Business Management Study Manuals Advanced Diploma in Business Management CORPORATE FINANCE The Association of Business Executives 5th Floor, CI Tower St Georges Square High Street New Malden Surrey KT3 4TE United Kingdom Tel: + 44(0)20 8329 2930 Fax: + 44(0)20 8329 2945 E-mail: info@abeuk.com www.abeuk.com © Copyright, 2008 The Association of Business Executives (ABE) and RRC Business Training All rights reserved No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form, or by any means, electronic, electrostatic, mechanical, photocopied or otherwise, without the express permission in writing from The Association of Business Executives Advanced Diploma in Business Management CORPORATE FINANCE Contents Unit Title Page The Context of Corporate Finance Introduction Basic Principles of Companies Financial Objectives Corporate Governance Corporate Financial Management 10 24 Company Performance, Valuation and Failure Introduction Ratio Analysis Using Ratio Analysis Introduction to Share Valuation Methods of Share and Company Valuation Non-financial Factors Affecting Share Valuation Predicting Company Failure Capital Reconstruction Schemes 35 37 37 44 51 52 61 61 64 Acquisitions and Mergers Introduction Company Growth The Regulation of Takeovers The Acquisition/Merger Process Measuring the Success and Failure of Mergers and Takeovers Disinvestment 67 69 69 73 78 82 86 Financial Markets Introduction Stock Markets Other Sources of Finance Other Financial Markets Recent Changes in Capital Markets Impact of the Markets on Market Decisions 91 92 92 99 102 103 103 Sources of Company Finance Introduction Share Capital Methods of Issuing Shares Share Repurchases Debt and Other Forms of Loan Capital Short-Term Finance International Capital Markets Finance and the Smaller Business 105 107 107 110 116 118 129 134 136 Unit Title Page Cost of Finance Introduction Investors and the Cost of Capital Cost of Equity Cost of Debt Capital Cost of Internally Generated Funds Weighted Average Cost of Capital Assessment of Risk in the Debt Versus Equity Decision Cost of Capital for Other Organisations 143 145 145 146 149 153 154 157 159 Portfolio Theory and Market Efficiency Introduction Risk and Return The Impact of Diversification Portfolio Composition The Application of Portfolio Theory Market Efficiency 161 162 162 164 168 175 177 The Capital Asset Pricing Model Introduction Risk, Return and CAPM Calculation of Betas Validity of the CAPM Practical Applications of CAPM The Arbitrage Pricing Model 189 190 190 196 197 199 200 Capital Structure Introduction Capital Gearing Factors Determining Capital Structure Theory of Capital Structure Capital Gearing and the Effects on Equity Betas Operational Gearing 203 204 204 208 211 217 218 10 Corporate Dividend Policy Introduction Key Influences on Dividend Policy Theories of Dividend Policy Practical Aspects of Dividend Policy 221 222 222 228 229 11 Working Capital and Short-Term Asset Management Introduction Working Capital Overtrading Cash Management Management of Stocks Management of Debtors Creditor Management Short-Term Finance and Investment 233 235 235 243 245 251 256 263 263 Unit Title Page 12 Capital Investment Decision Making 1: Basic Appraisal Techniques Introduction Future Cash Flows and the Time Value of Money Return on Investment (Accounting Rate Of Return) Payback Discounted Cash Flow Net Present Value (NPV) Internal Rate of Return Cost/Benefit Ratio Comparison of Methods Impact of Taxation on Capital Investment Appraisal Appendix: Discounting Tables 275 277 277 278 279 280 281 288 291 291 292 296 13 Capital Investment Decision Making 2: Further Considerations Introduction Allowance for Risk and Uncertainty Impact of Inflation and Taxation on Investment Appraisal Capital Rationing Lease Versus Buy Decisions Adjusted Present Value (APV) Use of the Capital Asset Pricing Model Worked Examples 307 308 308 311 312 313 316 319 319 14 Managing Risk The Nature of Risk Principles of Hedging Interest Rates, Risk and Exposure Internal Techniques of Managing Interest Rate Exposure Futures Contracts Forward Rate Agreements (FRAs) Interest Rate Swaps Options 339 341 343 346 350 350 354 355 357 15 International Trade and Finance Introduction Theory and Practice of International Trade International Investment Finance and International Trade Exchange Rates Risk and International Trade/Finance Internal Methods of Managing Exchange Rate Risk and Exposure External Methods of Managing Exchange Rate Risk and Exposure 371 373 373 380 383 394 400 402 404 Study Unit The Context of Corporate Finance Contents Page Introduction A Basic Principles of Companies Types of Company Regulatory Framework for Companies 3 B Financial Objectives The Prime Objective Valuation of Companies Shareholder Value Analysis (SVA) Long-term Versus Short-term Objectives Objectives of Multi-National Companies Objectives of Public Sector Organisations 6 8 8 C Corporate Governance Company Stakeholders Management/Shareholder Relationship and Agency Theory The Cadbury Report The Greenbury Report Hampel Committee Report The Combined Code The Turnbull Report Financial Services and Markets Act, 2000 and the FSA The Higgs and Smith Reports Other Disclosure and Behaviour Compliance Provisions 10 10 15 16 18 19 19 21 22 22 24 D Corporate Financial Management Financial Decision Making Financial Functions in Organisations The Role of the Finance Manager Planning Forecasting Budgeting Cash Management Economic and Government Influences 24 24 25 26 28 29 29 30 32 © ABE and RRC The Context of Corporate Finance INTRODUCTION Corporate finance covers a wide range of topics and functions within an organisation The three main areas we will look at in this course relate to answers to the following questions: Which investments should the firm undertake? How, where, when and how much finance should be raised? How should the firm's profits be used or distributed? These questions are more commonly referred to as: (a) The investment decision (b) The financing decision (c) The dividend decision In making such decisions, the firm must ensure that it achieves its objectives Central to this first unit, then, is the issue of what the objectives of companies are This is our first main area of study The prime objective is often stated as the maximisation of shareholder wealth This would imply that companies must be run in the interests of shareholders However, there are a range of interests involved in the way in which companies are managed We shall examine these in the second main section of the unit and consider, in particular, the importance of the stakeholder concept and the tensions that arise from the different interests involved Finally, we turn to the scope of corporate financial management We shall develop the issues of financial decision-making referred to above and consider their implications for the range of financial functions carried out in modern organisations and the roles required of the finance manager The modern financial manager also needs to consider two different issues: Risk Some of the financial decisions made will incur little risk, for example, investing in Government backed bonds, but other areas of investment, such as investing in derivatives, will incur a lot of risk There is a balance to be struck between the return that can be expected and the risk involved with the particular investment concerned The strategic role of the modern financial manager There is an ever increasing need in the modern business world for key staff, including the financial manager, to play a key role in the strategic vision and environment within which the business is operating There needs to be input at all three levels of strategic involvement – ie at a strategic level for broad issues, at a business or competitor level in respect of how strategic vision can be turned into reality, and at an operational level for how the broader plans can be turned into operational success © ABE and RRC The Context of Corporate Finance A BASIC PRINCIPLES OF COMPANIES We shall start by reviewing two fundamental concepts relating to companies which underpin much of our studies Types of Company When a company is formed, the person or people forming it decide whether its members' liability will be limited by shares The memorandum of association (one of the documents by which the company is formed) will state: the amount of share capital the company will have; and the division of the share capital into shares of a fixed amount The members must agree to take some, or all, of the shares when the company is registered The memorandum of association must show the names of the people who have agreed to take shares and the number of shares each will take These people are called the subscribers A company is a separate legal entity, which means that it may take legal action against its shareholders or vice versa Limited liability companies have capital divided into shares If a shareholder has paid in full for his or her shares, then liability is limited to those shares This is the concept of limited liability The two main classes of limited company are public and private companies: (a) Public companies Company legislation defines a public company as one which: Has an authorised share capital of at least £50,000; Is trading a minimum of £50,000 issued share capital Has a minimum membership of two (there is no maximum); Has a name ending with "public limited company" or plc Not all public companies have shares which are traded on the Stock Exchange Those traded on the Stock Exchange are known as quoted or listed companies (a) Private companies A private company can be formed by two or more persons They are often smaller or family owned businesses A private company: Can have an authorised share capital of less than £50,000, although there is no maximum to any company's authorised share capital and no minimum share capital for private limited companies Cannot offer its shares for sale to the general public You may know of private companies which have become public companies and have started to trade on the Stock Exchange An example was the clothing retailer Laura Ashley which started life as a family owned private company The amount of share capital stated in the memorandum of association is the company's "authorised" capital © A company can increase its authorised share capital by passing an ordinary resolution (unless its articles of association require a special or extraordinary resolution) A copy of the resolution – and notice of the increase on Form 123 – must reach Companies House within 15 days of being passed ABE and RRC The Context of Corporate Finance A company can decrease its authorised share capital by passing an ordinary resolution to cancel shares which have not been taken or agreed to be taken by any person Notice of the cancellation, on Form 122, must reach Companies House within one month Issued capital is the value of the shares issued to shareholders This means the nominal value of the shares rather than their actual worth The amount of issued capital cannot exceed the amount of the authorised capital A company need not issue all its capital at once, but a public limited company must have at least £50,000 of allotted share capital Of this, 25% of the nominal value of each share and any premium must be paid up before it can can get a trading certificate allowing it to commence business and borrow A company may increase its issued capital by allotting more shares, but only up to the maximum allowed by its authorised capital Allotments must only be done under proper authority A public company may offer shares to the general public Share offers to the public are made in a prospectus or are accompanied by listing particulars A private company is normally restricted to issuing shares to its members, to staff and their families, and to debenture holders However, by private arrangement, the company may issue shares to anyone it chooses "Allotment" is the process by which people become members of a company Subscribers to a company's memorandum agree to take shares on incorporation and the shares are regarded as "allotted" on incorporation Later, more people may be admitted as members of the company and be allotted shares However, the directors must not allot shares without the authority of the existing shareholders The authority will either be stated in the company's articles of association or given to the directors by resolution passed at a general meeting of the company Regulatory Framework for Companies The main legislation regulating companies is the Companies Act 1985 and the Companies Act 1989 The 1989 Act added to and amended the 1985 Act, but this is now being superceded by the Companies Act 2006 The 1985 and 1989 Acts have been changed in order to meet four key objectives: To enhance shareholder engagement and a long term investment culture; To ensure better regulation and a 'Think Small First' approach; lst To make it easier to set up and run a company; and To provide flexibility for the future Following the establishment of a Company Law Review Group in 1998 to consider in detail the modernisation of company law, The subsequent report of this group formed the basis of a White Paper for consultation in March 2005 and eventually the new Companies Act was passed in November 2006 Some of the key effects resulting from the Act include the following (a) Applying to all companies: A clear statement of directors' general duties clarifies the existing case law based rules Companies will be able to make greater use of electronic communications for communications with shareholders © ABE and RRC 398 International Trade and Finance This is expressed in the following formula: i i S t So f d + id So where: So the current spot rate St the spot rate at time t if the expected rate of inflation in the foreign country to time t id the expected domestic rate of inflation to time t Consider the following example Let us assume that there is currently purchasing power parity between USA and France with an exchange rate of 1€ to 1.5$ Let us also assume that, at the end of the year, US inflation is expected to be 5%, and French inflation is expected to be 10% Advise the French firm you are working for what the expected spot rate will be at the end of the year You are assumed to be working for a French firm so the domestic currency is the € Substituting into the above formula: S t 1.5 0.05 0.10 (1 € to 1.5$) (inflation rates expressed as a decimal) 1.5 + 0.10 St 1.5 1.5 ( 0.05) 1.4318 1.10 We can check these calculations by comparing the prices at the end of the year A good now costing 10€ will cost 10 1.5 15$ At the end of the year the same good will cost: 10€ (French inflation rate of 10%) 1.10 11€ 15$ (US inflation rate of 5%) 1.05 15.75$ The price of the goods in US is 15.75$/1.4318 11€ This method is often used to calculate exchange rates for use in investment appraisal if there are reasonable estimates of relative inflation rates available to the company However, in reality purchasing power parity only holds over the long term, market imperfections impeding its effects in the short term Just as relative inflation rates help to determine exchange rates, alterations (by a country's government or other factors discussed below) in a country's exchange rate can also have an impact on its inflation rate A devaluation of a currency would lead to an increase in the price of imports and a reduction in the price of exports For several countries, including the UK for which imports are price inelastic and exports are price elastic, this would lead to an increase in exports but have little impact on the level of imports Thus, inflation would rise caused by dearer imports – the greater the proportion of goods and services consumed that are imported the greater the rise in inflation An increase in the cost of goods and services will lead to higher wage claims which firms benefiting from increased exports would agree to These higher wages would increase the level of inflation Whilst the balance of trade may improve because of the increased export levels, any increases are likely to be offset by a net disinvestment of capital from the depreciating currency the overall impact being a further depreciation of the currency © ABE and RRC International Trade and Finance (b) 399 Interest rates and exchange rates We can observe the same processes at work in relation to interest rate differentials between countries as in inflation rate differentials We can see that, where there is a differential in the interest between two countries, investors wish to place their funds where the rates of interest are highest, so a country with higher interest rates will experience an influx of funds This influx of funds will lead to an increased demand for the currency and thus increase its price (exchange rate) At a later date, when the investment matures, the funds will be converted back into the original currency of exchange and repatriated This selling of the base currency will then cause its rate of exchange to fall relative to the exchange currency Just as purchasing power parity denotes the relationship of inflation rates to exchange rates, Interest Rate Parity (IPP) does the same for interest rates This states that the expected changes in the spot rate of exchange (i.e the difference between the spot and forward rates) are linked to the differential between interest rates in the two countries over the same period Any gain from an increase in interest rates in one country relative to another will, then, be cancelled out by an adjustment in the exchange rate The forward rate is then said to be at IPP The theory can be stated as: + ia forward rate + ib spot rate where i interest rate, and a and b are the two countries under consideration Thus, if the 90-day interest rate in the US is 5.25% and in the UK for the same period is 6.75%, and the current spot rate is £1:$1.9695, the 90-day forward rate may be calculated by substituting in the above formula: + 0.0525 forward rate + 0.0675 1.9695 (c) The forward rate $1.9418 Relationship between interest rates and inflation (the Fisher Effect) The relationship between expected levels of inflation and interest rates is described as the Fisher Effect after the economist who first documented it This states that the difference in nominal rates of interest between two countries will reflect the expected difference in inflation rates In equilibrium, the real rate of return on capital is the same in both countries – that is, the rate of return, adjusted for inflation, in one country will equate with the rate of return, adjusted for inflation, in the other Interest rates can be money rates (i.e the actual amount of cash paid) or real rates (i.e money rates adjusted to remove the effects of inflation) In general the higher the expected rate of inflation the higher the rate of interest – to allow investors to obtain a high enough return after the effects of inflation have been considered, and as a tool of government to help reduce the rate of inflation The Fisher equation states that: + the money or nominal rate of interest (1 + the real rate of inflation) (1 + the expected rate of inflation) The Fisher Effect is developed in the International Fisher Effect which states that the ratio of nominal interest rates between two countries is equal to the ratio of their inflation rates, and those currencies with higher nominal interest rates will depreciate in © ABE and RRC 400 International Trade and Finance relation to those with lower nominal interest rates The belief behind this theory is that higher rates of interest are required to offset the effects of currency depreciation, and given free world-wide capital markets adjustments to spot exchange rates will mean that real rates of interest will be equal in different countries The International Fisher Effect can be expressed as: + rf + if + rd + id where rd is the domestic money rate of interest and rf is the foreign money rate of interest E RISK AND INTERNATIONAL TRADE/FINANCE In addition to normal business and financial risk, companies face extra risks connected with trading and investing overseas These risks can be separated into political risk and foreign exchange risk Political or Country Risk Political risk (also known as country risk) includes the problems of managing subsidiaries geographically separated and based in areas with different cultures and traditions, and political or economic measures taken by the host government affecting the activities of the subsidiary Whilst a host country will wish to encourage the growth of industry and commerce within its borders, and offer incentives to attract overseas investment (such as grants), it may also be suspicious of outside investment and the possibility of exploitation of itself and its population The host government may restrict the foreign companies' activities to prevent exploitation or for other political and financial reasons Such restrictions may range from import quotas and tariffs limiting the amount of goods the firm can either physically or financially viably import, to appropriation of the company's assets with or without paying compensation Other measures include restrictions on the purchasing of companies, especially in sensitive areas such as defence and the utilities – such restrictions could be an outright ban, an insistence on joint ventures or a required minimum level of local shareholders In order to prevent the "dumping" of goods banned elsewhere (e.g for safety reasons) a host government may legislate as to minimum levels of quality and safety required for all goods produced or imported by foreign companies Host governments, particularly in developing and underdeveloped countries, may be concerned about maintaining foreign currency reserves and preventing a devaluation of their national currency In order to this they may impose exchange controls This is generally done by restricting the supply of foreign currencies – thus limiting the levels of imports and preventing the repatriation of profits by MNCs by restricting payments abroad to certain transactions This latter method often causes MNCs to have funds tied up unproductively in overseas countries Foreign Exchange or Currency Risk Exchange rate risk applies in any situation where companies are involved in international trade It arises from the potential for exchange rates to move adversely and, thereby, to affect the value of transactions or assets denominated in a foreign currency There are three main types of exchange rate risk to which those dealing overseas (importers, exporters, those with overseas subsidiaries or parents, and those investing in overseas markets) may be exposed © ABE and RRC International Trade and Finance (a) 401 Transaction exposure This occurs when trade is denominated in foreign currency terms and there is a time delay between contracting to make the transaction and its monetary settlement The risk is that movements in the exchange rate, during the intervening period, will increase the amount paid for the goods/services purchased or decrease the value received for goods/services supplied (b) Translation exposure This arises where balance sheet assets and liabilities are denominated in different currencies The risk is that adverse changes in exchange rates will affect their value on conversion into the base currency Any gains or losses in the book values of monetary assets and liabilities during the process of consolidation are recorded in the profit and loss account Since only book values are affected and these not represent actual cashflows, there is a tendency to disregard the importance of translation exposure This is, though, a false assumption since losses occurring through translation will be reflected in the value of the firm, affecting the share price and hence, shareholders' wealth and perceptions among investors of the firm's financial health (c) Economic exposure This refers to changes in the present value of a company's future operating cashflows, discounted at the appropriate discount rate, as a result of exchange rate movements To some extent, this is the same as transaction exposure, and the latter can be seen as a sub-set of economic exposure (which is its long term counterpart) However, economic exposure has more wide ranging effects For example, it applies to the repatriation of funds from a wholly-owned foreign subsidiary where the local currency falls in value in relation to the domestic currency of the holding company It can also affect the international competitiveness of a firm – for example, a UK company purchasing commodities from Germany and reselling them in China would be affected by either a depreciation (loss of purchasing power) of sterling against the Euro and/or an appreciation of Yuan It can also affect companies who are not involved in international trade at all Changes in exchange rates can impact on the relative competitiveness of companies trading in the domestic market vis-à-vis overseas companies when imports become cheaper Thus, reduced operating cashflows may be a consequence of a strengthening domestic currency – a situation which has affected UK companies in the late 1990s The management of exchange rate risk will involve hedging against adverse movements in order to contain the extent of any exposure At the operating level, the focus of attention is primarily on managing the exposure caused by transaction and economic risk, both essentially being underpinned by cashflows The techniques which we shall examine in the following sections, then, relate essentially to these aspects of exposure, with the greater emphasis on transaction exposure As with managing interest rate risk, these techniques fall into two categories: internal, or natural, techniques – those which are effected entirely by the financial organisation and structure of the company itself; and external, or transactional, techniques – those using the range of derivative instruments which are effected by the use of third party services, such as banks and specialist exchanges Although both types of technique provide effective means of covering the exposure, certain external techniques offer the possibility of taking advantage of favourable movements in exchange rates to generate profits © ABE and RRC 402 International Trade and Finance F INTERNAL METHODS OF MANAGING EXCHANGE RATE RISK AND EXPOSURE There are four main internal means of reducing exchange rate exposure These are based on methods of processing transactions and payments, and of offsetting assets and liabilities in different currencies Currency invoicing The first approach is simply to invoice foreign customers in the currency of the seller Invoicing for goods supplied, and paying for goods received, in a company's domestic currency removes the exchange rate risk for that company – but only one party to an exchange between foreign companies can have this facility, and the other bears the risk of exchange rate fluctuations However, the advantages of removing exchange rate risk need to be weighed against those of invoicing in the foreign currency These include marketing advantages such as the ease for the customer of dealing in his own currency and the possibility of purchasing at a discount if the foreign currency is depreciating relative to the domestic currency In fact, often the only way to win a contract overseas is to deal in the currency of that market One way to prevent one or both parties being subject to exchange rate risk is for the firms involved to set a level of exchange rate to use for a transaction regardless of what the actual exchange rate is on the day the money is transferred Netting This is an internal settlement system used by multinational companies with overseas subsidiaries It involves offsetting (netting out) the outstanding foreign exchange positions of subsidiaries against each other through a central point – the group treasury Suppose there are two overseas subsidiaries in different countries Subsidiary A expects to receive a payment in one month's time for the sale of goods to the value of $2m, while subsidiary B has to make a payment of $3m in one month's time to a supplier The central treasury can offset the two exposures and set up an external hedge for the net risk of $1m This negates the need for two separate hedges to be carried out – the first to cover the $3m against a rise in exchange rates against the dollar and second to cover the $2m against a fall in exchange rates against the dollar The single hedge is more efficient and cost-effective Matching This is the process of matching receipts in a particular currency with payments in the same currency This prevents the need to buy or sell the foreign currency and thus reduces exchange rate risk to the surplus or deficit the firm has of the foreign currency It is a cheap method of reducing or eliminating exchange rate risk provided that the receipts precede the payments, and the time difference between the two is not too long For example, where a company is selling to the US and has outstanding receipts denominated in $, it could purchase raw materials in the same currency The one transaction will offset the other and minimise the exchange exposure that requires external hedging It therefore does not matter whether the $ strengthens or weakens against the domestic currency Alternatively, a firm could match, say, dollar currency receipts from the export of goods to the US with a dollar loan The receipts will be used to pay off the loan This again secures the matching of an asset with a liability This process can be made easier either by having a bank account in the foreign country or a foreign currency account in a firm's own country, and putting in all receipts and taking from it © ABE and RRC International Trade and Finance 403 all payments in the overseas currency The exchange rate risk on the surplus or deficit can be avoided by utilising one of the other methods of risk management Matching may also be used to reduce translation exposure – offsetting an investment in assets in one currency with a corresponding liability in the same currency For example, the acquisition of an asset denominated in Yen could be achieved by borrowing funds in Yen As the exchange rate against the Yen varies, the effect it has on the translated value of the asset and liability will increase and decrease in concert The amount of the reduction in exposure will depend on the extent to which the expected economic life of the asset corresponds with when the loan matures Leads and Lags This final method of hedging internally involves varying payment dates to take advantage of the exchange rate – for example, paying either before or after the due date, depending on exchange rate movements The effectiveness of this is dependent on how well exchange rate movements can be anticipated A company will only pay in advance if it expects the domestic currency to weaken, but if it misreads the movement and the exchange rate strengthens, advance payment may prove expensive Leads are advance payments for imports to avoid the risk of having to pay more local currency if the supplier's currency increases in value Lags involve slowing down the exchange of foreign receipts by exporters who anticipate a rise in the value of the foreign currency received When this occurs, they will then benefit by an exchange rate in their favour The table below shows the scope for leading and lagging by financial managers of importers or exporters: Expectation of foreign currency Devaluation Revaluation Expectation of sterling Revaluation Devaluation UK Exporter Receiving foreign currency Leads Lags UK Importer Paying foreign currency Lags Leads Foreign Importer Paying in sterling Leads Lags Foreign Exporter Receiving sterling Lags Leads A UK exporter would accelerate (lead) his receipts in the event of an anticipated devaluation, but he would delay (lag) his foreign receipts if a revaluation was expected, and so forth In leading, he will need to borrow or otherwise raise the cash which will involve a cost of capital, whilst lagging will attract interest as there will be surplus for investment © ABE and RRC 404 International Trade and Finance G EXTERNAL METHODS OF MANAGING EXCHANGE RATE RISK AND EXPOSURE Here we shall consider the methods of using derivatives – forwards, futures and options contracts – as considered in the last unit in relation to interest rate exposure, as well as currency swaps and money market hedges Forward contracts Forward foreign exchange contracts are a binding agreement between two parties to exchange an agreed amount of currency on a future date at an agreed fixed exchange rate The exchange rate is fixed at the date the contract is entered into Forward contracts are binding and must be executed by both parties As we saw in the previous unit, they are not exchange regulated and one problem of this is that one of the parties might default However, they not – like futures contracts – come in standard sizes and have fixed delivery dates Rather, they are over the counter (OTC) instruments – in which the contract can be tailor made to suit the needs of the parties and delivery dates can range from a few days to upwards of several years In most cases, forward contracts have a fixed settlement date This is appropriate where the cash transaction being hedged will take place on the same day that the forward contract is settled However, there is no guarantee that the two days will tally – for example, a customer may be late paying – in which case the fixed settlement date is less than optimal An alternative, to provide flexibility, is an "option date forward contract" This offers a choice of dates on which the user can exercise the contract, although there is a higher premium payable on the contract for such an additional benefit The purpose of a forward exchange rate contract is to purchase currency at a future date at a price fixed today As such, it provides a complete hedge against adverse exchange rate movements in the intervening period Consider the following example A UK company needs to pay A$1m to a Australian company in three months' time The current spot and forward exchange rates for sterling are as follows: A$/£ Spot 2.060 – 2.065 months forward – cents pm What would be the cost in sterling to the UK company if it enters into a forward contract to purchase the A$1m needed? Note the way in which the rates are quoted The spot rate spread shows the sell and buy prices – the banks will sell A$s for sterling at the rate of A$2.060/£, and buy A$s in return for sterling at the rate of A$2.065/£ The forward rate is quoted in terms of the premium ("pm") in cents which the Australian dollar is to sterling in the future If the currency is at a premium, it is strengthening and the A$ will buy more pounds forward than it will spot or, conversely, the pound will buy less A$ forward than it will spot (If the quoted forward rate had been, say, "3 cents dis" this would indicate a weakening of the currency.) To calculate the cost of the forward contract, we need to convert the forward rate premium into an exchange rate Because it is a premium, we need to subtract the amount from the spot to give the following sell/buy forward rates: (2.060 – 0.04) – (2.065 – 0.03) 2.020 – 2.035 A$/£ © ABE and RRC International Trade and Finance 405 The cost of buying A$1m forward, therefore, is: A$1,000,000 495,050 2.020 Whilst we have said that forward contracts are binding, they can be closed out by entering into an opposite contract to sell the currency – either at the spot rate or through a different forward rate Partial close-outs can also be arranged where, for example, the full amount of the forward contract is not required However, these arrangements are costly and, hence, rare Currency swaps In general, a swap relates to an exchange of cashflows between two parties – as we saw in relation to interest rate swaps in the previous unit Thus, currency swaps relate to an exchange of cashflows in different currencies between two parties They are agreements to exchange both a principal sum and the interest payments on it in different currencies for a stated period Each party transfers the principal and then pays interest to the other on the principal received Swaps are arranged, through banks, to suit the needs of the parties involved The two key issues in setting up a currency swap are: the exchange rate to be used; and whether the exchange of principal is to take place at both commencement and maturity, or only on maturity The following example illustrates the general principles A German company is seeking to invest £20m in the UK and has been quoted an interest rate of 8% on sterling in London, whereas the equivalent loan in Euros is quoted at 7% fixed interest in Frankfurt At the same time, a UK company wants to invest an equivalent amount in its German subsidiary and has been quoted an interest rate of 7.5% to raise a loan denominated in Euros on the Frankfurt Exchange It could, however, raise the £20m in sterling in London at 5% fixed interest In the absence of a swap, each company would have to accept the quoted terms for its loan denominated in the foreign currency This would result in both companies paying a higher rate than would apply if the loan was raised in their domestic currency A swap agreement would involve each company taking out the loan in its own domestic currency and then exchanging the principals Each company would pay the interest on the principal received – i.e the other company's loan – and at the end of the loan period, the principals would be swapped back The exchange rate to be applied is clearly crucial If we assume that this is agreed as €1.25 £1, the swap would be conducted as follows The UK company borrows £20m in England at an interest rate of 5% pa It then swaps the principal of £20m for €25m (at the agreed exchange rate) with the German company The German company pays the interest payments on the £20m loan (at 5% interest) to the UK company, which then pays the bank At the end of the loan period, the principal of €25m is swapped back for the £20m with the German company The German company borrows €25m in Frankfurt at an interest rate of 7% pa It then swaps this principal with the UK company which pays the interest payments on the loan (at 7% interest) to the German company, which then pays its bank At the end of the loan period, the principal of £20m is swapped back for the €25m with the UK company The process is illustrated in Figure 15.1 © ABE and RRC 406 International Trade and Finance Figure 15.1: Currency swap London bank £20m Frankfurt bank 5% interest €25m 7% interest €25 UK Company 7% interest German Company 5% interest £20m UK company now has €25m available for investment at 7% interest German company now has £20m available for investment at 5% interest Currency Futures A currency futures contract is an agreement to purchase or sell a standard quantity of foreign currency at a pre-determined date As we saw previously, futures have standard quantities and delivery dates set by the exchange on which the contracts are traded As we have also seen, the vast majority of these contracts are not delivered, but are closed out The process of hedging exchange rate risk through the futures market is the same as we examined in relation to interest rate exposure in the previous unit Thus, a UK company exporting to the USA and invoicing in US dollars, would need to hedge against a rise in the exchange rate (sterling strengthening relative to the dollar) in the period before payment is received If we assume that payment is due in two months' time, the exporter will need to sell dollars then in exchange for sterling The strategy would be, therefore, to take out a three month sterling futures contract and close it out in two months' time – i.e buy sterling futures now, hold them for two months and then sell them to cancel out the obligation to deliver the underlying currency Any profit on the contract (the difference between the buying and selling prices) will offset any loss on the dollars received from an exchange rate rise over the period We can illustrate the process in more detail by reference to the actions of a speculator who is anticipating a rise in the value of the $ against the pound He will, therefore, take a position to sell sterling futures in anticipation that the future cost (in dollars) of buying the pounds necessary to meet the contract obligation will be less than the proceeds of the sale under the contract If the current spot rate is $1.900/£ and December sterling futures are trading at $1.875/£, what will be the gain or loss on five sterling futures contracts if the spot rate in December is $1.800/£? (The standard size of sterling futures is £62,500.) Sale of five December contracts (each of which is for £62,500) at the agreed rate of $1.875/£ results in proceeds of: £62,500 $1.875 $585,937.50 © ABE and RRC International Trade and Finance 407 Purchase of the equivalent amount in sterling in December at the spot rate of $1.8/£ results in an outlay of: £62,500 $1.8 $562,500 The gain on the transaction is $23,437.50 or, converting this into pounds at the December spot rate, £13,020 The advantage for the speculator of using the futures contract compared to the alternative of buying sterling at the current spot rate is that he only needs to put down a small deposit (the margin account) as opposed to an "up front" investment of $593,750 (£312,500 x $1.9) Hedging using futures and forwards contracts We can also consider the difference between a hedge using forward contracts and a hedge using futures contracts In December, a UK exporter invoices its US customer for $407,500 payable on February The exporter needs to hedge against a change in exchange rates whereby sterling becomes stronger relative to the dollar and he receives less pounds than now upon exchange of the dollars received in February To hedge this exchange rate exposure, the company could take out either a forward contract or a futures contract Which would be more appropriate given the following rates? In December: Spot rate $1.9575 – 1.9595/£ February forward rate $1.9550 – 1.9575/£ March sterling futures contracts $1.9600/£ (Contract size is £62,500) Those applying on February: Spot rate $1.9670 – 1.9690/£ March sterling futures contracts $1.9655 Using a forward contract would require the exporter to commit to the sale of the dollar receivables (i.e $407,500) at the February forward price of $1.9575/£, resulting in proceeds of: $407,500 £208,173 1.9575 The futures contract hedge would require the exporter to take a long position in sterling futures – i.e a commitment to buy sterling at the rate of $1.9600/£ – with the intention of closing out the contract on February, prior to the receipt of the dollars If sterling does strengthen against the dollar, this position will result in a gain However, if the exchange rate falls, then the exporter will lose on the futures contract, but gain in the cash market The number of sterling futures contracts necessary to cover the exposure is: $407,500 3.33 (i.e contracts will be needed) 1.9600 £62,500 The gain/loss on the futures transaction is calculated as follows: Buy four March contracts in December at $1.9600/£: x £62,500 $1.9600 $490,000 Sell four March futures contracts in February at $1.9655 x £62,500 $1.9655 $491,375 © ABE and RRC 408 International Trade and Finance Gain through closing out: $491,375 – $490,000 $1,375 Converting this into sterling at the February spot rate gives a gain of: $1,375 £698 1.9690 The total proceeds from the futures hedge is calculated by adding this gain to the proceeds of the exchange of the dollars received on February at the then current spot rate of 1.9690$/£: $407,500 £206,957 £698 £207,655 1.9690 This is marginally worse than the hedge using the forward contract Currency Options A currency option gives the holder the right, but not the obligation, to buy (in the case of a call option) or sell (a put option) a specified amount of currency at an agreed exchange rate (the exercise price) at a specific future date The principles of currency options are the same as those discussed in the previous unit in respect of other types of option Thus, using the options market to hedge exchange rate exposure sets a limit on the loss that can be made in the case of adverse movements in exchange rates, but also allows the holder to take advantage of favourable movements The following example illustrates their use At the beginning of July, a UK company purchased goods to the value of $300,000 from its US supplier on three months' credit, payable at the end of September The spot exchange rate is currently $1.95/£, and for the purposes of the example, we shall assume that it falls to $1.88/£ by the end of September, coinciding with the expiry of the option Because the company needs to pay for the goods in dollars, it needs a strategy which enables it to sell pounds and buy dollars The two choices are a long put or a short call The short call, though, can only provide protection against exchange rate losses up to the cost of the premium, so the favoured strategy would be a long put (Check with the previous unit to ensure that you understand the various pay-off profiles for these different types of option.) The relevant sterling options offered on the Philadelphia exchange (the major market for currency options) are at the following prices: Strike price September puts 1.93 2.32 1.94 2.65 1.95 3.22 Contracts expire on a monthly basis and are for denominations of exactly half of those for futures contracts Thus, the standard contract sizes for sterling options are £31,250 In this case, the company decides to buy a September put option with a strike price of $1.93/£ It could have opted for a different strike price, but this would have incurred higher premiums (albeit for a higher degree of protection) © ABE and RRC International Trade and Finance 409 The strategy works in the following way: The company needs to raise $300,000 which, at the exercise price of $1.93/£, equates to £155,440 To cover this amount, it will need to purchase five standard contracts The premium paid will be: 2.32 x £31,250 $3,625 100 In sterling, at the current exchange rate, that is: 3,625 £1,859 1.95 Because the spot exchange rate has declined during the period (the dollar having strengthened), it is advantageous to exercise the put option – i.e less pounds will need to be exchanged at the exercise price than at the spot price to buy the required amount of dollars Total proceeds from exercising all five option contracts: £31,250 $1.93 $301,562 (covering the liability) The net sterling cost of the transaction will be: £156,250 + £1,859 £158,109 If the option was not exercised, then the liability in dollars would need to be realised by selling sterling on the spot market The cost involved here would be: $300,000 £159,574 1.88 Thus, using a long put results in a saving of: £159,574 – £158,109 £1,465 Money Market Hedge The money market can be used to hedge against exchange rate fluctuations by borrowing an amount in foreign currency equal to the value of, say, invoiced exported goods, exchanging it for the domestic currency at the spot rate, and then using the receipts from the customer to repay the loan Effectively, this method uses the matching principle we saw earlier in respect of internal hedging, but applies it to the creation of an asset/liability in the money market, to match the liability/asset which needs to be hedged Thus, a UK exporter due a sum of dollars in three months' time may eliminate the exchange rate exposure by borrowing the sum of dollars at the outset – creating a matching liability It can then exchange the dollars for sterling at the current spot rate, fixing the exchange rate on the transaction The sterling can then be invested for the three months If the money markets and the foreign exchange markets are in equilibrium, we can expect that interest rate parity holds and the interest earned on the sterling investment will offset any change in the exchange rate The dollars received can be used to pay off the loan, plus interest accrued, in three months' time This should, then, provide the same result as a forward currency hedge Companies which regularly operate this form of hedging usually hold different accounts with their banks for the major currencies in which they trade In this way, money can be deposited easily, and interest earned when there are surplus funds, and borrowing (overdraft) facilities are readily available when necessary © ABE and RRC 410 International Trade and Finance Consider the following example A UK company is due $500,000 in three months' time from a customer in the USA The interest rate is 6% pa and the spot exchange rate is $1.93/£ The company stands to lose value in sterling on the asset (the $½m) if the dollar weakens against the pound To hedge this in the money market involves creating a matching dollar liability – a loan equivalent to $½m in three months' time – exchanging this for sterling (thereby fixing the exchange rate on the transaction) and investing the proceeds for three months, and then using the receipt of the $500,000 to pay off the loan, plus interest accrued The process is as follows We first need to calculate the amount of dollars to be borrowed now, so that it will grow, with interest, over the three months to $½m We shall call this amount "Q" The interest rate applied over the three month period is 1.5% (one quarter of the annual rate of 6%), so the sum borrowed will be: Q 1.015 $500,000 $500,000 1.015 $492,611 The UK company, therefore, only needs to borrow $492,611 now in order to create a liability of $½m in three months' time Now we convert this sum into sterling at today's spot rate, thereby fixing the exchange rate and eliminating the exposure: $492,611 £255,238 1.93 This sum is now available to the company in sterling and can be put on deposit in the money market for three months, earning interest of 6% pa (or 1.5% over the period): £255,238 1.015 £259,066 This return, assuming interest rate parity holds, will equate with a sterling forward market hedge on the $½m In three months' time, the receipt of the $½m from the US company will be used to repay the bank for the $492,611 loan, plus the interest accrued (which should equate to $½m) This is a highly simplified example, but it does, nevertheless, illustrate the process We can show it diagrammatically as in Figure 15.2 © ABE and RRC International Trade and Finance Figure 15.2: Money market hedge Asset (Debtor) US customer (invest) £255,238 @ 1.5% UK Company Liability (Bank loan) $492,611 Today © ABE and RRC $500,000 £259,066 Bank $500,000 Three months’ time 411 412 International Trade and Finance © ABE and RRC ... Business Management CORPORATE FINANCE Contents Unit Title Page The Context of Corporate Finance Introduction Basic Principles of Companies Financial Objectives Corporate Governance Corporate Financial... Government Influences 24 24 25 26 28 29 29 30 32 © ABE and RRC The Context of Corporate Finance INTRODUCTION Corporate finance covers a wide range of topics and functions within an organisation... independently on business-led lines © ABE and RRC 10 The Context of Corporate Finance (c) Private Finance Initiative (PFI) The Private Finance Initiative (PFI) is a small, but important part of the