Advanced Financial Management Solutions

This document provides solutions to a series of questions related to advanced financial management topics. The questions cover a wide range of concepts, including Forward Rate Agreements (FRAs), valuation metrics (P/E ratio, Dividend Discount Model, Price-to-Book ratio), Market Value Added (MVA) and Market-to-Book ratio (MBR), behavioral finance biases (overconfidence, self-preservation heuristics), the impact of emotions on financial decision-making, momentum and contrarian investment strategies, mergers and acquisitions, and the Efficient Market Hypothesis (EMH) and its anomalies. Each question is answered comprehensively, providing detailed explanations and insights into the relevant financial concepts. The solutions demonstrate a strong understanding of advanced financial principles and their practical applications.

Advanced Financial Management
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ADVANCED FINANCIAL MANAGEMENT
Question 1
FRA or Forward Rate Agreement refers to OTC (over the counter) contract with regards to
determination of either the interest rate or currency exchange rate at a future date. The
reference rate is agreed to by the two parties and any difference is settled in cash at the expiry
date of the FRA. With regards to interest rate, there is an exchange of a fixed rate with a
variable interest rate. The party which pays the fixed rate of interest also called the reference
rate is referred to as the buyer while the party which agrees to the variable interest rate is
called the seller. At the date of the settlement depending upon which is higher i.e. the fixed
rate 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 is
absence of any principal exchange but instead settlement at maturity based on the difference
in interest rates.
This is a common tool which is used by various businesses to hedge their interest rate
exposures or currency rate exposures. The party which is supposed to receive money or
currency at a later rate tends to buy a FRA for a fixed rate so as to assume that the interest
rate risk and currency risk is hedged.
Question 2
Consider an example where a Singapore based company is expected to receive USD 100
million payment after exactly 6 months. The company has exposure to the currency risk and
it 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 is
agreed for the conversion of USD and SGD by the buyer (company expected to receiver USD
100 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 it
will receive higher proceeds in SGD but part of these would go into settling the FRA for
which payment to seller would need to be made. However, if the currency movements are
adverse, then lower proceeds would be received but the remaining balance would be provided
by the FRA seller and hence the currency risk is managed.
Advantages of FRA:
 Absence of any margin payments
 High flexibility in terms of maturity period and the amount of the contract
Disadvantages of FRA:
 There is credit risk with regards to the final settlement at the maturity
 Lack of a formal market considering OTC trading
Question 3

ADVANCED FINANCIAL MANAGEMENT
One of the significant valuation metrics that is deployed is the P/E ratio or Price to earnings
ratio. 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 growth
of EPS, market share, floating stock available along with quality of corporate governance and
top management. Typically high growth sectors and companies are accorded higher P/E
which traditional businesses which have limited growth scope are given lower P/E. This ratio
for 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 or
DDM. The basic premise of this model is the stock price is the present value of all future
dividends. While theoretically this makes sense, but in practical there are methodological
issues with this method. These involve predicting the growth rate of dividends over the long
term. Further, this cannot be identified for those stocks which do not pay dividends or have
dividend growth rate higher than the cost of equity. Yet another way to measure the stock
value is through the use of Price to Book ratio which is preferred as it is not dependent on
EPS which is more prone to manipulation. The book value of the company is difficult to be
manipulated and thus provides a stable base to estimate prices.
Question 4
MVA or Market Value Added is a concept that has been developed by the consulting firm
Stern Stewart & Co. It is essentially the difference of the market value of the firm and the
total 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 corporate
managers have been able to deliver some value. There are some issues with the concept of
MVA. The first issue is to determine the capital that the business has put into business against
that being held as retained earnings which becomes quite difficult for firms that have been
trading for long. Secondly, MVA does not indicate the time when value creation actually
happened and does not provide any indication as to whether the process would continue in
the future or not. Thirdly, since MVA is an absolute measure, hence it would be adversely
impacted by the higher capital base of the larger companies which typically would have more
MVA. Fourthly, MVA is distorted by inflation also.
The shortcomings of MVA led to the introduction of MBR or Market to book ratio. This is
essentially the market value divided by the total capital deployed. While the issue with
regards to determination of the capital remain for MBR also like in MVA but one distinct
advantage of MBR is that it is a relative measure unlike MVA. As a result, the size of the
firm 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 assume
projects that tend to reduce the MBR.

ADVANCED FINANCIAL MANAGEMENT
Question 5
According to behavioural finance, the investment decision making process is fraught with
various biases and one of the worst cognitive biases is overconfidence. This refers to the
ability of the investors to overrate themselves and their respective judgements about the
various stocks or the market as a whole which tends to be higher in case of a bull market
when the prices are on the rise irrespective of the fact whether the same is justified or not. It
is essential that this bias needs to be controlled so that the investor can engage in prudent
decision making based on available information.
Self-preservation heuristics implies the tendency to limit losses whenever the investor senses
an unknown situation. However, as the situation becomes more familiar, the investor
becomes more willing to gamble. Hence, there is a fear of the unknown amongst the market
participants which over a period of time tends to subside and market participants become less
averse to the risk. This is imperative with regards to investment decision making in the global
markets where there is always the risk of events which may spook the investors.
Question 6
Emotion may be defined as an intuitive feeling which is different from knowledge or
reasoned. This plays a critical role in the financial decision making especially investing.
While the various financial models assume that investors tend to take rational decisions, but
in reality the process is much more complex. This is also apparent from the fact that despite
so much advancement in computing and understanding of markets, the algorithm which could
predict the future prices of a given security in any given market still remains elusive. The
only reason for the lack of such a computing algorithm is the failure in understanding the role
of human emotions in a detailed manner and mirroring the same.
Excessive optimism refers to the situation when the investor assumes that market or a given
security would keep on moving to higher levels without considering the fact whether the
same is justified by the underlying fundamentals. This is especially visible when the stock
markets are performing well and the stock prices are driven not by their respective
performance but by the greed of the investors. This was the situation which was visible just
before the global financial crisis when the stock prices had reached such a level which they
haven’t been able to touch since then. Hence, as an investor it is essential to guard against
excessive optimism so as to avoid making losses.
Question 7
Momentum strategy refers to the investment strategy whereby the underlying investor aims to
make investment choices driven by the ongoing market trend and thereby tends to ride the

ADVANCED FINANCIAL MANAGEMENT
momentum. As a result, the investor tends to go long on a security that is on a uptrend while
goes short on a security that decreasing in price. It is imperative that this strategy is meant
only for traders and investors rarely ride on momentum as this in the long term is usually not
supported by the fundamentals of the security and hence at the peak of the momentum, the
concerned security would either be overvalued or undervalued depending on the momentum
direction.
Contrarian strategy basically refers to an investment strategy whereby the underlying investor
would take a contrarian call on the particular stock and place a bet against the momentum.
Hence, if the stock is increasing, the investor would short that stock while for a stock that is
on the decline, the investor would go long. The contrarian strategy is based on the premise
that momentum tends to lead to the deviation of current stock price from the intrinsic price in
the direction of the momentum. As a result, the investor takes investment decisions acting
against the market trend.
Question 8
The impact of mergers varies for different stakeholders. For the employees, mergers represent
turbulent times which may result in loss of jobs. For the management also, mergers are taxing
specially the time when the two firms have to be integrated and various intended synergies
need to be reaped. For the shareholders of the acquired company, merger creates valid since it
is typically carried out at a premium to the market rice. However, for the shareholders for the
acquirer, the impact of merger would depend on whether the intended synergies and strategic
advantages can be built by the top management or not.
For the regulators, mergers may indicate lack of competition in the industry especially if the
merged entity has a significantly high market share. For the industry, merger implies change
in the overall competitive advantages of the remaining players and also the underlying
profitability and competition level. For the customers, mergers in the short run would imply
cheaper goods and services as additional cost savings are realised. Amongst the above,
arguably the impact on shareholders is the most pivotal as mergers are carried out with the
intention of increasing shareholders’ value and eventually it serves as the most appropriate
yardstick for the impact of any merger.
Question 9
There are a plethora of advantages associated with mergers and acquisitions from the
perspective of shareholders. The first is in the form of synergy gains which results from
lowering costs that essentially leads to improvement in the profit margins that propel the
growth of EPS (Earnings per Share) and essentially provide an impetus to the share price
which essentially determines the returns for shareholders. Besides, mergers of two players
can also lead to a strategic advantage in the form of greater market share which can result in
greater top line growth. This is especially true in highly competitive sectors where

ADVANCED FINANCIAL MANAGEMENT
consolidation tends to lead to significant gains for shareholders and increase the competitive
strength of the combined entity in comparison with the existing players.
Additionally, mergers are an effective way to increase geographical presence as well as
enhancing presence across new customer or product segments. This is particularly true for
pharmaceutical companies which typically have presence in certain diseases and hence
merger with another giant can result in a wider portfolio of products and better synergies
along with global supply chain. A similar merit is also visible in case of the mining industry
(for instance BHP Billiton) where mergers are quite common as it proves incremental to the
business and the shareholders’ value.
Question 10
The following are the major reasons why the mergers tend to fail.
 Incompatibility of the organisational culture of the two merging entities
 Resistance from the part of employees of either of the entities
 Overpaying by either of the entities
 Failure to reap the intended synergies
 Lack of able top management so as to integrate the two organisations
 Failure of due diligence
 Operational issues involved during the integration process with regards to difference
in systems and processes
Question 11
The EMH tends to assume that the markets are efficient and the stocks are priced at their
intrinsic value as a result of which the fundamental and technical analysis are of no use since
all the information available at a time is reflected in the price of a given security. However, in
practice the EMH does not hold true. The fundamental analysis tends to have links with
shareholders returns and thus poses significant challenges to the semi-strong version of EMH.
For instance, it has been observed that stocks with lower P/E tend to outperform those with
higher P/E which is attributed by some scholars to the presence of higher risk associated with
the former which leads to higher returns in compared with the later.
Additionally, the strong version of EMH does not hold true as is apparent from the cases of
insider trading. It is apparent that the before the result, at times there is some amount of
insider trading which takes place so as to leverage on the private information. Also, EMH
assumes that information is readily available which is not the case as the investors with
better information seem to outperform those with limited understanding over the long term.
Besides, the expectations of all the investors are not the same and further the interpretation of
information is different for investors. As a result, there estimation of the fair value of the

ADVANCED FINANCIAL MANAGEMENT
stock tends to vary from others which lead to undervaluation and overvaluation of stock thus
creating utility for fundamental analysis.
Question 12
The various anomalies of EMH are highlighted below.
 The P/E effect whereby the returns on lower P/E stocks tend to be higher than the
higher P/E stocks.
 The book to market ratio effect whereby companies that tend to have a higher book to
market ratio prove to be outperformers in comparison with those having low ratio.
 Size effect whereby the returns on small firms tend to outperform the larger firms.
 January effect whereby the small firms tend to outperform their larger counterparts
especially in the first two weeks of January.
Additionally unlike the prediction of EMH where investors are expected to make rational
decisions, in reality the human emotions tend to be a significant driver of investment decision
making as has been highlighted by the proponents of behavioural finance. This is visible in
case of investors who tend to deploy a momentum strategy whereby the market trend is
assumed to continue without considering whether the fall or rise in price is justified by the
available information in the stock market. Further, as has been visible in times of boom and
bust that stock prices are not driven by fundamentals, earnings or information available in the
market but are rather driven by the emotions of greed and fear along with various biases. As a
result, it is observed that the P/E allocated to the stock in time of boom is significantly higher
than long term average while the associated P/E tends to be significantly lower than the long
term average in case of downturn. Thus, stock prices are a function of the expectations of the
market participants which are driven by human emotions which renders behavioural finance
useful.