Advanced Financial Management notes – Revised and Updated Syllabus

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GENERAL OBJECTIVE
This paper is intended to equip the candidate with knowledge, skills and attitudes that will enable him/her to apply advanced financial management techniques in an organisation.

15.0 LEARNING OUTCOMES

A candidate who passes this paper should be able to:
– Make advanced capital budgeting decisions and make appropriate capital structure decisions for an organisation
– Evaluate portfolios and apply the capital asset pricing model and other multifactor Models in financial decision making
– Apply the relevant models and skills in prediction of corporate failure
– Apply derivatives in financial risk management and apply international finance concepts.
– Evaluate mergers and acquisitions
– Undertake corporate restructuring and re-organisation
– Apply valuation techniques in real estate finance.

CONTENT

15.1 Advanced capital budgeting decision

– Incorporating risk/uncertainty in capital investment decisions
– Techniques of handling risk: Basic Methods of analysis – Expected Monetary Value (EMV), The Standard deviation and Coefficient of Variation
– Advanced Methods of analysis; sensitivity analysis, scenario analysis, decision trees, simulation analysis, utility analysis, risk adjusted discounting rate (RADR) and certainty equivalent method
– Impact of financing on investment decisions – the concept of adjusted present value (APV)
– Incorporating capital rationing in capital investment appraisal; Single period capital rationing with divisible projects; Multi-period capital rationing with divisible capital investments.
– Incorporating inflation in capital investment appraisal
– Evaluation of projects of unequal lives; The equivalent annual annuity approach and the Replacement chain analysis (Constant scale finite period replication criteria)
– Project duration as a measure of risk
– The real options in Capital Budgeting-Characteristics of the real Options; Types of Options in Capital investment Appraisal-Strategic investment option (Expansionary Option), Timing option (Option to delay a project), abandonment option (Option to Withdraw a project), the replacement option and the Option to re-deploy a project, challenges in use of options in investment analysis.
– Common capital budgeting pitfalls

15.2 Portfolio theory and analysis:

– The modern portfolio theory: background of the theory; portfolio expected return; the actual and weighted portfolio risk; derivation of efficient sets; the capital market line (CML) model and its applications, the mean variance dominance rule; short comings of portfolio theory
– Capital Asset Pricing Model-CAPM: background of the theory; assumptions; beta estimation – beta coefficient of an individual asset and that of a portfolio and the interpretation of the result; security market line(SML) model and its applications; conceptual differences between portfolio theory and capital asset pricing model
– Shortcomings of the capital asset pricing model
– The Arbitrage pricing model (APM) and other multifactor models: background of the theory; conceptual differences between the Capital asset pricing model and the Arbitrage pricing model; application of the Arbitrage pricing model, shortcomings of Arbitrage pricing model; Pastor Stambaugh model
– Evaluation of portfolio performance: Treynor’s measure, Sharpe’s measure, Jensen’s measure, appraisal ratio measure, information ratio, Modigliani and Modigliani (M2)

15.3 Advanced financing decision

– The nature of financing decision, principle objectives of making financing decision
– Analysis of breakpoints in weighted marginal cost of capital schedule (more than two breakpoints)
– Capital structure theories: nature of capital structure; factors influencing the firm’s capital structure; traditional theories of capital structure – assumptions of the theories, Net income theory and Net operating income theory; Franco Modigliani and Merton Miller’s propositions – MM without taxes, MM with corporation taxes, MM with corporation and personal tax rates and MM with taxes and financial distress costs; other theories of capital structure; the pecking order theory; Static Trade-off theory and Agency effects, determination of the firm’s optimal capital structure using the Hamada model, CAPM and WACC
– Long term financing decisions; bond refinancing decision, lease-buy evaluation and rights issues
– Assess an organisation’s debt exposure to interest rate changes using the simple Macaulay duration and modified duration methods
– Benefits and limitations of duration including the impact of convexity

15.4 Mergers and acquisitions

– Nature of mergers and acquisitions
– Arguments for and against the use of acquisitions and mergers as a method of corporate expansion; Acquisition and Mergers verses organic growth
– Valuation of acquisitions and mergers: problem of overvaluation; valuation models- ‘Book value-plus’ models, Market based models, cash flow models; apply appropriate methods, such as: risk-adjusted cost of capital, adjusted net present values and changing price/earnings multipliers resulting from the acquisition or merger, to the valuation process where appropriate. Prediction of a takeover target: criteria for choosing an appropriate target for acquisition
– Defence tactics against hostile takeovers
– Financing of mergers and acquisitions: Outright purchase using cash, share for share exchange, share- Debenture exchange and share- preference share exchange, Analysis of combined operating profit (EBIT) and post-acquisition earning per share at the point of indifference in firm’s earnings under various financing options and Determination of range of combined operating profit within which to recommend a financing option
– Financial Evaluation of mergers and acquisitions – Post merger/Acquisition EPS, Post Merger/Acquisition MPS
– Regulatory framework for mergers and acquisitions
– Valuation of firms/ Shares for Mergers and acquisition Purposes- Use of Net asset basis, P/E ratio basis, Dividend growth model, Super profits model, Capital asset pricing Model and the Discounted free cash flow basis.
– Reasons why there are failed mergers and acquisitions
– Mergers and acquisitions in the Kenyan, regional and global context

15.5 Corporate restructuring and re-organisation

– Background on restructuring and reorganisation
– Indicators/symptoms of restructuring
– Causes of financial distress
– Forms of financial distress and solutions to financial distress
– Considerations in designing an appropriate restructuring programme
– Financial reconstruction: forms of financial reconstruction; impact of financial reconstruction on share price; impact of financial reconstruction on the weighted Average cost of capital (WACC)
– Portfolio reconstruction: various ways of unbundling a firm: divestment, de-merger, spin-off, liquidation, sell-offs, equity carve outs, strategic alliances, management buyout, leveraged buyouts and the management buy-ins.
– The relevance of the various forms of portfolio reconstruction
– Organisational reconstruction: The nature and benefits of this form of restructuring
– Other forms of restructuring
– Restructuring in the Public sector
– Models of predicting corporate failure; Quantitative Models-Multiple discriminant analysis (Z-Score model), Springate model, Fulmer model; Qualitative Models – Argenti Model

15.6 Financial risk management

– Types of risks: operational risks, political risks, economic risks, fiscal risks, regulatory risks, currency risks and interest rate risks
– The meaning, nature and importance of derivative instruments
– Operations of the derivatives market: The relative advantages and disadvantages of exchange traded versus over the counter (OTC) agreements; Key features, such as standard contracts, tick sizes, margin requirements and margin trading
– Types of derivatives: futures, forwards, options and swaps
– Application of option pricing theory in investment decisions: Apply the Black-Scholes Option Pricing (BSOP) model to financial product valuation and to asset valuation; assumptions, structure, application and limitations of the BSOP model; calculate and advise on the value of options to delay, expand, redeploy and withdraw using the BSOP model
– Binomial Option pricing model – Use of both riskless hedge and the risk neutral approach in Valuation of both European and American call and put options
– Foreign currency risk management: Types of forex risks, hedging currency risks, forward contracts, money market hedge, currency options, currency futures and currency swaps, Bilateral and Multilateral netting and Matching tools of managing forex risks
– Option trading Strategies- Spreads and Combinations
– Limitations of financial derivatives

15.7 International financial management

– Introduction – The nature of international finance, Motives for investing in foreign markets and Challenges experienced by the Multinational corporations
– International financial Systems – Players in the international financial systems such as International Monetary fund, World trade organisation, European Union and the World bank.
– International trade flows and foreign direct investments (FDI)
– Financing of International Trade – Methods of financing the trade.
– International Capital and Money Markets – The foreign exchange Market-Exchange rates, Foreign Exchange exposures, International arbitrage – locational arbitrage, triangular arbitrage and covered interest arbitrage, International parity conditions- Interest rate parity, purchasing power parity and International fisher effect, International capital markets and their importance
– International Capital Budgeting – Reasons for Investing abroad, Evaluation of capital investments using local cash flows and foreign cash flows.
– International Capital structure – Factors influencing capital structure of MNCs, Sources of international finance, Cost and benefits of the alternative sources of international finance, Factors leading to difference in cost of capital of domestic firms and Multinational corporations and Adjusting WACC for risk differential

15.8 Real estate finance

– Overview of real estate finance – Meaning of real estate finance, nature of real estate business, property rights and limitations of property rights, environment of real estate finance and participants in real estate business.
– Real estate valuation approaches (income approach, cost approach and sales comparison approach)
– Real estate investment trusts (REITS): Types; advantages and disadvantages
– Instruments of real estate financing – mortgages, lien, title, mortgage requirements and mortgage clauses
– Mechanics of real estate mortgage-mortgage payments, mortgage constant, amortisation schedules
– Secondary mortgage trading and mortgage securitisation and re-financing
– Financing real estate investments-optimal capital structure, review of capital MM Theories in relation to real estate finance, arbitrage process
– Permanent financing of commercial real estate-equity financing, debt financing, cash flow from operations, mechanics of leasing versus ownership

15.9 Contemporary issues and emerging trends

– Crypto currency
– Block chain technology
– Cloud funding
– Digitisation of financial transactions
– Big data project finance
– Islamic finance
– Behavioral finance
– Derivative markets in developing countries

TOPIC 1

ADVANCED CAPITAL BUDGETING DECISION

Introduction
Capital budgeting (investment) decisions may be defined as the firm’s decisions to invest its current funds most efficiently in the long-term assets in anticipation of an expected flow of benefit over a series of years.

Elements/Characteristics of Capital budgeting projects
They are long-term projects
Benefits are realised in future
They are highly risky
Involves huge capital
They are irreversible

Importance of capital budgeting
Ensures choosing of projects which have a long term cash inflows
Helps to control expenditures
Helps to determine the uncertainity and risk involved in investment decisions
Facilitates innovation and creativity thus economic growth

Types of capital budgeting decisions
Mutually exclusive decisions/projects
Are projects that serve the same purpose and compete with each other in terms of resources i.e. if one project is undertaken then others will have to be excluded.
Independent projects
Are projects that serve different purposes and don’t compete for resources. Therefore, they can be undertaken subject to availability of funds.
Dependent/contingent projects/decisions
Are those projects that depend on each other thus when one is undertaken then the other will have to be undertaken.
Divisible and indivisible projects
Divisible-Are those which generate income before they are complete
Indivisible-Don’t generate income before they are complete.
Outright acquisition projects
It involves purchase of a new long term assets for the first time
Usually done to meet the changing need of an enterprise
Expansion and diversification projects
Involves expanding of existing facilities which have become inadequate due to diversification into new areas of operation.
Replacement and modernization projects
Involves replacing an existing asset which has become technologically outdated in order to modernize operations of the business

Capital budgeting process
Project identification and generation
Project screening and evaluation
Project Selection
Implementation:
Performance review

Factors affecting budgeting capital budgeting
Capital structure
Working capital Capital return
Availability of funds
Earnings
Lending policies of financial institutions
Management decisions
Project needs
Accounting methods
Government policy
Taxation policy
Project’s economic value

Objectives of capital budgeting
Control of capital expenditure: Estimating the cost of investment provides a base to the management for controlling and managing the required capital expenditure accordingly.
Selection of profitable projects: The company have to select the most suitable project out of the multiple options available to it. For this, it has to keep in mind the various factors such as availability of funds, project’s profitability, the rate of return, etc.
Identifying the Right source of funds: Locating and selecting the most appropriate source of fund required to make a long-term capital investment is the ultimate aim of capital budgeting. The management needs to consider and compare the cost borrowing with the expected return on investment for this purpose.

Features/characteristics of capital budgeting decisions
Involve huge amounts of capital
Funds are invested in long term assets
Future benefits will occur to the firm over a series of years
They are usually irreversible-ones undertaken and not possible to reverse to original state involve huge loss to reverse.
There are a lot of uncertainty involved while undertaking such projects e.g. economic life and expected cash inflows.

Importance of investment/capital budgeting decisions
Investment decision requires special attention because of the following reasons:-
Involve commitment of large amounts of funds
Are irreversible or reversible at huge loss
Are among the most difficult decision to make
They influence the firms growth in the long term
They affect the risk of the firm

PROJECT EVALUATION TECHNIQUES

Proudly categorized in to two:
Non-discounting techniques
Discounting techniques

Non-discounting techniques
This techniques do not take into account time value of money. They include:-
Payback Period
Accounting rate of return

Discounting techniques
Techniques which take into account time value of money. They include:
Discount payback period (DPBP)
Net present value (NPV)
Modified Internal rate of return (MIRR)
Profitability Index (PI)
The internal Rate of return(IRR)

Features/Characteristics of an ideal investment appraisal method
It should take into account time value of money
It should use cashflow rather than accounting profit
It should give a clear indication on whether to accept or to reject a project
It should consider all cashflows
It should help in ranking independent projects

Discount Payback Period (DPBP)
Pay back period is the length of time taken to recover the initial capital investment. The shorter the period the better and less risky the project is and vice versa

Net Present Value (NPV)
This is the most appropriate and widely applied investment appraisal method. NPV is the difference between the present value of cash and cash outlows.

Decision criteria is as follows:
If NPV is the Positive (+ve); accept the Project
If the NPV is Negative (-ve) Reject the project
If NPV is Zero (0), Point of indefference

NPV=PVCIF-PVCOF

MODIFIED INTERNAL RATE OF RETURN (MIRR)

The required rate of return assuming that the cashflows generated can be re-invested to earn more returns

It is computed as follows
MIRR=√(n&(Future Value of Cashflows)/(Initial Investment))-1
Future value of cashflows is determined as follows;

a) Incase of Unequal Cashflows

FV=〖A(1+r)〗^n

a) Incase of equal Annuity

FV=A×((1+r)^n-1)/r

Illustration
Consider a project whose initial investment is 636,000 and the company expects to generate annual cash flows of 240,000 p.a. for a period of 5 years. The present cash flows can be re- invested at the rate of 16% pa and the cost of capital is 14% .

Determine the MIRR

Solution
FV=A×((1+r)^n-1)/r

FV=240,000×((1+0.16)^5-1)/0.16=1,650,512

MIRR=√(n&(Future Value of Cashflows)/(Initial Investment))-1

MIRR=√(5&1,650,512/636,000)-1=21%

Accept Since MIRR> Cost of Capital

PROFITABILITY INDEX (PI)

This is the relative measure of performance. Expressed as follows:

PI=A×PVCIF/PVCOF

If probability index is greater > than 1 accept the project
If profitability index is less < than 1 reject the project
PI is applied when the company is facing capital rationing

Illustration
May 2014 Question Two B
Madara Ltd. is considering investing in one of two mutually exclusive projects. The relevant cash flows of each of the projects are as shown in the table below. The firm’s cost capital is 15%. Cash flows accrue at the end of the year.

Project X Project Y
(Sh “000”) (Sh “000”)
Initial investment 38,500 37,000
Cash flows
Year: 1 25,000 30,000
2 -11,000 8,000
3 20,000 -4,000
4 15,000 22,000
5 6,000 -10,000
6 5,000 15,000

Required:
Calculate for each project:
(i) Discounted pay back period. (6 marks)
(ii) Modified internal rate of return (MIRR). (6 marks)
(iii) Profitability index. (4 marks)
(iv) Net Present Value

Solution
i) Discounted pay back period at 15%

Project X
Period Cashflows 〖PVIF〗_(15%)^n PV Accumulated
Cashflows
1 25,000 0.8690 21,740 21,740
2 -11,000 0.7561 -8,317.1 13,422.9
3 20,000 0.6575 13,150 26,572.9
4 15,000 0.5718 8,577 35,149.9
5 6,000 0.4972 2,983.2 38,133.1
6 5,000 0.4323 2,161.5 40,294.6

Pay back period will occur between the 5th and 6th year according to the table above. To exact the exact time required to recover the initial investment we calculate as follows:

Cost of investment = sh.38,500
Upper Limit = sh. 40,294.6
Lower limit = sh. 38,133.1
Payback period (PBP)=5yrs+((Initial Capital-Lower Limit)/(Upper Limit-Lower Limit)×12)

Payback period (PBP)=5yrs+((38,500-38,133.1)/(40,294.6-38,133.1)×12)=5.2

=5yrs and 2 months

Project Y
Period Cashflows 〖PVIF〗_(10%)^n PV Accumulated
Cashflows
1 30,000 0.8696 26,088 26,088
2 8,000 0.7561 6,048.8 32,136.8
3 -4,000 0.6575 -2,630 29,506.8
4 22,000 0.5718 12,579.6 42,086.4
5 -10,000 0.4972 -4,972 37,114.4
6 15,000 0.4323 6,484.5 43,598.9

Cost of investment = sh.37,000
Upper Limit = sh. 42,086.4
Lower limit = sh. 29,506.8
Payback period (PBP)=3yrs+((Initial Capital-Lower Limit)/(Upper Limit-Lower Limit)×12)

Payback period (PBP)=3yrs+((37,000-29,506.8)/(42,086.4-29,506.8)×12)=3.7

=3yrs and 7 months

Comment: undertake Project Y as it has the shortest Payback period

ii) Modified Internal Rate of Return
Project X
Period Cashflows FV=(1+r)^n FV
1 25,000 (1+0.15)^5 50,000
2 -11,000 (1+0.15)^4 -19,239
3 20,000 (1+0.15)^3 30,417.5
4 15,000 (1+0.15)^2 19,837.5
5 6,000 (1+0.15)^1 6,900
6 5,000 (1+0.15)^0 5,000
93,200

Project X: MIRR=√(6&93,200/38,500)-1=15.88%
Or
Future Value is 93,200
FV=〖A(1+r)〗^n
〖38,000(1+r/100)〗^6=93,200
(1+r/100)^6=2.421
(1+r/100)=√(6&2.421)
(1+r/100)=1.1588

r=15.88%

Project Y
Period Cashflows FV=(1+r)^n FV
1 30,000 (1+0.15)^5 60,340.7
2 8,000 (1+0.15)^4 13,992
3 -4,000 (1+0.15)^3 -6,083.5
4 22,000 (1+0.15)^2 29,095
5 -10,000 (1+0.15)^1 -11,500
6 15,000 (1+0.15)^0 15,000
100,844.2

Project Y: MIRR=√(6&100,844.2/37,000)-1=18.18%
Or

Future Value is 93,200
FV=〖A(1+r)〗^n
〖37,000(1+r/100)〗^6=100,844.27
(1+r/100)^6=2.7255
(1+r/100)=√(6&2.7255)
(1+r/100)=1.1819

r=18.18%

(iii) Profitability Index (PI)

PI=PVCIF/PVCOF

Project X: PI=PVCIF/PVCOF Project X: PI=40,294.6/38,500=1.05

Project Y: PI=PVCIF/PVCOF Project Y: PI=42,086.4/37,000=1.14

Comment: undertake Project Y as it has Higher profitability index

(iv) Net Present Value
Period Project X Project Y 〖PVIFA〗_(15%) Project X Project Y
1 25,000 30,000 (1+0.15)^5 21,740 26,088
2 -11,000 8,000 (1+0.15)^4 -8,317.1 6,048.8
3 20,000 -4,000 (1+0.15)^3 13,150 -2,630
4 15,000 22,000 (1+0.15)^2 8,577 12,578.6
5 6,000 -10,000 (1+0.15)^1 2,983.2 -4,972
6 5,000 15,000 (1+0.15)^0 2,161.5 6,484.5
PVCIF 40,294.6 43,598.9
PVCOF (38,500) (37,200
1,794.6 6,598.9

Decision: Undertake project Y since it has a higher NPV

THE INTERNAL RATE OF RETURN (IRR)

This is the rate where NPV is equal to Zero i.e.

PVCIF=PVCOF

IRR can be computed as follows depending on the nature of the project.

a) Incase of annuity cashflows for a specific period of time

In this case;
IRR=PVCOF/A
Illustration
Consider the following projects
Project Initial investment Annual cash flows Economic life
A 10,000 2,191.2 7years
B 20,000 5,427.84 6years
C 20,000 4,500 8years

Required:
Determine the IRR for each project

Solution
IRR=PVCOF/A

Project A
IRR=10,000/2,191.2=4.5637 Reading from the table 7yrs=12%

Project B
IRR=20,000/5,427.84=3.6847 Reading from the table 6yrs=16%

Project C
IRR=15,000/3,240=4.6296

2%=4.7135
IRR=4.6296
3%=4.5797

(IRR- Lower Limit)/(Upper Limit-Lower Limit) =(IRR- 2)/(3-2) =(4.6296-4.7135)/(4.5797-4.7135)

(IRR- 2)/1=0.6271 IRR-2=0.6271

=2+0.6271
=2.6271%

Illustration
May 2017 Question One B(iii)
Kenzel Ltd. has the following investment opportunities for the coming year:
Project Cash outlay Annual net
cash flow Project life
(years) Internal rate of return
Sh. Sh. %
A 675,000 155,401 8 9
B 900,000 268,484 5 15
C 375,000 161.524 3 ?
D 562,500 185,194 4 12
E 750,000 127,351 10 11

Required:
(iii) The internal rate of return (IRR) for project A and project C. (4 marks)

Solution
Discount rate estimate project A
= 675000/155401 =4.3436
Annuinity factor of 4.3436 for 8 years discount rate 16%. So internal rate of return for project A is 16%
Discount rate estimate project C
375,000/161,524 = 2.316
Present value interest factor annuity of 2.3216 for 3 years discount rate 14%. So internal rate of return for project c is 14%
b) Incase of 1 year Project
IRR=FV/PVCOF-1
Illustration
Consider a one year project whose initial investment is 100M. The project is expected to generate sh.125M at the end of the year.
Required: Compute the IRR of the project

Solution
IRR=FV/PVCOF-1

IRR=125/100-1=0.25
=25%

c) In case of Annuity cashflows until Infinity
IRR=A/PVCOF
Illustration
Consider a project whose initial investment is sh 250M. It is expected to generate annual cash inflows of sh 45M until infinity
Required: Determine the IRR of the project.

IRR=45/250=0.18
=18%
d) In case of Unequal cashflows
In this case IRR is computed on a trial and error method by adopting the following steps;
Compute the NPV using the cost of capital given
If the NPV obtained in step one is positive, re-discount using higher rate
If the computed NPV in step one is negative, rediscount using a lower rate
Determine the IRR as follows: