investment: The government is providing financial concession for foreign companies. The
company may be able to control the quality of the components more easily, and offer better and
targeted training facilities if it has direct control of the labour resources. The company may also be able
to maintain the confidentiality of its products.
 Drawbacks of direct investment: higher upfront cost, higher cultural, political and legal risk. The foreign
company will need to become familiar with the local system and culture, which may take time and make
it less efficient initially.

Assumptions made in producing the financial projections

 Assumed: estimates of sales, cost and inflation rates are accurate.

 Assumed: future exchange rates will reflect the differential in inflation rates between respective
countries.
 Risks of foreign investments: political, cultural, fiscal, monetary and regulatory risks.
 Company must value real options it may have to assess complete value of a project.

Question # 2

Dark pool network

 A dark pool network allows shares to be traded anonymously, away from public scrutiny. No information
on trade order is revealed prior to it taking place. They prevent the risk of other traders moving the share
prices up or down. They often result in reduced costs because traders normally take place at the mid-
price between the bid and offer and because broker dealers try and use their own private pools, and
thereby saving exchange fees.

Analysis of performance

 Calculate ratios + growth rates + CAPM

 Capital asset pricing model percentage is required return.
 Selling such large number of shares may cause the portfolio to become unbalances, and for unsystematic
risk to be introduced into the portfolio. Chawan company may want to re-invest the proceeds from the
sale of oden co in other equity shares within the same sector to ensure that the portfolio remains
balances and diversified.

Question # 3

Management Buy in and Management Buy out

 Management buy-out involves the purchase of a business by the management team running that
business.
 Management buy-in involves purchasing a business by a management team brought in from outside the
business.

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 Benefits of MBO relative to MBI are that the existing management is likely to have a detailed knowledge
of the business and its operations. It is also possible that a MBO will cause less disruption and resistance
from the employees when compared to a MBI.
 The drawbacks of MBO relative to MBI may be that the existing management may lack new ideas to
rejuvenate the business. A new management team, through their skills and experience acquired
elsewhere, may bring fresh ideas into the business.

Dividend Valuation Model

 Dividend valuation model can produce a large variation in results if the model’s variables are changed by
even a small amount. Therefore, the basis of estimating the variables should be examined carefully to
judge their reasonableness, and sensitivity analysis applied to the model to demonstrate the impact of
changes in the variables.

Question # 4

Mark-to-market and margins

 Both mark-to-market and margins are used by markets to reduce (eliminate) the risk of non-payment by
purchasers of the derivative products if prices move against them.
 Mark to market closes all the open deals at the end of each day at that day’s settlement price, and opens
them again at the start of the following day. The notional profit or loss on the deals in then calculated
and the margin account is adjusted accordingly on a daily basis. This may affect the company’s ability to
plan adequately and ensure that it has enough funds for other activities. On the other hand, extra cash
accruing from the notional profits can be withdrawn from the broker account if needed.
 Each time a market-traded derivative product is opened, the purchaser needs to deposit a margin (initial
margin) with the broker, which consists of funds to be kept with the broker while the position is open. As
stated above this amount may change daily, and would affect company’s ability to plan for its cash
requirements, but also open positions require that funds are tied up to support these positions and
cannot be used for other purposes by the company.

Value of an option

 The value of an option prior to expiry consists of time value and may also consist of intrinsic value if the
option is in the money. If an option is exercised prior to expiry, company will only receive intrinsic value
but no time value. If the option is sold instead the company will receive higher value for it due to time
value.

December 2015

Question # 1

Divestment through a sell off and a management buy-in as forms of unbundling

 The divestment through sell off normally involves selling a part of a company as an entity or as separate
assets to a third party for an agreed amount of funds or value. The company can then utilise the funds
gained in alternative, value-enhancing activities.

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 The management buy in is a particular type of sell off which involves selling a division or part of a
company to an external management team, who will take up the running of the new business and have
an equity stake in the business.

Sell off and acquisition of part

 Basing corporate value on the price earnings ratio method for the sell-off and on the free cash flow
valuation method for the absorbed business is theoretically sound.
 It is assumed that the length of the period of growth is accurate and the company operates in perpetuity
thereafter.

Disposing of assets to make company unattractive for a takeover bid

 Dispose off non-core assets of the business.

 The money raised from disposed off assets must be invested in profit generating activities or given to
shareholders in form of dividends or shares bought back.

Mandatory-bid condition through sell out rights, the principle of equal treatment and squeeze out rights

 The mandatory-bid condition through sell out rights allows remaining shareholders to exit the company
at a fair price once the bidder has accumulated a certain number of shares. The main purpose for this
condition is to ensure that the acquirer does not exploit their position of power at the expense of
minority shareholders.
 The principle of equal treatment condition stipulates that all shareholder groups must be offered the
same terms, and that no shareholder group’s terms are more or less favourable than another group’s
terms.
 The squeeze-out rights condition allows the bidder to force minority shareholders to sell their stake, at a
fair price, once the bidder has acquired a specific percentage of the target company’s equity.

Question # 2

Multilateral Netting

 Armstrong group may have problems if any of the governments of the countries where the subsidiaries
are located object to multilateral netting. The new system may not be popular with the management of
the subsidiaries because of the length of time before settlement (up to six months).

Question # 4

Securitization process

 Benefits- The finance cost of the securitization may be lower than the finance costs of ordinary loan
capital. The securitisation means that the company is no longer concerned with the risk that the level of
earnings from the properties will be insufficient to pay the finance costs.
 Risks – If company seeks funding from other sources for other developments, transferring out a lower
risk income stream means that the residual risks associated with the rest of company’s portfolio will be
higher. This may affect the availability and terms of other borrowing.

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Sukuk finance

 An asset-backed sukuk would be the same kind of arrangement as the securitisation, where assets are
transferred to a special purpose vehicle and the returns and repayments are directly financed by the
income from the assets.
 The other type of sukuk would be more like a sale and leaseback, where sukuk holders would be
guaranteed a rental
 There will also be costs involved in establishing and gaining approval for the Sukuk, although these costs
may be less than for the securitisation arrangement described above.

Mudaraba

 A mudaraba contract would involve bank providing the capital to invest. Company would manage the
investment. Profits from the investment would be shared with the bank but losses would be solely borne
by the bank. A mudaraba contract is essentially and equity partnership.
 It would not require the commitment to pay interest that loan finance would involve.
 The bank might be concerned about information asymmetry that the company’s management might be
reluctant to supply the bank with the information it needs to judge how well its investment is
performing.

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June 2016

Question # 1

Purchasing Power Parity and Economic exposure

 Purchasing power parity predicts that the exchange rates between two currencies depend on the relative
differences in the rates of inflation in each country.
 Economic exposure refers to the degree by which a company’s cash flows are affected by fluctuations in
exchange rates. It may also affect companies which are not exposed to foreign exchange transactions,
due to actions by international competitors.
 If PPP holds, then companies may not be affected by exchange rate fluctuations, as lower currency value
can be compensated by the ability to raise prices due to higher inflation levels.
 However, a permanent shift in exchange rates may occur, not because of relative inflation rate
differentials, but because a country loses their competitive positions.

Format of discussion paper

 Format of discussion paper

Discussion paper to the board of directors
Discussion paper compiled by
Date
Purpose of the discussion paper
Background information
Project assessment
Possible issues
Areas for further discussion by the board
Appendix

Forward, future and options

 Options require premium to be paid. Futures require margin payments to be made upfront and contracts
are marked to market daily.
 For futures, basis may not narrow in the linear fashion and therefore the amount received is not
guaranteed.
 Under forward rate a company knows the exact amount that it will receive or pay in the future.

Dividend valuation

 Dividend valuation model is based on a number of factors such as: an accurate estimation of the dividend
growth rate, a non-changing cost of equity and a predictable future dividend stream growing in
perpetuity.
 Dividend irrelevancy theory proposed by M and M suggests that corporate value should not be affected
by a corporation’s dividend policy but in practice changes in dividends do matter for two main reasons.
Dividends are used as a signalling device to the market and changes are generally not viewed positively.
Secondly, a change in dividends policy may result in the clientele changing and this changeover may
result in excessive and possibly negative share price volatility.

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Question # 2

Advantages of Acquisition

 Two companies who are good strategic fit for each other.
 Quick progress / growth.
 Synergistic benefits

Disadvantages of Acquisition

 Internal growth may be slower

 Cultural differences

Question # 3

Stakeholder conflict

 If a company takes a simple view of the role of stakeholders, it will prioritise the interest of shareholders
over other stakeholders and take actions to maximise profitability.

Question # 4

Black Scholes pricing model

 Black Scholes: Using real options for decision making has limitations. Assumptions in model: assumes that
there is a market for the underlying asset and the volatility of returns on the underlying asset follows a
normal distribution. Also, assumes constant risk free interest rate.

Rho

 The sensitivity of the valuation of options to interest rate changes can be measured by the option’s rho.
 The option’s rho is the amount of change in the option’s value for a 1% change in the risk-free interest
rate.
 The rho is positive for calls.
 A change in interest rates will be more significant the longer the time until expiry of an option.

World bank

 The world bank provides loans, often direct to governments, on a commercial basis, for capital projects.
 International Development Association is part of the world bank. This provides loans on more generous
terms to the poorest countries.

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December 2016

Question # 1

Business risk, Financial risk, risk mitigation and risk diversification

 Business risk depends on the decisions a business makes with respect to the services and products it
offers and consists of the variability in its profits. It could be related to the demand for its products, the
rate of innovation, actions of competitors etc.
 Financial risk relates to the volatility of earnings due to the financial structure of the business and could
be related to its gearing, the exchange rate risk it is exposed to, its credit risk, its liquidity risk, etc.
 Risk management involves the process of risk identification, of assessing and measuring the risk through
the process of predicting, analysing and quantifying it, and then making decisions on which risks to
assume, which to avoid, which to retain and which to transfer.

Question # 2

Duration

 The result indicates that it will take approximately 2.78 years to recover half the present value of the
project. Duration considers the time value of money and all of the cash flows of a project.

Investment in projects

 The net present value is the most important indicator of whether an investment is likely to maximize
shareholders’ wealth. When there is limited capital and it has to be rationed the project with highest NPV
will not be selected but the amount of investment will also be considered.
 Investors are also concerned with short term returns such as dividends.
 The payback method shows how long an investment will take to generate enough returns to pay back the
investment. It favours investments which pay back quickly, although it fails to take into account longer
term cash flows after the payback period.

Question # 4

Interest rate swap

 At the start of the contract, the value of the swap will be zero.
 If interest rate increase more than expected company will benefit from having to pay a fixed rate and the
value of the swap will increase. The value of the swap will also change as the swap approaches maturity,
with fewer receipts and payments left.

Disadvantages of swap arrangement

 The swap represents a long-term commitment at a time when interest rates appear uncertain. It may be
that interest rate rises are lower than expected in this case company will be committed to a higher
interest rate and its finance costs may be higher than if it had not taken out the finance arrangements.
 There may be some arrangement fee to be paid.

Advantages of swap arrangement

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 ACCA p4 2016 past papers summary
By Taha Popatia
 There is certainty over the amount that will be paid each year. A fixed figure may help planning.
 The swap is for a shorter period than the loan and thus allows company to reconsider the position after
four years’ time.

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 P4 GREEKS
By Taha Popatia
Greeks

DELTA

 Change in option price / change in value of share.

 The value of N(d1) can be used to indicate the amount of the underlying shares which the writer of an
option should hold in order to hedge (eliminate the risk of) the option position.
 Delta = change in option price / change in the price of shares.
 For long call options and/or short put options delta has a value between 0 and 1.
 For long put options and/or short call options delta has a value between 0 and -1.
 If share price goes up, the option price will go up if it is a call option or down if it is a put option.

GAMMA

 Change in delta value / Change in the price of the underlying

 The higher the gamma value, the more difficult it is for the option writer to maintain a delta hedge
because the delta value increases more for a given change in share price.
 The value of gamma for an option is very low as the certainty increases that the option will expire in the
money or out of the money.
 The value of gamma increases with uncertainty as to whether the option will expire in the money or out
of the money.

THETA

 Theta is a measure of the sensitivity of the option price to the remaining time to expiry of the option. It is
the change in options price (specifically its time premium) over time.
 Option premium has two components intrinsic value and time value. Theta deals with time value.
 Theta measures how much value is lost over time. Usually expressed as an amount lost per day.
 The nearer the expiration date, the higher the theta and the farther away the expiration date, the lower
the theta.

RHO

 Measures the sensitivity of options prices to interest rate changes.

 An options rho is the amount of change in value for a 1% change in risk free interest rate. Rho is positive
for calls and negative for puts.
 As exercise price has to be paid in the future, therefore the higher the interest rates the lower the
present value of the exercise price. This reduces the cost of exercising and thus adds value to the current
call option value.

VEGA

 Vega measures the change in value of an option that results from a 1% change in the volatility of the
underlying item
 Long term options have larger vegas than short term options. The longer the time period until the option
expires, the more uncertainty there is about the expiry price.

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 P4 GREEKS
By Taha Popatia

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 P4 ISLAMIC FINANCE
By Taha Popatia
ISLAMIC FINANCE

Murabaha (Trade credit or loan for purchase of asset)

 Bank buys asset (Rs.100) and sells it to customer (Rs.125). Bank makes a profit of Rs.25.
 Rs.125 can be paid by customer in instalments but the amount of profit cannot be increased even if payment is
delayed.

Musharaka (Venture Capital)

 Profits shared according to pre-agreed ratio.

 Losses shared according to capital contribution ratio.
 Organization = mudareb. Finance provider = rub ul maal.
 Under diminishing musharaka mudareb keeps paying greater amount to rub ul maal so that he eventually becomes
the owner of the venture capital.
 Bank can also take role of an active partner and participate in executive decision making process.

Mudaraba (Provision of equity finance)

 Capital from bank (rub ul maal) + Expertise from customer (mudareb).

 Profits distributed in a pre-agreed ratio.
 Bank will not participate in management.
 In cases of loss in this case the bank loses out.
 Bank not involved in executive decision making.
 In effect banks role in the relationship will be similar to that of equity provider.
 Customer would essentially be an agent of the bank.
 Customer may also have the propensity to take excessive risk because it is holding long call option with an unlimited
upside and a limited downside.

Ijara (Lease)

 Bank buys the asset and provide it to the customer for in return for lease rentals.
 The ownership is passed to the customer and the end of the term either by way of a gift deed or selling the asset for
a nominal amounts.

Sukuk (Debt finance)

 Sukuk holders have an ownership interest in the assets being financed.

 Types include – Ijara sukuk, Mudaraba sukuk, musharaka sukuk, Murabaha sukuk.

Salam (Forward)

 Prohibited for certain assets

 Commodity is sold today for future delivery with cash being received today.
 Sale is generally at discount for the fund provider to make a reasonable profit

Istisna (Phased payments, sana (derived from) means to manufacture or construct something)

 Used for funding large projects example construction work.

 Subject matter is raw material which has the characteristic of being transformed.

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