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without knowing the laws in your country, is it not likely that the receiving company can set off the tax they have “suffered” by way of with-holding tax?

Unfortunatelly, I didn’t quite understand what you meant there.

If you’re asking your question from an F7 perspective, you’re way over the top of what you need to know!

Well, F7 deals with simple groups, so I aked the question from the point of view of a simple group. However, as you correctly noticed, I am interested to get an answer for a ‘real’ situation, that is not covered in F7 study texts, i.e. when dividend income in parent’s books does not correspond to dividends in subsidiary’s books due to tax on dividends.
I would be grateful if you could provide a brief example of consolidation with dividends and taxes according to your country law.

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Thanks, I know that there should be no intragroup dividends in consolidated financial statements. I was interested in tax on dividends, that is usually withheld and paid to government authorities in my country.

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I passed p4 as well as p3 and p5! From the first attempt! I’m ACCA affiliate now! It’s unbelievable! Thank you guys from Opentuition! Thanks to all people who answered my questions in the forum! Good luck with the future exams 🙂 !

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I applied correct approach to Q2, however, I screwed up calculations and received unexpected output. Anyway, I was expecting question on hedging with currency futures/options.

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Why there is need in additional finance of working capital? The company in question has enough cash to pay off all its liabilites immediately. I just cannot get it right.

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Finance risk in question is increased sensitivity to systematic market risk due to gearing. By definition, investor cannot diversfy it, however, taking this risk is rewarded by higher returns.
Low business risk (asset beta 0.05), with gearing of 50% (no tax), will give equity beta 0.1 – also low. Therefore, your explanation is correct, with stable cashflows it is easier to cope with higher interest payments.

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I think you are confused with the concept of unsystematic risk.
Unsystematic risk is risk that has no correlation with the market portfolio. Let Rs be a random variable representing return on a given share within a year. Decompose it this way: Rs=Rf+beta*(Rm-Rf)+epsilon (proof that it is possible is simple, but requires some background in probability theory), where Rm – is market portfolio and epsilon is residual unsystematic company specific risk (both random variables) and Rf – is risk free return (constant). Epsilon and Rm do not correlate (!), and expected value of epsilon equals zero. Change in gearing affects both beta (sensitivity to market risk) and epsilon (e.g. increased gearing means higher credit risk), however, CAPM ignores residual risk, assuming that rational investors will diversify it away.

So, taking into account all the above said, the answer to your initial question is the following: I will use equity beta because gearing affects the sensitivity of shares in my well-diversified portfolio to market risk (i.e. volatility of market portfolio).

P.S. ACCA syllabus contains some math stuff like Black-Scholes model, linear programming, portfolio theory. I have never seen any non-math book, that could rigorously explain those topics :), so you just have to believe it or study math :).

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Losing 2 or 3 marks might make the difference between pass and fail, you cannot afford it 🙂 I passed P1 with 51 marks this winter, I could have afforded only 1 mark to lose 🙂

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What you gonna do when you given exchange rate intergalactic monetary unit 0.69 to pound? 🙂 Is it direct or indirect?

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Assume no tax. Suppose your business has asset beta 1.7 and that is all equity financed. Then you expect to receive Rf+1.7*ERP. Then you borrow the same amount of money (so that gearing becomes 50%), at risk free rate, you will then expect to receive 2*(Rf+1.7*ERP)-Rf=Rf+2*1,7*ERP. Your busines became more sensitive to systematic market risk, due to leverage. You can try different leverages, the result will be according to the M&M formula.

Beta represent how sensitive the return as compared to average market. Leverage increases exposure to systematic market risk (the higher leverage the higher profits when market rises, and vice versa).

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To question 3:
The company in question has net cashflow of 150, if you assume that the same conditions will hold infinetily long, the cash balance will be increasing to perpetuty, however, in real life companies do not accumulate cash, they reinvest excess cash into either working capital or non-current assets, or repay debt or repurchase shares.

Ideally, FCFE model should give the same answer as the dividend model (because they have the same underlying assumptions).

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Suppose market is rising, then you can borrow at risk free rate and invest in market portfolio (suppose no tax):
1)No borrowing. You have $100 that will bring income 100*Rf + 100*ERP in a year.
2)You have $100 and borrow $100 at risk free rate, then you will have 200*(Rf+ERP)-100*Rf =Rf*100 + 2*100*ERP. Due to financing sensitivity of your investment to market risk increased (beta increased from 1 to 2, gearing from 0% to 50%).
Unsystematic risks associated with increased risk of bancrupcy, costs of bancrupcy are ignored.

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Black – Scholes model assumes that underlying stock is distributed lognormally. I’ll try to illustrate:

S0 – current price, S – price in one year (lognormally distributed random variable). Assume that Rs is annual return on S. Then S/S0=exp(Rs), assuming continious compounding. Or ln(S/S0) = Rs – random variable. Volatility of Rs (which is actually normally distributed) is used in Black – Scholes formula.
Prediction of default
Assume that V – value of assets of the comany today, F – debt payable (in t years), if V distributed lognormally, using black-scholes formula you can calculate ‘value firms equity as european call option’ (from BPP study text):

E=N(d1)V-N(d2)F*exp(-rt)
d1=(ln(V/F)+(r+0,5*sigma^2)t/(sigma*sqrt(t))
d2=d1-sigma*sqrt(t), where sigma is volatility of ln(V) (in BPP study text sigma is volatility of V, which is inconsistent with Black-Scholes model assumptions)

1-N(d2) is the probability of default (when option is out of the money).

In Q3 from December 2008, for example, examiner in answers assumes that cashflow is distributed normally, then he calculates expected annual cashflow and its volatility, and finally probability that cash outflow is greater than cash in hand.

I did some simulations in Excel, and found that in 500 tries I had no default, I suspect there is a problem in examiner’s solution with calculation of annual deviation.

P.S. having read solutions to the exam questions, I would recommend just to do something (assume normality, for example), if you get stuck 🙂 .

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In order to arrive to the same result as with beta ungearing formula (beta_asset = beta_equity*Value_equity/(Value_equity+Value_debt*(1-T)) and CAPM formula, you have to use risk free rate as cost of debt.

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Thanx, anjan, you explanation seems to be quite reasonable, however, I agree with danielnq2008, that it is far from being obvious. Having done some more past exam papers, I found out that there are a lot of such ‘traps’ 🙁

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