AFM Advanced Financial Management

A. The senior financial adviser, strategy and ESG

The senior financial executive or adviser develops strategies to reach the organisation's goals within its policy framework, and manages its financial resources efficiently and transparently. The board is advised on investment selection and capital allocation, on minimising the cost of capital, on distribution and retention policy, on communicating financial policy to stakeholders, on financial planning and control, and on managing risk. Performance is assessed using ratios and trends, and the optimum capital mix is recommended for the business context.

Risk management strategies are compared: mitigation (reducing the likelihood or impact), hedging (using instruments to offset an exposure) and diversification (spreading exposure). The adviser assesses exposure to business and financial risks, including operational, reputational, political, economic, regulatory and fiscal risks, and sets up monitoring and risk management systems for capital investment. Behavioural finance explains why prices and decisions may not follow conventional theory, for example because of overconfidence, loss aversion or herding.

ESG and ethics. An organisation's commitment to environmental, social and governance criteria affects its business and investment decisions, its access to finance and its reputation. Conflicts between the criteria (for example between the cost of a lower carbon technology and returns to shareholders) must be resolved with the stakeholders in mind. The adviser must also recognise agency and ethical issues in the governance framework and recommend strategies to deal with them, grounded in high standards of probity.

Multinationals. The financial planning framework for a multinational must consider the regulations of each country, the mobility of capital and limits on remittances, the pattern of economic and political risks, and the balance between the autonomy of local operations and central control. International institutions such as the WTO, the IMF, the World Bank and central banks affect multinationals through trade rules, lending and monetary policy. Dividend policy in a multinational depends on its reinvestment plans, free cash flow to equity, the timing of remittances, local tax regimes and transfer pricing policy.

Key terms

• Behavioural finance: The study of how psychological factors influence financial decisions and market prices.
• Free cash flow to equity: Cash available to shareholders after the needs of debt holders and reinvestment.
• Transfer pricing: Setting prices for goods and services traded between group companies.

Study tip: For multinational questions, link each recommendation to a specific constraint, such as remittance limits, tax rates or exchange controls.

Practice questions for section A

B. Advanced investment appraisal

Discounted cash flow techniques. NPV is the main measure of value added. Project modelling should deal with inflation and specific price changes, taxation (including tax allowable depreciation and tax exhaustion, where there is not enough profit to use the allowances), capital rationing, probability and sensitivity analysis, risk-adjusted discount rates and project duration as a measure of risk. The internal rate of return (IRR) is the rate at which NPV is zero, and the modified IRR (MIRR) assumes that cash inflows are reinvested at the cost of capital and that the finance for outflows is at the cost of finance, which avoids the problem of multiple IRRs. NPV measures the absolute increase in wealth, while IRR is a relative measure and can mislead when comparing projects of different size or timing. Monte Carlo simulation shows the spread of possible outcomes and the likelihood of success, but you will not need to perform one in the exam. Project value at risk gives the maximum loss at a given probability over a period.

Option pricing. The Black-Scholes model values European options, using five drivers: the value of the underlying asset, the exercise price, time to expiry, volatility and the risk-free rate. A call option's value rises with the underlying price, time and volatility, and falls with the exercise price. The model's assumptions include log-normal returns, constant volatility and risk-free rate, no dividends and no transaction costs, and these limit its accuracy. Real options are embedded in projects: the option to delay, to expand, to redeploy (switch) and to withdraw (abandon). They add value because they give flexibility, and they can be valued using the model.

Financing and adjusted present value. The adjusted present value (APV) approach values a project first as if it were financed only by equity (the base case NPV, discounted at the ungeared cost of equity) and then adds the present value of the financing side effects: the tax shield on interest, issue costs, subsidies and any change in capacity to borrow. It suits projects that change the capital structure significantly, because WACC would not apply. Modigliani and Miller, the static trade-off theory, pecking order and agency effects explain how financing affects value.

Cost of capital and debt. The project-specific cost of equity uses the CAPM with an asset beta, re-geared for the financing of the project. The exposure of debt to interest rate changes is measured by Macaulay duration (the weighted average time to the cash flows) and modified duration (duration divided by one plus the yield), which estimates the percentage change in value for a change in yield. Convexity accounts for the curvature of the relationship. Credit risk is assessed using rating agency models, and the credit spread over the risk-free rate gives the cost of debt.

Valuation and international appraisal. Free cash flow models value an organisation using forecast free cash flows and a terminal value, with different horizons and growth rates. International projects are appraised under different exchange rate assumptions, in the currency of the cash flows using forecast rates (for example from purchasing power parity) or by converting a home currency discount rate, and they should consider exchange controls, blocked funds, tax and transaction costs.

Worked figures

APV: a project costs $2,000,000 and gives $600,000 a year for 5 years. The ungeared cost of equity is 12 percent, so the base case NPV is 600,000 x 3.6048 - 2,000,000 = $162,866. It is partly financed with $800,000 of debt at 7 percent, with tax at 25 percent, which gives a tax shield of $14,000 a year. Discounted at 7 percent for 5 years the present value is $57,403. Issue costs are $16,000. APV = 162,866 + 57,403 - 16,000 = $204,268.

Black-Scholes: a European call has an underlying price of $100, an exercise price of $95, a risk-free rate of 5 percent, 6 months to expiry and volatility of 30 percent. d1 = 0.4657, d2 = 0.2536 and the call value is $12.33.

MIRR: an outflow of $100 is followed by inflows of $50, $60 and $70. Inflows are reinvested at 8 percent: 50 x 1.08^2 + 60 x 1.08 + 70 = 193.12. MIRR = (193.12 / 100)^(1/3) - 1 = 24.5%.

Key terms

• Adjusted present value: The NPV of a project as if all-equity financed, plus the value of financing side effects.
• Real option: A right embedded in a project to take a future action, such as to delay, expand or abandon.
• Modified duration: A measure of the percentage change in a bond's value for a change in yield.
• Tax exhaustion: A situation in which there is insufficient profit to use tax allowances in the year.

Study tip: Do not use WACC for a project that changes the capital structure materially. Use APV and say why.

Practice questions for section B

C. Acquisitions and mergers

Acquisitions and mergers are an alternative to organic growth, joint ventures, alliances and licensing. Arguments in favour are speed of entry, access to markets, skills and technology, synergy and removing a competitor. Arguments against are cost, the risk of overpaying, integration problems, cultural clashes, and the frequent failure of acquisitions to add value for the acquirer's shareholders, often because of over-valuation of the target. The competitive and corporate nature of a proposal is evaluated, and the target is chosen using criteria such as strategic fit, size, market position, risk profile, financial position and availability.

Synergy can be revenue synergy (higher sales through cross-selling or a wider market), cost synergy (economies of scale, removing duplicated functions) and financial synergy (a lower cost of capital, use of tax losses, or higher debt capacity). Alternatives to a traditional listing include special purpose acquisition companies (SPACs), direct listings, Dutch auctions and reverse takeovers.

Valuation. Book value-plus models adjust net assets for fair values and intangibles, and market-based models use multiples such as the price earnings ratio and enterprise value to earnings. Cash flow models discount free cash flows, taking account of the change in risk profile of the combined entity. Methods such as the risk-adjusted cost of capital, APV and changing P/E multiples may be used. Valuing high-growth start-ups and loss-making companies is harder because current earnings are low or negative, so forecasts and exit values are more important.

Financing and regulation. A cash offer is financed by internal funds, borrowing or a rights issue, and a share exchange offer gives target shareholders a stake in the combined company, so mixed offers are common. An offer is assessed for its effect on the acquirer's reported earnings per share, gearing and control. Regulation seeks to protect shareholders and sometimes other stakeholders, and it covers the disclosure of information, equal treatment, mandatory offers at a certain level of ownership and competition issues. The target's directors may advise against an offer or use defences if it is hostile, such as seeking a better offer or a white knight, subject to the rules.

Worked figures

Valuation: the target has earnings of $2,400,000 and a P/E of 10, so its standalone value is $24,000,000. The acquirer has a P/E of 15. If the combined business would be valued at the acquirer's P/E, the value of the target's earnings is 2,400,000 x 15 = $36,000,000. The $12,000,000 difference is an upper limit for the premium paid and must be checked against the realistic synergy that can be achieved.

Key terms

• Synergy: Extra value created when two businesses combine, so that the whole is worth more than the parts.
• White knight: A friendly bidder invited by a target to rescue it from a hostile bid.
• SPAC: A company formed to raise capital in an IPO to acquire a business.

Study tip: For acquisition valuations, compare the maximum price (standalone value plus synergy) with the offer, and the effect on the acquirer's EPS.

Practice questions for section C

D. Corporate reconstruction and re-organisation

A financial reconstruction is appropriate when a company is in financial difficulty but its business is viable, and a restructuring of its capital will be better for stakeholders than liquidation. It usually involves exchanging debt for equity, writing down debt or equity, extending debt maturity, and raising new finance. The adviser must assess how the capital market and the individual suppliers of capital (shareholders, lenders and suppliers) are likely to respond, and whether each group would be better off than in a liquidation, because a scheme needs their agreement.

Business re-organisation. Strategies for unbundling parts of a quoted company include a sell-off, a spin-off (shares in the new company distributed to existing shareholders), an equity carve-out (shares in the subsidiary sold to the public) and a management buy-out. The benefits are a sharper strategic focus, release of value that was hidden in a conglomerate, new capital for the parent, and incentives for management, while the risks are loss of synergies, diseconomies and the costs and tax consequences. A management buy-out (by the existing managers) or buy-in (by outside managers) raises financial issues: how the price is set, the financing (usually a mix of senior debt, mezzanine and equity from private equity investors), the management's ability to deliver the plan, and the exit route for the investors.

Key terms

• Spin-off: A distribution of shares in a subsidiary to the existing shareholders of the parent.
• Equity carve-out: An offer of a minority of a subsidiary's shares to the public.
• Mezzanine finance: Subordinated debt, often with equity features, that ranks below senior debt.

Study tip: Show that each stakeholder group is better off under the reconstruction than in liquidation. A scheme that does not do this will not be accepted.

Practice questions for section D

E. Treasury and advanced risk management

The treasury function manages the organisation's financial resources and exposures, including liquidity, funding, foreign exchange and interest rate risk, and counterparty risk, in the short and longer term. In multinationals, there is a case for central treasury (economies of scale, expertise, netting and better control) and for local treasuries (responsiveness to local conditions), and it may be a cost centre or a profit centre. Policies should set limits, instruments allowed and reporting.

Derivatives. Exchange-traded derivatives have standard contracts, tick sizes, margin payments and a clearing house, so counterparty risk is low, but the hedge may not match exactly. Over-the-counter (OTC) derivatives are tailored but have counterparty risk. Basis risk arises when the derivative price does not move exactly with the exposure, and it can be reduced by selecting contracts that closely match. The option 'Greeks' measure sensitivity: delta (price change for a change in the underlying), gamma (change in delta), theta (time decay) and vega (volatility).

Foreign exchange risk. Translation risk affects consolidated statements, transaction risk affects cash flows on specific transactions, and economic risk is the effect on long-term competitiveness. Hedging methods include forward contracts, money market hedges, synthetic agreements for exchange rate agreements (SAFEs), exchange-traded currency futures, currency swaps and FOREX swaps, and currency options. Netting (bilateral and multilateral) and matching reduce the transaction costs and exposures of a group. The best hedge depends on the certainty of the cash flow, the cost, the attitude to risk and market barriers.

Interest rate risk. Instruments include forward rate agreements (FRAs), interest rate futures, interest rate options (including caps, floors and collars) and interest rate swaps. A swap exchanges fixed and floating interest payments, which can change an exposure and also reduce cost where each party has a comparative advantage in a different market. The gain from a swap is the difference in the spreads between the two borrowers in the fixed and floating markets, which is shared between the parties (less any bank fee).

Worked figures

Swap: company A can borrow at a fixed 6.0 percent or floating LIBOR + 0.5 percent. Company B can borrow at a fixed 7.5 percent or floating LIBOR + 1.0 percent. A wants floating and B wants fixed. The fixed rate spread is 1.5 percent and the floating spread is 0.5 percent, so the total gain from a swap is 1.0 percent, or 0.5 percent each if shared equally and ignoring a bank fee.

Key terms

• Delta: The change in an option's price for a unit change in the underlying asset price.
• Interest rate swap: An agreement to exchange fixed rate and floating rate interest payments.
• Netting: Offsetting receipts and payments between group companies in the same currency.

Study tip: When choosing a hedge, compare certainty, cost and flexibility. Give a clear recommendation.

Practice questions for section E