P4 Test Notes

Hi,

I recently passed the P4 exam, and beforehand I prepared some test notes, which I’ve pasted below. There were prepared in a hurry, so it’s a bit incomplete, and might need some tweaking and adding to (particularly the hedging section). I hope it might be helpful for others. Here it is.

Types of Risk

• Business risk
• Financial risk
• Political risk
• Economic risk
• Regulatory risk
• Operational risk
• Reputational risk

Free Cash Flow to Firm (to equity and debt holders)

• EBIT
• Less tax on EBIT
• Plus non-cash chares (e.g. depreciation)
• Less net working capital increases
• Plus net working capital decreases
• Plus salvage value received

Free Cash Flow to Equity

Direct Method

• Net Income (EBIT – net interest – tax paid)
• Add depreciation
• Less total net investment (change in capital investment + change in working capital)
• Ad net debt issued (new borrowings less any repayments)

Indirect Method

• FCF
• Less (net interest + debt paid)
• Add tax benefit from debt (net interest x tax rate)

Modified Duration

Modified durations = Macaulay duration / 1 + gross redemption yield (yield to maturity)

Risks by Companies dealing with Foreign Currencies

• Transaction
• Translation
• Economic

Advantages of mergers as expansion strategy

• Speed
• Lower cost
• Acquisition of intangible assets
• Access to overseas markets

Disadvantages of mergers as an expansion strategy

• Exposure to business risk
• Exposure to financial risk
• Acquisition premium
• Managerial competence
• Integration problems

Criteria for choosing an appropriate target for acquisition

• Benefit for acquiring undervalued company
• Diversification
• Operating synergy
• Tax savings
• Increase the debt capacity
• Disposal of cash slack
• Access to cash resources
• Control of the company
• Access to key technology

Types of Synergy

• Revenue
• Cost
• Financial

Explaining high failure rate of acquisitions in enhancing shareholder value

• Agency theory
• Errors in valuing a target firm
• Market irrationality
• Pre-emptive theory
• Window dressing
• Poor integration management
• Inflexibility
• Poor man-management

Reverse Takeover

Advantages

• Speed
• Cost
• Availability

Disadvantages

• Risk
• Lack of expertise
• Share price decrease

Business Valuation

• Asset-based models (book value-plus, CIV, LEV)
• Market-based models (P/E, earnings yield, market to book ratio)
• Cash-based models (dividend valuation, FCF/FCFE, APV)

Types of Reconstruction

• Financial
• Portfolio
• Organisational

Leveraged Buy-outs

Advantages

• Costs of meeting listing requirements saved
• Company is protected from volatility in share prices which financial problems may create
• Company less vulnerable to hostile takeover bids
• Management can concentrate on the long-term needs of the business rather than the short-term expectations of shareholders
• Shareholders are likely to be closer to management in a private company, reducing costs arising from the separation of ownership and control (the agency problem)

Disadvantages

• Shares non longer publicly traded and may lose some of its value

Unbundling

• Divestments
• Demergers
• Sell-offs
• Spin-offs
• Carve-outs
• Management buy-outs

Triple Bottom Line

Financial, Environmental, Social

Ensure each perspective is growing, but not at the expense of the others.

Sell-offs

Involves the sale of part of a company to another company. A sell-off can act to protect the rest of a business from a take-over, by selling part that is particularly attractive to a buyer. It can also provide cash, enabling the remaining business to invest further without the need for worsening its gearing by obtaining more debt finance.

Demergers

Is the splitting up of a corporate body into two or more separate and independent bodies. It is not a sale of the separate bodies themselves, as the original shareholders have shares in both companies. The split does enable analysts to understand the two businesses fully, particularly when the two main divisions are in different fields.

Divestment

Involves selling off assets rather than a part of a company. It can be completd moe quickly then either a sell-off or a demerger. It can be used to raise cash relatively quickly and can be used to ensure that the focus is on the core business.

Hostile takeover defences

• Golden parachute – large compensation payments made to the top management of the target firm if their positions are eliminated due to hostile takeover.
• Poison pill – this is an attempt to make a company unattractive normally by giving the right to existing shareholders to buy shares at a very low price.
• White knights – this would involve inviting a firm that would rescue the target from the unwanted bidder.
• Crown jewels – the firm’s most valuable assets may be the main reason that the firm became a takeover target in the first place. By selling these or entering into arrangements such as sale and leaseback, the firm is making itself less attractive as a target.
• Pacman defense – this defence is carried out by mounting a counter-bid for the attacker. It is an aggressive rather than defensive tactic and will only work where the original acquirer is a public company with diverse shareholdings. This tactic suggests that the company’s management are in favour of the acquisition but that they disagree about which company should be in control.
• Litigation or regulatory defence – the target company can challenge the acquisition by inviting an investigation by the regulatory authorities or through the courts. The target may be able to sue for a temporary order to stop the predator from buying any more of its shares.

Money Market Hedging

Owing

• Invest foreign currency owed net of interest
• Exchange at today’s spot
• Borrow the funds plus interest in local currency

Receiving

• Borrow foreign currency net of interest
• Exchange at today’s spot
• Invest the funds and add on interest accrued

Futures FOREX

• Reference point: convert at spot now
• Choose future whose month end is soonest after transaction
• Buying contract currency – buy future. Selling contract currency – sell future
• Number of contracts = transaction amount / future rate / contract size (round up or down, excess/shortfall hedged using forward)
• Over/(under) hedge = (number of contracts x future rate x contract size)-transaction amount
• Calculate futures price or lock-in rate
• Calculate underlying transaction at spot
• Add/subtract profit/loss on future. (No. of contracts x contract size x movement in futures prices = $ amount / spot = £ amount)
• Alternatively skip last two steps, and multiply by lock-in rate
• Lock-in rate = current future x basic at transaction date (or current spot x difference in base rate)

Options FOREX

• Choose option whose month end is soonest after transaction
• Buying contract currency – call option. Selling contract currency – put option
• Set out columns with the various strike prices
• Number of contracts = transaction amount / options rate / contract size (round up or down, excess/shortfall hedged using forward)
• Over/(under) hedge = (number of contracts x options rate x contract size)-transaction amount
• Premium = number of contracts x premium/100 x contract size = premium in $ / spot rate = premium in £
• If spot rate at transaction date not provided – show worst outcome (i.e. exercise option)
• Calculate transaction at spot
• If option not exercised, then stop there. If exercised, calculate profit/loss on option. Profit/loss = No. of contracts x contract size x movement in option prices = $ amount / spot = £ amount

Futures – Interest Rates

• Choose future whose month end is soonest after investing/borrowing date
• Investing – buy future. Borrowing – sell future.
• Number of contracts = transaction amount / contract size x months required/3 (round up or down, excess/shortfall hedged using forward)
• Calculate futures price or lock-in rate
• Calculate interest receivable/payable at current rate
• Calculate profit/loss on future. Profit/(loss) = transaction amount x number of contracts x (opening future price – closing future price)/400

Options – Interest Rates

• Choose option whose month end is soonest after investing/borrowing date
• Investing – call options. Borrowing – put options.
• Set out columns with the various strike prices
• Number of contracts = transaction amount / contract size x months required/3 (round up or down, excess/shortfall hedged using forward)
• Premium = number of contracts x contract size x premium/400
• If interest rate at transaction date not provided – show worst outcome (i.e. exercise option)
• Calculate interest receivable/payable at current rate
• Profit/(loss) on option = transaction amount x contract size x (opening option price – closing option price)/400

Islamic Finance

• Murabaha – trade credit/loan
• Musharaka – venture capital
• Muderaba – equity
• Ijara – leasing
• Sukuk – bonds
• Salam – forward contract
• Istisna – phased payments

Intergrated Reporting (NeMo FISH)

• Natural
• Manufactured
• Financial
• Intellectual
• Social and relationship
• Human

Greeks

• Delta – change in call option price/change in value of share
• Gamma – change in delta value/change in value of share
• Theta – change in option price over time
• Rho – change in option price as interest rates change
• Vega – change in option price as volatility changes

Limitations of the Black-Scholes model

• Only designed for the valuation of European call options
• Basic model is based on the assumption that shares pay no dividends
• Model assumes that there will be no transaction costs
• Model assumes knowledge of the risk-free rate of interest, and also assumes the risk-free rate will be constant throughout the option’s life
• Model assumes accurate knowledge of the standard deviation of returns, which is also assumed to be constant throughout the option’s life

Square root of Variance = Standard Variation