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ADVANCED FINANCIAL MANAGEMENT Question And Answers

   

Added on  2019-11-08

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Advanced FinancialManagement[Pick the date]

ADVANCED FINANCIAL MANAGEMENTQuestion 1FRA or Forward Rate Agreement refers to OTC (over the counter) contract with regards todetermination of either the interest rate or currency exchange rate at a future date. Thereference rate is agreed to by the two parties and any difference is settled in cash at the expirydate of the FRA. With regards to interest rate, there is an exchange of a fixed rate with avariable interest rate. The party which pays the fixed rate of interest also called the referencerate is referred to as the buyer while the party which agrees to the variable interest rate iscalled the seller. At the date of the settlement depending upon which is higher i.e. the fixedrate or the floating rate as on date, the difference in interest is settled between the two parties.Hence, it would be appropriate to term the FRA as forward starting loan in which there isabsence of any principal exchange but instead settlement at maturity based on the differencein interest rates.This is a common tool which is used by various businesses to hedge their interest rateexposures or currency rate exposures. The party which is supposed to receive money orcurrency at a later rate tends to buy a FRA for a fixed rate so as to assume that the interestrate risk and currency risk is hedged.Question 2Consider an example where a Singapore based company is expected to receive USD 100million payment after exactly 6 months. The company has exposure to the currency risk andit may so happen that adverse currency movement may impact the proceeds received in SGD.Hence, this given firm tends to buy a FRA to the tune of USD million whereby a fixed rate isagreed for the conversion of USD and SGD by the buyer (company expected to receiver USD100 million) while the seller would settle for the applicable exchange rates at that time. Thus,after six months if the currency rates are favourable for the Singapore based company, then itwill receive higher proceeds in SGD but part of these would go into settling the FRA forwhich payment to seller would need to be made. However, if the currency movements areadverse, then lower proceeds would be received but the remaining balance would be providedby the FRA seller and hence the currency risk is managed.Advantages of FRA:Absence of any margin paymentsHigh flexibility in terms of maturity period and the amount of the contractDisadvantages of FRA:There is credit risk with regards to the final settlement at the maturity Lack of a formal market considering OTC tradingQuestion 3

ADVANCED FINANCIAL MANAGEMENTOne of the significant valuation metrics that is deployed is the P/E ratio or Price to earningsratio. This is dependent on the earnings per share associated with the particular firm.However, the P/E ratio would depend on a host of factors such as profit margins, the growthof EPS, market share, floating stock available along with quality of corporate governance andtop management. Typically high growth sectors and companies are accorded higher P/Ewhich traditional businesses which have limited growth scope are given lower P/E. This ratiofor a given stock or industry tends to alter with time and does not remain constant.Another way to compute the value of the share is through the Dividend Discount Method orDDM. The basic premise of this model is the stock price is the present value of all futuredividends. While theoretically this makes sense, but in practical there are methodologicalissues with this method. These involve predicting the growth rate of dividends over the longterm. Further, this cannot be identified for those stocks which do not pay dividends or havedividend growth rate higher than the cost of equity. Yet another way to measure the stockvalue is through the use of Price to Book ratio which is preferred as it is not dependent onEPS which is more prone to manipulation. The book value of the company is difficult to bemanipulated and thus provides a stable base to estimate prices. Question 4MVA or Market Value Added is a concept that has been developed by the consulting firmStern Stewart & Co. It is essentially the difference of the market value of the firm and thetotal capital in the form of debt and equity that has been put in the business. Hence, MVA = Market Value of firm – Total capital in the firm (Debt & Equity)It is favourable for the shareholders if the MVA is positive as it implies that the corporatemanagers have been able to deliver some value. There are some issues with the concept ofMVA. The first issue is to determine the capital that the business has put into business againstthat being held as retained earnings which becomes quite difficult for firms that have beentrading for long. Secondly, MVA does not indicate the time when value creation actuallyhappened and does not provide any indication as to whether the process would continue inthe future or not. Thirdly, since MVA is an absolute measure, hence it would be adverselyimpacted by the higher capital base of the larger companies which typically would have moreMVA. Fourthly, MVA is distorted by inflation also.The shortcomings of MVA led to the introduction of MBR or Market to book ratio. This isessentially the market value divided by the total capital deployed. While the issue withregards to determination of the capital remain for MBR also like in MVA but one distinctadvantage of MBR is that it is a relative measure unlike MVA. As a result, the size of thefirm does not have an impact and hence comparison across firms can be done more easily.Additionally, it helps in making investment decisions as companies should not assumeprojects that tend to reduce the MBR.

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