When an investor deposits money into a financial institution, the investor expects (1) A certificate of deposit is an example of a money market instrument Money market hedge: Rose Co is expecting a euro receipt in six months' time and it
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When an investor deposits money into a financial institution, the investor expects (1) A certificate of deposit is an example of a money market instrument Money market hedge: Rose Co is expecting a euro receipt in six months' time and it
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©ACCA20152InterestratesandinterestrateriskInterestratesWhenaninvestordepositsmoneyintoafinancialinstitution,theinvestorexpectsthefinancialinstitutiontopayforbeingabletousetheinvestor'sfundsforitsownpurposesfortheperioditholdsthefunds.Paymentsthefinancialinstitutionmakesforuseoftheinvestor'sfundsarecalledinterestpayments.Interestisalsopaidbycustomerswhentheyborrowmoneyfromfinancialinstitutions.Thecommer cialinterestratesforborrowin gfrom financialinstitutionswill behighe rthanthecommercialratesfromdepositingwithfinancialinstitutions.Differentratesareofferedinordertoensurethatfinancialinstitutionsmakeaprofit.Arealreturniscalculatedbyadjustingtheincomeincashthatinvestorsreceivetotakeaccountoftheinflationrate.Inflationresultsinafixedamountofinterestincomebecominglessvaluabletotheinvestor,astheinvestorcanbuylessgoodsorserviceswiththatincome.Thereforeasinflationratesincrease,investorswillwantinterestratestoincreaseaswell,sothatthelevelofrealreturnstaysthesameandtheinvestorcanbuythesamequantityofgoodsorservices.Theinterestrateexp essesin%te mstheincometheinvesto eceivescompa edwiththeamountthattheinvesto hasinvested.Theincomefigu eusedismostoftentheannualincomethattheinvesto eceivesandsomostinte est atesyou'llseea eannual ates.Thecommercialinterestrateistheinte est atethataninvesto willexpectto eceivef ommajo financialinstitutionsonthefundsinvested,o the atebo owe swillexpecttopaytofinancialinstitutions.Diffe entinstitutionswilloffe diffe entte ms,sothecomme cial atesgiveninexamquestionswillbeave age ates.
©ACCA20153YieldcurveTheperiodforwhichinvestorsarepreparedtoinvestsignificantlyinfluencesthelevelofinterestrates.Theyieldcurveisacomparisonof:• Returnonaninvestment(whichmaybecalledtheinterestrateortheyield)withthe• Remainingperiodforwhichfundsareinvested(theinvestment'stermtomaturity).Theyieldcurvewillbeupwardslopingwhen:• Investorswantahigherreturnforinvestingtheirfundsforalongerperiodoftime• Investorsbelievethatthereisahigherlevelofriskwiththeincometheyreceivefromalonger-terminvestmentthanashorter-terminvestmentTheyieldcurvemaybedownwardslopingwhen:• Interestratesareexpectedtofallovertheshort-term.Iftheinvestorinvestsfundsforalonger-termatafixedinterestrate,itwillbecomeamorevaluableinvestmentifotherinterestratesthenfall.Thereforefinancialinstitutionswillnotwanttocommittopayinghighinterestratestoinvestorsoveralongperiodoftime.• Thegovernmentmaywanttokeepinterestrateshighforsometime.Againtheexpectationwillbethatrateswilleventuallyfall.Theyieldcu vemaybeupwa dsloping,wheninte est ateswillbehigher,thelongerthete mtomatu ity.Theyieldcu vemayhoweve bedownwa dsloping,wheninte est ateswillbehigher,theshorterthete mtomatu ity..
©ACCA20154• Financialinstitutionsmaybemoreinterestedinshort-terminvestments;individualssavingfortheirretirementmaybeinterestedinlonger-terminvestments.• Largefinancialinstitutionswillhavemoreinfluenceoverthelevelofreturntheyreceiveontheirinvestmentsthanindividualswillbecauseoftheirsize.Thepreferencesandrelativepowerofdifferentinvestorscanmeantheyieldcurveslopesupwardsordownwards.Itcanalsomeanthattheyieldcurveisn'tasmoothcurve(iskinked).Theyieldcurveisanaveragereflectingthewholemarket,anditwillhavekinkswhereonetypeofinvestorbecomesmoresignificantthananother.Let'slookattheJune2015examwherein SectionAweex aminedint erestrates,marketsegmentationandyieldcurves.Marketsegmentationtheoryisthetheo ythatinvesto sdonotallhavethesameconce nswithinvestmentso thesamelevelofinfluenceove theinte est atesthatthey eceive.
©ACCA20156Interestraterisk TheFRAinterestchargeiscalculatedastheinterestonanimaginarysumtobeborrowedonadateinthefuture.Thisimaginarysumwillgenerallybetheamountthecompanyexpectstoborrowonthisfuturedate.Howevertheactualamountborrowedmaydifferfromtheimaginarysum.Therearetwoissuesrelatingtotiming:• ThedateinthefuturewhentheFRAstarts• TheperiodforwhichtheFRAlastsTheinterestisonlycalculatedfortheperiodforwhichtheFRAlasts.IfanFRAbeginsinfourmonths'timeandlastsforsixmonthsafterthatdate,interestiscalculatedforthosesixmonths(months4-10).AtthestartoftheperiodoftheFRA(infourmonths'time),thebankwillcompare:• InterestpayableundertheFRA• Interestthatwouldbepayableontheimaginarysumifthechargewasbasedonactual(market)interestratesAforwardrateagreement(FRA)fixestheamountofinte estacompanypaysinthefutu eo fixestheinte estacompany eceivesinthefutu e.Mostlyinexamquestionsacompanythatisbo owingmoneyiswo iedthatinte est ateswillinc easeove timeanditsinte estpaymentswill ise(inte est ate isk).Acompanygene allyente sintoanFRAwithabank.AnFRAisanag eementaboutaninte est atehoweve ,notanag eementtobo owfunds.
©ACCA20157Iftheninterestratesriseandacompany'sinterestcostincreases,itcansetoffagainstitsactualinterestcostthereceiptfromthebankundertheFRA,effectivelyfixingitsnetinterestcost.Thehighertheactualinterestratesthatthecompanyhastopay,thehighertheamountthatitwillreceiveincompensationfromthebank.WewillnowtakealookataSectionBquestionfromJune2015whichexaminedtheFRA.Twopossibilitiesa ise:•Iftheinte estunde theFRAisg eate thantheinte estpayablebasedonactual ates,thecompanypaysthebankthediffe ence•Iftheinte estunde theFRAislessthantheinte estpayablebasedonactual ates,thebankpaysthecompanythediffe ence
©ACCA20158June2015SectionBQuestion1(b)Aforwardrateagreement(FRA)canfixtheborrowingrateonasumofmoneyforanagreedperiodstartingonanagreedfuturedate.AcompanycanuseanFRAtomanageinterestrateriskbecausetheFRAfixesthefutureborrowingrateforanagreedperiod,andhencefixesthecompany'sfutureborrowingcost.IfthefutureinterestratepaidbythecompanyturnsouttobehigherthantheborrowingrateintheFRA,thebankwillcompensatethecompanywiththedifferencebetweenthetworatesappliedtotheagreedsumfortheagreedperiod.IfthefutureinterestratepaidbythecompanyturnsouttobelessthantheborrowingrateintheFRA,theoppositeoccursandthecompanycompensatesthebank.TheneteffectisthatthecompanyislockedintotheborrowingratespecifiedintheFRA.BecausethecompanyislockedintotheFRAborrowingrate,theFRAdoesnotallowthecompanytobenefitfromfavourableinterestratemovements.ThebankwhichisapartytotheFRAdoesnotneedtobethesamebankwhichoffersthefundstobeborrower.Thisquestiontestsyou abilitytoexplainwhatanFRAisandwhatitdoes.Thequestionisfo 5ma kssoaone-linedefinitionwon'tbeenough.Thedefinitioninthefi stlinecontainsthemostimpo tantelements-theinte est ateisfixed,thesta tingdateandtimepe iod.Thisexpandsthedefinitionbystatingthepu poseoftheFRA.Thisanswe sthesecondpa tofthe equi ement;youneedtogivedetailsabouthowtheFRAwo ks.Theanswe mentionsthisasakeyfeatu eofanFRA-thecompanyiscommittedtoa ate.Thismaybead awbackifthema ket atefalls.Thisislessimpo tant,butemphasisesthattheactualbo owingandFRAa esepa atearrangements.
©ACCA20159MoneymarketsMoneymarketsaremarketswhereshort-term:• Borrowing• Lending• Tradingtakesplace.Moneymarketinstrumentsarefinancial'products'thataretradedonthemoneymarkets.Moneymarketdepositsrelatetolending/borrowing.Theyareshort-termloansbetweenbanksandotherinstitutions.Acertificateofdepositisace tificatethatstatesthatmoneyhasbeendepositedwithabankfo aspecifiedpe iodoftime.Thispe iodissho t,pe hapsafewmonths.Theholde ofthece tificatehasa ightto eceiveinte estf omthebank.Somece tificatesofdepositcanbesoldonthece tificateofdepositma ket.In etu nfo acashsum,thefi stholde ofthece tificatet ansfe sittoanewowne .Thenewowne thenhasthe ightto eceiveinte estandtheamounto iginallydepositedattheendofthepe iod.Gove nmentscanbo owmoneybyissuingtreasurybillstoinvesto s.Thep icethatthebuye ofthet easu ybillpaystothegove nmentiseffectivelythesumofmoneythatthebuye islendingtothegove nment.In etu nthebuye hasthe ightto eceivetheamountstatedonthebillattheendofitslife.
©ACCA201512CompanyvaluationEarningsanddividendsEarningsisanothernameforprofitaftertax.Thepost-taxearnin gs/profitsfigureistheamou ntofearni ngsafterco stsandtaxhavebe endeducted.Earningsyieldcomparesearningswiththemarketvalueofshares.Itisearningsexpressedasa%ofmarketvalue.Dividendsa ecashamountspaidtosha eholde sbycompaniesoutofea nings.Dividendpayoutratioisthe%ofea ningsthatispaidtosha eholde sasdividends.
©ACCA201513ValueofsharesNominalvalueofashareisthevalueshownonthesharecertificate.Nominalvalueshouldonlybeusedtovaluesharesifotherinformation,suchasassets,earningsorcashflows,isnotavailable.Marketcapitalisation(stockmarketvalue)relatestocompanieswhosesharesarelistedonastockexchange.Marketcapitalisation=MarketpricepersharexNumberofordinarysharesEquitymarketvalueiswhatthestockma ketvaluewouldbeifitwasdete minedbyanacceptedmethodofsha evaluation.Howeve theactualma ketvalueofsha esmaynotbethesameasthevaluecalculatedbyanyofthegene allyacceptedmethodsofsha evaluation,duetothestockma kettakingothe facto sintoaccount.Costofequityisameasu ein%oftheminimum etu nthatsha eholde sexpectthecompanytomake.
©ACCA201514ValuationmethodsTheearningsyieldmethodinvolvesusingtheotherinformationinanearningsyieldcalculationtocalculatewhattheequitymarketvalueshouldbe.Youneedtoknow:• Earningsyield• EarningsTherearetwowaysyoucanbegiveninformationaboutearnings:• Theearningsfigureisstatedinthequestion• YouhavetocalculateEarningsasEarningspersharexNumberofsharesEquitymarketvalue=Earnings/EarningsyieldThedividendgrowthmethodusestheamountthatacompanyexpectstopayasdividendsinthefutureasthebasisofvaluingitsshares,onthegroundsshareholdersvaluesharesbecausetheygeneratedividendincome.Equitymarketvalue=Totaldividendsforthisyearx(1+Dividendgrowthrate)/(Costofequity-Dividendgrowthrate)OrD0(1+g)/(ke-g)Thefigureontopoftheequationrepresentsnextyear'sexpecteddividends.Ifyouaregiventhatfigure,youdon'tneedtoknowwhatthisyear'sdividendsare.Thequestionmaygiveyou• Thedividendgrowthrate• InformationaboutdividendsoverthelastfewyearsandaskyoutocalculatethegrowthrateonthebasisthatthemostrecentgrowthratewillcontinueThehigherthegrowthrate,thehigherthefigureontopofthevaluationandthelowerthefigureonthebottom,bothofwhichwillmeanthattheequitymarketvalueishigher.Youwillbegiventhecostofequity.Usingthecostofequityrelatesthevaluationtothereturnrequiredbyshareholders.SectionBinJune2015examinedthisareaofthesyllabusinsomedetail-let'stakealookatthisnext.
©ACCA201515June2015SectionBQuestion2ChadCoisastock-market-listedcompanywhichhasmanagedtoincreaseearningsoverthelastyear.Asaresult,theboardofdirectorshasincreasedthedividendpayoutratiofrom40·0%fortheyeartoMarch2014to 41·4%for theyearto March2015.ChadC ohasaco stofequi tyof12·5%. Thefollowinginformationisalsoavailable:YeartoMarch20142015$000$000Earnings13,20013,840Ordinaryshares8,0008,000O dina ysha es-assumethisisthe nominalvalue-you'llbetoldifthey' enotThenominalvalueoftheordinarysharesofChadCois$0·50pershare.ListedcompaniessimilartoChadCohaveanearningsyieldof8·2%.You' enottoldthenumbe ofsha esbutyoucanusethetotal nominalvalue andthenominalvaluepe sha etocalculatethetotalnumbe ofsha esifyouneedto.Required:(a)Calc ulatetheequitymarketvalueo fChadCo usingthedividendgrowthmodel.(3marks)Youneedtoknowwhatthedividendsa efo 2014and2015tocalculatethedividendg owth ate.Asyou' enottoldthem,you'llneedtousethedividendpayout atioandea ningsfigu estocalculatethem.(b)Calc ulatetheequitymarketvalueo fChadCo usingtheearningsyieldmethod.(2marks)You' egivenanea ningsyieldfigu einthequestion,althoughitisfo simila listedcompanies,notfo ChadCo.(c)Disc usstherelativemeritsofthedividendgrowthmodelandtheearningsyieldmethodasawayofvaluingChadCo.(5marks)(10marks)Thisphaseimpliesthatyouwillneedtomakeapoint-by-pointcompa ison ofthetwomethods athe thantalkingaboutonemethodandthentalkingabouttheothe .
©ACCA201516Answer(a)Asthepayoutratiohasincreasedfrom40·0%intheyeartoMarch2014to41·4%intheyeartoMarch2015,thetotaldividendhasincreasedfrom$5,280,000(13,200,000x0·4)fortheyeartoMarch2014to$5,729,760(13,840,000x0·414)fortheyeartoMarch2015.Thisrepresentsdividendgrowthof8·52%(5,729,760/5,280,000).Providedthefuturedividendgrowthrateisexpectedtobesimilartothehistoricdividendgrowthrate,thecalculateddividendgrowthrateof8·52%canbeusedinthedividendgrowthmodel.Theequitymarketvalueusingthedividendgrowthmodelistherefore:(5,729,760x1·0852)/(0·125-0·0852)=$156,229,537or$156·2million.(b)Equitymarketvalueusingtheearningsyieldapproach:Earnings/earningsyield=13,840,000/0·082=$168,780,488or$168·8millionYouhavetoassumeitis,asweonlyhavedividendinfo mationfo thelasttwoyea sYoucannowusethedividendg owthequationasyouhave:Thisyea 'sdividendd0$5,729,760Rea angingtheEa ningsyieldequationMa ketvalue=Ea nings/Ea ningsyieldYouhaveEa nings$13,200,000Thenfindtheg owth atebycompa ingthe2014and2015dividends.Thefi ststageistofindoutthedividendsfo 2014and2015.Dividends=Ea ningsxDividendpayout atio
©ACCA201517(c)Cash-flowvaluationmodelstendtobepreferredtoprofit-basedvaluationmodelsandsothedividendgrowthmodel(DGM)couldbepreferredtotheearningsyieldmethod(EYM),astheDGMusescash,whiletheEYMusesprofit.TheDGMhasusedinformationspecifictoChadCo,whereastheearningsyieldmethodhasusedanaverageearningsyieldrelatingtocompanieswhicharesimilartoChadCo.TheDGMvaluationisthereforelikelytobemorerelevanttoChadCothantheEYMvaluation,asChadCoislikelytobedifferentfromtheaveragecompanyinitsbusinessarea.Thetwovaluationmethodsrelatetodifferentvaluationpurposesinanacquisitioncontext.Thedividendgrowthmodelvaluesaminorityshareholdinginatargetcompany,whiletheearningsyieldvaluationgivesavaluefromtheperspectiveoftheacquirer,providedtheearningsyieldusedisappropriate.BoththeDGMandtheEYMassumethatrelevantvaluationvariables,suchasthedividendgrowthrate,thecostofequityandtheearningsyield,willremainconstantinthefutureinperpetuity.Thisisveryunlikelytobetrueandreducestheusefulnessofthetwovaluationmethods.The equi ementsuggeststhatyoushouldfocusonthediffe encesbetweenthetwomethods.Onediffe enceisthebasefigu esused:dividends,acashamount,vsea nings,ap ofitfigu e.Youknowthedividendsfigu esa e elevanttoChad,whe eastheothe companies'ea ningsyieldfigu eisanave age.Chadmaydiffe f omtheave age.Thedividendvaluationmodelisusedfo smallsha eholdingsbecausedividendsa ewhatsmallsha eholde s eceiveandsmallsha eholde shavenopowe ove ea nings.Howeve anacqui e willtakecont olofacompanyandbeabletodecidefo itsownpu poseshowmuchea ningstopayoutasdividends.It'sfinetoincludesomethingthatis elevanttobothmethods,thathisto icaldatamaynotbea eliableguidetothefutu e.
©ACCA201518ExchangeratesExchangeratesarequotedasXunitsofonecurrencytooneunitoftheothercurrency.Ifyoupossessacurrency(p)andyouwantanothercurrency(w),tofindouthowmuchofthecurrencyyouwantyouwillobtain:• Iftherateisquotedasw1=pX,dividetheamountofcurrencypthatyouhavebyXtoseehowmuchofcurrencywyouwillobtain• Iftherateisquotedasp1=wX,multiplytheamountofcurrencypthatyouhavebyXtoseehowmuchofcurrencywyouwillobtainForwardrateistheexchangerateavailabletodaythatisguaranteedforanexchangeofcurrenciesthattakesplaceinthefuture.Afinancialinstitutionwillofferathree-monthforwardratetodaythatfixestherateatwhichcurrenciesareexchangedinanexchangeofcurrenciesinthreemonths'time.Spotexchangerateisthe ateatwhichyouexchangeonecu encyfo anothe .Ifyoua egoingab oad,youwillneedtomakepaymentsinthecu encyofthecount ywhe eyoua egoing.Ifyoua ecomingbackf omafo eigncount y,youwillhavefo eigncu encythatyouwanttoexchangefo you homecu ency.
©ACCA201519ForwardmarkethedgemeansmakinganagreementtoexchangedifferentcurrenciesinXmonths'timeattheXmonths'forwardratethatisavailabletoday.Knowingthatthisrateiscertainmeansthatthecompanyknowsforcertainhowmuchofitsowncurrencyitwillreceiveorpay,soitremovesexchangeraterisk.•Exchangerateriskisthe iskthatfutu eexchange atechangeswillaffectthevalueinyou owncu encyofamountsthatyou eceiveo payinafo eigncu ency.Fo example,assumethatthefo eigncu encyistheF$andthehomecu encyistheH£:•Ifthecu entspotexchange ateisF$2=H£1andyouhavea eceipttodayofF$100,000,thevalueinhomecu ency=F$100,000/2=H£50,000•Ifyouhavethesame eceiptf omanothe custome insixmonths'timeandtheexchange ateisF$2.5=H£1,thevalueinhomecu ency=F$100,000/2.5=H£40,000Moneymarkethedgeisinvestingo bo owinginthemoneyma ketsino de toc eateahedgethatisequivalenttothefo wa dma kethedge.Thetwomethodshaveve ysimila outcomesbecausethefo wa d atesthata eusedinfo wa dma kethedgesa edete minedbytheinte est atesavailableinthemoneyma kets.
©ACCA201520Themethodofmoneymarkethedgingthatyouusedependsonwhetheryouarehedgingaforeigncurrencyreceiptoraforeigncurrencypayment.Ifyou arehedging aforeigncur rencypayment,youw illneed tohavethatamount offoreigncurrencyavailable.• Investforeigncurrencynowtoensurethatyouwillhaveenoughavailabletomeetthepayment.Theamountyouinvestwillbelessthanthepayment,becauseyouwilladdtheinterestyouwillreceivefortheperiodofinvestment• Youthereforeneedfundsnowtomaketheforeigncurrencyinvestment• Borrowhomecurrencynowtogiveyouthefundstomaketheforeigncurrencyinvestment.Convertthehomecurrencyyou'veborrowedtotheforeigncurrencyattoday'sspotexchangerate• Theequival entpaymentinthehomecurren cy=Homecurrencyborrowed+Interestonborrowing.YouassumeyourepaytheborrowingwhentheforeigncurrencypaymentismadeIfyouarehedgingaforeigncurrencyreceipt,youwillhavethatforeigncurrencyavailableatafuturedate• Borrowforeigncurrencynow,asyouwillhavetheforeigncurrencyreceiptavailableinfuturetorepaytheborrowing.Theamountyouborrowwillbelessthanthereceipt,becauseyouwilltakeintoaccounttheinterestyouwillpayfortheperiodofborrowing.• Youthereforehavesurplusforeigncurrencynow.• Converttheforeigncurrencytohomecurrencyattoday'sspotrateandinvesthomecurrency.• Theequival entreceiptinthe homecurrenc y=Homecurrencyinvested+Interestontheinvestment.Youassumetheinvestmentfinisheswhentheforeigncurrencyreceiptisreceived.MoneymarketandforwardmarkethedgeswereexaminedinJune2015-wewilllookatthespecificquestionnext.
©ACCA201521June2015SectionBQuestion1(a)RoseCoexpectstoreceive€750,000fromacreditcustomerintheEuropeanUnionFo eigncu ency€ eceipt,so€bo owingwhich€ e ceiptwill epay,t anslatedintoHome cu ency$investment.insixmonths'time.Fo moneyma kethedge,needtoadjustfo sixmonthsinte est.Thespotexchangerateis€2·349per$1andthesix-monthforwardrateis€2·412per$1.ThefollowingcommercialinterestratesareavailabletoRoseCo:Needthistocalculatethefo wa dma kethedgeDepositrateBorrowrateEuros4%peryear8.0%peryearDollars2%peryear3.5%peryearYou' eno mallytoldthedepositandbo ow ateinbothcu enciesandhavetochoosethe ightones,he e€bo owand$deposit.RoseCodoesnothaveanysurpluscashtouseinhedgingthefutureeuroreceipt.Soitwillhavetobo ow€.Required:EvaluatewhetheramoneymarkethedgeoraforwardmarkethedgewouldbepreferredonfinancialgroundsbyRoseCo.(5marks)AnswerForwardmarkethedge:Thedollarvalueofaforwardmarkethedgeinsixmonths'timecanbecalculated:Futurevalue=€750,000/2·412=$310,945Moneymarkethedge:RoseCoisexpectingaeuroreceiptinsixmonths'timeanditcanhedgethisreceiptinthemoneymarketsbyborrowingeurostocreateaeuroliability.Theseeuroscanbeconvertedintodollarsatspotandthenplacedondepositforsixmonths.Needtoexplainb ieflyhowhedgewillwo k.Youwillhave€,want$, ateis€2.412=$1,the efo edivide€by2.412toobtain$thatyouwant.
©ACCA201522Euroborrowingratefor6months=8·0/2=4%Dollardepositratefor6months=2·0/2=1%Eurostobeborrowednow=€750,000/1·04=€721,154Dollarvalueoftheseeurosatspot=€721,154/2·349=$307,005Futurevalueofdollardeposit=$307,005x1·01=$310,075Theforwardmarkethedgewouldbebetterby310,945-310,075=$870andwouldthereforebepreferredonfinancialgroundsbyRoseCo.Divide atepe yea by2toobtain6months' ate.Amountbo owed=Futu e eceipt/(1+inte est ate),lessthanfutu e eceipt,becauseyouhavetopayinte estonamountbo owed.G owth ateg8.52%Costofequity12.5%Spotexchange ategiveninquestion.Have€,want$, ateis€2.349=$1,the efo edivide€by2.349toobtain$thatyouwant.Ea ningsyield8.2%Futu evalue=$ eceipttodayx(1+inte est ate)Pu elyfinancialcompa isonisfinehe e.Diffe encewillnotbela ge.
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