ACCA P4 Advanced Financial Management - 2010 - Study text

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Chapter 10: Corporate reconstruction and reorganisation

Venture capital firms expect a high return on their investments, because a

proportion of them are not successful and the investment risk is high.

The financing of a management buyout or management buy-in might be as follows:

 The individual managers in the management team agree to subscribe some of

their own money to buy shares in the company they are buying. (If the MBO or

MBI involves setting up a new company, the managers agree to buy a quantity

of shares in the new company.)

 The venture capital firm also buys a quantity of equity shares, so that the

proportions of shares owned by the management team and by the venture

capital firm are in a satisfactory balance. The venture capital firm will want an

equity stake in the company, but will not want its stake to be so large that there

is no incentive or motivation for the management team to make the company a

success.

 The venture capital firm will provide additional finance, possibly in the form of

redeemable preference shares or unsecured lending. The intention should be

that as the company grows and becomes more profitable and cash-rich, it will be

able to redeem the preference shares or loan.

 The venture capital firm often negotiates additional loans, possibly secured bank

loans, to bring the total capital available up to the amount needed to buy the

company.

 The management team may be given an incentive scheme (such as a share

option scheme) that will allow them to take more equity if the company is

successful.

An MBO or MBI cannot go ahead unless enough capital is provided to purchase the

business, and the expected profits from the business must be sufficient to meet the

costs of debt interest and preference share dividends, and achieve a profit for the

equity shareholders.

3.5 Share buy-back (share repurchase scheme)

A share buy-back is the purchase by a company of some of its own equity shares,

which are then cancelled.

 The shares might be purchased in the stock market at the current market price.

 Alternatively, the company might offer to buy back a quantity of shares at a

fixed price from shareholders willing to sell them. Or the company might invite

its shareholders to submit bids for the price at which they would be willing to

sell a quantity of their shares to the company. When the company invites tenders

from its shareholders in this way, it will buy back shares from the shareholders

submitting the lowest prices for selling their shares.

Share repurchases are carried out as a part of a planned programme, which requires

the prior consent of the shareholders, and which must treat all the equity

shareholders fairly (for example, by giving them all an opportunity to sell back

some of their shares).

After a share buy-back, the company will have fewer shares in issue.

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Purpose of a share buy-back

A share buy-back might be appropriate when the company has a large amount of

surplus cash, and cannot find enough new investment opportunities for investing

the money. Instead of holding the cash (and earning a low rate of interest), it would

benefit shareholders if the cash is paid back to them.

An alternative to a share buy-back is a special dividend payment. A dividend

would be paid to all the shareholders, and so all the shareholders would receive

some cash. However, the company might wish to avoid giving the impression that

higher dividends will continue to be paid in the future.

There might be a tax advantage for shareholders in selling back shares rather than

receiving a higher dividend.

By reducing the number of shares in issue, the cash profits per share and earning

per share after the buy-back should be higher, and the market value of the

remaining shares should therefore increase. A share buy-back should therefore be

expected to increase the wealth of the remaining shareholders.

Increasing the company’s financial gearing

Another reason for a share buy-back is to increase the company’s gearing. The

company may borrow debt capital and use the money to buy back and cancel some

of its shares. Replacing equity with low-cost debt may reduce the WACC and

increase the value per share of the remaining shares.

3.6 Going private

A ‘public company’ might ‘go private’. The public company must be a company

whose shares are traded on a stock market. When it goes private, it abandons its

stock market status and it shares are no longer traded on the market.

Going private usually involves a major change in the share ownership of the

company. When its shares are traded on a stock market, the majority of the shares

are probably held by institutional investors. When the company ‘goes private’, the

shares are normally acquired by either:

 a small number of former managers in the company and venture capital

organisations, or

 a private equity organisation.

Typically, the chairman or chief executive officer of the company, who might be a

significant shareholder, decides to withdraw the company from the stock market.

He seeks financial support from venture capitalists and banks, and makes an offer

to the existing shareholders to buy their shares. The existing shareholders must be

offered a sufficiently high price for their shares, to persuade them to sell.

Chapter 10: Corporate reconstruction and reorganisation

Reasons for going private

When a company goes private, the reasons may be as follows:

 The company is obtaining no benefit from its stock market status. For example:

− the company might not want to use the stock market to raise new equity

capital

− investors might be unwilling to support a new share issue, so that the

company is unable to obtain new funding from the stock market

− the company either does not want to issue new equity to finance takeovers,

or is unable to persuade the shareholders of target companies to accept its

shares as the purchase consideration for a takeover.

 The chairman or chief executive officer, who is also a major shareholder, might

think that the shares are under-valued. By taking the company private and

acquiring more of the shares, he will expect to increase his own wealth.

When a significant number of companies revert to private status and give up their

stock market status, this would be an indication that the stock market is not acting

efficiently in providing capital to companies and that having a stock market status

does not help to increase share values.

Private equity

Private equity organisations specialise in buying companies, often companies that

are not as successful as they should be.

 The private equity firm has a fund for buying companies, and often borrows

from banks to obtain large quantities of additional debt finance.

 A company acquired by a private equity firm may be a public company whose

shares are traded on a stock market. If so, the private equity firm will buy the

company and ‘take it private’. This means that the company’s shares are

withdrawn from trading on the stock market, and the shares are ‘de-listed’.

A new management team is appointed to run the company. These managers are

usually offered large incentives to make the company successful. This is the key to a

successful private equity venture: the acquired company must be changed from an

under-performing company to a company with much more value.

In addition, the purchased company might have valuable assets such as land and

buildings that the new owners use to raise more capital. For example, property

might be sold and leased back or used as collateral for additional borrowing.

If the company is successful, the private equity firm may decide to ‘cash in’ its

investment. One way of doing this is to re-list the shares and re-launch the company

on the stock market. When the company is re-launched on the market, the private

equity firm will sell its shares to other investors.

Private equity firms have been particularly successful in recent years. Some of this

success has been due to the low cost of borrowing. A large proportion of the

purchase price of target companies has been paid for with debt capital, on which the

interest rate has been fairly low (and there is tax relief on the interest payments).

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Paper P4

Advanced Financial Management

CHAPTER

The money markets.

The treasury function

Contents

1 The money markets

2 Money market instruments

3 The treasury function

4 Risk management methods in banks

5 Finance of international trade

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The money markets

 Definition of the money markets

 Purpose of the money markets

 The inter-bank market

 The repo market

 Comparison of the repo market and inter-bank market

1 The money markets

1.1 Definition of the money markets

The money markets are wholesale markets for dealing in short-term lending and

borrowing and for trading short-dated financial instruments.

 ‘Wholesale’ markets are markets for large-value transactions.

 Short-dated financial instruments are financial instruments that have one year or

less to maturity when they are issued. They include Treasury bills, bills of

exchange, commercial paper and certificates of deposit (CDs). The repo market,

which is one of the money markets, also deals in short-dated bonds (bonds with

a short time remaining to maturity) as well as other money market securities.

The main money markets are:

 the inter-bank market and

 the repo market.

There are international money markets for all the main currencies. For example,

London is a major money market centre which operates large money markets in US

dollars, euros, yen, Swiss francs and Canadian dollars as well as sterling.

1.2 Purpose of the money markets

The main purpose of the money markets is to provide:

 short-term liquidity to entities needing money, and

 short-term investment opportunities for entities with surplus liquidity.

Banks are the most active participants in the money markets, but some large

companies also have direct access to the markets. Smaller companies and

individuals might be offered an opportunity by their bank to borrow or lend at

money market interest rates, and their access to the money markets is made through

the bank. This means that companies are able to borrow or deposit money short-

term in the money markets through their bank. When they participate through their

bank, they can borrow or lend much smaller amounts of money than the normal

size of money market transaction.

Chapter 11: The money markets. The treasury function

Money markets also provide ready access to short-term borrowing and lending

opportunities in foreign currency. This is important for companies involved in

international trade that need short-term finance for transactions involving a foreign

currency.

1.3 The inter-bank market

The inter-bank market is a market for borrowing and lending large amounts of

money for a short-term, often ‘overnight’ (for one day) but possibly up to one year.

As the name of the market indicates, it is mainly a market for borrowing or lending

between banks, but as explained earlier, companies are able to participate directly or

through their bank. (When they participate through their bank, they can borrow or

lend much smaller quantities of money.)

Interest rates in the inter-bank market vary according to:

 the duration of the loan, and

 the credit rating or credit status of the borrowing bank.

Banks with a very high credit rating are able to borrow at lower rates than banks

with a lower credit rating.

The interest rates charged to top-quality banks are monitored. In London for

example, a number of banks report their borrowing rates to the British Bankers

Association (BBA) each day, and the BBA uses these rates to determine the average

borrowing rates for top-rated banks.

LIBOR

The BBA publishes these rates as the BBA London Inter-Bank Offered Rate or

LIBOR. LIBOR (also written as Libor) is an important rate in the London markets,

because it provides a guideline on interest rates to banks and it is also used as a

benchmark interest rate in some derivatives markets. (Derivatives are explained

later.)

The financial press publishes LIBOR rates, which might be presented as follows:

Market interest rates

18th July Overnight Month

Three

months

Six

months

One year

US$ Libor 5.30375 5.32000

5.36000

5.40906 5.50594

Euro Libor 4.09063 4.11463

4.14250

4.28488 4.52538

£ Libor 5.60625 5.67125

5.84875

6.00250 6.26000

Swiss Fr Libor

2.39000 2.42000

2.48833

2.65083 2.91250

Yen Libor 0.61250 0.64250

0.74563

0.84938 0.99750

Canada Libor

4.34833 4.32167

4.46000

4.64000 4.89833

LIBOR can be regarded as a risk-free money market rate. The money market yield

curve is normally upward-sloping, but this is not always the case, and a yield curve

may be downward sloping along all or a part of its length.

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Only a few LIBOR rates are published in the financial press, and it is possible to

borrow or lend for any money market period.

Money market rates are shown as annual rates of interest. The actual amount of

interest payable on a money market loan, or receivable on a money market deposit,

depends on the term of the loan or deposit as well as the interest rate.

There are specific rules for the calculation of money market interest, but for the

purpose of your examination, you can assume that the interest payable or receivable

is the annual interest rate multiplied by the number of months of the loan or deposit

and divided by 12. Here are some examples.

 For a three-month loan of $1,000,000 when three-month LIBOR is 5.36%, the

interest rate is (5.36% × 3/12) 1.34% and the interest payable is $13,400.

 For a six-month deposit of €1,000,000 when six month LIBOR is 4.28488%, the

interest rate is 2.14244% and interest receivable will be €21,424.40.

Only top-rated banks are able to borrow at LIBOR. Other banks and companies

borrow at a ‘spread’ above LIBOR or earn interest on deposits at a rate below

LIBOR. For example a company might be able to borrow at LIBOR plus 0.5% (plus

50 basis points), and if one-month LIBOR is 6.125%, it is able to borrow for one

month at 6.625%.

Note on base rates

Not all companies borrow from their bank at a rate of interest based on LIBOR.

Many companies, especially smaller companies, might pay a rate of interest on an

overdraft or variable rate loan at an interest rate linked to the bank’s base rate. For

example a company might borrow at base rate plus 2%. A base rate is an

‘administered rate’ which means that it is set by the lending bank and is not directly

related to market rates of interest.

Changes in money market interest rates

Money market interest rates can change rapidly, in response to market conditions

and prospects for the economy. However, in the United States, the European Union

and the UK, the biggest influence on LIBOR rates is the central bank. The central

bank is able to raise or lower the money market interest rate for its dealings with

commercial banks, and it uses interest rates to try to influence the state of the

economy (and in particular the rate of inflation). If the central bank in the UK raises

its interest rate by 0.25% for example, banks will immediately increase their LIBOR

rates by the same amount.

1.4 The repo market

A repo is a sale and repurchase transaction. In a repo transaction, one party sells a

quantity of short-dated bonds or money market securities to the other party and at

the same time undertakes to buy them back at a specified future date at a higher

price.

Chapter 11: The money markets. The treasury function

For example Bank A might arrange a repo transaction with Bank B, in which Bank A

sells a quantity of short-dated government bonds and money market instruments to

Bank B for $20 million and agrees to buy them back after 14 days for $20.046 million.

In effect a repo transaction is a short-term secured loan. In this example, Bank B is

effectively lending $20 million to Bank A for 14 days and takes government bonds

and money market instruments as security for the loan. When the repurchase takes

place after 14 days, Bank B receives $46,000 more than it lent, which is the interest

on the loan.

Importance of the repo market

The repo market is important in the USA, European Union and UK for two reasons.

 The central bank uses the repo market to provide liquidity to commercial banks,

and sets the interest rate (repo rate) for these transactions. The 14-day ‘gilt repo’

rate is in effect the marginal cost of borrowing for banks that cannot obtain

liquidity anywhere else. This rate is used by the central bank to influence other

money market interest rates, as explained above.

 Commercial banks use the repo market for secured borrowing and lending

between themselves. It is an alternative to the inter-bank market, where

borrowing and lending is unsecured.

1.5 Comparison of the repo market and inter-bank market

Interest rates in the inter-bank market are slightly higher than interest rates in the

repo market. This is because repo transactions are a form of secured lending

whereas inter-bank loans are unsecured.

A bank with a large quantity of short-dated government bonds or money market

securities will therefore prefer to borrow in the repo market than in the inter-bank

market, because borrowing costs are less. However, banks might not hold large

quantities of short-dated government bonds or money market securities. If these

banks need to borrow, they will use the inter-bank market.

For the purpose of your examination, the inter-bank market and inter-bank market

interest rate (LIBOR) are more significant than the repo rate, because the inter-bank

rate is more relevant for obtaining short-term liquidity and for hedging both interest

rate risk and foreign exchange risk. (Hedging risks is described later.)

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Money market instruments

 Coupon-bearing and discount instruments

 Treasury bills

 Bills of exchange

 Certificates of deposit (CDs)

 Commercial paper (CP)

2 Money market instruments

The largest money market is the inter-bank market for loans and deposits. There are

also markets for dealing in other money market ‘instruments’ or securities. These

include:

 Treasury bills

 Bills of exchange (including bankers’ acceptances or BAs)

 Certificates of deposit (CDs)

 Commercial paper (CP).

2.1 Coupon-bearing and discount instruments

There are two broad categories of money market instrument, coupon-bearing and

discount instruments.

 Coupon-bearing instruments are instruments or securities on which interest is

payable at a stated interest rate (or ‘coupon’) on a fixed amount of principal.

When the instrument or security reaches its maturity date, its holder receives the

initial principal plus interest in settlement. Examples of coupon-bearing

instruments are certificates of deposit.

 Discount instruments are instruments or securities where the borrower

undertakes to pay a fixed amount of principal at maturity, and the instrument is

issued at a discount to its ‘face value’. The difference between the discounted

issue price and the eventual redemption price (face value) represents interest on

the borrowing. Examples of discount instruments are Treasury bills, bills of

exchange and commercial paper.

2.2 Treasury bills

Treasury bills are short-dated securities issued by a government, when money is

needed to meet a short-term financing requirement. Treasury bills are normally

issued for 91 days (three months).

They are discount instruments. The government might issue 91-day Treasury bills

with a face value of $100 million at a price of, say, 98.75. It would raise $98.75

million from the issue and at the end of the 91 days it would pay $100 million to the

holders of the bills. Interest for the three-month period would be $1.25 million on

the $98.75 million raised, which is an interest rate of about 5% (annual).

ACCA P4 Advanced Financial Management - 2010 - Study text - Emile Woolf Publishing

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